value chain analysis

Definition
Michael Porter published the Value Chain Analysis in 1985 as a response to criticism that his Five Forces framework lacked an implementation methodology that bridged the gap between internal capabilities and opportunities in the competitive landscape. This framework focused on industry attractiveness as a determinant of the profit potential of all companies within that particular industry. However, significant differences in performance exist between companies operating within the same industry that can be explained either by the company's participation in a successful strategic group or by a firm's specific competitive advantages. Value Chain Analysis helped identify a firm's core competencies and distinguish those activities that drive competitive advantage. The cost structure of an organisation can be subdivided into separate processes or functions assuming that the cost drivers for each of these activities behave differently. Porter's strength was to condense this activity based cost analysis into a generic template consisting of five primary activities and four support activities. The nine activity groups are: Primary activities: 1. inbound logistics: materials handling, warehousing, inventory control, transportation; 2. operations: machine operating, assembly, packaging, testing and maintenance; 3. outbound logistics: order processing, warehousing, transportation and distribution; 4. marketing and sales: advertising, promotion, selling, pricing, channel management; 5. service: installation, servicing, spare part management; Support activities: 6. firm infrastructure: general management, planning, finance, legal, investor relations; 7. human resource management: recruitment, education, promotion, reward systems; 8. technology development: research & development, IT, product and process development; 9. procurement: purchasing raw materials, lease properties, supplier contract negotiations. By subdividing an organisation into its key processes or functions, Porter was able to link classical accounting to strategic capabilities by using value as a core concept, i.e. the ways a firm can best position itself against its competitors given its relative cost structure, how the composition of the value chain allows the firm to compete on price, or how this composition allows the firm to differentiate its products to specific customer segments.

Assessment
Pros: Value Chain Analysis provides a generic framework to analyse both the behaviour of costs as well as the existing and potential sources of differentiation. Porter emphasised the importance of (re)grouping functions into activities to produce, market, deliver and support products, to think about relationships between activities and to link the value chain to the understanding of an organisation's competitive position. The value chain made clear that an organisation is multifaceted and that its underlying activities need to be analysed to understand its overall competitive position. An organisation's strengths and weaknesses can only be identified in relation to the profiles of its direct competitors. Competitive advantage is derived from an integrated set of decisions on these key activities. The Value Chain model was intended as a quantitative analysis. It can also be used as a quick scan to describe the strengths and weaknesses of an organisation in qualitative terms. With the Value Chain Analysis, Porter tried to overcome the limitations of portfolio planning in multidivisional organisations. The concept of Strategic Business Units stated that businesses within a conglomerate should act independently while headquarters should be responsible only for budgetary decisions to be based on a business unit's position in the overall portfolio. Porter used his Value Chain Analysis to identify synergies or shared activities between Strategic Business Units and to provide a tool to focus on the whole rather than on the parts. Cons: The quantitative analysis is time consuming since it often requires recalibrating the accounting system to allocate costs to individual activities. Porter provided qualitative guidance for a quantitative exercise. His analysis began with identifying the relevant activities that lead to competitive differences and are significant enough to influence the organisation's overall cost base. The Value Chain Analysis should be accompanied with a customer segmentation analysis to mix the internal and external view. A feature or product provides the firm with a differentiating competitive advantage only if customers are willing to pay for it. Customer value chains need to be analysed to determine where value is created. The Value Chain is used to analyse a firm's position in relation to its direct competitors with the assumption that rivalry drives profitability. This excludes other assumptions such as customer bonding in Alexander Hax's delta model. The Value Chain Analysis was developed to analyse physical assets in product environments. Other authors amended the model to accommodate intangible assets and service organisations.

