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value chain
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chosen strategy of the firm. These categories
can be described as follows:
value chain
John McGee
The activities that a firm performs become part
of the value added produced from a raw material
to its ultimate consumption. Figure 1 shows
how the supply chain forms the basic spine
of the Five Forces analysis. It contains all the
activities required to bring the final product
or service to the final customer. Along the way
many different firms or businesses have their
own activities along the supply chain. Thus,
each firm has its own value chain, a subset of the
supply chain. Figure 1 is Porter’s classic picture
of the value chain. It has two parts. The lower
part contains those activities (labeled primary
activities) that are organized in sequence just
like a production line. Thus, inbound logistics
is the first step, leading to manufacturing operations, then outbound logistics, marketing and
sales, and eventually service. This is a caricature
of each firm’s value chain and will contain
different headings according to the nature of the
operations.
Value is the amount that buyers are willing
to pay for the product or service that a firm
provides. Profits alter when the value created by
the firm exceeds the cost of providing it. This is
the goal of strategy, and therefore value creation
becomes a critical ingredient in competitive
analysis. Every value activity employs costs such
as raw materials, and other purchased goods
and services for “purchased inputs,” human
resources (direct and indirect labor), and technology to transform raw materials into finished
goods. Each value activity also creates information that is needed to establish what is going on
in the business. Similarly, value is created by
reducing stocks, accounts receivable, and so on,
while value is lost via raw material purchases and
other liabilities. Most organizations, thus engage
in many activities in the process of creating
value. These activities can generally be classified
into either primary or support activities. These
are illustrated in Figure 1, which details the
view of Michael Porter, who states that there
are five generic categories of primary activities
involved in competing in any industry. Each
of these is divisible into a number of specific
activities that vary according to the industry and
• Inbound logistics. Activities associated with
receiving, storing, and disseminating rights
to the product, such as material handling,
warehousing, stock management, and so on.
• Operations. All of the activities required
to transform inputs into outputs and the
critical functions which add value, such as
machining, packaging, assembly, service,
testing, and so on.
• Outbound logistics. All of the activities
required to collect, store, and physically
distribute the output. This activity can
prove to be extremely important both in
generating value and in improving differentiation, as in many industries control
over distribution strategies is proving to
be a major source of competitive advantage – especially as it is realized that up to
50% of the value created in many industry
chains occurs close to the ultimate buyer.
• Marketing and sales. Activities associated
with informing potential buyers about the
firm’s products and services, and inducing
them to do so by personal selling, advertising
and promotion, and so on.
• Service. The means of enhancing the physical product features through after-sales
service, installation, repair, and so on.
The second part of the value chain is the upper
section which contains all the overhead service
elements (labeled support activities) required
by the firm. In Porter’s picture he named four
elements, firm infrastructure, human resource
management, technology development, and
procurement:
1.
Procurement. This concerns the acquisition of inputs or resources. Although,
technically this is the responsibility of the
purchasing department, almost everyone
in the firm is responsible for purchasing
something. While the cost of procurement
itself is relatively low, the impact can be very
high.
2. Human resource management. This consists
of all activities involved in recruiting, hiring
Wiley Encyclopedia of Management, edited by Professor Sir Cary L Cooper.
Copyright © 2014 John Wiley & Sons, Ltd.
2 value chain
Firm infrastructure
Human resource management
Support
activities
Technology development
Procurement
Service
Inbound
logistics
Operations
Outbound
logistics
Marketing
& sales
Primary activities
Figure 1 The generic value chain. Source: Porter (1985).
3.
4.
and training, developing, rewarding, and
sanctioning the people in the organization.
Technology development. This is concerned
with the equipment, hardware, software,
technical skills, and so on, used by the firm
in transforming inputs to outputs. Some
such skills can be classified as scientific,
while others – such as food preparation
in a restaurant – are “artistic.” Such skills
are not always recognized. They may also
support limited activities of the business,
such as accounting, order procurement, and
so on, and in this sense may be likened to the
value added component of the experience
effect.
Firm infrastructure. This consists of the
many activities, including general management, planning, finance, legal, external
affairs, and so on, which support the operational aspect of the value chain. This may
be self-contained in the case of an undiversified firm or divided between the parent
and the firm’s constituent business units.
