REFERENCE: Porter, M. E. "Competitive Advantage: Creating and Sustaining Superior Performance", The Free Press, 1985. [INTERNET: http://www.theantidote.co.uk/read/articles/wd8103.html]
In 1985, Professor Michael Porter of Harvard Business School introduced the concept of the 'value chain' in his seminal book Competitive Advantage: Creating and Sustaining Superior Performance. Since then, this original thinking has prompted or underpinned a wide variety of management tools and techniques that have become familiar to managers around the world. Here we go back to the original thinking.
By 1985, Michael Porter had established himself as one of the foremost thinkers on strategy with his first book, Competitive Strategy, published in 1980. Indeed, Porter's work dominated the strategy debate throughout much of the 1980s.
When it was introduced, the concept of the value chain was seen as a powerful tool that would enable strategists to diagnose and enhance competitive advantage. As such, it was intended as a means to take the concepts of competitive strategy put forward in Porter's first book a stage further. Analysis of the value chain allowed the separation of the particular underlying activities that firms employ to design, produce, market and distribute their products or services. Porter contended that it was these underlying activities that contained the seeds of competitive advantage. By examining them in an integrated way, new but practical perspectives on competitive strategy would be found.
In presenting his ideas, Porter gave credit to work that McKinsey had already been doing in the early 1980s on the 'business system concept'. This used the idea that a firm is a series of functions (eg R&D, manufacturing, marketing, etc) and that insights could be gained by analysing how each was performed relative to competitors. However, this earlier work, Porter suggested, had remained at the broad functional level. It did not break down each function into its individual constituent activities - the key step in distinguishing between types of activity and their interrelationships.
THE STARTING POINT
To appreciate the significance that Porter attached to the value chain, it is important to recognise that in his first book he had identified two separate and fundamental sources of competitive advantage: a lower relative cost advantage or some form of differentiation. Although, subsequently, others have argued that many companies, especially Japanese ones, have been able to combine these two supposedly separate sources into one, Porter was looking for ways of pinpointing how either source could be developed.
THE BASIC CONCEPT
The focus of Porter's argument is that the achievement of either lower cost or differentiation will depend on all the discrete activities that a company undertakes. By "disaggregating" these into "strategically relevant" groups, managers should be able to understand the behaviour of costs as well as identify existing or potential sources of differentiation.
WHAT IS A VALUE CHAIN?
Porter defines 'value' as "the amount buyers are willing to pay for what a firm provides". The value chain was therefore designed to display total value and consisted of the firm's value activities (defined below) and its margin ("the difference between total value and the collective costs of performing the value activities"). Thus, the generic value chain for a single firm comprises three main elements: its primary activities, its support activities and the margin. Primary activities are those involved in the creation of the product, its sale and transfer to the buyer as well as after-sales service. Support activities are those which support primary activities and each other. Three of these - procurement, technology development and human resource management - can be associated with specific primary activities while the fourth, firm infrastructure, supports the entire chain.
In describing how to identify value activities, Porter points out that they must be "technologically and strategically distinct" and that accounting classifications (such as overhead or direct labour) are not the same.
- Inbound Logistics includes warehousing, materials handling, inventory control, etc.
- Operations are the activities that transform inputs into finished products (eg machining, testing, packaging, equipment maintenance, etc).
- Outbound Logistics includes the activities that store and distribute products to buyers (eg warehousing, delivery vehicle operations, order processing, etc).
- Marketing and Sales are the activities that provide the means for the buyer to purchase (eg advertising, sales force operations, selection and management of distribution channels, etc).
- Service includes activities which enhance or maintain the value such as installation, repair, parts supply, etc).
- Procurement specifically refers to the function of purchasing not to the purchased inputs themselves. While raw materials procurement is usually concentrated in a purchasing department, other purchasing is often dispersed throughout a firm (temporary office staff, hotel and travel expenses, office equipment and even strategic consulting).
- Technology Development as Porter defines it is wider than R&D. It includes engineering and process development and, while usually associated with an engineering or development function, is also dispersed (office automation, telecommunications, etc).
- Human Resource Management includes the recruitment, hiring, training, development and compensation of all personnel. Partly centralised but increasingly dispersed, Porter points out that the skills and motivation of employees and the costs involved may be critical to competitive advantage.
- Firm Infrastructure broadly encompasses general management activities, as well as finance, accounting, legal, corporate affairs and quality management. Often viewed as an overhead, these can be a considerable source of advantage (eg skilful negotiations with regulatory bodies).
