Value Chain Analysis for Assessing Competitive Advantage

VA L U E C H A I N A N A LYS I S F O R A S S E S S I N G C O M P E T I T I V E A DVA N TAG E

INTRODUCTION

Competitive advantage for a companymeans not just matching or surpassingwhat competitors can do, but discov-ering what customers want and thenprofitably satisfying, and even exceed-ing, their expectations. As barriers tointerregional and international tradehave diminished and as access to goodsand services has grown, customers canlocate and acquire the best of whatthey want, at an acceptable price,wherever it is in the world. Undergrowing competition and, hence, risingcustomer expectations, a company’spenalty for complacency becomeseven greater.

INTRODUCTION 1THE VALUE CHAIN DEFINED 2COMPETITIVE ADVANTAGE

AND CUSTOMER VALUE 2THE ROLE OF THE

MANAGEMENT ACCOUNTANT 4THE VALUE CHAIN APPROACH

FOR ASSESSING COMPETITIVE ADVANTAGE 4

Internal Cost Analysis 5Internal Differentiation Analysis 8Vertical Linkage Analysis 10STRATEGIC FRAMEWORKS FOR

VALUE CHAIN ANALYSIS 13Industry Structure Analysis 13Core Competencies Analysis 15Segmentation Analysis 16LIMITATIONS OF VALUE

CHAIN ANALYSIS 20ORGANIZATIONAL AND

MANAGERIAL ACCOUNTING CHALLENGES 20

CONCLUSION 21APPENDIX 22ENDNOTES 23BIBLIOGRAPHY 24

Organizations today are faced with increasing

competition in a global marketplace. In order

to assess and improve their competitive advantage,

companies must determine how well they are

meeting or exceeding the changing expectations

of their customers. An essential tool of strategic

planning, value chain analysis looks at value

creation across the complete range of activities

and processes that shape the final offering to

the end customer and offers insights important

to the firm’s long-term growth and survival.

This publication defines terms and concepts;

describes the main elements of the value chain

approach: internal cost analysis, internal differ-

entiation analysis and vertical linkage analysis;

outlines three useful strategic frameworks: industry

structure, core competencies and segmentation;

and discusses the issues and challenges involved

in value chain analysis. The concepts and tech-

niques presented can be applied to all types of

organizations.

PAGE

A strategic tool to measure the im-portance of the customer’s perceivedvalue is value chain analysis. By enabling companies to determine thestrategic advantages and disadvantagesof their activities and value-creatingprocesses in the marketplace, valuechain analysis becomes essential forassessing competitive advantage.

This guideline is addressed tomanagers, and more specifically tomanagement accountants, who maylead efforts to implement value chainanalysis in their organizations.

The concepts, tools and techniquespresented apply to all organizationsthat produce and sell a product orprovide a service.

Responsibility for the content of this material rests solely with The Society of Management Accountantsof Canada. Value Chain Analysis for Assessing Competitive Advantage is designed to provide accurate infor-mation in regard to the subject matter covered. This publication does not represent an official positionof The Society of Management Accountants of Canada and is distributed with the understanding thatthe authors, editor and publisher are not rendering tax, legal, accounting or other professional servicesin the publication.

C O N T E N T S E X E C U T I V E S U M M A R Y

STRATEGICMANAGEMENT

SERIES

ManagementAccountingGuideline

Published by:

C A N A D A

Shaping the Future

CUSTOMER AND SUPPLIER VALUE CHAIN

This guideline will help readers to:• link value chain analysis to organiza-

tional goals, strategies and objectives;• broaden management awareness about

value chain analysis;• understand the value chain approach

for assessing competitive advantage;• comprehend useful strategic frameworks

for value chain analysis; and• appreciate the organizational and man-

agerial accounting challenges.

THE VALUE CHAIN DEFINED

The idea of a value chain was first suggestedby Michael Porter (1985) to depict howcustomer value accumulates along a chainof activities that lead to an end product orservice.

Porter describes the value chain as theinternal processes or activities a companyperforms “to design, produce, market, de-liver and support its product.” He furtherstates that “a firm’s value chain and theway it performs individual activities are a reflection of its history, its strategy, itsapproach to implementing its strategy, andthe underlying economics of the activitiesthemselves.”

Porter describes two major categories of business activities: primary activities andsupport activities. Primary activities are directly involved in transforming inputsinto outputs and in delivery and after-salessupport. These are generally also the lineactivities of the organization. They include:• Inbound logistics. Material handling and

warehousing;• Operations. Transforming inputs into the

final product;• Outbound logistics. Order processing and

distribution;• Marketing and sales. Communication,

pricing and channel management; and• Service. Installation, repairs and parts.

Support activities support primary activ-ities and other support activities. They arehandled by the organization’s staff func-tions and include:• Procurement. Purchasing of raw materials,

supplies and other consumable items aswell as assets;

• Technology development. Know-how, pro-cedures and technological inputs neededin every value chain activity;

• Human resource management. Selection,promotion and placement; appraisal; rewards; management development;and labor/employee relations; and

• Firm infrastructure. General management,planning, finance, accounting, legal,government affairs and quality manage-ment.

John Shank and V. Govindarajan (1993)describe the value chain in broader termsthan does Porter. They state that “the valuechain for any firm is the value-creating ac-tivities all the way from basic raw materialsources from component suppliers throughto the ultimate end-use product deliveredinto the final consumers’ hands.” This description views the firm as part of anoverall chain of value-creating processes.

According to Shank and Govindarajan,the industry value chain starts with thevalue-creating processes of suppliers, whoprovide the basic raw materials and com-ponents. It continues with the value-creat-ing processes of different classes of buyersor end-use consumers, and culminates inthe disposal and recycling of materials.

The industry value chain and the valuechain activities within the firm are com-pared in Exhibit 1.

COMPETITIVE ADVANTAGE AND CUSTOMER VALUE

In order to survive and prosper in an in-dustry, firms must meet two criteria: theymust supply what customers want to buy, and they must survive competition. A firm’s overall competitive advantage derives from the difference between thevalue it offers to customers and its cost ofcreating that customer value.

Competitive advantage in regard toproducts and services takes two possibleforms. The first is an offering or differentia-tion advantage. If customers perceive aproduct or service as superior, they becomemore willing to pay a premium price relativeto the price they will pay for competingofferings. The second is a relative low-costadvantage, which customers gain when acompany’s total costs undercut those of itsaverage competitor.

Differentiation Advantage

A differentiation advantage occurs whencustomers perceive that a business unit’sproduct offering (defined to include all attributes relevant to the buying decision)is of higher quality, incurs fewer risks and/oroutperforms competing product offerings.For example, differentiation may include afirm’s ability to deliver goods and services

2

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

in a timely manner, to produce better quality,to offer the customer a wider range of goodsand services, and other factors that provideunique customer value.

Once a company has successfully differen-tiated its offering, management may exploitthe advantage in one of two ways: increaseprice until it just offsets the improvementin customer benefits, thus maintaining cur-rent market share; or price below the “fullpremium” level in order to build marketshare.

Low-Cost Advantage

A firm enjoys a relative cost advantage if itstotal costs are lower than the market average.This relative cost advantage enables a businessto do one of two things: price its product orservice lower than its competitors’ in orderto gain market share and still maintain cur-

rent profitability; or match the price ofcompeting products or services and increaseits profitability.

Many sources of cost advantage exist: access to low-cost raw materials; innovativeprocess technology; low-cost access to distri-bution channels or customers; and superioroperating management. A company mightalso gain a relative cost advantage by exploit-ing economies of scale in some markets.

The relationship between low-cost advan-tage and differentiation advantage is illus-trated in Exhibit 2.

Superior relative cost position offersequivalent customer value for a lower price.Superior relative differentiation position of-fers better customer value for an equivalentprice.

Va lue Cha i n Ana l y s i s fo r As se s s i n g Compe t i t i ve Advan t a ge

3

Exhibit 1 – The Value Chain

Supplier ValueChain

INDUSTRYVALUE CHAIN

VALUE CHAIN ACTIVITIESWITHIN THE FIRM

SupportActivities

PrimaryActivities

End-

Use

Con

sum

er P

ays

for

Prof

it M

argi

ns T

hrou

ghou

t th

e Va

lue

Cha

in

Firm ZValue Chain

DistributionValue Chain

Buyer ValueChain

Disposal/RecycleValueChain

R&D

X Y

Design

Production

Marketing

Procurement

TechnologyDevelopment

Human ResourceManagement

FirmInfrastructure

Distribution

Service

Organizations that fail to gain competitiveadvantage through low cost or superiordifferentiation, or both, are “stuck-in-the-middle.” For instance, several American bicycle makers, including Schwinn, Huffy,Murray and Columbia, found themselvesin this position during the 1980s. Thesecompanies lacked a cost advantage andfailed to foresee the emerging mountainbike market. By contrast, Cannondale captured market share after introducing its large-diameter frame bicycle.

