Theory of Competitive Advantage & Value Chain Analysis
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Published: Mon, 16 Apr 2018
The initial theory regarding relative advantages was related to comparative advantages of regions or nations. It included land, location, labor, natural resources and local population size. But it is not true always as rise of some the most advanced industrial nations have proved that the above factors have less influence in their course of development. For example, Japan had disadvantage regarding availability of raw materials, abundant space and even access to other lands. But still the Japanese companies have prospered and rose to be among the best in the world. Again Japan also has disadvantage in terms of population size available. But that could not stop Japan from being a leader in business. Also economic hardship can really fuel growth in a nation. It has been seen both in case if both Japan and Germany. Both these nations were under severe economic trouble after World War II, but still they grew to be industry major countries in the world.
The reason for such behavior of nations or organizations in particular can be understood from ‘The theory of competitive advantage’ which says that there are other critical factors that determine the industry leadership. As per Michael Porter, the renowned Harvard business school professor sustainable industrial growth is hardly dependent on the above inherited factors. But it depends on groups of interconnected firms, suppliers, related industries, and institutions that arise in certain locations and termed them as ‘clusters’. These clusters are geographic concentrations of interconnected companies, specialized suppliers, service providers, and associated institutions in a particular field. They grow on locations where enough resources and competences amass and reach a critical threshold, giving it a key position in a given economic branch of activity, with a decisive sustainable competitive advantage over others places, or even a world supremacy in that field.
Porter says clusters can influence competition in three ways:
- They can increase the productivity of the companies in the cluster.
- They can drive innovation in the field.
- They can stimulate new businesses in the field.
The competitive advantage of any industry or organization is determined by five forces of Porter. These five forces help the managers to focus on competitive forces that prevail in the industry and the possible threats to their organizations.
Diagrammatic view of Porter’s five forces
Existing competitive rivalry among organizations in industry: The more that companies compete against one another for customers, ex- by lowering the prices of their products or by increasing advertising the lower is the level of industry profits. So this is a threat to the companies. Hence in order to sustain the companies may come up with new strategies and innovations in their technologies as well as business processes. Thus competition fuels growth in the industry as well as leads to innovations.
Threat of new market entrants: The easier it is for companies to enter the industry, because for ex- barriers to entry, such as brand loyalty are low, more the likely it is for industry prices and hence the industry profits to be low. In the wake of such a situation the companies might go for further innovations or even differentiations in their products or businesses. Thus it helps in the evolution process of the companies.
Bargaining power of buyers: It depends on the size of the customers. The bargaining powers of the customers come if they are large in size. So they can bargain to drive down the price of that output. As a result the industry producers might encounter low profits. So the bargaining power of buyers also decides the competitive advantage of the industry.
Power of suppliers: The suppliers also have important role in deciding the competitive advantage of firms. If there are only few large suppliers of an important input, then suppliers can drive up the price of that input and expensive inputs result in lower profits for profits for companies in an industry.
Threat of substitute products (including technology change): Often the output of one industry is a substitute for the output of another industry. Ex- plastic may be substitute for steel in some industry. When this type of substitutes exists in the industry companies cannot demand very high prices for it or customers will switch to the substitute and this constraint keeps their profits low.
Again the above all factors lead the managers to take decisions in four business level strategies to gain competitive advantage.
Low cost strategy: It is the strategy where the company focuses all its energies to lower its costs in all the departments. As a result it can sell its products in lower costs than its rivals. Here though the companies are selling the products at low prices but since the production costs are low the company still makes profits. Ex- BIC competes Gillette with this strategy in razor blade industry.
Focused low cost strategy: In such a strategy managers focus to serve only a segment of overall market and tries to be lowest cost organization in that segment.
Differentiation strategy: It is the strategy where organizations’ products can be distinguished from the products of other organizations on factors like product design, quality, service, or after sales service. Here the process of differentiation may be unique and expensive. Coca cola, PepsiCo, P&G practice such strategies.
Focused differentiation strategy: it is the strategy that tries to serve only one segment of the overall market and aims to be the most differentiated organization serving that segment. For ex, BMW focuses on this strategy.
