3.3 Understanding the value chain
The value of any end product or service is built up in stages. These stages may all take place in the same organisation or across a series of organisations. By analysing the value chain, an organisation can gain a better understanding of the key capabilities involved in creating the products or services it is involved with. Essentially, the value chain can be regarded as a complete transformation model overlaid by the necessary support functions. Figure 5 shows a simplified model of the value chain involved in producing Open University educational services.
At its simplest, a value chain is an activity path through an organisation. It tells you what the organisation does and the order in which it does it. It should also tell you something about how it does it. A value chain can be a very helpful tool for understanding the difference between two organisations that appear to be functioning in similar ways in the same sector. This is because organisations can construct their value chains in very different ways. A different design of the value chain, by which we mean a different activity path through the organisation, might simply indicate a different way of doing things, or it might generate notable competitive advantage.
Value chains can be used to identify sources of increased efficiency and also to facilitate ‘benchmarking’ of how competitors create value and how their activities compare with yours. Value chain analysis has four underlying elements:
identifying the cost of each activity
understanding what factors are driving the costs behind each activity
monitoring the processes of competitor organisations in relation to each activity (‘benchmarking’)
understanding the linkages in the chain and horizontal strategy opportunities.
You may find that even a very simple overview of an organisation's value chain gives a great deal of insight into its relative strengths and weaknesses. It is also the case that imaginative approaches to reconstructing (‘reconfiguring’) the value chain can release new ways of clustering resources and therefore new types of capability within organisations.
Analysis of the value chain enables us to identify where an organisation's distinctive capabilities are based. They may arise from clear advantages in particular functions (e.g. R& D, manufacture), or from the integration of individual functional capabilities. These distinctive capabilities give rise to core competencies, which are what make the organisation what it is. They are the key to the continued success of the institution, and effective strategies need to recognise and build on them.
Value chain analysis, together with an understanding of an organisation's key capabilities, can provide a basis for decisions about whether to integrate all stages of the value chain within the same organisation or to enter into partnerships with other organisations better equipped to deliver some of those stages. Equally, value chain analysis may allow an organisation to make decisions about whether to extend its activities up or down the value chain. Certain activities on any value chain might add a high proportion of financial value to the finished product or service: these are known as high value-added activities.
Box 3 Managing the value chain at Li & Fung
Li & Fung is Hong Kong's largest export trading company. The company has moved from acting as a middleman between retailers and manufacturers to playing a much more extensive role in the management of the whole value chain. They work closely with their customers in the design and specification of products. Li and Fung have a close involvement in the high value-added front-end and back-end activities in the value chain. They are closely involved with design, engineering and product planning at the front end. At the back end, they carry out quality control, testing and handle logistics. They manage the lower value-added middle stages through a large network of (7,500) suppliers across the region. Li & Fung's CEO, Victor Fung, explains:
Say we get an order from a European retailer to produce 10,000 garments. It's not a simple matter of our Korean office sourcing Korean products or our Indonesian office sourcing Indonesian products. For this customer we might decide to buy yarn from a Korean producer but have it woven and dyed in Taiwan. So we pick the yarn and ship it to Taiwan. The Japanese have the best zippers and buttons, but they manufacture them mostly in China. OK, so we go to YKK, a big Japanese manufacturer and we order the right zippers from their Chinese plants. Then we determine that, because of quotas and labour conditions, the best place to make the garments is Thailand. So we ship everything there. And because the customer needs quick delivery we may divide the order across five factories in Thailand. Effectively we are customising the value chain to best meet the customer's needs.
In a sense, we are a smokeless factory. We do design. We buy and inspect the raw materials. We have factory managers, people who set up and plan production and balance the lines. We inspect production. But we don't manage the workers, and we don't own the factories.
Think about the scope of what we do. We work with about 7,500 suppliers in more than 26 countries. If the average factory has 200 workers – that's probably a low estimate -then in effect there are more than a million workers engaged on behalf of our customers. That's why our policy is not to own any portion of the value chain that deals with running factories. Managing a million workers would be a colossal undertaking. We'd lose all flexibility; we'd lose our ability to fine-tune and co-ordinate. So we deliberately leave that management challenge to the individual entrepreneurs we contract with.
Our target in working with factories is to take anywhere from 30% to 70% of their production. We want to be important to them, and at 30% we're most likely their largest customer. On the other hand, we need flexibility – so we don't want the responsibility of having them completely dependent on us. And we also benefit from their exposure to their other customers.
If we don't own factories, can we say we are in manufacturing? Absolutely, because, of the 15 steps in the manufacturing value chain, we probably do 10.
Such close attention to the value chain enables Li & Fung both to drive down costs and to reduce the time from order to delivery, buying their customers (retail chains) vital time in which to track customer tastes and deliver products that correspond to quickly shifting fashions.
Consider the description of Li & Fung above. What would you say are the distinctive capabilities of this organisation? You can use Table 2 to help you to analyse their capabilities and consider what may lead to future problems.
Contribution of organisational capabilities to competitive advantage
|Organisational capabilities||Leading to competitive advantage||Potential weakness||Information not available|
|Architecture: Relationships within firm|
|Architecture: Relationships with firms in value chain, manufacturers and suppliers|
|Architecture: Relationships with firms in value chain, customers/ buyers|
It seems likely that Li & Fung see themselves as having good skills in the areas of design, product planning, engineering, quality control and logistics. They also have an important capability in their supply chain architecture: their network of relationships with suppliers over a large and diverse geographical region. However, all of these are, at least in some degree, common and imitable. Underlying the importance of these factors is the capability they have developed to bring them together by managing large and complex value chains.