THE ROLE OF THE MANAGEMENT ACCOUNTANT

The management accountant is traditionallyconsidered the resident expert on costanalysis; cost estimation; cost behavior;standard costing; profitability analysis byproduct, customer or distribution channel;profit variance analysis; and financialanalysis.

Today, management accountants mustalso bring skills in activity-based costing,benchmarking, re-engineering, target cost-ing, life-cycle costing, economic valueanalysis, total quality management andvalue chain analysis. The Appendix contraststraditional management accounting withthe requirements of value chain analysis.

Value chain analysis is a team effort.Management accountants need to collabo-rate with engineering, production, market-ing, distribution and service professionalsto focus on the strengths, weaknesses, opportunities and threats identified in thevalue chain analysis results.

By championing the use of value chainanalysis, the management accountant en-hances the firm’s value and demonstrates

the value of the finance staff to the firm’sgrowth and survival.

THE VALUE CHAIN APPROACH FOR ASSESSING COMPETITIVE ADVANTAGE

Most corporations define their mission asone of creating products or services. Forthese organizations, the products or servicesgenerated are more important than anysingle step within their value chain. Incontrast, other companies are acutely awareof the strategic importance of individualactivities within their value chain. Theythrive by concentrating on the particularactivities that allow them to capture maxi-mum value for their customers and them-selves.

These firms use the value chain approachto better understand which segments, dis-tribution channels, price points, productdifferentiation, selling propositions andvalue chain configurations will yield themthe greatest competitive advantage.

The way that the value chain approachhelps organizations assess competitive advantage is through the following typesof analysis:• internal cost analysis to determine the

sources of profitability and the relativecost positions of internal value-creatingprocesses;

• internal differentiation analysis to under-stand the sources of differentiation (including the cost) within internal value-creating processes; and

• vertical linkage analysis to understandthe relationships and associated costsamong external suppliers and customersin order to maximize the value deliveredto customers and to minimize cost.

4

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

Exhibit 2 – Competitive Advantage Through Low Cost and/or Differentiation

Relative

Differentiation

Position

Relative Cost Position

DifferentiationAdvantage

Stuck-in-the-Middle

Inferior

Superior

Inferior

Differentiation with Cost Advantage

Low-Cost Advantage

Superior

Source: Shank, and Govindarajan, 1993.

These types of analysis are not mutuallyexclusive. Rather, firms begin by focusingon their internal operations and graduallywiden their focus to consider their competi-tive position within their industry.

The value chain approach for assessingcompetitive advantage is an integral part ofthe strategic planning process. Like strategicplanning, value chain analysis is a continu-ous process of gathering, evaluating andcommunicating information for businessdecision-making. By stimulating strategicthinking, the analysis helps managers envi-sion the company’s future and implementdecisions to gain competitive advantage.

Internal Cost Analysis

Organizations use the value chain approachto identify sources of profitability and tounderstand the cost of their internal processesor activities. The principal steps of internalcost analysis are:• identify the firm’s value-creating processes;• determine the portion of the total cost of

the product or service attributable toeach value-creating process;

• identify the cost drivers for each process;• identify the links between processes; and• evaluate the opportunities for achieving

relative cost advantage.

Identify the Firm’s Value-Creating Processes

To identify its value-creating processes, a firmmust de-emphasize its functional structure.Most large businesses still organize them-selves as cost, revenue, profit and investmentcenters. These and other organizationalsub-units, such as departments, functions,divisions or separate companies, that arefrequently used for control purposes are notvery useful for identifying value-creatingprocesses. Adopting a process perspectiverequires a horizontal view of the organiza-tion, beginning with product inputs andending with outputs and customers.

Processes are structured and measuredsets of activities designed to produce a spec-ified output for a particular customer ormarket. Emphasizing process means focusingnot on what work is done, but on how workis done within the organization.

While an organization’s hierarchical struc-ture typically lays out responsibilities andreporting relationships, its process structureshows how the organization delivers cus-tomer value. While it is not possible to

measure or improve hierarchical structurein any absolute sense, processes lend them-selves to such measures as cost, time, out-put quality and customer satisfaction.

Because processes normally cut acrossfunctional areas, defining process boundariesis not always a straightforward task. Peopleassociated with a particular business processmay view it in different ways. For example,the new product development process couldstart with marketing surveys or with deliveryof product requirements from marketing todevelopment engineering. The processcould end with the release of product speci-fications or with shipment of the first order.Process boundaries should be defined inde-pendently of the way in which activities areorganized.

Selecting the appropriate activity categorymay be anything but straightforward. Thekey is to classify value activities accordingto their true contribution to the firm’s com-petitive advantage. For example, if orderprocessing is important to a firm’s customerinteractions, then this activity should beclassified under marketing.

Management at American Airlines, forexample, handed its marketing unit the taskof developing and implementing the carrier’sSABRE computerized reservation system.The result: a significant competitive advan-tage that left the other airlines scramblingto copy the system. Even mighty UnitedAirlines has failed to match American’s in-stalled base of terminals in travel agencies.

Determine the Portion of the Total Cost ofthe Product or Service Attributable toEach Value-Creating Process

The next step of internal cost analysis is totrace or assign costs and assets to each value-creating process identified. Although firmsmaintain internal reports and cost account-ing information, this information may notalign with their processes. Companies mighthave to reclassify their data or conduct coststudies to assign costs and assets to eachprocess. Rather than conduct a detailed coststudy, an organization might use rough estimates to assign costs to their value-creating processes.

A full-cost approach provides the best estimate of life-cycle costs for evaluatingthe strategic cost advantage of a firm’s value-creating process. Without adopting this approach, a firm risks sacrificing productdevelopment costs to short-term profits.


5

For example, the savings in factory laborthat an organization gains through usingflexible manufacturing systems, roboticsand computer-integrated manufacturingmight be offset by the high cost of comput-er software programmers. The informationsystems support costs should be allocatedto the value-creating processes that benefitfrom the new systems as part of the fullcost.

For estimating the full cost of each value-creating activity, the full utilization of the capacity of the activity, or its practicalcapacity, is normally used. Facility managersand equipment vendors are useful sourcesof capacity estimates. If estimates of fullcapacity vary widely, a firm could performthe analysis with the resulting costs to as-sess the sensitivity of the analysis to thedifferent capacity measures. When costsvary dramatically, companies should seekmore information for a more realistic long-term estimate of capacity.1

Although many of the processes identi-fied may be instrumental for achievingcompetitive advantage, various value-creat-ing processes may have differing effects ona firm’s costs or products. Companies sell-ing pencils, pens or paper clips, for example,are unlikely to concern themselves withafter-sales service. But customer support isa vital part of the competitive strategy formakers of computers or high-speed copiers.

Identify the Cost Drivers for Each Process

The next step of internal cost analysis is toidentify the factor or cost determinants foreach value-creating process. By under-standing what factors drive costs, a firmcan assign priorities among its cost im-provement initiatives. In order to deter-mine its relative cost advantage, a firmshould also know the cost factors of itscompetitors.2

While management accounting systemsmay contain the total cost of each value-creating process, they may not reveal thecauses or factors for the significant individ-ual costs. Using single output or volumemeasures (e.g., units, labor hours, salesdollars) to assign costs is often misleading.Multiple cost drivers usually provide moreuseful information. Exhibit 3 illustrates examples of structural and executional costdrivers.

Structural cost drivers consist of organi-zational factors that determine the economic

structure driving the cost of a firm’s prod-ucts. These cost drivers reflect a firm’slong-term decisions, which position thefirm in its industry and marketplace.Structural cost drivers may change.

For example, large pharmaceutical com-panies enjoy economies of scale that lowertheir unit costs for expensive R&D. Else-where, Texas Instruments has exploited theexperience curve in lowering its life-cycleproduct cost. However, bigger is not neces-sarily better, as evidenced by the success ofsteel companies’ mini-mill strategy.

Executional cost drivers capture afirm’s operational decisions on how bestto employ its resources to achieve its goals and objectives. These cost drivers aredetermined by management policy, styleand culture. How well a firm executes itsuse of human and physical resources willdetermine its level of success or failure. Forexample, worker empowerment and flat-tened organizations are helping many firmsin their continuous improvement efforts.

Few structural and executional cost driverscan be operationalized under existingmanagement accounting systems in thecost analysis of the value chain. However,these cost drivers do offer an important reminder of the strategic decisions thatfirms need to make, or at least acknowledge,in designing their value-generating systems.Increasingly, companies are using activity-based costing to understand the resources/costs consumed by the activities andprocesses used in delivering their productsand services.

