JMARVolume Four

Fall 1992

Strategic Cost Management: TheValue Chain Perspective

John K. ShankVijay GovindarajanDartmouth College

Abstract: The value chain concept has been discussed in the strategy litera-ture for more than a decade now. As a generic concept for organizing our think-ing about strategic positioning, its significance is widely accepted. But empiricalexamples of the power of the concept tor shaping cost analysis have not yetreached the literature. This paper reports a disguised field study in which a valuechain is constructed. The insights for cost management which emerge are con-trasted with those which are suggested by two traditional analysis techniques— a 2x2 growth/share matrix and conventional cost analysis. The purpose ofthe paper is to extend our knowledge about how to construct and use valuechains in managerial accounting. The authors believe the concept is powerfuland deserves far more empirical study as a way to make the strategic perspec-tive more explicit in managerial cost analysis.

"While accounting systems do contain useful data for cost analysis,they often get in the way of strategic cost analysis"

— Porter [1985, page 63]

One of the major themes In strategic cost management (SCM) concernsthe focus of cost management efforts. Stated ln question form: How do weorganize our thinking about cost management? In the SCM framework,managing costs effectively requires a broad focus, external to the firm.Porter [19851 has called this the "value chain." The "Value chain" for anyfirm in any business is the linked set of value-creating activities all theway from basic raw material sources through to the ultimate end-use prod-uct delivered into the final consumers' hands. This focus is exiemcd to thefirm, seeing each firm in the context of the overall chain of value-creatingactivities of which it is very probably only a part. We are aware of no firmswhich span the entire value chain in which they operate.

A firm such as Chevron in petroleum spans wide segments of the valuechain in which it operates, from oil exploration to service stations, but itdoes not span the entire chain. Fifty percent of the crude oil it refinescomes from other producers, and more than one third of the oil it refines issold through other retail outlets. Also, Chevron is not in the auto businessat all, the major user of gasoline. More narrowly, a firm such as MaxusEnergy is only in the oil exploration and production business. The LimitedStores are big "downstream" in retail outlets but own no manufacturingfacilities. Reebok Is a famous shoe brand, but the firm owns very few retailoutlets. Reebok does, however, own its factories.

Though the value chain concept has been around for more than 10years, the strategic power of this concept has not been well articulated.Based on an extensive literature search, we were not able to find even onecomplete, empirically derived value chain for a firm. There is a clear need

180 Journal oj Management Accounting Research. Fall 1992

to begin to document real world examples of how the value chain frame-work provides strategic Insights that are unlikely to emerge from otherframeworks. We believe it is important to begin to bring this perspectiveinto the domain of managerial accounting. This paper is an attempt tobegin to fill this need.

STRATEGIC POWER OF THE VALUE CHAINANALYSIS—THE BASICS

Whether or not a firm can develop and sustain differentiation and/orcost advantage depends fundamentally on the configuration of its valuechain relative to the value chain configuration of each of its competitors.We believe Porter [ 1985] is correct when he argues that competitive advan-tage in the marketplace ultimately derives from providing better customervalue for equivalent cost or equivalent customer value for a lower cost.From this perspective, value chain analysis is essential to determine ex-actly where In the firm's segment of the chain—from design to distribu-tion—customer value can be enhanced or costs lowered. As argued by Shank[19891, Ignoring linkages upstream from the firm as well as downstream isjust too restrictive a perspective.

Danger of Ignoring Value Chain Linkages

The value chain framework is a method for breaking down the chain ofactivities that runs from basic raw materials to end-use customers intostrategically relevant segments In order to understand the behavior of costsand the sources of differentiation. As noted earlier, a firm is typically onlya part of the larger set of activities in the value creation and delivery sys-tem. Since no two firms of which we are aware, even in the same industry.compete in exactly the same set of markets with exactly the same set ofsuppliers, the overall value chain for each firm is unique. Suppliers notonly produce and deliver Inputs used in a firm's value activities, but theyimportantly influence the firm's cost/differentiation position. For example,developments by steel "mini-mills" lowered the operating costs of wire prod-ucts users who are the customers of the customers of the mini mill — 2stages down the value chain. Similarly, customer's actions can have a sig-nificant Impact on the firm's value activities. For example, when printingpress manufacturers create a new press of "3 meters" width, the profitabil-ity of paper mills is affected, because paper machine widths must matchsome multiple of printing press width. Mill profit is affected by customeractions even though the paper mill is 2 stages upstream from the printerwho is a customer of the press manufacturer! As we will discuss more fullybelow, gaining and sustaining competitive advantage requires that a firmunderstand the entire value creation and delivery system, no(just the por-tion of the value chain In which it participates. Suppliers and customersand suppliers' suppliers and customers' customers have profit marginsthat are important to identify in understanding a firm's cost/differentia-tion positioning, since the end-use customers ultimately pay for all theprofit margins along the entire value chain.

The center column of Exhibit 1 presents a conceptual value chain forthe paper industry. The distinct value activities, such as timber growing.

