The Value Chain and Competitive Advantage of the firm

Every firm is a collection of activities that are performed to design, produce, market,  deliver, and support its product.  All these activities can be represented using a value chain, shown in Figure 2-2. A firm’s value chain and the way it performs individual activities are a reflection of its history, its strategy, its approach  to implementing  its strategy, and the underlying economics of the activities themselves.

The relevant level for constructing a value chain is a firm’s activi­ ties in a particular industry (the business unit). An industry- or sector- wide value chain is too broad, because it may obscure im portant sources of competitive advantage. Though  firms in   the   same   industry  may have similar chains the value chains of competitors often differ. People Express   and   United  Airlines   both   compete  in   the   airline   industry, for example, but they have very different value chains embodying significant differences in boarding gate operations, crew policies, and aircraft operations.   Differences among  competitor  value chains are a key source of competitive advantage.  A firm’s value chain in an indus­ try may vary somewhat for different items in its product line, or differ­ ent buyers, geographic areas, or distribution channels. The value chains for such subsets of a firm   are closely   related,   however,   and  can only be understood in the context of the business unit chain.

Figure 2-2.  The Generic Value Chain

In competitive terms, value is the am ount  buyers  are willing to pay for what a firm provides them.  Value is measured  by total revenue, a reflection of the price a firm’s product commands  and  the units it can sell. A firm   is profitable if the value it commands  exceeds the costs involved in creating the product. Creating value for buyers that exceeds the cost of doing so is the goal of any generic strategy. Value, instead of cost, m ust be used in analyzing  competitive position since firms often deliberately raise their cost in order to command a premium price via differentiation.

The value chain displays total value, and consists of value activities and margin. Value activities are the physically   and   technologically distinct activities a firm performs. These are the   building   blocks by which a firm creates a product valuable to its buyers. Margin  is the difference between total   value   and   the   collective   cost   of  performing the value activities. Margin can be measured  in a variety of ways. Supplier and channel value chains also include a margin  that is impor­ tant to isolate in understanding  the sources of a firm’s cost position, since supplier and   channel  margin  are   part  of the   total   cost   borne by the buyer.

Every value activity employs purchased inputs, human  resources (labor and   management),  and  some   form   of   technology   to   perform its function. Each  value activity   also   uses   and   creates   information, such as buyer  data  (order  entry), performance  parameters  (testing), and product failure statistics. Value activities may also create financial assets such as inventory and accounts receivable, or liabilities such as accounts payable.

Value activities can be divided into two broad  types, primary activities and support activities. Prim ary activities, listed along the bottom of Figure 2-2, are the activities involved in the physical creation of the product and its sale and  transfer to the buyer as well as after­ sale assistance. In   any   firm,   prim ary   activities   can   be   divided   into the five generic categories shown  in Figure  2-2. Support  activities support the primary activities and each other by providing purchased inputs, technology, human  resources,   and  various firmwide functions. The dotted lines reflect the fact that procurement, technology develop­ ment, and human resource management can be associated with specific primary activities as well as support the entire chain. Firm intrastruc­ ture is not associated   with particular  primary  activities but  supports the entire chain.

Value activities are therefore the discrete building blocks of com­ petitive advantage. How each activity is performed combined with its economics will determine whether a firm is high or low cost relative to competitors. How each value activity is performed  will also deter­ mine its contribution to buyer needs and hence differentiation. Compar­ ing the value chains of competitors exposes differences that determine competitive advantage.3

An analysis of the value chain rather than value added is the appropriate way to examine competitive advantage.  Value added (sell­ ing price less the cost   of purchased  raw   materials)   has   sometimes been used as the focal   point   for cost   analysis because   it   was viewed as the area in which a firm can control  costs. Value added  is not a sound basis for cost analysis, however, because it incorrectly  distin­ guishes raw   materials  from   the   many  other  purchased  inputs  used in a firm’s activities. Also, the cost behavior of activities cannot be understood without simultaneously examining  the costs of the inputs used to perform them. Moreover, value added fails to highlight the linkages between a firm and its suppliers that can reduce cost or en­ hance differentiation.

