Each of these two strategies requires a different management emphasis. For example, a low-price strategy would require an emphasis on maintaining a cost structure significantly lower than competitors. This might be accomplished by limiting product offerings, reducing the complexity of products, or limiting customer service. A differentiation strategy also requires on--going cost--control efforts, but the strategic management emphasis would be directed toward differentiating the product. This might be accomplished by offering increased product features, increased product lines, or expanded customer service. Whichever strategy is selected, however, value chain analysis can help the company focus on its chosen strategic plan and, thus, achieve a competitive advantage.

There are two components of value chain analysis: the industry value chain and the company's internal value chain. The industry value chain is composed of all the value-creating activities within the industry, beginning with the basic raw material and ending with delivery of the product to the final consumer. The company's internal value chain is composed of all the value-creating activities within that particular firm. Exhibit 1 depicts the value chain both for the axle manufacturing industry and for an individual firm within the industry.

1. Identify value chain activities;

2. Determine which of the value chain activities are strategic;

3. Trace costs to value chain activities; and

4. Use the activity--cost information to manage the strategic value chain activities better than other companies in the industry.

Identify Internal Value Chain Activities. To identify the company's internal value chain activities, the company should:

1. Look for discrete activities;

2. Identify structural, procedural, and operational activities; and then

3. Focus on structural and procedural activities.

First, the company should look for discrete activities that create value in fundamentally different ways. These activities will probably have different costs, different cost drivers, separable assets, and different personnel involved. For example, contrast product design activities with advertising activities: each has different costs, different cost drivers, separable assets, different employees, and each activity creates value in a fundamentally different way.

Second, when identifying value chain activities, the company should take a broad view of the company's activities. In so doing, the company should identify and separate out three types of value chain activities: structural, procedural, and operational. The accompanying sidebar at the end of this article provides some examples of these three types of activities, including possible cost drivers for each.

Structural activities, such as the number and location of production facilities, determine the underlying economic nature of the company. Procedural activities, such as total quality management, pervade all aspects of company operation and reflect the organization's ability to perform processes efficiently and effectively. Operating activities, such as product assembly, are the day-to-day activities of the company.

Third, the company should focus on structural and procedural activities. Most traditional cost management efforts concentrate on operational activities that have unit- or batch-driven costs. These traditional cost control efforts can be relatively easy to initiate, but may be too narrow in focus because they seek to control short-run operational costs. If competition is intense, then controlling short-run operational cost is necessary but may be insufficient. It is important to identify, and then focus management attention on, the organizational and procedural cost drivers because they often represent the long-run, strategic drivers of corporate costs. It is likely that such activities will be the source of a company's competitive advantage.

Determine Which Activities Are Strategic. To determine which of the value chain activities are strategic, begin by identifying the product characteristics that are valued by existing customers. Also, consider characteristics that the company can best exploit, and thereby create value for future customers. These characteristics may include quality, service, product features, or any number of tangible or intangible features of the product or the company.

After identifying the distinctive product characteristics, find out which specific activities in the company are responsible for creating those product characteristics. Those activities represent the most important value chain activities or, in other words, they represent the strategic value chain activities that provide a competitive advantage. For example, a department store might view price and selection as its competitive advantages. Therefore, management might identify procurement and inventory management as the company's strategic value chain activities.

After the company has identified the strategic value chain activities, the remaining nonstrategic activities must be identified. These remaining value chain activities are important, but they do not represent the sources of strategic advantage for the company. For example, consider a low-cost airline company such as Frontier Airlines. Frontier provides on-board service to customers. On-board service, however, is not a source of strategic advantage and therefore, it is a nonstrategic value chain activity. A comparison of strategic and nonstrategic value chain activities among companies in various industries is shown in Exhibit 2.[2]

Trace Costs to Activities. The accounting system should trace costs to separate value chain activities. For example, Super Valu, Inc. recognized that proper management of inventory activities could provide a competitive advantage in the grocery-wholesale industry. Thus, SuperValu created an activity-based accounting system that reports the costs associated with both inventory control and product handling activities. SuperValu also created financial and non financial performance measures that focused on these two activities. As a result, Super Valu was able to manage these activities better than its competitors, and the company now dominates the industry.

Tracing costs to structural and procedural activities will present a challenge. For example, managing product complexity is a procedural value chain activity that may cross over the functional boundaries of research and development, manufacturing, procurement, and marketing. Thus, management accountants must be creative in developing data collection and aggregation systems that track the linkages between functional areas.