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logging, pulp manufacture, paper manufacture, conversion and distribu-tion are the building blocks by which this industry creates a product valu-able to buyers. It is possible to quantify the economic value created at eachstage by identifying the costs, revenues, and assets for each activity. Whatwe argue is that every hypothetical firm shown on the left or right side inExhibit 1—A, B, C, D, E, F, and G—must construct a value chain for thetotal paper industry, breaking the total value in the chain into its funda-mental sources of economic value. Such an analysis has potential strate-gic implications for every competitor in each segment of this industry.

Value Chain Insights for DifTerent Competitors:• If competitor A (the most fully integrated company in the exhibit) cal-

culates the Return on Assets at each stage of the chain by adjusting alltransfer prices to competitive market levels, it could highlight potentialareas where the firm could more economically buy from the outside

182 Journal of Management Aax)imting ResearcK Fall 1992

Instead of "making" (strategic choice of make or buy). For example,most of the "fully integrated" forest product companies still use inde-pendent loggers to cut their trees on the way to their mills.

• With a complete value chain, competitors B. C. D. E. F. and G might beable to identify possibilities to forward or backward integrate into ar-eas which can enhance their performance. Westvaco, for example, re-cently stopped manufacturing envelope paper although it still owns alarge envelope converter. Champion International, on the other hand,has sold its envelope converting business but still produces envelopepaper. Both choices, although apparently inconsistent, could be plau-sible given the specific strategies of Westvaco and Champion.

• Each value activity has a set of unique cost drivers that explain varia-tions in costs in that activity [Shank, 1989]. Thus, each value activityhas its unique sources of competitive advantage. Companies are likelyto face a different set of competitors at each stage. Some of these com-petitors would be more fully integrated companies and some of themwould be more narrowly focussed specialists. For instance, firm D inExhibit 1 faces competition from firms A, C. and G in the paper millstage. Yet, firms A. C, and G bring very different competitive advantageto this stage of the value chain vis-a-vis firm D. It is possible for firm Dto compete effectively with firms A, C, and G only by understanding thetotal value chain and the cost drivers that regulate each activity. Forexample if lack of "scope" (vertical integration) is an Important struc-tural driver of paper mill cost, A has a significant advantage and D asignificant disadvantage in this marketplace.

• Since each firm illustrated in Exhibit 1 is both a buyer and a sellersomewhere within the chain, calculating the profit (and ROA) earnedat each stage can help in understanding the relative power of buyersversus sellers at that stage. For example, comparing the returns forfirm E versus F can help identify the relative power within the chain ofthe converting stage for which E is a supplier but F is a buyer. Thisthen could help the firms in identifying ways to exploit their linkageswith their suppliers as well as with their customers to reduce costs orenhance differentiation or both.

Value Chain versus Value Added Analysis

The value chain concept can be contrasted with the internal focus thatis often adopted in management accounting, as alluded to in the quote atthe outset of this paper. Management accounting, as explained In leadingtextbooks, usually takes a "value-added" perspective, starting with pay-ments to suppliers (purchases), and stopping with charges to customers(sales). The key theme is to maximize the difference—the value-added—between purchases and sales, under the assumption that this is the onlyway a firm can influence profits. We argue that the value chain—not valueadded—is the more meaningful way to explore strategic issues. Value addedanalysis, in which the firm focuses only on its own operations in lookingfor profit enhancement opportunities, can be quite misleading in two ways:• The value-added concept starts too late. Starting cost analysis with

purchases misses all the opportunities for exploiting linkages with the

Shank and Govindarqjan 183

firm's suppliers. The word "exploit" does not imply that the relation-ship with the supplier is a zero sum game. Quite the contrary, it im-plies that the lirik should be managed so that both the ftrm and itssupplier can benefit. For instance, when bulk chocolate began to bedelivered in liquid form in tank cars instead of ten pound molded bars,an industrial chocolate firm (i.e.. the supplier) eliminated the cost ofmolding bars and packing them and a confectionery producer savedthe cost of unpacking and melting [Porter, 1985].

• In addition to starting too late, the value-added analysis has anothermajor flaw; it stops too soon. Stopping cost analysis at sales misses allthe opportunities for exploiting linksiges with the firm's customers. Hereagain, we contend that the relationship with the customer need not bea zero sum game, but one in which both parties can gain. For instance,some container producers have constructed manufacturing facilitiesnext to beer breweries and deliver the containers through overheadconveyers directly onto the customers' assembly line. This results insignificant cost reductions for both the container producers and theircustomers by expediting the transport of empty containers which arebulky and heavy [Hergert and Morris, 1989].

The value chain framework highlights how a firm's products fit into thebuyer's value chain. For instance, under the value chain framework, it isreadily apparent what percentage the firm's product costs are in the buyer'stotal costs. The fact that paper constitutes over 40 percent of the totalcosts of a magazine is signiflcant in encouraging the paper mill and thepublisher to work together in cost reduction activities. The San FranciscoChronicle recently adopted JIT for paper delivery to its printing plant, aprogram only possible with close supplier cooperation. Since the value-added concept ignores activities after the product leaves the firm, it oftendoes not highlight the degree of buyer power.

