What is value chain analysis?
The value chain, also known as value chain analysis, is a concept from business management that was first described and popularized by Michael Porter in his 1985 best-seller, Competitive Advantage: Creating and Sustaining Superior Performance. It is an approach for breaking down the sequence (chain) of business functions into the strategically relevant activities through which value is added by the business. The objective is to identify the behaviour of costs and the areas for differentiation.
It can be conducted at the firm level (internal value chain) or at an industry level (industry value chain). For a vertically integrated business the internal and industry values chains are almost the same.
The industry value chain
The industry value chain is composed of all the value-creating activities within the industry, beginning with raw materials, and ending with the completed product delivered to the customer.
So an example the chemical industry value chain may look like:
- Raw minerals (e.g. oil, gas, air, water)
- Basic chemicals production (e.g. inorganics and organics such e.g. ammonia, salts, benzene)
- Chemical processing
- Advanced chemicals production (fertilizers, industrial chemicals, plastics)
- Advanced processing and technology (speciality chemicals, consumer care products, life science)
The objective of industry value chain analysis is to work out how your part in the industry value chain fits in with your suppliers and customers value chains.
The internal value chain
The internal value chain of a business consists of all physically and technologically distinct activities within the firm that add value to the customer’s experience. The key to this is understanding the activities that create a competitive advantage, and then managing those activities better than other companies in the industry.
Porter (1985) suggested that business activities can fall into two headings: primary activities, those that are directly involved with the physical creation and delivery of the product or service; and support activities, which feed both into primary activities and into each other. Support activities (e.g., human resource management, technology development) are not directly involved in production, but have the potential to increase effectiveness and efficiency.
Porter’s generic value chain looks like the following:
Primary activities consist of:
- 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.
Support activities consist of:
- Organizational infrastructure – support systems and functions, such as finance, planning, quality control, and general senior management.
- Human resource management - activities concerned with recruiting, developing, motivating, and rewarding the workforce of the organization.
- Technology development – managing information processing and the development and protection of “knowledge” in the organization.
- Procurement – how resources are acquired for the organization (e.g., sourcing and negotiating with suppliers).
The internal 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.
The hard part is actually doing this for you company and there are not that many examples available. In my next post I will be going through an example step-by-step to get an idea of what a value chain looks like in practice.