The primary purpose of any business is to produce goods or provide services in a way that they have a higher value for the customers than the original cost for the firm. Companies engage in numerous activities while converting inputs to outputs. Porter’s Value Chain helps us create a clear overview of the internal organization, which in turn helps us to assess where the business creates actual value and where we can make improvements in the processes.
Analysts need a systematic way to examine all internal processes and their interactions, to analyze the source of competitive advantages or disadvantages. To gain a competitive advantage, the company has to perform strategic procedures, either better or cheaper than others.
On the bottom half of the diagram, we see a list of our primary activities groups. These are the processes that are directly involved in the production and sales of the products, from physically creating the product to providing aftermarket services and support.
This section includes all activities related to inventory handling for incoming raw materials and parts, from receiving in the warehouse to issuing the inventory to production.
These activities encompass the production process itself, covering every aspect of turning all the inputs to the final product.
This group includes activities related to collecting the finished goods from production, storing them, and dispatching orders to clients. This section covers all processes that physically get the product to the customer.
Sales and Marketing
These are all activities for finding potential clients, introducing the product, and enticing new customers to purchase it. The group includes running ads and promotions, pricing, quoting, sales, and others.
All activities engaged with improving or maintaining the product’s value for the customer after the sale fall in this section. These may include installations, training, support, repairs, warranty replacement, and others.
The supporting activities go across the primary ones to support and organize their function and communication with each other. These can either be associated with a specific primary activity or contribute to the whole value chain.
Here we find activities for general management, planning, finance and accounting, analysis, legal, quality control, and others. These activities almost always support the whole value chain instead of a single primary activity. In finance and accounting, we refer to these mostly as overhead costs. It is important to note that strategic management has a considerable impact on the firm’s ability to achieve and sustain a competitive advantage, as it shapes all future decisions within the company.
Human Resources Management
This group consists of activities like recruiting, hiring, development, training, assessment, and firing of employees. Human resources management has a tight connection to the competitive advantages of the company through the aim to hire, train, and keep the best people.
These are activities that have to do with developing internal technologies. These can range from know-how to technical aspects of various processes, or multiple procedures, including R&D. We can broadly separate them into two types:
- Improve the product (product design, testing, and others);
- Improve the process (accounting systems, costing procedures, CRM, and others).
All activities related to the purchase of inputs are in this section. It is essential to separate purchasing from handling of the inputs, which is outside the Procurement activities. The activities cover all inputs for the company, not just those required for Operations activities. Examples are consumables, raw materials and parts, also property, plant and equipment, intangibles, and others.
A Value Chain is not a group of independent activities. All primary and supporting activities have a constant connection and information flow between them. Porter describes these as ‘bridged.’ Any such links are where we usually find a great room for improvement, to achieve or maintain a competitive advantage.
Businesses often neglect the links within the Value Chain, which can lead to significant adverse effects on profits, and missing out on opportunities to improve and create more value.
Let’s look at a chatbot that aims to handle customer queries for warranty claims. Such an implementation will come from activity within the Technology Development group. However, it will significantly improve the support activity in the After-market Services group and will help improve the competitive advantage of the company.
Porter’s Value Chain is a robust framework we can apply to analyze the internal structure and environment of the business. It gives us a structured approach to find where the firm creates value and where we can improve the margins by optimizing costs. It also helps improve communication and information flow between departments in the company, which in turn aids the achieving and maintaining competitive advantages.
A company’s Value Chain is a part of a larger-scale Industry Value Chain. The more activities a company performs from the industry Value Chain, the more vertically integrated it is.
Value Chain Analysis
Value Chain Analysis is the process in which we identify the company’s primary and supporting activities and analyze the ones that add value to the product. We intend to either differentiate more from our competitors or find room for cost reductions.
It is an internal strategy tool, which aims to recognize the activities that provide the most value to the product. The model focuses on understanding the internal processes of the company to optimize them to achieve or maintain the company’s competitive advantage. Value Chain Analysis reveals the source of the firm’s competitive advantages and disadvantages. It gives us a visual model of our Value Chain.
According to Porter, there are ten cost drivers that a firm can try to control, to be more efficient and create more value:
- Economies of scale;
- The pattern of capacity utilization;
- Internal relationships;
- Organizational policies;
- Institutional factors.
The Value Chain Analysis is more than just a cost-to-profit model. It considers the principles of economies of scale and capacity. There’s a limit to cost-reductions and increases in capacity, after which the company’s growth can start to suffer. Competitive advantage can also come from the perceived value for the customer. Finding the sources of such perceived value can mean the difference between charging $ 250 for a smartphone and $ 700 for an iPhone.