Emphasizing the Interdependence of Linked Activities Along a ValueChain

Value chain analysis explicitly recognizes the fact that the individualvalue activities within a flrm are not independent, but rather are interde-pendent. For instance, at McDonalds, the timing of promotional campaigns(one value activity) signiflcantly influences capacity utilization in "produc-tion" (another value activity). These linked activities must be coordinated ifthe full effect of the promotion is to be realized. As another example, Japa-nese VCR producers were able to reduce retail prices from $1,300 in 1977to $298 by 1984 by emphasizing the impact of an early step in the chain(product design) on a later step (production) by drastically reducing thenumber of parts in VCRs [Hergert and Morris, 19891. It is common to hearof conventional approaches to cost reduction which emphasize "across-the-board" cuts. However, by recognizing interlinkages, the value chainanalysis highlights the possibility that deliberately increasing costs in onevalue activity can bring about a reduction in total costs. The expense in-curred by P & G to place its order entry computers directly in Walmartstores significantly reduces overall order entry and processing costs forboth firms.

184 Journal of Management Accounting ResearcK Fall 1992

Calculationai DifficultiesWe do not wish to imply that constructing a value chain for a flrm is

easy. There are several thorny problems to confront: calculating a valuefor intermediate products, isolating key cost drivers, identifying linkagesacross activities, and computing supplier and customer margins.

The analysis starts by segmenting the chain into those components forwhich some flrm somewhere does make a market, even if other firms donot. This will catch the segments outlined in Exhibit 1 for the paper indus-try, for example. One could start the process by identifying every point inthe chain at which an external market exists. This gives a good first cut atidentifying the value chain segments. One can always find some narrowenough stage such that an external market does not exist. An examplewould be the progress of a roll of paper from the last press section of apaper machine to the first dryer section on the same machine. There isobviously no external market for paper halfway through a continuous flowpaper machine! Thus, seeing the press section and the dryer section of thepaper machine as separate stages in the value chain is probably not op-erational.

Part of the "art" of strategic analysis is deciding which stages in thevalue chain can meaningfully be decoupled conceptually and which can-not. Unless some flrm somewhere has decoupled a stage by making a mar-ket at that stage, one cannot independently assess the economic profitearned at that stage. But the opportunities for meaningful analysis acrossa set of firms that have deflned differently what they make versus whatthey buy and what they sell are often very significant. The fact that this isnot always possible does not, in our view, negate the significance when itis possible..

Despite the calculationai problems, we contend that every flrm shouldattempt to estimate its value chain. Even the process of performing thevalue chain analysis, in and by itself, can be quite instructive. In our expe-rience, we have found this exercise invaluable to managers by forcing themto carefully evaluate how their activities add value to the chain of custom-ers who use their product (service).

We present below a case study from our field research (the name of thecompany and the flnancial data are disguised) which we believe illustratesthe strategic power of a value chain analysis.

NORTHAM PACKAGING COMPANY

The Business Setting

NorthAm Packaging Company produced 206,000 tons of coated paper-board in 1989. This paperboard was sold to consumer product firms (pro-cessors) who formed the paperboard into cartons, then filled and sealedthem for shipment to retail outlets. NorthAm served two market segments.In 1989, 146,000 tons of the company's output went to "commodity" prod-uct flrms for whom the carton was Just a "box." For these firms, price isthe major purchase characteristic, assuming normal quality and service.The company had 40 percent market share in this segment. These proces-

Shank and Govindarajan 185

sors' products were considered commodities because they did not have anability to achieve a price premium for the brand name. These processorswere typically smaller in size. NorthAm sold to over 300 customers in thissegment. Overall sales in this segment had declined 3 percent per yearover the last five years, but were believed to have stabilized in 1989.

The second customer segment, to whom NorthAm sold 60,000 tons ofpaperboard in 1989, was high quality, differentiated processors for whomthe carton was an important element of the marketing strategy. NorthAmhad a 15 percent market share in this segment. These processors weretypically larger in size. NorthAm sold to only six customers in this seg-ment. This segment was growing at approximately 10 percent per year,and was projected to grow even faster in the future. The quality of thepackaging material (strength, durability, and printability) was particularlyimportant for this segment since the carton was a point-of-sale merchan-dising aid for the differentiated products. NorthAm's market share in thissegment had declined over time. Customers attributed the decline toNorthAm's inability to consistently produce the high quality board this seg-ment demands.

NorthAm was one of four major competitors in the coated paperboardindustry. Because of the scale, technology, and integration economies ofthese firms, new entrants were effectively shut out.

SubstitutesPlastic was the major substitution threat to the manufacturers of coated

paperboard. Shell Chemical and Hoover Intemationai (now Johnson Con-trols) had changed the consumer packaging industry overnight in 1965when they combined to introduce the plastic resin pellet and the blow mold-ing machine to manufacture plastic cartons. At first, the polyethylene pel-lets, supplied by Shell Chemical, were quite expensive. But, the blow moldingmachine was so easy to use that plastic made steady inroads into the con-sumer packaging industry. However, there were several reasons why coatedpaperboard continued to be used.

