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Definition

Value chain analysis (VCA) is a process where a firm identifies its primary and support activities that add value to its final product and then analyze these activities to reduce costs or increase differentiation.

Value chain represents the internal activities a firm engages in when transforming inputs into outputs.

Understanding the tool

Value chain analysis is a strategy tool used to analyze internal firm activities. Its goal is to recognize, which activities are the most valuable (i.e. are the source of cost or differentiation advantage) to the firm and which ones could be improved to provide competitive advantage. In other words, by looking into internal activities, the analysis reveals where a firm’s competitive advantages or disadvantages are. The firm that competes through differentiation advantage will try to perform its activities better than competitors would do. If it competes through cost advantage, it will try to perform internal activities at lower costs than competitors would do. When a company is capable of producing goods at lower costs than the market price or to provide superior products, it earns profits.

M. Porter introduced the generic value chain model in 1985. Value chain represents all the internal activities a firm engages in to produce goods and services. VC is formed of primary activities that add value to the final product directly and support activities that add value indirectly.

Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com
Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com   Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com

Although, primary activities add value directly to the production process, they are not necessarily more important than support activities. Nowadays, competitive advantage mainly derives from technological improvements or innovations in business models or processes. Therefore, such support activities as ‘information systems’, ‘R&D’ or ‘general management’ are usually the most important source of differentiation advantage. On the other hand, primary activities are usually the source of cost advantage, where costs can be easily identified for each activity and properly managed.

Firm’s VC is a part of a larger industry VC. The more activities a company undertakes compared to industry VC, the more vertically integrated it is. Below you can find an industry value chain and its relation to a firm level VC.

Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com
Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com

Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com
Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com

Using the tool

There are two different approaches on how to perform the analysis, which depend on what type of competitive advantage a company wants to create (cost or differentiation advantage). The table below lists all the steps needed to achieve cost or differentiation advantage using VCA.

Competitive advantage types

 

Cost advantage

Differentiation advantage

This approach is used when organizations try to compete on costs and want to understand the sources of their cost advantage or disadvantage and what factors drive those costs.

The firms that strive to create superior products or services use differentiation advantage approach.

  • Step 1. Identify the firm’s primary and support activities.

  • Step 2. Establish the relative importance of each activity in the total cost of the product.

  • Step 3. Identify cost drivers for each activity.

  • Step 4. Identify links between activities.

  • Step 5. Identify opportunities for reducing costs.

  • Step 1. Identify the customers’ value-creating activities.

  • Step 2. Evaluate the differentiation strategies for improving customer value.

  • Step 3. Identify the best sustainable differentiation.

 

Cost advantage

To gain cost advantage a firm has to go through 5 analysis steps:

Step 1. Identify the firm’s primary and support activities. All the activities (from receiving and storing materials to marketing, selling and after sales support) that are undertaken to produce goods or services have to be clearly identified and separated from each other. This requires an adequate knowledge of company’s operations because value chain activities are not organized in the same way as the company itself. The managers who identify value chain activities have to look into how work is done to deliver customer value.

Step 2. Establish the relative importance of each activity in the total cost of the product. The total costs of producing a product or service must be broken down and assigned to each activity. Activity based costing is used to calculate costs for each process. Activities that are the major sources of cost or done inefficiently (when benchmarked against competitors) must be addressed first.

Step 3. Identify cost drivers for each activity. Only by understanding what factors drive the costs, managers can focus on improving them. Costs for labor-intensive activities will be driven by work hours, work speed, wage rate, etc. Different activities will have different cost drivers.

Step 4. Identify links between activities. Reduction of costs in one activity may lead to further cost reductions in subsequent activities. For example, fewer components in the product design may lead to less faulty parts and lower service costs. Therefore identifying the links between activities will lead to better understanding how cost improvements would affect he whole value chain. Sometimes, cost reductions in one activity lead to higher costs for other activities.

Step 5. Identify opportunities for reducing costs. When the company knows its inefficient activities and cost drivers, it can plan on how to improve them. Too high wage rates can be dealt with by increasing production speed, outsourcing jobs to low wage countries or installing more automated processes.

Differentiation advantage

VCA is done differently when a firm competes on differentiation rather than costs. This is because the source of differentiation advantage comes from creating superior products, adding more features and satisfying varying customer needs, which results in higher cost structure.

Step 1. Identify the customers’ value-creating activities. After identifying all value chain activities, managers have to focus on those activities that contribute the most to creating customer value. For example, Apple products’ success mainly comes not from great product features (other companies have high-quality offerings too) but from successful marketing activities.

Step 2. Evaluate the differentiation strategies for improving customer value.Managers can use the following strategies to increase product differentiation and customer value:

  • Add more product features;

  • Focus on customer service and responsiveness;

  • Increase customization;

  • Offer complementary products.

Step 3. Identify the best sustainable differentiation. Usually, superior differentiation and customer value will be the result of many interrelated activities and strategies used. The best combination of them should be used to pursue sustainable differentiation advantage.

Example

This example is partially adopted from R. M. Grant’s book ‘Contemporary Strategy Analysis’ p.241. It illustrates the basic VCA for an automobile manufacturing company that competes on cost advantage. This analysis doesn’t include support activities that are essential to any firm’s value chain, thus the analysis itself is not complete.

Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com
Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com
Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com
Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com
Value Chain Analysis - Contemporary Concepts, Cost Management | Cost Management - B Com

 

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FAQs on Value Chain Analysis - Contemporary Concepts, Cost Management - Cost Management - B Com

1. What is value chain analysis?
Ans. Value chain analysis is a strategic management tool that allows businesses to identify the activities and processes that create value for their customers. It involves breaking down a company's operations into primary and support activities to understand how each activity contributes to the overall value creation process.
2. What are the primary activities in the value chain analysis?
Ans. Primary activities in the value chain analysis include inbound logistics (receiving and storing inputs), operations (converting inputs into final products), outbound logistics (delivering finished products to customers), marketing and sales (promoting and selling products), and service (providing after-sales support).
3. What are the support activities in the value chain analysis?
Ans. Support activities in the value chain analysis include procurement (purchasing inputs), technology development (research and development activities), human resource management (recruiting and training employees), and firm infrastructure (general management activities like finance, legal, and quality management).
4. How can value chain analysis help in cost management?
Ans. Value chain analysis can help in cost management by identifying activities that do not add value to the final product or service. By eliminating or optimizing these non-value-adding activities, companies can reduce costs and improve efficiency. It also helps in identifying cost drivers and cost-saving opportunities within the value chain.
5. What are the contemporary concepts related to value chain analysis?
Ans. Some contemporary concepts related to value chain analysis include lean management, Six Sigma, total quality management, and sustainability. These concepts emphasize efficiency, waste reduction, continuous improvement, and environmental considerations in the value chain. By incorporating these concepts, companies can enhance their competitive advantage and meet the changing customer expectations.
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