Value chain analysis
Summary
Businesses prosper by retaining as profit a portion of the value they create.
Ever-increasing proportions of indirect and overhead activities make it hard to identify the true profitability of particular services and customer groups.
Our techniques unravel the steps within the value chain(s) of a business, revealing those efforts which create net value and those which destroy it.
Management strategy can then focus on doing more of what is done well, and on transforming less profitable activities into stronger contributors.
Introduction
All economic activity, whether in the public or private sector, ultimately revolves around the process of creating value. For an organisation to be self-sustaining it must create more value, as measured by its users, than the cost of the resources it uses up. We define "value" as the benefits a (potential) user will gain from a product or service, measured, for example, by the maximum price he or she may be willing to pay.
In some commercial situations, it is relatively easy to identify whether value is being created or not. For example, a commodity market trader knows rather quickly when he is not providing value to potential customers because nobody buys anything! This information in itself does not solve his strategic problem of what to do, but at least it makes the problem clear.
By contrast, most typical large, complex organisations may not actually know whether or not they are creating value in each and every part of their business. Because they undertake so many activities to produce so many products or services in so many places to serve so many customers, the true costs of each segment of the business get hidden or averaged away. One method often employed to attack this problem is to break up large organisations ("hierarchies") into many smaller ones which then trade with each other at arms' length ("markets"), and so reveal the creation or destruction of value.
Unfortunately, big, complex organisations exist for good economic reasons such as the existence of transaction costs, differential access to information and the absence of efficient intermediate markets, so, although breaking up complex organisations can be very healthy, it is not a universal solution.
Understanding how, or whether, your organisation creates value is critical to developing good business strategy. Simplistically, a profit-oriented business generates higher returns at lower risks if it competes in attractive market segments in a way that establishes a sustainable competitive advantage, measured against the key requirements of customers in those segments. Measuring segment attractiveness and relative competitive advantage properly requires a robust understanding of the process of value creation.
The process of developing value-based strategies falls into three main activities:
- measuring value creation
- creating more value
- benefiting from value creation
A healthy self-renewing organisation builds these activities into its culture and operations in a permanent cycle of improvement, using past analysis and performance to stimulate the next, higher level of achievement.
Measuring value creation
In order to understand how organisations can differentiate themselves from their competitors, Michael Porter created the value chain concept in his book "Competitive Advantage" (published in the USA by The Free Press). A value chain can be thought of as a series of activities adding cost and value, targeted towards a given market segment. Most organisations will have several overlapping value chains, sharing some or all of the same activities, aimed at a range of market segments.
Porter's value chain framework suffers from what we consider to be an artificial distinction between "primary" and "support" activities, reducing its effectiveness in providing insight to a company's overhead layers. We prefer to structure our value chain analysis around core business processes, which is a more natural way to think about value creation, and a lot more revealing.
The first task in measuring value is to understand the behaviour of individual elements of business process value chains from a strategic perspective. This can then be used as a basis for analysing the profitability of key market segments. Regrettably, many businesses put a lot of resource into building and implementing complicated strategies without basic information about the underlying forces which drive the profitability of individual segments. By breaking the chain down into individually costed outputs which can be associated with individual business transactions, value chain analysis gives enormous insight into, for example, the differences between the serviced contribution of apparently similar customers, or the total business cost differences between new and old products in a given range.
"Value", of course, is not the same as "profit", although the two are strongly linked - you cannot make a profit without creating value. The remaining steps in measuring value focus on understanding the profit/value gap, by analysing profit sensitivity, understanding customer trade-offs and evaluating competitive room for manoeuvre.
Understanding your own, and competitors', value chains and strategic profitability enables you to make informed decisions about where you should be focusing your competitive efforts, in terms of both market segments and activities along the value chains. Developing value chain analysis for key competitors can provide explanations for their market and operational behaviour, and provides a backdrop for assessing how competitors may react to specific initiatives. However, it is necessary to treat competitor value chain analysis with some caution, since competitors may not have analysed themselves as well as you have, and thus may appear to act irrationally!
Creating more value and benefiting from value creation
These are natural successors to the first task of measurement in value chain analysis and use the building blocks which the work we are proposing will develop for your business.
Reconfiguring a segment value chain can create more value, sometimes quite dramatically, without affecting the quality of the services offered to the market. Knowing where the value opportunity is buried is the key, so that effort can be focused where it has the most impact.
Business prosperity arises not just from creating value, but from retaining the benefits of creating it, as well. The key to benefiting from value creation is to price and promote your products or services correctly to the target market. Price levels should derive from the efforts you have put into understanding and improving the value creation process and into focusing relentlessly on those market segments where you can best deliver value relative to your competitors.