The Value Chain Analysis

The Value Chain

To better understand the activities through which a firm develops a competitive advantage and creates shareholder value, it is useful to separate the business system into a series of value-generating activities referred to as the value chain. In his 1985 book Competitive Advantage, Michael Porter introduced a generic value chain model that comprises a sequence of activities found to be common to a wide range of firms. Porter identified primary and support activities as shown in the following diagram:

Porter's Generic Value Chain

Inbound

Logistics

>

Operations

>

Outbound

Logistics

>

Marketing

&

Sales

>

Service

>

M

A

R

G

I

N

Firm Infrastructure

HR Management

Technology Development

Procurement

The goal of these activities is to offer the customer a level of value that exceeds the cost of the activities, thereby resulting in a profit margin.

The primary value chain activities are:

*

Inbound Logistics: the receiving and warehousing of raw materials, and their distribution to manufacturing as they are required.

*

Operations: the processes of transforming inputs into finished products and services.

*

Outbound Logistics: the warehousing and distribution of finished goods.

*

Marketing & Sales: the identification of customer needs and the generation of sales.

*

Service: the support of customers after the products and services are sold to them.

These primary activities are supported by:

*

The infrastructure of the firm: organizational structure, control systems, company culture, etc.

*

Human resource management: employee recruiting, hiring, training, development, and compensation.

*

Technology development: technologies to support value-creating activities.

*

Procurement: purchasing inputs such as materials, supplies, and equipment.

The firm's margin or profit then depends on its effectiveness in performing these activities efficiently, so that the amount that the customer is willing to pay for the products exceeds the cost of the activities in the value chain. It is in these activities that a firm has the opportunity to generate superior value. A competitive advantage may be achieved by reconfiguring the value chain to provide lower cost or better differentiation.

The value chain model is a useful analysis tool for defining a firm's core competencies and the activities in which it can pursue a competitive advantage as follows:

*

Cost advantage: by better understanding costs and squeezing them out of the value-adding activities.

*

Differentiation: by focusing on those activities associated with core competencies and capabilities in order to perform them better than do competitors.

Cost Advantage and the Value Chain

A firm may create a cost advantage either by reducing the cost of individual value chain activities or by reconfiguring the value chain.

Once the value chain is defined, a cost analysis can be performed by assigning costs to the value chain activities. The costs obtained from the accounting report may need to be modified in order to allocate them properly to the value creating activities.

Porter identified 10 cost drivers related to value chain activities:

* Economies of scale

* Learning

* Capacity utilization

* Linkages among activities

* Interrelationships among business units

* Degree of vertical integration

* Timing of market entry

* Firm's policy of cost or differentiation

* Geographic location

* Institutional factors (regulation, union activity, taxes, etc.)

A firm develops a cost advantage by controlling these drivers