Value chain analysis

Statements on Management Accounting

P R A C T I C E O F M A N A G E M E N T A C C O U N T I N G

C R E D I T S

T I T L E

This statement was approved for issuance as aStatement on Management Accounting by theManagement Accounting Committee (MAC) of theInstitute of Management Accountants (IMA). IMA appre-ciates the support of The Society of ManagementAccountants of Canada (SMAC) in helping create thisSMA and extends appreciation to Joseph G. SanMiguel, of the Naval Postgraduate School, who draftedthe manuscript.

Special thanks are due to Randoif Holst, SMACManager, Management Accounting Guidelines, for hiscontinuing project supervision and to the members ofthe focus group (including MAC members Dennis Dalyand Thomas Huff) for contributing to the improvementof the final document.

Value Chain Analysis for Assessing

Competitive Advantage

Published byInstitute of Management Accountants10 Paragon DriveMontvale, NJ 07645-1760www.imanet.org

Copyright © 1996Institute of Management Accountants

All rights reserved

Statements on Management Accounting

T A B L E O F C O N T E N T S

Value Chain Analysis for Assessing Competitive Advantage


I. Rationale . . . . . . . . . . . . . . . . . . . . . . . 1

II. Scope . . . . . . . . . . . . . . . . . . . . . . . . . 1

III. The Value Chain Defined . . . . . . . . . . . . .1

IV. Competitive Advantage and Customer Value . . . . . . . . . . . . . . . . . . .2

V. The Role of the Management Accountant . . . . . . . . . . . . . . . . . . . . . . .4

VI. The Value Chain Approach for Assessing Competitive Advantage . . . . . .5

Internal Cost Analysis . . . . . . . . . . . . . . .5

Internal Differentiation Analysis . . . . . . .10

Vertical Linkage Analysis . . . . . . . . . . . .13

VII. Strategic Frameworks for Value Chain Analysis . . . . . . . . . . . . . . .17

Industry Structure Analysis . . . . . . . . . .18

Core Competencies Analysis . . . . . . . . .19

Segmentation Analysis . . . . . . . . . . . . .22

VIII. Limitations of Value Chain Analysis . . . .26

IX. Organizational and Managerial Accounting Challenges . . . . . . . . . . . . . .27

X. Conclusion . . . . . . . . . . . . . . . . . . . . .28

Appendix – Value Chain Analysis vs. ConventionalManagement Accounting

Bibliography

ExhibitsExhibit 1: The Value Chain . . . . . . . . . . . . . .3

Exhibit 2: Competitive Advantage Through Low Cost and/or Differentiation . . .4

Exhibit 3: Process Cost Drivers . . . . . . . . . . .8

Exhibit 4: Competitor Cost Analysis . . . . . . .10

Exhibit 5: Value Chain for Crown, Cork and Seal Company . . . . . . . . . . .12

Exhibit 6: Vertical Linkages in the Production of Plastic Food Containers . . . . . .13

Exhibit 7: Value Chain Differences: TheTelecommunications Industry . . . .16

Exhibit 8: How Tetra-Pak Reconfigured the Value Chain . . . . . . . . . . . . .21

Exhibit 9: How IKEA Reconfigured the Furniture Industry . . . . . . . . . . . .22

Exhibit 10: Approaches to DefiningSegmentation Variables . . . . . . . .24

Exhibit 11: Segmenting the British Frozen Food Industry . . . . . . . . . .25

Exhibit A-1: Value Chain vs. ConventionalManagement Accounting . . . . . . .30

I . RAT IONALECompetitive advantage for a company means notjust matching or surpassing what competitorscan do, but discovering what customers want andthen profitably satisfying, and even exceeding,their expectations. As barriers to interregionaland international trade have diminished and asaccess to goods and services has grown,customers can locate and acquire the best ofwhat they want, at an acceptable price, whereverit is in the world. Under growing competition and,hence, rising customer expectations, a company’spenalty for complacency becomes even greater.

A strategic tool to measure the importance ofthe customer’s perceived value is value chainanalysis. By enabling companies to determinethe strategic advantages and disadvantages oftheir activities and value-creating processes inthe marketplace, value chain analysis becomesessential for assessing competitive advantage.

I I . SCOPEThis guideline is addressed to managers, andmore specifically to management accountants,who may lead efforts to implement value chainanalysis in their organizations.

The concepts, tools and techniques presentedapply to all organizations that produce and sell aproduct or provide a service.

This guideline will help readers to:

l link value chain analysis to organizationalgoals, strategies and objectives;

l broaden management awareness about valuechain analysis;

l understand the value chain approach forassessing competitive advantage;

l comprehend useful strategic frameworks forvalue chain analysis; and

l appreciate the organizational and managerialaccounting challenges.

I I I . THE VALUE CHAIN DEF INEDThe idea of a value chain was first suggested byMichael Porter (1985) to depict how customervalue accumulates along a chain of activitiesthat lead to an end product or service.

Porter describes the value chain as the internalprocesses or activities a company performs “todesign, produce, market, deliver and support itsproduct.” He further states that “a firm’s valuechain and the way it performs individual activitiesare a reflection of its history, its strategy, itsapproach to implementing its strategy, and theunderlying economics of the activities themselves.”

Porter describes two major categories of busi-ness activities: primary activities and supportactivities. Primary activities are directly involvedin transforming inputs into outputs and in deliveryand after-sales support. These are generally alsothe line activities of the organization. Theyinclude:

l inbound logistics—material handling and warehousing;

l operations—transforming inputs into the finalproduct;

l outbound logistics—order processing and dis-tribution;

l marketing and sales—communication, pricingand channel management; and

l service—installation, repair and parts.

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Support activities support primary activities andother support activities. They are handled by theorganization’s staff functions and include:

l procurement—purchasing of raw materials,supplies and other consumable items as wellas assets;

l technology developmen—know-how, proceduresand technological inputs needed in every valuechain activity;

l human resource management—selection,promotion and placement; appraisal; rewards;management development; and labor/employeerelations; and

l firm infrastructure—general management,planning, finance, accounting, legal, governmentaffairs and quality management.

John Shank and V. Govindarajan (1993) describethe value chain in broader terms than doesPorter. They state that “the value chain for anyfirm is the value-creating activities all the wayfrom basic raw material sources from componentsuppliers through to the ultimate end-use productdelivered into the final consumers hands.” Thisdescription views the firm as part of an overallchain of value-creating processes.

According to Shank and Govindarajan, the industryvalue chain starts with the value-creatingprocesses of suppliers, who provide the basicraw materials and components. It continues withthe value-creating processes of different classesof buyers or end-use consumers, and culminatesin the disposal and recycling of materials.

The industry value chain and the value chainactivities within the firm are compared in Exhibit 1.

IV. COMPETIT IVE ADVANTAGEAND CUSTOMER VALUEIn order to survive and prosper in an industry,firms must meet two criteria: they must supplywhat customers want to buy, and they must survive competition. A firm’s overall competitiveadvantage derives from the difference betweenthe value it offers to customers and its cost ofcreating that customer value.

Competitive advantage in regard to products andservices takes two possible forms. The first is anoffering or differentiation advantage. If customersperceive a product or service as superior, theybecome more willing to pay a premium price relative to the price they will pay for competingofferings. The second is a relative low-costadvantage, which customers gain when a company’s total costs undercut those of its average competitor.

Differentiation AdvantageA differentiation advantage occurs when customersperceive that a business unit’s product offering(defined to include all attributes relevant to thebuying decision) is of higher quality, incurs fewerrisks and/or outperforms competing productofferings. For example, differentiation may includea firm’s ability to deliver goods and services in atimely manner, to produce better quality, to offerthe customer a wider range of goods and services,and other factors that provide unique customervalue.

Once a company has successfully differentiatedits offering, management may exploit the advan-tage in one of two ways: increase price until itjust offsets the improvement in customer benefits,thus maintaining current market share; or pricebelow the “full premium” level in order to buildmarket share.

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Low-Cost AdvantageA firm enjoys a relative cost advantage if its totalcosts are lower than the market average. Thisrelative cost advantage enables a business todo one of two things: price its product or servicelower than its competitors in order to gain marketshare and still maintain current profitability; or match the price of competing products or services and increase its profitability.