Improve Management of Value Chain Activities. Companies achieve a competitive advantage by managing the value chain better than other companies in their industry. Managing the value chain implies reducing total company cost while enhancing the competitive advantage. However, this does not necessarily mean reducing the cost of all activities. Costs for an activity can be reduced only if it does not adversely affect the strategic advantage.

For example, an across-the-board spending cut may result in a short-run cost reduction, but it could be a disastrous long-run strategy. Reducing spending on product design could reduce product quality, increase overall production costs, and delay new product introductions. Thus, internal value chain analysis makes one thing crystal clear: value chain activities are interrelated, and no activity should be managed independently without considering the impact on all other activities. This point is demonstrated in the following case study.

A Case Study: the Internal Value Chain

Acme Axles, Inc. (a disquised name) makes custom--designed axles, wheels, and related parts for trailers, tractors, generators, welders, and other equipment requiring axle systems. Acme differentiates itself from competitors by providing fast, on-time delivery of high-quality, custom-designed axles.

The value chain outline for Acme and the Axle industry was introduced in Exhibit 1. Exhibit 3 extends the analysis by comparing Acme's internal value chain costs with the industry averages (both sets of figures have been disguised). Competitor's value chain data could also be used in place of industry averages and may be more appropriate in some cases. However, competitor's cost structure information is difficult to obtain, so industry averages are used here.

Ongoing Cost Control Versus Strategic Cost Management. Even though low cost is not Acme's competitive advantage, it must maintain a reasonable price. Therefore, the company must both control costs and maintain its product differentiation. Acme may use ongoing, overall cost reduction tools such as total quality management and activity-based management.

Value chain analysis, on the other hand, provides a framework for focusing cost control in order to take advantage of the company's strategic advantage. For example, across-the-board spending cuts may result in short-run cost reduction, but it could be a disastrous long-run strategy for Acme Axle. Across-the-board cuts ignore the complex linkages between axle design and manufacturing costs. Moreover, reduced spending on a strategic activity such as axle design could impair product quality and on-time delivery, which represent Acme's competitive advantages. Acme may instead want to increase spending in the product design process because design improvements could reduce production costs, reduce throughput time, and improve delivery performance.

Nonstrategic activities such as advertising and administrative functions are candidates for cost reduction or outsourcing. For example, Acme Axle, Inc. might consider a marketing partnership with noncompeting companies. The company might also consider outsourcing some of its administrative activities (e.g., payroll and accounts payable) to allow Acme's management to concentrate on its strategic activities (e.g., design, quality, and on-time delivery).

The cost results that Acme should be working toward are shown in Exhibit 3. Acme's design, material handling, and manufacturing costs are higher than industry averages, which is acceptable considering Acme's strategic position. Acme's advertising, sales and service, and administration costs are low, which is the result of cost reduction and outsourcing efforts in these nonstrategic activities.

The value chain report shown in Exhibit 3 has important behavioral benefits. When shared with line and staff managers, it gives a clear picture of the product's costs, including the portion of the cost that is traceable to individual managers. As shown in Exhibit 3, Acme Axle includes "name tags" for each segment of the chain. These "ownership tags" help visually highlight the portion of product costs controlled by each manager.

Exhibit 1 depicts the value chain for the axle manufacturing industry that produces axle systems used in equipment such as trailers and golf carts. Natural resource extracting (i.e., ore mining and rubber plantations), raw material fabricating (i.e., steel mill, steel foundries, and tire manufacturers), and industrial parts manufacturing are the upstream links in the value chain. Downstream links include military and nonmilitary ground equipment manufacturing. These downstream manufacturers use the axle systems as component parts of equipment such as welding trailers, airport baggage handling trailers, golf carts, and tractors.

Each link in the industry value chain represents an independent, economically viable segment of the industry. To determine what constitutes a separate link in the industry value chain, consider the following questions:

• Is there a market for the output of this link in the industry's value chain, or can a market price be determined objectively?

• Are there any companies that produce and sell only within this link of the chain?

If the answer to either question is "yes," then the segment of the industry under consideration may be a separate link in the industry value chain. For example, custom axle design is not a separate industry link because there are no companies that perform only the design function. However, design and manufacturing combined represents a separate link because many companies produce and sell within the design and manufacturing link of the industry value chain.

After the industry value chain is defined, the company should assess the relative strength of its position in the industry value chain (a process demonstrated in the following case study).

Case Study (cont.): the Industry Value Chain

Acme's first step in the industry value chain analysis would be to identify the individual links in the industry value chain (e.g., natural resource extractors, raw material fabricators). After the industry value chain is defined, the margins and return on assets for each segment should be estimated, as demonstrated in Exhibit 4.

