As an organization matures past the start-up stage, processes become embedded into systems that may or may not continue to add value to the enterprise. It's amazing how quickly a particular method becomes "the way we've always done it around here."
Those processes comprise the value chain — the range of activities that businesses conduct to bring a product or service to market. For manufacturing companies, the value chain extends to the raw materials used to make products, and consists of every step before the products are sold to consumers. The value chain includes design, production, marketing and distribution.
The goal of a value chain analysis is to discover which activities deliver the most value in terms of lower costs or competitive differentiation, and which ones could be improved. Successful enterprises focus resources and investment in the activities that bring them the most value. They will also reduce the focus on the activities that do not deliver higher value from the customer's point of view.
Most organizations engage in hundreds or thousands of these processes. They can range from managing employees to producing and delivering products or services. Organizational structures don't always evolve with the business, leaving silos that limit communication and clarity. It can be difficult for management to sift through the layers to understand how value is created and deployed within the organization. A value chain analysis can reveal the hidden costs and friction within an enterprise that affect profits in sometimes surprising ways.
A value chain analysis looks at an organization as a system made up of subsystems that must work together in order to turn inputs into outputs that customers will value. To provide an accurate picture of the organization, the analysis must include support activities as well as primary production tasks. The value chain consists of the procurement and deployment of resources, overhead costs such as buildings and administration, and supply chain activities. The company's ultimate value depends on carrying out the myriad of activities in the most efficient way possible while still delivering maximum value to customers.
Intro to Porter's Value Chain Model
Business management consultant Michael Porter launched his Value Chain Analysis model in his 1985 book Competitive Advantage: Creating and Sustaining Superior Performance. His model viewed the value chain as a collection of activities that a company performs to create value for its customers. Delivering a higher level of value will lead to a competitive advantage and higher profitability for the organization.
The model focuses on all systems and activities targeted toward customers as the central point of value rather than focusing on corporate departments and accounting expense categories. The system links activities across departments and functions to reveal the impact on costs and profits. Porter's Value Chain Analysis highlights sources of value creation and loss that might otherwise be hidden in corporate silos.
According to Porter, “A company's competitive advantage cannot be seen from the perspective of the entire enterprise as a whole”. Instead, "it stems from the many discrete activities a firm performs in designing, producing, marketing, delivering and supporting its product. Each of these activities can contribute to a firm's relative cost position and create a basis for differentiation," Porter wrote.
To create long-term value, a company must become more than the sum of its parts.
Primary & Secondary Value Chain Activities
Porter identified two categories of activities: primary and secondary. Primary activities are core functions for the enterprise, creating and delivering products and services for customers. Secondary activities support the primary activities and are common to many organizations. These activities often play a more significant role in the success of the primary activities than is commonly thought.
Inbound Logistics: Includes all processes related to suppliers and the activities required to receive, store, and disseminate inputs or raw materials.
Operations: Value-added activities required to transform the inputs into outputs, i.e., products and services.
Outbound Logistics: All activities that a company undertakes to gather, store, and distribute the output to customers.
Marketing and Sales: Activities that inform buyers about products and services, engage buyers in purchasing them and facilitating the purchase process. This set including product development, pricing, promotions and sales force management.
Service: All after-sales activities required to maintain the product or service working for the buyer after it is sold and delivered. This set includes installation, training, maintenance, warranty response and repairs.
Procurement: Acquiring raw materials or inputs for the products, managing relationship with suppliers and negotiating prices. Ideally, this should be in sync with marketing, inbound logistics and operations to source materials on time and cost-effectively.
Human Resources: All activities involving recruiting, hiring, training, developing, compensating and dismissing personnel that design, build, and distribute the product.
Technology: Includes equipment, hardware, software, procedures and technical knowledge used to transform materials into products.
Infrastructure: Administrative functions including accounting, legal, finance, planning, public affairs, government relations, quality assurance and general management.
Examine each main activity for three categories of sub-activity:
Direct: Related to the primary activity of the function.
Indirect: Necessary activities that support the direct activities.
Quality Assurance: Ensuring compliance with relevant standards.