Many sources of cost advantage exist: access to low-cost raw materials; innovative processtechnology; low-cost access to distribution channels or customers: and superior operatingmanagement. A company might also gain a relative cost advantage by exploiting economiesof scale in some markets.

The relationship between low-cost advantage anddifferentiation advantage is illustrated in Exhibit 2.

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EXHIBIT 1: THE VALUE CHAIN

Industry Value Chain

Value Chain Activitieswithin the Firm

PrimaryActivities

SupportActivities

SupplierValue Chain

R&D

End-

Use

Con

sum

er P

ays

for

Prof

it M

argi

ns T

hrou

ghou

t th

e Va

lue

Cha

in

Procurement

TechnologyDevelopment

HumanResource

Management

FirmInfrastructure

Design

Production

Marketing

Distribution

Service

Firm ZValue ChainX Y

DistributionValue Chain

BuyerValue Chain

Disposal/Recycle

Value Chain

Source:

EXHIBIT 1. THE VALUE CHAIN

Superior relative cost position offers equivalentcustomer value for a lower price. Superior relativedifferentiation position offers better customervalue for an equivalent price.

Organizations that fail to gain competitive advantage through low cost or superior differen-tiation, or both, are “stuck-in-the-middle.” Forinstance, several American bicycle makers,including Schwinn, Huffy, Murray and Columbia,found themselves in this position during the1980s. These companies lacked a cost advantageand failed to foresee the emerging mountainbike market. By contrast, Cannondale capturedmarket share after introducing its large-diameterframe bicycle.

V. THE ROLE OF THE MANAGEMENT ACCOUNTANTThe management accountant is traditionally con-sidered the resident expert on cost analysis;cost estimation; cost behavior; standard cost-ing; profitability analysis by product, customer or

distribution channel; profit variance analysis;and financial analysis.

Today, management accountants must also bringskills in activity-based costing, benchmarking,re-engineering, target costing, life-cycle costing,economic value analysis, total quality manage-ment and value chain analysis. The Appendixcontrasts traditional management accountingwith the requirements of value chain analysis.

Value chain analysis is a team effort.Management accountants need to collaboratewith engineering, production, marketing, distribu-tion and service professionals to focus on thestrengths, weaknesses, opportunities and threatsidentified in the value chain analysis results.

By championing the use of value chain analysis,the management accountant enhances thefirm’s value and demonstrates the value of thefinance staff to the firm’s growth and survival.

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EXHIBIT 2: COMPETITIVE ADVANTAGE THROUGH LOW COST AND/OR DIFFERENTIATION

Source: Shank, and Govindarajan, 1993.

DifferentiationAdvantage

Differentiationwith Cost Advantage

Stuck–in–the–Middle

Inferior

Inferior

Superior

Superior

Low-Cost Advantage

RelativeDifferentiationPosition

Relative Cost Position

EXHIBIT 2. COMPETITIVE ADVANTAGE THROUGH LOW COST AND/OR DIFFERENTIATION

Source: Shank and Govindarajan, 1993.

VI . THE VALUE CHAIN APPROACH FOR ASSESSINGCOMPETIT IVE ADVANTAGEMost corporations define their mission as one ofcreating products or services. For these organi-zations, the products or services generated aremore important than any single step within theirvalue chain. In contrast, other companies areacutely aware of the strategic importance of individual activities within their value chain. Theythrive by concentrating on the particular activities that allow them to capture maximumvalue for their customers and themselves.

These firms use the value chain approach to bet-ter understand which segments, distributionchannels, price points, product differentiation,selling propositions and value chain configura-tions will yield them the greatest competitiveadvantage.

The way that the value chain approach helpsorganizations assess competitive advantage isthrough the following types of analysis:

l internal cost analysis—to determine thesources of profitability and the relative costpositions of internal value-creating processes;

l internal differentiation analysis—to understandthe sources of differentiation (including the cost)within internal value-creating processes; and

l vertical linkage analysis—to understand therelationships and associated costs amongexternal suppliers and customers in order tomaximize the value delivered to customers andto minimize cost.

These types of analysis are not mutually exclusive.Rather, firms begin by focusing on their internaloperations and gradually widen their focus toconsider their competitive position within theirindustry.

The value chain approach for assessing com-petitive advantage is an integral part of thestrategic planning process. Like strategic planning, value chain analysis is a continuousprocess of gathering, evaluating and com–municating information for business decision-making. By stimulating strategic thinking,the analysis helps managers envision the company’s future and implement decisions togain competitive advantage.

Internal Cost AnalysisOrganizations use the value chain approach toidentify sources of profitability and to understandthe cost of their internal processes or activities.The principal steps of internal cost analysis are:

l identify the firm’s value-creating processes;l determine the portion of the total cost of the

product or service attributable to each value-creating process;

l identify the cost drivers for each process;l identify the links between processes; andl 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 themselvesas cost, revenue, profit and investment centres.These and other organizational sub-units, suchas departments, functions, divisions or separatecompanies, that are frequently used for controlpurposes are not very useful for identifying value-creating processes. Adopting a process perspec-tive requires a horizontal view of the organization,beginning with product inputs and ending withoutputs and customers.

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Processes are structured and measured sets ofactivities designed to produce a specified outputfor a particular customer or market. Emphasizingprocess means focusing not on what work is donebut on how work is done within the organization.

While an organization’s hierarchical structure typically lays out responsibilities and reportingrelationships, its process structure shows howthe organization delivers customer value. Whileit is not possible to measure or improve hierar-chical structure in any absolute sense, processeslend themselves to such measures as cost,time, output quality and customer satisfaction.

Because processes normally cut across func-tional areas, defining process boundaries is notalways a straightforward task. People associatedwith a particular business process may view it indifferent ways. For example, the new productdevelopment process could start with marketingsurveys or with delivery of product requirementsfrom marketing to development engineering. Theprocess could end with the release of productspecifications or with shipment of the first order.Process boundaries should be defined independ-ently of the way in which activities are organized.

Selecting the appropriate activity category maybe anything but straightforward. The key is toclassify value activities according to their truecontribution to the firm’s competitive advantage.For example, if order processing is important toa firm’s customer interactions, then this activityshould be classified under marketing.

Management at American Airlines, for example,handed its marketing unit the task of developingand implementing the carrier’s SABRE computer-ized reservation system. The result: a significantcompetitive advantage that left the other airlinesscrambling to copy the system. Even mighty

United Airlines has failed to match American’sinstalled base of terminals in travel agencies.

Determine the portion of the total cost ofthe product or service attributable to eachvalue-creating process.The next step of internal cost analysis is to traceor assign costs and assets to each value-creatingprocess identified. Although firms maintain internalreports and cost accounting information, thisinformation may not align with their processes.Companies might have to reclassify their data orconduct cost studies to assign costs and assetsto each process. Rather than conduct a detailedcost study, an organization might use rough esti-mates to assign costs to their value-creatingprocesses.

A full-cost approach provides the best estimateof life-cycle costs for evaluating the strategiccost advantage of a firm’s value-creatingprocess. Without adopting this approach, a firmrisks sacrificing product development costs toshort-term profits.

For example, the savings in factory labor that anorganization gains through using flexible manu-facturing systems, robotics and computer-integrated manufacturing might be offset by thehigh cost of computer software programmers.The information systems support costs shouldbe allocated to the value-creating processes that benefit from the new systems as part of the full cost.

For estimating the full cost of each value-creatingactivity, the full utilization of the capacity of the activity or its practical capacity is normallyused. Facility managers and equipment vendorsare useful sources of capacity estimates. If estimates of full capacity vary widely, a firmcould perform the analysis with the resulting

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costs to assess the sensitivity of the analysis tothe different capacity measures. When costsvary dramatically, companies should seek moreinformation for a more realistic long-term estimate of capacity.1

Although many of the processes identified maybe instrumental for achieving competitive advan-tage, various value-creating processes may havediffering effects on a firm’s costs or products.Companies selling pencils, pens or paper clips,for example, are unlikely to concern themselveswith after-sales service. But customer support is a vital part of the competitive strategy for makers of computers or high-speed copiers.

