What is Value Chain Analysis?

Topic Covered: What is value chain analysis, definition, meaning, Steps, Importance, advantage and disadvantage of value chain analysis, classification of Porter’s Value Chain model.

Value Chain Definition

Every organisation consists of a chain of activities that link together to develop the value of the business. The value chain identifies where the value is added in the process and links it with the main functional parts of the organisation.

It is used for developing competitive advantage because such chains tend to be unique to an organisation. It then attempts to make an assessment of the contribution that each part makes to the overall added value of the business.

Essentially, Porter linked two areas together:

1. the added value that each part of the organisation contributes to the whole organisation
2. the contribution that each part makes to the competitive advantage of the whole organisation.

Value Chain thus views the organisation as a chain of value-creating activities. Value is the amount that buyers are willing to pay for what a product provides them.

What is Value Chain Analysis?

The value chain model is also known as Porter’s Value Chain model. The analysis is a business management tool that was developed by Michael Porter and described in his popular book Competitive Advantage: Creating and Sustaining Superior Performance in 1985.

Value chain analysis is a process where firm focuses on analyzing its primary and support activities of a business in an effort to understand costs, locate the activities that add the most value, and differentiate from the competition.

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Classification of Porter’s Value Chain model

According to Porter’s Value Chain model, value chain activities are divided into two broad categories, as shown in the figure.

1. Primary activities
2. Support activities

Primary Activities

Primary activities contribute to the physical creation of the product or service, its sale and transfer to the buyer and its service after the sale. The primary activities are inbound logistics, operations/production, outbound logistics, marketing, and services.

Inbound Logistics

These activities focus on inputs. They include material handling, warehousing, inventory control, vehicle scheduling, and returns to suppliers of inputs and raw materials.

Operations

These include all activities associated with transforming inputs into the final product, such as production, machining, packaging, assembly, testing, equipment maintenance etc.

Outbound Logistics

These activities are associated with collecting, storing, physically distributing the finished products to the customers. They include finished goods warehousing, material handling and delivery, vehicle operation, order processing and scheduling.

Marketing and Sales

These activities are associated with the purchase of finished goods by the customers and the inducement used to get them to buy the products of the company. They include advertising, promotion, salesforce, channel selection, channel relations and pricing.

Services

This includes all activities associated with enhancing and maintaining the value of the product. Installation, repair, training, parts supply and product adjustment are some of the activities that come under services.

Support Activities

Support activities include such activities as procurement, HR etc. which either add value by themselves or add value through primary activities and other support activities.

Procurement

Activities associated with purchasing and providing raw materials, supplies and other consumable items as well as machinery, laboratory equipment, office equipment etc.

Porter refers to procurement as a secondary activity, although many purchasing gurus would argue that it is (at least partly) a primary activity. Included are such activities as purchasing raw materials, servicing, supplies, negotiating contracts with suppliers, securing building leases and so on.

Technology Development

Activities relating to product R&D, process R&D, process design improvements, equipmentdesign, computer software development etc.

Human Resource Management

Activities associated with recruiting, hiring, training, development, compensation, labour relations, development of knowledge-based skills etc.

Firm Infrastructure

Activities relating to general management, organisational structure, strategic planning, financial and quality control systems, management information systems etc.

Johnson and Sholes (2002) observe that few organisations undertake all activities from production of raw materials to the point–of–sale of finished products themselves. But, the value chain exercise must incorporate the whole process, that is, the entire value system.

For example, even if an organisation does not produce its own raw materials, it must nevertheless seek to identify the role and impact of its supply sources on the final product.

Similarly, even if it is not responsible for after-sales service, it must consider how the performance of those who deliver the service contribute to overall product/service cost and quality.

Read: What is Strategic Management Process?

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Conducting a Value Chain Analysis

Steps in value chain analysis

Identify Activities

The first step in value chain analysis is to divide a company’s operations into specific activities and group them into primary and secondary activities.

Within each category, a firm typically performs a number of discrete activities that may reflect its key strengths and weaknesses.