These estimates are often difficult to obtain, but several possible sources exist. First, some companies undertake their own competitor analysis research. Second, industry experts can be hired. Finally, some industry trade associations conduct studies of industry cost structure (for example, description of the grocery industry cost study is included in the following section).

Industry margins and return on assets help the company assess the relative strength of each link in the industry value chain. Exhibit 4 shows that the axle system manufacturing segment is earning a significantly lower return than ground equipment manufacturers. Acme should investigate the underlying reason for these return differentials to make the appropriate strategic decisions.

For example, assume Acme discovers that the return differentials are the result of temporary excess capacity in the axle system manufacturing link. In this case, Acme may decide to "ride out" the temporary situation. On the other hand, assume Acme discovers that there is long-run excess capacity and that the ground equipment manufacturers are earning higher returns because they accept higher operating risk. In this case, Acme may make a strategic decision to reduce its axle manufacturing capacity and begin integration into the ground equipment manufacturing segment of the value chain.

Benchmarking. In addition to comparing margins and return on assets for each segment of the industry, it is also possible to benchmark other efficiency measures such as processing cost per purchase order. The grocery industry has taken a leadership role in providing such benchmark measures. The Food Marketing Institute's Efficient Consumer Response value chain report defines seventeen primary activities performed across the industry distribution system (see Exhibit 5).[3]

When the study is completed, industry members will be able to compare their performance with best practices in the industry. The grocery industry has recognized that it is critical for industry members to "maximize the effectiveness of the entire supply chain, especially at the point of linkages between trading partners."

Capital Budgeting. Consider another use of industry value chain analysis--capital budgeting. Assume that the production manager of Acme Axle has proposed an investment of $45,000 to improve the equipment used in the production of military axles. This expenditure would reduce labor and material costs by $9,200 per year for the next ten years, yielding an internal rate of return of 16 percent. Assume that this investment would double Acme's return on assets in the military product line from 4 percent to 8 percent. The internal rate of return and return on assets analysis might suggest that Acme should accept the project.

However, a value chain perspective of the entire .industry yields significantly different insights. Exhibit 4 shows us that only 3 percent of the entire value chain profits are earned by the manufacturer of military axle systems, and the return on assets for the nonmilitary axle product line is 13 percent, which is more than three times the return for the military product line. Because the military equipment product line is the weakest, several strategic alternatives should be considered:

• Vertically integrate into ground equipment manufacturing where margins are higher.

• Suspend further investments in military axle systems.

• Discontinue the military product line.

As part of an analysis of these alternatives, the company should determine the underlying reason for the weakness in the military segment of the value chain. Is the military segment of the industry in decline? Is the axle manufacturer's negotiating strength weak compared with its upstream and downstream partners? If so, why? Can the company partner with upstream or downstream segments to take advantage of these external linkages?

NEW INSIGHTS

With value chain analysis, the cost management efforts are focused on improving the strategic activities of the company, while streamlining, shrinking, or outsourcing all nonproprietary, nonstrategic activities. This approach differs from traditional cost analysis that relies on functional cost classifications such as marketing, research and development, manufacturing, and administration.

Value chain analysis also provides insights into complex internal and external linkages. For example, improving product design may lower production costs; treating suppliers as partners may reduce upstream costs or improve supply quality; and vertical integration may strengthen a company's strategic position in the industry.

CONCLUSION

There are several significant challenges in using value chain analysis. First, accounting systems are not designed for classifying costs by value activities. But as we have learned with the implementation of activity-based costing, this type of cost classification problem can be solved. Second, it may be difficult to obtain accurate return on sales and return on asset data to construct the industry value chain. However, important insights can be gleaned from rough estimates. Finally, some companies and some industries may have very complex value chains, which make the analysis difficult.

In spite of these challenges, value chain analysis is an important tool for strategic management, and when competition is intense, companies must manage activities and costs strategically or they will lose their competitive advantage.

Notes

1. The procedures described here are based, in part, on J. K. Shank and V. Govindarajan, Strategic Cost Management: The New Tool for Competitive Advantage (New York, NY: The Free Press, 1993) and M. Hergert and D. Morris, "Accounting Data for Value Chain Analysis," Strategic Management Journal (V. 10, 1989): 175-188.

2. For additional discussion of strategic cost drivers, see M. Partridge and L. Perren,"Cost Analysis of the Value Chain: Another Role for Strategic Management Accounting," Management Accounting (UK), (July/August 1994): 22-26, and R. Wilson,"Strategic Cost Analysis," Management Accounting (October 1990): 42-43.

3. R. Mathews, "A New Look at Efficient Consumer Response," Progressive Grocer (June 1994): 29-32.