The theory of competitive advantage can be also easily extended to the position of various nations. Here four factors have taken into consideration to nalayze the competitive position of the nations. Germany and Japan are most apt examples of such a competitive advantage. These are discussed as follows:
Four factors for competitive advantage:
The strategy, structure and rivalry of firms: As there is high competition among the firms, this competitive environment leads the firms to work harder for increase in productivity and innovation. The Japanese companies are cooperative at certain levels but they are also fiercely competitive. Thus it is the strategy and structure and rivalry of the firms that gives rise to excellence to the firms in terms of efficiency.
Demand conditions: If the firms face challenging and demanding customers then they constantly face pressure to improve their competiveness by innovative products, high quality etc.
Related supporting industry: A company prospers when supporting companies are located in the same area. Presence of supporting companies in the vicinity gives the firm added advantage in terms of gaining technological support and expertise.
Factor conditions: Specialized factors of production are skilled labor, capital and infrastructure. “Non-key” factors or general use factors, such as unskilled labor and raw materials, can be obtained by any company and, hence, do not generate sustained competitive advantage. However, specialized factors involve heavy, sustained investment. They are more difficult to duplicate. This creates a competitive advantage, because if other firms cannot easily duplicate these factors, they are valuable.
Value Chain is a model that helps to analyze specific activities through which firms can create value and competitive advantage. A value chain is a chain of activities for a firm operating in a specific industry. The business unit is the appropriate level for construction of a value chain, not the divisional level or corporate level. Products pass through all activities of the chain in order, and at each activity the product gains some value. The chain of activities gives the products more added value than the sum of the independent activity’s value. It is important not to mix the concept of the value chain with the costs occurring throughout the activities. A diamond cutter, as a profession, can be used to illustrate the difference of cost and the value chain. The cutting activity may have a low cost, but the activity adds much of the value to the end product, since a rough diamond is significantly less valuable than a cut diamond.Value Chain framework model
Value Chain Model of Porter
THE ACTIVITIES OF THE VALUE CHAIN
Primary activities (line functions)
Inbound Logistics. Includes receiving, storing, inventory control, transportation planning.
Operations. Includes machining, packaging, assembly, equipment maintenance, testing and all other value-creating activities that transform the inputs into the final product.
Outbound Logistics. The activities required to get the finished product at the customers: warehousing, order fulfillment, transportation, distribution management.
Marketing and Sales. The activities associated with getting buyers to purchase the product, including: channel selection, advertising, promotion, selling, pricing, retail management, etc.
Service. The activities that maintain and enhance the product’s value, including: customer support, repair services, installation, training, spare parts management, upgrading, etc.
Support activities (Staff functions, overhead)
Procurement. Procurement of raw materials, servicing, spare parts, buildings, machines, etc.
Technology Development. Includes technology development to support the value chain activities. Such as: Research and Development, Process automation, design, redesign.
Human Resource Management. The activities associated with recruiting, development (education), retention and compensation of employees and managers.
Firm Infrastructure. Includes general management, planning management, legal, finance, accounting, public affairs, quality management, etc.
A COST ADVANTAGE BASED ON THE VALUE CHAIN
A firm may create a cost advantage:
by reducing the cost of individual value chain activities, or
by reconfiguring the value chain.
Note that a cost advantage can be created by reducing the costs of the primary activities, but also by reducing the costs of the support activities. Recently there have been many companies that achieved a cost advantage by the clever use of Information Technology.
Once the value chain has been defined, a cost analysis can be performed by assigning costs to the value chain activities. Porter identified 10 cost drivers related to value chain activities:
Economies of scale.
Linkages among activities.
Interrelationships among business units.
Degree of vertical integration.
Timing of market entry.
Firm’s policy of cost or differentiation.
Institutional factors (regulation, union activity, taxes, etc.).
A firm develops a cost advantage by controlling these drivers better than its competitors do. A cost advantage also can be pursued by “Reconfiguring” the value chain. “Reconfiguration” means structural changes such as: a new production process, new distribution channels, or a different sales approach.
