Strategic Cost Accounting

M. Com (Semester IV)

Topic- Value Chain Analysis
Rajani Gupta
(Senior Research Fellow)
Department of Commerce
University of Lucknow

What is Value Chain Analysis?

Value chain analysis (VCA) is a process where a firm identifies its primary and support
activities that add value to its final product and then analyse these activities to reduce costs or
increase differentiation. Value chain represents the internal activities a firm engages in when
transforming inputs into outputs.
Value chain analysis is a strategy tool used to analyse internal firm activities. Its goal is to
recognize, which activities are the most valuable (i.e. are the source of cost or differentiation
advantage) to the firm and which ones could be improved to provide competitive advantage.
In other words, by looking into internal activities, the analysis reveals where a firm’s
competitive advantages or disadvantages are.
Value Chain Analysis is a useful way of thinking through the ways in which you deliver value
to your customers, and reviewing all of the things you can do to maximize that value. It takes
place as a three-stage process:
1. Activity Analysis, where you identify the activities that contribute to the delivery of
your product or service.
2. Value Analysis, where you identify the things that your customers value in the way
you conduct each activity, and then work out the changes that are needed.
3. Evaluation and Planning, where you decide what changes to make and plan how you
will make them.
By using Value Chain Analysis and by following it through to action, you can achieve
excellence in the things that really matter to your customers.
Advantages of Value Chain Analysis
 Improves quality by providing better understanding of customer requirements when
products are assembled from multiple input sources (e.g. cars, computers...).
 Provides a way to evaluate competitive cost position and thereby improving strategic
positioning.
 Reduces time when there is a great deal of interdependency between the participants in
a value chain.
 Reduce cost by focusing attention on areas needing cost reduction and by reconfiguring
the value chain.
How to Improve the Value Chain?

When a firm takes into account its value chain, it needs to consider its value proposition, or
what sets it apart from its competitors. Value chain analysis is designed to improve profits by
creating a product or service that is so superior that customers are willing to pay more than the
cost to develop it.

But improving a value chain for the sake of improvement should not be the end goal. Instead,
a company should decide why it wants to improve its value chain in the context of its
competitive advantage to differentiate itself among its peers.

Two common competitive advantage strategies include low cost provider or

specialization/differentiation of product or service.

 Low-cost provider – value chain analysis focuses on costs and how a company can
reduce those costs.
 Specialization – value chain analysis focuses on the activities that create a unique
product or differentiation in service.

Thus, there are two different approaches on how to perform the analysis, which depend on what
type of competitive advantage a company wants to create (cost or differentiation advantage).
The table below lists all the steps needed to achieve cost or differentiation advantage using
VCA.

Types of Competitive Advantages

Cost advantage Differentiation advantage

This approach is used when organizations try The firms that strive to create superior
to compete on costs and want to understand products or services use differentiation
the sources of their cost advantage or advantage approach.
disadvantage and what factors drive those
costs.

Step 1. Identify the firm’s primary and Step 1. Identify the customers’ value-
support activities. creating activities.
Step 2. Establish the relative importance of Step 2. Evaluate the differentiation strategies
each activity in the total cost of the product. for improving customer value.
Step 3. Identify cost drivers for each activity. Step 3. Identify the best sustainable
Step 4. Identify links between activities. differentiation.
Step 5. Identify opportunities for reducing
costs.
Steps of Cost Advantage

To gain cost advantage a firm has to go through 5 analysis steps:

