VALUE CHAIN ANALYSIS

AMOL KHANOLKAR 29

The Value Chain Concept According to Porter (1980), a business unit can develop a sustainable competitive advantage based on cost or on differentiation or on both as shown in exhibit below. EXHIBIT Developing Competitive Advantage

Superior Differentiation Advantage Relative Differentiation Position Differentiation with Cost Advantage

Inferior

Stuck-in-the-Middle

Low Cost Advantage

Inferior Relative Cost Position

Superior

The primary focus of a low cost strategy is to achieve low cost relative to competitors. Cost leadership can be achieved through approaches such as: Economies of scale of production. Experience curve effects. Tight cost control. Cost minimization in areas such as R&D, service, sales force, or advertising. Examples of firms following low cost strategy include Texas Instruments in consumer electronics. Emerson Electric in electric motors, Hyundai in automobiles, Briggs and Stratton in gasoline engines, Black and Decker in machine tools. Commodore in business machines, K-Mart in retailing, BIC in pens and Timex in wrist watches.

With a strategy of differentiation, the primary focus is on differentiating the product of the business unit by creating something that is perceived by customers as unique. Value chain analysis is essential to determine exactly where in the chain customer value can be enhanced or costs lowered. The Dangers of Ignoring the Value Chain Linkages The value chain framework is a method of breaking down the chain from basic raw materials to end-use customers-into strategically relevant activities in order to understand the behaviour of costs and the sources of differentiation. Value Chain Insights for Different Competitiors Value Chain versus Value Added The value chain concept can be contrasted with the internal focus that is typically adopted in management accounting. Management accounting usually takes a value-added perspective. From strategic perspective, unlike the value added concept, the value chain highlights the four profit improvement areas: 1. 2. 3. 4. Linkages with Suppliers Linkages with Customers Process linkages within the value chain of a business unit Linkages across business unit value chains within the firm

Value Chain Methodology The methodology for constructing and using a value chain involves the following steps: 1. Identify the industrys value chain and assign costs, revenues and assets to value activities. 2. Diagnose the cost drivers regulating each value activity. 3. Develop sustainable competitive advantage, either through controlling cost drivers better than competitors or by reconfiguring the value chain. Calculational Difficulties It should not be implied that constructing a value chain for a firm is easy. There are several problems to confront including: calculating value (revenues) for intermediate products, isolating key cost drivers, identifying linkages across activities, computing supplier and customer margins, and constructing competitors cost structures. Despite the calculational difficulties the organization must perform value chain analysis. Value Chain Analysis is an instructive process. It enables mangers to understand how their activity adds value to the chain of customers who use their products( or services) and how their cost structure compares with those of their competitors.

VALUE CHAIN METHODOLOGY 1. Identify the Value Chain Competitive advantage cannot be meaningfully examined at a level of the industry as a whole. The value chain disaggregates the industry into its distinct strategic activities. Therefore, the starting point for cost analysis is to define an industrys value chain and assign costs, revenues and assets to value activities. Therefore, the starting point for the cost analysis is to define an industrys value chain and assign costs, revenues and assets to value activities. These activities are the building blocks by which the firms in the industry create a product valuable to buyers. Activities should be isolated and separated if: They represent a significant percentage of operating costs; or The cost behaviour of the activities (or the cost drivers) is different; or They are performed by competitors in different ways; or They have a high potential for creating differentiation.

Each value activity incurs costs, generates revenues, and ties up assets in the process. After identifying the value chain, one must assign operating costs, revenues and assets to individual value activities. For intermediate value activities, revenues should be assigned by adjusting internal transfer prices to competitive market prices. With this information, it should be possible to calculate the return on assets for each value activity. 2. Diagnose Cost Drivers The next step is to identify the cost drivers that explain variations in costs in each value activity. In the value chain framework multiple cost drivers are at work. Further, cost drivers differ across value activities. The cost drivers are broken into two categories: 1. Structural cost drivers. 2. Executional cost drivers. The key ideas are: Value chain analysis is the broader framework; the cost driver concept is a way to understand cost behaviour in each activity in the value chain. Thus, ideas such as ABC are only a subset of the value chain framework. For strategic analysis, volume is an uninteresting way to explain cost behaviour. What is more useful in a strategic sense is to explain cost position in terms of the structural choices and executional skills that shape the firms competitive position. For example, Porter (1986b) analyzes the classical confrontation between General Electric and Westinghouse in steam turbines in 1962 in terms of the structural and executional cost driver for each firm.

Develop Sustainable Competitive Advantage Since the firm has identified the value chain and diagnosed the cost drivers of each value activity, the firm can gain sustainable competitive advantage in one of the two ways: By controlling those cost drivers better than competitors. By reconfiguring the value chain. Control Cost Drivers Better Than Competitors For each value activity, the key questions are: Can we reduce costs in this activity, holding value (revenues) constant? Can we increase value (revenues) in this activity, holding costs constant? Can we reduce assets in this activity, holding costs and revenues constant? By systematically analyzing costs, revenues and assets in each activity, the firm can achieve differentiation-with-cost advantage-something which Japanese manufacturers have been able to achieve. An effective way to accomplish differentiation-with-cost advantage is to compare the value chain of the value chain of the firm with the value chains of one or two of its major competitors and identify the actions needed to manage the firms value chain better than that of its competitors. Thus, competitive advantage is purely relative. The dynamics of competition automatically lead to continuously shifting benchmarks. Cost analysis is crucial to developing and sustaining competition advantage. Reconfigure the Value Chain While continuing the focus on managing the firms existing value chain better than competitors, greater efforts need to be spent on redefining the value chain where pay offs could be even more significant. For instance, in mature and tough meat-packing industry, Iowa Beef Processors has performed exceptionally well by controlling their processing, distribution, and labour costs.They accomplished these cost reductions by redefining the traditional value chain in this industry. Earnings per share for Iowa Beef (Processors) have soared at a compound annual rate of over 23 percent since 1973. The company has achieved this remarkable record by never wavering from its strategy and obsession to be the low-cost beef producer. To that end, it rewrote the rules for killing, chilling, and shipping beef. It built plants on a grand scale, automated them to a fare-thee-well, and now spends up to $20 million a year on renovation to keep them operating efficiently. The old line packers shipped live animals to the abbatoirs at such rail centres as Chicago, but Iowa Beef brought the plant to the cattle in the sprawling feedlots of the High Plains and Southwest. This saved transportation and avoided the weight loss that commonly occurs when live animals are shipped. Iowa Beef also led the industry in cleaving and trimming carcasses into loins, ribs and other cuts, and boxing the pieces at the plant, which further reduced transport charges by removing excess weight.

The Company has fought tenaciously to hold down labour costs. Though some of its plants are unionised, it refused to pay the wages called for in the United Food & Commercial Workers expensive master agreement, which the eders of the industry have been tied to for 40 years. Iowa Beefs wages and benefits average half those less hard-nosed competitors.