What is Value chain analysis?

The article focuses on the main aspects of Value chain analysis. The activities entailed in the framework are discussed in detail, with respect to competitive strategies and value to the customer. The article includes tips for students and analysts on how to write a good Value chain analysis for a firm. Moreover, sources of findings information for value chain analysis have been discussed. The limitations of Value Chain analysis as a model have also been discussed.

The value chain approach was developed by Michael Porter in the 1980s in his book “Competitive Advantage: Creating and Sustaining Superior Performance” (Porter, 1985). The concept of value added, in the form of the value chain, can be utilised to develop an organisation’s sustainable competitive advantage in the business arena of the 21st C. All organisations consist of activities that link together to develop the value of the business, and together these activities form the organisation’s value chain. Such activities may include purchasing activities, manufacturing the products, distribution and marketing of the company’s products and activities (Lynch, 2003). The value chain framework has been used as a powerful analysis tool for the strategic planning of an organisation for nearly two decades. The aim of the value chain framework is to maximise value creation while minimising costs (www.wikipedia.org).

Main aspects of Value Chain Analysis
Value chain analysis is a powerful tool for managers to identify the key activities within the firm which form the value chain for that organisation, and have the potential of a sustainable competitive advantage for a company. Therein, competitive advantage of an organisation lies in its ability to perform crucial activities along the value chain better than its competitors.

The value chain framework of Porter (1990) is “an interdependent system or network of activities, connected by linkages” (p. 41). When the system is managed carefully, the linkages can be a vital source of competitive advantage (Pathania-Jain, 2001). The value chain analysis essentially entails the linkage of two areas. Firstly, the value chain links the value of the organisations’ activities with its main functional parts. Then the assessment of the contribution of each part in the overall added value of the business is made (Lynch, 2003). In order to conduct the value chain analysis, the company is split into primary and support activities (Figure 1). Primary activities are those that are related with production, while support activities are those that provide the background necessary for the effectiveness and efficiency of the firm, such as human resource management. The primary and secondary activities of the firm are discussed in detail below.

Primary activities
The primary activities (Porter, 1985) of the company include the following:

  • Inbound logistics
    These are the activities concerned with receiving the materials from suppliers, storing these externally sourced materials, and handling them within the firm.
  • Operations
    These are the activities related to the production of products and services. This area can be split into more departments in certain companies. For example, the operations in case of a hotel would include reception, room service etc.
  • Outbound logistics
    These are all the activities concerned with distributing the final product and/or service to the customers. For example, in case of a hotel this activity would entail the ways of bringing customers to the hotel.
  • Marketing and sales
    This functional area essentially analyses the needs and wants of customers and is responsible for creating awareness among the target audience of the company about the firm’s products and services. Companies make use of marketing communications tools like advertising, sales promotions etc. to attract customers to their products.
  • Service
    There is often a need to provide services like pre-installation or after-sales service before or after the sale of the product or service.

Support activities
The support activities of a company include the following:

  • Procurement
    This function is responsible for purchasing the materials that are necessary for the company’s operations. An efficient procurement department should be able to obtain the highest quality goods at the lowest prices.
  • Human Resource Management
    This is a function concerned with recruiting, training, motivating and rewarding the workforce of the company. Human resources are increasingly becoming an important way of attaining sustainable competitive advantage.
  • Technology Development
    This is an area that is concerned with technological innovation, training and knowledge that is crucial for most companies today in order to survive.
  • Firm Infrastructure
    This includes planning and control systems, such as finance, accounting, and corporate strategy etc. (Lynch, 2003).

Figure 1: The Value Chain: Source: Porter (1985)
Figure 1

Porter used the word ‘margin’ for the difference between the total value and the cost of performing the value activities (Figure 1). Here, value is referred to as the price that the customer is willing to pay for a certain offering (Macmillan et al, 2000). Other scholars have used the word ‘added value’ instead of margin in order to describe the same (Lynch, 2003). The analysis entails a thorough examination of how each part might contribute towards added value in the company and how this may differ from the competition. In a study of Saudi companies, Ghamdi (2005) found that 22% of the companies in the study used value chain frequently, while 17% reported that they somewhat used it, and 42% did not use the tool at all. An interesting finding of the study was that the manufacturing firms were frequent users of the tool compared to their service counterparts (Ghamdi, 2005).

How to write a Good Value Chain Analysis
The ability of a company to understand its own capabilities and the needs of the customers is crucial for a competitive strategy to be successful. The profitability of a firm depends to a large extent on how effectively it manages the various activities in the value chain, such that the price that the customer is willing to pay for the company’s products and services exceeds the relative costs of the value chain activities. It is important to bear in mind that while the value chain analysis may appear as simple in theory, it is quite time-consuming in practice. The logic and validity of the proven technique of value chain analysis has been rigorously tested, therefore, it does not require the user to have the same in-depth knowledge as the originator of the model (Macmillan et al, 2000). The first step in conducting the value chain analysis is to break down the key activities of the company according to the activities entailed in the framework. The next step is to assess the potential for adding value through the means of cost advantage or differentiation. Finally, it is imperative for the analyst to determine strategies that focus on those activities that would enable the company to attain sustainable competitive advantage.