First, although plastic was more economical when the price of plasticresin was low, high plastic resin prices made coated board look good. Guess-ing future levels of ethylene gas prices (the basic driver of polyethyleneprice) was a notoriously difficult task. Second, processors did not want tobe at the total mercy of oil companies. By using dual suppliers, processorscreated a hedge against the volatile price of plastic resin. For instance, in1988, a ftre in a Shell refinery in Louisiana destroyed 30 percent of thepolyethylene pellet supply in the U.S. overnight and forced many proces-sors who had largely converted to plastic back to coated board. Third, asnew uses of the plastic resin were created (industrial and consumer usesof plastic containers), the input price was bound to go up. Fourth, sinceplastic was just a by-product for the oil companies, there was no real as-surance of supply. Finally, "environmental indignation" over plastic jugswas heating up. They were being outlawed in many states because of prob-lems with burning them or dumping in landfills. The most populous countyin the U.S., Suffolk County on Long Island, passed legislation in 1987 ban-ning plastic cartons from its landfills.

186 Journal of Management Accounting Research. Fall 1992

Cost StructureOne way to understand NorthAm's position Is to analyze and discuss

the process flow from basic raw material sources through to the ultimateend-use product delivered into the final customers' hands. However, inorder to keep this paper to manageable length, we focus our discussion onthe paper mill, extrusion, and conversion stages of the chain which relateto NorthAm. The timber, logging, chipping and pulp mill stages are de-emphasized because they are not critical to the issues addressed here.Obviously, the full value chain would consider these stages as well.

Step 1—Paperboard Manu&cturlng: The MillNorthAm's primary manufacturing facility bought pulp on the open

market for $319 per ton and converted the pulp into uncoated paperboardat an additional cost of $105 per ton. The $105 is an average actual, fullcost figure. We believe the analysis should use full cost since the focus islong run. We use average, actual cost as the best proxy for future cost.

The company sold some of the uncoated board to outside customers atan average price of $483 per ton. plus freight to the customer. On theseshipments the mill earns a profit of $59 (483-319-105). as shown in E:X-hibit 2. But. the major customer for the uncoated board was NorthAm'sown plastic extruding plant.

Step 2 - Adding the Plastic Coating: Extrusion

The uncoated board was then trucked to a nearby coating plant at anaverage cost of $3 per ton. Polyethylene coating was applied to both sidesof the board by two "extruders" at an average full cost of $91 per ton. Atthis stage the product cost is $518 (319-flO5+3-i-91). But. using marketprice to value the transfer, the economic cost is $577 (483+3+91).

Coated board was currently sold in the market for an average price of$605. plus freight. On these shipments, the "extruding'* plant earns aneconomic proilt of $28 per ton (605-577). as shown in Exhibit 2. Theuncoated board from the mill is valued here at the external market price inorder to measure segment profit.

Step 3 - Carton Conversion

After extrusion, the coated board is shipped to NorthAm's carton con-verting plant at an average freight cost of $35 per ton. In the first stage ofthe converting operation, rolls of coated paperboard are spliced together toform a long, continuous "web." Next, each particular processor's name,logo, and design is printed on one side. Then, the carton (container) blanksare stamped out and stacked on shipping pallets for loading. The total costof the conversion operation averaged $234 per ton. The converting plantalso paid an average of $10 per ton for freight to the end use customers.Industiy statistics showed that one ton of board yielded an average of 14.400containers. All carton conversion costs are shown in Exhibit 2.

Step 4 - The Filling Piants: Processors of Consumer Products

The blank cartons (containers) were setup, filled and then sealed in theprocessor's factory. The processors delivered their products to convenience

Shank and Govtndarqjan 187

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188 Journal of Management Accounting Research, Fall 1992

stores and supermarkets. Without recycling, the cycle was complete whenconsumers purchased the products and eventually threw away the dispos-able cartons. The processors who produced an undlfferentiated productusually paid $.08 per carton. The other costs of such processors were, onaverage: product cost, $.75 per carton; and converting, distribution, andshrinkage. $.12 per carton. They sold a carton of the commodity productfor an average of $1.04 to supermarkets. Their profit per carton was $.09(1.O4-.O8-.75-.12). This converts to $1,296 per ton of coated paperboard(14.400 cartons/ton x $.09). as shown in Exhibit 2.

The differentiated processors, on the other hand, had a very differentcost structure. Their average container cost was $.07; product cost. $.64per carton; converting, distribution, and shrinkage. $.11 per carton; na-tional selling and advertising. 25 percent of the $1.42 per carton wholesaleprice to supermarkets, or $.36 per carton. The branded processor thusearned a profit per carton of $.24 (1.42-.07-.64-.11-.36). This converts to$3,456 per ton of paperboard (.24x14.400). as shown in Exhibit 2.

It is an anomaly of this industry that the higher quality differentiatedcarton actually sells for less than the commodity carton ($.07 versus $.08).This is because of substantial quantity discounts in the difierentlated seg-ment. In this segment 60.000 tons are spread over 6 customers, whereas146,000 tons are spread over 300 customers in the commodity segment.

