Published: 17 November 2023
Contributor: Alexandra Jonker
Value chain analysis is the process of observing and evaluating each business activity involved in the creation of a finished product or service. The purpose of value chain analysis is to find areas of improvement within the value chain that will increase a company’s competitive advantage.
Harvard Business School Professor Michael Porter introduced the concept of a value chain in his 1985 book, Competitive Advantage: Creating and Sustaining Superior Performance.
He explains that value chains represent the activities a company performs to design, produce, market, deliver and support its products. These activities are narrower than traditional functions, such as marketing. He writes that a company’s value chain and the way it performs the activities within it are a “reflection of its history, its strategy, its approach to implementing its strategy and the underlying economics of the activities themselves.”
Core to his concept is the idea that value chain activities—from assembling products to training employees—create customer value and are the “basic units of competitive advantage.”1 Therefore, maximizing the value for each activity is key to market success.
While often used interchangeably, supply chains and value chains are distinct, but interconnected, terms.
A supply chain is the network of suppliers instrumental to product creation—from the providers of raw materials to the organizations that deliver the final product to consumers. This is why supply chains are vital to the activities within a company’s value chain.
Optimized, high-performing supply chains allow value chains to function effectively, improving customer satisfaction and creating greater product value. For example, effective supply chain management will minimize cost, waste and time in the production cycle. On the other hand, efficient value chains that maximize value and improve a company’s competitive advantage enable supply chains that produce optimal products that meet customer needs and wants.
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According to Porter, the goal of value chain analysis should be improving the value chain to gain a competitive advantage—delivering the most value, which, in turn, increases profit margins. In his value chain framework, there are two main types of competitive advantage a company can pursue: cost leadership and differentiation.
Cost leadership advantage
Also called a cost advantage, this type of competitive advantage focuses on how to reduce costs by making activities in the value chain more efficient. The goal is to produce a product for a lower price than competitors, sell it at a lower price and still enjoy a higher profit margin. By doing so, companies can work to become the low-cost producers in their industry.
This goal can be accomplished through economies of scale, proprietary technology or preferred access to suppliers. It’s key to remember that products still need to be high quality and comparable to those offered by competitors. Walmart and McDonalds are examples of companies with a cost leadership competitive advantage.
Differentiation advantage
The second type of competitive advantage seeks product differentiation that is unique and so valued by customers that companies can charge a premium price. Success here hinges on the higher price exceeding the extra costs incurred while making a product stand out among competitors.
Differentiation varies and can be based on product features; the way products are sold or even how they are marketed. Starbucks and Apple are examples of companies that have gained a competitive advantage through differentiated, premium products.
Porter’s value chain model divides its activities into two broad categories: primary and support.
Primary activities are involved in the production process of a product, its sale to the customer and post-sale customer service. Primary activities are split into five generic categories:
- Inbound logistics activities are related to receiving raw materials and parts for products, such as warehousing, inventory management and supplier returns.
- Operations activities are associated with transforming raw materials and parts (inputs) into final products (outputs), such as machining, assembly, testing and facility operations.
- Outbound logistics activities center around collecting, storing and delivering products to customers, such as packaging, shipping logistics and order processing.
- Marketing and sales activities encourage and provide a way for customers to buy a product, such as advertising, promotions and pricing.
- Service activities are those that enhance or maintain product value after the sale, such as quality assurance, trainings and warranties.
Support activities, also called secondary activities, back the primary activities by making them more efficient. Support activities are split into four generic categories:
- Procurement activities are those involved in the purchasing of raw materials and parts used in the value chain, from product-specific inputs to office supplies.
- Technology development activities are those that upgrade and improve products and processes, such as research, product design and servicing procedures.
- Human resource management activities are those related to recruiting, hiring, training, developing and compensating employees.
- Firm infrastructure includes activities that are often considered overhead, such as general management, quality control and legal operations.
The importance of each category to a company’s competitive advantage varies by business type and industry. For example, inbound and outbound logistics may be more vital to a distributor than to a retailer, for whom outbound logistics may not be a significant consideration.
While there are many different templates and routes to completing a value chain analysis, these four steps tend to stay consistent:
Classify and understand your value chain activities
To make improvements to your value chain for a competitive edge, you need to gain a strong understanding of every relevant activity that goes into the creation of your product or service. This includes both primary and support activities. If your company has multiple products or services, then repeat this step until you have a clear picture of the activities for each one.
Define the value and cost drivers of each activity
Next, identify the value and cost drivers of each activity. For example, establish how each activity works to increase customer satisfaction with the product or service. Then, identify the costs involved. To identify the value of your products or services, try to understand your customers’ perception of value—such as by giving surveys.
Benchmark your value chain against your competitors’
In the game of competitive strategy, knowing how your peers are performing is critical. While competitors’ value chains are unlikely to be publicly available, you can get an idea of them through benchmarking. One way to do this is by comparing relevant processes, business models and performance metrics from the competition with your own.
Identify your opportunities to gain a competitive advantage
After you’ve identified your value chain activities, their values and their costs, you can move forward into analysis to determine where best to achieve a competitive advantage. To streamline value chain analysis, set a primary goal—such as lower costs. Then, analyze each activity with the goal of cost reduction.
While gaining a competitive advantage to increase customer value and profit margins is the overarching benefit of value chain analysis, there are plenty of other benefits that fall under that umbrella. For example, a strong understanding of each activity within your value chain makes it easier to identify opportunities for supporting environmental, social and governance (ESG) goals; increasing efficiencies; reducing waste and introducing automation.
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Footnotes
1 “Competitive Advantage: Creating and Sustaining Superior Performance” (link resides outside ibm.com), Michael E. Porter, NY: Free Press, 1985