What is a Value Chain?

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Definition:

A value chain represents each of the functions within a company’s operations that add value to the customer, thus increasing what they are willing to pay.

🤔 Understanding value chains

A value chain refers to all of the things a company does to add value to the goods and services it provides. The concept was formally introduced in a 1985 book called Competitive Advantage by Michael Porter. The value chain concept involves breaking down the company operations into component parts, then optimizing the value it creates within each of those components. This process is strategically different from attempting to maximize a business by looking at the entire operation as one big machine. Analyzing the value chain highlights the source of a company’s competitive advantage — that is, what they do better than their competition.

Example

Apple is a giant corporation with a market capitalization of $1.2T. It maximizes its profits by optimizing its value chain. To begin, the company gets the lowest possible price on materials by developing competition in sourcing contracts. It then reduces labor costs by outsourcing manufacturing to China. It creates exceptional perceived value through its brand. The two-year cycle of upgraded models increases customer lifetime value by encouraging its loyal customers to replace products regarded as outdated. And ostensibly exceptional service by an Apple employee attracts customers to the storefront to get help with issues that require a "genius" to solve.

Takeaway

A value chain is like cooking a meal…

A recipe lays out all the steps that you need to complete. But you can’t be sloppy with the measuring cup and expect to get consistent results. Nor can you use low-quality products or substitute one item for another. If you want the best results, you need to pay close attention to every ingredient and every step in the instructions. Only if you use the best quality ingredients (get the best sourcing contracts), take great care while cooking (optimize operations), and pay close attention to detail as you plate the dish (provide exceptional customer service) can you expect to provide the best possible dining experience (maximize profits).

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What is a Value Chain?

A value chain consists of all the steps in which a company adds value to a product. Michael Porter described the value chain in his 1985 best-selling book called Competitive Advantage: Creating and Sustaining Superior Performance. Many business students still learn about the value chain while studying business management.

The value chain idea boils down to viewing a corporation’s activities as a series of subsystems, each transforming inputs into a higher valued output. The idea behind analyzing the value chain is to locate cost drivers, identify competitive advantages, find the key sources of value creation, determine opportunities for product differentiation, and discover how to deliver a high-quality customer experience. This form of strategic management theoretically creates a higher profit margin by minimizing costs and commanding a higher price for the company’s products.

What are the components of a value chain?

The value chain represents the activities of a business unit, not an entire corporation. The process of creating a product consists of two levels of activity.

Primary Activities

There are five primary activities that any business uses to create value. Each link in the value chain contributes to the value the company generates for a customer. The company converts that value to profits through pricing and customer loyalty.

Inbound logistics includes all of the work done to acquire the things needed to make a product. For a manufacturer, that includes negotiating sourcing contracts for materials and parts. For a retailer, this is contracting with wholesalers for inventory. Then, inbound logistics includes coordinating the movement of those materials, components, and wholesale goods to the business location.

Operations is the process of converting an input into a higher value output. This process could be transforming materials into intermediate goods (goods used to make other goods) or assembling parts into a finished product.

Outbound logistics involves moving the finished products the business creates to the customer. It also includes inventory management, storage, and information flows.

Marketing (aka sales) is the step that attracts the customer to the product. It involves creating advertisements, but also includes direct communications with clients and potential customers.

Service encompasses all of the activities the business performs to keep the customer satisfied, especially after the sale.

Support Activities

In addition to the primary business activities, every company has some level of support systems that allow it to function. The value chain identifies four support activities.

Infrastructure consists of all the back-end processes required for the business to run. These are things like accounting, quality assurance, public relations, and others.

Technological development pertains to the hardware, software, and procedures that allow information and production to move forward.

Human resource management relates to the recruitment, onboarding, retention, training, development, discipline, and compensation of employees.

Procurement is the acquisition of all the necessary goods and services from vendors and contractors from outside the organization.

What is Porter’s value chain model?

The Porter value chain model is the framework for a value chain analysis. Michael Porter, a professor at Harvard Business School, presented it in his best-selling book called Competitive Advantage. The value chain model consists of value chain activities that are common to almost any business. A business manager can use the model to conduct an analysis of the value chain framework, which is a four-step process.

Step 1

For each of the primary activities (inbound logistics, operations, outbound logistics, marketing, and service), determine the direct activities, indirect activities, and quality assurance procedures that add value for the customer. For example, making phone calls is a direct subactivity of marketing. Updating the customer relations database would be an indirect subactivity. And proofreading advertisements would be a quality assurance subactivity.

Step 2

For each of the support activities (firm infrastructure, technology development, human resource management, and procurement), determine the discrete activities that create value by improving the primary activities. Again, consider the direct, indirect, and quality assurance aspects of the specific activities. In this step, think about how training improves marketing. And how technology enhances outbound logistics.

Step 3

In this step, locate the ways that all of the value-creating activities relate to one another. This process is time-consuming, but it is the key to effectively using the value chain model. Try to locate all of the links between subactivities. For example, there is a link between service and outbound logistics because decreasing delivery errors also reduces the number of frustrated customers that call for assistance. Likewise, inadequate storage can lead to inventory disruptions, which might impact operations, which could disrupt outbound logistics, and so on.

Step 4

Looking at how the business activities are linked will allow you to identify critical points of failure and opportunity. Each activity should create some added value. And improving each activity may provide improved value at points down the chain. Look for ways to enhance the value created at each link in the chain. Enhancing value can mean implementing new processes, purchasing new equipment, investing in training opportunities, securing a cost advantage, or setting your products or brand apart from the competition. Increasing value can take the form of lower costs or increasing the amount that customers are willing to pay for your products. Either of those outcomes improves the company’s profit margins.

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

A value chain describes the process by which a business adds value to a customer. Conversely, a supply chain defines the movement of materials from the land to the customer. The concepts have some similarities but are very different in application.

A company’s value chain details all of the things it does to create value as it delivers a product. It starts with acquiring the materials and parts it needs and moving those items to the business location. Then, it involves the operations of the factory, assembly line, warehouse, or retail outlet. The next links are the marketing and delivery of the product to the customer. Finally, the value chain ends with a satisfied customer that receives excellent service. A web of links also work behind the scenes, which allow the business to operate smoothly.

Unlike a value chain, which happens entirely within one firm, a company is usually one link in a product’s supply chain. The supply chain starts by mining or growing raw materials — like oil, gold, copper, corn, or wheat. Those materials move to the next link, which turns those raw materials into higher-valued commodities. This link includes refineries, smelters, processing plants, and mills.

Next, these commodities move to a factory, which transforms them into intermediate goods (goods that are used to make other goods). Those intermediate goods move to the next link, where they get combined into products at a manufacturing plant. This process might take place at an iPhone factory in China or a car assembly plant in Detroit, for example. Next, the finished products move to wholesalers, which manage the inventory of the product. Finally, the last link in the supply chain is the retail outlet that connects the final product to the end user.

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