Your goal as a business is to create value for your customers. When you create value for your customers, you create value for your shareholders through your profit margins.
But how do you go about creating value when building new products? How do you go about building new products that customers buy while optimizing your margins? How is value creation conceived both for customers and shareholders?
The process of ideating, creating, and selling products can be seen through the value chain.
What is a value chain?
The definition of a value chain is a set of business activities involving the creation, commercialization and correction of products or services.
An example of a value chain in manufacturing is the creation of S’well water bottles. First, someone had to come up with the idea for S’well water bottles. Then, they had to design the innovative water bottle using software and other tools. Then, they had to source a manufacturer for developing the product. After sourcing the manufacturer, they may have to acquire raw materials for the manufacturer to use.
Once the product is created, they have to sell the product — which, in this case, is a combination of wholesale, retail, and direct to consumer. Then, they have to service the product which, in this case, is likely handling returns. Regardless of their business model, they must create and deliver the product to the end customer, whether that’s an individual or a retail store.
All of these steps create a value chain — literally, a chain where value can be extracted or added at every step of the chain.
Value chain vs. supply chain
Many individuals get the value chain confused with supply chains.
Supply chains are systems of people, activities, organizations, and resources involved in delivering a product or service to the consumer.
Wait…how is that different from a value chain?
A value chain encompasses much more than the supply chain does. The supply chain is all about the delivery of goods or services, while the value chain is “a set of interrelated activities a company uses to create a competitive advantage.”
A value chain, for example, includes the marketing and servicing of a product, while a supply chain only encompasses the creation and distribution of a product.
If you’re confused, just remember:
- Supply chain = supplying products
- Value chain = delivering value
What is Porter’s Value Chain Model?
Michael Porter’s value chain model was established in his 1985 book Competitive Advantage. Porter’s value chain establishes primary and secondary activities every company goes through in the process of creating value for customers. Michael Porter is an American academic who also created Porter’s five forces.
These components of a value chain help create the equation that leads to calculating margins. Margins are the revenue generated from the value chain.
Value Created and Captured – Cost of Creating that Value = Margin
Primary value chain activities
The primary activities in a value chain include inbound and outbound logistics, operations, marketing, sales and services. Primary value chain activities include every step in the physical creation, sale, maintenance and support of a product. It’s the entire production process of creating a new product. These specific activities can be broken down into Porter’s model of the value chain.
This includes all of the processes of receiving, distributing and storing of products internally. This is the process of going from raw material to an actual product.
Inbound logistics is all about sourcing the raw materials required to create a finished product. In the case of S’well water bottles from above, this includes the stainless steel and copper used in their product. Supplier relationships are integral when it comes to inbound logistics.
Outbound logistics refers to the delivery of a final product and the services associated with them; the process of delivering final products or services to the end consumer. The steps in this process may be external or internal — i.e. you might not store your items in your own warehouses. For example, S’well water bottles sells directly to consumers, in stores and in bulk. Each type of selling has a different process for outbound logistics. This includes the warehousing of products.
Operations is the process of transforming inputs into complete, finished products and services. Operations are all of the transformation activities that turn raw materials into finished goods. This includes quality assurance.
Marketing and sales
Marketing and sales are the processes an organization uses to influence customers to purchase from your organization instead of a competitor. This includes the benefits offered, how well they’re communicated, and if they are sources of value to the end customer.
Marketing and sales is pretty clear — it’s the marketing and selling of products. Due to the incredibly competitive world we live in where manufacturing products is easier than ever, high-quality, relevant, and timely sales and marketing can be a make or break. Sales and marketing often drives the distribution channels based on research.
Services are the activities designed to maintain products and enhance consumer experience. Often includes add-on services, warranties, refunds and returns.
Services, like sales and marketing, are becoming more and more significant in delivering products. This is due to the rise of Products-as-a-Service like Peloton or smart thermostats. They are a physical product that rely on recurring revenue through services like new classes or access to data to optimize the product in the future.
Secondary value chain activities
On the other hand, secondary or support value chain activities are everything that supports each phase of the value chain. These include procurement, HR management, technology and infrastructure.
Procurement refers to the obtainment of resources to produce the end product. Procurement involves finding vendors and securing contracts for goods and services the business needs to create and deliver a final product. Procurement can include everything from obtaining a lease for an office to securing a partnership to produce a piece of the end product.
HR management is how well a company recruits, hires, trains and retains their workforce. HR management is all about human resources and managing people. Because of the changing workforce, human resources is becoming even more important. Human resources is responsible for recruiting, training, motivating, and retaining employees across the organization.
Technology refers to the equipment, hardware, software, procedures and technical knowledge of an organization. Technology development is becoming hypercritical in the fourth industrial revolution. Today, many companies are focused on technology including automation, cloud computing, and the Internet of Things (IoT).
Infrastructure includes the company's support systems like legal, accounting and administrative functions. A firm’s infrastructure is everything else that goes into building a product that’s not directly connected to the final product. This is the general management of an organization including accounting, administration, and legal.
When you put both primary and secondary activities together, you can understand any organization holistically. By understanding your value chain in detail, you can create a competitive advantage.
What is value chain analysis?
Value chain analysis is a way for organizations to analyze all of the activities they carry out to create a product. There are a few steps in this process.
Step 1 - Identify sub-activities for each primary activity
Step 2 - Analyze the cost and value of the sub-activities
Step 3 - Identify new opportunities to gain a competitive advantage
Competitive advantages can be either cost advantages or product differentiation. A cost driver is a unit of an activity that causes the change in the activity's cost. These can include direct labor hours worked to produce the product, number of machine hours used, and product returns from customers. All of these have huge influence over the value chain’s profit margins.
When optimizing your value chain, you can break down business improvements into the following categories:
- Improved bids and proposals
- Enhanced product planning, research and development
- Improved vendor management
- Standardized processes
The importance of value chain analysis is the ability to find opportunities to create product differentiation or reduce costs to maximize profit.
How will you optimize your value chain?
Whether you’re focused on lower costs or product differentiation to increase profit margins, understanding value chains is the first step. Porter’s value chain model is a fantastic tool to help you optimize each phase of your business.
The next time you create a business strategy, break it down into primary and support activities and how you can optimize each phase of your strategy. Always think about your margins and the end user’s experience and you will find the ultimate success.