Identify the Links Among Processes

While individual value activities are con-sidered separate and discrete, they are notnecessarily independent. Most activitieswithin a value chain are interdependent.Firms must not overlook value chain link-ages among interdependent activities thatmay impact on their total cost.

For example, cost improvement programsin one value chain process may lower orincrease costs and/or revenues in otherprocesses. Transfers of goods and servicesfrom one value chain process to anotherincreases cost. Eliminating these transfersreduces the costs of purchasing, invoicingand other recordkeeping functions.

Tandem Computers eliminated its costsof purchase orders, invoicing and otherfunctions by jointly developing a detailed

6

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

bar code process with its suppliers. By improv-ing its upstream design and engineeringprocesses for the Taurus, Ford saved ondownstream production and customer servicecosts. Using fewer floppy drives and mother-boards in its PCs has enabled IBM to halveits delivered cost in two years.

As sources of competitive advantage, theserelationships or linkages among activitiescan be as important as the activities them-selves. Such linkages may also offer sustain-able competitive advantage, because theirsubtle, complex nature makes them difficultfor competitors to imitate.

Evaluate the Opportunities for AchievingRelative Cost Advantage

In many organizations, cost reductions aremade across the board (e.g., “eliminate 10%from every department”). Because thesefirms do not reduce their costs strategically,this effort usually fails. More often thannot, across-the-board cost reduction mis-construes the underlying problem. Thepoint is not to become more efficient at insignificant activities, but to better meetcustomer demands.

Using the value chain approach, a com-pany goes beyond simple across-the-boardcuts and attempts to lower cost and improveefficiency within each value-creating process.

For instance, a company might negotiatelower costs of process inputs such as wagesor purchases, or evaluate make-or-buy options.

Reducing process input costs often meansnegotiating lower wages (as with Chryslerand the U.S. airlines during the mid-1980s)or moving production to countries withcheaper labor costs. Suppliers might be willing to drop their prices if the companynegotiates long-term contracts, an approachused by Levi-Strauss in contracting with itstextile suppliers. Companies also use buyer-seller partnerships to gain advantages incost, quality, time, flexibility, delivery andtechnology.3

United Parcel Service (UPS) outsourcedits customer service centers. In the process,the company consolidated 65 customer ser-vice centers representing 5,000 jobs downto between eight and 10 service centers runby contractors. UPS service center employeesearn $10 to $12 an hour versus the $6.50 to$8 an hour paid to contractors.

Some processes may offer more opportu-nities for improvement than others. In orderto get the most out of its cost reductionprograms, a company should prioritize itsvalue-creating processes. Under the 80:20rule, 20% of the value-creating processes of-ten account for 80% of total costs.


7

Exhibit 3 – Process Cost Drivers

Structural Cost Drivers

• Scale • How big an investment to make in manufacturing, R&D, marketing and other resources?

• Scope • What is the degree of vertical integration – horizontal integration is more relatedto scale?

• Experience or learning • How often has the firm already done this?

• Technology • What process technologies are used within each step of the firm’s value chain?

• Complexity • How wide a line of products or services to offer to customers?

Executional Cost Drivers

• Workforce involvement • Is the workforce involved in decisions and improvements in performance?or participation

• Total quality management • Are the workforce and managers committed to total quality in processes andproducts?

• Capacity utilization • What are the scale choices on maximum plant construction?

• Plant layout efficiency • How efficient, against current norms, is the plant’s layout?

• Product configuration • Is the design or formulation of the product effective?

• Linkages with suppliers • Is the linkage with suppliers and customers exploited, according to the firm’s and customers value chain?

Source: Riley 1987.

An example of the value chain approachto achieving a relative cost advantage is illustrated in Exhibit 4. This exhibit com-pares a specialty brake repair firm with anindependent auto repair firm. By focusingon cost drivers such as scale, skill levels,wages and capacity utilization, the specialtybrake shop was able to reduce its costs by21%. Its largest percentage cost reductionwas in material cost.

Companies can use comparisons withbest practices, benchmarking and businessprocess redesign to reduce their costs. Thecost of quality emphasizes that eliminatingprocess and material waste leads to signifi-cant cost savings and customer satisfaction.

Internal Differentiation Analysis

The value chain approach is also used byorganizations to identify opportunities forcreating and sustaining superior differenti-ation. In this situation, the primary focusis on the customer’s perceived value of theproducts and services.

As with internal cost analysis, internaldifferentiation analysis requires firms tofirst identify their value-creating processesand primary cost drivers. They are thenready to perform a differentiation analysisusing the following guidelines:• identify the customers’ value-creating

processes;• evaluate differentiation strategies for

enhancing customer value; and• determine the best sustainable differen-

tiation strategies.

Identify the Customers’ Value-CreatingProcesses

To pursue a superior differentiation strategy,a firm’s processes must enhance those ofits customers. Thus, a firm should carefullystudy the value-creating processes of itscustomers. Exhibit 5 presents such ananalysis for Crown, Cork and Seal Company(CCS), a metal can maker, and its customersin the late 1970s. The metal container industry was characterized by low growth,low profits and intense competition. CCSsucceeded with a differentiation strategy,which is usually very difficult to accom-plish in a commodity-type business. Twodifferent groups of customers – food andbeverage canners – accounted for 80% ofthe metal containers produced.

Evaluate Differentiation Strategies for Enhancing Customer Value

The key to successful differentiation underthe value-chain approach is to identify thevalue-creating processes that distinguish afirm’s products or services from those ofits competitors. In making this distinction,customer value is emphasized.

The ways customer value can be enhanced through differentiation include: • product features that are esthetically

appealing or functionally superior. Forexample, the Mercedes-Benz automobileaccomplished this feat so well for yearsthat its name became synonymous withthe highest level of quality – peoplewould describe a product as the “Mercedes-Benz” of its category;

8

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

Exhibit 4 – Competitor Cost Analysis

Independent Specialty Cost Cost

Auto Repair Brake Repair Drivers Reduction

100% 79% 21%

MaterialMaterial

Purchasing scaleMore efficient distribution 9%

LaborLabor

Less-skilled laborLower compensationMore specialization & productivity 7%

Variable ShopVariable Shop

Scale offset by larger and SG&A

and SG&Aadvertising expenses 0%

Fixed ShopFixed Shop

Higher utilization of and SG&A

and SG&Aequipment & facilities 5%

• marketing channels that provide desiredlevels of responsiveness, convenience, variety and information. By placing itsorder-entry computers in Wal-Mart’sstores, Procter & Gamble significantly reduced the overall order-entry and pro-cessing costs for both firms. Providingthis unique service to a customer also enabled P&G to improve its on-time delivery of ordered merchandise;

• service and support tailored to end-user andchannel member sophistication and urgency of need. For several decades, superior service capabilities and highvendor switching costs produced by pro-prietary architecture and software enabledIBM to build and maintain a commanding

leadership position in the mainframecomputer industry. Until open systemsappeared in the mid-1980s, risk-aversecustomers were reluctant to make largecapital and conversion outlays for main-frame computer systems without themanufacturer’s strong assurance of relia-bility;

• brand or image positioning that lends greaterappeal to the company’s offerings oncritical selection criteria. For many years,this quality image has allowed the Amer-ican Express Co. to command a significantprice premium in the highly competitivefinancial services market – a premiumthat reflects, in its words, the “privilegeof membership”; and


9

1. Designing distinctive cans for customers may assist their own marketing activities.2. Consistent can quality lowers customers’ canning costs by avoiding breakdowns and holdups on their canning lines.3. By maintaining high stocks and offering speedy delivery, customers can economize on their own stockholding

(they may even be able to move to a just-in-time system of can supply).4. Efficient order processing can reduce customers’ ordering costs.5. Capable and fast technical support can reduce the costs of breakdowns on canning lines.Adapted from:“Crown, Cork and Seal Company and the Metal Container Industry,” and “Crown, Cork and Seal Company, Inc.” Harvard Business School, 1978.

Exhibit 5 – Value Chain for Crown, Cork and Seal Company

Consistency of product.Quality of product.Flexibility of manufacturing.

Containers for specializeduses. Special designs of containers. Specially strongor light containers.

Reliability of supply evenduring metal shortages.

High quality inputs.

Ability to meet unexpected orders from customers at short notice.

Speed and flexibility of delivery.

Fast, reliable order processing.

Speed and competence inmaintaining customers’ canning lines. Quality of technical advice.

