Encyclopaedia of Strategic Management 3rd edition

The Value Chain

The activities that a firm performs become part of the value added produced from a raw
material to its ultimate consumption. Figure1 shows how the supply chain forms the basic
spine of the Five Forces analysis. It contains all the activities required to bring the final
product or service to the final customer. Along the way many different firms or businesses
have their own activities along the supply chain. Thus each firm has its own value chain, a
subset of the supply chain. Figure 1 is Porter’s classic picture of the value chain. It has two
parts. The lower part contains those activities (labelled primary activities) that are
organised in sequence just like a production line. Thus, inbound logistics is the first step,
leading to manufacturing operations, then outbound logistics, marketing & sales, and
eventually service. This is a caricature of each firm’s value chain and will contain different
headings according to the nature of the operations.

Value is the amount that buyers are willing to pay for the product or service that a firm
provides. Profits alter when the value created by the firm exceeds the cost of providing it.
This is the goal of strategy, and therefore value creation becomes a critical ingredient in
competitive analysis. Every value activity employs costs such as raw materials, and other
purchased goods and services for “purchased inputs,” human resources (direct and indirect
labour), and technology to transform raw materials into finished goods. Each value activity
also creates information that is needed to establish what is going on in the business.
Similarly, value is created by producing stocks, accounts receivable, and the like; while value
is lost via raw material purchases and other liabilities. Most organizations thus engage in
many activities in the process of creating value. These activities can generally be classified
into either primary or support activities. These are illustrated in Figure 1, which details the
view of Michael Porter, who states that there are five generic categories of primary
activities involved in competing in any industry. Each of these is divisible into a number of
specific activities that vary according to the industry and chosen strategy of the firm. These
categories can be described as follows:

 Inbound logistics. Activities associated with receiving, storing, and disseminating

rights to the product, such as material handling, warehousing, stock management,
and the like.
 Operations. All of the activities required to transform inputs into outputs and the
critical functions which add value, such as machining, packaging, assembly, service,
testing, and the like.
 Outbound logistics. All of the activities required to collect, store, and physically
distribute the output. This activity can prove to be extremely important both in
generating value and in improving differentiation, as in many industries control over
distribution strategies is proving to be a major source of competitive advantage –
especially as it is realized that up to 50 per cent of the value created in many
industry chains occurs close to the ultimate buyer.
 Marketing and sales. Activities associated with informing potential buyers about the
firm's products and services, and inducing them to do so by personal selling,
advertising and promotion, and the like.
 Service. The means of enhancing the physical product features through after-sales
service, installation, repair, and the like.
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Firm infrastructure

Human resource management

Support
activities Technology development

Procurement

Service
Inbound Operations Outbound Marketing
logistics logistics & sales

Primary activities

Figure 1 The generic value chain

Source: Porter (1985)

The second part of the value chain is the upper section which contains all the overhead
service elements (labelled support activities) required by the firm. In Porter’s picture he
named four elements, firm infrastructure, human resource management, technology
development, and procurement.

1. Procurement. This concerns the acquisition of inputs or resources. Although technically

this is the responsibility of the purchasing department, almost everyone in the firm is
responsible for purchasing something. While the cost of procurement itself is relatively low,
the impact can be very high.
2. Human resource management. This consists of all activities involved in recruiting, hiring,
and training, developing, rewarding, and sanctioning the people in the organization.
3. Technology development. This is concerned with the equipment, hardware, software,
technical skills, and the like used by the firm in transforming inputs to outputs. Some such
skills can be classified as scientific, while others – such as food preparation in a restaurant –
are “artistic.” Such skills are not always recognized. They may also support limited activities
of the business, such as accounting, order procurement, and the like, and in this sense may
be likened to the value added component of the experience effect see experience and
learning effects.
4. Firm infrastructure. This consists of the many activities, including general management,
planning, finance, legal, external affairs, and the like, which support the operational aspect
of the value chain. This may be self-contained in the case of an undiversified firm or divided
between the parent and the firm's constituent business units.