Step 5 - The Retailer: The Supermarkets

A typical supermarket sells the undifferentiated product for $1.16 andthe branded product for $1.89. The entire value chain (all 5 steps) is sum-marized in Exhibit 2. This exhibit shows only gross margin for the super-market, without an allocation of store operating expenses. Such an alloca-tion is not relevant for the purposes of this example. The first three stepsin the chain relate to NorthAm. The final two steps relate to the processorsof consumer products and the supermarkets to whom they sell.

The assets invested at each stage of the process were estimated asfollows. We valued assets using current replacement cost and assumingfull utilization of the item. This included allocation of common assets basedon full utilization where several products were involved.

Current Replacement Value ofAssets Per Ton of Paperboard

(when operating at practical capacity)

Paperboard MillExtruding PlantCarton ConverterCommodity ProcessorDifferentiated Processor (lower investment

per ton because of scale economies)Supermarket

$2,800$ 190$ 830$5,400

$2,890$1,800

This five step value chain approach to cost reporting is very unusual inmanagement accounting, but we believe the inferences it suggests, as shownlater, justify this framework.

Parenthetically, we might note that in generating the cost and assetnumbers for processors and supermarkets, we followed multiple ap-

shank and Govindarqjan 189

proaches: we Interviewed NorthAm executives about their customers' coststructures; we visited several processors and supermarkets and Interviewedmanagers about their costs and investments. The resulting numbers, thoughnot precise, are reasonable enough estimates to draw meaningful infer-ences.

We turn now to the business decisions NorthAm was facing.

Strategic Options

Which market segment should NorthAm emphasize? Where should ItInvest capital dollars? The strategic positioning and capital spending deci-sions facing NorthAm as of 1989 would shape its future for many years tocome.

On the choice of market segments, NorthAm considered two specificalternatives. The company could continue to emphasize the commodityprocessors whose total market had been declining 3 percent a year butwho had always been their main customers. Or, they could try to aggres-sively build market share with differentiated processors whose market wasgrowing at 10 percent or more and who would pay top dollar for board(holding quantity discounts constant), but who demanded a consistent highquality.

NorthAm recognized Its weaknesses vIs-a-vIs the differentiated segment:• Technologically obsolescent manufacturing. Most of the plant and equip-

ment had been bought in the 1960s.• Nagging problems with the quality of the board, caused by lack of up to

date machinery.• Limited extrusion capacity.• Lack of rotogravure printing in the conversion plant.

Their 15 percent market share in the differentiated segment reflectedtheir status as largely a "backup" supplier. Major capital investments (atotal of $61.5 million) had to be made If NorthAm was serious about re-building market share In this fast growing segment. Three specific newInvestments would be:• About $43 million to upgrade its primary manufacturing facility to im-

prove board strength, printability. and smoothness.• About $17 million to add a new extruder to compete in multilayered

polymer coating applications. Differentiated processors required mul-tiple coatings to extend the shelf life of products and to hold difficultproducts (liquids, for example).

• About $1.5 million to purchase a rotogravure printing press. CurrentlyNorthAm printed the cartons with fiexographic presses which use rub-ber printing rolls. This method is Inexpensive but produces low qualityimages. After the initial capital investment, the rubber plates cost about$150 each, with six needed for a standard six color process. Althoughthe quality was not as good as with rotogravure printing, high qualityprinting had never been required by the commodity processors. Roto-gravure printing uses etched metal printing rolls and gives an extremetyprecise and high quality finish—but It is expensive. After the initialcapital expense, each etched metal printing plate costs $2,500. With asix color process. $15,000 must be spent for only one run. Once that

190 Journal of Management Accounting ResearcK Fall 1992

run Is complete, those etched cylinders will probably never be usedagain.This completes the case study itself. In the next section, we compare

the results of several different ways of analyzing the strategic options.

Conventional Analysis of the Strategic Options

How should NorthAm's senior executives evaluate the marketing andinvestment options open to them? Conventional capital expenditure re-quests, using discounted cash flow analyses had been prepared to "Justify"the proposed investments. These focussed solely on projected "Value added"for NorthAm. Using assumptions recommended by the marketing group,these DCF analyses showed acceptable returns for NorthAm for investing$61.5 million to build market share in the differentiated segment (Exhibit3).

Exhibit 3NorthAm Packaging Company: Capital Investment Analysis

DiHerentiated SegmentCapital investments needed in year 0:

Primary manufacturing $ 43 millionThird extruder 17 millionRotogravure printing 1.5 miliion

Total $61.5 millionAnnual Cash Flows: Per Ton

Revenue (assumes a 10% price increasedue to a better quality board 7.7« x 14.400) $l,iO9Costs (per Exhibit 2)(319+105+3+91+35+234+10) (797)Plus additional printing costs(due to rotogravure printing) (10)

Proilt per ton 302Total market (differentiated segment) = 400.000 tonsProjected market growth = 14%Additional volume next year (400.000 x 14%) = 56.000Assume we can capture 50% of this additional volume = 28.000Plus a 5% increase in our share of the existing market

(400.000 X 5%) = 20.000Additional Volume 48.000 tons*

•(We ignore additional growth beyond year 1. to be conservative.)Annual Cash Proilts (48.000 x $302) = $14.5 million

