Microsoft and its Windows operating systems, the nucleus of the personal computer desktop for which much business software is developed, is often cited as a prime example of a company and product that drives a value chain. The businesses who buy personal computer software may spend far more on the add-on software than on the essential operating system that is the de facto standard for running the software. To the extent that companies standardize on Windows, Microsoft is said to control a value chain. This particular value chain was reported in a McKinsey study to be worth $383 billion in 1998. Although Microsoft's share of the value chain was reported to be only 4% of the total, that was still $15.3 billion.
A company that develops a product or service that engenders a value chain by providing a platform for other companies is considered more likely to increase its market share than a company that tries to provide the entire value chain on its own.
The Value Chain
By Dagmar Recklies
The term ‘Value Chain’ was used by Michael Porter in his book "Competitive Advantage: Creating and Sustaining superior Performance" (1985). The value chain analysis describes the activities the organization performs and links them to the organizations competitive position.
Value chain analysis describes the activities within and around an organization, and relates them to an analysis of the competitive strength of the organization. Therefore, it evaluates which value each particular activity adds to the organizations products or services. This idea was built upon the insight that an organization is more than a random compilation of machinery, equipment, people and money. Only if these things are arranged into systems and systematic activates it will become possible to produce something for which customers are willing to pay a price. Porter argues that the ability to perform particular activities and to manage the linkages between these activities is a source of competitive advantage.
Porter distinguishes between primary activities and support activities. Primary activities are directly concerned with the creation or delivery of a product or service. They can be grouped into five main areas: inbound logistics, operations, outbound logistics, marketing and sales, and service. Each of these primary activities is linked to support activities which help to improve their effectiveness or efficiency. There are four main areas of support activities: procurement, technology development (including R&D), human resource management, and infrastructure (systems for planning, finance, quality, information management etc.).
The basic model of Porters Value Chain is as follows:
The term ‚Margin’ implies that organizations realize a profit margin that depends on their ability to manage the linkages between all activities in the value chain. In other words, the organization is able to deliver a product / service for which the customer is willing to pay more than the sum of the costs of all activities in the value chain.
Some thought about the linkages between activities: These linkages are crucial for corporate success. The linkages are flows of information, goods and services, as well as systems and processes for adjusting activities. Their importance is best illustrated with some simple examples:
Only if the Marketing & Sales function delivers sales forecasts for the next period to all other departments in time and in reliable accuracy, procurement will be able to order the necessary material for the correct date. And only if procurement does a good job and forwards order information to inbound logistics, only than operations will be able to schedule production in a way that guarantees the delivery of products in a timely and effective manner – as pre-determined by marketing.
In the result, the linkages are about seamless cooperation and information flow between the value chain activities.
In most industries, it is rather unusual that a single company performs all activities from product design, production of components, and final assembly to delivery to the final user by itself. Most often, organizations are elements of a value system or supply chain. Hence, value chain analysis should cover the whole value system in which the organization operates.
Within the whole value system, there is only a certain value of profit margin available. This is the difference of the final price the customer pays and the sum of all costs incurred with the production and delivery of the product/service (e.g. raw material, energy etc.). It depends on the structure of the value system, how this margin spreads across the suppliers, producers, distributors, customers, and other elements of the value system. Each member of the system will use its market position and negotiating power to get a higher proportion of this margin. Nevertheless, members of a value system can cooperate to improve their efficiency and to reduce their costs in order to achieve a higher total margin to the benefit of all of them (e.g. by reducing stocks in a Just-In-Time system).
A typical value chain analysis can be performed in the following steps:
• Analysis of own value chain – which costs are related to every single activity
• Analysis of customers value chains – how does our product fit into their value chain
• Identification of potential cost advantages in comparison with competitors
• Identification of potential value added for the customer – how can our product add value to the customers value chain (e.g. lower costs or higher performance) – where does the customer see such potential
© Dagmar Recklies, 2001
Literature Recommendations - Books by Michael Porter
The Value Chain
To better understand the activities through which a firm develops a competitive advantage and creates shareholder value, it is useful to separate the business system into a series of value-generating activities referred to as the value chain. In his 1985 book Competitive Advantage, Michael Porter introduced a generic value chain model that comprises a sequence of activities found to be common to a wide range of firms. Porter identified primary and support activities as shown in the following diagram:
Porter's Generic Value Chain
Inbound
Logistics > Operations > Outbound
Logistics > Marketing
&
Sales > Service > M
A
R
G
I
N
Firm Infrastructure
HR Management
Technology Development
Procurement
The goal of these activities is to offer the customer a level of value that exceeds the cost of the activities, thereby resulting in a profit margin.
