Your goal as a business is to create the most value for your customers. When you create value for your customers, you create value for your shareholders through your profit margins.
But how do you go about adding value when building new products? How do you go about building new products that customers buy while optimizing your margins? How is value creation conceived both for customers and shareholders?
The process of ideating, creating, and selling products can be seen through the value chain.
What is a value chain?
The definition of a value chain is a set of business activities involving the creation, commercialization, and correction of products or services.
An example of a value chain in manufacturing is the creation of S’well water bottles. First, someone had to come up with the idea for S’well water bottles. Then, they had to design the innovative water bottle using software and other tools. Then, they had to source a manufacturer for developing the product. After outsourcing the manufacturer, they may have to acquire raw materials for the manufacturer to use.
Once the product is created, they have to sell the product — which, in this case, is a combination of wholesale, retail, and direct-to-consumer. Then, they have to service the product which, in this case, is likely handling returns. Regardless of their business model, they must create and deliver the product to the end customer, whether that’s an individual or a retail store.
All of these steps create a value chain — literally, a chain where value can be extracted or added at every step of the chain. When executed well, a value chain framework can double as a competitive strategy that offers a differentiation advantage for your products.
Value chain vs. supply chain
Many individuals get the value chain confused with supply chains.
Supply chains are systems of people, activities, organizations, and resources involved in delivering a product or service to the consumer.
Wait…how is that different from a value chain?
A value chain encompasses much more than the supply chain does. The supply chain is all about the delivery of goods or services—the outputs—while the value chain is “a set of interrelated activities a company uses to create a competitive advantage.”
A company’s value chain, for example, includes the marketing and servicing of a product, while a supply chain only encompasses the creation and distribution of a product.
If you’re confused, just remember:
- Supply chain = supplying products
- Value chain = delivering value
What is Porter’s Value Chain Model?
Michael Porter’s value chain concept model was established in his 1985 book Competitive Advantage. Porter’s value chain establishes primary and secondary activities every company goes through in the process of creating value for customers. Michael Porter is an American academic who also created Porter’s five forces.
These components of a value chain help create the equation that leads to calculating margins. Margins are the revenue generated from the value chain.
Value Created and Captured – Cost of Creating that Value = Margin
Primary value chain activities
The primary activities in a value chain include inbound and outbound logistics, operations, marketing, sales, and services. Primary value chain activities include every step in the physical creation, sale, maintenance, and support of a product. It’s the entire production process of creating a new product. These specific activities can be broken down into Porter’s model of the value chain.
This includes all of the processes of receiving, distributing and storing of products internally. This is the process of going from raw material to an actual product.
Inbound logistics is all about sourcing the raw materials required to create a finished product. In the case of S’well water bottles from above, this includes the stainless steel and copper used in their product. Supplier relationships are integral when it comes to inbound logistics.
Outbound logistics refers to the delivery of a final product and the services associated with them; the process of delivering final products or services to the end consumer. The steps in this process may be external or internal — i.e. you might not store your items in your own warehouses. For example, S’well water bottles sells directly to consumers, in stores and in bulk. Each type of selling has a different process for outbound logistics. This includes the warehousing of products.
Operations is the process of transforming inputs into complete, finished products and services. Operations are all of the transformation activities that turn raw materials into finished goods. This includes quality assurance.
Marketing and sales
Marketing and sales are the processes an organization uses to influence customers to purchase from your organization instead of a competitor. This includes the benefits offered, how well they’re communicated, and if they are sources of value to the end customer.
Marketing and sales is pretty clear — it’s the marketing and selling of products. Due to the incredibly competitive world we live in where manufacturing products is easier than ever, high-quality, relevant, and timely sales and marketing can be a make or break. Sales and marketing often drive the distribution channels and channel metrics, based on research.
Services are the activities designed to maintain products and enhance consumer experience. Often includes add-on services, warranties, refunds and returns.
Services, like sales and marketing, are becoming more and more significant in delivering products. This is due to the rise of Products-as-a-Service like Peloton or smart thermostats. They are a physical product that rely on recurring revenue through services like new classes or access to data to optimize the product in the future.
