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
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Operations
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Outbound Logistics
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Marketing & Sales
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Service
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M A R G I N
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Firm Infrastructure  HR Management  Technology Development  Procurement
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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
- Transportation
- Material handling
- Material storage
- Communications
- Testing
- Information systems
- Operations Technologies
- Process
- Materials
- Machine tools
- Material handling
- Packaging
- Maintenance
- Testing
- Building design & operation
- Information systems
- Outbound Logistics Technologies
- Transportation
- Material handling
- Packaging
- Communications
- Information systems
- Marketing & Sales Technologies
- Media
- Audio/video
- Communications
- Information systems
- Service Technologies
- Testing
- Communications
- 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
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Supplier Value Chain
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Firm Value Chain
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Channel Value Chain
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Buyer Value Chain
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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.