The value chain and cost analysis

The behavior of a firm’s costs and  its relative cost position stem from the value activities the firm performs in competing in an industry. A meaningful cost analysis, therefore,  examines costs within these activities and not the costs of the firm as a whole. Each  value activity has its own cost structure and the behavior of its cost may be affected by linkages   and   interrelationships  with   other  activities   both   with­ in and   outside   the   firm.   Cost advantage  results   if the   firm   achieves a lower cumulative cost of performing value activities than  its com­ petitors.

1. Defining the Value Chain for Cost  Analysis

The starting  point  for   cost   analysis   is   to   define   a   firm’s value chain and to assign operating  costs and  assets to value activities. Each activity   in the                    value   chain      involves both   operating  costs and assets in the form of fixed and working  capital.    Purchased inputs makeup part  of the cost of every value activity, and can   contribute  to both operating costs (purchased   operating   inputs)   and   assets   (purchased assets). The  need   to   assign   assets   to   value   activities   reflects   the   fact that  the amount  of assets in an activity and the efficiency of asset utilization are frequently im portant to the activity’s cost.

For purposes of cost analysis, the disaggregation  of the generic value chain into individual  value activities should  reflect three princi­ ples that are not mutually exclusive:

  • the size and growth of the cost represented  by the activity
  • the cost behavior of the activity
  • competitor differences in performing the activity

Activities   should  be separated  for cost   analysis if they   represent a significant or rapidly growing percentage of operating costs or assets. While most firms can easily identify   the   large components  of their cost, they frequently overlook smaller but growing value activities that can eventually change their cost structure.  Activities that represent a small and stagnant percentage of costs or assets can be grouped together into broader categories.

Activities must also be separated  if they have different cost drivers, to be defined in more  detail below. Activities with similar cost drivers can be safely grouped  together. For  example, advertising and promo­ tion   usually   belong   in   separate   value   activities   because   advertising cost is sensitive to scale while promotional  costs are largely variable. Any activity a business unit shares  with others  should  also be treated as a separate value   activity   since conditions  in other  business units will affect its cost behavior. The  same   logic   applies to   any   activity that has im portant linkages with other activities. In practice, one does not always know the drivers of cost behavior  at the beginning of an analysis; hence the identification of  value activities tends  to require several iterations. The initial breakdown  of the value chain into activi­ ties will inevitably represent  a best guess of im portant  differences in cost behavior. Value activities can then  be aggregated  or disaggregated as further analysis exposes differences or similarities in cost behavior. Usually an aggregated value chain is analyzed first, and then particular value activities that prove to be im portant  are investigated in greater detail.

A final test for  separating value activities is the behavior of com­ petitors. Significant activities should be treated separately when a com­ petitor performs them in a different way.1 For example, People Express and other  no-frills airlines   offer very   different on-board  service than the established trunk carriers such as American, Eastern,  TW A, and United. Differences among competitors raise the possibility that  an activity is the source of a relative cost advantage or disadvantage.

2. Assigning Costs and Assets

After identifying its value chain, a   firm   must  assign   operating costs and assets to value activities. Operating  costs should be assigned to the activities in which they are incurred.  Assets should  be assigned to the activities that  employ,   control,  or   most  influence   their   use. The assignment of operating costs is straightforward in principle, al­ though it can be time-consuming.  Accounting records must often be recast to match costs with value activities rather than with accounting classifications, particularly in areas such as overhead and purchased inputs.