When we perform the analysis, we must engage as many stakeholders as possible, and study the industry and market in its entirety, to identify competitive opportunities. Setting the proper goals is crucial, as there are thousands of activities with varying importance within a company. We should also consider the cycle-time performance of the Value Chain and look into it for additional room for improvement.
Value Chain Analysis is a complex undertaking. We may face the following challenges:
- Gathering the required data may be a time-consuming task;
- It can be hard to identify the activities that add real or perceived value to the product;
- It can be challenging to develop and deploy a plan with optimizations
The idea of the Value Chain Analysis is to achieve one of two things to increase margins:
- Cost advantage – perform activities cheaper than the competition;
- Differentiation advantage – do activities in a manner to get a superior final product.
In modern days primary activities are mostly a source for cost advantages. On the other hand, supporting activities provide differentiation advantages, coming from strategic management, R&D, and technological advancements.
Depending on the aim at hand, we perform different steps for our Value Chain Analysis.
We perform such analysis in companies that aim to compete on costs. The goal is to understand the sources of the costs and the drivers behind them. Such companies are Tesco, Ford, Burger King, and others.
The process consists of five steps.
Step 1. Identify the firm’s primary and support activities
We need to make sure we identify and separate the procedures. Doing so requires good knowledge of the company and its business operations and the links between the activities within.
Step 2. Calculate the relative importance of each activity in the total cost of the product
We have to analyze the total cost of production or provision of service and break them down so that we can assign them to the separate activities. Those with higher costs or performed inefficiently, when compared to competitors, are the ones we will address first.
Step 3. Identify the cost drivers for each activity
We need to know what are the drivers behind each cost so that we can improve them. We have to remember that different processes have different cost drivers. For example, labor-intensive processes will most likely be driven by work hours, wage rates, or others.
Step 4. Identify links between activities
It is crucial that we correctly identify the links within the Value Chain because some cost-reductions might lead to increased costs in other activities. We need to be aware and look synergies where optimizations in one procedure can also lead to optimizations in other ones.
Step 5. Identify cost-reduction opportunities
Once we know the cost drivers and have identified the company’s inefficiencies, we can start planning improvements.
The process of performing a Value Chain Analysis looks differently when the company aims for a differentiation advantage. These advantages come from introducing additional features and creating a superior product.
Step 1. Identify the value-creating activities
In this step, we identify the activities that create the most value for the customer.
Step 2. Evaluate strategies to improve value for the customer
In this step, we evaluate a variety of strategies to helps us improve customer value. The most common of those are:
- More product features;
- Better customer support;
- Complementary products;
- Optimization choices.
Step 3. Identify the most sustainable differentiation
To achieve and maintain a competitive differentiation advantage, we will usually implement many strategies in various activities.
Example Value Chain Analysis
Let us take a look at a white label bicycle manufacturer that sources parts and performs assembly in its plants. If we apply the Value Chain Model, we might get something like the following:
After creating our Value Chain, we can start with our analysis. In the first step, we will identify the activities within the company.
Then we can evaluate which ones create the most cost for the company.
To better understand our expenses, we list the cost drivers behind each activity.
After this, we can continue to Step 4, where we identify the links between activities:
- High-quality assembly process reflects in fewer warranty claims;
- Bulk purchases reduce relative transportation cost;
- Fewer new model designs decrease assembly costs;
- Larger order size from supplier increase warehouse costs.
And, finally, in Step 5, we can formulate cost-reduction opportunities, that will help us optimize our activities and gain competitive advantage.
Push the same models to more clients, offering small customizations only (mostly branding). This way, we will increase order sizes of the same parts and materials, simplify the assembly process and increase quality, hence reducing warranty claims.
Value Chain Analysis is a robust management tool, which helps us identify the activities within the organization that create a premium product or service. If we provide such products and services to our customers, they will be willing to pay more, thus generating higher profits for the company.
The ultimate goal of the method is to create or maintain and strengthen competitive advantage. It helps us identify areas we can optimize to be more efficient and profitable. Value Chain Analysis is crucial in evaluating the product quality, cost, and effectiveness of related activities. Then we can start implementing the appropriate improvement strategies.
The model is instrumental, as it provides management with insights needed to focus on the areas where the business creates value. It helps companies develop a vision around competitive advantage and shows the importance of supporting activities, which are sometimes neglected by management.
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FCCA, FMVA, Co-founder of Magnimetrics
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
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