Secondary value chain activities
On the other hand, secondary or support value chain activities are everything that supports each phase of the value chain. These include procurement, HR management, technology and infrastructure.
Procurement refers to the obtainment of resources to produce the end product. Procurement involves finding vendors and securing contracts for goods and services the business needs to create and deliver a final product. Procurement can include everything from obtaining a lease for an office to securing a partnership to produce a piece of the end product.
HR management is how well a company recruits, hires, trains and retains their workforce. HR management is all about human resources and managing people. Because of the changing workforce, human resources is becoming even more important. Human resources is responsible for recruiting, training, motivating, and retaining employees across the organization.
Technology refers to the equipment, hardware, software, procedures and technical knowledge of an organization. Technology development is becoming hypercritical in the fourth industrial revolution. Today, many companies are focused on technology including automation, cloud computing, and the Internet of Things (IoT).
Infrastructure includes the company's support systems like legal, accounting and administrative functions. A firm’s infrastructure is everything else that goes into building a product that’s not directly connected to the final product. This is the general management of an organization including accounting, administration, and legal.
When you put both primary and secondary activities together, you can understand any organization holistically. By understanding your value chain in detail, you can create a competitive advantage.
What is value chain analysis?
Value chain analysis is a way for businesses to evaluate each of the activities involved in the creation and delivery of a product.
Businesses conduct a value chain analysis when they want to understand how they can decrease costs or increase product differentiation. The final result in a value chain analysis should be recommendations to optimize each phase or step of the value chain to create higher margins.
There are only two ways a business can gain a competitive advantage: Cost reduction or product differentiation.
If a company is deploying a cost leadership strategy, their goal is to become the lowest cost option for the end user. Typically, companies who succeed in a cost leadership strategy use low-cost materials, offshore their manufacturing to low-cost manufacturing hubs, and have maximum operational efficiency.
McDonald's and their dollar menu or generic brands in stores are cost reduction examples.
A product differentiation strategy’s competitive advantage is through having a unique offering or a specialized finished product. This enables the company to charge a premium price. Product differentiation is usually the result of research and development. Innovative companies creating innovative products deploy this strategy, enabling them to charge a higher price.
In the fourth industrial revolution, we will see mass personalization become a leader in product differentiation strategies.
Examples of product differentiation include Apple and Louis Vuitton.
Cost reduction vs. product differentiation
When analyzing your value chain, it’s important to figure out which competitive advantage is your main focus. This will help shape your efforts while enabling you to evaluate the effectiveness of your value chain analysis.
When conducting a value chain analysis, companies are typically either focused on product differentiation, which typically means a bigger investment in support activities, or are focused on increasing margins by cutting costs, which is mainly about optimizing primary activities.
Value chain analysis checklist
Now that we’ve covered the definition and the two primary drivers — cost advantages or product differentiation — it’s time to dive into the steps of a value chain analysis.
Value chain analysis steps
1. Understand each of the primary and secondary activities in the business
From procuring raw materials and shipping them to factories to delivering a final product to the end consumer, there are dozens of steps in the value chain process. This is the hardest step as it requires a deep investigatory look at each of the primary and secondary activities.
For example, when analyzing the human resource management process, you have to look at everything from where you post job opportunities to how long it takes to onboard a new hire and every step in between. The deeper you go in your value chain analysis, the more results you’ll be able to yield.
2. Analyze the cost and value of each activity
When creating your value chain analysis, you must look at the cost drivers of each step. Do you have steps in the process of building your finished product that are low value, high cost?
If we are to keep with the human resources example, how much does it cost to post on job boards? How much time is involved in interviewing candidates on average? What is the average cost of that time? Or, if you want to take the example to manufacturing explicitly, how much does a certain material cost? Are you focused on sourcing the most sustainable materials or the cheapest?
Then, those conducting the value chain analysis should analyze the value that each step brings. Do a majority of top candidates come from one channel? Does checking references really make a difference in the job interview process?