Allocate Costs

The next step is to allocate costs to each activity. Each activity in the value chain incurs costs and ties up time and assets. Value chain analysis requires managers to assign costs and assets to each activity.

It views costs in a way different from traditional cost accounting methods. The different method is called activity-based costing.

Identify the Activities that Differentiate the Firm

Scrutinizing the firm’s value chain not only reveals cost advantages or disadvantages but also identifies the sources of differentiation advantages relative to competitors.

Examine the Value Chain

Once the value chain has been determined, managers need to identify the activities that are critical to buyer satisfaction and market success. This is essential at this stage of the value chain analysis for the following reasons:

1. If the company focuses on low-cost leadership, then managers should keep a strict vigil on costs in each activity. If the company focuses on differentiation, an advantage given by each activity must be carefully evaluated.
   
   
2. The nature of the value chain and the relative importance of each activity within it, vary from industry to industry.
   
   
3. The relative importance of the value chain can also vary by a company’s position in a broader value system that includes value chains of upstream suppliers and downstream distributors and retailers.
   
   
4. The interrelationships among value-creating activities also need to be evaluated. The final basic consideration in applying value chain analysis is the need to use a comparison. when evaluating a value activity as a strength or weakness. In this connection, RBV and SWOT analysis will supplement the value chain analysis.

The final basic consideration in applying value chain analysis is the need to use a comparison when evaluating a value activity as a strength or weakness. In this connection, RBV and SWOT analysis will supplement the value chain analysis.

Finally, in assessing the value chains there are two levels that must be addressed

1. Interrelationships among the activities within the firm.
2. Relationships among the activities within the firm and with other organisations that are a part of the firm’s expanded value chain.

Read: What is Strategic Management? Characteristics, Risk, Benefits

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Importance of Value Chain Analysis

The value chain analysis is useful to recognize that individual activities in the overall production process play an important role in determining the cost, quality and image of the end-product or service.

Analyzing the separate activities in the value chain helps management to address the following issues:

1. Which activities are the most critical in reducing cost or adding value? If quality is a key consumer value, then ensuring the quality of supplies would be a critical success factor.
   
   
2. What are the key cost or value drivers in the value chain?
   
   
3. What linkages help to reduce cost, enhance value or discourage imitation?
   
   
4. How do these linkages relate to the cost and value drivers?

The value chain model is a useful management tool for identifying the firm’s core competencies and the activity that give them a competitive advantage as follow: Cost Advantage and Differentiation Advantage.

Cost Advantage

This approach is used when the firm tries to compete on costs and wants to understand the source of their cost advantage and disadvantage and what factors drive those cost.

Porter identified the following as the most important cost and value drivers:

Cost Drivers

1. Economies of scale
2. Pattern of capacity utilization
3. Linkages between activities
4. Interrelationships
5. Geographical location
6. Policy choices
7. Institutional factors

Differentiation Advantage

The firms that strive to create superior products or service use differentiation advantage approach.

Value Drivers

Value drivers are similar to cost drivers, but they relate to other features (other than low price)valued by buyers. Identifying value drivers comes from understanding customer requirements, which may include:

1. Policy choices
2. Linkages between activities

The cost and value drivers vary between industries. The value chain concept shows that companies can gain competitive advantage by controlling cost or value drivers and/or reconfiguring the value chain, that is, a better way of designing, producing, distributing or marketing a product or service.

For example, Ryanair has become one of the most profitable airlines in Europe through concentrating on the parts of its value chain, such as ticket transaction costs, no-frills etc.

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Advantages of Value Chain Analysis

• Fully understand the associated costs and areas of differentiation by breaking product and service activities into smaller pieces.
  
  
• Identify those activities where you can quickly reduce cost, optimize effort, eliminate waste, and increase profitability.
  
  
• Analyzing activities also gives insights into elements that bring greater value to the end-user.

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Disadvantages of Value Chain Analysis

• Not a simple practice to implement a firm operates in a dynamic environment.
  
  
• Difficulties involved in gathering the data and find appropriate information in order to break your value chain down into primary and supporting activities.
  
  
• Difficulties in finding the appropriate information in order to break your value chain down into primary and supporting activities.

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