It is important for analysts to remember to use the value chain as a simple checklist to analyse each activity in the business with some depth (Pearson, 1999). The value chain should be analysed with the core competence of the company at its very heart (Macmillan et al, 2003). The value chain framework is a handy tool for analysing the activities in which the firm can pursue its distinctive core competencies, in the form of a low cost strategy or a differentiation strategy. It is to be noted that the value chain analysis, when used appropriately, makes the implementation of competitive strategies more systematic overall. Analysts should use the value chain analysis to identify how each business activity contributes to a particular competitive strategy. A company may benefit from cost advantages if it either reduces the cost of individual activities in the value chain or the value chain is essentially reconfigured, through structural changes in the activities. One of the problematic areas of the value chain model, however, is that the costs of the different activities of the value chain need to be attributed to an activity. There are few costing systems that contain detailed activity level costing, unless an Activity Based Costing (ABC) system is in place in the company (Macmillan et al, 2003). Another relevant area of concern that analysts must pay particular attention to is the customers’ view point of value. The customers of the firm may view value in a generic way, thereby making the process of evaluating the activities in the value chain in relation with the total price increasingly difficult. It is imperative for analysts to note that the overall differentiation advantage may result from any activity in the value chain. A differentiation advantage may be achieved either by changing individual value chain activities to increase uniqueness in the final product or service of the company, or by reconfiguring the company’s value chain.

The difference between a low cost strategy and differentiation in practice is unlike the rigidity that is provided regarding the same in theory. Analysts must note that the difference between these two strategies is one of the shades of grey in real life compared to the black and white that is offered in theory. For example, Emerson Electric, which is a cost leader, has quality as a strategic concern in achieving its ‘best costs’ strategy (Pearson, 1999). Ivory Soap, a leading product of P&G, is a broad differentiator that turned into a cost leader. Quality is a strategic concern for managers of Ivory Soap, along with delivering a high value product consistently.

Note that in a company with more than one product area, it is appropriate to conduct the value chain analysis at the product group level, and not at the corporate strategy level. It is crucial for companies to have the ability to control and make most of their capabilities. In the advent of outsourcing, progressive companies are increasingly making their value chains more elastic and their organisations inherently more flexible (Gottfredson et al, 2005). The important question is to see how the companies are sourcing every activity in the value chain. A systematic analysis of the value chain can facilitate effective outsourcing decisions. Therefore, it is important to have an in-depth understanding of the company’s strengths and weaknesses in each activity in terms of cost and differentiation factors.

The strategy of Wal-Mart worked when the company improved its business through innovative practices in activities such as purchasing, logistics, and information management, which resulted in the value offering of “everyday low prices” (Magretta, 2002). It is important to note that refining business models on a constant basis is as critical to the success of the company as its business strategy. Notably, both the strategy and business model of an organisation are crucial for the robustness of the overall value chain.

For example, 7-Eleven had been vertically integrated, controlling most activities in the value chain by itself. The company has now outsourced many parts of its business including functions like HR, IT management, finance, logistics, distribution, product development, and packaging. According to Gottfredson et al (2005), the value chain decisions of companies will increasingly shape their overall organisational structure. Moreover, the value chain decisions will play a role in determining the type of management skills that companies may need to develop or acquire to survive in fiercely competitive business markets.

The Apple podcasting value chain is comprised of nine steps that essentially move from raw content to the listener. All the steps of the value chain include content, advertising, production, publishing, hosting/bandwidth, promotion, searching, catching, and listening. It is important to note that each step in the value chain adds value to the podcast in distinctive ways, has its own sets of challenges and opportunities.

It is important to note that the nature of value chain activities differs greatly in accordance with the types of companies and industries. For companies with complex systems like IBM, Accenture and Cisco etc., it is not possible for one member of the value chain to provide all the products and services from start to finish. The marketing function in such companies focuses on aligning with key partners and allies that must collaborate with each other. For example, installing SAP's ERP system requires direct involvement from companies like HP, Oracle, and Accenture, along with indirect involvement of companies like EMC, Cisco, and Microsoft, and collaboration between many departments within the company. The market assets contrast starkly between the companies with complex systems and those that are driven by volume operations. For example, in case of Apple’s leading products like Macintosh and the iPod, the entire offer is inside a package, and the entire value chain is preassembled. The change of supplier for the Macintosh from IBM, to Intel, improved the system performance while retaining the value in terms of price to the consumer. The only variable to manage in Apple’s case is the consumers’ preferences. The role of creating differentiation through unique quality features, along with promotion in order to create brand awareness, image and eventually brand equity becomes imperative for volume operations driven companies like Apple (Moore, 2005).