Since the purpose of analysing the value chain is to identify areas that might provide competitive advantage, Porter highlights three different types of activity:
1. Direct activities - those which directly involve the creation of value for the buyer. They vary widely and, depending on the firm, may include, for example, parts assembly, sales force operations, product design, advertising and recruitment.
2. Indirect activities - those which enable direct activities to be performed on a continuing basis, such as maintenance, scheduling, sales force administration, record keeping, etc. Not generally well understood, these may play a significant part in either cost or differentiation. Accounting and other practices tend to "lump" indirect and direct activities together although "the two often have very different economics". Porter points out that there are often trade-offs - more spending on maintenance reduces machine costs, for example - and warns that another practice, that of grouping indirect activities into overheads, obscures their cost implications and/or contribution to differentiation.
3. Quality Assurance - those activities which ensure quality within other activities, eg monitoring, inspection, checking. This definition, Porter pointed out in 1985, was not the same as 'quality management' as it was then perceived. This was because 'quality' is the result of many activities.
DEFINING A VALUE CHAIN
Diagnosis starts with definition. Starting with the generic value chain, individual value activities must be identified for the particular firm within its particular industry. Each of the main categories in the generic model can be subdivided into discrete activities. For instance, Sales and Marketing might be subdivided into marketing management, advertising, sales force administration, sales force operations, technical literature, promotion, etc. This process of subdivision can continue down to increasingly narrow activities provided that they are discrete. This disaggregation can be guided by three considerations. Activities should be isolated if they have different economics, have a significant impact on differentiation, or represent a significant proportion of cost.
Determining which activity lies within which category requires judgement. In particular it will depend on the nature of the firm, its industry and its source(s) of competitive advantage. Thus, order processing could be part of outbound logistics or, if it is an important element of the way a firm interacts with its buyers, it could be defined as marketing. One way or another, however, everything a firm does should be captured and identified. The specific value activity labels "are arbitrary and should be chosen to provide the best insight into the business".
LINKAGES WITHIN THE CHAIN
Although definition requires this process of disaggregation, the value chain is not a series of independent activities - it is a system of interdependent ones. Linkages exist because of the relationship between how one activity is performed and its impact on the cost or performance of another. Porter argues that competitive advantage frequently emerges from such linkages - for instance, how buying high quality, well-prepared raw material can simplify manufacturing and reduce scrap, or how the timing of promotional campaigns can help capacity utilisation in a fast food chain.
Linkages are subtle and need to be understood. Porter points out that "the same function can be performed in different ways". Thus, conformance to specification can be achieved by buying in high quality parts, by specifying tight manufacturing tolerances or by imposing 100% inspection of finished goods - different firms will choose different routes and achieve different potential advantages. Another under-recognised factor is that "the cost or performance of direct activities is improved by greater efforts in indirect activities." Here, better scheduling (indirect) can reduce time spent by either the sales force (customer complaints) or delivery vehicles (repeated runs). It is this process of recognising linkages and then building information about them which prompts Porter to believe that "managing linkages is thus a more complex organizational task than managing value activities themselves." This also leads him to suggest that the ability to recognise and then manage linkages "often yields a sustainable source of competitive advantage".
THE VALUE SYSTEM
Porter extends the value chain concept to what he defines as a "Value System". This takes account of the fact that an individual firm's value chain is inevitably "embedded" in a larger stream of activities. This suggests that there are at least three additional value chains of which account must be taken:
- Supplier Value Chains which create and deliver the essential inputs to the firm's own chain
- Channel Value Chains which are the delivery mechanism(s) for the firm's products on their way to the end buyer, customer or consumer
- Buyer's Value Chains which are the ultimate source of differentiation because it is the product's role in this chain that determines buyer needs
It is therefore imperative, Porter argues, that managers understand not only their own firm's value chain, but also how it fits into the industry's overall value system. The underlying point being that the value chains of separate firms in an industry will differ according to each organisation's history, its strategies and its skills at implementation. For instance, one or more firms may have restricted their "competitive scope". This decision to serve a focused industry segment may enable a firm to tailor its particular value chain to that segment and thus gain advantage either through lower costs or greater differentiation (see Porter's concerns about the push for growth, The Antidote, Issue 4, pages 20-23).
But not only is each firm's value chain likely to be different, its ability to understand how this best fits the whole value system is critical. Competitive advantage does not just arise within the firm. It can be developed by looking at the entire system and recognising that different firms can adjust and improve their own value system. For instance, Porter argues that "supplier linkages mean that the relationship with suppliers is not a zero sum game in which one gains only at the expense of the other, but a relationship in which both can gain." Similarly, co-ordination and joint optimisation with different distribution channels can be important - especially in those industries where the channel may represent as much as 50% of the ultimate selling price to customers (eg consumer goods, wine, etc).