Distribution

Marketing

Canning

Processing

Inventory Holding

Purchasing

Service & Technical

Support

Sales

Distribution

Inventory Holding

Manufacturing

Design,Engineering

Inventory Holding

Purchasing

Supplies of Steel &

Aluminum

45

1

23

Crown, Cork & Seal Canners

• price including both net purchase priceand cost savings available to the cus-tomer through the use of the productand service.

Determine the Best Sustainable Differentiation Strategies

For a firm to achieve superior differentiation,it must utilize the best mix of resources increating value for its customers. In order toprioritize its processes as sources of differ-entiation, a company must determine whatattributes of each process enhance customervalue.

The more unique a firm’s resources andskills, the more sustainable is its differenti-ation advantage over competitors.

CCS, (Exhibit 5) for example, focusedonly on tin-plated steel can production,not aluminum; produced for beverage andaerosol customers, not food processors;and invested in more can-forming lines atits plants to reduce changeovers and set-upwages. CCS was also willing to devote moreresources to customizing metal containersfor customers and to increase its responsive-ness to customers’ schedule and qualityneeds.

The payoffs for effective differentiation,and the penalties for not differentiating,are clear. In 1980, Purolator Courier wasbigger than Federal Express; today the reverse is true. In 1982, Dreyfus had moreassets under management than Fidelity – a situation that had reversed itself by themid-90s.

Vertical Linkage Analysis

Linkages among value-creating processesdo not end with the activities within afirm. The greatest competitive advantagemay come out of linkages between a firm’svalue-creating activities and those of itssuppliers, channels or users.

Vertical linkage analysis is a muchbroader application of internal cost anddifferentiation analysis that includes allupstream and downstream value-creatingprocesses throughout the industry. Verticallinkage analysis considers all links fromthe source of raw materials to the disposaland/or recycling of the product. Exhibit 6outlines the vertical links involved in theproduction of “fast food” containers.

Shank and Govindarajan (1993) statethe importance of vertical linkages:

... gaining and sustaining a competitive advantage requires that a firm understandthe entire value delivery system, not justthe portion of the value chain in which itparticipates. Suppliers and customers andsuppliers’ suppliers and customers’ cus-tomers have profit margins that are impor-tant to identify in understanding a firm’scost/differentiation positioning, because theend-use customers ultimately pay for allthe profit margins along the entire valuechain.

Vertical linkage can reveal which activi-ties are the most (and least) critical tocompetitive advantage (or disadvantage).For example, Swiss watchmakers succeededfor years as relatively small, labor-intensiveassemblers. Then came the 1970s and theadvent of low-cost, mass-produced watches.The Swiss responded by restructuring theirindustry to gain economies of scale similarto those enjoyed by their new global com-petitors.

10

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

Exhibit 6 – Vertical Linkages in the Production of Plastic FoodContainers

Natural Gas Producers

Ethane Producers

Styrene Producers

Polystyrene Producers

Fast Food Carton Producers

Fast Food Restaurants

Final Consumers

However, the Swiss failed to realize thattheir critical problem was not in manufac-turing. This set of activities added only asmall proportion of the value of their finalproduct. Far more significant were down-stream activities in output logistics, market-ing, sales and service. Beyond being able tomake a watch cheaply, the Swiss had tolower their costs of distribution and service.They came up with the hugely successfulSwatch, which, besides being inexpensivelypriced, was virtually indestructible andcould be distributed through numerouslow-cost channels, from department storesto discount houses.

Vertical linkage analysis includes the following steps:• identify the industry’s value chain and

assign costs, revenues and assets to value-creating processes;

• diagnose the cost drivers for each value-creating process; and

• evaluate the opportunities for sustainablecompetitive advantage.

Identify the Industry’s Value Chain and Assign Costs, Revenues and Assets toValue-Creating Processes

Because vertical linkages can be complexand intangible, they are often overlookedby organizations. For example, the petrole-um industry consists of numerous value-creating processes or activities, includingexploration, production, refining, marketingand distribution. These processes define thevalue chain for this industry. One companymay participate in all parts of this value chain;another firm may participate in only a few.This diversity of operations and organiza-tions makes it difficult to adopt a standardapproach for identifying industry valuechain processes.

Few firms have information systems thatcan identify and analyze these subtle rela-tionships. For example, profitability and return on assets are key measures of com-petitive advantage throughout an industry’svalue chain. It can be extremely difficult toobtain pertinent information for these mea-sures, including operating costs, revenuesand assets for each process throughout theindustry’s value chain. However, this infor-mation is necessary to calculate a rate of return on assets for each value chain process.

Obtaining the replacement or currentcost of physical assets used by a value-creatingactivity is a necessary but often complex

undertaking. Historical or book values usuallyprovide inadequate measures of current investment. Plant engineers, equipmentvendors and independent appraisal profes-sionals may be consulted to help establishcurrent asset values. Likewise, establishingprices for transferring goods and servicesamong value chain processes requires anunderstanding of market or competitive-based rates. If at least one firm competes ineach stage of value creation, then competi-tive market prices are available. If not, thena company must use judgment in determin-ing a transfer price that incorporates a nor-mal profit margin on full costs. For long-term strategic decision-making, companiesshould use full cost under conditions of fullcapacity for the value activity. While severalmeasures of capacity exist, the best measureshould represent the long-term utilizationof the value activity’s assets (sometimescalled “practical capacity”).

Publicly available financial reports pro-duced by firms throughout the industryvalue chain can provide key financial infor-mation. Typically, this information is neitherin the proper format nor disaggregatedenough to accommodate vertical linkageanalysis. Significant analysis, data manipu-lation and judgment may be necessary toobtain the appropriate information for eachvalue chain process.

For intermediate transfers betweenprocesses, competitive market prices, ifavailable, should be substituted for the internal transfer prices. For example, com-petitive market prices for a single link inthe value chain may be obtained from indi-vidual firms that operate only in that linkof the chain. For long-term cost estimation,full costs should be used rather than mar-ginal, variable or incremental costs.

Diagnose the Cost Drivers for Each Value-Creating Process

Traditional management or cost accountingsystems often assign costs by using a singleoutput measure of operating activity, suchas output volume. For vertical linkageanalysis, a single measure is inadequate to capture the underlying cost categories.Direct labor-based measures may be appro-priate for labor-intensive activities; operatinghours may be appropriate for machine-basedactivities. The cost drivers illustrated in Exhibit 3 may be used to identify the factorsthat determine costs throughout the industryvalue chain.


11

Evaluate the Opportunities for Sustainable Competitive Advantage

By nature, competitive advantage is relative.In an ideal world, a firm can gauge itscompetitive position by knowing its com-petitor’s value chains and the rates of returnon each. In reality, however, this may berather difficult: the competitor’s internalcost, revenue and asset data for its process-es are generally unavailable. Sufficientqualitative information usually exists on afirm’s major value-creating processes andthe strategies for each. By understandinghow other companies compete in eachprocess of the industry value chain, a firmcan use the qualitative analysis to seek outcompetitive niches even if financial dataare unavailable.

Value chains for three competitors inthe rapidly changing telecommunicationsindustry – AT&T, NYNEX and IBM – arelisted in Exhibit 7, along with the strategicdifferences for each firm (Hax and Majluf,1991). The strategic differences reflectvarying structural and executional cost drivers. In marketing, for instance, AT&Tstarted with no organization but with sig-

nificant name recognition. The regionalmarketing scale of NYNEX and the world-wide marketing scale of IBM are importantcost advantages.

Finding innovative ways to perform val-ue-creating activities helps firms improvetheir overall performance and achievecompetitive advantage. In order to thrivein the mature, highly competitive meatpacking industry, for example, Iowa BeefProcessors built its plants near cattleranches, thus eliminating the high cost ofshipping cattle to northern processingplants. In order to lower its costs, Tropi-cana froze slabs of orange juice concen-trate near the orange groves in Florida andshipped the slabs to its large markets inthe Northeastern U.S. Only then did thecompany mix the concentrate with water,thus avoiding the lengthy and costly ship-ment of water.

Increased global competition forcesfirms to focus on worldwide, sustainablecompetitive advantage. Porter (1990), oneof a few strategists who have systematical-ly studied global competition, cites four

12

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

Exhibit 7 – Value Chain Differences: The Telecommunications Industry

IBM

• Owns Rolm, CPEmanufacturer

• Strong R&D in computerhardware and software tech-nologies

• Global presence

• Leading computer technology

• Partnership with MCI

• Strong reputation for marketingexcellence

• Already sells to most major corporations

• Experienced sales force

AT&T

• Owns manufacturing branch(Western Electric)

• Technological leadershipthrough Bell Labs

• National presence

• High quality of equipmentthrough heavy capital expenditure

• Similar communications standards nationwide

• Strongest national telecommunications network

• New emphasis on marketing(still weak)

• High name recognition

• Long-term relationship withclients

• Recruits computer executives

NYNEX

• Free to use any supplier itwants

• Focus on software products

• Regional monopoly

• Innovative equipment fromoutside suppliers

• High-quality regional network through heavycapital investment

• Use of Bell logo

• Focus on top 1,000corporate customers

• Sales and distribution centers close to customers

Value Chain

Processes

Procurement

Technology development

Operations

Marketing and sales

Source: Hax and Majluf 1991.

