Value Chain Analysis (With Diagram)| Cost Accounting

In this article we will discuss about the Value Chain:- 1. Meaning of Value Chain Analysis 2. Steps in Value Chain Analysis 3. Linking to Competitive Advantages 4. Assessing Competitive Advantage 5. Problems.

Contents:

  1. Meaning of Value Chain
  2. Steps in Value Chain Analysis
  3. Linking Value Chain Analysis to Competitive Advantages
  4. Value Chain Analysis for Assessing Competitive Advantage
  5. Problems of Value Chain Analysis



1. Meaning of Value Chain Analysis
:

The term ‘Value Chain’ was used by Michael Porter in his book “Competitive Advantage: Creating and Sustaining Superior Performance” (1985). The value chain analysis describes the activities the organization performs and links them to the organization competitive position.

Value chain analysis describes the activities within and around an organization, and relates them to an analysis of the competitive strength of the organization. Therefore, it evaluates which value each particular activity adds to the organization’s products or services. This idea was built upon the insight that an organization is more than a random compilation of machinery, equipment, people and money.

Only if these things are arranged into systems and activate systematically it will become possible to produce something for which customers are willing to pay a price. Porter argues that the ability to perform particular activities and to manage the linkages between these activities is a source of competitive advantage.

Porter distinguishes between primary activities and support activities. Primary activities are directly concerned with the creation of delivery of a product or service. They can be grouped into five main areas: inbound logistics, operations, outbound logistics, marketing and sales and service.

Each of these primary activities is linked to support activities which help to improve their effectiveness or efficiency. There are four main areas of support activities: procurement, technology development (including R & D), human resource management, and infrastructure (systems for planning, finance, quality, information management, etc.).

The basic model of Porter’s Value is as follow:

Basic Model of Porter's Value

The term, ‘Margin’ implies that organizations realize a profit margin that depends on their ability to manage the linkages between all activities in the value chain. In other words, the organization is able to deliver a product/service for which the customer is willing to pay more than the sum of the costs of all activities in the value chain.

Primary Activities:

Primary Activity

Support Activities:

Support activities include:

Secondary Activity



2. Steps in Value Chain Analysis
:

Value chain analysis can be broken down into a three sequential steps:

(a) Breakdown a market/organisation into its key activities under each of the major headings in the model;

(b) Assess the potential for adding value via cost advantage or differentiation, or identify current activities where a business appears to be at a competitive disadvantage.

(c) Determine strategies built around focusing on activities where competitive advantage can be sustained.

These linkages are crucial for corporate success. The linkages are flows of information, goods and services, as well as systems and processes for adjusting activities.

Their importance is best illustrated with some simple examples:

Only if the Marketing and Sales function delivers sales forecasts for the next period to all other departments in time and in reliable accuracy, procurement section will be able to order the necessary material for the correct date.

And only if procurement section does a good job and forwards order information to inbound logistics, only then operations will be able to schedule production in a way that guarantees the delivery of products in a timely and effective manner—as pre-determined by marketing.

In the result, the linkages are about seamless cooperation and information flow between the value chain activities. In most industries, it is rather unusual that a single company performs all activities from product design, procurement of components, and final assembly to delivery to the final user by itself.

Most often, organizations are elements of a value system or supply chain. Hence, value chain analysis should cover the whole value system in which the organization operates.

Within the whole value system, there is only a certain value of profit margin available. This is the difference of the final price the customer pays and the sum of all costs incurred with the production and delivery of the products/service (e.g. raw material, energy etc.).

It depends on the structure of the value system, how this margin spreads across the suppliers, producers, distributors, customers, and other elements of the value system.

Each member of the system will use its market position and negotiating power to get a higher proportion of this margin. Nevertheless, members of a value system can cooperate to improve their efficiency and to reduce their costs in order to achieve a higher total margin to the benefit to all of them (e.g. by reducing stocks in a Just-in-Time system).

A typical value chain analysis can be performed in the following steps:

a. Analysis of own value chain—which costs are related to every single activity.

b. Analysis of customers value chains—how does our product fit into their value chain.

c. Identification of potential cost advantages in comparison with competitors.

d. Identification of potential value added for the customer—how can our product add value to the customer’s value chain (e.g. lower costs or higher performance)—where does the customer see such potential.



3. Linking Value Chain Analysis to Competitive Advantages
:

What activities a business undertake is directly linked to achieving competitive advantage. For example, a business which wishes to outperform its competitors through differentiating itself through higher quality will have to perform its value chain activities better than the opponents.

