What is value chain analysis?

Introduction

Value chain analysis is a particularly useful tool for looking at competitors, and identifying sources of competitive advantage. It was first described formally by Michael Porter in his book Competitive Advantage back in 1985. Porter described five primary activities which added value to the final output of a company, as well as a number of support activities. These primary activities were termed

in-bound logistics involving the gathering of raw materials used to produce the company products,
operations where the raw materials are converted into the final products for sale,
outbound logistics which looks at the processes involved in ensuring the products reach the customer where and when wanted,
marketing and sales for informing customers about the products and services offered and the actual processes involved in making the sale,
service which helps ensure that the product or service delivers the promises made that resulted in the sale – keeping the customer satisfied.

Value chain analysis looks at the efficiency, effectiveness and costs of each of these processes required to deliver the product to the customer. On top of this it also includes support activities such as infrastructure maintenance,R&D and employment costs.

Comparing the results for different competitors can be highly informative. Also if there are changes it can indicate strategic approaches.

How can value chain analysis be used in competitor analysis?

Take two (hypothetical) companies. Company A spends 10% of its total budget of $100m on purchasing raw materials, 50% on production processes, 5% on outbound logistics, 20% on marketing and sales and 5% on post sales servicing. Overhead costs represent 10% of the total budget.

Company B also has a budget of $100m and in year 1 spends the same proportions as company A on each process. But in year 2 – with the same budget, it spends an additional $4m on marketing and sales and reduces the amount spent on production by the same amount. This seems only a small change overall – and may be dismissed. However it would be wrong to do so. The new values are as follows:

$10m on raw materials
$46m on production. This is a 8% decrease which may be made through various efficiency drives and cost reductions. Not a massive change.
$5m on distribution costs
$24m on marketing and sales
$5 on customer service
$10m on support activities

The important figure here is the increase in marketing. By spending an extra $4m on marketing, the firm has increased its marketing budget by 20%. This is significant and would indicate a major strategic change in focus and approach and also suggest that Company B would become much more visible in the marketplace if its new marketing strategies were effective. The 20% increase could probably offset any shortfall in quality or other problems (if any) caused by the reduction in the production costs. If the strategy succeeds then there could be additional revenues in following years to correct this.

Essentially, this gives a quick example of value chain analysis and what can be achieved. There are many more uses, and I would recommend Michael Porter’s book, Competitive Advantage, where the value chain approach is first described. (Buy this book at Amazon UK version / US version)