The primary value chain activities are:
• Inbound Logistics: the receiving and warehousing of raw materials, and their distribution to manufacturing as they are required.
• Operations: the processes of transforming inputs into finished products and services.
• Outbound Logistics: the warehousing and distribution of finished goods.
• Marketing & Sales: the identification of customer needs and the generation of sales.
• Service: the support of customers after the products and services are sold to them.
These primary activities are supported by:
• The infrastructure of the firm: organizational structure, control systems, company culture, etc.
• Human resource management: employee recruiting, hiring, training, development, and compensation.
• Technology development: technologies to support value-creating activities.
• Procurement: purchasing inputs such as materials, supplies, and equipment.
The firm's margin or profit then depends on its effectiveness in performing 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. It is in these activities that a firm has the opportunity to generate superior value. A competitive advantage may be achieved by reconfiguring the value chain to provide lower cost or better differentiation.
The value chain model is a useful analysis tool for defining a firm's core competencies and the activities in which it can pursue a competitive advantage as follows:
• Cost advantage: by better understanding costs and squeezing them out of the value-adding activities.
• Differentiation: by focusing on those activities associated with core competencies and capabilities in order to perform them better than do competitors.
Cost Advantage and the Value Chain
A firm may create a cost advantage either by reducing the cost of individual value chain activities or by reconfiguring the value chain.
Once the value chain is defined, a cost analysis can be performed by assigning costs to the value chain activities. The costs obtained from the accounting report may need to be modified in order to allocate them properly to the value creating activities.
Porter identified 10 cost drivers related to value chain activities:
• Economies of scale
• Learning
• Capacity utilization
• Linkages among activities
• Interrelationships among business units
• Degree of vertical integration
• Timing of market entry
• Firm's policy of cost or differentiation
• Geographic location
• Institutional factors (regulation, union activity, taxes, etc.)
A firm develops a cost advantage by controlling these drivers better than do the competitors.
A cost advantage also can be pursued by reconfiguring the value chain. Reconfiguration means structural changes such a new production process, new distribution channels, or a different sales approach. For example, FedEx structurally redefined express freight service by acquiring its own planes and implementing a hub and spoke system.
Differentiation and the 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
• Timing
• Location
• Interrelationships
• Learning
• Integration
• Scale (e.g. better service as a result of large scale)
• Institutional factors
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 the 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
o Transportation
o Material handling
o Material storage
o Communications
o Testing
o Information systems
• Operations Technologies
o Process
o Materials
o Machine tools
o Material handling
o Packaging
o Maintenance
o Testing
o Building design & operation
o Information systems
• Outbound Logistics Technologies
o Transportation
o Material handling
o Packaging
o Communications
o Information systems
• Marketing & Sales Technologies
o Media
o Audio/video
o Communications
o Information systems
• Service Technologies
o Testing
o Communications
o Information systems
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 inadvertantly 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.
The Value Chain System
A firm's value chain is part of a larger system that includes the value chains of upstream suppliers and downstream channels and customers. Porter calls this series of value chains the value system, shown conceptually below:
The Value System
... > Supplier
Value Chain > Firm
Value Chain > Channel
Value Chain > Buyer
Value Chain
Linkages exist not only in a firm's value chain, but also between value chains. While a firm exhibiting a high degree of vertical integration is poised to better coordinate upstream and downstream activities, a firm having a lesser degree of vertical integration nonetheless can forge agreements with suppliers and channel partners to achieve better coordination. For example, an auto manufacturer may have its suppliers set up facilities in close proximity in order to minimize transport costs and reduce parts inventories. Clearly, a firm's success in developing and sustaining a competitive advantage depends not only on its own value chain, but on its ability to manage the value system of which it is a part.
Strategic Management > Value Chain
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