THE VALUE CHAIN AND ORGANISATIONAL STRUCTURE
Although he did not develop the idea at the time, Porter also saw the concept of a value chain as important in terms of how organisations are structured. Pointing out that structures are formed around the grouping of certain activities (such as marketing or production) and that the resultant departments then need co-ordination, Porter contends that in many instances such structures fail to optimise the linkages between activities or collect the necessary information that would enable them to do so. He suggests, therefore, that a firm's co-ordination might be improved "by relating its organizational structure to the value chain, and the linkages within it and with suppliers or channels."
USE OF THE VALUE CHAIN
Competitive Advantage runs to over 500 pages. It describes in detail how the value chain can be used to identify opportunities for cost advantage and differentiation, how to apply technology within the value chain to gain advantage, where it can help to select and deliver appropriate products to different segments and even highlight better interrelationships between business units. While there is not space here to do justice to this detail, the following summarises the steps Porter suggests for achieving competitive advantage through either lower costs or differentiation.
Six steps in strategic cost analysis
1. Identify the individual firm's value chain and then assign costs and assets to it
2. Diagnose the key elements that drive the costs of each value activity (cost drivers)
3. Identify competitors' value chains and determine both their relative costs and the sources of differences in cost
4. Develop a strategy to lower relative costs by controlling cost drivers or by reconfiguring the value chain itself
5. Ensure that any cost reduction does not erode differentiation or, if it does, make sure that this is a conscious choice
6. Test the cost reductions to ensure that they are sustainable
Eight steps for determining the basis for differentiation
1. Determine who the real buyer is - the one or more specific individuals, within the buying entity, who set the purchase criteria (the buying entity may be a firm, an institution or a household)
2. Identify the buyer's value chain - the value the firm provides to the buyer is determined by the way, directly or indirectly, it impacts upon the buyer's value chain, either by lowering costs or improving performance
3. Determine and rank buyer purchase criteria - analysis of the buyer's value chain provides the foundation for identifying such criteria which should then be ranked according to the value the buyer attaches to each
4. Assess the existing and potential sources of differentiation - by determining which of its value activities impact each of the purchase criteria, a firm can identify its current or potential sources of uniqueness
5. Identify the cost of these sources of differentiation - the cost of differentiation is a function of the cost drivers for those activities that provide the firm's sources of uniqueness
6. Configure the value chain to create the greatest value relative to cost - the intention is to create the widest gap between buyer value and the cost of differentiation
7. Test for sustainability - this requires identifying both stable sources of buyer value and erecting barriers to imitation
8. Reduce costs in activities that do not affect the chosen forms of differentiation
Michael Porter's approach in the late 1970s was prescient. He foresaw the globalisation of businesses and industries and with it a shift from straightforward growth as the main corporate objective to an era when companies would need to identify and strengthen their competitive position if they were to survive. His first book, Competitive Strategy, bridged the gap between micro-economics and business strategy in such a way that practising managers and business schools alike fastened on it as a means to explain and understand why competition, in all its forms, works continuously to erode profits. Porter's identification of five competitive forces (see Issue 8, page 27) and his arguments for positioning companies so as to reduce their impact has become known as the "strategy as position" school of thought.
However, once competition became the central focus, finding competitive advantage and, best of all, sustainable competitive advantage became the next critical step. The search for sources of cost and/or differentiation advantage meant that what companies actually did needed to be looked at in close detail. Previous work had looked at functions and departments, but this level of approach was too broad a brush to isolate the nuances that can be so important in deriving competitive advantage. Hence the drive down to discrete activities, the recognition of linkages and how they work in combination and the subsequent significance attached to their interrelatedness. The fact that these activities are all submerged within the overall organisation and that managers have choices about how they undertake and combine them remains a serious barrier to recreating a competitor's advantage.
Given the many subsequent management tools and techniques that have evolved from Porter's original concept (referred to in Issue 8, pages 3-4), it is instructive to go back to the roots of his thinking. His recently expressed concern that "bit by bit, almost imperceptibly, management tools have taken the place of strategy" is no doubt a reflection of the fact that in some instances the tools do appear to have become ends in themselves rather than the means to achieve sustainable competitive advantage and hence a successful strategy.
Having said all that, it is worth mentioning that a point of criticism has been that Porter's value chain model was codified in a way that made it more suited to manufacturing than service industries. More recently, it has been criticised for being modelled too closely on the assembly line analogy - being too linear, too unidirectional and too sequential.