Value chain

A value chain explains how a business transforms inputs, information and effort into an offer for which customers will pay more than the total cost of producing it. It separates the firm into linked activities so managers can see where cost, differentiation and margin arise.

When to use it

• Identify how product or service value is created through the operating system.
• Locate cost, differentiation, coordination problems and opportunities for advantage.

Origins

Harvard Business School professor Michael Porter introduced the value-chain framework as part of his work on competitive advantage. It complements his industry-structure analysis: the competitive-forces framework examines pressures outside the firm, while the value chain examines the activities inside it. Porter’s Competitive Strategy appeared in 1980, and his later work developed the value chain explicitly as a way to connect activity design with cost position and differentiation.

What it is

Step 1 is to map the five primary activities:

• Inbound logistics: Receive, store and move the materials, components or information required by operations. Supplier relationships and input quality strongly influence performance.

• Operations: Transform inputs into the final product or service through production, technical work, maintenance, testing and packaging.

• Outbound logistics: Store, distribute and deliver the completed offer, including activities performed by external logistics partners.

• Marketing and sales: Generate demand, communicate the proposition, manage channels and the sales force, and establish pricing.

• Service: Sustain or increase value after purchase through installation, training, warranties, parts, support and repair.

Four support activities enable the primary flow:

• Firm infrastructure: General management, planning, finance, accounting and legal systems that coordinate and govern the enterprise.

• Human-resource management: Recruit, develop, reward and retain the people required across the chain.

• Technology development: Create and apply product and process technologies that improve cost or differentiation.

• Procurement: Source the goods and services used throughout the business, not only raw materials for production.

Margin is the difference between the value customers pay and the combined cost of the activities. Competitive position cannot be understood from an aggregate company total alone: each activity affects relative cost, differentiation or both.

Links between activities matter as much as the activities themselves. A sales team may acquire a promising customer, only for an inflexible credit-control process to destroy the relationship before revenue is earned. Mapping handoffs and trade-offs prevents one function’s local optimisation from reducing total value.

Developments of the model

The framework is now applied beyond a single firm to supply chains, distribution systems and wider value networks. That broader view helps a company see which participants control access, where profit pools sit and how technology or channel change redistributes bargaining power. The illustration shows a simplified chain for a chemicals manufacturer.

Distributor

Global National Local

distributor distributor distributor

Intermediaries

Importer Reseller Formulators

Users of chemicals

Glass

Paper Soap and detergent Textiles Food additives Bricks Toothpaste manufacture

General public

How to use it

Starbucks provides an illustrative application. Founded in Seattle in 1971, the company expanded to roughly 24 thousand coffee shops. When growth slowed in 2007, founder Howard Schultz returned as chief executive and examined how the whole system needed to respond to higher input costs and stronger competition.

• Inbound logistics: Starbucks used around half a billion pounds of beans annually—about 3 per cent of world supply—from more than 300 growers across Asia, Africa and Latin America. In 2008, only 3 out of 10 store orders arrived perfectly. Supply-chain reorganisation raised that result to 9 out of 10. The company also bought a Costa Rican plantation as a research and product-development resource rather than simply to integrate supply.

• Operations: In February 2008, Starbucks closed 7 thousand US stores for 3 hours to retrain baristas. Stores returned to grinding beans locally and discarded brewed coffee after 30 minutes. Schultz invited ideas from employees and customers, receiving 93 thousand suggestions, and redesigned stores to restore a coffeehouse atmosphere.

• Outbound logistics: Fewer than half of store deliveries had been arriving on time while distribution cost rose. The company simplified the structure, reduced cost to serve and built a single global logistics system.

• Marketing and sales: After historically limited national advertising, Starbucks invested in a major campaign and introduced a rewards card to strengthen loyalty.

• Service and support: Technology leadership, the website and social media were upgraded. Health-care support for part-time employees and new partner incentives addressed the human system behind the experience.

Following Schultz’s return in 2008 and these linked changes, the company’s market value increased from $15 billion to $84 billion by 2016. The figures do not prove that every change caused the valuation gain, but the case demonstrates how coordinated activity redesign can reinforce a value proposition.

Some things to think about

• Where does your company create value, where does it merely incur cost and which weak handoffs destroy value created elsewhere? What evidence supports the map?

• Beyond the firm, how are products reaching the final customer, who controls critical interfaces and where are profit pools moving? What role could the business play more effectively?

Top practical tip

Map one customer journey across functional boundaries and quantify cost, delay, quality and customer impact at each activity and handoff. The most valuable opportunity often sits between departments rather than inside one of them.

Top pitfall

Do not treat Porter’s categories as a static organisation chart. Digital products, partners and ecosystems may distribute activities differently. Follow the actual flow of value and examine linkages, external dependencies and customer outcomes.

Further reading

• Porter, M.E. (nineteen eighty-five). Competitive Advantage. Free Press.
• Porter, M.E. (nineteen ninety-six). “What Is Strategy?” Harvard Business Review.