After-tax profits (40% tax rate) = $8.7 millionPlus depreciation lax shield (straight-line depreciation

for 10 years) $6.15 million x 40% = $2.46 millionTotal annual cash flows $11.16 million

Time horizon for the project =10 yearsSalvage value of the plant and equipment In year 10 (after tax) = $3 millionAll cash flows are in "real" dollars; inflation is not incorporatedInternal Rate of Return = Approx. 13% (after tax. "real" return)

Shank and Govindarqjan 191

Another way to address these options would be through a simple 2x2growth/share matrix as originally introduced by the Boston ConsultingGroup IHenderson, 1979]. Exhibit 4 displays NorthAm's strategic optionson this familiar portfolio grid using the dimensions of market growth (aproxy for market "attractiveness") and market share. NorthAm had histori-cally emphasized the commodity segment. Even though volume had beenshrinking at 3 percent per year over the past five years, the ftrm had main-tained market share at 40 percent in this large segment (350,000 tons peryear). This segment appears to be the classic "cash cow" in the BCG termi-nology—"high market share with low-growth." The strategic inference fromthe BCG grid would be that NorthAm should "harvest" this commodity seg-ment.

The firm, on the other hand, had a relatively modest 15 percent of themarket in the differentiated package segment. The overall market in thissegment was growing at 10 percent per year with projections to grow evenfaster in the future. NorthAm has a low market share in this high growthsegment. The strategic inference from the BCG-grid would be that NorthAmshould aggressively "build" market share in this segment by making the$61.5 million in new Investments. Hiis was, in fact, the prevailing senti-ment within NorthAm when we undertook the value chain analysis. Thispoint of view was supported by formal financial analysis using DCF tech-niques (Exhibit 3), as indicated above. A 13 percent "real" return certainlyargues for investing $61.5 million to build share in the differentiated seg-ment.

An alternative way of viewing NorthAm's problem, using different inputassumptions, might yield different analytic inferences. For instance, valuechain analysis, as we will show later, casts severe doubt on the assump-tion In Exhibit 3 that the differentiated segment will give NorthAm a 10percent price increase.

Exhibit 4Boston Consulting Group Grid

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192 Journal of Management Accounting Research, Fall 1992

Strategic Analysis - A Value Chain PerspectiveOrganizing the information in the value chain framework (Exhibit 2)

provides a fundamentally different view of the marketing and investmentoptions facing NorthAm. Exhibits 5 through 7 summarize the inferencesfrom the value chain framework. Recapping, the methodology we used increating the value chain was as follows:• Identify Value Chain Stages. We identified the mill, extruder, converter,

processor, and supermarket as the key building blocks in the valuechain. A conventional management accounting system will tend to ig-nore the value created by the processors and supermarkets becausethey are beyond the scope of profitability to the firm.

• Identify Strategic Options. Since the value chain analysis was done todraw inferences about two strategically distinct market segments, weprepared separate value chains for the commodity and differentiatedprocessor segments.

• Assign Costs and Revenues to Value Chain Steves. After identifying thevalue chain activities and strategic options, the next step was to assignoperating costs and revenues to these activities (Exhibit 2). All costsand revenues have been calculated for one ton of paperboard, usingestimated average actual full cost.

• Estimated Market Value Transfer Prices. NorthAm's converting opera-tions have a "true" market price for sales to the processors. But howcan we approximate "value" for intermediate products? Uncoated boardis transferred internally from the mill to the extruder and coated boardis transferred Internally from the extruder to the converter. Sinceuncoated and coated paperboard are also traded in external markets.we used the competitive market prices for the intermediate products.Calculating profit per ton for each value activity based on the competi-tive market price, as opposed to arbitrary accounting transfer prices,helps to identify the fundamental sources of economic value and al-lows each stage to be evaluated independently. Exhibit 5 summarizesthe profit earned at each stage in the linked value chain.

• Estimated Asset Ini^stment We then estimated the assets per ton ofboard at each value activity, using current replacement costs and as-suming full utilization of capacity (see earlier discussion). Current re-placement costs were estimated from discussions with plant engineersand equipment vendors. Tons of production at full capacity were esti-mated from discussions with manufacturing management and equip-ment vendors. With profit and assets, we calculated Return on Assetsfor each value stage as summarized In Exhibit 6.

• Calculational Accuracy. We should emphasize that the computations InExhibits 2. 3. 5, and 6 do not involve the same level of precision thatone is likely to encounter in audited financial statements. In fact, profitmargins for processors and supermarkets are based on estimates thataverage away substantial, continual day to day volatility in net prices.As the analysis proceeds and particular activities become critical inanswering strategic questions, greater effort at precision can be made.

shank and Govintiarajan 193

Exhibit 6Profit Per Ton of Board

(Data Uken from Exhibit 2)

Commodity SegmentSupermarket $1,728Processor $1,296ConverterExtruderMIU

Total

NorthAm %

NorthAm$268

$28$59

$355

$3,379

of Profit 10.5%

Differentiated Segment$6,768$3,456

$124$28$59

$211

$10,435

2.0%

Exhibit 6Return On Assets Per Ton of Paperboard

(Based on Current Replacement Cost and Full Capacity Utilization)Commodity Segment Differentiated Segment

SupermarketProcessorConverterExtruderMillTotal

New Insights?

