The second step in value chain analysis is to identify the cost driver at each value activity

How does your organization create value?

How do you change business inputs into business outputs in such a way that they have a greater value than the original cost of creating those outputs?

This isn't just a dry question: it's a matter of fundamental importance to companies, because it addresses the economic logic of why the organization exists in the first place.

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Manufacturing companies create value by acquiring raw materials and using them to produce something useful. Retailers bring together a range of products and present them in a way that's convenient to customers, sometimes supported by services such as fitting rooms or personal shopper advice. And insurance companies offer policies to customers that are underwritten by larger re-insurance policies. Here, they're packaging these larger policies in a customer-friendly way, and distributing them to a mass audience.

The value that's created and captured by a company is the profit margin:

Value Created and Captured – Cost of Creating that Value = Margin

The more value an organization creates, the more profitable it is likely to be. And when you provide more value to your customers, you build competitive advantage.

Understanding how your company creates value, and looking for ways to add more value, are critical elements in developing a competitive strategy. Michael Porter discussed this in his influential 1985 book "Competitive Advantage," in which he first introduced the concept of the value chain.

A value chain is a set of activities that an organization carries out to create value for its customers. Porter proposed a general-purpose value chain that companies can use to examine all of their activities, and see how they're connected. The way in which value chain activities are performed determines costs and affects profits, so this tool can help you understand the sources of value for your organization.

Elements in Porter's Value Chain

Rather than looking at departments or accounting cost types, Porter's Value Chain focuses on systems, and how inputs are changed into the outputs purchased by consumers. Using this viewpoint, Porter described a chain of activities common to all businesses, and he divided them into primary and support activities, as shown below.

Primary Activities

Primary activities relate directly to the physical creation, sale, maintenance and support of a product or service. They consist of the following:

• Inbound logistics – These are all the processes related to receiving, storing, and distributing inputs internally. Your supplier relationships are a key factor in creating value here.
• Operations – These are the transformation activities that change inputs into outputs that are sold to customers. Here, your operational systems create value.
• Outbound logistics – These activities deliver your product or service to your customer. These are things like collection, storage, and distribution systems, and they may be internal or external to your organization.
• Marketing and sales – These are the processes you use to persuade clients to purchase from you instead of your competitors. The benefits you offer, and how well you communicate them, are sources of value here.
• Service – These are the activities related to maintaining the value of your product or service to your customers, once it's been purchased.

Support Activities

These activities support the primary functions above. In our diagram, the dotted lines show that each support, or secondary, activity can play a role in each primary activity. For example, procurement supports operations with certain activities, but it also supports marketing and sales with other activities.

• Procurement (purchasing) – This is what the organization does to get the resources it needs to operate. This includes finding vendors and negotiating best prices.
• Human resource management – This is how well a company recruits, hires, trains, motivates, rewards, and retains its workers. People are a significant source of value, so businesses can create a clear advantage with good HR practices.
• Technological development – These activities relate to managing and processing information, as well as protecting a company's knowledge base. Minimizing information technology costs, staying current with technological advances, and maintaining technical excellence are sources of value creation.
• Infrastructure – These are a company's support systems, and the functions that allow it to maintain daily operations. Accounting, legal, administrative, and general management are examples of necessary infrastructure that businesses can use to their advantage.

Companies use these primary and support activities as "building blocks" to create a valuable product or service.

Using Porter's Value Chain

To identify and understand your company's value chain, follow these steps.

Step 1 – Identify subactivities for each primary activity

For each primary activity, determine which specific subactivities create value. There are three different types of subactivities:

• Direct activities create value by themselves. For example, in a book publisher's marketing and sales activity, direct subactivities include making sales calls to bookstores, advertising, and selling online.
• Indirect activities allow direct activities to run smoothly. For the book publisher's sales and marketing activity, indirect subactivities include managing the sales force and keeping customer records.
• Quality assurance activities ensure that direct and indirect activities meet the necessary standards. For the book publisher's sales and marketing activity, this might include proofreading and editing advertisements.

Step 2 – Identify subactivities for each support activity.

For each of the Human Resource Management, Technology Development and Procurement support activities, determine the subactivities that create value within each primary activity. For example, consider how human resource management adds value to inbound logistics, operations, outbound logistics, and so on. As in Step 1, look for direct, indirect, and quality assurance subactivities.

Then identify the various value-creating subactivities in your company's infrastructure. These will generally be cross-functional in nature, rather than specific to each primary activity. Again, look for direct, indirect, and quality assurance activities.

Step 3 – Identify links

Find the connections between all of the value activities you've identified. This will take time, but the links are key to increasing competitive advantage from the value chain framework. For example, there's a link between developing the sales force (an HR investment) and sales volumes. There's another link between order turnaround times, and service phone calls from frustrated customers waiting for deliveries.

Step 4 – Look for opportunities to increase value

Review each of the subactivities and links that you've identified, and think about how you can change or enhance it to maximize the value you offer to customers (customers of support activities can be internal as well as external).

Your organization's value chain should reflect its overall generic business strategies. So, when deciding how to improve your value chain, be clear about whether you're trying to set yourself apart from your competitors or simply have a lower cost base.

Tip 2:

You'll inevitably end up with a huge list of changes. See our article on prioritization if you're struggling to choose the most important changes to make.

Tip 3:

This looks at the idea of a value chain from a broad, organizational viewpoint. Our separate article on value chain analysis takes different look at this topic, and uses an approach that is also useful at a team or individual level. Click here to explore this.

Porter's Value Chain is a useful strategic management tool.

It works by breaking an organization's activities down into strategically relevant pieces, so that you can see a fuller picture of the cost drivers and sources of differentiation, and then make changes appropriately.

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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.

Understanding the Value Chain

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.