This is “Cost Approach Versus Resource Approach to Production Planning”, section 4.4 from the book Managerial Economics Principles (v. 1.0).
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The conventional approach to planning production is to start with the goods and services that a firm intends to provide and then decide what production configuration will achieve the intended output at the lowest cost. This is the cost approachStarting with the goods and services a firm intends to provide and then deciding what configuration will achieve output at the lowest cost. to production planning.Stevenson (1986) addresses this approach to production planning extensively. Once output goals are set, the expected revenue is essentially determined, so any remaining opportunity for profit requires reducing the cost as much as possible.
Although this principle of cost minimization is simple, actually achieving true minimization in practice is not feasible for most ventures of any complexity. Rather, minimization of costs is a target that is not fully realized because the range of production options is wide and the actual resulting costs may differ from what was expected in the planning phase.
Additionally, as we saw in Chapter 2 "Key Measures and Relationships", the decision about whether to provide a good or service and how much to provide requires an assessment of marginal cost. Due to scale effects, this marginal cost may vary with the output level, so firms may face a circular problem of needing to know the marginal cost to decide on the outputs, but the marginal cost may change depending on the output level selected. This dilemma may be addressed by iteration between output planning and production/procurement planning until there is consistency. Another option is to use sophisticated computer models that determine the optimal output levels and minimum cost production configurations simultaneously.
Among the range of procurement and production activities that a business conducts to create its goods and services, the firm may be more proficient or expert in some of the activities, at least relative to its competition. For example, a firm may be world class in factory production but only about average in the cost effectiveness of its marketing activities. In situations where a firm excels in some components of its operations, there may be an opportunity for improved profitability by recognizing these key areas, sometimes called core competenciesKey areas or components of operation in which a firm excels and that provide an opportunity for improved profitability. in the business strategy literature, and then determining what kinds of goods or services would best exploit these capabilities. This is the resource approachThe recognition of core competencies and the determination of what kinds of goods or services best exploit them. to the planning of production.Wernerfelt (1984) wrote one of the key initial papers on the resource-based view of management.
Conceptually, either planning approach will lead to similar decisions about what goods and services to provide and how to arrange production to do that. However, given the wide ranges of possible outputs and organizations of production to provide them, firms are not likely to attain truly optimal organization, particularly after the fact. The cost approach is often easier to conduct, particularly for a firm that is already in a particular line of business and can make incremental improvements to reduce cost. However, in solving the problem of how to create the goods and services at minimal cost, there is some risk of myopic focus that dismisses opportunities to make the best use of core competencies. The resource approach encourages more out-of-the-box thinking that may lead a business toward a major restructuring.