Pro/it$1,728

1,2962 6 8

28

59

$3,379

Assets$1,800

5.4008 3 0

190

2,800$11,020

ROA

9 6 %

2 4 %

32%

15%

2%

3 1 %

Profit$6,768

3,456124

2 8

59

$10,435

Assets

$1,8002,890

8 3 0

190

2,800$8,510

ROA

376%120%

15%

15%

2%

123%

Does the information based on value chain analysis lead to new in-sights? We believe it does. Dramatically different strategic insights emergewhen one considers the value chain analysis summarized in Exhibit 7.• Of the total profit of $3,379 per ton of paperboard created in the com-

modity processor segment, NorthAm realized $355 (10.5 percent of thetotal value). In sharp contrast, in the differentiated processor segment,NorthAm's share of the total profit in the chain is only 2 percent! Thebuyer power in the differentiated segment is extremely strong! As wenoted earlier, the average customer In the differentiated segment is muchlarger than the average commodity segment customer. Even thoughthe carton is of higher quality and is much more a marketing tool inthe differentiated segment, volume discounts and overall buyer powerhold unit prices below those for the commodity carton. Thus, NorthAmactually does more work here with more assets for a lower sales price,on a per unit basis.

• We should note that there is no particular reason, ex ante, to believethat 10.5 percent of the overall profit in the commodity segment Is a"reasonable" or "unreasonable" share for the carton manufacturer ver-sus the processor or the retailer. But. whatever the share is for the

194 Journal of Management Accounting Research, Fall 1992

Exhibit 7NorthAm Packaging Company: A Value Chain Perspective

Commodity Segment% of the

TotalPront Pront ROA

59 3%

28

2%r

Differentiated Segment% of the

TotalPront Pront ROA

MIU 59 .5%

268 7% 32% I Converter

L_T_'J1.296 40% 24% [Processor

1,728 49% 96% Supermarket 6,768 65% 376%

$3,379 100% $10,435 100%

2%

1% 15% I Extruder | 28 .25% 15%

124 1.2% 15%

3.456 33% 120%

carton manufacturer in the commodity segment, the share should behigher in the differentiated segment where the carton is more expen-sive to make and is much more important as a polnt-of-sale marketingtooL Although NorthAm does not separate commodity end use cartonstock from differentiated end use carton stock as it is produced, thedifferentiated end use product must run slower to produce smooth-ness, thus yielding fewer tons per hour and higher cost per ton. For theshare of overall profit to drop from 10.5 percent to 2 percent is dra-matic evidence of the lack of seller power for NorthAm in the highervalue segment. The $.07 carton price ln the differentiated segment pre-sumes a product which meets quality standards. That is, there is noway to charge more than $.07 (the prevailing price in this segment)once the quality improvements are achieved.

NorthAm's Return on Assets (ROAs) in the commodity segment is 2percent at the mill, 15 percent at the extruder, and 32 percent at theconverter. On the other hand, in the differentiated segment, the ROAsare 2 percent, 15 percent, and 15 percent for the mill, extruder, andconverter, respectively. This further reinforces the unattractiveness ofthe differentiated segment.From the BCG-grid (Exhibit 4). the differentiated processor segmentlooked extremely attractive. But based on the value chain analysis,this market looks much less attractive. The differentiated processorshave enormous leverage (buyer power). Why invest over $60 million tobuild market share in the differentiated segment where NorthAm iscurrently able to extract only 2 percent of the total value created in thechain? This insight is neither apparent In the BCG-type strategic analy-

Shank and Govtndarqjan 195

sis nor In a conventional management accounting approach relying onDCF based project returns to NorthAm. In fact, the value chain analy-sis calls into question the sales volume and selling price assumptionsused in the DCF analysis contained in Exhibit 3. Further, conventionalmanagement accounting is of little help in quantifying buyer powersince it ignores the total value created in the chain. It is highly unlikelythat NorthAm will be able to extract any more than 2 percent of thetotal value in the differentiated segment even after it matches its lead-ing competitor's investment, due to the buyers' tremendous bargainingpower (unless the differentiated processors are willing to share some oftheir profit in order to entice an investment by NorthAm):

• There are very few buyers in the differentiated segment — fewerthan ten versus more than 1,000 in the commodity segment.

• Buyers are very large.• The average order size tends to be quite large.• Differentiators typically keep two or more sources of supply. Poor

service, quality, or uncompetitive prices are punished by cuts inorder size.

• Plastic has several attractive features as a packaging material—break resistance, design versatility, eye appeal, printability. Plasticposes a more significant threat to coated board in the differentiatedsegment since this segment values more highly the marketing ap-peal of the package. This substitution threat sets a cap on paper-board carton prices and a corresponding cap on investment returns,once the overwhelming buyer power is factored into the analysis.

