All companies exist to create value for their customers – the fundamental core of all modern-day business.
But how do you evaluate how much value you’re actually creating for your customers? How can you assess where you position against competitors? And most importantly, ensure you’re maximizing your profit margin.
To evaluate all this, you’ll need to master the value chain business tool.
Throughout this guide, I’ll aim to show you what a value chain is, why it’s such an important concept to grasp, and the necessary steps to follow so you can conduct an independent analysis of your own.
Table of Content
- What is a Value Chain?
- Porter’s Value Chain Model
- Value Chain Activities
- Competitive Advantage
- How to Do a Value Chain Analysis
- Value Chain Example
- Value Chain Template
- Learn How to Analyze Your Business
What is a Value Chain?
“The value chain identifies the full range of activities required to bring a product or service from conception, through production, to the final delivery of value to customers.”
I’ll use an example from the furniture industry to try and give you a better idea of how it works.
Imagine you’re in a local furniture store with your partner scouting out dining room tables.
What you see in front of you are essentially reworked pieces of timber, right? So why are the tables valued between $800-$1500 apiece? The cost of timber is just a fraction of the price…
Well, the timber passes through a series of value-adding “activities” that turn into a table.
The wood had to be seeded, grown, and eventually logged (using specialist equipment and water) from the forestry sector.
These cut logs are then distributed to a sawmill where they are sawn down and stripped before being passed onto manufacturers. There, adhesives and paints are added and the wood further sculpted (based on the design and drawings sourced from an external agency).
The table then passes through various intermediary stages before it finally reaches you, at the furniture store.
While this is a simplified summary of the entire activity chain for table furniture, you can see how each process adds value to customers.
Of course, each link in the chain procures its own costs. Our job in conducting a value chain analysis is to identify how and where we can increase value, while simultaneously reducing costs.
Porter’s Value Chain Model
The value chain model was first introduced by Harvard Business School professor, Michael E. Porter in his book Competitive Advantage.
In it, he suggested that:
“Competitive advantage cannot be understood by looking at a firm as a whole. It stems from the many discrete activities a firm performs in designing, producing, marketing, delivering, and supporting its product.”
In other words, the value chain analyzes the entires series of activities required to turn raw materials into a customer-facing product, and uncover how and where along that chain value can be added
Porter also developed other macro business analysis frameworks you might be familiar with, such as Porter’s Five Forces, Diamond, and Four Corners Analysis models.
Value Chain Activities
Porter breaks down those value chain activities into two categories:
- Primary Activities
- Secondary Activities
A company has five primary activities required for the physical creation, sale, maintenance, and support of a product or service
These activities are placed in chronological order, i.e. inbound logistics (raw material storage, data collection, etc.) comes before Marketing and Sales (advertising and sale of the final product).
All activities required to receive, store, and disseminate inputs, such as raw material storage, warehousing, supplier relations, inventory control, transportation, etc.
Operations are the activities required to convert raw materials and resources into a final product or service. This would include machinery, assembly lines, equipment maintenance, etc.
All the activities related to physically collecting, storing, and distributing the products such as packaging, shipping, order processing, scheduling, product collection, etc.
Marketing and Sales
Activities required to ensure a) customers are aware of your product or service, and b) they have the means to purchase it. This includes advertising, inbound/outbound sales, channel selection, channel service, promotion, pricing strategy, etc.
The final primary activity segment looks at how you can provide after-sales support to customers, such as product training, warranties, repair, product supply, etc.
As the name suggests, the role of support activities is to ensure that all your primary activities run as smoothly as possible. As you can see from Porter’s value chain model, support activities simultaneously cover all five of the primary activity segments.
This entails all the management, financial, and legal systems a business has in place to make business decisions and effectively manage resources.
Human Resource Management
This activity includes the hiring, training, and rewarding of employees. Retaining talent in today’s “knowledge economy” can be crucial in maintaining a competitive advantage.
This refers to all technology required to turn your inputs, into outputs. It’s also where R&D, product design, market research, and product development fall.
It’s also often referred to as “purchasing” and it involves finding new suppliers, sourcing raw material, and essentially negotiating for the best prices possible.
