A value chain analysis is a process that allows businesses to visualize each stage on the value chain and determine where cuts can be made to reduce costs or how value can be added.
Before you begin to analyze production at your company, you should first understand the terminology that will be used in the remainder of the article.
A value chain describes every stage of creating a product from start to finish, e.g. activities like design, production, and distribution. It details the costs and value-added at each stage.
Doing value chain analysis is meant to add value to a product or service. Managers must consider, then, how much they can charge for the final product that creates a profit for the company but customers still pay for it. As you read, keep in mind that your company’s total revenue and margin are the basis for the budget that you will begin to optimize with a value chain analysis.
When determining the value of a product or service, the total revenue is what buyers are willing to pay for it. Subtracting the total cost of the steps on the value chain from the total revenue provides the business’s margin. This profit margin amount implies that the company will be able to deliver a product or service that a customer will be willing to pay for, even as the sum of the value chain is less than the cost of the product.
Improving the company’s operational efficiency to add value is just one aspect of a value chain analysis; the more important motivation is to gain a competitive advantage. We will be discussing competitive advantage and how to attain it later in the article.
Background of VCA
Michael Porter, an influential business strategist and academic, created the value chain analysis to measure value-added in the form of a value chain. Businesses who want to determine where the company is over-spending or inefficient can conduct a value chain analysis as described by Porter to isolate and improve areas of high need. Some companies, rather than focusing on cost-efficiency may want to add even more value in areas that are already strong to create a superior product.
In this article, we will discuss how a value chain analysis can start the process of increasing efficiency and cutting costs or adding value. Then, we will go into detail about the ways a company can gain an edge over its competition. Finally, we will dive into the different activities on a value chain (the process of creating your product) to help managers decide which activities directly contribute to value and which activities create a competitive advantage.
Along the way, you will find free resources for conducting your own value chain analysis including real-life business examples and a customizable template to start your own VCA and add value to your company.
How Does a Value Chain Analysis Work?
The goal of a value chain analysis is to determine which activities on the value chain are most valuable and which are most in need of improvement. The maximizing value will create a competitive advantage with similar products.
Looking into the internal activities on a value chain reveals the advantages and disadvantages of a product. Perhaps a product’s advantages are in its superiority as a product and its disadvantages are in its total cost. If a company can determine ways to cut costs that don’t jeopardize the advantages of its product, it earns profits and a competitive advantage.
What Is A Competitive Advantage?
A competitive advantage occurs when favorable circumstances offer a company a better business position than its competitors.
There are two different methods by which one can create value in the value chain that would allow a competitive advantage: cost advantage and differentiation advantage.
A type of competitive advantage that focuses on cost. A company seeking a cost advantage through this strategy wants to become the lowest-cost provider among its competitors. Using low-cost materials and resources increases operational efficiency and reduces the overall cost of the product.
When a company wants to understand which aspects of the value chain create advantages or disadvantages in order to become the lowest-cost provider, they follow the steps below.
- Identify the firm’s primary support activities: All the activities on the value chain have to be identified and separated out from the beginning stage of production (sourcing and storing materials) to the end stages (advertising and sales support).
The person conducting the value chain analysis at this level must be familiar with every aspect of production because the primary activities may not be organized in the same way as the company itself. Managers undergoing this process should look into how the product delivers value to customers at each stage and in each activity.
- Establish the relative importance of each activity in the total cost of the product: The total cost of each activity must be determined and weighed against the total value it produces. Analyses should first address activities that are considered as major sources for the total costs or don’t measure up well against competitors in terms of efficiency.
- Identify cost drivers for each activity: Once the cost of each activity has been determined, managers can begin to understand what factors contribute to those costs. Different activities will have different cost drivers, e.g. work hours, production speed, wages, or even machine costs, returns, or customer contacts.
- Identify links between activities: Some areas of costs create a domino effect. If a manager can cut costs in one area, it may, through links in activities, lower costs in another area. The opposite may also occur where cost reductions for one activity create higher costs later in the chain.
- Identify opportunities to reduce costs or to gain a competitive advantage: When a company knows all the advantages and disadvantages, cost drivers, links, and inefficiencies in the chain, it can then take steps to make improvements. Examples of opportunities may include rectifying high wages with faster or more automated production.
A type of competitive advantage that focuses on value. A differentiation strategy that sees success depends on dedicating time and resources to innovation, research, and development, but allows the business to set their superior product at a premium price. Adding features and satisfying customers create a higher cost structure and a superior product to allow for a differentiation advantage.