1. Identifying Value Activities

Identifying value activities requires  the isolation of activities that are technologically and strategically distinct. Value activities and ac­ counting classifications are rarely the same. Accounting  classifications (e.g., burden, overhead, direct labor) group together activities with disparate technologies, and separate costs that are all part of the same activity.


There   are   five   generic   categories   of primary  activities   involved in competing in any industry,  as shown  in Figure  2-2. Each  category is divisible into a number of distinct activities that  depend  on the particular industry and firm  strategy:

  • Inbound Activities associated with receiving, storing, and disseminating inputs to the product, such as material han-dling, warehousing, inventory control, vehicle scheduling, and returns to suppliers.
  • Actitivies associated with transforming inputs into the final product form, such as machining, packaging, assembly, equipment maintenance,  testing, printing, and  facility opera­-tions.
  • Outbound    Activities associated with collecting, stor­-ing,   and  physically   distributing  the   product  to   buyers,   such as finished goods warehousing, material handling, delivery vehi­-cle operation, order processing, and scheduling.
  • Marketing and Activities associated with providing a means by which buyers can purchase the product and inducing them to do so, such as advertising, promotion, sales force, quot­-ing, channel selection, channel relations, and pricing.
  • Activities associated with providing service to enhance or maintain the value of the product, such as installation, repair, training, parts supply, and product adjustment.

Each of the categories may be vital to competitive  advantage depending on the industry. For a distributor, inbound and outbound logistics are the most critical. For  a service firm providing  the service on its premises such as a restaurant  or   retailer,   outbound  logistics may be largely nonexistant  and operations  the vital category. For a bank engaged in corporate lending, marketing and sales are a key to competitive advantage  through  the effectiveness of the calling officers and the way in which loans are   packaged  and   priced.   For  a high speed copier manufacturer, service represents a key source of competi­ tive advantage. In any firm, however, all the categories of primary activities will be present to some degree and play some role in competi­ tive advantage.


Support  value activities involved in competing  in   any   industry can be divided   into   four   generic   categories,   also   shown  in   Figure 2-2.   As   with   primary  activities,   each   category  of support  activities is divisible into a number  of distinct  value activities that  are specific to a given industry. In technology development, for example, discrete activities might include component design, feature design, field testing, process engineering, and technology  selection. Similarly, procurement can be divided into activities such as qualifying new suppliers, procure-nient of different groups of purchased inputs, and ongoing monitoring of supplier performance.

Procurement. Procurement refers to the function  of purchasing inputs used in the firm’s value chain, not to the purchased  inputs themselves. Purchased inputs include raw materials, supplies, and other consumable items as well as assets such as machinery, laboratory equip­ ment, office equipment, and buildings. Though purchased inputs are commonly associated with primary  activities, purchased  inputs  are present in every value activity including support activities. For exam­ ple, laboratory supplies and independent testing services are common purchased inputs  in technology development,  while an accounting firm is a common purchased input in firm infrastructure. Like all value activities, procurement employs a “ technology,”  such as procedures for dealing with vendors, qualification   rules,   and   information   sys­-tems.

Procurement tends to be spread  throughout a firm. Some items such as raw materials are purchased by the traditional purchasing department, while other items are purchased by plant managers (e.g., machines), office managers (e.g., tem porary  help), salespersons (e.g., meals and lodging), and even the chief executive officer (e.g., strategic consulting). I use the term procurement rather than purchasing because the usual connotation  of purchasing is too narrow  among  managers. The dispersion of the procurement function  often obscures the magni­-tude of total purchases, and means that many purchases receive little scrutiny.

A   given   procurement  activity   can   normally  be   associated   with a specific value activity   or activities   which   it   supports,  though  often a purchasing department serves many value activities and purchasing policies apply firmwide. The cost of procurement activities themselves usually   represents   a   small if not  insignificant portion  of total   costs, but often has a large impact on the firm’s overall cost and  differentia­ tion. Improved purchasing practices can strongly affect the cost and quality of purchased  inputs, as well as of other  activities associated with receiving and  using   the   inputs,  and  interacting  with   suppliers. In chocolate manufacturing and electric utilities, for example, procure­ ment of cocoa beans and fuel respectively is by far the most important determinant of cost position.

