Value chain analysis is very poorly done more often than not. Its one of those concepts that has become so common in business that when you hear the words “value chain analysis” you don’t even think about it.
But you should.
Value chain is a concept which was introduced by Michael Porter in 1985 and popularized in his best-selling book Competitive Advantage: Creating and Sustaining Superior Performance. The book introduced a new way of looking at an organization as a series of activities which link together into what Porter called “a value chain.”
“My quest was to find a way to conceptualise the firm that would expose the underpinnings of competitive advantage and its sustainability”, said Porter.
Porter explained that a firm can only be understood by looking at discrete activities an organization performs in designing, producing, marketing, delivering, and supporting its product. Looking at the industry or sector as a whole is too broad and will not allow one to isolate sources of competitive advantage for a particular organization.
In fact, those very differences between competitors’ value chains is a vital source of competitive advantage. Value chain analysis was introduced as a tool to analyze the sources of competitive advantage by systematically examining all the activities an organization performs and how they interact.
Porter wrote, “The value chain disaggregates a firm into its strategically relevant activities in order to understand the behaviour of costs and the existing and potential sources of differentiation. A firm gains competitive advantage by performing these strategically important activities more cheaply or better than its competitors.”
An organization’s value chain is, of course, embedded in a larger stream of activities which Porter termed the value system. For example, suppliers and distributors may influence an organization’s performance. Porter wrote, “Gaining and sustaining competitive advantage depends on understanding not only a firm’s value chain but how the firm fits in the overall value system.”
The whole point of the value chain of an organization is to create “value” for the final customer. A good measure of value is the amount a buyer is willing to pay for a particular product or service. In other words, an organization’s revenue: the price of the products or services an organization sells times the volume of products or services sold.
Of course, value may also be non-monetary. For example, Facebook may classify users as customers but most of those customers are not paying Facebook for its paid services (advertising) but only use Facebook’s free service, its social media platform.
So we established that value chain analysis identifies the building blocks by which an organization creates a product or service valuable to its customers. It helps us identify sources of competitive advantage. Therefore, value chain analysis can be used as a strategic tool to analyze differentiation, relative cost positioning and how competitive scope (which segments are targeted) impacts achieving competitive advantage.
Now lets briefly talk about value chain analysis done as part of power study.
Because the value chain of organizations in the same industry differs, using off-the-shelf reports as an input for value chain analysis is usually not particularly useful. Also, what you typically find is that everybody is using different definitions. They may use a different definition for a transformer, a different definition of what is a sale etc.
For example, in the case of the power sector study, for some of the reports, sales included the cost of selling the construction project. For others it did not. For those of you who know the construction industry it costs millions and millions of dollars to land the concession to build a power station. Sometimes tens of millions. Sometimes hundreds of millions. If you add it in the numbers become screwed up, especially when you do not know they have been included.
And very few documents have correct and useful footnotes.
So when you take all of these reports what you realize is that they are not really useful. And one of the most difficult decisions for this study was the decision to not use any of the off-the-shelf reports for sizing the sector and breaking down the value chain. Instead we decided to construct it ourselves by conducting a lot of focus interviews with numerous executives. And that is a tough process to follow. But that is the way it should be done for studies of the size and level of impact like the power study.
Obviously, if you can get some good reports, great, use them. If you are working on a tight timeline or if the client does not really care about the value chain analysis, or if the client is paying you very little money where they don’t expect depth in the value chain analysis then, yes, of course, use off-the-shelf reports.
But given the scale of this client and what was at stake, typically in these situations we would want to do in-depth work. And what we were looking for is breaking down the value chain into some reasonable components.
This is what we came up with:
Design. Build. Operate. Maintain.
We left out the operate part below since it wasn’t as important.
For those of you in the engineering sector you know it as E.P.C.M., which is another way to break it down.
Engineering. Procurement. Construction. Maintenance/Management.
So we have generation, transmission, you can also have distribution here. We broke it down this way because it made the most sense. And then we had a very difficult task of figuring out the components that go into building a generation or a power station. There are obviously feasibility studies, preliminary design and there are other areas as well. We did not list other areas because they are many years down the line. So we focused on the most immediate areas that Empire International would be focusing on to do work.
And what we figured out is that Empire International was only going to secure about $4.4 billion worth of work if they maintained their market share. Remember it does not mean that because Empire International is converting itself to build power stations that Empire Energy should give them the contracts.
Empire Energy should give their contracts to the most capable party and it may not be Empire International. So if we want the Empire International to shift to become the construction division of Empire Energy we have to be sure there is enough work for them to do and they have the capability to secure that work.
Now, in the actual study you will see us break this down in numerous ways. The example above is just one way we did the analyses. The value chain analyses was easily one of the most thorough and pivotal pieces of work done. Zooming in, zooming out, and going down to the project level as well. But the thing that jumps out to us is that if you look at the size of the construction work it dwarfs everything.
That makes sense, right? Building a power station is more expensive than the design work.
Refurbishing is also very costly.
Now the reason why refurbishment is a lucrative area for Empire International is because they were involved with building and maintaining the power stations that today need refurbishment. So they have some advantage here.
With regards to new construction they have no advantage. They are behind in technology and so on. They have to beef up.
Now, when we tell a company, “you need to play in this market, this region, and this part of the value chain”, we have to be absolutely sure that out of this $11 billion, or whatever number we calculated, that this revenue will be possible, that $11 billion dollars or something very close to this will be spent within a particular timeframe, that Empire International has a reasonable chance of securing a viable share of that market and they can do so in a cost effective way that creates value for their owner, which is Empire Energy.
If you don’t, you are off-course toast. And not the good kind served in high-end restaurants. We are referring to the burnt kind found in the dingy apartments of those who oversleep and are rushing to work and cannot watch their breakfast being made.
And that is where the study focuses. Corporate strategy quickly zooms in and we ask how do we play, what does it take, what kind of market share do we need, what kind of capabilities are required to compete etc. And eventually we give them a kind of set of rules, saying “If you want to implement this strategy you need to get this amount of market share, you need this amount of skills, price yourself this way, market yourself this way, organize yourself this way and if you do the following things you will create so much value.”
Of course, in this case value includes ensuring the lights stay on in a very important economy. That distinction is crucial when we make our recommendations. So that is a very high level look at the value chain analysis we have done as part of the power study.
There is a lot more detail in the Executive Program. But you can get a sense for how we tackle value chain analysis.
The value chain analysis work can be quite exciting. There are different ways to do it. But as long as you remember why you are doing it and understand how you want to use it, you are on the right path.
Doing this kind of work is a skill. Most consultants struggle to do it. Most do not even know they are doing it incorrectly. Ignorance is indeed bliss.
Strategy is an integrated set of activities to help companies achieve a sustainable competitive advantage and value chain analysis is a tool to help companies determine such set of activities. In other words, value chain analysis is at the core of business strategy, and hence at the core of strategy consulting.
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