It is imperative to note that the value chains of companies have undergone many changes over the last two decades, due to the rapidly changing business environment. Information technology and the Internet have played a fundamental role in transforming certain parts and the interlinkages between parts of the value chains of companies today. Moreover HRM is increasingly becoming a vital asset in the value chain that contributes to competitive advantage. Strategic alliances are also becoming an integral part of the value chains. For example, IBM once enjoyed backward vertical integration into the disk drive industry and forward vertical integration into the consulting services and computer software industries (Hill et al, 2007). According to the changing business environment, IBM had more than 400 strategic alliances as of 2003 (Thompson et al, 2003). Herein, the value chain analysis is useful in providing a framework to examine the advantages that partners can give to each other (Pathania-Jain, 2001). It is important to note the source of competitive advantage of a company for the value chain analysis. The competitive advantage for IBM, for example, lies in depth, breadth and the geographic spread of its global operations (Rai, 2006) and the loyalty that the big blue enjoys from its clientele.

Lastly, analysts should look for the managerial implications that the new era of capability outsourcing may bring. The value chain decisions of companies will increasingly shape their organisational structure. Furthermore these decisions will determine the types of managerial skills that companies may need to develop to survive in an increasingly competitive business environment.

Where to find information for Value Chain Analysis
Analysts can explore various sources to find information necessary for conducting the value chain analysis. Up to three years of annual reports of the company can be analysed to see how the costing of the activities are changing over the period and whether they are in unison with the competitive strategy of the firm. These annual reports of the company can be compared to the annual reports of the key competitors in order to see how competitive strategies differ between the companies, along with finding the difference in the contribution of activities to the company’s profitability.

In order to gain knowledge about the core competence of the company, analysts can look at the company and competitor websites. SWOT analysis of the companies done by companies like Datamonitor etc. can help the analyst to understand the key strengths and weaknesses of the company and how the firm differs from its competitors. Furthermore, journal articles, trade publications and magazines are useful sources of information to identify how value is created in the particular industry in which the company operates and which activities play a key role in the generation of that value.

Limitations of Value Chain Analysis
One of the limitations of the value chain model is that it describes an industrial organization which essentially buys raw materials and transforms these into physical products. Notably, at the time when the model was introduced (Porter, 1985), service industries in the western countries employed lesser workforce compared to today’s statistics of the same (www.wikipedia.org). Academics and practitioners alike have critiqued the model and its applicability in the context of service organisations. Partnerships, alliances and collaboration along with differentiation and low costs are common drivers of value today.

The limitations of the model include the fact that ‘value’ for the final customer is the value only in its theoretical context (Svensson, 2003), and not practical terms. The real value of the product is assessed when the product reaches the final customer, and any assessment of that value before that moment is only something that is true in theory. Despite this limitation, analysts can effectively use the value chain model to determine the value to the final customers in a theoretical way. Use of other planning tools and techniques like Porter’s generic strategies, analysis of critical success factors etc. is recommended in conjunction with the value chain framework for a more comprehensive analysis of a company’s strategy and planning.

The value chain framework has been used as a powerful analysis tool for organisational strategic planning for nearly two decades now. The value chain framework shows that the value chain of a company may be useful in identifying and understanding crucial aspects to achieve competitive strengths and core competencies in the marketplace. The model also reveals how the value chain activities are tied together to ultimately create value for the consumer. The five primary activities and four support activities form an interdependent system that is connected by linkages. Analysts conducting the value chain analysis should break down the key activities of the company according to the activities entailed in the framework, and assess the potential for adding value through the means of cost advantage or differentiation. Finally, it is important to determine strategies that focus on those activities that would enable the company to attain sustainable competitive advantage.

It is important to analyse the value chain of a company with the core competence at its very heart. The nature of value chain activities differs greatly in accordance with the types of companies and industries. The value chains of companies have undergone many changes in the last two decades due to advancements in technology facilitating change at a very rapid pace in the business environment. Outsourcing will cause major changes in organisations and their value chains, with significant managerial implications.

Sources for finding information on value chain analysis include three years annual reports of the particular company and its key competitors, company websites, journal articles, and other reputed trade magazines etc. Use of other planning tools and techniques like Porter’s generic strategies, analysis of critical success factors etc. is suggested in conjunction with the value chain framework for a more comprehensive analysis of a company’s strategic planning.

If you found this article useful please have a look at the other articles we have written: Ansoff analysis, McKinsey 7S Framework, SWOT analysis, Scenario Planning, Porter's 5 Forces analysis, Product Life Cycle, BCG Growth-Share Matrix, Pest Analysis, Balanced Scorecard, Competitor Analysis, Critical Success Factors, Industry Lifecycle, Marketing Mix and Porter's Generic Strategies.

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