Technology Development.    Every   value   activity   embodies technol-equipment. The array of technologies employed in most firms is very broad,  ranging from those technologies used in preparing  documents and transporting goods to those technologies embodied in the product itself. Moreover,  most  value activities use a technology  that  combines a number of different subtechnologies involving different scientific disci­ plines. Machining, for example, involves metallurgy, electronics, and mechanics.

Technology development consists of a range  of activities that can be broadly grouped into efforts to improve the product and the process. I term this category of activities technology development instead of research and development because R& D has too narrow a connotation to most managers.  Technology  development  tends  to be associated with the engineering department or the development group. Typically, however, it occurs in many parts of a firm, although this is not explicitly recognized. Technology development may support any of the numerous technologies embodied in value activities, including such areas as tele­ communications technology for the order entry system, or office auto­ mation for the accounting department. It does not solely apply to technologies directly linked to the end  product.  Technology  develop­ ment also takes many  forms, from basic research  and  product  design to media research, process equipment design, and servicing procedures. Technology development that is related to the product and its features supports the entire chain, while other technology development is associ­ ated with particular primary or support activities.

Technology development is im portant to competitive  advantage , in all industries, holding  the key in some. In   steel,   for   example,   a firm’s process technology is the single greatest factor in competitive advantage.   The  competitive   implications  of  the   array  of  technologies in the value chain are treated in  Chapter 5.

Human Resource Management. H um an resource management consists of activities involved in the recruiting, hiring, training, develop­ ment, and compensation of all types of personnel. H um an resource management supports both individual prim ary and support activities (e.g., hiring of engineers) and the entire value chain (e.g., labor negotia­ tions). Human  resource  management activities occur in different parts of a firm, as do other support activities, and the dispersion of these activities can lead to inconsistent  policies. Moreover,  the cumulative costs of human  resource management are rarely well understood  nor are the tradeoffs in different hum an resource  management costs, such as salary compared to the cost of recruiting and training due to turn­ over.

Human resource management affects competitive  advantage  in any firm, through  its   role in determining  the   skills and  motivation of employees and  the cost of hiring  and  training.  In   some  industries it holds the key to competitive advantage. The world’s leading account­ ing firm A rthur Andersen, for example, draws a significant competitive advantage from its approach to recruiting and training  its tens of thousands of professional staff. A rthur Andersen has bought a former college campus  near  Chicago, and  has   invested   heavily   in codifying its practice and regularly bringing staff from around  the world  to its college for training in the firmwide methodology. Having a deeply understood methodology throughout the firm not only makes all en­-gagements more effective but also greatly facilitates the servicing of national and multinational clients.

Firm Infrastructure. Firm infrastructure consists of a number of activities including general management, planning, finance, accounting, legal, government affairs, and quality management. Infrastructure, un­ like other  support  activities,   usually  supports  the entire chain  and not individual activities.   Depending  on   whether  a firm   is diversified or not,   firm   infrastructure  may   be self-contained   or divided   between a business unit and the parent corporation.4 In diversified firms, infra­ structure activities are typically split between the business unit  and corporate levels (e.g., financing is often done  at the corporate  level while quality management is done at the business unit level). Many infrastructure activities occur at both the business unit  and  corporate levels, however.

Firm infrastructure is sometimes viewed only as “ overhead,” but can be a powerful source of competitive advantage. In a telephone operating company, for example, negotiating and maintaining ongoing relations with regulatory bodies can be among the most  important activities for competitive advantage. Similarly, proper management information systems can contribute  significantly to cost position,   while in some industries  top management plays a vital role in dealing with the buyer.


Within each   category  of prim ary   and  support  activities,   there are three activity types that play a different role in competitive advan-tage:

  • Direct. Activities directly involved in creating value for the buyer, such as assembly, parts machining, sales force operation, advertising, product design, recruiting, etc.
  • Indirect. Activities that make it possible to perform direct ac­ tivities on a continuing basis, such as maintenance, scheduling, operation of facilities, sales force administration, research ad­ ministration, vendor record keeping, etc.
  • Quality Assurance. Activities that ensure the quality of other activities, such as monitoring, inspecting, testing, reviewing, checking, adjusting, and reworking. Quality assurance is not synonymous with quality management, because many value activities contribute to   quality,   as will be discussed   in Chapter 4.