As I mentioned earlier, the primary goal of a value chain analysis is to uncover areas within the activity process where customer value can be increased, the cost of creating value decreased, resulting in a higher profit margin.
“Value Created – Cost of Creating Value = Margin”
Now, an organization can claim a competitive advantage over its rivals if it sustains profits that exceed the industry average.
The goal of much of business strategy is, therefore, to achieve sustainable competitive advantage.
Porter identified two distinct areas of competitive advantage:
- Cost Advantage
- Differentiation Advantage
Cost advantage refers to a business that sets out to become a low-cost producer within the industry.
Companies who achieve this goal are incredibly efficient, have negotiated lower prices for their raw materials, and as such can sell their products at a lower price point.
Some potential strategies include the pursuit of economies of scale, preferential access to raw materials, learning and spillover, and the coordination and optimization of linkages (between activities).
A cost advantage exists when a company is able to deliver the same benefits (and value) as competitors but at a lower cost.
Instead of competing over cost, companies can alternatively pursue a differentiation advantage strategy. This is when a business is able to deliver benefits that exceed those of competitors, or is unique in some way.
As such, a premium price can be commanded for these products or services.
Conducting a value chain analysis using Porter’s model will help you identify which competitive advantage to focus on.
How to Do a Value Chain Analysis
Let’s take a look at the steps required to conduct a value chain analysis for your own organization.
Step #1 – Identify Your Value Chain Activities
The first step in conducting a value chain analysis is to identify all of your organization’s primary and secondary activities.
Think about every single action required to convert raw material into your final product. What processes are involved? What actions need to be taken? Which key suppliers need to be included?
If your business sells multiple products this step will need repeating for each one.
Step #2 – Assign Cost and Value
Now that the key activities have been listed, it’s time to determine how much value each activity adds as well as its associated costs.
When completing this step of your value chain analysis always remember to keep your customers front of mind.
How does this activity increase customer satisfaction? Will opting for X material over Y improve the product’s flexibility? Will removing an activity make it easier for customers to access our services?
It’s equally important to evaluate the costs associated with each activity.
How much more expensive will it be to change to a more flexible material? How will that impact our relationship with suppliers? What are the labor costs associated with changing material?
Reducing expenses is a great way to add value to customers through the lowering of the end product price point.
Step #3 – Identify Opportunties
Once a cost-benefit analysis of each value chain activity is completed, you should be able to identify opportunities to gain a competitive advantage.
If you decide your primary goal is to focus on a cost advantage, then you should evaluate identify activities that could be run more efficiently. Similarly, there could be certain activities that create little value to customers that could be outsourced or removed completely.
On the other hand, if you decide to focus on differentiation advantage, try to identify activities from your cost-benefit analysis that have scope for additional value. Is there an area you feel you can pull away from your competitors, and offer something unique?
Value Chain Example
Still a little unsure about how a value chain works? Then let us take a look at an example from Tesla.
Tesla Value Chain
Tesla is clearly an extremely complex company, with many divisions and subdivisions making up its corporate infrastructure.
Therefore, to give you an idea of how the value chain analysis works we’ll focus on some of its most important activities, and how they’re able to gain a competitive advantage over competitors.
As an electric vehicle manufacturer, one challenge Tesla faced was the sourcing (and cost) of lithium batteries to power their cars.
However, Tesla was able to overcome this challenge by partnering with Panasonic to build a Gigafactory, vastly reducing battery production costs.
Tesla also struck up partnerships with Daimler and Toyota to exchange standard car parts, knowledge, and funding for their battery and powertrain technology.
The company also acquired SolarCity. The solar energy system producers add knowledge and installation facilities for electric car chargers, also helping Tesla attain their goals of accelerating the world’s transition to sustainable energy.
In terms of storing all these raw materials and manufacturing equipment, Tesla runs a large number of warehouses worldwide. Their principal manufacturing facility in Fremont, California, operates as both a warehouse and manufacturing plant.
Again, contrary to traditional car manufacturers, Tesla vertically integrates the packing and assembly (and now increasingly the production) of battery cells and energy management systems within their own facilities.
