A baker in Abuja buys flour and sugar, mixes and bakes the dough, packs the bread and sells it through supermarkets and her own delivery vans. A rival buys the same flour and bakes the same loaf but wins more customers and earns a better margin. Where does the difference come from?
Not from the oven alone: it may come from cheaper flour because of better buying, fewer breakages in delivery, a stronger brand, faster handling of complaints or better-trained staff. A business is not one activity but a chain of activities, and the difference in competitive success lies somewhere along it.
Value chain analysis, developed by Michael Porter, examines each activity to see where value is created, where cost is incurred and where there is an advantage over rivals.
This topic explains value and competitive advantage, Porter’s two generic strategies (cost leadership and differentiation), the primary and support activities of the value chain with examples, how to use the analysis for performance management (cost and value by activity, comparison with rivals, outsourcing, linkages and measures), and its limits. It builds on the earlier topic on transfer pricing problems, tax and the repatriation of funds.
The next topic covers complex business structures: alliances, joint ventures and supply chains.
In 30 seconds
Value is the benefit a customer obtains from a product or service; customers pay for it, so the price they are willing to pay puts a value on the benefits. A business creates added value when it converts inputs into something worth more (components bought for ₦1,000 and turned into a watch sold for ₦10,000 create ₦9,000 of value).
In a competitive market the most successful companies create more value, or create it more effectively, more efficiently or at lower cost. Porter’s two competitive strategies: cost leadership (the same value as rivals at lower cost) and differentiation (more value than rivals, so customers pay more). The value chain is the set of linked activities that create value.
Five primary activities: inbound logistics (receiving, storing materials), operations (conversion), outbound logistics (storing and delivering finished goods), marketing and sales, and service (after sale). Four support activities: procurement, technology development, human resource management and firm (corporate) infrastructure. Value can be created by any of them, including logistics and support activities.
Management analyses each activity to see where the organisation is most and least effective, which gives advantage over rivals, what to improve, and whether to stop activities that cost more than the value they create. Full marks come from classifying activities correctly, using cost and benchmark data, and linking to strategy.
Value and competitive advantage
A business is organised into departments or divisions that perform different functions. But value is added by a series of activities and processes that occur in a co-ordinated way, and they must be linked effectively. Value relates to the benefit a customer obtains from a product or service, provided by its attributes: customers pay because of the benefits received.
A customer will often pay more for something that gives more value, and, given a choice, will pick the one that gives more value for money, quality, reliability, functions, convenience and so on.
Business entities create added value when they make goods and provide services. In a competitive market the most successful companies are those that are best at it. Porter argued that firms must seek competitive advantage over rivals by creating more value, or by creating value more effectively, efficiently or cheaply, and suggested two generic strategies:
- Cost leadership: create the same value as competitors but at lower cost, so that profit is higher at the same price or sales are higher at a lower price.
- Differentiation: create more value than competitors for a competing product or service, so that customers are willing to pay more.
The value chain: primary and support activities
Porter’s value chain is the set of inter-connected activities that create value. Value can be created by any of them. By analysing them management can decide how to improve value creation, how to improve competitive advantage and whether to stop activities that cost more than the value they create.
The model is most often used for firms that handle physical resources, such as manufacturers and retailers, though the idea applies to all, including service firms. Activities fall into two groups, five primary and four support. Most value is usually created in the primary activities.
| Primary activity | What it covers | Examples |
|---|---|---|
| Inbound logistics | Receiving, handling and storing purchased materials and components until needed | Delivery systems for materials, warehouses for receiving goods |
| Operations | Converting materials into items that customers will buy: machining, assembly, packing, testing, maintenance | Manufacturing methods; total quality management; just-in-time production |
| Outbound logistics | Storing finished goods, distributing and delivering goods or services to customers | Finished-goods warehouses; delivery methods |
| Marketing and sales | Persuading customers to buy and taking their orders | Advertising; sales promotion; order processing; pricing |
| Service | All activities after the point of sale | Installation, repairs, after-sales service, handling queries and complaints |
Value is added by all of these, including logistics: customers may pay more for a product that is delivered conveniently, for example household shopping brought to the door.