Strategic Differences

13

Va l ue Cha i n Ana l y s i s fo r As se s s i n g Compe t i t i ve Advan t a ge

major factors that influence national com-petitive advantage. These are:i) Factor conditions. The nation’s position

in factors of production, such as skilledlabor or infrastructure, necessary tocompete in a given industry.

ii) Demand conditions. The nature of domes-tic demand for the industry’s product orservice.

iii) Related and supporting industries. Thepresence or absence in the nation ofsupplier industries and related industriesthat are internationally competitive.

iv) Firm strategy, structure and rivalry. Theconditions in the nation governing howcompanies are created, organized andmanaged, and the nature of domesticrivalry.

Geographic scope can allow firms to gainsubstantial competitive advantages by shar-ing or coordinating similar value activitiesin different places. The importance of thisadvantage is illustrated by the recent successof firms with a global scope, such as Canon(Japan), Caterpillar (U.S.), N.V. Philips(Netherlands) and Siemens (Germany).These firms sell and service their productsin practically every corner of the globe.

Automakers like Ford or GM are evenmore global: they carry out many key value-creating activities – from engineering tomanufacturing and sales – in dozens ofcountries around the world. Japanese autocompanies are also globalizing rapidly,making huge investments in manufacturingfacilities in, for example, South Korea, Singapore and the U.S.

Nike’s key value-creating processes areshoe design, manufacture of shoe compo-nents and final assembly. All major inputsto each process are available in the U.S.However, Nike locates component manufac-turing, requiring moderately skilled laborand capital, in Taiwan and South Korea. Itlocates assembly operations, a labor-inten-sive activity, in low-wage Asian countriessuch as China, Thailand and the Philippines.

Taking a global view of the value chain isnot without disadvantages. One possiblenegative factor is transportation betweenlinked processes. Transportation consumestime and adds to costs. Shipments of elec-tronic components between the Far Eastand North American assembly plants maytake at least a month. Transporting compo-nents to local assembly plants may savetransport and inventory costs.

Scattering value-creating processes aroundthe world can also lead to poor control,communication and coordination. Closeproximity of R&D, engineering, productionand marketing personnel may provide syn-ergistic benefits in meeting customer needs.

For example, to increase its worldwidetire production capacity to compete withMichelin, Japan’s Bridgestone acquired Firestone Tire & Rubber in the U.S. Muddledstrategies, slow decision-making and poorcommunication between Tokyo and Akron,Ohio, led to major losses, layoffs and a sell-off of assets.

The North American Free Trade Agree-ment among Canada, Mexico and the U.S.has introduced new relationships affectingvalue-chain analysis for suppliers and buy-ers alike. These relationships require carefulscrutiny. For example, lower labor costs inMexico have motivated companies to locatetheir assembly and manufacturing processesthere. However, some firms have experiencedcostly productivity and quality problemsthat more than offset their labor savings.Each firm must balance the benefits/cost ofa multi-location decision.

To properly evaluate the opportunitiesfor competitive advantage in the global mar-ketplace, firms need to consider such thingsas a country’s values, political climate, envi-ronmental concerns, trade relations, tax laws,inflation rates and currency fluctuations.The devaluation of the Mexican peso is anexample of the risks of moving operations touncertain economies.

STRATEGIC FRAMEWORKS FOR VALUECHAIN ANALYSIS

Value chain analysis requires a strategicframework or focus for organizing internaland external information, for analyzing information, and for summarizing findingsand recommendations. Because value chainanalysis is still evolving, no uniform practiceshave yet been established. However, borrow-ing recent concepts from strategists and organization experts, three useful strategicframeworks for value chain analysis are:i) industry structure analysis;ii) core competencies; andiii) segmentation analysis.

Industry Structure Analysis

Michael Porter (1980, 1985) developed thefive forces model as a way to organize infor-mation about an industry structure to eval-uate its potential attractiveness.

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

14

Under this model, the profitability of anindustry or market – measured by the long-term return on investment of the averagefirm – depends largely on five factors thatinfluence profitability. These are:• bargaining power of buyers;• bargaining power of suppliers;• threat of substitute products or services;• threat of new entrants; and• intensity of competition.

Bargaining Power of Buyers

The degree of buyer power generally depends on: • customer concentration (the higher the

concentration of customers, the greatertheir negotiating leverage);

• the propensity for customers to integratebackward (the higher the propensity forbackward integration, the greater thebargaining leverage);

• costs of switching suppliers (the lowerthe switching costs, the greater the buyer’s leverage); and

• the number of alternative suppliers (thegreater the number, the greater the customer’s leverage).

Bargaining Power of Suppliers

Just as powerful buyers can squeeze profitsby putting downward pressure on prices,suppliers squeeze profits by increasing in-put costs. The same factors that determinethe power of buyers also determine thepower of suppliers. The bargaining powerof suppliers and buyers relative to the firmdepends on the relationships betweentheir value chains. Bargaining power willbe a function of relative strengths, in par-ticular, value activities that depend on oneanother.

Identifying the specific activities involvedand the nature of their strengths and rela-tionships can give important insights intothe power balance between buyer and seller,and how it may be altered for the firm’sbenefit.

Threat of Substitute Products or Services

The potential for profit in an industry isdetermined by the maximum price thatcustomers are willing to pay. This dependsprimarily on the availability of substitutes.When few substitutes exist for a product –e.g., gasoline – consumers are willing topay a potentially high price. If close sub-stitutes for a product exist, then there is a

limit to what price customers are willingto pay. Any price increase will then causesome customers to switch to substitutes. A thorough understanding of the valuechains of buyers as they relate to thefirm’s product can help in assessing (andcombating) the threat of substitution.

Threat of New Entrants

If an industry is earning a return on invest-ed capital above the cost of capital, thatindustry will act as a magnet to firms out-side the industry. Unless the entry of newfirms is barred, the rate of profit must fallto the competitive level. Even the merethreat of entry may be sufficient to ensurethat established firms constrain their pricesto the competitive level.

Intensity of Competition

Markets experiencing rapid growth typicallysee less intense competition. Rival compa-nies can usually satisfy profitability andgrowth without having to take marketshares from their competitors.

The variety and nature of the valuechains of competitors shape many of thecharacteristics of an industry. The relativeimportance of economies of scale versuseconomies of scope, for example, dependson the kind(s) of technology employed incompetitors’ value chains. The stability ofthe industry and of its competitive situa-tion also relates to what happens to thevalue chains of firms in the industry. Theeffectiveness of low-cost versus differentia-tion strategies depends on the nature ofusers’ value chains, and on how competi-tors’ value chains interact with those ofboth sellers and users.

Since these five forces are ever-changing,Porter’s framework needs to be employedas a dynamic analytical tool. This is becausecompetition is a dynamic process: equilib-rium is never reached and industry struc-tures are constantly being reformed.

A major difficulty in industry structureanalysis lies in defining the specific industry.No industry has clear boundaries either interms of products or geographical areas.For example, does one analyze the indus-try environment of Ford as the “trans-portation equipment” industry, the “motorvehicles and equipment” industry or the“automobile” industry?

To overcome the difficulty of definingan industry, the concept of substitutability


15

can be applied to a firm’s supply and demandchains. On the demand side, if buyers arewilling to substitute one product for anoth-er – e.g., Toyotas for Fords – then the manu-facturers belong in a single industry. How-ever, this guideline does not always hold.For example, customers may be unwillingto substitute Apple Macintosh computersfor Compaq computers, even though bothmanufacturers belong to the same industry.On the supply side, if two manufacturerscan make each other’s products, then theybelong to a single industry.

Porter’s model sometimes draws criticismfor neglecting the difficulty of obtainingand maintaining the information requiredto perform an industry structure analysis.While such an exercise may be time-consuming, it is essential to obtain a detaileddatabase in order to fully understand an organization’s competitive environment.Dismissing the task as too difficult is tempt-ing, and may lead to inappropriate decision-making.

