The Value Chain
When developing a strategy and attempting to secure a competitive advantage, it is important to note that a firm is not simply a ‘black box’ into which raw materials go and from which products emerge. Instead, a firm undertakes a series of steps which add value to the finished goods and turn them into the final product. This series of steps can be referred to as the company’s value chain, and Michael Porter defined a generic value chain featuring a series of activities that most firms undertook to add value to their final products or services. Porter claimed that the ultimate reason firms did all of these activities was to add value to the customer which is greater than the cost of the activities to the firm. As such, these activities allow a firm to sell the finished goods for greater than the costs of production, which results in a profit margin for the firm and value creation for its shareholders.
Porter’s generic model of the value chain features five primary activities and four support activities. The primary activities are those which directly affect the raw materials work in progress and finished goods. They are:
- Inbound Logistics. This refers to receiving and storing raw materials and other inputs, and supplying them to the operations as required.
- Operations. This is the process or processes by which the inputs are converted to finished goods.
- Outbound Logistics. This refers to the collection of finished goods from the operations, and their storage and distribution to distributors, retailers or customers.
- Marketing and Sales. This aspect involves identifying customer needs and marketing products which fill these needs.
- Service. This represents any after sales support, for a product or service supplied by the company.
The five primary activities are supported by four secondary activities:
- The organisational structure and control systems of the company, including its organisational culture.
- Human resource management. This includes all activities related to employees, such as recruiting, training and rewarding.
- Research and development of new technologies to add more value.
- Procurement of raw material and equipment.
The firm’s success in performing these activities will influence the value it is able to provide to the customer relative to the cost of the firm’s inputs, labour, capital and other costs. As such, the value added is effectively equivalent to the margin that the firm can charge, however the firm can choose to vary its margin to make its product attractive to more or fewer customers. Indeed, it can be argued that the foundation of all competitive advantage is in a company’s ability to configure its value chain to provide lower costs, greater differentiation, or specialist focus. A firm can obtain a cost a cost advantage by reducing the cost of all its value adding activities, can obtain greater differentiation by ensuring their activities add more value that competitors’ and achieve specialist focus by configuring their activities to add more value to a specific market niche.
Cost Advantage and the Value Chain
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A firm generally has two options when looking to use its value chain to build a cost advantage. Firstly it can attempt to reduce the cost of certain individual activities in the chain, and secondly it can reconfigure the entire chain to eliminate any non value adding activities. When attempting to reduce the cost of certain activities, Porter argued that there are ten specific cost drivers which can be used:
- Create greater economies of scale
- Increase the rate of organisational learning
- Improve capacity utilisation
- Create stronger linkages between activities
- Develop synergies between business units
- Look to increase vertical integration
- Improve the timing of market entry
- Alter the firm’s strategy regarding cost or differentiation leadership
- Change the geographic location of the activities
- Look to address institutional factors such as regulation and tax efficiency
A firm can also create a cost advantage by fundamentally reconfiguring the value chain to alter the relationships between activities. Often this implies looking to eliminate any activities which don’t add value; however it can also lead to new production processes or new distribution channels.
Differentiation and the Value Chain
Similar to cost advantages, a firm can obtain differentiation advantages by increasing the value and uniqueness of any part of its value chain. This is because differentiation ultimately arises when a firm adds value in a way that is unique amongst its competitors. As with cost advantages, a differentiation advantage can be obtained by changing the individual activities in the value chain to increase the uniqueness of the final product, or simply by reconfiguring the entire value chain. Porter identified nine specific drivers of unique value in the value chain:
- Changing policies and strategic decisions
- Improving linkages among activities
- Altering market timing
- Altering production locations
- Increase the rate of organisational learning
- Create stronger linkages between activities
- Develop relationships between business units
- Change the scale of operations
- Look to address institutional factors such as regulation and product requirements
Whilst most of these factors can also serve as cost drivers, differentiation tends to work in the opposite direction. Differentiation tends to increase costs, with the aim of providing a greater increase in value, whilst cost control tends to reduce costs with the aim of providing a lesser, or no, reduction in value.
Also similar to cost advantage seeking, the firm can reconfigure its value chain to create unique value, and hence differentiation. For example, a firm can forward integrate to provide its customers with greater levels of support, or backward integrate to give it more control over the quality and uniqueness of its inputs, such as food companies insisting on organic sourcing. The firm can also use new process technologies or distribution channels which create additional value for the end customer.
Technology and the Value Chain
Technology plays a specific role in the value chain. As technology tends to impact on all aspects of the value chain, investing in new technology research and implementation will generally provide additional value through improving the activities themselves or by facilitating reconfiguration of the entire value chain. Indeed, many technologies are used across the entire chain, most notably IT, and similar technologies tend to be used in the supporting activities. As a result, by developing technology to support either a cost advantage or a differentiation advantage, businesses can produce a competitive advantage effect across their entire value chain.
Relationships Between Value Chain Activities
It is important to understand that value chain activities cannot be viewed in isolation, and changes in any one value chain activity will tend to have knock on effects up and down the chain, and in the support activities. For example, if a company reduces its level of inventory held, and hence reduces its warehousing costs, the resulting fall in raw material levels may cause production hold ups. This, combined with a fall in the level of finished goods held, can cause shortages which lead to marketing and sales products. Any customer who receives a faulty product will also have a longer wait for a replacement, thus causing service issues and reducing overall customer value. As such, if a company wishes to reduce its inventory levels it must also improve its operational efficiency and ensure its marketing and service functions are prepared for the reduction in available finished goods. Equally, in some cases a firm may find that an improvement in one area has positive effects in another, such as when a firm uses technology to design a smaller product which also reduces the demand for raw materials and the warehousing requirements. These improvements are often crucial in developing competitive advantages.
In addition, there are also likely to be relationships between the value chain activities of different business units, which can be used to improvement the advantages of all business units. Some of the simplest examples of this include if one input is required by a number of business units. As such, benefits may be obtained from creating one function to purchase, store and distribute that input to all business units. This can help with a cost reduction, or the consistency of inputs into a variety of processes can be used to create a single brand for all products, providing differentiation advantages. Unfortunately, real life value chains are not as simple as this example, and often encounter issues which reduce or eliminate the expected benefits. For example, in the case above, creating a single purchasing function may result in shortages if all business units find their demand increases at the same time, and if there is any spoilage at the warehouse then the inputs for many business units will be affected.
Control Of Value Chain Activities
A firm not only needs to decide what value chain activities to focus its efforts on, but also what activities are not critical, and hence do not need to be directly controlled. For example, Coca-Cola keeps control of its marketing and part of its manufacturing operations, whilst the rest of the manufacturing: the mixing of the syrup with carbonated water, and the final distribution to retailers is carried out by the company’s network of distribution partners. In contrast, BP carries out all activities, from exploration to extraction to refining to distribution to selling refined petrol through its own petrol stations. The degree of control a firm has over its supply chain is termed the vertical integration of the chain.
A value chain analysis can help determine which functions should be controlled by the company, which should be devolved to partners, and which can be completely outsourced to third party providers. However, managers need to be careful to consider whether partners or third parties will be able to perform an activity as well, or perhaps better, than the company itself. Part of this consideration should focus on whether the activity provides a direct cost or differentiation advantage to the firm. In addition, the firm needs to consider any risks associated with performing the activity in house or outsourcing it, as well as the potential for business process improvements from using specialist partners or third parties.