Porter's Value Chain.
How does your organization create value? How do you change business inputs into business outputs in such a way that they have a greater value than the original cost of creating those outputs?
This isn't just a dry question: it's a matter of fundamental importance to companies, because it addresses the economic logic of why the organization exists in the first place.
Manufacturing companies create value by acquiring raw materials and using them to produce something useful. Retailers bring together a range of products and present them in a way that's convenient to customers, sometimes supported by services such as fitting rooms or personal shopper advice. And insurance companies offer policies to customers that are underwritten by larger re-insurance policies. Here, they're packaging these larger policies in a customer-friendly way, and distributing them to a mass audience.
The value that's created and captured by a company is the profit margin:
Value Created and Captured – Cost of Creating that Value = Margin
The more value an organization creates, the more profitable it is likely to be. And when you provide more value to your customers, you build competitive advantage.
Understanding how your company creates value, and looking for ways to add more value, are critical elements in developing a competitive strategy. Michael Porter discussed this in his influential 1985 book "Competitive Advantage," in which he first introduced the concept of the value chain.
A value chain is a set of activities that an organization carries out to create value for its customers. Porter proposed a general-purpose value chain that companies can use to examine all of their activities, and see how they're connected. The way in which value chain activities are performed determines costs and affects profits, so this tool can help you understand the sources of value for your organization.
Rather than looking at departments or accounting cost types, Porter's Value Chain focuses on systems, and how inputs are changed into the outputs purchased by consumers. Using this viewpoint, Porter described a chain of activities common to all businesses, and he divided them into primary and support activities, as shown below.
Primary activities relate directly to the physical creation, sale, maintenance and support of a product or service. They consist of the following:
These activities support the primary functions above. In our diagram, the dotted lines show that each support, or secondary, activity can play a role in each primary activity. For example, procurement supports operations with certain activities, but it also supports marketing and sales with other activities.
Companies use these primary and support activities as "building blocks" to create a valuable product or service.
To identify and understand your company's value chain, follow these steps.
For each primary activity, determine which specific subactivities create value. There are three different types of subactivities:
For each of the Human Resource Management, Technology Development and Procurement support activities, determine the subactivities that create value within each primary activity. For example, consider how human resource management adds value to inbound logistics, operations, outbound logistics, and so on. As in Step 1, look for direct, indirect, and quality assurance subactivities.
Then identify the various value-creating subactivities in your company's infrastructure. These will generally be cross-functional in nature, rather than specific to each primary activity. Again, look for direct, indirect, and quality assurance activities.
Find the connections between all of the value activities you've identified. This will take time, but the links are key to increasing competitive advantage from the value chain framework. For example, there's a link between developing the sales force (an HR investment) and sales volumes. There's another link between order turnaround times, and service phone calls from frustrated customers waiting for deliveries.
Review each of the subactivities and links that you've identified, and think about how you can change or enhance it to maximize the value you offer to customers (customers of support activities can internal as well as external).
Your organization's value chain should reflect its overall generic business strategies. So, when deciding how to improve your value chain, be clear about whether you're trying to set yourself apart from your competitors or simply have a lower cost base.
You'll inevitably end up with a huge list of changes. See our article on prioritization if you're struggling to choose the most important changes to make.
Porter's Value Chain is a useful strategic management tool.
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