Why do some companies’ profit margins exceed their competitors? How does one company garner a competitive advantage against its peers? The answers to these questions may be found in value chain analysis.
Value chain analysis is the process of looking at the activities that go into changing the inputs for a product or service into an output that is valued by the customer. Companies conduct value-chain analysis by looking at every production step required to create a product and identifying ways to increase the efficiency of the chain.
Porter's Value Chain Analysis
Back in 1985, Michael Porter, a Harvard Business School professor, introduced a basic value chain model in his book Competitive Advantage. He identified several key steps common among all value chain analyses and determined that there are primary and supporting activities that when performed at the most optimal levels will create value for their customers, such that the value offered to the customer exceeds the cost of creating that value, resulting in higher profit. Porter’s framework groups activities into primary and support categories
The primary activities focus on taking the inputs, converting them into outputs and delivering the output to the customer. The support activities play an auxiliary role to the primary activities. When a company is efficient in combining these activities to deliver a superior product or service, then the customer is willing to pay more for the product than the cost to make and deliver the product which results in a higher profit margin.
Let’s work through an example of an asset management firm. The goal of the client is to achieve the highest possible return on investment within the guidelines and restrictions set forth by the client.
The firm’s primary activities include:
- Investment team (portfolio managers, analysts) – tasked with making the investment decisions.
- Operations and traders – tasked with ensuring the investments are in line with the guidelines set forth by the client and the trades are at the best execution price.
- Marketing and sales – responsible for procuring clients.
- Service (client relationship management) – responsible for providing all the touch points to the client.
Support activities include:
- Technology – designs a trading and client module that is efficient and effectively allows the team to provide the highest level of service and make the best investment decisions.
- Human Resources – finds and retains the highest level of talent at the firm.
- Infrastructure – includes the lawyers and risk managers whose oversight is crucial to ensuring the client’s guidelines are followed, the investment risk is controlled and the firm is operating within the regulations established by the SEC.
How to Improve the Value Chain
When a firm takes into account its value chain, it needs to consider its value proposition, or what sets it apart from its competitors. Value chain analysis is designed to improve profits by creating a product or service that is so superior that customers are willing to pay more than the cost to create it.
But improving a value chain for the sake of improvement should not be the end goal. Instead, a company should decide why it wants to improve its value chain in the context of its competitive advantage in order to differentiate itself among its peers.
Two common competitive advantage strategies include low cost provider or specialization/differentiation of product or service.
- Low cost provider – value chain analysis focuses on costs and how a company can reduce those costs.
- Specialization – value chain analysis focuses on the activities that create a unique product or differentiation in service.
Let’s go back to our asset management example. After the value chain is identified, then the asset manager should determine its competitive advantage and pursue activities that go towards reaching those goals. In this case, the asset manager wants to pursue a strategy of differentiation by delivering a product that has steady, top quartile returns over three years.
Based on the drivers of uniqueness Porter identified, the firm needs to focus on its policies and decisions and learn to differentiate itself in terms of performance. By focusing on these drivers, the two primary activities of the investment team, operations and the traders along with all the identified support activities can manage a product that achieves its differentiated competitive advantage.
The Bottom Line
Value chain analysis is an extremely useful management tool which identifies the activities that go into creating a superior product or service that is highly valued by customers. The outcome of creating this highly valued product is that customers are willing to pay a premium, which exceeds its costs, thereby delivering higher profit.
The usefulness of this model created by Michael Porter is mostly seen in its ability to breakdown work product into various activity groups to strategically focus the management on what are truly useful activities, and what creates value. It also concentrates a company to determine a vision utilizing a competitive advantage strategy which will drive future products and services. Supporting activities are further validated in the process, creating an understanding that these sometimes overlooked activities are integral to the value chain and value proposition for a company.