What Is a Value Chain?
A value chain is a business model that describes the full range of activities needed to create a product or service. For companies that produce goods, a value chain comprises the steps that involve bringing a product from conception to distribution, and everything in between—such as procuring raw materials, manufacturing functions, and marketing activities.
A company conducts a value-chain analysis by evaluating the detailed procedures involved in each step of its business. The purpose of a value-chain analysis is to increase production efficiency so that a company can deliver maximum value for the least possible cost.
- A value chain is a step-by-step business model for transforming a product or service from idea to reality.
- Value chains help increase a business's efficiency so the business can deliver the most value for the least possible cost.
- The end goal of a value chain is to create a competitive advantage for a company by increasing productivity while keeping costs reasonable.
- The value-chain theory analyzes a firm's five primary activities and four support activities.
Understanding Value Chains
Because of ever-increasing competition for unbeatable prices, exceptional products, and customer loyalty, companies must continually examine the value they create in order to retain their competitive advantage. A value chain can help a company to discern areas of its business that are inefficient, then implement strategies that will optimize its procedures for maximum efficiency and profitability.
In addition to ensuring that production mechanics are seamless and efficient, it's critical that businesses keep customers feeling confident and secure enough to remain loyal. Value-chain analyses can help with this, too.
The overarching goal of a value chain is to deliver the most value for the least cost in order to create a competitive advantage.
Michael E. Porter, of Harvard Business School, introduced the concept of a value chain in his book "Competitive Advantage: Creating and Sustaining Superior Performance" (Free Press, 1998). "Competitive advantage cannot be understood by looking at a firm as a whole," Porter wrote. "It stems from the many discrete activities a firm performs in designing, producing, marketing, delivering, and supporting its product."
In other words, it's important to maximize value at each specific point in a firm's processes.
Components of a Value Chain
In his concept of a value chain, Porter splits a business's activities into two categories, "primary" and "support," whose sample activities we list below. Specific activities in each category will vary according to the industry.
Primary activities consist of five components, and all are essential for adding value and creating competitive advantage:
- Inbound logistics include functions like receiving, warehousing, and managing inventory.
- Operations include procedures for converting raw materials into a finished product.
- Outbound logistics include activities to distribute a final product to a consumer.
- Marketing and sales include strategies to enhance visibility and target appropriate customers—such as advertising, promotion, and pricing.
- Service includes programs to maintain products and enhance the consumer experience—like customer service, maintenance, repair, refund, and exchange.
The role of support activities is to help make the primary activities more efficient. When you increase the efficiency of any of the four support activities, it benefits at least one of the five primary activities. These support activities are generally denoted as overhead costs on a company's income statement:
- Procurement concerns how a company obtains raw materials.
- Technological development is used at a firm's research and development (R&D) stage—like designing and developing manufacturing techniques and automating processes.
- Human resources (HR) management involves hiring and retaining employees who will fulfill the firm's business strategy and help design, market, and sell the product.
- Infrastructure includes company systems and the composition of its management team—such as planning, accounting, finance, and quality control.
Examples of Value Chains
Starbucks Corporation (SBUX: NASDAQ)
Starbucks offers one of the most popular examples of a company that understands and successfully implements the value-chain concept. There are numerous articles about how Starbucks incorporates the value chain into its business model.
Trader Joe's (Private)
Another example is Trader Joe's grocery store, which also has received much press about its tremendous value and competitive edge. Because the company is privately held, however, there are many aspects of its strategy that we don't know. However, when you enter a Trader Joe's store, you can readily observe instances of Trader Joe's business that reflect the five primary activities of the value chain.
1. Inbound logistics. Unlike traditional supermarkets, Trader Joe's does all of its receiving, shelving, and inventory-taking during regular store hours. Although potentially maddening for shoppers, this system creates a ton of cost savings in terms of employee wages alone. Moreover, the logistics of having this work take place while customers are still shopping sends the strategic message that "we're all in this together."
2. Operations. Here's an example of how a company could apply the value chain creatively. In primary activity number two above, "converting raw materials into finished product" is cited as an "operations" activity. However, because converting raw materials is not an aspect of the supermarket industry, we can use operations to mean any other regular grocery store function. So, let's substitute "product development," as that operation is critical for Trader Joe's.
The company selects its products carefully, featuring items that you generally can't find elsewhere. Its private-label products account for at least 70 percent of its offerings, which often have the highest profit margins, too, as Trader Joe's can source them efficiently in volume. Another vital piece of product development for Trader Joe's is its taste-testing and chef-partnership programs, which ensure high quality and continuous product refinement.
3. Outbound logistics. Many supermarkets offer home delivery, but Trader Joe's does not. Yet here, we can apply the activity of outbound logistics to mean the range of amenities that shoppers encounter once they are inside a Trader Joe's store. The company has thought carefully about the kind of experience it wants us to have when we visit its stores.
Among Trader Joe's many tactical logistics are its in-store tastings. Usually, there are a few product tastings happening simultaneously, which create a lively atmosphere, and often coincide with the seasons and holidays. The tasting stations feature both new and familiar items that are prepared and served by staff.
4. Marketing and sales. Compared to its competitors, Trader Joe's barely does any traditional marketing. However, its entire in-store experience is a form of marketing. The company's copywriters craft product labels to appeal specifically to its customer base. Trader Joe's' unique branding and innovative culture indicate that the company knows its customers well—which it should, as the firm has actually chosen the type of customers it prefers and has not deviated from that model.
Via this indirect marketing of style and image, Trader Joe's has succeeded in differentiating itself in the marketplace, thus sharpening its competitive edge.
5. Service. Customer service is paramount for Trader Joe's. Generally, you see twice as many employees as shoppers in their stores. Whatever work they are doing at the moment, the friendly, knowledgeable, and articulate staff are there primarily for you. Employees welcome shoppers' interruptions and will instantly rush to find your item or answer your question. In addition, the company has always employed a no-questions-asked refund program. You don't like it, you get your money back—period.
This list could go on and on before ever reaching the four support activities cited above, as Trader Joe's is a wildly successful example of applying value-chain theory to its business.