In manufacturing specifically, does sourcing sustainably add value to the organization? Does it bring about product differentiation?
By analyzing both the cost advantages and profit margins of each activity and the value it provides to the organization, you can holistically understand how to optimize each activity.
3. Identify competitive advantage opportunities
Now that you’ve broken down each process - from procuring raw materials to hiring employees or acquiring new technology - it’s time to optimize your value chain. This is why having a focus on either product differentiation or cost advantages is critical.
Whoever is developing the value chain analysis should make recommendations based on how the company wants to improve margins. Companies should first focus on optimizing high cost, low value processes regardless of their focus on differentiation or cost reduction.
The overall goal of any value chain analysis is to increase profit margins while providing customers with a satisfactory final product that meets their expectations.
Value chain analysis example
To understand value chain analysis, let’s look at the example of Apple. Apple is a brand focused on product differentiation. Their technology, on average, eclipses their competition by hundreds of dollars, and they’re often the first to produce a technology or they dramatically improve upon existing technology.
Let’s break down a value chain analysis of Apple into primary and support activities.
Primary activities in the value chain include inbound and outbound logistics, operations, marketing and sales, and services.
Let’s start with inbound logistics.
Inbound logistics is how a company sources materials from suppliers.
When it comes to Apple, their inbound logistics include sourcing and shipping different types of materials to build their technology. In analyzing this process, the company would look at if their supply is sourced sustainably and if they have the highest quality materials.
Operations references the process of actually building a finished product. This includes the people and machines involved in the process.
For Apple, this is the method of producing computers, phones, headphones, watches, and more. Apple’s product design focuses on creating high quality products that are unique in their capabilities.
Outbound logistics is the warehousing and delivery of finished goods.
Apple sells their products online and in their stores. They must ship products from where they are produced to warehouses and their stores around the world.
Marketing and sales
Marketing and sales is...well, marketing and sales. It’s how a brand gets the word out about their product and convinces someone to purchase. This can include social media, online advertising, print advertising, commercials, video content, and more.
Apple is known for their “shot on iPhone” commercials and photography, for example. They focus a lot on brand building.
More and more, companies are having to focus on how they service their products after a purchase. Companies are shifting to Product-as-a-Service that utilize subscriptions as a new business model.
Apple focuses quite heavily on customer service. They’re also building in subscription models within their App Store and with Apple Music.
Secondary or support activities include all of the operational activities that don’t directly involve producing a product including firm infrastructure, human resources, technology, and procurement.
Infrastructure encompasses the business management, financial, and legal systems, and quality control within an organization. These are general management roles that must be filled to uphold the business.
Apple has their main headquarters in Cupertino, California but they also have satellite offices around the world to help maintain their research, manufacturing, and distribution.
Human resources is pretty self explanatory - it’s the management of human capital.
Apple employs over 137,000 individuals around the world. They have to have robust human resource management practices in place to keep the ball rolling.
Technology not only includes the technology a business uses to operate and produce products, but also the technology development process of producing new, innovative products and processes.
Apple is a technology company. They use technology to lower costs and to differentiate their products while also creating new products.
Procurement is the sourcing of raw materials from suppliers.
Apple has suppliers around the world for different pieces of technology and parts that go into each of their products.
Value chain analysis template
Now that you understand what a value chain analysis looks like and have a value chain example, it’s likely that you’re looking for a value chain analysis template to get started.
First, Michael Porter’s value chain model is going to be the first diagram you want to master.
As Porter wrote:
“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. Each of these activities can contribute to a firm's relative cost position and create a basis for differentiation."
Second is a value chain analysis template for cost/profit margins.
Use this when you are analyzing cost drivers versus expected profit margin.
How will you optimize your value chain?
Whether you’re focused on lower costs or product differentiation to increase profit margins, understanding value chains is the first step. Porter’s value chain model is a fantastic tool to help you optimize each phase of your business.
The next time you create a business strategy, break it down into primary and support activities and how you can optimize each phase of your strategy. Always think about your margins and the end user’s experience and you will find the ultimate success.
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