Everything you need to know about your company's value chain

Value chain analysis breaks a company into the discrete activities it performs to design, produce, sell, deliver and support its product, and then examines how each activity affects cost and the customer's willingness to pay. Its purpose is to show where the company creates value, where it loses it, and which changes will strengthen either a low-cost or a differentiation strategy.

The board of a mid-sized consumer goods manufacturer is reviewing a disappointing year. Revenue grew, but operating margin fell for the third consecutive year. The sales director says prices are under pressure from retailers. The operations director says input costs and freight have risen. The marketing director says the brand is strong and the problem lies elsewhere. Each argument is plausible, and each is incomplete. What the directors lack is a shared picture of how the company actually creates value, which activities add to what customers will pay, which only add to cost, and how they depend on one another. That picture is precisely what a value chain analysis provides.

The internet has given companies access to a worldwide customer base, and with it unprecedented competition. Even niche businesses now meet competitors from other parts of the world. This brings obstacles, but it also gives companies the chance to take advantage of globalization and place themselves in a position of competitive advantage. Value chain analysis helps a company coordinate all its actions toward either a differentiation strategy or a low-cost strategy. Combined with a clear view of its business models and with the discipline described in the ICX service on business model design, it lets a company stand out from its competition, generate value and strengthen its position as an industry leader.

What is value chain analysis?

The analysis consists of examining your competitive advantage by decomposing the company into discrete activities or processes and then looking at how each contributes to the company's relative cost position and to what customers are willing to pay. The activities carried out to design, produce, sell, deliver and maintain a product are those that ultimately incur cost and create willingness to pay. The differences between companies in those activities, which is to say in what they do every day, lead to differences in cost and in the price customers accept. Michael Porter introduced the idea in his book Competitive Advantage, which the publisher describes as presenting the value chain as the basic tool for diagnosing competitive advantage and finding ways to enhance it, and which stresses that advantage comes not only from individual activities but from how they relate to one another and to the activities of suppliers and customers (Competitive Advantage, publisher page).

Porter returned to the theme a decade later in the Harvard Business Review. He argued that operational effectiveness, performing similar activities better than rivals, is necessary but not sufficient, because the techniques that deliver it spread quickly and produce convergence. Strategy, in his words, means choosing a unique and valuable position by performing different activities than rivals or performing similar ones in different ways, and the strongest advantages come from the way activities reinforce one another, since a rival must then match the whole system and not a single part (Michael Porter, What Is Strategy?, Harvard Business Review). For an executive, the implication is practical. A value chain analysis is not a diagram to be framed. It is a way to see which of the company's activities support the position it has chosen and which merely follow habit.

What are the benefits of value chain analysis?

The goal is to determine how to create maximum value for the business and its customers at the lowest cost, and the analysis gives a complete panorama of the business. Without a recommendation for improvement grounded in that panorama, decisions rest on conjecture, and the company cannot anticipate whether the changes it makes will generate significant value. The manufacturer in our opening scene is in that position. It is debating causes from partial views, and any remedy it chooses will be a bet.

By improving its value chain, a company increases its competitive advantage in one of two ways. The first is a differentiation strategy, which increases the customer's willingness to pay for a product or service with only a slight increase in cost. The second is a low-cost strategy, which obtains significant cost savings at the expense of only a small decrease in willingness to pay. Consider, as an illustration, Toyota and Hyundai vehicles. Most customers would be willing to pay more for a Toyota than for a Hyundai, and the cost of producing a Toyota is higher. Toyota's somewhat higher margins arise because the difference in willingness to pay is slightly greater than the incremental cost of what it offers. The example is useful less for its precise figures than for its logic. Margin is the gap between what customers will pay and what it costs to serve them, and a company grows it either by widening the first term or by narrowing the second.

The choice between the two strategies matters because mixing them badly is costly. A company that cuts costs in the activities its customers value most will lose willingness to pay, and a company that adds expensive differentiation in activities its customers ignore will lose margin. Value chain analysis forces the question of which activities customers actually notice.

How do you do a value chain analysis?

Porter provided a template that breaks the company into primary and support activities, which together contribute to the creation of value from conception to delivery. The first task is to identify those activities. There are five generic categories of primary activities that relate to competition in any industry, and each can be divided into many specific activities depending on the sector and the company's strategy.

Inbound logistics covers the receipt of raw materials or other products from suppliers, their storage, and their distribution to the production process. Operations covers the transformation of inputs such as raw material, energy and human resources into a final product or service. Outbound logistics covers the storage and distribution of the final product to distribution centers, wholesalers, retailers and consumers. Marketing and sales covers the means by which buyers can purchase the product and are induced to do so, including advertising, promotion, channels and price. Service covers the activities required to keep the product or service working well for the buyer, among them installation, training, repair and maintenance.

Which category matters most depends on the industry. For a distributor, inbound and outbound logistics are critical. For a service business such as a restaurant, outbound logistics may hardly exist, and operations is the vital category. For a bank, marketing and sales is a key source of advantage, through the effectiveness of the officers who explain how loans are packaged and priced. For a manufacturer of high-speed copiers, service is a decisive source of advantage, since customers pay for uptime. It is important to remember that every company, whether a service or a manufacturing firm, performs all five categories to some degree. This answers a frequent criticism of the model, which holds that it is useful only for manufacturers.

Support activities help the primary activities achieve competitive advantage, and Porter's template names four. Technology development covers how the company uses technology to automate processes and develop new products. Human resources management covers recruitment, training and employee retention. Procurement covers purchases and the pursuit of the best quality at the best price. Company infrastructure covers structure, management, planning, accounting and finance. In a digital economy the first of these has grown in importance, because data and software now run through every primary activity, a point that ICX develops in its work on business process and in its article on systematization and automation.

