To analyse the specific activities through which firms can gain a competitive advantage, it is useful to model the firm as a chain of value creating activities. For this purpose, Porter identified a range of interrelated generic activities common to a wide range of firms. The resulting model is known as the value chain.
According to Porter (1985),
” Competitive Advantage arises out of the way firms organise and arrange discrete activities”.
Through using the Value Chain, the activities performed by a firm competing in a particular industry can be grouped into categories as shown in the model below:
Upstream Activities Downstream Activities
Porter distinguishes between primary activities and support activities. Primary activities are directly concerned with the creation or delivery of a product or service. The goal of the primary activities is to create value that exceeds the cost of providing the product or service and therefore generating a profit margin.
They can be grouped into five main areas:
1. Inbound Logistics: Includes the receiving, warehousing and inventory control of input materials
2. Operations: The value creating activities that transform the inputs into the final product
3. Outbound logistics: activities required to get the finished product to the customer e.g. order fulfilment
4. Marketing and sales: Activities associated with getting buyers to buy the product e.g. advertising
5. Service: Activities that maintain and enhance the products value e.g. customer 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:
1. Procurement: Purchasing of raw materials and other inputs used in the value creation process
2. Technology development (including R&D): Process automation and other technology development used to support the value chain activities
3. Human Resource Management: Recruitment, development and compensation of employees
4. Infrastructure: Systems for planning, finance, quality, information management etc.
The corporate strategy adopted by the firm guides the performance of individual activities and organises its entire value chain. It is important to remember that each activity is generic and may vary depending on the industry. In consumer goods advertising and marketing are crucial, whilst in manufacturing this is practically non-existent and it is the primary activities such as logistics that are used to add value.
Value Chain Competency
The Value Chain is useful for defining the firm’s core competencies and the activities in which it can pursue a competitive advantage as follows:
q Cost Advantage- by better understanding costs they can be eliminated from the value adding process
q Differentiation- by focusing on those activities associated with core competencies and capabilities in order to perform them better than competitors
A firm may create a cost advantage either by reducing the cost of individual value chain activities or by reconfiguring the value chain. A differentiation advantage can arise from any part of the value chain e.g. procurement of inputs that are unique to competitors. Ultimately, differentiation arises from uniqueness. A differentiation advantage may be gained by changing individual value chain activities to increase uniqueness in the final product or also by reconfiguring the value chain.
Frequently, firms gain competitive advantage by conceiving new ways to conduct activities, employing new procedures or utilising different inputs. Allied Irish Banks are currently using customer relationship marketing (CRM) as a way of gaining competitive advantage and adding value to their business.
The term ‘margin’ is used within the model and implies that organisations realise a profit margin that depends on their ability to manage the linkages between all activities in the value chain. In other words, the organisation 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.
As mentioned, gaining competitive advantage requires that a firm’s value chain be managed as a system rather than a collection of separate parts. Reconfiguring the value chain by relocation, reordering or even eliminating certain activities can often lead to a major improvement in competitive position.
Upstream and Downstream
A firm’s value chain links to the value chains of the upstream suppliers and downstream buyers. The result is a larger stream of activities known as the
value system. The development of a firm specific competitive advantage not only depends on the firms value chain but also on the value system of which the firm is a part. In most industries, it is rather unusual that a single company performs all activities from product design, production of components, and final assembly to delivery to the final user by itself. Most often, organisations 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 product/service. 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 of 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:
1. Analysis of own value chain – which costs are related to every single activity
2. Analysis of customer’s value chains – how does our product fit into their value chain
3. Identification of potential cost advantages in comparison with competitors
4. 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?
Outsourcing is becoming a popular option for firms in streamlining their value chain. This is where they specialise in one or more of the value chain activities and outsource the remainder. The extent to which a firm performs its upstream and downstream activities is described by the degree of vertical integration. A thorough value chain analysis can illuminate the business system to facilitate outsourcing decisions. To decide which activities to outsource managers must understand the firm’s strengths and weaknesses in each activity, both in terms of cost and ability to differentiate. Managers may consider the following when deciding whether to outsource:
1. Can the activity be performed cheaper or better by suppliers?
2. Is the activity a core competency, from which the firm gains cost or differentiation advantage?
3. The degree of risk in performing the activity in-house. For example, if the activity involves fast changing technology it may be beneficial to outsource the activity to remain flexible and avoid the risk of investing in specialised assets.
4. Will outsourcing result in business process improvements e.g. reduced lead-time, reduced inventory, increased flexibility etc.
Bank of Ireland have recently outsourced their I.T department to Hewlett Packard as they realised they did not have a competitive advantage in this area and it would be undertaken more efficiently by another company.