Core Competencies Analysis

Industry structure analysis is well suited todescribing the what of competitiveness, i.e.,what makes one firm or one industry moreprofitable than another. But understandingthe particulars of such advantages as lowcost, quality, customer service and time tomarket may still leave the question of whylargely unanswered. For example, why dosome companies seem able to continuallycreate new forms of competitive advantagewhile others seem able only to observe andfollow? Why are some firms net advantagecreators and others net advantage imitators?For assessing competitive advantage it isnecessary not only to keep score of existingadvantages – what they are and who hasthem – but also to discover what it is thatdrives the process of advantage creation. Industry structure analysis is much bettersuited to the first task than to the second.

Thus, industry structure analysis must besupplemented by an equally explicit corecompetence focus. Organizations need tobe viewed not only as a portfolio of productsor services, but also as a portfolio of corecompetencies.

Core competencies are created by superiorintegration of technological, physical andhuman resources. They represent distinctiveskills as well as intangible, invisible, intel-lectual assets and cultural capabilities. Cul

tural capabilities refer to the ability to managechange, the ability to learn and teamworking.Organizations should be viewed as a bundleof a few core competencies, each supportedby several individual skills.

Core competencies are the connectivetissue that holds together a portfolio ofseemingly diverse businesses. They are the lingua franca that allows managers totranslate insights and experience from onebusiness setting into another. Core compe-tence-based diversification reduces risk andinvestment and increases the opportunitiesfor transferring learning and best practiceacross business units.

For instance, the New York Times statedthat Microsoft’s only factory asset is the human imagination. This company has excelled in inventing new ways of using information technology for a wide varietyof end users. In contrast, using its corecompetence in information processing, Xerox developed icons, pull-down menusand the computer mouse, but failed to exploit the marketplace.

A core competence is identified by thefollowing tests:• Can it be leveraged? Does it provide poten-

tial access to a wide variety of markets?• Does it enhance customer value? Does it

make a significant contribution to theperceived customer benefits of the endproduct?

• Can it be imitated? Does it reduce thethreat of imitation by competitors?

Applying the value chain approach tocore competencies for competitive advantageincludes the following steps:• validate core competencies in current

businesses;• export or leverage core competencies

to the value chains of other existingbusinesses;

• use core competencies to reconfigure thevalue chains of existing businesses; and

• use core competencies to create new value chains.

Validate Core Competencies in CurrentBusinesses

Core competencies should tie together theportfolio of end products and help a firmexcel in dominating its industry. For example,Corning’s core competence is its ability tomelt specialty glass. Pyrex, television bulbs,headlamps and optical wave guides are justa few of the products of this successful

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

16

producer. Procter & Gamble’s R&D expertiseand marketing/distribution skills provide asignificant competitive advantage in awide range of mass consumer products(e.g., Ivory, Tide, Folgers, Crisco, Pampers).

Core competencies need to be continuallyvalidated. In the early 1970s, Timex heldhalf of the global market for watches withits core competence in low-cost manage-ment of precision manufacturing. By themid-1970s, the watch industry moved todigital technology, making Timex’s corecompetence irrelevant.

Export or Leverage Competencies to the Value Chains of Other Existing Businesses

The same set of core competencies can beexploited in multiple businesses by export-ing core competencies to the value chainsof other existing businesses.

For example, one of Honda’s core competencies is designing and producingsmall engines. By exporting this core com-petence to a wide variety of business lines,the company seeks to have six Hondas inevery garage: autos, motorcycles, snowmo-biles, lawnmowers, snow blowers, chainsaws and power tools. Other Honda corecompetencies are dealership managementand shorter product development cycles.

Marriott Corp. has core competencies infood service and hospitality skills, standard-ized hotel operating procedures, and ashared procurement and distribution system. Besides employing these core competencies in hotels, the company usesthem in its other businesses, including institutional food service, consumer foodand restaurants, cruise ships and themeparks.

AT&T extended its core competence asan efficient processor of customer accountsby entering the credit card business. Kimberly Clark’s entry into disposable diapers extended its core competence inthe design of paper products.

Use Core Competencies to Reconfigure theValue Chains of Existing Businesses

While firms may manage their existingvalue chains better than do their competi-tors, sophisticated firms work harder onusing their core competencies to reconfig-ure the value chain to improve payoffs.Otherwise, competitors may exploit opportunities.

For example, Japanese watchmakers side-stepped traditional distribution channelsin favor of mass merchandisers such as department store chains. By efficientlyconsolidating freight, Emery Freight domi-nated the air freight industry and was consistently a leader in profitability in U.S.industry. Federal Express (Fed Ex) reconfig-ured the air freight business by focusingon the overnight delivery of small packages.

Tetra-Pak is an excellent example of afirm that reconfigured the value chain inthe packaging industry for dairy productsand orange juice. Tetra-Pak designed a fill-ing machine for its aseptic packages andchanged the packaging industry. Exhibit 8illustrates Tetra-Pak’s changes to the valuechain.

Another example of a value chain reconfiguration is IKEA, which grew froma small, Swedish mail-order furniture oper-ation to one of the world’s largest retailersof home furnishings (Normann & Ramirez,1993). As illustrated in Exhibit 9, IKEA select-ed numerous factors to offer prices that are25–50% lower than those of competitors.

Use Core Competencies to Create New Value Chains

With strong core competencies in its existingbusinesses, an organization can seek newcustomers by developing new value chains.

For example, FedEx transferred its ex-pertise in the delivery of small packages tocontract new business with L.L. Bean forovernight distribution. Disney has export-ed its people-moving skills to urban masstransit for Oakland, California.

The development of the corporate pur-chasing card is exporting the expertise ofcredit card companies, such as AmericanExpress and Visa, to process small purchasetransactions for other companies.

In a recent agreement, Roadway LogisticsSystems, a unit of Roadway Services Inc.,will manage and track all inbound andoutbound shipments for Dell ComputerCorp., including operations in Europe andAsia. The logistics company will also handletransportation for service and repair needs.

Segmentation Analysis

Industries are sometimes collections of dif-ferent market segments. Vertically integratedindustries are good examples of a string ofnatural businesses from the source of raw

material to the end use by the final consumer.Several firms in the paper and steel industriesare vertically integrated. Not all firms in anindustry participate in all segments.

If the nature and intensity of Porter’s fiveforces or the core competencies vary forvarious segments of an industry, then thestructural characteristics of different indus-try segments need to be examined. Thisanalysis will reveal the competitive advan-tages or disadvantages of different segments.A firm may use this information to decideto exit the segment, to enter a segment, re-configure one or more segments, or embarkon cost reduction/differentiation programs.

Differences in structure and competitionamong segments may also mean differencesin key success factors among segments.

Using the value chain approach for seg-mentation analysis, Grant (1991) recommendsfive steps:i) identify segmentation variables and

categories;ii) construct a segmentation matrix;iii) analyze segment attractiveness;iv) identify key success factors for each

segment; and

v) analyze attractiveness of broad versusnarrow segment scope.

Identify Segmentation Variables and Categories

There may be literally millions of ways todivide up the market into segments. Typically,an analysis considers between five and 10segmentation variables. These variables areevaluated on the basis of their ability toidentify segments for which different com-petitive strategies are (or should be) pursued.

The selection of the most useful segment-defining variables is rarely obvious. Industriesmay be subdivided by product lines, type of customer, channels of distribution andregion/geography. The most common seg-mentation variables considered are type ofcustomer and product related, as illustrated inExhibit 10.

The first set of variables describes segmentsin terms of general characteristics unrelatedto the product involved. Thus, a bakerymight be concerned with geographic seg-ments, focusing on one or more regions oreven neighborhoods. It might also divideits market into organizational types such as


17

Exhibit 8 – How Tetra-Pak Reconfigured the Value Chain

Filling TransportRetail

DisplayCustomers

– Make container – No refrigerated – Low store – Longer shelf life on site trucks handling

–Tetra–Pak – No wasted – No need to – No need tospecialized space in filling refrigerate & refrigerate & equipment & packing less space is less space

required is required

Exhibit 9 – How IKEA Reconfigured the Furniture Industry

Value Chain Major Choice

Design Simple, high quality, designed to lower cost

Parts Standard & common, global supplier network

Assembly By the customer

Transport/stocking Computerized system for suppliers & warehouses

Marketing Scandinavian image

Display Focus on designs, not pieces, to create value

Home delivery By the customer

Source: Normann and Ramirez 1993.

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

18

at-home customers, restaurants, dining operations in schools, hospitals and so on.Demographics can define segments represent-ing strategic opportunities such as singleparents, professional women and elderlypeople.

The second category of segment variablesincludes those that are related to the product.One of the most frequently employed is usage. A bakery may employ a very differentstrategy in serving restaurants that are heavyusers of bakery products than restaurantsthat use fewer bakery products. Zenith madea niche for itself in the very competitivepersonal computer industry by focusing ongovernment, which is the largest computeruser.