| Support activity | What it covers | How it can add value |
|---|---|---|
| Procurement | Buying materials, plant, equipment and other resources: choice of suppliers, terms, just-in-time purchasing, negotiating prices and credit | Finding a cheaper or better source |
| Technology development | Product design, research and development, IT systems, e-commerce | A new IT system that improves operations |
| Human resource management | Recruiting, training, developing and rewarding people; incentive pay, skills | Training that improves employees’ skills |
| Firm (corporate) infrastructure | Organisation structure and management systems: planning, finance, head office, hierarchy, decision-making | A leaner structure and faster decisions |
Support activities are often seen as necessary overheads that support the primary activities, but they too can create value, as the right-hand column shows. The nature of the activities varies by industry, and there are differences between manufacturers, retailers and service companies, but the idea of a primary value chain is valid for all.
Using the value chain for performance management
- Cost and value by activity. Assign costs (and assets) to each activity, find what drives the cost of each (cost drivers), and see which activities add most value and which least. This gives a different picture from a cost analysis by department.
- Comparison with rivals (benchmarking). Compare the cost and performance of each activity with those of competitors or best-practice firms to find where advantage or disadvantage lies, and set targets for improvement.
- Choosing and supporting the strategy. A cost leader looks for savings in every activity without losing the value customers need; a differentiator invests in the activities that customers value most (brand, quality, service) and accepts higher cost there.
- Linkages. Activities affect each other: better procurement may cut operating waste; more design effort may cut after-sales cost; faster delivery may raise marketing value but increase outbound cost. Optimising each activity separately may not optimise the chain, so they must be managed together.
- Make or buy (outsourcing). Activities that cost more than the value they add, or that a specialist does better and cheaper, may be outsourced. Core activities that give advantage are kept.
- Information and measures. Identify the information needed for each activity so that it creates value. Set performance measures for each (for example inbound: supplier on-time delivery, stock days; operations: defect rate, cycle time; outbound: on-time delivery, damage rate; marketing: customer acquisition cost; service: complaint resolution time).
- The wider chain. A firm’s chain connects to those of its suppliers and customers (the value system), so advantage may come from working with them.
Limits
It is hard to allocate costs and assets to activities, and to measure the value that customers attach to each. Activities in service firms are less clear-cut. Data on rivals’ activity costs may be unavailable. The analysis is a framework that shows where to look; it does not give the answer. It may lead to over-emphasis on cost in activities that create value in ways not captured by cost.
Layouts for value chain analysis
- List activities under the nine headings and assign costs.
- Compute cost by activity, share of total, and margin (price less total cost).
- Compare with a rival or with last year, activity by activity (gap and percentage).
- Identify where advantage and disadvantage lie, and the strategy that fits.
- Recommend improvements, outsourcing or stopping, and measures.
Money is in naira per unit unless stated; percentages to one decimal place; each answer is rounded once, at the end.
Worked examples
Example 1: cost by activity. A company’s cost per unit is: materials ₦600; inbound logistics ₦40; operations ₦220; outbound logistics ₦60; marketing and sales ₦110; service ₦50. The selling price is ₦1,500. Required: the total cost, margin and the share of each activity.
- Total cost.
600 + 40 + 220 + 60 + 110 + 50 = ₦1,080. - Margin.
1,500 − 1,080 = ₦420 (28.0% of the price). - Shares of total cost:
operations 220 ÷ 1,080 = 20.4%; marketing and sales 10.2%; outbound 5.6%; service 4.6%; inbound 3.7%; materials 55.6%. - Comment. Materials (procurement) and operations are where cost is concentrated, so savings there matter most. But the value to the customer may come from marketing, delivery and service, which cost less; cuts there could reduce price or sales. A cost leader would study procurement and operations; a differentiator would protect service and marketing.