1. Step 1. Identify the firm’s primary and support activities. All the activities (from
receiving and storing materials to marketing, selling and after sales support) that are
undertaken to produce goods or services have to be clearly identified and separated
from each other. This requires an adequate knowledge of company’s operations because
value chain activities are not organized in the same way as the company itself. The
managers who identify value chain activities have to look into how work is done to
deliver customer value.
2. Step 2. Establish the relative importance of each activity in the total cost of the
product. The total costs of producing a product or service must be broken down and
assigned to each activity. Activity based costing is used to calculate costs for each
process. Activities that are the major sources of cost or done inefficiently (when
benchmarked against competitors) must be addressed first.
3. Step 3. Identify cost drivers for each activity. Only by understanding what factors
drive the costs, managers can focus on improving them. Costs for labour-intensive
activities will be driven by work hours, work speed, wage rate, etc. Different activities
will have different cost drivers.
4. Step 4. Identify links between activities. Reduction of costs in one activity may lead
to further cost reductions in subsequent activities. For example, fewer components in
the product design may lead to less faulty parts and lower service costs. Therefore,
identifying the links between activities will lead to better understanding how cost
improvements would affect the whole value chain. Sometimes, cost reductions in one
activity lead to higher costs for other activities.
5. Step 5. Identify opportunities for reducing costs. When the company knows its
inefficient activities and cost drivers, it can plan on how to improve them. Too high
wage rates can be dealt with by increasing production speed, outsourcing jobs to low
wage countries or installing more automated processes.

Steps of Differentiation Advantages

VCA is done differently when a firm competes on differentiation rather than costs. This is
because the source of differentiation advantage comes from creating superior products, adding
more features and satisfying varying customer needs, which results in higher cost structure.

1. Step 1. Identify the customers’ value-creating activities. After identifying all value
chain activities, managers have to focus on those activities that contribute the most to
creating customer value. For example, Apple products’ success mainly comes not from
great product features (other companies have high-quality offerings too) but from
successful marketing activities.
2. Step 2. Evaluate the differentiation strategies for improving customer
value. Managers can use the following strategies to increase product differentiation and
customer value:

 Add more product features;

 Focus on customer service and responsiveness;
 Increase customization;
 Offer complementary products.
 3. Step 3. Identify the best sustainable differentiation. Usually, superior differentiation
and customer value will be the result of many interrelated activities and strategies used.
The best combination of them should be used to pursue sustainable differentiation
advantage.

Porter’s Value Chain Model

M. Porter introduced the generic value chain model in 1985. He identified several key steps
common among all value chain analyses and determined that there are primary and supporting
activities that when performed at the most optimal levels will create value for their
customers, such that the value offered to the customer exceeds the cost of creating that value,
resulting in higher profit. Porter’s framework groups activities into primary and support
categories Value chain represents all the internal activities a firm engages in to produce goods
and services. The primary activities focus on taking the inputs, converting them into outputs,
and delivering the output to the customer. The support activities play an auxiliary role in
primary activities. Thus, VC is formed of primary activities that add value to the final product
directly and support activities that add value indirectly. When a company is efficient in
combining these activities to provide a superior product or service, then the customer is willing
to pay more for the product than the cost to make and deliver the product which results in a
higher profit margin.

Although, primary activities add value directly to the production process, they are not
necessarily more important than support activities. Nowadays, competitive advantage mainly
derives from technological improvements or innovations in business models or processes.
Therefore, such support activities as ‘information systems’, ‘R&D’ or ‘general management’
are usually the most important source of differentiation advantage. On the other hand, primary
activities are usually the source of cost advantage, where costs can be easily identified for each
activity and properly managed.

Elements in Porter's Value Chain

Rather than looking at departments or accounting cost types, Porter's Value Chain focuses on
systems, and how inputs are changed into the outputs purchased by consumers. Using this
viewpoint, Porter described a chain of activities common to all businesses, and he divided them
into primary and support activities, as shown below.
Primary Activities
Primary activities relate directly to the physical creation, sale, maintenance and support of a
product or service. They consist of the following:
1. Inbound logistics – These are all the processes related to receiving, storing, and
distributing inputs internally. Your supplier relationships are a key factor in creating
value here.
2. Operations – These are the transformation activities that change inputs into outputs that
are sold to customers. Here, your operational systems create value.
3. Outbound logistics – These activities deliver your product or service to your customer.
These are things like collection, storage, and distribution systems, and they may be
internal or external to your organization.
4. Marketing and sales – These are the processes you use to persuade clients to purchase
from you instead of your competitors. The benefits you offer, and how well you
communicate them, are sources of value here.
5. Service – These are the activities related to maintaining the value of your product or
service to your customers, once it's been purchased.
Support Activities
These activities support the primary functions above. In our diagram, the dotted lines show that
each support, or secondary, activity can play a role in each primary activity. For example,
procurement supports operations with certain activities, but it also supports marketing and sales
with other activities.
1. Procurement (purchasing) – This is what the organization does to get the resources it
needs to operate. This includes finding vendors and negotiating best prices.
2. Human resource management – This is how well a company recruits, hires, trains,
motivates, rewards, and retains its workers. People are a significant source of value, so
businesses can create a clear advantage with good HR practices.
3. Technological development – These activities relate to managing and processing
information, as well as protecting a company's knowledge base. Minimizing
information technology costs, staying current with technological advances, and
maintaining technical excellence are sources of value creation.
4. Infrastructure – These are a company's support systems, and the functions that allow
it to maintain daily operations. Accounting, legal, administrative, and general
management are examples of necessary infrastructure that businesses can use to their
advantage.
Companies use these primary and support activities as "building blocks" to create a valuable
product or service.