- Identify the customer’s value-creating activities: Once a manager has established which activities are in the value chain, they will isolate which ones create more value for the customer.
- Evaluate the differentiation strategies for improving customer value: At this stage, the manager will develop strategies that will create higher value in their product and increase product differentiation. They might add features, increase customization, put more energy into customer service, create accessibility for customers with disabilities, etc.
- Identify the best sustainable differentiation: Creating a differentiation advantage by making a product with superior value to its competitors will usually involve several different activities on the value chain. Pursuing sustainable differentiation advantage would involve boosting value in a combination of activities.
Once a manager has identified value activities they would like to boost or cut, they can then focus on those areas in the value chain to optimize production and increase either cost efficiency or value, depending on which value chain analysis the company chooses to undergo.
Value Chain Analysis Examples
Conducting a VCA requires many steps and great attention to detail, so to make it easier for managers who want to do this with less hassle and less of a learning curve, we are providing a free downloadable value chain analysis template. This template covers every step in the process to either cut costs or create value for your businesses, allowing you to create your own firm-specific VCA template for future use.
Porter’s Value Chain Analysis Model
In Porter’s model for value chain analysis, he split activities on the value chain into two categories: primary and support activities. Identifying primary and support activities will help managers to find their highest spending categories and areas most in need of improvement.
These activities on the value chain go into creating the base product or service offered by a company. Items on the primary activity chain contribute directly to the total value and costs of the product and are eventually linked to support activities to increase overall efficiency or effectiveness.
The following is a list of these activities:
- Inbound logistics – Whatever materials or resources go into creating the product are included here. Managers look at where these resources come from and the costs involved.
- Operation – The manner in which the materials come together to create the product. This could include locations, machinery, and wages involved in the manufacturing process. As the analysis moves through such production, value is added.
- Outbound logistics – How the product is delivered and distributed is described in outbound logistics. Distributor charges for sales, shipping costs, or other fees may be included in this category.
- Marketing and sales – Methods like advertising and marketing to reach the target audience for the product are included in this category. The set of tools a company uses to market its product (locations, list price, design, and quality)–the marketing mix–is used to create an effective logistical strategy for getting the product to the target audience.
The promotional mix–the variables chosen by the marketing team to help the company reach its sales and target group goals (public relations, advertising, personal sales)–clearly communicates the product’s advantages to the target group, possibly including the tools in the marketing mix as advantages to the product.
- Services – Support offered to the customer base falls under services. Things like warranties and customer support are the kinds of services a company may offer. Costs for this category could include repair, training, and product updates.
These activities on the value chain take the base value of a product and attempt to offer more value to create a competitive advantage.
- Firm Infrastructure – Effective resource management lies in a firm’s managerial infrastructure. The people involved in each system of a business, from financial to legal to management, should be able to add value to a business through their actions and resource management.
Inefficient infrastructures, on the other hand, could cause a loss or waste of resources that could affect the reputation of the company. Consequences could include fines and sanctions that damage the company’s financial standing and customer trust.
- Human esource Management – Hiring staff and managing existing employees falls under the support activities category. Quality staff is a huge asset to value creation in a company, especially for a product or service that requires in-person customer interaction.
- Technology Development – Technology used to cut costs, increase efficiency, or create value for the product can create an advantage. Innovation in the form of technology development can help a business at any stage of activity on the value chain.
- Procurement – Suppliers and sources for the materials used to create the product are included here. If a business is able to find better quality sources or suppliers that fit the budget, value is added to the product.
From examining each category, it may seem as though the primary activities on the value chain are more important for creating value, but this isn’t an accurate assumption. Neither primary activities nor support activities are more important than the other; however, it is easier to identify and manage costs and see where value is added from primary activities.
Yet, in the current market, adding value that creates competitive advantage more often comes from innovation or improvement in technology. Creating a differentiation advantage, therefore, greatly depends on support activities like information systems and general management.
Conducting a value chain analysis may seem intimidating, but we hope that with our guide and resources, you will be able to add value to your business. Remember that there is no better path. Some of the most successful businesses in our economy stay on top of their competition by cutting costs, and others by creating a product that no other company can compete with in terms of the value of the product they give to their customers.
Determining which advantage you are going to seek will be a decision unique to your company’s needs and what you offer. As a manager for your firm, you are already adding value that creates a competitive advantage for your company by being familiar with the inner workings of your business and taking action to improve.
We hope that by further analyzing each step in the manufacturing and distribution of your product, you can add value for your customers and increase your company’s profit margin at the same time.