Example 2: comparison with a rival. Costs per unit (ours, rival): materials 250, 240; inbound 30, 28; operations 180, 150; outbound 40, 42; marketing and sales 90, 70; service 30, 35. Our price is ₦800 and the rival’s ₦760. Required: the gaps and a comment.
- Totals.
Ours 250 + 30 + 180 + 40 + 90 + 30 = ₦620
rival 240 + 28 + 150 + 42 + 70 + 35 = ₦565.
Gap ₦55 against us. - Gaps by activity (ours − rival). Materials +10; inbound +2; operations +30; outbound −2; marketing and sales +20; service −5. Sum +55.
- Margins.
Ours 800 − 620 = ₦180
rival 760 − 565 = ₦195. - Comment. The biggest disadvantage is in operations (₦30, 20% above the rival), followed by marketing (₦20) and materials (₦10). The company spends less on service (₦5 less than the rival), which is where a rival may win loyalty. A cost-focused response would target operations and procurement; if the ₦40 price premium reflects stronger brand value from the extra marketing, it may be differentiation that works, and should be checked against customer data.
Example 3: outsourcing an activity. A firm’s own warehouse (outbound logistics) costs ₦24m a year. A specialist offers the same service for ₦20m. Required: the saving and other considerations.
- Saving.
₦4m a year, 4 ÷ 24 = 16.7%. - Other factors. Control of delivery quality (a customer-facing activity, which may be a source of advantage); reliability and contract terms; redundancy costs; whether the warehouse is a core competence; the price risk once the firm is dependent on the supplier.
Expect variants: a case study asking you to classify given activities, to assess which activities give advantage, to say how a differentiation or cost leadership strategy would shape the chain, and to suggest measures.
Common mistakes
- Putting an activity in the wrong group. Procurement is a support activity; inbound logistics is primary.
- Treating support activities as pure overhead that creates no value.
- Calling the value chain a departmental structure. Activities cut across departments.
- Cutting cost without asking what the customer values.
- Ignoring linkages between activities.
- Listing activities without data or recommendations.
Quick revision
- Value = what customers will pay for; added value = price less cost of inputs.
- Strategies: cost leadership; differentiation.
- Primary: inbound, operations, outbound, marketing and sales, service. Support: procurement, technology, HRM, infrastructure.
- Use: cost and value by activity, benchmark, outsource, link, measure.
How the marks are earned
- Activities correctly classified.
- Cost data used to find advantage.
- Strategy and recommendations.
Practice questions
These are original questions, written in the style of the Skills examination. Work each one before you open the answer.
Recall check: multiple choice
Question 1. Value is:
- Cost
- Profit
- The benefit a customer obtains, shown by what they will pay
- Revenue
Show the answer
C. Customers pay for benefits.
Question 2. Porter’s two generic competitive strategies are:
- Cost leadership and differentiation
- Growth and decline
- Price and volume
- Debt and equity
Show the answer
A. Either may have a broad or niche focus.
Question 3. The five primary activities are:
- Plan, do, check, act, review
- Inbound logistics, operations, outbound logistics, marketing and sales, service
- Buy, make, store, sell, pay
- Finance, HR, IT, legal, audit
Show the answer
B. Most value is usually created here.
Question 4. A support activity is:
- Operations
- Outbound logistics
- Service
- Procurement
Show the answer
D. With technology, HRM and infrastructure.
Question 5. Inbound logistics concerns:
- Receiving and storing purchased materials
- Delivering to customers
- Advertising
- Repairs
Show the answer
A. Until they are needed.
Question 6. Service in the value chain means:
- Cleaning
- Selling
- Activities after the point of sale
- Recruitment
Show the answer
C. Installation, repair and after-sales support.
Question 7. Value chain analysis is used to:
- Calculate tax
- Identify where value is created and where costs exceed the value created
- Set transfer prices
- Measure liquidity
Show the answer
B. And so where to improve or stop.
Question 8. Procurement can add value by:
- Raising prices
- Selling more
- Reducing staff
- Finding a cheaper or better source of supply
Show the answer
D. A support activity can create value.
Question 9. A differentiation strategy aims to:
- Create more value than rivals so that customers pay more
- Cut every cost
- Copy rivals
- Avoid customers
Show the answer
A. Customers see the product as better.
Question 10. Cost leadership aims to:
- Charge the highest price
- Add features
- Create the same value as rivals at lower cost
- Reduce sales
Show the answer
C. To win share or profit.
Section B style: written questions
Question 11 (10 marks). (a) Explain what is meant by value and how a business creates it. (3 marks) (b) Describe Porter’s two competitive strategies. (3 marks) (c) Name the nine activities of the value chain. (4 marks)
Question 12 (15 marks). Costs per unit (ours, rival): materials 250, 240; inbound 30, 28; operations 180, 150; outbound 40, 42; marketing and sales 90, 70; service 30, 35. Our price is ₦800 and the rival’s ₦760.
(a) Calculate total cost and margin for each. (3 marks) (b) Calculate the gap for each activity. (5 marks) (c) Comment on the strategy each firm seems to follow. (4 marks) (d) Suggest THREE support activities that could help to close the gap. (3 marks)
Question 13 (20 marks). A Lagos company delivers fresh vegetables to restaurants.
(a) Explain the primary and support activities of the value chain with an example of each for the company. (8 marks) (b) Suggest one performance measure for each primary activity. (5 marks) (c) Discuss whether the company should outsource its delivery. (4 marks) (d) State TWO limitations of value chain analysis. (3 marks)
Model answers
Show the model answer to Question 11
(a) Value is the benefit that a customer obtains, shown by what they are willing to pay. A business creates it by converting inputs into goods or services worth more than the cost of the inputs (3).
(b) Cost leadership: the same value as rivals at lower cost. Differentiation: more value than rivals so that customers pay more (3).
(c) Primary: inbound logistics, operations, outbound logistics, marketing and sales, service. Support: procurement, technology development, human resource management, firm infrastructure (4).
Show the model answer to Question 12
(a)
- Ours ₦620, margin 800 − 620 = ₦180.
- Rival ₦565, margin 760 − 565 = ₦195 (3).
(b) Materials +10; inbound +2; operations +30; outbound −2; marketing and sales +20; service −5; total +55 (5).
(c) The rival appears to follow cost leadership, with lower operations, materials and marketing cost and a lower price; we spend more on operations and marketing and charge ₦40 more, suggesting an attempt at differentiation, but our margin is lower, so the extra price does not cover the extra cost (4).
(d) Procurement (better buying); technology development (process improvement in operations); human resource management (training to raise productivity) (3).
Show the model answer to Question 13
(a) Primary: inbound logistics (receiving and cold-storing produce); operations (sorting, washing, packing); outbound logistics (delivery vans, routes); marketing and sales (taking orders, price lists); service (handling complaints, replacing spoiled goods). Support: procurement (choice of farms and prices); technology development (ordering app, route planning); human resource management (training drivers and packers); firm infrastructure (management systems, finance) (8).
(b) Inbound: wastage at receipt; operations: packing time or rejects; outbound: percentage delivered on time and damaged; marketing: customer acquisition cost; service: time to resolve complaints (5).
(c) Compare the quoted cost with the in-house cost; delivery is customer-facing and may be a source of advantage, so quality and control matter; check reliability, contract terms and the effect on staff; outsource if the specialist is cheaper and as reliable and delivery is not a core competence (4).
(d) Hard to allocate costs and assets to activities; hard to value what customers attach to each; rivals’ data unavailable; it shows where to look, not the answer (any two) (3).
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