Every firm has direct, indirect, and quality assurance  value activi­ ties.   All three types are present  not  only   among  primary  activities but also among support activities. In technology development,  for example, actual laboratory teams are direct activities, while research administration is an indirect activity.

The  role of indirect and quality assurance  activities is often not well understood, making the distinction  among the three activity types an important one for diagnosing competitive advantage. In many indus­ tries, indirect activities represent  a large and rapidly growing propor­ tion of cost and   can play a significant role in differentiation through their effect on direct activities. Despite this, indirect activities are fre­ quently lumped together with direct  activities when managers  think about their firms, though the two often have very different economics. There are often tradeoffs between direct and indirect activities— more spending   on   maintenance  lowers   machine  costs.   Indirect  activities are also frequently grouped together into “ overhead” or “ burden” accounts, obscuring their cost and contribution to differentiation.

Quality assurance  activities are also   prevalent  in   nearly   every part  of a firm, though  they are seldom   recognized   as such.   Testing and inspection are associated with many  primary  activities. Quality assurance activities outside of operations are often less apparent though equally prevalent. The  cumulative  cost of quality assurance  activities can be very large, as recent attention to the cost of quality has demon­ strated. Quality assurance  activities often affect the cost or effectiveness of other activities, and the way other activities are performed  in turn affects the need for and types of quality assurance activities. The possi­ bility of simplifying or eliminating the need for quality assurance activi­ties through performing other activities better is at the root  of the notion that quality can be “free.”

2. Defining the Value Chain

To diagnose competitive advantage,  it is necessary to define a firm’s value chain for competing  in a particular  industry.  Starting with the generic chain, individual value activities are identified in the particular firm. Each generic category can be divided into discrete activities, as illustrated for one generic category in Figure 2-3. An example of a complete value chain is shown  in Figure 2-4,  the value chain of a copier manufacturer.

Defining relevant value activities requires  that activities with dis­ crete technologies   and   economics   be   isolated.   Broad   functions   such as manufacturing or marketing m ust be subdivided into activities. The product flow, order flow or paper flow can be useful in doing so. Subdividing activities can proceed to the level of increasingly narrow activities that are to some degree discrete. Every machine in a factory, for example, could be treated  as a separate  activity. Thus the number of potential activities is often quite large.

The appropriate degree of disaggregation depends on the econom­ ics of the activities and the purposes  for which the   value chain   is being analyzed. Though I will return  to this question in later chapters, the basic principle is that  activities should  be isolated and   separated that (1) have different   economics,   (2)   have   a   high   potential  impact of differentiation, or (3) represent  a significant or growing  proportion of cost.   In   using   the   value   chain,   successively   finer   disaggregations of some activities are made as the analysis exposes differences important to competitive advantage; other activities are combined  because they prove to be unimportant  to   competitive  advantage  or are   governed by similar economics.

Selecting the appropriate  category  in which to put  an   activity may require judgment and can be illuminating in its own right. Order processing, for example, could be classified as part of outbound logistics or as part  of marketing.  In a distributor,  the role of order processing is more a marketing function. Similarly, the sales force often performs service functions. Value   activities   should   be   assigned   to   categories that best represent their contribution  to a firm’s competitive advantage. If order  processing is an im portant  way in   which   a firm   interacts with its buyers, for example, it should be classified under marketing.

Figure 2 -3 .    Subdividing a Generic Value Chain

Figure 2 -4 .    Value Chain for a Copier Manufacturer

Similarly, if inbound material handling and  outbound  material han­ dling use the same facilities and personnel,  then  both  should probably be combined into one value activity and classified wherever the function has the greatest competitive impact. Firm s have often gained competi­ tive advantage  by redefining the roles of traditional  activities— Vetco, an oil field equipment supplier, uses customer training  as a marketing tool and a way to build switching costs, for example.

Everything a firm does should be captured in a primary or support activity. Value activity labels are arbitrary  and should be chosen to provide the best insight into the business. Labeling activities in service industries often causes confusion because operations, marketing, and after-sale support are often closely tied. Ordering of activities should broadly follow the process flow, but ordering  is judgmental  as well. Often firms perform  parallel activities,   whose order  should  be chosen to enhance the intuitive clarity of the value chain to managers.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.

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