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Value Chain

There are several analytic tools for assessing the resources and capabilities of firms. One tool is the value chain. The utility of the value chain can only be appreciated in actual application, not in the abstract. While the generic concept is simple, real-life value chain analysis can be very difficult and challenging. It can be very useful and revealing, too.

Perhaps the simplest way to introduce the concept is to remind ourselves what firms do. They convert inputs into outputs. They buy inputs and sell the outputs. If the outputs are worth more than the inputs, the firm has created value. The value created is the difference between the revenue yielded from selling outputs and the expenditures incurred in acquiring inputs. Now, if the value created is greater than the cost of transforming inputs into outputs, the firm makes a profit. Algebraically expressed:

Value Created = Revenue (Sale of Outputs) – Acquisition Costs (Cost on Inputs)

Profit (Loss) = Value Created – Transformation Costs (Cost of Turning Inputs into Outputs)

The value chain is nothing other than a representation of what the firm does to create value. The value chain is a sequential map of the value-added activities engaged in by the firm to create value. Perhaps the simplest value chain is the McKinsey business system, represented below:

Sounds simple, right? In large vertically integrated companies the value chain often is very straightforward. Yet value chains are becoming more complex. Think of Nike. They allow Asian companies to do much of their manufacturing, so this segment of the value chain is outsourced. Or consider Cisco. While Cisco does conduct its own R&D, Cisco has generally acquires its most important technology through acquisitions, so this part of the value chain is, again, largely external to the company. Finally, think of Dell. How much of the value chain in personal computers is Dell actually engaged in? For such a large company, its value chain is surprisingly thin.

And that is one part of the payoff to value chain analysis. Should a company be involved in all stages of production and distribution, or should it concentrate on specific stages while leaving others to partners and suppliers? Should we do our own R&D? Our own manufacturing? Our own distribution? Can we conduct these activities efficiently, compared with our competitors or compared to how well other firms can do them for us? Companies often used activity-based accounting methods to compute the efficiency of their value-adding activities and compare them with those of competitors. This comparison is called benchmarking.

The value chain can be conceptualized in other ways. The most well-known value chain is that of Porter, reproduced below. This value chain distinguishes between primary stage activities and secondary overhead activities. The primary activities are sequential, the secondary ones cut across the various stages. The Porter value chain should not be regarded as sacred and does not accurately represent all firms. In particular, the categories of inbound and outbound logistics (i.e. delivery of inputs to and products from manufacturing centers) make sense for factory-produced goods like automobiles and personal computers, but apply less well to many service industries.

The worst way to conduct value chain analysis is to take the Porter value chain as a given and try to make the company you are analyzing fit it. Most likely, the company you are analyzing does not correspond to the Porter value chain very accurately. Very well, then, change it, alter it, re-do the value chain from scratch until it accurately represents your company!

Of course, in order to do this, you need to conduct research about the company! The value chain is valuable because it helps structure the research you conduct. What does your company actually do? Where does it get its supplies from? What is the nature of its internal operations, and what are the core skills and facilities needed to make its operations work? How does the firm deliver its products to customers? Is marketing a minor or major activity? Is R&D a vital or not-so-vital function within the firm? If the value chain you construct consists of nothing but generic categories without any detailed grasp of what the firm actually does at each value-adding stage and how, then probably your analysis is incomplete. Your research is at a more advanced stage when your constructed value chain is not generic, but truly tailored to your company.