DIFFERENTIATION AND VALUE CHAIN
A differentiation advantage can arise from any part of the value chain. For example, procurement of inputs that are unique and not widely available to competitors can create differentiation, as can distribution channels that offer high service levels.
Differentiation stems from uniqueness. A differentiation advantage may be achieved either by changing individual value chain activities to increase uniqueness in the final product or by reconfiguring the value chain.
Porter identified several drivers of uniqueness:
Policies and decisions
Linkages among activities
Scale (e.g. better service as a result of large scale)
Many of these also serve as cost drivers. Differentiation often results in greater costs, resulting in tradeoffs between cost and differentiation. There are several ways in which a firm can reconfigure its value chain in order to create uniqueness. It can forward integrate in order to perform functions that once were performed by its customers. It can backward integrate in order to have more control over its inputs. It may implement new process technologies or utilize new distribution channels. Ultimately, the firm may need to be creative in order to develop a novel value chain configuration that increases product differentiation.
TECHNOLOGY AND VALUE CHAIN
Because technology is employed to some degree in every value creating activity, changes in technology can impact competitive advantage by incrementally changing the activities themselves or by making possible new configurations of the value chain.
Various technologies are used in both primary value activities and support activities:
Inbound Logistics Technologies
Building design & operation
Outbound Logistics Technologies
Marketing & Sales Technologies
Note that many of these technologies are used across the value chain. For example, information systems are seen in every activity. Similar technologies are used in support activities. In addition, technologies related to training, computer-aided design, and software development frequently are employed in support activities.
To the extent that these technologies affect cost drivers or uniqueness, they can lead to a competitive advantage.
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 inadvertently the new product design results in increased service costs; the cost reduction could be less than anticipated and even worse, there could be a net cost increase.
Sometimes however, the firm may be able to reduce cost in one activity and consequently enjoy a cost reduction in another, such as when a design change simultaneously reduces manufacturing costs and improves reliability so that the service costs also are reduced. Through such improvements the firm has the potential to develop a competitive advantage.
ANALYZING BUSINESS UNIT INTERRELATIONSHIPS
Interrelationships among business units form the basis for a horizontal strategy. Such business unit interrelationships can be identified by a value chain analysis.
Tangible interrelationships offer direct opportunities to create a synergy among business units. For example, if multiple business units require a particular raw material, the procurement of that material can be shared among the business units. This sharing of the procurement activity can result in cost reduction. Such interrelationships may exist simultaneously in multiple value chain activities.
Unfortunately, attempts to achieve synergy from the interrelationships among different business units often fall short of expectations due to unanticipated drawbacks. The cost of coordination, the cost of reduced flexibility, and organizational practicalities should be analyzed when devising a strategy to reap the benefits of the synergies.
OUTSOURCING VALUE CHAIN ACTIVITIES
A firm may specialize in one or more value chain activities and outsource the rest. The extent to which a firm performs upstream and downstream activities is described by its degree of vertical integration.
A thorough value chain analysis can illuminate the business system to facilitate outsourcing decisions. To decide which activities to outsource, managers must understand the firm’s strengths and weaknesses in each activity, both in terms of cost and ability to differentiate. Managers may consider the following when selecting activities to outsource:
Whether the activity can be performed cheaper or better by suppliers.
Whether the activity is one of the firm’s core competencies from which stems a cost advantage or product differentiation?
The risk of performing the activity in-house. If the activity relies on fast-changing technology or the product is sold in a rapidly-changing market, it may be advantageous to outsource the activity in order to maintain flexibility and avoid the risk of investing in specialized assets.
Whether the outsourcing of an activity can result in business process improvements such as reduced lead time, higher flexibility, reduced inventory, etc.
Thus we can see that every aspect of an organization can be rightly explained in light of value chain analysis to judge the competitive position of the organization. Normally, the Value Chain of a company is connected to other Value Chains and is part of a larger Value Chain. Hence, developing a competitive advantage depends on how efficiently we can analyze and manage the entire Value Chain.
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