Process of Porter's Value Chain

To identify and understand your company's value chain, follow these steps.
Step 1 – Identify sub activities for each primary activity
For each primary activity, determine which specific sub activities create value. There are three
different types of sub activities:
Direct activities create value by themselves. For example, in a book publisher's marketing and
sales activity, direct sub activities include making sales calls to bookstores, advertising, and
selling online.
Indirect activities allow direct activities to run smoothly. For the book publisher's sales and
marketing activity, indirect sub activities include managing the sales force and keeping
customer records.
Quality assurance activities ensure that direct and indirect activities meet the necessary
standards. For the book publisher's sales and marketing activity, this might include
proofreading and editing advertisements.
Step 2 – Identify sub activities for each support activity.
For each of the Human Resource Management, Technology Development and Procurement
support activities, determine the sub activities that create value within each primary activity.
For example, consider how human resource management adds value to inbound logistics,
operations, outbound logistics, and so on. As in Step 1, look for direct, indirect, and quality
assurance sub activities. Then, identify the various value-creating sub activities in your
company's infrastructure. These will generally be cross-functional in nature, rather than
specific to each primary activity. Again, look for direct, indirect, and quality assurance
activities.
Step 3 – Identify links
Find the connections between all of the value activities you've identified. This will take time,
but the links are key to increasing competitive advantage from the value chain framework. For
example, there's a link between developing the sales force (an HR investment) and sales
volumes. There's another link between order turnaround times, and service phone calls from
frustrated customers waiting for deliveries.
Step 4 – Look for opportunities to increase value
Review each of the sub activities and links that you've identified, and think about how you can
change or enhance it to maximize the value you offer to customers (customers of support
activities can be internal as well as external).
Table 1. Comparison of Traditional Management Accounting Systems and
Value Chain Costing
Problems of Value Chain Analysis
There are several problems when using VC analysis in relation to cost effective management
as given below-
1. Incorrect allocation of cost within the chain: Certain costs are extremely difficult to
allocate to certain individual products, but they are the costs of activities which are very
significant in relation to total quality and in turn competitive advantage.
2. Long and time-consuming process: If the total philosophy of value chain is not
adopted, there is risk of overlooking strategic aspects in decision making. This exercise
needs to be repeated again and again looking at competition, both in the present and in
the future.
3. Non availability of information regarding competition, product lines and
structure: The whole exercise of developing a value chain in practice may be very
difficult as the information required is very seldom available.
4. Depends on lots of assumptions or supposition: Another problem inherent when
using VC analysis is that management accountant has to make lot of assumptions or
suppositions because of non-availability of information. These may be correct.

Conclusion
Value Chain Analysis is a complex and an industry specific phenomenon which has evolved
over the period of time. It is a continuous process of gathering, evaluating and communicating
information for decision making and will help you to identify all the value-creating activities
and processes within your organisation. Implementing Value chain analysis is highly complex
in nature due to the difficulty and the differences that exist between the Value Chain Analysis
requirements and the existing organizational methods and records. However, integrating the
two on similar lines can enable organizations work smartly reaping greater profits. Today’s
cost accountant must understand many functions of a business’s value chain, from
manufacturing to marketing to distribution to customer service.