How do you analyze the activities and turn the analysis into a plan?

Do not be afraid to work as a team. You will probably depend heavily on the leaders of the departments in charge of each activity, and it is unlikely that any one person knows the daily operation of every department. Once the activities are mapped, think about how your business will compete. Will it create additional value and compete on differentiation, or will it be the lowest-cost provider in its industry? That decision guides the whole analysis, because it lets you assess every activity in a coordinated way, toward a single objective. Link each activity to the value it offers, and evaluate what the company must do, and what it must change, to be consistent with the way it competes.

Then create an action plan. A value chain analysis takes time to complete, and the main risk is losing momentum. After identifying the activities that generate the most value, you must make decisions and change the system, which is to say the company, so that it aligns with the strategy, whether that is differentiation or low cost. Stay practical when you identify changes. If some changes bring only marginal improvement but demand great effort and cost, ask honestly whether they deserve to be done. Focus on significant changes, prioritize them, and share them with stakeholders so they approve and support them. We advise starting with the simplest changes. When they succeed they create small victories that keep the team's morale high, and once the team sees results it gains the confidence to address the largest and most valuable changes.

One refinement separates a useful analysis from a superficial one, and it comes straight from Porter's emphasis on how activities relate to one another. Do not examine each activity in isolation. Look at the linkages between them, because the cost or quality of one activity often depends on how another is performed. Spending more on careful procurement can lower the cost of operations and service later, and a rushed handover between sales and delivery can undo the value created by a strong sales effort. These linkages are also where competitors find it hardest to copy a company, since they live in the way the organization works and not in any single tool. For that reason the workshop should always include the people who sit on both sides of each handover.

What does value chain analysis look like in practice?

Return to the consumer goods manufacturer. A value chain review might begin with the activity that customers notice most, which in this case is outbound logistics and in-store availability. Retailers punish stockouts, and a brand that is often missing from the shelf loses willingness to pay long before the price list changes. If the review finds that a handful of products account for most of the missed deliveries, and that those products are also the least profitable, the company has a clear choice. It can fix the service on the products that matter, withdraw the others, or reprice them to reflect their true cost to serve. That conclusion comes from linking activity, cost and customer value, which the board's original debate could not do.

A regional bank offers a second illustration. Its management believes its advantage lies in its credit officers, yet the analysis shows that loan applications take longer than those of competitors because documents are requested three times from the customer. The primary activity of marketing and sales is strong, while a support activity, the technology that handles document capture, undermines it. Changing the support activity improves the primary one. Costing the activities, which ICX addresses through activity-based costing and value analysis, then shows which of them deserve investment and which should be simplified or eliminated.

What this means for the C-level

For the chief executive, value chain analysis is a discipline for choosing. Porter's emphasis on deciding what not to do applies in every industry, and the analysis supplies the evidence for those choices. Ask the leadership team to state, in one sentence, whether the company competes on differentiation or on cost, and then test every major initiative against that sentence. Initiatives that serve neither should be questioned.

The chief financial officer gains a map of where margin is made and lost, which is far more useful than an aggregate figure. Costing by activity shows which products, customers and channels earn their keep, and it connects directly to pricing decisions. Commercial leaders can attract and convert more effectively when they know which activities customers value enough to pay for, and service leaders can build retention and loyalty by strengthening the activities that customers experience directly. Operations leaders gain efficiency by identifying activities that consume resources without adding to what the customer will pay. The analysis also tells the executive team where technology investment will matter most, because it shows which activities limit the others.

How do you start on Monday morning?

Convene the leaders of each function for a half-day workshop and ask them to list the activities their departments perform, using the primary and support categories as a frame. For each activity, ask two questions: what does it cost, and what does the customer notice? The answers will not be precise, and they do not need to be. They will reveal where the team's view of value differs, which is the most valuable output of the first session.

Next, decide on the strategic position that the company wishes to defend and mark the three activities that matter most to it. Assign an owner to each, define one measure of cost and one of customer value, and review them monthly. Choose a small, visible improvement to complete within the quarter, and use it to build confidence for larger changes. Teams that want a structured template can use the ICX Define Activities and Processes Toolkit and the Business Model Canvas Toolkit.

How ICX helps

ICX Consulting, a commercial strategy and customer experience firm headquartered in Miami, helps executive teams turn value chain thinking into decisions about pricing, cost and customer experience. Our value proposition development clarifies what customers will pay for, our cost management practice shows what each activity costs, and our pricing and revenue work connects both to margin. Where activities need to be redesigned, our business process improvement team does the work with the owners of each activity.

Frequently asked questions

Is value chain analysis only useful for manufacturers?

No. Every company performs all five primary activities to some degree. A bank, a hospital group or a software company simply emphasizes different ones, and the framework helps identify which. The criticism that it suits only manufacturers usually reflects a narrow reading of what each category means.

How often should a company repeat the analysis?

Review it annually, and whenever the strategy, a major customer segment or a core technology changes. Between reviews, track a few measures of activity cost and customer value so that drift becomes visible before it reaches the income statement.

What is the difference between a value chain and a supply chain?

A supply chain follows the flow of materials and products among organizations. A value chain looks inside a company at the activities that create value, including marketing, service and support functions, and how they link to suppliers and customers. The two are related but answer different questions.

Where should a small company start?

Start with the activities customers mention when they praise or complain about you. Those are usually the ones tied to willingness to pay. Cost them roughly, decide which strategy you are pursuing, and improve one activity at a time.

Companies that understand their own activities can choose where to compete and what to stop doing. If your leadership team is debating margin without a shared map of how value is created, request a diagnostic with an ICX consultant and we will help you build that map and turn it into a plan.