Identify the cost drivers for each process.The next step of internal cost analysis is to identifythe factor or cost determinants for each value-creating process. By understanding what factorsdrive costs, a firm can assign priorities among itscost improvement initiatives. In order to determineits relative cost advantage, a firm should alsoknow the cost factors of its competitors.2

While management accounting systems maycontain the total cost of each value-creatingprocess, they may not reveal the causes or factorsfor the significant individual costs. Using singleoutput or volume measures (e.g., units, labor hours,sales dollars) to assign costs is often misleading.Multiple cost drivers usually provide more usefulinformation. Exhibit 3 illustrates examples ofstructural and executional cost drivers.

Structural cost drivers consist of organizationalfactors that determine the economic structuredriving the cost of a firm’s products. These costdrivers reflect a firm’s long-term decisions, whichposition the firm in its industry and marketplace.Structural cost drivers may change.

For example, large pharmaceutical companiesenjoy economies of scale that lower their unitcosts for expensive R&D. Elsewhere, TexasInstruments has exploited the experience curve inlowering its life-cycle product cost. However, biggeris not necessarily better, as evidenced by the success of steel companies’ mini-mill strategy.

Executional cost drivers capture a firm’s opera-tional decisions on how best to employ itsresources to achieve its goals and objectives.These cost drivers are determined by manage-ment policy, style and culture. How well a firmexecutes its use of human and physicalresources will determine its level of success orfailure. For example, worker empowerment andflattened organizations are helping many firms intheir continuous improvement efforts.

Few structural and executional cost drivers canbe operationalized under existing managementaccounting systems in the cost analysis of thevalue chain. However, these cost drivers do offeran important reminder of the strategic decisionsthat firms need to make, or at least acknowl-edge, in designing their value-generating systems.Increasingly, companies are using activity-basedcosting to understand the resources/costs consumed by the activities and processes usedin delivering their products and services.

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1 The reader should refer to IMA’s Statement on ManagementAccounting, “Measuring the Cost of Capacity,” for additional information regarding the various approaches usedfor measuring capacity.

2. The reader should refer to IMA’s Statement on ManagementAccounting, “Developing Comprehensive CompetitiveIntelligence,” for additional information regarding the acquisition of competitive cost information.

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EXHIBIT 3: PROCESS COST DRIVERS

Source: Riley, 1987.

STRUCTURAL COST DRIVERS

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

Scope What is the degree of verticalintegration— horizontal integration ismore related to scale?

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

Technology What process technologies are used within each step of thefirm’s value chain?

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

EXECUTIONAL COST DRIVERS

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

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

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

EXHIBIT 3. PROCESS COST DRIVERS


Identify the links among processes.While individual value activities are consideredseparate and discrete, they are not necessarilyindependent. Most activities within a value chainare interdependent. Firms must not overlookvalue chain linkages among interdependentactivities that may impact their total cost.

For example, cost improvement programs in onevalue chain process may lower or increase costsand/or revenues in other processes. Transfers ofgoods and services from one value chainprocess to another increases cost. Eliminatingthese transfers reduces the costs of purchasing,invoicing and other recordkeeping functions.

Tandem Computers eliminated its costs of purchase orders, invoicing and other functions byjointly developing a detailed bar code processwith its suppliers. By improving its upstreamdesign and engineering processes for theTaurus, Ford saved on downstream productionand customer service costs. Using fewer floppydrives and motherboards in its PCs has enabledIBM to halve its delivered cost in two years.

As sources of competitive advantage, these rela-tionships or linkages among activities can be asimportant as the activities themselves. Suchlinkages may also offer sustainable competitiveadvantage, because their subtle, complex naturemakes them difficult for competitors to imitate.

Evaluate the opportunities for achievingrelative cost advantage.In many organizations, cost reductions are madeacross the board (e.g., “eliminate 10 per centfrom every department”). Because these firmsdo not reduce their costs strategically, this effortusually fails. More often than not, across-the-board cost reduction misconstrues the underlyingproblem. The point is not to become more

efficient at insignificant activities, but to bettermeet customer demands.

Using the value chain approach, a company goesbeyond simple across-the-board cuts andattempts to lower cost and improve efficiencywithin each value-creating process. For instance,a company might negotiate lower costs ofprocess inputs such as wages or purchases, orevaluate make-or-buy options.

Reducing process input costs often means nego-tiating lower wages (as with Chrysler and theU.S. airlines during the mid-1980s) or movingproduction to countries with cheaper labor costs.Suppliers might be willing to drop their prices ifthe company negotiates long-term contracts, anapproach used by Levi-Strauss in contractingwith its textile suppliers. Companies also usebuyer-seller partnerships to gain advantages in cost,quality, time, flexibility, delivery and technology.3

United Parcel Service (UPS) outsourced its customer service centers. In the process, thecompany consolidated 65 customer service centers representing 5,000 jobs down tobetween eight and 10 service centers run by contractors. UPS service center employees earn $10 to $12 an hour versus the $6.50 to $8 an hour paid to contractors.

Some processes may offer more opportunitiesfor improvement than others. In order to get themost out of its cost reduction programs, a com-pany should prioritize its value-creating process-es. Under the 80:20 rule, 20 per cent of thevalue-creating processes often accounts for 80per cent of total costs.

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3 For more information on buyer-seller partnerships, the reader should refer to The Society of Management Accountantsof Canada’s Management Accounting Guideline #32,“Building Buyer-Seller Partnerships.”

An example of the value chain approach toachieving a relative cost advantage is illustratedin Exhibit 4. This exhibit compares a specialtybrake repair firm with an independent auto repairfirm. By focusing on cost drivers such as scale,skill levels, wages and capacity utilization, thespecialty brake shop was able to reduce itscosts by 21 per cent. Its largest percentage costreduction was in material cost.

Companies can use comparisons with best practices, benchmarking and business processredesign to reduce their costs. The cost of qualityemphasizes that eliminating process and materialwaste leads to significant cost savings and customer satisfaction.

Internal Differentiation AnalysisThe value chain approach is also used by organ-izations to identify opportunities for creating and sustaining superior differentiation. In thissituation, the primary focus is on the customer’sperceived value of the products and services.

As with internal cost analysis, internal differenti-ation analysis requires firms to first identify theirvalue-creating processes and primary cost drivers.They are then ready to perform a differentiationanalysis using the following guidelines:

l identify the customers’ value-creating processes;l evaluate differentiation strategies for enhancing

customer value; andl determine the best sustainable differentiation

strategies.

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EXHIBIT 4: COMPETITOR COST ANALYSIS


Material

Independent

Auto Repair

100%

Specialty

Brake Repair

79%

Cost

Drivers

Cost

Reduction

21%

Purchasing scaleMore efficient distribution

Less-skilled laborLower compensationMore specialization& productivity 7%

Scale offset by largeradvertising expenses 0%

Higher utilization ofequipment & facilities 5%

Labor

Variable Shopand SG&A

Fixed Shopand SG&A

Material

Labor

Variable Shopand SG&A

Fixed Shopand SG&A

9%

EXHIBIT 4. COMPETITOR COST ANALYSIS

Identify the customers’ value-creatingprocesses.To pursue a superior differentiation strategy, afirm’s processes must enhance those of its customers. Thus, a firm should carefully studythe value-creating processes of its customers.Exhibit 5 presents such an analysis for Crown,Cork and Seal Company (CCS), a metal can maker,and its customers in the late 1970s. The metalcontainer industry was characterized by lowgrowth, low profits and intense competition. CCSsucceeded with a differentiation strategy, whichis usually very difficult to accomplish in a commodity-type business. Two different groupsof customers—food and beverage canners—accounted for 80 per cent of the metal containersproduced.

Evaluate differentiation strategies forenhancing customer value.The key to successful differentiation under thevalue-chain approach is to identify the value-creat-ing processes that distinguish a firm’s products or services from those of its competitors. In making this distinction, customer value is emphasized.

