What is the value chain concept?

Some influential business thinkers, most notably Michael Porter at Harvard Business School, have introduced the concepts of value chains that we discuss here.

When a company enters and competes in any industry it performs a number of discrete but interconnected value-creating activities. Examples are engineering and designing, producing and marketing, warehousing and shipping, and servicing and supporting.

These activities are connected with the activities of suppliers, internally with marketing channels, and ultimately to the end-users. Linked together, they must include a markup, which is also called a profit margin, over the cost of performing these value-creating activities.

The value chain is the sum of all these business activities—even if all the activities add up to producing just a pencil. For fun, we suggest that readers take a look at Milton Friedman’s thoughts on the “infinitesimal amount of services that each of the thousands contributed toward producing the pencil.”

Porter separated all these services into two groups of business activities: primary and support.

Primary Business Activities

Purchasing includes activities, costs, and assets related to buying the inputs and supplies, and inbound logistics like receiving, storing, and distributing.

Operations include activities, costs, and assets associated with converting inputs into final product form, such as production, assembly, packaging, equipment maintenance, and quality assurance.

Outbound logistics include activities, costs, and assets dealing with physically distributing the product to buyers like warehousing, order processing, order picking, packing, shipping, and delivery vehicle operations.

Marketing and sales are related to sales force efforts, advertising and promotion, market research and planning, and dealer/distributor support.

Service is associated with providing assistance to buyers, such as installation, spare parts delivery, maintenance and repair, technical assistance, buyer inquiries, and handling complaints.

Support Activities

Research, technology, and systems development includes all activities, costs, and assets related to product R&D, process R&D, equipment design, data-basing, and computerized support systems.

Human resource management includes all activities, costs, and assets associated with the recruitment, hiring, training, development, and compensation of all types of personnel and development of knowledge-based skills.

General administration relates to general management, accounting and finance, legal and regulatory affairs, safety and security, management information systems, and all other overhead functions.

Untangling the Value Web in Your Industry

For your start-up to survive, you must find a defensible market not dominated by any major players. In the years prior to and during the Perfect Storm, many entrepreneurs ignored Gause’s Principle of Competitive Exclusion, named after Professor G.F. Gause of Moscow University. Today known as the “father of mathematical biology,” Gause simply deduced in 1934, after observing protozoans fight it out in the same bottle, that “No two species can coexist that make their living the same way.”

This fact is clear: An entrepreneurial strategy aimed at exploiting an innovation must achieve leadership within a given environment. Otherwise, the venture will simply create an opportunity for the competition.

Business today is tremendously interwoven and complex. Understanding this complexity is the first major challenge for any entrepreneur. Like a taxonomist classifying organisms in an ordered system that indicates natural relationships in a biological ecosystem, an entrepreneur needs to have a deep understanding of the ecosystem and how the venture will survive in it.

The ecosystem refers to the large, loosely connected web of all stakeholders, including competitors, their partners, suppliers, customers, investors, and even regulators particular to each industry. Some ecosystems are hundreds of years old, have complicated cultures, regulations, and systems, and have hundreds of billions of dollars invested in them by some very large protozoans. How can anyone expect a small start-up to change the science of biology?

For example, business concepts not integrated into a value web are merely science projects that have little chance to survive in the open air. Sky Dayton is founder of Earthlink and a co-founder of eCompanies, an incubator that was based in Santa Monica, California. When eCompanies failed to launch any winners after some $20 million was thrown at a dozen “half-baked ideas,” Dayton noted that what he learned is that “just because you have a great idea, that doesn’t mean the world’s ready for it.”

As Ray Ozzie, founder of Groove Networks and creator of Lotus Notes, says, “There has to be an ecosystem. This is something I learned from the Notes experience—the value of this ecosystem.”

We now return back to Porter, who developed tools to help companies analyze their respective ecosystems, and to learn how to create more value. He created value chain analysis as a means to organize and understand the customer-value-creating activities and processes within a company. It is a tool that helps a company focus on and analyze its internal business activities that affect (1) a company’s costs, and (2) the activities that add value to the end-users through its end product or service.

To help you arrive at a sound diagnosis of your venture’s true competitive capabilities, we now turn to the task of “untangling the value web” in your space.

First, identify the leaders in the industry, or maybe the niches you want to enter, and collect as much information as you can on their business models and value chains.

Second, determine which activities in their value chains are exclusive to these businesses. For example, identify which are internal and core competencies, and which are outsourced or at least have the potential to be outsourced. Also identify as many stakeholders as possible, including the key customers, suppliers, competitors, strategic partners, and investors.

Third, disaggregate their value chains, activity by activity, into strategically relevant activities and business processes. Only then it is possible to better understand the cost structures, and to see where the major cost elements are, because each activity in the value chain incurs costs and ties up assets. Then look for problems where you can provide an immediate solution.

Look For Value Gaps

Only to those with skilled, keen eyes will these “value gaps” become apparent. These gaps are weakened links of ownership in an established value chain. For example, during periods of high growth, such gaps will be overlooked by the big players. And other macroenvironmental pressures can create value gaps. They include: keeping up with information and communication technologies, increasing dependence on strategic partnering and outsourcing, race for global expansion, and the increasing pace of introducing new business concepts, products, and services.

Following any one of these disruptions comes a new set of wants and opportunities:

  • The end customers want instant fulfillment, more perfect information, and increasing choices of new and improved products.
  • Competitors fighting for survival want better integration of customer fulfillment, information integration, and facilitation of globalization.
  • Suppliers want consolidation, improved information visibility, and management of strategic alliances.
  • Marketing channels want more perfect information, lower prices, and personal service.
  • Even the government has wants, including enforcement of anti-trust laws, rulings on digital rights, and information usages.

Clayton Christensen says that new business organisms have the best chance for survival when “minimizing the need for customers to reorder their lives.” He also states that “if an innovation helps customers do things they are already trying to do more simply and conveniently, it has a probability of success.”

But as a rule, entrepreneurs who exploit competitor weaknesses stand a better chance of succeeding than those who challenge competitor strengths head-on, especially if the weaknesses represent important vulnerabilities and the rivals are caught by surprise with no ready defense.

Finally, whatever disruptions lie ahead, one thing remains certain: Companies are pushing information up the value chain, and out to the edges. According to one group of consultants, “The business world is hurtling toward the day when customer purchases at the end of the value chain will be acknowledged at the start of the chain within hours or minutes. The purchase of an espresso by a tourist in Italy, for example, will trigger a sequence of signals that will ultimately be seen on the PC of a coffee farmer in Colombia.”