Since assets are expensive and their selection and use often involve tradeoffs with operating costs, assets m ust be assigned to value activities in some way that will permit an analysis of cost behavior. Assignment of assets to activities is more  complex  than  assignment  of operating costs. Asset accounts must usually be regrouped to correspond  to activities, and  assets must  be valued in some  consistent  way.   There are two broad  approaches to assigning assets. They  may be assigned at their book or replacement  value and  compared  to operating  costs in this form, or book or replacement value may be translated  into operating costs via capital charges. Either valuation approach poses difficulties. Book   value may   be   meaningless because it is sensitive to the timing of initial purchase and to accounting policies. Calculating replacement value is also frequently a difficult task. Similarly, deprecia­ tion schedules are often arbitrary, as are capital charges for both fixed and current assets. The particular m ethod chosen to value assets should reflect industry characteristics, which in turn will determine the most significant biases inherent  in the data  and  the practical  considerations in collecting it. The analyst m ust recognize the biases inherent  in whatever m ethod is chosen.2 It may prove illuminating for cost analysis to assign assets in several ways.

The costs and assets of shared value activities should be allocated initially to the value chain of the business unit using whatever method­ ology the firm currently employs, typically based on some  allocation formula. The cost behavior of a shared value activity reflects the activity as a whole and  not just the part  that is attributable  to one business unit. The cost of a scale-sensitive shared activity will depend  on the volume of all involved business units, for example. In addition,  the allocation formulas covering shared activities may not reflect their economics but may have been set based on convenience or political considerations. As  the analysis proceeds,  the costs of shared  activities can be refined using more  meaningful  allocation  methods  based on the cost behavior of the activities.

The time period chosen for assigning costs and  assets to value activities should be representative of a firm’s performance. It should recognize seasonal or cyclical fluctuations  and  periods of discontinuity that would affect cost. The comparison of costs at different points in time can illuminate the effect of strategy changes, as well as help diagnose cost behavior itself. Looking at the cost of an activity during successive periods can highlight learning effects, for example, while comparing costs during  periods of  widely differing levels of  activity may give some indications about scale sensitivity and the role of capac­ ity utilization.

It is im portant to remember that assigning costs and assets does not require the precision needed for financial reporting  purposes. Esti­ mates are often more  than  sufficient to highlight strategic cost issues, and can be employed in assigning costs and  assets to value activities where generating  accurate  cost figures would  require great  expense. As the analysis proceeds and particular value activities prove to be important to cost advantage, greater efforts at precision can be made. Finally, a firm may find that competitors assign their operating costs and assets differently. The  way in which  competitors  measure  their costs is im portant  because it will   influence   their  behavior.   Part  of the task of competitor cost analysis is to attem pt to diagnose competitor costing practices.

3. First Cut  Analysis of Costs

The  allocation   of  costs and  assets   will produce  a   value chain that illustrates graphically  the distribution  of  a firm’s costs. It can prove revealing to separate the cost of each value activity into three categories: purchased operating inputs, hum an resource costs, and as­ sets by m ajor category. The  proportions  of the value chain can be drawn to reflect the distribution  of  costs and  assets among  activities as shown in Figure 3-1.

Even the initial allocation of operating  costs and  assets to   the value chain may suggest areas for cost improvement. Purchased operat­ ing inputs will often represent a larger proportion of costs than com­ monly perceived,   for example,   because   all   the   purchased  inputs  in the value chain are rarely cumulated. O ther insights can result from grouping value activities into direct, indirect  and  quality assurance activities as defined in Chapter 2, and cumulating costs in each cate­ gory. Managers often fail to recognize burgeoning indirect costs and have a tendency to focus almost exclusively on direct costs. In many firms, indirect  costs not  only   represent  a large proportion  of total cost but also have grown more rapidly than other cost elements. The introduction of sophisticated information systems and automated pro­ cesses is reducing direct costs but boosting indirect costs by requiring such things as sophisticated  maintenance and computer programmers to prepare machine tapes. In valve manufacturing, for example, indirect cost represents more  than  10 percent  of total  cost. Firms  can also find that  the sum   of all quality assurance  activities in the value chain is strikingly large. In many industries, this has led to the growing conclusion that other approaches  to quality assurance besides inspec­ tion, adjusting, and testing can yield large cost savings.

Figure 3 -1 .    Distribution of Operating Costs and Assets in Flow Control Valves

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

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