Within each category of primary and support
activities, Porter identifies three types of activity,
which play different roles in achieving competitive advantage:
•
Direct. These are activities directly involved
in creating value for buyers, such as assembly,
sales, and advertising.
•
•
Indirect. These are activities that facilitate
the performance of the direct activities on
a continuing basis, such as maintenance,
scheduling, and administration.
Quality assurance. These are activities that
insure the quality of other activities, such
as monitoring, inspecting, testing, and
checking.
The value chain is another generic framework that permits a range of applications and
analyses. It permits the analyst to divide the
firm’s activities into broad categories (as above)
and increasingly into more specific categories.
Thus, operations might be refined into subcomponents and assembly: marketing and sales
into market research, product development,
sales force, and so on. The usefulness of this
is to be able to identify those activities that are
the source of the competitive advantage and to
be able to locate them within the value chain.
For example, if Intel’s competitive advantage is
product performance and this is derived (at least
in large part) from R&D activities, then this can
be isolated within the value chain and measured,
compared to competitors, and provided with
support.
Competitive advantage is often quite subtle in
its manifestation and in its sources. Cost advantage might arise from the way in which every
single activity in the value chain is linked to the
others and managed for efficiency. The story of
value chain
the low-cost airlines such as EasyJet, Ryanair,
and Southwest Airlines is about system management of the costs as well as focus on driving
down each cost component. Differentiation
may be delivered as a service quality perception
driven by the way in which each element of
service delivery is managed systematically along
with all other elements in order to differentiate
the product.
The value chain can be a powerful tool in
diagnosing and explaining how the management
of competitive advantage takes place within
the firm. The interrelationships between the
elements of the value chain provide an important explanation of the nature of competitive
advantage in large, complex organizations. Such
organizations typically are rich in tacit knowledge. This is the kind of knowledge that you
call upon to ride a bicycle. We all know how
to do this – but it is impossible to explain
it. Similarly, large corporations are used to
making links between complex and far-flung
activities, and between related and unrelated
technologies. This “glue,” binds these companies together and makes it impossible for others
to imitate quickly. The “hidden” part of the
value chain is these linkages that contain the
tacit knowledge. The way this “glue,” works
determines the level of vertical integration,
that is, those elements of the supply chain that
can be brought within the value chain and
within the firm and those that should remain
outside the firm. The guiding principle is that
when the costs of internal transactions (making
the glue work properly) exceed the costs of
buying outside, then the firm should source
outside its boundaries.
THE VALUE CHAIN AND COST ANALYSIS
The value chain provides a good basis on which
to conduct a cost analysis. Its principal advantage is that the elements of the value chain are
already organized around those issues that are
important in driving competitive advantage and
profitability. Porter (1985) was, therefore, able
in his book to make very strong links with the
array of literature and practice on cost cutting
that was already available. A criticism of the cost
analysis literature was the difficulty of defining
3
the correct units of analysis, an issue which the
value chain solved brilliantly.
Therefore a normal cost analysis procedure
can take place with the following stages.1
1.
Define the value chain in terms of those
elements that relate to the sources of
competitive advantage. Key considerations
are
– the separateness and independence of
one activity from another;
– the importance of an activity in relation
to competitive advantage and to the
margin;
– the dissimilarity of activities in terms of
requiring different cost drivers;
– the extent to which there are differences
in the way competitors perform activities (i.e., where there are differences
there are potential advantages to be
gained).
2. Establish the relative importance of
different activities in the total cost of the
product. This means assigning costs to each
activity based on management accounts
or other customized analysis procedures.
The distinctions made earlier about fixed
and variable costs, sunk costs, and cost
allocations are really significant issues at
this stage. Errors in cost analysis can lead
to significant misunderstanding of what
contributes to profits and how valuable is a
competitive advantage.
3. Compare costs by activity and benchmark against competitors. The comparison
is not in terms of how big are the costs
but how different are they from efficiency
benchmarks and from competitor standards.