Overall, the value chain perspective yields a much different picture ofthis industry. It appears to be an industry where the closer one gets to theend-use customer and the more one creates product differentiation, themore money will be made (Exhibit 7). NorthAm seems to lose on both counts.They lack the ability to forward integrate into the processor and super-market segments. Further, we have already argued that NorthAm lacksthe product quality to successfully compete as a supplier to the differenti-ated processor segment. What should they do? NorthAm's position is simi-lar to having failed to improve your hand in the draw in a poker game. Doyou put more money in the pot. even if you know you have a bad hand? Doyou fold? Or do you stay in as long as possible without adding much to thepot?• NorthAm. instead of de-emphasizing the commodity segment as would

be recommended by the BCG-type analysis, needs to find ways to ef-fectively compete in the commodity segment by being the low cost pro-ducer. Here again, the value chain framework can provide importantinsights. NorthAm needs to understand the structural and executionaldrivers of cost behavior for the major cost items in the mill, extruder,and converter operations [Shank. 1989]. NorthAm then needs to man-age these drivers better than its competitors. Staying in the commoditysegment is the only logical choice for NorthAm. TTie attractiveness ofthis option is further enhanced by possible significant growth in com-modity carton demand in export markets. Their manufacturing system

196 Journal of Managertient Accounting Research, Fall 1992

Exhibit 8

Traditioiud ManagementAccounting

Focus Internal

Perspective Value-added

Cost DriverConcept

CostContainmentPhilosophy

Insights forStrategicDecisions

A single fundamentalcost driver pervades theliterature — Cost is afunction of volume

Applied too often, onlyat the overall firm level

Cost reductionapproached viaresponsibility centersor via product costIssues

None are readily apparent.This is a major reasonwhy the strategicconsulting firmstypically throw awaythe conventional reportsas they begin their costanalysis

Value Chain Analysis inthe SCM Framework

External

Entire set of linked activities fromraw material suppliers to ultimateend use customers

• Multiple cost drivers

• Structural drivers (examples:scale, scofje. experience,technology, complexity)

• E^ecutlonal drivers (examples:participative management,total quality management.plant layout)

value activity has a setof unique cost drivers

Cost containment is a functionof the cost driver(s) regulatingeach value activity

• Exploit linkages with suppliers

• Ebcploit linkages with customers

• "spend to save"

• Identify cost drivers at theindividual activity level: developcost/differentiation advantageeither by controlling those driversbetter than comp)etitors or byreconfiguring the value chain(examples: Federal Express inmail delivery. MCI in longdistance telephone)

• For each value activity, askstrategic questions pertaining to:• make versus buy• forward/backward integration

• Quantify and assess "supplierpower" and "buyer power;"exploit linkages with suppliersand buyers

Shank and Covlndarqjan 197

is geared to this market, and their reputation has been n^ade in thismarket. Also, they have a low investment base to support this busi-ness, since most of the plant and equipment were bought before 1970.Major new investments are not required to compete here.

• Looking at the economics of the mill, extruder, and converting opera-tions, NorthAm is currently destroying value (rather than creating value)by selling in the differentiated segment. Also, the profitability at themill is well below satisfactory levels. A cost driver analysis at the milland extruder stages might go a long way in identiiying profit improve-ment opportunities. Such analysis is beyond the scope of this paper.

CONCLUSION

We have argued in this paper that the value chain need not be Just anabstract conceptual tool. It can become a powerful tool of empirical analy-sis, even though actual examples of value chains are not yet available inthe published literature. This paper presents a first attempt at a valuechain for the coated paperboard carton business. The value chain analysisin this situation yields insights which are much different from those sug-gested by more conventional analytic tools. We contrasted the value chainperspective with the project analysis perspective (via DCF analyses) fromconventional managerial accounting and the familiar BCG growth/sharematrix perspective. The value chain analysis in this situation helps to ex-amine and validate the implications which arise from the more conven-tional analyses. The SCM-value chain perspective thus extends our abilityto achieve meaningful managerial cost analysis. A summary of the keydifferences between value chain and traditional management accountingperspectives is shown in Exhibit 8.

Since virtually no two companies compete in exactly the same set ofvalue activities, value chain analysis is a critical flrst step in understand-ing how a firm is positioned in its industry. Building sustainable competi-tive advantage requires a knowledge of the full linked set of value activitiesof which the firm and its competitors are a part.

Once the value chain is fully articulated, critical strategic decisionsregarding make/buy and forward/backward integration become clearer.Investment decisions can be viewed from the perspective of their impact onthe overall chain and the ilrm's position within it. For strategic decisionmaking, cost analysis today cannot afford to ignore this critical dimension.The authors hope this paper will encourage more widespread attention toempirical estimation of value chains as a useful extension of modem stra-tegic cost analysis.

REFERENCESHenderson, B. D.. Corporate Strategy. Cambridge, Mass: Abt Books, 1979.Hergert, M., and D. Morris, Accounting data for value chain analysis. Strategic Management

Joumal 10, 1989, 175-188.Porter, M. E., Competitive Advantage. Glenwood, Illinois. The Free Press, 1985.Shank, J. K., Strategic cost management: New wine, or just new bottles? Journal of Manage-

ment Accounting Reseawh, Fall 1989, 47-65,, and Vijay Govindarajan, Strategic Cost Analysis, Homewood, Illinois. Richard D. Irwin,

Inc., 1989.