Value Chain Analysis

Value Chain Analysis is a method used to identify potential sources of economic or competitive advantage by integrating the organization's internal core competencies with its external environment in order to achieve optimal resource allocation.

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Porter's Value Chain

Before you can explain Value Chain Analysis, you need to understand what the Value Chain is.

The value chain is a concept developed and popularized by Michael Porter in his 1985 book, Competitive Advantage.

He developed a model which he hoped would enable organizations to identify and close any strategic gaps between the organization's internal capabilities and the external competitive environment.

The basic objective of doing value chain analysis is to create customer value in excess of the cost of delivering that value. Customer value is derived from the linking of the value creating activities that the organization performs.

Porter's value chain is composed of all of the activities and processes that an organization does to design, produce, market, deliver, and support its products or services.

The activities are classified as primary or support activities.

Primary activities include:

• Inbound logistics,
  (purchasing and inventory warehousing and handling)
• Operations,
  (the transformation of inputs into the final product or service)
• Outbound logistics,
  (distribution of the products or services)
• Marketing and sales, and
• Service.
  (post sale support).

Support activities include:

• Technology development,
• Human resource management, and
• Organizational infrastructure.

The price paid by the organization's customers less the cost of all of the activities in the value chain determines the organization's profit.

Basically the critical value-creating activities are the functions or activities within your organizations that form your value chain (i.e. Porter's primary and support activities). Value creating activities are those that:

• have different economic structures,
• contribute to a large or growing percentage of total costs, or
• either contribute to, or stands a high probability of contributing to product or service differentiation.

Internal Cost Analysis

An internal cost analysis involves assigning costs to each critical value-creating activity identified in the previous step.

Unless the organization has adopted activity based costing, it may be difficult to accurately isolate the costs of each activity.

It is also important at this point in the analysis to identify the cost drivers for each activity. Cost drivers are the reason that the cost occurs and can provide valuable information about individual activities and the inter-relationships between activities.

Industry Profit Pool

This step involve mapping out the industry value chain. You assume the perspective of your competitors and your customers to identify the value-creating activities that create competitive advantage within the industry.

Estimate the total size of the profit pool in your industry, and then your own knowledge of the economics of your own business and external sources of competitive information to work out how the profit is distributed across the industry value chain and identify possible sources of competitive advantage for your business.

Sources of external competitive information include financial statements, analyst reports, trade journals, industry associations and research studies.

Repeat as Necessary?

Repeat the process of analyzing your value chain periodically, to enable you anticipate and respond to changes in your industry.

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