Segmenting by competitor is useful becauseit frequently leads to a well-defined strategyand a strong positioning statement. Thus, atarget customer group for the Toyota Cressidaconsists of buyers of high-performance European cars such as the BMW. The Cressidais positioned against the BMW as offeringcomparable performance for a substantiallylower cost.

Construct a Segmentation Matrix

After customer- and product-related variableshave been selected for identifying differentsegments, a segmentation matrix can be developed. Two or more dimensions may beused to partition an industry.

For example, restaurants could be dividedinto four dimensions: type of cuisine, pricerange, type of service (e.g., sit-down, buffet,cafeteria, take-out, fast food) and location.

A segmentation matrix for the Britishfrozen foods industry is presented in Exhibit11. Five types of product and five channelsof distribution are used to construct the two-dimensional segmentation matrix consistingof 25 potential segments. However, notevery cell in the matrix may be relevant.Empty cells may represent future opportuni-ties for products or services.

Analyze Segment Attractiveness

Competitive assessments using industrystructure analysis or core competenciesanalysis can also be used to evaluate theprofitability of different segments. However,the competitive focus shifts to an analysisof the different segments.

For example, in the frozen foods industrysegmentation, independent grocers andcaterers may be willing to substitute freshfruits and vegetables for frozen goods. There-fore, the threat of substitutes within the segments and from outside sources must becarefully examined.

In addition, the interrelationship amongsegments must be carefully considered. Forexample, caterers may purchase frozen fooditems from supermarkets at bargain prices.Segments may be natural buyers, sellers orsubstitutes for one another.

Exhibit 10 – Approaches to Defining Segmentation Variables

Customer Characteristics

• Geographic • Small communities as markets for discount stores• Type of organization • Computer needs of restaurants versus manufacturing firms versus

banks versus retailers• Size of firm • Large hospital versus medium versus small• Lifestyle • Jaguar buyers tend to be more adventurous, less conservative than

buyers of Mercedes-Benz and BMW• Sex • The Virginia Slims cigarettes for women• Age • Cereals for children versus adults• Occupation • The paper copier needs of lawyers versus bankers versus dentists

Product-related Approaches

• User type • Appliance buyer – home builder, remodeller, homeowner• Usage • The heavy potato user – the fast-food outlets• Benefits sought • Dessert eaters – those who are calorie-conscious versus those who are

more concerned with convenience• Price sensitivity • Price-sensitive Honda Civic buyer versus the luxury

Mercedes-Benz buyer• Competitor • Those computer users now committed to IBM• Application • Professional users of chain saws versus the homeowner• Brand loyalty • Those committed to IBM versus others


19

In the automobile industry, the luxurycar and sports car segments were high-priced,high-margin products with less intensecompetition than other automobile segments.The introduction of high-quality, lower-priced Acura, Lexus and Infiniti autos changedthe competitive structure of these high-pricedsegments.

Identify Key Success Factors for Each Segment

Quality, delivery, customer satisfaction,market share, profitability and return on investment are common measures of corpo-rate success. In this regard, each segmentmust be assessed using the most appropri-ate key success factors. Cost and differentia-tion advantages should be highlighted bythese measures.

Examination of differences among seg-ments in buyers’ purchase criteria can revealclear differences in key success factors.

Analyze Attractiveness of Broad versusNarrow Segment Scope

A wide choice of segments for an industryrequires careful matching of a firm’s resourceswith the market. The competitive advantage

of each segment may be identified in termsof low cost and/or differentiation.

Sharing costs across different market seg-ments may provide a competitive advantage.For example, Gillette broadened its shavingsystems to include electric shavers throughits 1970 acquisition of Braun. Lipton recentlyentered the bottled iced-tea market.

On the other hand, when the Toro Com-pany broadened its distribution channelsfor its snow blowers and lawnmowers to include discount chains, it almost wentbankrupt. Feeling betrayed, a number ofToro’s dealers dropped its products.

Taking a narrow segment focus may leave a firm vulnerable to competitors. Forinstance, by relying solely on its lemon-limesoft drink, 7-Up left itself at a competitivedisadvantage to Coca-Cola and Pepsi. Recently, Hallmark Cards Co. has begun tomarket its premium image greeting cardsthrough discounters. Hurt by discounters,some of Hallmark’s 9,000 independent spe-cialty shops have begun selling cards fromHallmark’s competitors.

In many industries, aggressive firms aremoving toward multiple-segment strategies.Campbell Soup, for example, makes its

Exhibit 11 – Segmenting the British Frozen Food Industry

DISTRIBUTION CHANNELS

Supermarkets Independent SpecialistProducers’ Retailers’ Grocery FreezerBrands Brands Retailers Stores Caterers

Vegetables

Fruits

Meat Products

Desserts

ConvenienceReady Meals

Note: The above matrix identifies five categories of frozen food, and five distribution channels.While the basic distinction of customersis between retail and catering, within retailing there are three distinct categories of outlet: supermarkets, independent grocery stores,and specialist retailers of frozen foods (“home freezer centers”). In addition, different market conditions exist for processors supplyingfrozen foods for sale under their own brand names as opposed to those supplying frozen foods for sale under the brand name of theretailer.

Source: Monopolies and Mergers Commission, Frozen Foods (HMSO, London 1976); and P. Geroski and T.V lassopoulos,“The rise andfall of a market leader; Frozen foods in the UK,” London Business School, Case series 9, 1989.

PR

OD

UC

T T

YP

ES

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

20

nacho cheese soup spicier for Texas and California customers and offers a Creole soupfor Southern markets and a red-bean soupfor Hispanic areas. In New York, Campbelluses promotions linking Swanson frozendinners with the New York Giants footballteam; in the Sierra mountains, skiers aretreated to hot soup samples. Developingmultiple strategies is costly and often mustbe justified by an enhanced aggregate impact.

Some firms decide to avoid or abandonsegments because of limited resources or because of uncertain attractiveness. For example, in the 1960s, IBM decided not toenter the mini-computer segment. This allowed upstart Digital Equipment Corp. todominate this segment of the computer industry. General Electric abandoned thecomputer industry completely. Under CEOJack Welch, GE’s major segments must befirst or second in market share, or risk beingsold.

A segment justifying a unique strategymust be of worthwhile size to support abusiness strategy. Furthermore, that businessstrategy needs to be effective with respect tothe target segment in order to be cost effec-tive. In general, it is costly to develop astrategy for a segment. The question usuallyis whether or not the effectiveness of thestrategy will compensate for this added cost.

LIMITATIONS OF VALUE CHAIN ANALYSIS

Value chain analysis is neither an exact sciencenor is it easy. It is more “art” than preparingprecise accounting reports. There are severallimitations to the implementation and interpretation of value chain analysis. First,the internal data on costs, revenues and assetsused for value chain analysis are derivedfrom one period’s financial information. Forlong-term strategic decision-making, changesin cost structures, market prices and capitalinvestments from one period to the nextmay alter the implications of value chainanalysis. Organizations should ensure thatthe value chain analysis is valid for futureperiods. Otherwise, the value chain analysismust be repeated under new conditions.

Identifying stages in an industry’s valuechain is limited by the ability to locate atleast one firm that participates in a specificstage. Breaking a value stage into two ormore stages when an outside firm does notcompete in these stages is strictly judgmental.

As discussed previously, finding the costs,revenues and assets for each value chain ac-tivity sometimes presents serious difficulties.There is much experimentation underwaythat may provide better approaches. Havingat least one firm operate in each value chainactivity helps identify external prices forgoods and services transferred between valuechains. For intermediate products or serviceswith no external or competitive market in-formation, transfer prices must be estimatedon the basis of the best information available.

Isolating cost drivers for each value-creatingactivity, identifying value chain linkagesacross activities and computing supplierand customer profit margins present seriouschallenges. The use of full cost assumes thatthe full capacity of the value chain activity’sfacilities is used to derive the costs. Plantand manufacturing personnel and vendorsof equipment are good sources for capacityinformation. They can also be helpful in estimating the current or replacement costof the assets. Independent companies, suchas Valuation Research Corp. in Milwaukee,provide valuation services for assets.

Despite the calculational difficulties, experience indicates that performing valuechain analysis can yield firms invaluable information on their competitive situation,cost structure and linkages with suppliersand customers.

ORGANIZATIONAL AND MANAGERIALACCOUNTING CHALLENGES

Value chain analysis offers an excellent opportunity to integrate strategic planningwith management accounting to guide thefirm to growth and survival. This change infocus for management accounting is necessaryto maintain its critical role as the informationprofession.

The most significant challenge for seniormanagement and management accountantsis to recognize that the traditional, functional,internally oriented information system is inadequate for the firm engaged in globalcompetition.