4. Identify cost drivers. These are the forces
that move costs up or down. Planned scale of
activities is a driver of overall plant cost and
so also is degree of capacity utilization. A
driver of sales force costs might be product
range – if the range is too small costs will be
high. Another driver will be geographical
concentration of customers and another
might be sales communication methods
(face to face or remote teleconferencing).
For labor intensive activities critical drivers
might be wage rates, speed of production
line, and defect rates. It is through the
4 value chain
understanding of cost drivers that signifies
how well you understand the nature of your
business. One needs to look behind the
obvious to identify the fundamentals.
5. Identify linkages between activities. Interrelationships may be very many in number
– the critical cost drivers may seemingly
relate to another activity entirely. A comparison can be made between Xerox and
Canon in the photocopying industry. Xerox
found that its service costs were driven
by design complexity and manufacturing
inefficiencies. Grant observes that:
… the optimisation of activities through
the value chain has become a major source
of cost reduction, and speed enhancement
has become a key challenge for computer
integrated manufacturing.
(Grant, 2002, p. 271)
6.
Identify opportunities for reducing costs.
By identifying areas of obvious inefficiency
(i.e., deviations from designed machine
performance standards) and of deficiencies
against competitive benchmarks, opportunities for cost reduction become evident.
Very often the option is posed of contracting
outside the firm for components or services.
Some firms have subcontracted entire IT
departments. Currently, European firms are
outsourcing their call centers to India. The
automobile companies are going through an
extensive process of outsourcing. The Ford
Fiesta plants in Cologne outsource fully
made-up doors (as a subsystem) to plants
adjacent to the Ford plant.
IDENTIFYING THE VALUE CHAIN
The value chain concept thus helps to identify cost behavior in detail. From this analysis,
different strategic courses of action should be
identifiable to develop differentiation and less
price sensitive strategies. Competitive advantage
is then achieved by performing strategic activities better or cheaper than competitors.
To diagnose competitive advantage, it is necessary to define the firm’s value chain for operating
in a particular industry and compare this with
those of key competitors. A comparison of the
value chains of different competitors often identifies ways of achieving strategic advantage by
reconfiguring the value chain of the individual
firm. In assigning costs and assets it is important
that the analysis be done strategically rather
than seeking accounting precision. This should
be accomplished using the following principles:
•
•
•
•
operating costs should be assigned to activities where incurred;
assets should be assigned to activities where
employed, controlled, or influencing usage;
accounting systems should be adjusted to fit
value analysis;
asset valuation may be difficult but should
recognize industry norms – particular care
should be taken in evaluating property
assets.
The reconfiguration of the value chain has
often been used by successful competitors in
achieving competitive advantage. When seeking
to reconfigure the value chain in an industry, the
following questions need to be asked:
•
•
•
how can an activity be done differently or
even eliminated?
how can linked value activities be reordered
or regrouped?
how could coalitions with other firms reduce
or eliminate costs?
Successful reconfiguration strategies usually
occur with one or more of the following moves: a
new production process, automation differences,
direct versus indirect sales strategy, the opening
of new distribution channels, new raw materials
used, differences in forward and/or backward
integration, a relative location shift, and new
advertising media. A good example of this is
the emergence of German volume discounters (Lidl and Aldi) on the UK food retailing
scene. According to The Economist (2008) these
“hard” discounters “stock a fraction of the goods
that a normal supermarket offers, resulting in
fewer suppliers, a high volume of purchases
and sales, and massive economies of scale.” The
German discount model is based on a different
combination of competitive positioning and
value chain configuration resulting in a new
and possibly better business model according to
some observers.2
value chain
ENDNOTES
1 This section draws on Grant (2002, Chapter 7).
2 For
instance, Philippe Suchet of Exane BNP
Paribas in Paris quoted in The Economist
(2008).
Bibliography
Grant, R.M. (2002) Contemporary Strategy Analysis:
Concepts, Techniques and Applications, 4th edn, Blackwell Business, Oxford.
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5
McGee, J., Wilson, D. and Thomas, H. (2010) Strategy:
Analysis and Practice, 2nd edn, McGraw-Hill, Maidenhead.
Porter, M.E. (1985) Competitive Advantage; Creating and
Sustaining Superior Performance, The Free Press, New
York.
The Economist (2008) The Germans are coming, 16
August.