Conducting the Value Chain Analysis
There are two approaches to the value chain analysis: cost and differentiation advantage, according to Strategic Management Insight.
Cost advantage: For companies that compete on cost, identify the cost drivers for each activity such as raw materials, manufacturing and labor. Analyze the links between the activities to understand how they are interrelated. For instance, additional automation could be deployed to help reduce labor costs. Companies can outsource costly secondary functions such as logistics to a third party. One of the many pros of outsourcing costly secondary functions like logistics is that companies can virtually eliminate all internal costs for warehousing, fulfillment and transportation.
Differentiation advantage: Companies competing on product quality or exclusivity, customer service or other factors evaluate those strategies to deliver more value to the customer. The priority is to identify the activities that the customers value most, and then examine the option to maintain or increase differentiation in those various activities.
Value Chain Vs. Supply Chain
The concepts of the value chain and the supply chain may sound similar, but in reality, they are different.
Simply put, the value chain is all the activities that a company undertakes to create a competitive advantage and value for its customers. That includes the supply chain that can consist of product design, procurement, manufacturing, distribution and fulfillment.
The supply chain is a component of the value chain. In the strict sense of the supply chain, the enterprise does not add value to the products other than in transporting materials and products to the correct locations. The value chain is a series of interrelated activities that an enterprise employs to create a competitive advantage.
It's a matter of looking at an enterprise from two different perspectives. From the supply chain point of view, the flow of activities is from the source to the consumer. Companies begin at the state of raw materials or basic inputs and then follow the chain to the end user, looking at all the process along the way.
In the value chain perspective, the analysis starts with the consumer. The process begins with the end user and assigns a higher value to those activities that are most important to the customer. Supply chain analysis typically focuses on the costs of goods or services. Value chain focuses on creating value in the customer's eyes. An enterprise that understands its value chain will create strong connections between those things customers value and the company's activities. Value chains provide a strategic view, emphasizing innovation, technology, social trends and research and development.
An enterprise that competes on differentiation rather than cost typically enjoys higher margins and greater customer loyalty. Look at any number of companies from Burberry to Mercedes-Benz to Apple; they all have competitors that offer essentially similar products at lower price points. Their value chains allow them to charge higher prices that the consumers are willing to pay.
Apply the Value Chain to Inbound & Outbound Logistics
It's vitally important to understand the activities that make up the supply chain and how they related to the rest of the value chain within the enterprise. Often the supply chain is seen from a cost standpoint. However, today, the supply chain can be a competitive differentiator as customers — both businesses and consumers — expect a fast, highly personalized shipping experience.
Porter's original Value Chain Analysis model identified 10 cost drivers:
- Economies of scale
- Capacity utilization
- Linkages among activities
- Interrelationships among business units
- The degree of vertical integration
- The timing of market entry
- Firm's policy of cost or differentiation
- Geographic location.
- Institutional factors (regulation, union activity, taxes, etc.)
Enterprises that manage these drivers better than their competitors can develop an advantage in the marketplace. Supply chain activities are among those cost factors should be examined to see if they can be restructured for lower costs or to add value for customers.
A value chain analysis can uncover hidden relationships among the various activities that may be lowering the value the customers receive. For example, a drive to reduce labor costs may translate into shipping delays from an understaffed fulfillment center. An analysis of the interrelated costs might show that customers would purchase more often if fulfillment were faster, with revenue far surpassing the increased labor spend.
The supply chain is a vital part of the value chain. Without it, an enterprise could not move inputs and outputs to the point at which the enterprise adds value for customers. Grocery store shelves would go unstocked, and assembly lines would halt waiting on components.
Supply chain management optimization typically focuses on removing costs, often through incremental changes in materials sources and management of transportation and storage. By contrast, focusing on the entire value chain changes the economics of value-creating by fundamentally altering the stages of the value change. Value chain analysis, including the supply chain, can increase efficiency through accuracy and automation, increasing value for customers through things like error-free orders and fast shipping.
Interested in learning more about how the value chain works? See our article on how to conduct a value chain analysis and industry examples here.