The ways customer value can be enhancedthrough differentiation include:

l product features—that are esthetically appeal-ing or functionally superior. For example, theMercedes-Benz automobile accomplished thisfeat so well for years that its name became synonymous with the highest level of quality— people would describe a product as the“Mercedes-Benz” of its category;

l marketing channels—that provide desired levels of responsiveness, convenience, varietyand information. By placing its order-entry com-puters in Wal-Mart’s stores, Procter & Gamblesignificantly reduced the overall order-entryand processing costs for both firms. Providing

this unique service to a customer also enabledP&G to improve its on-time delivery of ordered merchandise;

l service and support—tailored to end-user andchannel member sophistication and urgency ofneed. For several decades, superior servicecapabilities and high vendor switching costsproduced by proprietary architecture and soft-ware enabled IBM to build and maintain a commanding leadership position in the main-frame computer industry. Until open systemsappeared in the mid-1980s, risk-averse cus-tomers were reluctant to make large capitaland conversion outlays for mainframe computersystems without the manufacturer’s strongassurance of reliability;

l brand or image positioning—that lends greaterappeal to the company’s offerings on criticalselection criteria. For many years, this qualityimage has allowed the American Express Co.to command a significant price premium in thehighly competitive financial services market—a premium that reflects, in its words, the “privilege of membership”; and

l price—including both net purchase price andcost savings available to the customer throughthe use of the product and service.

Determine the best sustainable differentia-tion strategies.For a firm to achieve superior differentiation, itmust utilize the best mix of resources in creatingvalue for its customers. In order to prioritize its processes as sources of differentiation, acompany must determine what attributes of each process enhance customer value.

The more unique a firm’s resources and skills,the more sustainable is its differentiation advan-tage over competitors.

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P R A C T I C E O F M A N A G E M E N T A C C O U N T I N GEXHIBIT 5: VALUE CHAIN FOR CROWN, CORK AND SEAL COMPANY

Crown, Cork & Seal Canners

1

Supplies of S

teel&

Aluminum

Purchasing

Inventory Holding

Design, Engineering

Manufacturing

Inventory Holding

Distribution

Sales

Purchasing

Inventory Holding

Processing

Canning

Marketing

Distribution

Service &

TechnicalS

upport

2

3

45

Adapted from: “Crown, Cork and Seal Company and the Metal Container Industry,” and “Crown, Cork and Seal Company, Inc.” Havard Business School, 1978.

High quality inputs.

Reliability of supply evenduring metal shortages.

Speed and competencein maintainingcustomers’ canning lines. Quality of technical advice.

Fast, reliable order processing.

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.

Speed and flexibility of delivery.

Ability to meet unexpected orders from customers at short notice.

Containers forspecialized uses. Special designs ofcontainers. Specially strong or light containers.

Consistency of product. Quality of product.Flexibility ofmanufacturing.

EXHIBIT 5. VALUE CHAIN FOR CROWN, CORK AND SEAL COMPANY

CCS (Exhibit 5), for example, focused only on tin-plated steel can production, not aluminum; produced for beverage and aerosol customers, notfood processors; and invested in more can-forminglines at its plants to reduce changeovers and set-up wages. CCS was also willing to devote moreresources to customizing metal containers for customers and to increase its responsiveness tocustomers’ schedule and quality needs.

The payoffs for effective differentiation, and thepenalties for not differentiating, are clear. In1980, Purolator Courier was bigger than FederalExpress; today the reverse is true. In 1982,Dreyfus had more assets under managementthan Fidelity—a situation that had reversed itselfby the mid-90s.

Vertical Linkage AnalysisLinkages among value-creating processes do notend with the activities within a firm. The greatestcompetitive advantage may come out of linkagesbetween a firm’s value-creating activities andthose of its suppliers, channels or users.

Vertical linkage analysis is a much broader appli-cation of internal cost and differentiation analysisthat includes all upstream and downstreamvalue-creating processes throughout the indus-try.Vertical linkage analysis considers all linksfrom the source of raw materials to the disposaland/or recycling of the product. Exhibit 6 out-lines the vertical links involved in the productionof “fast food” containers.

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EXHIBIT 6: VERTICAL LINKAGES IN THE PRODUCTION OF PLASTIC FOOD CONTAINERS

Source:

Natural gas producers

Ethane producers

Styrene producers

Polystyrene producers

Fast food carton producers

Fast food restaurants

Final consumers

EXHIBIT 6. VERTICAL LINKAGES IN THE PRODUCTION OF PLASTIC FOOD CONTAINERS

Shank and Govindarajan (1993) state the importance of vertical linkages:

...gaining and sustaining a competitive advan-tage requires that a firm understand the entirevalue delivery system, not just the portion of thevalue chain in which it participates. Suppliersand customers and suppliers’ suppliers and customers’ customers have profit margins thatare important to identify in understanding afirm’s cost/differentiation positioning, becausethe end-use customers ultimately pay for allthe profit margins along the entire value chain.

Vertical linkage can reveal which activities arethe most (and least) critical to competitiveadvantage (or disadvantage). For example, Swisswatchmakers succeeded for years as relativelysmall, labor-intensive assemblers. Then camethe 1970s and the advent of low-cost, mass-produced watches. The Swiss responded byrestructuring their industry to gain economies ofscale similar to those enjoyed by their new global competitors.

However, the Swiss failed to realize that their critical problem was not in manufacturing. Thisset of activities added only a small proportion ofthe value of their final product. Far more significantwere downstream activities in output logistics,marketing, sales and service. Beyond being ableto make a watch cheaply, the Swiss had to lowertheir costs of distribution and service. Theycame up with the hugely successful Swatch,which, besides being inexpensively priced, wasvirtually indestructible and could be distributedthrough numerous low-cost channels, fromdepartment stores to discount houses.

Vertical linkage analysis includes the followingsteps:

l identify the industry’s value chain and assigncosts, revenues and assets to value-creatingprocesses;

l diagnose the cost drivers for each value-creatingprocess; and

l evaluate the opportunities for sustainablecompetitive advantage.

Identify the industry’s value chain andassign costs, revenues and assets tovalue-creating processes.Because vertical linkages can be complex and intangible, they are often overlooked byorganizations. For example, the petroleum industry consists of numerous value-creatingprocesses or activities, including exploration,production, refining, marketing and distribution.These processes define the value chain for thisindustry. One company may participate in allparts of this value chain; another firm may participate in only a few. This diversity of opera-tions and organizations makes it difficult toadopt a standard approach for identifying industry value chain processes.

Few firms have information systems that canidentify and analyze these subtle relationships.For example, profitability and return on assetsare key measures of competitive advantagethroughout an industry’s value chain. It can beextremely difficult to obtain pertinent informationfor these measures, including operating costs,revenues and assets for each process through-out the industry’s value chain. However, thisinformation is necessary to calculate a rate ofreturn on assets for each value chain process.

Obtaining the replacement or current cost ofphysical assets used by a value-creating activity

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is a necessary but often-complex undertaking.Historical or book values usually provide inade-quate measures of current investment. Plantengineers, equipment vendors and independentappraisal professionals may be consulted tohelp establish current asset values. Likewise,establishing prices for transferring goods andservices among value chain processes requiresan understanding of market or competitive-based rates. If at least one firm competes ineach stage of value creation, then competitivemarket prices are available. If not, then a companymust use judgment in determining a transferprice that incorporates a normal profit margin on full costs. For long-term strategic decision-making, companies should use full cost underconditions of full capacity for the value activity.While several measures of capacity exist, thebest measure should represent the long-term utilization of the value activity’s assets (some-times called “practical capacity”).

Publicly available financial reports produced byfirms throughout the industry value chain canprovide key financial information. Typically, thisinformation is neither in the proper format nordisaggregated enough to accommodate verticallinkage analysis. Significant analysis, datamanipulation and judgment may be necessary to obtain the appropriate information for eachvalue chain process.

For intermediate transfers between processes,competitive market prices, if available, should besubstituted for the internal transfer prices. Forexample, competitive market prices for a singlelink in the value chain may be obtained from individual firms that operate only in that link ofthe chain. For long-term cost estimation, fullcosts should be used rather than marginal,variable or incremental costs.

Diagnose the cost drivers for each value-creating process.Traditional management or cost accounting systems often assign costs by using a single out-put measure of operating activity, such as outputvolume. For vertical linkage analysis, a singlemeasure is inadequate to capture the underlyingcost categories. Direct labor-based measuresmay be appropriate for labor-intensive activities;operating hours may be appropriate for machine-based activities. The cost drivers illustrated in Exhibit 3 may be used to identify the factorsthat determine costs throughout the industryvalue chain.