They also internally manage the body design, assembly, and recharging systems. Traditionally, a large amount of this work would be outsourced to external suppliers.
Another important point to add is that both the engineering and design teams are also situated at the Fremont factory (where all the vehicles are built). This smoothens the entire production and logistics process.
In terms of delivering the cars, Tesla switched from a traditional dealer-based distribution model to direct delivery.
This greatly reduces costs in terms of investing in buildings and large inventories. It’s also helped by the fact that Tesla vehicles are made to order.
Marketing and Sales
As we just mentioned, Tesla went against the conventional dealership model for its vehicle distribution.
In its place, a new, multi-channel model for purchasing vehicles was created, involving online stores and Apple-like retail outlets.
These retail outlets are typically found in densely populated urban areas to maximize the brand’s exposure while offering additional after-sales services.
Tesla’s marketing strategy is loosely based on “Zero Dollar Marketing”. As the name suggests, they’re able to (largely thanks to Elon Musk’s Twitter account) attract extensive media coverage to boost their brand awareness and increase sales.
All this without spending a dime on advertising…
Another ambitious plan of Tesla’s is its Supercharger Network.
“Located on major routes near convenient amenities, Tesla’s 25,000+ Superchargers are the largest global, fast-charging network in the world.”
They’re also completely free to use for Tesla owners.
Its acquisition of SolarCity has made the installation of this network a lot easier and could end up being an important strategic move on their part. One of the barriers to electric vehicle purchasing is the fear or anxiety of running out of charge…
Tesla’s firm infrastructure is broken down into two operating segments:
- Energy Generation
The automotive segment includes the design, development, manufacturing, sales, and leasing of electric vehicles.
The energy generation and storage segment includes the design, manufacture, installation, sales, and leasing of solar energy generation and energy storage products and related services and sales of solar energy systems incentives.
Human Resource Management
As Tesla notes in their Annual 10K Report:
“Our future success also depends upon our ability to attract, hire and retain a large number of engineering, manufacturing, marketing, sales and delivery, service, installation, technology, and support personnel.”
Human resource management is clearly a priority for Tesla.
The company’s success also hinges on the retainment of CEO Elon Musk, who with a single Tweet was able to dramatically impact the value of cryptocurrency…
A huge area for potential differentiation between electric vehicle producers is found in research and technology
It also happens to be an area Tesla excels in. Their proprietary powertrain systems (users can have up to three depending on the vehicle) are efficient, reliable, and cost-effective.
Additional technology development includes:
- Lithium-ion battery cells
- Radar sensors
- FSD computer system
- Autopilot control systems
- Solar energy products
To reduce customer anxiety surrounding long-range batteries, Tesla shares its car data with telecommunication partners, enabling vehicles to connect with maintenance centers and the Supercharger Network.
Also, to maintain their competitive advantage, Tesla invests heavily in R&D.
According to their 10K Report:
“Expenses increased $148 million, or 11%, in the year ended December 31, 2020, as compared to the year ended December 31, 2019. The increase was primarily due to a $62 million increase in expensed materials as we continue to expand our product roadmap.”
As an electrical vehicle producer, Tesla relies heavily on direct suppliers to source expensive raw materials such as Copper, Cobalt, and other core elements required to produce lithium-ion batteries.
The partnerships established with Panasonic, Toyota, and Daimler are also crucial for Tesla to establish a cost advantage (until Musk can afford to go it alone, that is.)
Tesla also built a Gigafactory in Shanghai to increase the affordability of their electric vehicles for customers in China. This strategy reduces transportation and manufacturing costs and avoids the impact of unfavorable tariffs.
Value Chain Template
If you’re looking to conduct your own value chain analysis, you can go ahead and download this free template below.
Learn How to Analyze Your Business
If you’re interested in learning how to analyze your business using models, such as the value chain, then take a quick look at our online business program.
You’ll learn to master other business concepts such as lean startup methodology, product differentiation models such as the Ansoff Growth Matrix and BCG Matrix, and most importantly, how to practically apply them to your business.
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