Successful businesses create value with each transaction—for their customers in the form of satisfaction and for themselves and their shareholders in the form of profit. Companies that generate greater value with each sale are better positioned to profit than those that produce less value.
To evaluate how much value your company is creating, it’s critical to understand its value chain. Below is a look at what a value chain is, why it’s important to understand, and steps you can take to conduct one and help your company create and retain more value from its sales.
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The term value chain refers to the various business activities and processes involved in creating a product or performing a service. A value chain can consist of multiple stages of a product or service’s lifecycle, including research and development, sales, and everything in between. The concept was conceived by Harvard Business School Professor Michael Porter in his book The Competitive Advantage: Creating and Sustaining Superior Performance.
Taking stock of the processes that comprise your company’s value chain can help you gain insight into what goes into each of its transactions. By maximizing the value created at each point in the chain, your company can be better positioned to share more value with customers while capturing a greater share for itself. Similarly, knowing how your firm creates value can enable you to develop a greater understanding of its competitive advantage.
Components of a Value Chain
According to Porter’s definition, all of the activities that make up a firm's value chain can be split into two categories that contribute to its margin: primary activities and support activities.
Primary activities are those that go directly into the creation of a product or the execution of a service, including:
- Inbound logistics: Activities related to receiving, warehousing, and inventory management of source materials and components
- Operations: Activities related to turning raw materials and components into a finished product
- Outbound logistics: Activities related to distribution, including packaging, sorting, and shipping
- Marketing and sales: Activities related to the marketing and sale of a product or service, including promotion, advertising, and pricing strategy
- After-sales services: Activities that take place after a sale has been finalized, including installation, training, quality assurance, repair, and customer service
Secondary activities help primary activities become more efficient—effectively creating a competitive advantage—and are broken down into:
- Procurement: Activities related to the sourcing of raw materials, components, equipment, and services
- Technological development: Activities related to research and development, including product design, market research, and process development
- Human resources management: Activities related to the recruitment, hiring, training, development, retention, and compensation of employees
- Infrastructure: Activities related to the company’s overhead and management, including financing and planning
What Is Value Chain Analysis?
Value chain analysis is a means of evaluating each of the activities in a company’s value chain to understand where opportunities for improvement lie.
Conducting a value chain analysis prompts you to consider how each step adds or subtracts value from your final product or service. This, in turn, can help you realize some form of competitive advantage, such as:
- Cost reduction, by making each activity in the value chain more efficient and, therefore, less expensive
- Product differentiation, by investing more time and resources into activities like research and development, design, or marketing that can help your product stand out
Typically, increasing the performance of one of the four secondary activities can benefit at least one of the primary activities.
How to Conduct a Value Chain Analysis
1. Identify Value Chain Activities
The first step in conducting a value chain analysis is to understand all of the primary and secondary activities that go into your product or service’s creation. If your company sells multiple products or services, it’s important to perform this process for each one.
2. Determine the Cost and Value of Activities
Once the primary and secondary activities have been identified, the next step is to determine the value that each activity adds to the process, along with the costs involved.
When thinking about the value created by activities, ask yourself: How does each increase the end user’s satisfaction or enjoyment? How does it create value for my firm? For example, does constructing the product out of certain materials make it more durable or luxurious for the user? Does including a certain feature make it more likely your firm will benefit from network effects and increased business?
Similarly, it’s important to understand the costs associated with each step in the process. Depending on your situation, you may find that lowering expenses is an easy way to improve the value each transaction provides.
3. Identify Opportunities for Competitive Advantage
Once you’ve compiled your value chain and understand the cost and value associated with each step, you can analyze it through the lens of whatever competitive advantage you’re trying to achieve.
For example, if your primary goal is to reduce your firm’s costs, you should evaluate each piece of your value chain through the lens of reducing expenses. Which steps could be more efficient? Are there any that don’t create significant value and could be outsourced or eliminated to substantially reduce costs?
Similarly, if your primary goal is to achieve product differentiation, which parts of your value chain offer the best opportunity to realize that goal? Would the value created justify the investment of additional resources?
Using value chain analysis, you can uncover several opportunities for your firm, which can prove difficult to prioritize. It’s typically best to begin with improvements that take the least effort but offer the greatest return on investment.
One Piece of the Puzzle
Value chain analysis can be a highly effective means of understanding and contextualizing your business’s processes, but it’s just one tool at your disposal. There's a host of other frameworks and concepts that can help you evaluate organizational performance, craft winning strategies, and be more effective in your role.
Ready to learn additional frameworks that can enable you to make smarter business decisions? Explore our eight-week course Economics for Managers and other online Strategy courses, and find out more about how to develop effective pricing strategies.