Evaluate the opportunities for sustainablecompetitive advantage.By nature, competitive advantage is relative. Inan ideal world, a firm can gauge its competitiveposition by knowing its competitor’s value chainsand the rates of return on each. In reality, howev-er, this may be rather difficult: the competitor’sinternal cost, revenue and asset data for itsprocesses are generally unavailable. Sufficientqualitative information usually exists on a firm’smajor value-creating processes and the strategiesfor each. By understanding how other companiescompete in each process of the industry valuechain, a firm can use the qualitative analysis toseek out competitive niches even if financialdata are unavailable.

Value chains for three competitors in the rapidlychanging telecommunications industry—AT&T,NYNEX and IBM—are listed in Exhibit 7, along withthe strategic differences for each firm (Hax andMajiuf, 1991). The strategic differences reflect vary-ing structural and executional cost drivers. In market-ing, for instance, AT&T started with no organizationbut with significant name recognition. The regionalmarketing scale of NYNEX and the worldwide mar-keting scale of IBM are important cost advantages.

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Finding innovative ways to perform value-creatingactivities helps firms improve their overall perfor-mance and achieve competitive advantage. Inorder to thrive in the mature, highly competitivemeat packing industry, for example, Iowa BeefProcessors built its plants near cattle ranches,thus eliminating the high cost of shipping cattleto northern processing plants. In order to lowerits costs, Tropicana froze slabs of orange juiceconcentrate near the orange groves in Florida

and shipped the slabs to its large markets in theNortheastern U.S. Only then did the companymix the concentrate with water, thus avoiding thelengthy and costly shipment of water.

Increased global competition forces firms to focuson worldwide sustainable competitive advantage.Porter (1990), one of a few strategists who havesystematically studied global competition, cites fourmajor factors that influence national competitive

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Procurement

TechnologyDevelopment

Operations

Marketing and Sales

Owns manufacturing branch (Western Electric)

Technological leadershipthrough Bell Labs

National presenceHigh quality of equipmentthrough heavy capital expenditure Similar communicationsstandards nationwideStrongest nationaltelecommunicationsnetwork

New emphasis on marketing (still weak)High name recognitionLong-term relationshipwith clients Recruits computer executives

Free to use any supplier it wants

Focus on softwareproducts

Regional monopolyInnovativeequipment from outside suppliers High-quality regional networkthrough heavycapital investment

Use of Bell logoFocus on top 1,000corporate customersSales anddistribution centresclose to customers

Owns Rolm, CPE manufacturer

Strong R&D incomputer hardwareand softwaretechnologies

Global presenceLeading computertechnologyPartnership with MCI

Strong reputationfor marketingexcellenceAlready sells to most major corporationsExperienced sales force

Strategic Differences

AT&T NYNEX IBM

Source: Hax and Majluf, 1991.

EXHIBIT 7: VALUE CHAIN DIFFERENCES:THE TELECOMMUNICATIONS INDUSTRY

Value Chain

Processes

EXHIBIT 7. VALUE CHAIN DIFFERENCES: THE TELECOMMNICATIONS INDUSTRY

Source: Hax and Majluf, 1991.

advantage. These are:

l factor conditions—the nation’s position in factors of production, such as skilled labor orinfrastructure, necessary to compete in agiven industry;

l demand conditions—the nature of domesticdemand for the industry’s product or service;

l related and supporting industries—the presenceor absence in the nation of supplier industriesand related industries that are internationallycompetitive; and

l firm strategy, structure and rivalry—the conditionsin the nation governing how companies are created, organized and managed, and thenature of domestic rivalry.

Geographic scope can allow firms to gain substantial competitive advantages by sharing orcoordinating similar value activities in differentplaces. The importance of this advantage is illustrated by the recent success of firms with aglobal scope, such as Canon (Japan), Caterpillar(U.S.), N.Y. Philips (Netherlands) and Siemens(West Germany). These firms sell and service theirproducts in practically every corner of the globe.

Automakers like Ford or GM are even more global:they carry out many key value-creating activities—from engineering to manufacturing and sales—indozens of countries around the world. Japaneseauto companies are also globalizing rapidly, makinghuge investments in manufacturing facilities in,for example, South Korea, Singapore and the U.S.

Nike’s key value-creating processes are shoedesign, manufacture of shoe components andfinal assembly. All major inputs to each processare available in the U.S. However, Nike locatescomponent manufacturing, requiring moderatelyskilled labor and capital, in Taiwan and SouthKorea. It locates assembly operations, a labor-

intensive activity, in low-wage Asian countriessuch as China, Thailand and the Philippines.

Taking a global view of the value chain is notwithout disadvantages. One possible negativefactor is transportation between linked processes.Transportation consumes time and adds tocosts. Shipments of electronic componentsbetween the Far East and North Americanassembly plants may take at least a month.Transporting components to local assemblyplants may save transport and inventory costs.

Scattering value-creating processes around theworld can also lead to poor control, communica-tion and coordination. Close proximity of R&D,engineering, production and marketing personnelmay provide synergistic benefits in meeting customer needs.

For example, to increase its worldwide tire pro-duction capacity to compete with Michelin,Japan’s Bridgestone acquired Firestone Tire &Rubber in the U.S. Muddled strategies, slowdecision-making and poor communicationbetween Tokyo and Akron, Ohio, led to majorlosses, layoffs and a sell-off of assets.

The North American Free Trade Agreementamong Canada, Mexico and the U.S. has intro-duced new relationships affecting value-chainanalysis for suppliers and buyers alike. Theserelationships require careful scrutiny. For example,lower labor costs in Mexico have motivated companies to locate their assembly and manu-facturing processes there. However, some firms have experienced costly productivity and qualityproblems that more than offset their labor savings.Each firm must balance the benefits/cost of amulti-location decision.

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To properly evaluate the opportunities for com-petitive advantage in the global marketplace,firms need to consider such things as a country’svalues, political climate, environmental concerns,trade relations, tax laws, inflation rates and currency fluctuations. The recent devaluation ofthe Mexican peso is an example of the risks ofmoving operations to uncertain economies.

V I I . STRATEGIC FRAMEWORKSFOR VALUE CHAIN ANALYSISValue chain analysis requires a strategic frameworkor focus for organizing internal and external infor-mation, for analyzing information, and for summariz-ing findings and recommendations. Because valuechain analysis is still evolving, no uniform practiceshave yet been established. However, borrowingrecent concepts from strategists and organizationexperts, three useful strategic frameworks for valuechain analysis are:

l industry structure analysis;l core competencies; andl segmentation analysis.

Industry Structure AnalysisMichael Porter (1980, 1985) developed the fiveforces model as a way to organize informationabout an industry structure to evaluate its potential attractiveness.

Under this model, the profitability of an industryor market measured by the long-term return oninvestment of the average firm depends largelyon five factors that influence profitability. These are:

l bargaining power of buyers;l bargaining power of suppliers;l threat of substitute products or services;l threat of new entrants; andl intensity of competition.

Bargaining power of buyersThe degree of buyer power generally depends on:

l customer concentration (the higher the concentration of customers, the greater theirnegotiating leverage);

l the propensity for customers to integrate back-ward (the higher the propensity for backwardintegration, the greater the bargaining leverage);

l costs of switching suppliers (the lower theswitching costs, the greater the buyer’s lever-age); and

l the number of alternative suppliers (the greaterthe number, the greater the customer’s leverage).

Bargaining power of suppliersJust as powerful buyers can squeeze profits byputting downward pressure on prices, supplierssqueeze profits by increasing input costs. Thesame factors that determine the power of buyersalso determine the power of suppliers. The bar-gaining power of suppliers and buyers relative tothe firm depends on the relationships betweentheir value chains. Bargaining power will be afunction of relative strengths, in particular, valueactivities that depend on one another.

Identifying the specific activities involved and thenature of their strengths and relationships cangive important insights into the power balancebetween buyer and seller, and how it may bealtered for the firm’s benefit.

Threat of substitute products or servicesThe potential for profit in an industry is deter-mined by the maximum price that customers are willing to pay. This depends primarily on theavailability of substitutes. When few substitutesexist for a product—e.g., gasoline—consumersare willing to pay a potentially high price. If closesubstitutes for a product exist, then there is alimit to what price customers are willing to pay.

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Any price increase will then cause some customersto switch to substitutes. A thorough understand-ing of the value chains of buyers as they relateto the firm’s product can help in assessing (andcombating) the threat of substitution.

