How does your business gain a competitive advantage?
You really have two choices: Product differentiation or cost reduction.
In order to beat competitors and gain a competitive advantage, a business must understand their value chain framework from start to finish.
This process is called value chain analysis.
What is a value chain?
A value chain is a culmination of all the business strategies and processes involved in the production process and product lifecycle. Not to be confused with a supply chain, which includes specific activities, primarily the technical processes of creating a finished product.
The value chain concept as we know it today was created by Michael E. Porter a professor at Harvard Business School. He introduced the topic in his book Competitive Advantage: Creating and Sustaining Superior Performance, meticulously breaking down the operations of a company into strategic activities, adding value from inputs to outputs, and thereby enhancing operational effectiveness.
In the book Competitive Advantage, Porter explains how organizations can systematically dissect their processes and metrics to identify areas where they can innovate, optimize, and create the most value to set them apart in the marketplace.
Value chain activities include both primary and secondary activities. Primary activities are the actual steps included in building a product, including inbound and outbound logistics, operations, marketing and sales, and, finally, services.
Secondary or support activities in the value chain encompass the processes that support the primary activities and are also known as business activities. These include procurement, human resource management, firm infrastructure, and technology.
To learn more about value chains, and their primary and support activities, read our Complete Guide to Value Chains.
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 your company’s 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 advantage refers to having a unique offering or a specialized finished product. This enables the company to charge a premium price. A product’s value and differentiation are usually the result of a combination of research and development and quality assurance. 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.
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‚Äôs product design focuses on creating high-quality products that are unique in their capabilities.
Outbound logistics is the warehousing and delivery of finished goods, including managing distributors and all distribution channels.
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.
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‚Äôre 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‚Äôt 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.
Are you ready to conduct a value chain analysis?
Understanding whether your business is focused on differentiation or cost advantages is the first step in conducting a value chain analysis. Once you’ve locked that in, you must break down each step in both primary and secondary activities throughout the process of building your product. Take a step back and understand which processes can be eliminated or automated to reduce costs while increasing margins.
Remember, it’s all about creating value everywhere, both for your end user and your shareholders.
Keep reading about value chains in our complete guide.