obtain competitive advantage through value chain linkages

nr.
1

linkage
separate individual activities within the firms value chain
interlinked primary activities in the firms value chain interlinked secondary activities in the firms value chain vertical linkages within the industry value system

example
industry leader in marketing and sales

2 3
4

add quality inspections on materials to increase customer value restructure organisation to foster learning in all relevant activity areas develop close relationships with suppliers to improve new product development

source: Fleischer & Bensoussan, strategic and competitive analysis

value chain template

firm infrastructure

human resource management technological development

support activities

procurement
operations service

primary activities
source: Michael Porter, competitive advantage

outbound logistics

inbound logistics

marketing & sales

value chain analysis

headquarters activities

human resource management technological development procurement

operations service

source: Michael Porter, competitive advantage

outbound logistics

inbound logistics

marketing & sales

capstone value chain activites

firm infrastructure

human resource management technological development procurement

operations service

source: Michael Porter, competitive advantage

outbound logistics

inbound logistics

marketing & sales

cost driver categories

structural: related to strategic choices that drive costs
executional: related to an organizations ability to execute successfully

structural cost drivers (related to organizational choices)

scale: investment size in manufacturing, R&D and marketing scope: degree of vertical integration experience: learning based on previous repetitions of current work technology: process technologies used at each step in value chain complexity: broadness of product line

provenmodels

executional cost drivers (related to organizational skills)

work force involvement: participation; empowerment; commitment to continuous improvement
capacity utilization: given scale choices on plant construction plant layout efficiency: compared to current norms product configuration: design or formulation effectiveness exploiting linkages with suppliers/customers: in relation to the value chain

key ideas behind cost drivers

volume is usually not the best way to explain cost behavior

more useful to explain cost position in terms of structural choices and executional skills not all strategic cost drivers are equally important all the time but most of the time some driver are very important

objective value chain analysis

the objective is to analyse competitive advantage by disintegrating an organisation into discrete activities or processes and examine how each activity contributes to the organisations relative cost position or the customers comparative willingness to pay. the analysis provides: insight into why the firm does or does not have added value; a way to identify opportunities to improve added value; an understanding how added value may change over time.

source: Pankaj Ghemawat, strategy and the business landscape

value chain analysis process

process: 1. setup: classify an organisations activities based on the value chain. Single out individual activities which:

2.

Have different economics; Have a high potential impact of differentiation; Represent a significant or growing proportion of costs.

cost analysis: managers examine the costs associated with (the most important) activities to understand why and how their cost base differs from competitors. Defining relevant cost drivers helps to estimate competitors positions and to assess the own organisations flexibility; value analysis: managers analyse how each activity generates customer willingness to pay. Customer willingness often varies per customer segment; strategic decision making: consider changes in activities so that costs are lowered or customer willingness is increased. Identify linkages, relationships between value activities, within the chain. The more complex the linkage the higher chance it will provide a competitive advantage. The competitors profiles need to be taken into account when repositioning oneself.

3. 4.

source: Pankaj Ghemawat, strategy and the business landscape

tips for value chain analysis

focus on the important activities; those that matter to the strategic position;

make a clear distinction between annual recurring cost and one time investments;
keep track of all assumptions that underline the allocation of costs over the activity groups; use sensitivity analysis to validate the assumptions underlying the value chain analysis in order to assess which assumptions really matter; value chain analysis allows for the inclusions of multiple drivers per activity. only include drivers that vary across competitors; do not focus on differences between total cost levels, but on costs per activity. Activities provide competitive advantage; research should focus on customers willingness to pay for an activity as part of a products profile instead of only a customers desire; reduce the list of customer needs to a manageable number.

source: Pankaj Ghemawat, strategy and the business landscape

analysing industrys profit pools

estimate the total size of the industry profit pool using aggregated data and assumptions estimate the distribution of the profit pool - use you own firms profit structure per activity; - concentrate on the largest firms first - start with the focused ones - estimate the contributed of relevant SBUs within conglomerates - sample the smaller firms validate finding by matching the sum of the distribution and the total size

profit pool
80% company C 70% 70% 80%

60%

60%

profit margin (%)

50% company B 40% company D 30% company F 20% company A 10% company E

50%

40%

30%

20%

10%

0%

20%

10%

10% sales (%)

30%

5%

25%

0%

customer needs chart

source: Pankaj Ghemawat, strategy and the business landscape