Threat of new entrantsIf an industry is earning a return on invested capital above the cost of capital, that industrywill act as a magnet to firms outside the industry.Unless the entry of new firms is barred, the rateof profit must fall to the competitive level. Eventhe mere threat of entry may be sufficient toensure that established firms constrain theirprices to the competitive level.

Intensity of competitionMarkets experiencing rapid growth typically seeless intense competition. Rival companies can usu-ally satisfy profitability and growth without havingto take market shares from their competitors.

The variety and nature of the value chains ofcompetitors shape many of the characteristics of an industry. The relative importance ofeconomies of scale versus economies of scope,for example, depends on the kind(s) of technologyemployed in competitors’ value chains. The stability of the industry and of its competitive situation also relates to what happens to thevalue chains of firms in the industry. The effective-ness of low cost versus differentiation strategiesdepends on the nature of users’ value chains,and on how competitors’ value chains interactwith those of both sellers and users.

Since these five forces are ever-changing,Porter’s framework needs to be employed as a dynamic analytical tool. This is because competition is a dynamic process: equilibrium isnever reached and industry structures are constantly being reformed.

A major difficulty in industry structure analysislies in defining the specific industry. No industryhas clear boundaries either in terms of productsor geographical areas. For example, does oneanalyze the industry environment of Ford as the“transportation equipment” industry, the “motorvehicles and equipment” industry or the “automobile” industry?

To overcome the difficulty of defining an industry,the concept of substitutability can be applied toa firm’s supply and demand chains. On thedemand side, if buyers are willing to substituteone product for another—e.g., Toyotas for Fords—then the manufacturers belong in a single industry. However, this guideline does not alwayshold. For example, customers may be unwillingto substitute Apple Macintosh computers forCompaq computers, even though both manufac-turers belong to the same industry. On the supply side, if two manufacturers can make each other’s products, then they belong to a single industry.

Porter’s model sometimes draws criticism forneglecting the difficulty of obtaining and main-taining the information required to perform anindustry structure analysis. While such an exercise may be time-consuming, it is essentialto obtain a detailed database in order to fullyunderstand an organization’s competitive environment. Dismissing the task as too difficultis tempting, and may lead to inappropriate decision-making.

Core Competencies AnalysisIndustry structure analysis is well suited todescribing the what of competitiveness, i.e., whatmakes one firm or one industry more profitablethan another. But understanding the particularsof such advantages as low cost, quality, customerservice and time to market may still leave the

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question of why largely unanswered. For example,why do some companies seem able to continuallycreate new forms of competitive advantage whileothers seem able only to observe and follow?Why are some firms net advantage creators andothers net advantage imitators? For assessingcompetitive advantage it is necessary not only tokeep score of existing advantages—what theyare and who has them—but also to discoverwhat it is that drives the process of advantagecreation. Industry structure analysis is much bettersuited to the first task than to the second.

Thus, industry structure analysis must be supplemented by an equally explicit core compe-tence focus. Organizations need to be viewednot only as a portfolio of products or services,but also as a portfolio of core competencies.

Core competencies are created by superior integration of technological, physical and humanresources. They represent distinctive skills aswell as intangible, invisible, intellectual assetsand cultural capabilities. Cultural capabilitiesrefer to the ability to manage change, the abilityto learn and teamworking. Organizations shouldbe viewed as a bundle of a few core competen-cies, each supported by several individual skills.

Core competencies are the connective tissuethat holds together a portfolio of seeminglydiverse businesses. They are the lingua franca thatallows managers to translate insights and expe-rience from one business setting into another.Core competence-based diversification reducesrisk and investment and increases the opportu-nities for transferring learning and best practiceacross business units.

For instance, the New York Times stated thatMicrosoft’s only factory asset is the human imag-ination. This company has excelled in inventing

new ways of using information technology for a widevariety of end users. In contrast, using its core com-petence in information processing, Xerox devel-oped icons, pull-down menus and the computermouse, but failed to exploit the marketplace.

A core competence is identified by the followingtests:

l Can it be leveraged?—does it provide potentialaccess to a wide variety of markets?

l Does it enhance customer value?—does it makea significant contribution to the perceived customer benefits of the end product?

l Can it be imitated?—does it reduce the threatof imitation by competitors?

Applying the value chain approach to core com-petencies for competitive advantage includesthe following steps:

l validate core competencies in current businesses;

l export or leverage core competencies to thevalue chains of other existing businesses;

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

l use core competencies to create new value chains.

Validate core competencies in current businesses.Core competencies should tie together the portfolioof end products and help a firm excel in dominat-ing its industry. For example, Corning Glass’s corecompetence is its ability to melt specialty glass.Pyrex, television bulbs, headlamps and opticalwave guides are just a few of the products of thissuccessful producer. Procter & Gamble’s R&Dexpertise and marketing/distribution skills pro-vide a significant competitive advantage in a widerange of mass consumer products (e.g., Ivory,Tide, Folgers, Crisco, Pampers).

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Core competencies need to be continually validated. In the early 1970s, Timex held half of the global market for watches with its corecompetence in low-cost management of precisionmanufacturing. By the mid-1970s, the watchindustry moved to digital technology, makingTimex’s core competence irrelevant.

Export or leverage competencies to thevalue chains of other existing businesses.The same set of core competencies can beexploited in multiple businesses by exportingcore competencies to the value chains of otherexisting businesses.

For example, one of Honda’s core competenciesis designing and producing small engines. Byexporting this core competence to a wide varietyof business lines, the company seeks to have sixHondas in every garage: autos, motorcycles,snowmobiles, lawnmowers, snow blowers, chainsaws and power tools. Other Honda core compe-tencies are dealership management and shorterproduct development cycles.

Marriott Corp. has core competencies in foodservice and hospitality skills, standardized hoteloperating procedures, and a shared procurement

and distribution system. Besides employingthese core competencies in hotels, the companyuses them in its other businesses, includinginstitutional food service, consumer food andrestaurants, cruise ships and theme parks.

AT&T extended its core competence as an efficient processor of customer accounts by entering the credit card business. Kimberly Clark’sentry into disposable diapers extended its corecompetence in the design of paper products.

Use core competencies to reconfigure thevalue chains of existing businesses.While firms may manage their existing valuechains better than their competitors, sophisticatedfirms work harder on using their core competen-cies to reconfigure the value chain to improvepayoffs. Otherwise, competitors may exploitopportunities.

For example, Japanese watchmakers side-stepped traditional distribution channels in favorof mass merchandisers such as departmentstore chains. By efficiently consolidating freight,Emery Freight dominated the air freight industryand was consistently a leader in profitability inU.S. industry. Federal Express reconfigured the

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Make containeron site

Tetra-Pak specializedequipment

No refrigerated trucks

No wasted spacein filling & packing

Low store handling

No need torefrigerate & lessspace is required

Longer shelf life

No need torefrigerate & lessspace is required

Source:

EXHIBIT 8: HOW TETRA-PAK RECONFIGURED THE VALUE CHAIN

FILLING TRANSPORTRETAIL

DISPLAYCUSTOMERS

EXHIBIT 8. HOW TETRA-PAK RECONFIGURED THE VALUE CHAIN

air freight business by focusing on the overnightdelivery of small packages.

Tetra-Pak is an excellent example of a firm thatreconfigured the value chain in the packagingindustry for dairy products and orange juice.Tetra-Pak designed a filling machine for its aseptic packages and changed the packagingindustry. Exhibit 8 illustrates Tetra-Pak’s changesto the value chain.

Another example of a value chain reconfigurationis IKEA, which grew from a small, Swedish mail-order furniture operation to one of the world’slargest retailers of home furnishings (Normann &Ramirez, 1993). As illustrated in Exhibit 9, IKEAselected numerous factors to offer prices that are25-50 per cent lower than those of competitors.

Use core competencies to create newvalue chains.With strong core competencies in its existingbusinesses, an organization can seek new customers by developing new value chains.

For example, Federal Express (FedEx) transferredits expertise in the delivery of small packages tocontract new business with L.L. Bean forovernight distribution. Disney has exported itspeople-moving skills to urban mass transit forOakland, California.