By contrast, a strategy based on seeking cost leadership will require a reduction in the costs associated with the value chain activities, or a reduction in the total amount of resources used.



4. Value Chain Analysis for Assessing Competitive Advantage
:

Value chain analysis is a way of assessing competitive advantage by determining the strategic advantages and disadvantages of the full range of activities that shape the final offering to the end user. These activities include not only in-company activities but also activities outside the company (e.g. at the supplier, distribution and disposal/recycling levels).

In other words, the company is viewed as part of an overall chain of value-creating processes focused on the customer.

Value chain analysis enables a company to better understand which segments, distribution channels, price points, product differentiation, selling propositions and which value chain configurations (i.e., linkages between activities/processes within and outside the company) will yield the greatest competitive advantage.

A key concept for value chain analysis is to de-emphasise functional structure and adopt a process perspective—that is, a horizontal view of the organization beginning with product inputs and ending with outputs and customers. Processes are structured and measured sets of activities designed to produce a specified output for a particular customer or market.

Emphasizing process means focusing not on what work is done but how it is done. Often this perspective calls for reclassifying value activities—for example, if order processing is important to a company’s customer interactions, then this activity should be classified under marketing.

Here’s how value chain analysis helps organizations assess competitive advantage:

Internal Cost Analysis:

Determining the sources of profitability and the relative cost positions of internal value-creating processes.

Internal Differentiation Analysis:

Understanding the sources of differentiation (including the cost) within internal value-creating processes.

Vertical Linkage Analysis:

Understanding the relationships and associated costs among external suppliers and customers in order to maximize the value delivered to customers and to minimize cost.

Vertical linkage analysis is aimed at developing competitive advantage through linkages between a company’s value-creating activities and those of its suppliers, channels or users.

Understanding vertical linkages is not always easy—for example, calculating a rate of return on assets requires obtaining information on operating costs, revenues and assets for each process throughout the industry’s value chain—something that can be very difficult.

Evaluating opportunities for sustainable cost advantage involves gauging one’s competitive position by knowing the competitor’s value chains (internal and external) and rates of return on each. Internal cost, revenue and asset data for a competitor’s processes are generally unavailable, so quantitative analysis will not usually be feasible.

However, qualitative information on a competitor’s value-creating processes and the strategies for each usually exists. By understanding how other companies compete in each process of the industry value chain, a company can use the qualitative analysis to seek out competitive niches even financial data is unavailable.

Three Strategic Frameworks for Value Chain Analysis are:

To organize and analyse value chain information, and to summarize findings and recommendations, three useful frameworks are:

Industry Structure Analysis:

The profitability of an industry or market—measured by the long-term ROI of the average company—depends on five factors that influence profitability. These are: bargaining power of buyers, bargaining power of suppliers, threat of substitute products or services, threat of new entrants and intensity of competition.

Core Competency Analysis:

Core competencies are distinctive skills, intellectual assets and cultural capabilities such as the ability to learn and team working.

Here the value chain approach rails for:

Validating core competencies in current businesses.

Exporting or leveraging them to value chain of other existing businesses.




5. Problems of Value Chain Analysis
:

There are several problems when using VC analysis in relation to cost effective management as given below:

a. Incorrect Allocation of Costs within the Chain:

Certain costs are extremely difficult to allocate to certain individual products, but they are the costs of activities which are very significant in relation to total quality and in turn competitive advantage. Failure of production equipment is an example of this, affecting a number of products making them late for delivery and causing priorities to change.

Problem arises as how to allocate costs? As modern production systems are becoming more complex, the ratio of overheads to total costs is likely to increase in relation to material and labour. The absolute allocation of these overheads is difficult.

b. Long and Time Consuming Process:

If the total philosophy of value chain is not adopted, there is risk of overlooking strategic aspects in decision making. This exercise needs to be repeated again and again looking at competition, both in the present and in the future.

c. Non Availability of Information regarding Competition, Product Lines and Structure:

The whole exercise of developing a value chain in practice may be very difficult as the information required is very seldom available.

d. Assumptions:

Another problem inherent when using VC analysis is that management accountant has to make lot of assumptions or suppositions because of non-availability of information. These may be correct. However, very unlikely that they will be so in their entirety, there is a danger that these inaccuracies could be magnified and lead to incorrect strategic decisions.

For these reasons, VC analysis should not be seen as a cure for all the business costing strategy. The role of VC, however, does give an insight which lays down a useful framework allowing us to consider activities involved in production of service and products in relation to customer significance.


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