Within each category of primary and support activities, Porter identifies three types of
activity which play different roles in achieving competitive advantage:

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 Direct. These are activities directly involved in creating value for buyers, such as
assembly, sales, and advertising.
 Indirect. These are activities that facilitate the performance of the direct activities on
a continuing basis, such as maintenance, scheduling, and administration.
 Quality assurance. These are activities that insure the quality of other activities, such
as monitoring, inspecting, testing, and checking.

The value chain is another generic framework that permits a range of applications and
analyses. It permits the analyst to divide the firm’s activities into broad categories (as
above) and increasingly into more specific categories. Thus operations might be refined into
sub-components and assembly: marketing & sales into market research, product
development, sales force and so on. The usefulness of this is to be able to identify those
activities that are the source of the competitive advantage and to be able to locate them
within the value chain. For example, if Intel’s competitive advantage is product
performance and this is derived (at least in large part) from R&D activities, then this can be
isolated within the value chain and measured, compared to competitors, and provided with
support.

Competitive advantage is often quite subtle in its manifestation and in its sources. Cost
advantage might arise from the way in which every single activity in the value chain is linked
to the others and managed for efficiency. The story of the low cost airlines such as EasyJet,
Ryanair and Southwest Airlines is about system management of the costs as well as focus on
driving down each cost component. Differentiation may be delivered as a service quality
perception driven by the way in which each element of service delivery is managed
systematically along with all other elements in order to differentiate the product.

The value chain can be a powerful tool in diagnosing and explaining how the management
of competitive advantage takes place within the firm. The interrelationships between the
elements of the value chain provide an important explanation of the nature of competitive
advantage in large, complex organisations. Such organisations typically are rich in tacit
knowledge. This is the kind of knowledge that you call upon to describe how you ride a
bicycle. We all know how to do this – but it is impossible to explain it. Similarly large
corporations are used to making links between complex and far-flung activities, and
between related and unrelated technologies. This ‘glue,’ that binds these companies
together and makes it impossible for others to imitate quickly. The “hidden” part of the
value chain is these linkages that contain the tacit knowledge. The way this ‘glue,’ works
determines the level of vertical integration, i.e. those elements of the supply chain that can
be brought within the value chain and within the firm, and those that should remain outside
the firm. The guiding principle is that when the costs of internal transactions (making the
glue work properly) exceed the costs of buying outside, then the firm should source outside
its boundaries.

The Value Chain and Cost Analysis

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The value chain provides a good basis on which to conduct a cost analysis. Its principal
advantage is that the elements of the value chain are already organised around those issues
that are important in driving competitive advantage and profitability. Porter was therefore
able in his 1985 book to make very strong links with the array of literature and practice on
cost cutting that was already available. A criticism of the cost analysis literature was the
difficulty of defining the correct units of analysis, an issue which the value chain solved
brilliantly.
Therefore a normal cost analysis procedure can take place with the following stages 1.

1. Define the value chain in terms of those elements that relate to the sources of
competitive advantage. Key considerations are:
 The separateness and independence of one activity from another
 The importance of an activity in relation to competitive advantage
and to the margin
 The dissimilarity of activities in terms of requiring different cost
drivers
 The extent to which there are differences in the way competitors
perform activities (i.e. where there are differences there are potential
advantages to be gained).

2. Establish the relative importance of different activities in the total cost of the
product. This means assigning costs to each activity based on management accounts
or other customised analysis procedures. The distinctions made earlier about fixed
and variable costs, sunk costs, and cost allocations are really significant issues at this
stage. Errors in cost analysis can lead to significant misunderstanding of the what
contributes to profits and how valuable is a competitive advantage.

3. Compare costs by activity and benchmark against competitors. The comparison is

not in terms of how big are the costs but how different are they from efficiency
benchmarks and from competitor standards.

4. Identify cost drivers. These are the forces that move costs up or down.
Planned scale of activities is a driver of overall plant cost and so also is degree of
capacity utilization. A driver of sales force costs might be product range – if the
range is too small costs will be high. Another driver will be geographical
concentration of customers and another might be sales communication methods
(face to face or remote teleconferencing). For labour intensive activities critical
drivers might be wage rates, speed of production line, and defect rates. It is through
the understanding of cost drivers that signifies how well you understand the nature
of your business. One needs to look behind the obvious in order to identify the
fundamentals.

