My thinking on strategy is heavily influenced by Michael Porter and his classic book Competitive Advantage introduced the concept of the value chain analysis.
The value chain is an original Porter concept although he built on the idea of the business system from strategy consultants McKinsey and its main purpose is to help you to find, create or develop competitive advantages.
Types of Competitive Advantage
Michael Porter argues that there are only two types of competitive advantage:
- competitive advantage that comes from differentiation – providing some kind of unique value to particular customers
- competitive advantage that comes from having the cost leadership position
While it would be nice to have both, under normal conditions, the two forms of competitive advantage are mutually exclusive and, if businesses fail to choose, they get stuck in the middle.
Michael Porter believes that these competitive advantages derive from the activities the business does which are:
- done better than competitors;
- done differently than competitors;
- that create unique benefits; or
- done at a lower cost than competitors.
To understand the source of competitive advantage then you need to perform a value chain analysis which identifies the separate value activities.
The Formal Elements of Value Chain Analysis
Porter built his value chain analysis model on a manufacturing business – back in 1985 there were many more around in the United States.
He split the value chain into two parts:
- Primary value activities
- Support value activities
Primary value activities included:
- Inbound logistics
- Outbound logistics
- Marketing & sales
- Customer service
Support value activities include:
- Human resources
- Firm infrastructure
This is a very general, helicopter view of a business and when you’re carrying out your value chain analysis you are supposed to go much more specific and detailed for your business.
You keep analysing activities which give a differentiation advantage (or have the potential to do so) or disadvantage and which have a cost advantage or disadvantage.
The idea of value chain analysis is that you understand how your business compares with competitors at a detailed level. You can go into a lot of detail for your own business but you’ll be surprised at what you can learn about your competitors by talking to ex-employees (who may already work for you), suppliers, customers and being the customer yourself.
The value chain has been criticised as too prescriptive because the value chain elements don’t fit all types of businesses. This is missing the point entirely.
You don’t have to follow Michael Porter’s categorisation – and I suspect that he’d be astonished if you did – but if you want to understand the sources of your competitive advantages in terms of differentiation and cost, you do need to perform a value chain analysis which fits your business/industry.
It does take some thought and effort but that can be more of a reason to do it. Your lazy, superficial competitors either won’t understand the value chain or will look at what’s involved and think “That’s too difficult”.
Adapting Value Chain Analysis For Differentiation Or Cost Leadership
In his book Competitive Advantage (a must-read for any strategy professional), there are long chapters for how you can use value chain analysis to create cost or differentiation competitive advantages.
You’ll have guessed from the title of my blog, I’m not a huge fan of the cost leadership. That’s because I think there’s always someone who can come along and product whatever [product or service you sell a bit cheaper. For a cost leadership strategy to work, you have to have a significant cost differential which competitors recognise. Otherwise, you’re caught in a commodity trap selling an undifferentiated product at lower and lower prices.
But you can’t ignore costs if you follow the differentiation advantage path.
If your main differentiators are in marketing and customer service then you must keep a focus on costs in the logistics and operations activities and all the support activities. Your differentiation advantage only excuses you incurring extra costs in the activities which create a competitive advantage and only then if the advantage outweighs the extra costs.
How To Do Value Chain Analysis: Identify Your Value Activities
Use Michael Porter’s model if you find it helpful but otherwise create your own high level process map for your business which can also be used for your competitors.
Then drill down to identify the individual activities which create a differentiation advantage or which incur significant costs. Group minor activities together in categories like “other marketing activities”.
It helps if there are several people working on the value chain analysis. Functional specialists who know what’s happening and others who can provide an outsider’s perspective and ask the “dumb questions” which can challenge conventional wisdom and provide significant insight.
How To Do Value Chain Analysis: Allocate Costs To The Value Chain Activities
You can spend a lot of time trying to allocate costs precisely but it’s a false exercise.
It’s much better to be approximately right than precisely wrong.
Activities will incur some costs directly while other costs need to be apportioned based on various assumptions. Don’t confuse the two since you can draw very different conclusions if you change the underlying assumptions.
How To Do Value Chain Analysis: Identify Sources Of Differentiation Advantage
Differentiation comes from:
- the way individual activities are performed
- the way related activities link together
- the way the entire value chain is structured
I recommend you work both ways:
From your current or desired key success factors and differentiation factors through to your value activities in a deliberate challenge to see what you can do to support your differentiation advantages.
Then from your individual activities back out to your customers by asking “is there anything in the way we do this activity (or could do the activity) which creates special value for the customer?”
Differentiation & Your Customer’s Value Chain
You can learn a lot from applying value chain analysis to your own business and thinking through how all the parts fit together to support your customer value proposition.
You may get even more insights by looking at the value chain of your typical customer (or different groups of customers) and identifying ways that you can add value or reduce costs to their business by better understanding:
- What your customers are trying to do.
- How they operate.
- Their problems and frustrations.
Having a better understanding of your market and the customers who make it up is potentially a big competitive advantage since it lets you develop better products and to respond to changing needs faster than your competitors.
Is The Value Chain Analysis Only For Big Businesses?
No I don’t think so.
Small businesses are often simpler to understand so it means a value chain analysis can be put together quicker.
There’s no getting away from the idea that competitive advantages and disadvantages flow from the activities you do in your business but you can only understand them and how they link together by doing value chain analysis.
The Value Chain And The Six Step Profit Formula
I use a Six Step Profit Formula to help keep strategic management grounded in what can help you to increase profits in the short and long term.
The value chain is useful in a number of steps. In particular, it has a role to play in helping you to develop your irresistible promise and making sure that you deliver it consistently. It also helps you to think through how you continue to get revenue and profit from the relationship.
The Value Chain Is A Strategic Planning Model
The Value Chain is one of the frameworks included in my Strategic Planning Models guide.
Click the link to fined out what other models could help you to develop a winning business strategy.
What Do You Think About Value Chain Analysis?
Do you find Michael Porter’s ideas for value chain analysis a useful technique for creating competitive advantage, analysing the advantages of competitors and spotting opportunities for advantage?
I’d like to know what you think so please leave a comment.
In particular, do you believe that value chain analysis is a suitable technique for SMEs and businesses that don’t have strategic planning specialists.