The development of the corporate purchasingcard is exporting the expertise of credit cardcompanies, such as American Express and Visa,to process small purchase transactions for othercompanies.

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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.

EXHIBIT 9: HOW IKEA RECONFIGURED THE FURNITURE INDUSTRY

Value Chain Major Choice

EXHIBIT 9. HOW IKEA RECONFIGURED THE FURNITURE INDUSTRY

Source: Normann and Ramirez, 1993.

In a recent agreement, Roadway LogisticsSystems, a unit of Roadway Services Inc., willmanage and track all inbound and outboundshipments for Dell Computer Corp., includingoperations in Europe and Asia. The logisticscompany will also handle transportation for service and repair needs.

Segmentation AnalysisIndustries are sometimes collections of differentmarket segments. Vertically integrated industriesare good examples of a string of natural business-es from the source of raw material to the end useby the final consumer. Several firms in the paperand steel industries are vertically integrated. Not allfirms in an industry participate in all segments.

If the nature and intensity of Porter’s five forces or the core competencies vary for various segments of an industry, then the structural charac-teristics of different industry segments need to beexamined. This analysis will reveal the competitiveadvantages or disadvantages of different segments.A firm may use this information to decide to exit thesegment, to enter a segment, reconfigure one ormore segments, or embark on cost reduction/differentiation programs.

Differences in structure and competition amongsegments may also mean differences in key success factors among segments.

Using the value chain approach for segmentationanalysis, Grant (1991) recommends five steps:

l identify segmentation variables and categories;l construct a segmentation matrix;l analyze segment attractiveness;l identify key success factors for each segment;

andl analyze attractiveness of broad versus narrow

segment scope.

Identify segmentation variables and categories.There may be literally millions of ways to divide upthe market into segments. Typically, an analysisconsiders between 5 to 10 segmentation variables.These variables are evaluated on the basis of theirability to identify segments for which different com-petitive strategies are (or should be) pursued.

The selection of the most useful segment-definingvariables is rarely obvious. Industries may besubdivided by product lines, type of customer,channels of distribution and region/geography.The most common segmentation variables considered are type of customer and productrelated, as illustrated in Exhibit 10.

The first set of variables describes segments interms of general characteristics unrelated to theproduct involved. Thus, a bakery might be con-cerned with geographic segments, focusing onone or more regions or even neighborhoods. Itmight also divide its market into organizationaltypes such as at-home customers, restaurants,dining operations in schools, hospitals and soon. Demographics can define segments repre-senting strategic opportunities such as singleparents, professional women and elderly people.

The second category of segment variablesincludes those that are related to the product.One of the most frequently employed is usage. Abakery may employ a very different strategy inserving restaurants that are heavy users of bakery products than restaurants that use fewerbakery products. Zenith made a niche for itself in the very competitive personal computer industry by focusing on government, which is the largest computer user.

Segmenting by competitor is useful because itfrequently leads to a well-defined strategy and a

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strong positioning statement. Thus, a target customer group for the Toyota Cressida consistsof buyers of high-performance European carssuch as the BMW. The Cressida is positionedagainst the BMW as offering comparable perfor-mance for a substantially lower cost.

Construct a segmentation matrix.After customer- and product-related variableshave been selected for identifying different

segments, a segmentation matrix can be developed. Two or more dimensions may beused to partition an industry.

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

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Customer Characteristics

Geographic – Small communities as markets for discount storesType of organization – Computer needs of restaurants versus manufacturing firms versus banks versus retailersSize of firm – Large hospital versus medium versus smallLifestyle – Jaguar buyers tend to be more adventurous, less conservative than buyers of Mercedes-Benz and BMWSex – The Virginia Slims cigarettes for womenAge – Cereals for children versus adultsOccupation – The paper copier needs of lawyers versus bankers versus dentists

Product-related Approaches

User type – Appliance buyer - home builder, remodeler, homeownerUsage – The heavy potato user - the fast-food outletsBenefits sought – Dessert eaters - those who are calorie-conscious versus those who are more concerned with conveniencePrice sensitivity – Price-sensitive Honda Civic buyer versus the luxury Mercedes-Benz buyerCompetitor – Those computer users now committed to IBMApplication – Professional users of chain saws versus the homeownerBrand loyalty – Those committed to IBM versus others

Source:

EXHIBIT 10: APPROACHES TO DEFINING SEGMENTATION VARIABLES

EXHIBIT 10. APPROACHES TO DEFINING SEGMENTATION VARIABLES

A segmentation matrix for the British frozenfoods industry is presented in Exhibit 11. Fivetypes of product and five channels of distributionare used to construct the two-dimensional seg-mentation matrix consisting of 25 potential segments. However, not every cell in the matrixmay be relevant. Empty cells may representfuture opportunities for products or services.

Analyze segment attractiveness.Competitive assessments using industry structureanalysis or core competencies analysis can also

be used to evaluate the profitability of differentsegments. However, the competitive focus shiftsto an analysis of the different segments.

For example, in the frozen foods industry seg-mentation, independent grocers and caterersmay be willing to substitute fresh fruits and vegetables for frozen goods. Therefore, thethreat of substitutes within the segments andfrom outside sources must be carefully examined.

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Source: Monopolies and Mergers Commission, Frozen Foods (HMSO, London 1976); and P. Geroski and T. Vlassopoulos, “The rise and fall of a market leader; Frozen foods in the UK,”

London Business School, Case series 9, 1989.

Note: The above matrix identifies five categories of frozen food, and five distribution channels. While the basicdistinction of customers is between retail and catering, within retailing there are three distinct categories of outlet: supermarkets, independent grocery stores, and specialist retailers of frozen food (”home freezer centres”). Inaddition, different market conditions exist for processors supplying frozen foods for sale under their own brandnames as opposed to those supplying frozen foods for sale under the brand name of the retailer.

EXHIBIT 11: SEGMENTING THE BRITISH FROZEN FOOD INDUSTRY

DISTRIBUTION CHANNELS

PRODUCT

TYPES

Vegetables

Supermarkets

Producers’Brands

Retailers’Brands

Independent Grocery Retailers

SpecialistFreezer Stores Caterers

Fruits

MeatProducts

Desserts

ConvenienceReady Meals

EXHIBIT 11. SEGMENTING THE BRITISH FROZEN FOOD INDUSTRY

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

In addition, the interrelationship among segmentsmust be carefully considered. For example, caterersmay purchase frozen food items from supermar-kets at bargain prices. Segments may be naturalbuyers, sellers or substitutes for one another.

In the automobile industry, the luxury car andsports car segments were high-priced, high-marginproducts with less intense competition thanother automobile segments. The introduction ofhigh-quality, lower-priced Acura, Lexus and Infinitiautos changed the competitive structure ofthese high-priced segments.

Identify key success factors for each segment.Quality, delivery, customer satisfaction, marketshare, profitability and return on investment arecommon measures of corporate success. In thisregard, each segment must be assessed usingthe most appropriate key success factors. Costand differentiation advantages should be high-lighted by these measures.

Examination of differences among segments inbuyers’ purchase criteria can reveal clear differ-ences in key success factors.

Analyze attractiveness of broad versus narrow segment scope.A wide choice of segments for an industryrequires careful matching of a firm’s resourceswith the market. The competitive advantage ofeach segment may be identified in terms of lowcost and/or differentiation.

Sharing costs across different market segmentsmay provide a competitive advantage. For example,Gillette broadened its shaving systems toinclude electric shavers through its 1970 acqui-sition of Braun. Lipton recently entered the bottled iced-tea market.

On the other hand, when the Toro Companybroadened its distribution channels for its snowblowers and lawnmowers to include discountchains, it almost went bankrupt. Feelingbetrayed, a number of Toro’s dealers dropped its products.

Taking a narrow segment focus may leave a firmvulnerable to competitors. For instance, by relyingsolely on its lemon-lime soft drink, 7-Up left itselfat a competitive disadvantage to Coca-Cola andPepsi. Recently, Hallmark Cards Co. has begunto market its premium image greeting cardsthrough discounters. Hurt by discounters, someof Hallmark’s 9,000 independent specialtyshops have begun selling cards from Hallmark’scompetitors.