Another challenge for management accountants is to bring the importance ofcustomer value to the forefront of manage-ment’s strategic thinking. For many man-agers and firms, this requires a great deal ofeducation and awareness. Management accountants should take the initiative tobring the value chain message to major


21

players in the firm. Seminars, articles, valuechain examples and company-specific appli-cations are useful to illustrate the advantagesof value chain analysis.

Although value chain analysis requiresexpertise in internal operations and infor-mation, it demands a great deal of externalinformation. Management accountants mustseek relevant financial and non-financialinformation from sources outside the orga-nization.

Management accountants must integratedatabases and potential sources of timelyinformation on competitive forces confront-ing the business. This calls for innovationand creativity in gathering and analyzinginformation for management decisions.

Designing internal and external informa-tion systems to assist managers in planning,monitoring and improving value-creatingprocesses is another challenge facing man-agement accountants.

Information technology is improvingdaily but existing information systems areslow to change. Management accountantsshould solicit support from all senior man-agers for allocating resources to develop andimprove value chain-oriented informationsystems.

Value chain analysis requires the cooper-ation of all managers involved in value chainprocesses, including engineers, designers,production managers, marketing managersand distribution managers. Leadership fromthe CEO is vital to successful cooperationamong managers. The management accountant should ensure that the CEO iscommitted to value chain analysis and theorganizational changes necessary for its successful implementation.

For many service companies, Porter’s value chain model emphasizing manufac-turing firms may appear inappropriate. How-ever, every organization (banks, hospitals,airlines, professional firms) has a variety ofprimary and support value-creating activitiesto which value chain analysis applies. Forexample, a publishing company might havethe following primary activities: informationacquisition, editorial, production, distribu-tion, sales and service. Support activities include new product and business develop-ment, technology assessment and develop-ment, human resource management andfirm infrastructure. If strategy is seen as thepursuit of competitive advantage, the linkbetween the formulation of service strategyand operational service delivery is vital.

CONCLUSION

As a unifying theme, value chain analysispresents organizations with an overarchingtool for improving their strategic planningand resource allocation. The goal is to pro-vide management with sufficient options tosustain its competitive advantage in an ever-changing business environment.

Analyzing costs and differentiationthrough the value chain is an essentialcomponent in the search for competitiveadvantage. The data problems are not in-significant and the answers will not alwaysbe precise.

Nevertheless, there will be considerablebenefit in the debate that results from theprocess and in the enhanced quantitativeawareness of the external competitive arenaand of the firm’s part in it. As so often instrategic planning, the process is often asvaluable as the outcome.

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

22

Exhibit A-1 – Value Chain vs. Conventional Management Accounting

Traditional Management Value Chain Analysis

Accounting in the Strategic Framework

Focus Internal External

Perspective Value added Entire set of linked activities from suppliersto end-use customers

Cost Driver Concept Single cost driver (cost is a function Multiple cost driversof volume) • Structural drivers (e.g., scale, scope,

experience, technology and complexity)

Application at the overall firm level • Executional drivers (e.g., participative(cost-volume-profit analysis) management, total quality management

and plant layout)A set of unique cost drivers for each value activity

Cost Containment “Across the board” cost reductions View cost containment as a function ofPhilosophy the cost drivers regulating each value activity

Exploit linkages with suppliersExploit linkages with customersExploit process linkages within the firm“Spend to save”

Insights for Strategic Somewhat limited Identify cost drivers at the individualDecisions activity level, and develop cost/

differentiation advantage either bycontrolling those drivers better thancompetitors or by reconfiguring the valuechain (e.g., Federal Express in mail delivery,and MCI in long distance telephone)For each value activity, ask strategic questionspertaining to:• Make versus buy• Forward/backward integrationQuantify and assess “supplier power” and “buyer power,” and exploit linkages with suppliers and buyers

Adapted from Shank and Govindarajan 1993.

APPENDIX: VALUE CHAIN ANALYSIS VS.CONVENTIONAL MANAGEMENT ACCOUNTING

Information generated from the traditionalmanagement accounting systems, includingcost accounting, is generally unsuitable forvalue chain analysis for a variety of reasons.Exhibit A-1 provides a comparison of valuechain analysis and traditional managementaccounting.

Generally, traditional management account-ing focuses on internal information. It oftenplaces excessive emphasis on manufacturingcosts. It also assumes that cost reductionmust be found in the “value-added” process,i.e., selling price less the cost of raw material.

Using a value-added approach can bemisleading, since there are many other pur-chased inputs such as engineering, mainte-nance, distribution and service. The value-added process starts too late because it ignoreslinkages with suppliers, and stops too earlybecause it ignores linkages with customers.

The value chain approach encompassesexternal and internal data, uses appropriatecost drivers for all major value-creatingprocesses, exploits linkages throughout thevalue chain and provides continuous moni-toring of a firm’s strategic competitive advantage.


23

ENDNOTES

1 For additional information on the variousapproaches used for measuring capacity,see the guideline Measuring the Cost ofCapacity.

2 For additional information on the acqui-sition of competitive cost information, seethe guideline Developing ComprehensiveCompetitive Intelligence.

3 For more information on buyer-sellerpartnerships see, the guideline BuildingBuyer-Seller Partnerships.

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

24

BIBLIOGRAPHY

Abell, Derek F., and John S. Hammond.1979. Cost dynamics: Scale and experienceeffects. Chapter 3. Strategic Market Planning.Englewood Cliffs, NJ: Prentice-Hall.

Christensen, C.R., et al. 1982. Crown, Corkand Seal Company, Inc. In Business Policy:Text and Cases. Homewood, IL: Irwin.

Grant, Robert M. 1991. Contemporary StrategyAnalysis. Cambridge, MA: Basil Blackwell.

Hamel, Gary, and C.K. Prahalad. 1994. Competing for the Future. Boston, MA: Harvard Business School Press.

Hax, Arnoldo C., and Nicolas S. Majluf.1991. The Strategy Concept and Process.Englewood Cliffs, NJ: Prentice-Hall.

Henderson, Bruce D. 1979. Corporate Strategy.Cambridge, MA: Abt Books.

Hergert, M., and D. Morris. 1989. Accountingdata for value chain analysis. Strategic Management Journal Vol. 10: 175-188.

Normann, Richard, and Rafael Ramirez. 1993.From value chain to value constellation: Designing interactive strategy. Harvard Business Review (July-August).

Porter, Michael E. 1990. The Competitive Advantage of Nations. New York, NY: Free Press.

–––––. 1985. Competitive Advantage. New York,NY: Free Press.

–––––. 1980. Competitive Strategy. New York,NY: Free Press.

Prahalad, C.K., and Gary Hamel. 1990. Thecore competence of the corporation. HarvardBusiness Review (May-June).

Riley, Daniel. 1987. Competitive cost-basedinvestment strategies for industrial companies.In Manufacturing Issues. New York, NY: Booz,Allen, and Hamilton.

San Miguel, Joseph G. 1994. Emerson Electric Company. In R.N. Anthony and V. Govindarajan, Management Control Systems.Homewood, IL: Irwin.

Scherer, Frederic M. 1980. Industrial MarketStructure and Economic Performance. 2nd Ed.New York, NY: Rand McNally.

Shank, John K., and V. Govindarajan. 1989.Strategic Cost Analysis. Homewood, IL:Richard D. Irwin.

–––––. 1992. Strategic cost management:The value chain perspective. Journal of Man-agement Accounting Research (Fall): 179-197.

–––––. 1993. Strategic Cost Management. NewYork, NY: Free Press.

Society of Management Accountants ofCanada, The. 1995, revised 1999. MonitoringCustomer Value. Management AccountingGuideline. Mississauga, ON: The Society ofManagement Accountants of Canada.

Steiner, George A. 1979. Strategic Planning.New York, NY: Free Press.

Upbin, Bruce. 1995. The sincerest form offlattery. Forbes (July 31): 12.


25

NOTES

CU

ST

OM

ER

AN

D S

UP

PL

IER

VA

LU

E C

HA

IN

26


27

©1992, 1999 by The Society of Management Accountants of CanadaAll rights reserved.ISBN 1-55302-092-8Printed in Canada 08/99

To order Strategic Management Seriespublications, or for more information on other products available contact:

The Society of Management Accountants of Canada

Mississauga Executive CentreOne Robert Speck ParkwaySuite 1400Mississauga, ON CanadaL4Z 3M3

Order desk: 8:30 a.m. – 4:30 p.m. EST1-800-520-4262E-mail: [email protected]

Online ordering: www.cma-canada.org

C A N A D A

Shaping the Future

Value Chain Analysis for Assessing Competitive Advantage

Documents

Transcript of Value Chain Analysis for Assessing Competitive Advantage