Value Chain Analysis

The value chain is a chronological depiction of all the activities an organization uses to produce its products and services. It shows the linked set of activities the organization performs in order to generate profit. Each activity an organization performs should add value to the final product or service, if it does not, it should be evaluated for discontinuance or outsourcing.

What is Value?

What does it mean for an activity to create or add value? How can you tell if there is any value being created? Value is quite difficult to measure. It is more of a philosophy than a measurable concept. The image below can help to present the concept of value.

Consumer Surplus represents the total value the consumer receives from the product or service. This is subjective, it is based on individual opinion. For example, say you buy a hot dog on the street for $3, but you would have paid a maximum of $5. The consumer surplus, or value you receive from that transaction is $2, the maximum you would have paid minus the price you actually paid.
Profit Margin is the price the consumer pays minus the cost of production.
Cost of Production is the total cost associated with bringing the product or service to market.

Value Chain Analysis

Value chain analysis provides a systematic way of examining all the activities a firm performs and how they interact in order to analyze the source of competitive advantage. The value chain disaggregates a firm into its strategically relevant activities in order to understand the behavior of costs and the existing and potential sources of differentiation. A firm gains competitive advantage by performing these strategically important activities more cheaply or better than its competitors. Every firm’s value chain is composed of nine generic categories of activities which are linked together in characteristic ways. The generic chain is used to demonstrate how a value chain can be constructed for a particular firm, reflecting the specific activities it performs.

Primary Activities

Activities associated with receiving, storing, and disseminating inputs to the product, such as material handling, warehousing, inventory control, vehicle scheduling, and returns to suppliers.
Activities associated with transforming inputs into the final product form, such as machining, packaging, assembly, equipment maintenance, testing, printing, and facility operations.
Activities associated with collecting, storing, and physically distributing the product to buyers, such as finished goods warehousing, material handling, delivery vehicle operation, order processing, and scheduling.
Activities associated with providing a means by which buyers can purchase the product and inducing them to do so, such as advertising, promotion, sales force, quoting, channel selection, channel relations, and pricing.
Activities associated with providing service to enhance or maintain the value of the product, such as installation, repair, training, parts supply and product adjustment.

Support Activities

The function of purchasing inputs used in the value chain. Procurement employs a technology, such as procedures for dealing with vendors, qualification rules, and information systems. The cost of procurement activities themselves usually represents a small if not insignificant portion of total costs, but often has a large impact on the firms’s overall cost and differentiation.
Every value activity embodies technology, be it know-how, procedures, or technology embodied in process equipment, technologies used in preparing documents and transporting goods to those technologies embodied in the product itself. Technology development consists of a range of activities that can be broadly grouped into efforts to improve the product and the process.
Human resource management consists of activities involved in the recruiting, hiring training, development, and compensation of all types of personnel and supports both primary and support activities.
Firm infrastructure consists of a number of activities including general management, planning, finance, accounting, lega, government affairs, and quality management.

Activity Types

Within each category of primary and support activities, there are three activity types that play a different role in competitive advantage:

Activities directly involved in creating value for the buyer, such as assembly, parts machining, sales force operation, advertising, product design, recruiting, etc.
Activities that make it possible to perform direct activities on a continuing basis, such as maintenance, scheduling, operation of facilities, sales force administration, research administration, vendor record keeping, etc.
Activities that ensure the quality of other activities, such as monitoring, inspecting, testing, reviewing, checking adjusting, and reworking. Quality assurance is not synonymous with quality management, because many value activities contribute to quality

The value chain displays total value, and consists of value activities and margin. Value activities are the physically and technologically distinct activities a firm performs. These are the building blocks by which a firm creates a product valuable to its buyers. Margin is the difference between total value and the collective cost of performing the value activities.

Value activities can be divided into two broad types, primary activities and support activities. Primary activities are the activities involved in the physical creation of the product and its sale and transfer to the buyer as well as after sale assistance. Support activities support the primary activities and each other by providing purchased inputs, technology, human resources, and various firm-wide functions.

Value activities are the discrete building blocks of competitive advantage. How each activity is performed combined with its economics will determine whether a firm is high or low cost relative to competitors. How each value activity is performed will also determine its contribution to buyer needs and hence differentiation. Comparing the value chains of competitors exposes differences that determine competitive advantage.

Using the Value Chain

The value chain can be used to understand an organization’s strategy and diagnose problems in the organization, as well as determine sources of competitive advantage.

Step 1: Draw the organization’s current value chain

A value chain diagram should first be drawn to represent the true activities that an organization pursues. Each organization has a different value chain, rarely are they similar between organizations, even organizations with similar products or services. The value chain depicts the organization’s strategy, and it should uniquely express how the organization’s activities are arranged. An accurate model of the organization’s value chain must be drawn, but just as important, an assessment must be made about the strength of each activity in the chain. Each activity should be examined to confirm that it is creating some value for the customer that receives the output from the activity.

Step 2: Examine the strength of the linkages between the activities

This step focuses on the alignment between the activities. In order for the entire organization to perform well, all of the individual activities must be well coordinated. There are no pre-established criteria regarding how to evaluate the linkages between the primary activities. The management team conducting a value chain analysis must decide what criteria re important for evaluating the alignment between activities. This step should reveal relationships between activities that can be stream lines, smoothed tightened, coordinated, or rearranged. Weaknesses might be evident form poor communication, broken promises, misunderstandings, and delays in throughput.

Step 3: Examine the relationships at the beginning and ending of the value chain

Improvement can be made to the linkages outside of the organization, specifically, suppliers and distributors, or even customers. Most commonly, these improvements come in the form of improved relationships with vendors, joint venture/alliance partners, or customers. Traditionally, relationships with customers and vendors tend to be competitive, and sometimes even adversarial. Instead, some companies have view these relationships as opportunities to gain advantages that create value for both parties.