Porter Generic value Chain

The Value Chain

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. Process flows can be mapped, and these flows used to isolate the individual value creating activities. Once the discrete activities are defined, linkages between activities should be identified. A linkage exists if the performance or cost of one activity affects that of another. Competitive advantage may be obtained by optimizing and coordinating linked activities.

The value chain also is useful in outsourcing decisions. Understanding the linkages between activities can lead to more optimal make-or-buy decisions that can result in either a cost advantage or a differentiation advantage. 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:

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:

1. Inbound Logistics: the receiving and warehousing of raw materials and their distribution to manufacturing as they are required.
2. Operations: the processes of transforming inputs into finished products and services.
3. Outbound Logistics: the warehousing and distribution of finished goods.
4. Marketing & Sales: the identification of customer needs and the generation of sales.
5. Service: the support of customers after the products and services are sold to them.

These primary activities are supported by:

1. The infrastructure of the firm: organizational structure, control systems, company culture, etc.
2. Human resource management: employee recruiting, hiring, training, development, and compensation.
3. Technology development: technologies to support value-creating activities.
4. 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:

1. Cost advantage: by better understanding costs and squeezing them out of the value-adding activities.
2. 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:

1. Economies of scale
2. Learning
3. Capacity utilization
4. Linkages among activities
5. Interrelationships among business units
6. Degree of vertical integration
7. Timing of market entry
8. Firm's policy of cost or differentiation
9. Geographic location
10. 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:

1. Policies and decisions
2. Linkages among activities
3. Timing
4. Location
5. Interrelationships
6. Learning
7. Integration
8. Scale (e.g. better service as a result of large scale)
9. Institutional factors

Many of these also serve as cost drivers. Differentiation often results in greater costs, resulting in trade-offs 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:

1. Inbound Logistics Technologies
• Transportation
• Material handling
• Material storage
• Communications
• Testing
• Information systems
2. Operations Technologies
• Process
• Materials
• Machine tools
• Material handling
• Packaging
• Maintenance
• Testing
• Building design & operation
• Information systems
3. Outbound Logistics Technologies
• Transportation
• Material handling
• Packaging
• Communications
• Information systems
4. Marketing & Sales Technologies
• Media
• Audio/video
• Communications
• Information systems
5. 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.

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 outsources

1. Whether the activity can be performed cheaper or better by suppliers.
2. Whether the activity is one of the firm's core competencies from which stems a cost advantage or product differentiation?
3. The risk of performing the activity inhouse. 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.
4. Whether the outsourcing of an activity can result in business process improvements such as reduced lead time, higher flexibility, reduced inventory, etc.

The Advantages of Value Chain Analysis

1. A big advantage is that the value chain is a very flexible strategy tool for looking at your business, your competitors and the respective places in the industry’s value system.
2. The value chain can be used to diagnose and create competitive advantages on both cost and differentiation. I’ve written about this in Using the value chain to Create Competitive Advantage.
3. It helps you to understand the organisation issues involved with the promise of making customer value commitments and promises because it focuses attention on the activities needed to deliver the value proposition.
4. Comparing your business model with your competitors using the value chain can give you a much deeper understanding of your strengths and weaknesses to be included in your SWOT analysis.
5. The value chain is well known and has been a mainstay of strategy teaching in business schools for the last 30 to 35 years. The book, Competitive Advantage was published in 1985.
6. It can be adapted for any type of business manufacturing, retail or service, big or small.
7. The value chain has developed into an extra model, the industry value chain or value system which lets you get a better understanding of the much broader competitive arena. If you’re interested in this aspect of the value chain, watch the Value Chain Videos for an easy to understand introduction.

The Disadvantages of Value Chain Analysis

1. Its very strengths of flexibility mean that it has to be adapted to a particular business situation and that can be a disadvantage since, to get the best from the value chain, it’s not “plug and play”
2. The format of the value chain laid out in Porter’s book Competitive advantage is heavily oriented to a manufacturing business and the language can be off putting for other types of business.
3. The scale and scope of a value chain analysis can be intimidating. It can take a lot of work to finish a full value chain analysis for your company and for your main competitors so that you can identify and understand the key differences and strategy drivers.
4. Many people are familiar with the value chain but few are experts in its use.
5. Michael Porter’s book is excellent but it is a tough read. It’s also dated in its examples which can make some of the ideas more difficult to relate to and understand how things fit together in the Internet age.
6. The value chain idea has been adopted by supply chain and operations experts and therefore its strategic impact for understanding, analyzing and creating competitive advantage has been reduced.
7. Business information systems are often not structured in a way to make it easy to get information for analysis.

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