In many industries, aggressive firms are movingtoward multiple-segment strategies. CampbellSoup, for example, makes its nacho cheesesoup spicier for Texas and California customersand offers a Creole soup for Southern marketsand a red-bean soup for Hispanic areas. In NewYork, Campbell uses promotions linkingSwanson frozen dinners with the New YorkGiants football team; in the Sierra mountains,skiers are treated to hot soup samples.Developing multiple strategies is costly andoften must be justified by an enhanced aggregate impact.

Some firms decide to avoid or abandon segmentsbecause of limited resources or because of uncer-tain attractiveness. For example, in the 1960s,IBM decided not to enter the mini-computer segment. This allowed upstart Digital EquipmentCorp. to dominate this segment of the computerindustry. General Electric abandoned the computerindustry completely. Under CEO Jack Welch, GE’smajor segments must be first or second in marketshare, or risk being sold.

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A segment justifying a unique strategy must beof worthwhile size to support a business strategy.Furthermore, that business strategy needs to beeffective with respect to the target segment inorder to be cost effective. In general, it is costlyto develop a strategy for a segment. The questionusually is whether or not the effectiveness of thestrategy will compensate for this added cost.

V I I I . L IMITAT IONS OF VALUECHAIN ANALYSISValue chain analysis is neither an exact sciencenor is it easy. It is more art than preparing precise accounting reports. There are severallimitations to the implementation and interpreta-tion of value chain analysis. First, the internaldata on costs, revenues and assets used forvalue chain analysis are derived from one period’sfinancial information. For long-term strategicdecision-making, changes in cost structures,market prices and capital investments from oneperiod to the next may alter the implications ofvalue chain analysis. Organizations shouldensure that the value chain analysis is valid forfuture periods. Otherwise, the value chain analy-sis must be repeated under new conditions.

Identifying stages in an industry’s value chain islimited by the ability to locate at least one firmthat participates in a specific stage. Breaking avalue stage into two or more stages when an outside firm does not compete in these stagesis strictly judgmental.

As discussed previously, finding the costs,revenues and assets for each value chain activitysometimes presents serious difficulties. There ismuch experimentation underway that may providebetter approaches. Having at least one firm operatein each value chain activity helps identify externalprices for goods and services transferredbetween value chains. For intermediate products

or services with no external or competitive marketinformation, transfer prices must be estimatedon the basis of the best information available.

Isolating cost drivers for each value-creatingactivity, identifying value chain linkages acrossactivities, and computing supplier and customerprofit margins present serious challenges. Theuse of full cost assumes that the full capacity ofthe value chain activity’s facilities is used toderive the costs. Plant and manufacturing personnel and vendors of equipment are goodsources for capacity information. They can also behelpful in estimating the current or replacementcost of the assets. Independent companies,such as Valuation Research Corp. in Milwaukee,provide valuation services for assets.

Despite the calculational difficulties, experienceindicates that performing value chain analysiscan yield firms invaluable information on theircompetitive situation, cost structure, and link-ages with suppliers and customers.

IX . ORGANIZAT IONAL AND MANAGERIAL ACCOUNTINGCHALLENGESValue chain analysis offers an excellent opportunityto integrate strategic planning with managementaccounting to guide the firm to growth and survival.This change in focus for management accountingis necessary to maintain its critical role as theinformation profession.

The most significant challenge for senior man-agement and management accountants is to recognize that the traditional, functional, internallyoriented information system is inadequate forthe firm engaged in global competition.

Another challenge for management accountantsis to bring the importance of customer value to

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the forefront of managements’ strategic thinking.For many managers and firms, this requires agreat deal of education and awareness.Management accountants should take the initia-tive to bring the value chain message to majorplayers in the firm. Seminars, articles, valuechain examples and company-specific applica-tions are useful to illustrate the advantages ofvalue chain analysis.

Although value chain analysis requires expertisein internal operations and information, itdemands a great deal of external information.Management accountants must seek relevantfinancial and non-financial information fromsources outside the organization.

Management accountants must integrate data-bases and potential sources of timely informationon competitive forces confronting the business.This calls for innovation and creativity in gathering and analyzing information for manage-ment decisions.

Designing internal and external information sys-tems to assist managers in planning, monitoringand improving value-creating processes is anotherchallenge facing management accountants.

Information technology is improving daily butexisting information systems are slow to change.Management accountants should solicit supportfrom all senior managers for allocatingresources to develop and improve value chain-oriented information systems.

Value chain analysis requires the cooperation ofall managers involved in value chain processes,including engineers, designers, production managers, marketing managers and distributionmanagers. Leadership from the CEO is vital tosuccessful cooperation of managers. The

management accountant should ensure that theCEO is committed to value chain analysis andthe organizational changes necessary for its successful implementation.

For many service companies, Porter’s value chainmodel emphasizing manufacturing firms mayappear inappropriate. However, every organization(banks, hospitals, airlines, professional firms)has a variety of primary and support value-creatingactivities to which value chain analysis applies.For example, a publishing company might havethe following primary activities: informationacquisition, editorial, production, distribution,sales and service. Support activities include newproduct and business development, technologyassessment and development, human resourcemanagement and firm infrastructure. If strategyis seen as the pursuit of competitive advantage,the link between the formulation of service strategy and operational service delivery is vital.

X . CONCLUSIONAs a unifying theme, value chain analysis presentsorganizations with an overarching tool for improvingtheir strategic planning and resource allocation.The goal is to provide management with sufficientoptions to sustain its competitive advantage in anever-changing business environment.

Analyzing costs and differentiation through thevalue chain is an essential component in the searchfor competitive advantage. The data problemsare not insignificant and the answers will notalways be precise.

Nevertheless, there will be considerable benefitin the debate that results from the process andin the enhanced quantitative awareness of theexternal competitive arena and of the firm’s partin it. As so often in strategic planning, theprocess is often as valuable as the outcome.

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APPENDIX : VALUE CHAIN ANALYSIS VS. CONVENTIONALMANAGEMENT ACCOUNTINGInformation generated from the traditional man-agement accounting systems, including costaccounting, is generally unsuitable for valuechain analysis for a variety of reasons. Exhibit A-1provides a comparison of value chain analysisand traditional management accounting.

Generally, traditional management accountingfocuses on internal information. It often placesexcessive emphasis on manufacturing costs. Italso assumes that cost reduction must be foundin the “value-added” process, i.e., selling priceless the cost of raw material.

Using a value added approach can be misleading,since there are many other purchased inputssuch as engineering, maintenance, distributionand service. The value-added process starts toolate because it ignores linkages with suppliers,and stops too early because it ignores linkageswith customers.

The value chain approach encompasses externaland internal data, uses appropriate cost driversfor all major value-creating processes, exploitslinkages throughout the value chain, and provides continuous monitoring of a firm’s strategic competitive advantage.

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Traditional Management

Accounting

Value Chain Analysis

in the Strategic Framework

Focus Internal External

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

Cost Driver Single cost driver Multiple cost driversConcept (cost is a function of volume) – Structural drivers (e.g., scale, scope experience, technology and complexity) Application at the overall – Executional drivers (e.g., participative firm level (cost-volume- management, total quality management profit analysis) and plant layout) A set of unique cost drivers for each value activity

Cost “Across the board” cost View cost containment as a function ofContainment reductions the cost drivers regulating each valuePhilosophy activity Exploit linkages with suppliers Exploit linkages with customers Exploit process linkages within the firm “Spend to save”

Insights for Somewhat limited Identify cost drivers at the individualStrategic activity level, and develop cost/Decisions differentiation advantage either by controlling those drivers better than competitors or by reconfiguring the value chain (e.g., Federal Express in mail delivery, and MCI in long distance telephone) For each value activity, ask strategic questions pertaining to: – Make versus buy – Forward/backward integration Quantify and assess “supplier power” and “buyer power,” and exploit linkages with suppliers and buyers

Adapted from: Shank and Govindarajan, 1993.

EXHIBIT A-1: VALUE CHAIN VS. CONVENTIONAL MANAGEMENT ACCOUNTINGEXHIBIT A-1. VALUE CHAIN VS. CONVENTIONAL MANAGEMENT ACCOUNTING

Adapted from: Shank and Govindarajan, 1993.

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Value chain analysis

Business

harvard business review

managerial accounting challenges

greatest competitive advantage

validate core competencies

executional cost drivers

assessing competitive advantage

sustainable competitive advantage

london business school