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Donelan, J. G. and E. A. Kaplan. 1998. Value Chain Analysis: A Strategic Approach To Cost Management. Journal of Cost Management (March/April): 7-15.

Summary by David Alvarez
Master of Accountancy Program
University of South Florida, Fall 2001

Cost Management Main Page | Strategy Related Main Page | Value Chain Main Page


Introduction

For a company to survive in today’s highly flooded markets a company must, at least temporarily, achieve a competitive advantage. There are many ways for a firm to achieve this advantage and two generic ones are: price leadership and differentiation. Price leadership is simply when a company keeps prices below those of his competitors. Differentiation occurs when a company creates a distinctive position in the market through product functionality, service, or quality.

If either of these two management strategies are chosen to be implemented by a company, value chain analysis can help the firm focus its 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 includes all of the value-creating activities within the whole industry, beginning with the basic raw material and finishing with the delivery of the product. The internal value chain of a company includes all the value creating activities within that specific firm.

The Company’s Internal Value Chain

A firm’s internal value chain includes all the physical and technological activities within the company that add value to the product. The key to evaluating a company’s internal value chain is to understand the activities that give that company a competitive advantage, and then pin point and exploit those advantages better than other companies in the industry. This evaluation is done in four steps:

Identify value chain analysis

Look for discrete activities. These create value in different ways. They will include different costs, different cost drivers, separable assets, and different personnel involved. For example, contrast product design activities with advertising activities.

Identify structural, procedural, and operational activities. Structural activities determine the basic economic nature of the company. Procedural activities include all aspects of the firm's operations and reflect the company's ability to carryout the processes efficiently and effectively.

Focus on structural and procedural activities. Most companies emphasize operational activities, but proponents of value chain analysis say that focus is too narrow and only deals with the short run and will not be able to give the company an overall competitive advantage.

Determine which activities are strategic

To determine which activities are strategic a company must identify which product characteristics are valued by existing customers.

A company should then find characteristics that it can exploit, and thereby create value for future customers. Examples of these characteristics are quality, service, or any tangible or intangible product features.

Trace costs to activities

The company needs an accounting technique that traces costs to different value chain activities. This is important for a company to focus on these value-added processes, so they will be able to manage them more efficiently.

Improve management of value chain activities

To achieve a competitive advantage a company must manage their value chain better than their competitors. This means reducing a company's total cost while enlarging the competitive advantage. This does not however mean that all costs have to be reduced, it means that all costs that do not adversely affect the competitive advantage can and should be reduced.

The Industry Value Chain

The value chain of an industry starts with the raw material manufacturer and finishes with the delivery of the final product to the customer. The key to analyzing the industry value chain is to comprehend and use the advantage of a company’s comparative strength within the industry.

All industries begin with a raw material and end with a sale to a customer. There are many links within this process. There are upstream links and downstream links. Each separate link stands for an independent, economically viable segment of the industry. To establish which links in the industry value chain are separate, assess these two questions:

1. Is there a market for the output of this link in the industry value chain, or can a market price be determined objectively?
2. Are there any companies that produce and sell only within this link of the chain?

If the answer is “yes” to either of these questions, then the industry under consideration may be a separate link in the industry value chain. Then, after the industry value chain is determined, a company should examine the relative strength of its position, in any separate link, in the industry value chain. A company’s position within the industry link can be found by using a myriad of measurements, including industry margins, return on assets, benchmarking, and capital budgeting. When a company then finds where it has deficiencies in relative industry strength, it can go back to the internal value chain activities to improve its standing with its competitors and then gain a competitive advantage.

Conclusion

Value chain analysis comes with a few challenges. First, accounting systems are not designed to assign costs to value-added activities, but when ABC is implemented that problem can be solved. Second, it can be difficult to find accurate return on sales and return on asset data to determine the value chain. But, rough estimates still can be used to give some insight into the value chain. Lastly, not only do estimates make the value chain difficult to determine, but many industries have very complex value chains. Even though there are some challenges to a value chain approach it can be a very effective strategic management tool. When competition is fierce, firms must very precisely manage their activities and costs to continue their competitive advantage.

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Related summaries:

Baggaley, B. and B. Maskell. 2003. Value stream management for lean companies, Part I. Journal of Cost Management (March/April): 23-27. (Summary).

Baggaley, B. and B. Maskell. 2003. Value stream management for lean companies, Part II. Journal of Cost Management (May/June): 24-30. (Summary).

Borthick, A. F., P. L. Bowen, and M. C. Sullivan. 1998. Controlling JIT II: Making the system monitor itself. Journal of Cost Management (July/August): 33-41. (Summary).

Carr, L. P., W. C. Lawler and J. K. Shank. 2002. Reconfiguring the value chain: Levi's personal pair. Journal of Cost Management (November/December): 9-17. (Summary).