5. Identify linkages between activities. As we see from the Novotel example

interrelationships may be very many in number – the critical cost drivers may
seemingly relate to another activity entirely. We will see in later chapters a

1
This section draws on Grant (2002), Ch. 7.
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comparison between Xerox and Canon in the photocopying industry. Xerox found
that its service costs were driven by design complexity and manufacturing
inefficiencies. Grant observes that:

“… the optimisation of activities through the value chain has become a

major source of cost reduction, and speed enhancement has become a key
challenge for computer integrated manufacturing.” Grant (2002, p.271)

6. Identify opportunities for reducing costs. By identifying areas of obvious

inefficiency (i.e. deviations from designed machine performance standards) and
of deficiencies against competitive benchmarks, opportunities for cost reduction
become evident. Very often the option is posed of contracting outside the firm
for components or services. Some firms have subcontracted entire IT
departments. Currently European firms are outsourcing their call centres to
India. The automobile companies are going through an extensive process of
outsourcing. The Ford Fiesta plants in Cologne outsource fully made-up doors
(as a subsystem) to plants adjacent to the Ford plant.

Identifying the Value Chain

The value chain concept thus helps to identify cost behaviour in detail. From this analysis,
different strategic courses of action should be identifiable in order to develop differentiation
and less price sensitive strategies. Competitive advantage is then achieved by performing
strategic activities better or cheaper than competitors.

To diagnose competitive advantage, it is necessary to define the firm's value chain for
operating in a particular industry and compare this with those of key competitors. A
comparison of the value chains of different competitors often identifies ways of achieving
strategic advantage by reconfiguring the value chain of the individual firm. In assigning costs
and assets it is important that the analysis be done strategically rather than seeking
accounting precision. This should be accomplished using the following principles:

 operating costs should be assigned to activities where incurred

 assets should be assigned to activities where employed, controlled, or influencing
usage
 accounting systems should be adjusted to fit value analysis
 asset valuation may be difficult, but should recognize industry norms – particular
care should be taken in evaluating property assets.

The reconfiguration of the value chain has often been used by successful competitors in
achieving competitive advantage. When seeking to reconfigure the value chain in an
industry, the following questions need to be asked:

 how can an activity be done differently or even eliminated?

 how can linked value activities be reordered or regrouped?
 how could coalitions with other firms reduce or eliminate costs?

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Successful reconfiguration strategies usually occur with one or more of the following moves:
a new production process, automation differences, direct versus indirect sales strategy, the
opening of new distribution channels, new raw materials used, differences in forward
and/or backward integration, a relative location shift, and new advertising media. A good
example of this is the emergence og German volume discounters (Lidl and Aldi) on the UK
food retailing scene. According to The Economist (2008) these ‘hard’ discounters “stock a
fraction of the goods that a normal supermarket offers, resulting in fewer suppliers, a high
volume of purchases and sales, and massive economies of scale.” The German discount
model is based on a different combination of competitive positioning and value chain
configuration resulting in a new and possibly better business model according to some
observers2.

Bibliography

The Economist (2008), “The Germans are coming”, 16 August

Grant, R.M. (2002), Contemporary Strategy Analysis: Concepts, Techniques and Applications,
4th edition, Blackwell Business; Oxford
McGee, John, David Wilson, & Howard Thomas (2010), Strategy: Analysis and Practice (2nd
edition) Maidenhead: McGraw-Hill
Porter, M. E. (1985). Competitive advantage; creating and sustaining superior performance,
New York, The Free Press

John McGee

Keywords

Cost analysis, supply chain, competitive advantage, five forces, value

Abstract

The value chain is that part of the supply chain that the firm directly controls usually
through direct ownership. Each element of the value chain represents a certain cost but the
term value is used to show how each of these activities is potentially a value creator in being
capable of being transformed into product that contains value for customers and value
(usually profits) for the firm, i.e. competitive advantage. The value chain has a generic
structure, attributed to Porter, and has considerable value in assessing the configuration of
assets and activities in the firm.

(2423)

2
For instance, Philippe Suchet of Exane BNP Paribas in Paris quoted in The Economist (2008)
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