Value Chain Analysis

Value Chain Analysis 2

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Value Chain Analysis is another tool that may prove useful during the consulting case interview. It can be used to analyse the cost structure of a company as part of a declining profitability case, or to analyse the supply chain as part of an operations case.

Value Chain

To understand which activities provide a company with a competitive advantage, either through cost advantage or product differentiation, it is helpful to separate operations into a series of value-generating activities referred to as “the value chain”.

Value Chain Analysis involves identifying all of the important activities in which a company engages and then determining which ones give the company a competitive advantage. By doing this, a company can:

  1. Determine which activities are best undertaken internally and which ones are able to be outsourced or eliminated;
  2. Identify and compare strengths and weaknesses with the competition; and
  3. Identify synergies between activities.

The primary value chain activities include:

  1. Inbound Logistics: Receiving and storing raw materials;
  2. Operations: Manufacturing products and services; the way in which inputs are converted into final products;
  3. Outbound Logistics: Inventory storage and distribution to customers;
  4. Marketing & Sales: Identification of customer needs and preferences, marketing and sales generation;
  5. Service: Interacting with and supporting customers.

[For more information on consulting interviews, please download “The HUB’s Guide to Consulting Interviews“.]

Value Chain Analysis

To understand which activities provide a business with a competitive advantage, it is helpful to separate operations into a series of value-generating activities referred to as the “value chain”

Value Chain Analysis

(Source: Flickr)

1. Background

VALUE Chain Analysis is a concept that was first described and popularised by Michael Porter in his 1985 book, Competitive Advantage.

2. Relevance of Value Chain Analysis

In order to understand the activities that provide a business with a competitive advantage, it is useful to separate the business operation into a series of value-generating activities referred to as the value chain.

Value Chain Analysis involves identifying all of the important activities in which a business engages and then determining which ones give the company a defensible competitive advantage. By doing this, we can identify which activities are best undertaken by the company itself and which ones are able to be outsourced.

3. Value Chain Analysis explained

Michael Porter introduced a generic value chain model that comprises a sequence of activities common to a wide range of firms. Porter suggested that the activities of a business could be grouped under two headings:

  1. Primary activities: those that are directly concerned with creating and delivering a product; and
  2. Support activities: those that are not directly involved in production, but may increase effectiveness or efficiency.

The firm’s margin or profit depends on its ability to perform 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.

3.1. Primary activities

The primary activities in Porter’s model include:

  1. Inbound Logistics: Receiving and storing externally sourced materials.
  2. Operations: Manufacturing products and services – the way in which inputs are converted into final products.
  3. Outbound Logistics: Getting finished goods and services to consumers.
  4. Marketing & Sales: Identification of customer needs and the generation of sales.
  5. Service: Supporting customers after the product or service has been sold to them.

3.2. Support activities

The support activities in Porter’s model include:

  1. Human resource management: Recruitment, training, development, motivation and compensation of employees.
  2. Infrastructure: Includes a broad range of support systems including organisational structure, planning, management, quality control, culture, and finance.
  3. Procurement: Sourcing resources and negotiating with suppliers.
  4. Technology development: Managing information, developing and protecting new products and services, developing more efficient processes, and improving quality.

4. Application of the Value Chain Analysis

4.1. Steps to take

Value Chain Analysis can be broken down into a three sequential steps:

  1. Break down a company into its key activities under each of the headings in the model;
  2. Identify activities that contribute to the firm’s competitive advantage either by giving it a cost advantage or creating product differentiation. Also identify activities where the business appears to be at a competitive disadvantage; and
  3. Develop strategies around the activities that provide a sustainable competitive advantage.

4.2. Cost advantage

A business can achieve a cost advantage over its competitors by firstly understanding the costs that are associated with each activity and then organising each activity to be as efficient as possible.

Porter identified 10 cost drivers related to each activity in the value chain:

  1. Economies of scale
  2. Learning
  3. Capacity utilisation
  4. Linkages among activities
  5. Interrelationships among business units
  6. Degree of vertical integration
  7. Timing of market entry
  8. Firm’s policy on targeting cost or product differentiation
  9. Geographic location
  10. Institutional factors (regulation, union activity, taxes, etc.)

A firm can develop a cost advantage by controlling these 10 cost drivers better than its competitors.

A cost advantage can also be pursued by reconfiguring the value chain. Reconfiguration means introducing structural changes such as a new production process, new distribution channels, or a different sales approach. For example, Qantas structurally redefined its maintenance of aircraft, which was traditionally conducted by inhouse engineers, by outsourcing this function to private overseas contractors.

4.3. Product differentiation

Product differentiation can be achieved by a business by focusing on its core competencies in order to perform them better than its competitors.

Product differentiation can be achieved through any part of the value chain. For example, procurement of inputs that are unique and not widely available to competitors, providing high levels of product support services, or designing innovative and aesthetically attractive products are all ways of creating product differentiation.

5. Issues arising from the Value Chain Analysis

5.1. Linkages between Value Chain activities

Value Chain activities are not isolated from one another. Rather, one value chain activity often affects the cost or performance of other ones. Linkages may exist between primary activities and also between primary and support activities.

Consider the case in which the design of a product is changed in order to reduce manufacturing costs. Suppose that the new product design inadvertantly results in increased service costs; the cost reduction could be less than anticipated and even worse, there could be a net cost increase.

5.2. Business unit interrelationships

Business unit interrelationships can be identified using the Value Chain Analysis.

Business unit interrelationships offer opportunities to create synergies among business units. For example, if multiple business units require the same raw material and the procurement process can be coordinated then bulk purchasing may result in cost reductions. Such interrelationships may exist simultaneously in multiple value chain activities.

5.3. Outsourcing

Value Chain Analysis assists management decide which activities should be outsourced. It is rare for a business to undertake all primary and support activities internally. In order to decide which activities to outsource managers must understand the firm’s strengths and weaknesses, both in terms of cost and ability to differentiate.

6. Case example

For example, Coca-cola might have the following value chain elements:

  1. Research and development (Will cherry taste good with cola?)
  2. Manufacturing (How much does the bottling plant cost to build and run? How often do factories need to be re-engineered?)
  3. Cost of goods sold (How much does it cost to manufacture cola? Is there a frost in Florida that will drive up the cost of cherries?)
  4. Packaging and shipping (How much does that new design of packaging cost? Are many cans of cola lost in transit? What are the fixed costs of shipping?)

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]