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Accounting Data for Value Chain Analysis

Author(s): Michael Hergert and Deigan Morris

Source: Strategic Management Journal , Mar. - Apr., 1989, Vol. 10, No. 2 (Mar. - Apr., 1989), pp. 175-188

Published by: Wiley

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Strategic Management Journal, Vol. 10, 175-188 (1989)

ACCOUNTING DATA FOR VALUE CHAIN ANALYSIS

MICHAEL HERGERT College of Business Administration, San Diego State University, San Diego, Cali- fornia, U.S.A.

DEIGAN MORRIS INSEAD, Fontainebleau, France

Strategic planning frameworks provide a means of combining internal data about the firm's capabilities with external information about the competitive environment in a manner designed to guide resource allocation. The value chain approach to strategic planning, as described by Michael Porter in his book Competitive Advantage (1985), is a recent addition to this family of planning frameworks. In this article, we address some of the difficulties in using accounting data for value chaini analysis. These difficulties are divided into those that are inherent, because of differences in methods of data accumulation, and those that are avoidable.

INTRODUCTION

All corporations make decisions that affect their

long run competitive position and profitability.

Some, perhaps many, of these decisions turn out

to be mistaken. Strategic planning is an attempt to

formalize the process of making these important

decisions and so reduce the incidence of costly

mistakes. The purpose is to help the firm position

itself against its competitors in the pursuit of

competitive advantage. A variety of conceptual

frameworks have been proposed for guiding this

process. They combine information about the

environment with information about the internal

workings of the firm in order to determine

investment priorities. This article addresses two

issues. First, we discuss the different types of

accounting data and previous observations on their relevance to strategic planning. Second, we

analyze the value chain framework of strategic

planning proposed by Michael Porter (1985), and

discuss some of the problems in obtaining the

necessary accounting data. We conclude with suggestions about improving accounting systems

and data for the purpose of value chain analysis.

Most approaches to strategic planning make use of accounting data in some form or another.

0143-2095/89/020175-14$07. 00

? 1989 by John Wiley & Sons, Ltd.

However, an article in Fortune (Keichel, 1981: 140) on the formulation of corporate strategy states that 70% of the analyst's time was devoted not to obtaining external data (about the industry, market shares, activities of competitors), but to reworking internal accounting numbers.

The general irrelevance of traditional account- ing data for strategic decision making has been commented on recently by a number of academics. This article focuses on the accounting data needed for value chain analysis and discusses why they were not readily available and what can be done about it; part of the reason can be traced to the fact that the dimensions of data accumulation for value chain analysis are incompatible with those of accounting. Part is due to the way in which accounting systems are

designed and implemented.

ACCOUNTING DATA AS AN INPUT TO STRATEGIC PLANNING

The accounting literature distinguishes three types of accounting: financial (e.g. Anthony and Reece, 1983), cost (e.g. Shillinglaw, 1982) and management (e.g. Horngren, 1981). Recently the

Received 10 March 1986 Revised 20 July 1987

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176 M. Hergert and D. Morris

distinction between the last two has become blurred as more emphasis is put on the uses of cost accounting data than on its preparation.

Financial Accounting

Financial accounting is the oldest of the three

(Solomons, 1968). Its primary purpose is to give a true and fair view of the financial position of the firm to an external constituency. The accounting principles and their interpretation, which govern the content and format of financial reporting documents, render financial accounting entirely inappropriate for strategic decision mak-

ing (Allen, 1985; Rappaport, 1981, 1983). The latter summarizes his arguments thus:

The essential problem lies in the use of accrual accounting numbers, developed for ex post external reporting, for unintended, inappropriate purposes such as strategic planning. After all, in the final analysis, economic value is created by cash flows not accounting convention (Rappa- port, 1983: 58).

Cost Accounting

Cost accounting originally had two missions: product costing for external reporting (Solomons, 1968) and responsibility accounting for internal control (Kaplan, 1984).

Problems arose when executives used these

numbers for decision making in the belief that they represented 'true costs'. Horngren calls this conviction that products had objectively determined actual costs, the 'absolute-truth approach' (Horngren, reprinted in Bell, 1983: 5-22). Neither accountant nor executive had heeded Clark's dictum, 'different costs for differ- ent purposes' (quoted in Parker, 1969).

To remedy this situation a third mission was added-providing cost information for decision making. A modern example of the results of this evolution is provided by Shillinglaw (1982: 3), who says that the uses of cost accounting data are:

1. Managerial planning and control. 2. Preparation of financial statements for distri-

bution to outsiders. 3. Preparation of business income tax returns. 4. Determination of the reimbursable amounts

under cost-based contracts or similar pricing or funding arrangements.

Strategic planning is specifically mentioned as one type of planning activity. However, careful examination of this and other cost accounting texts reveals little or no discussion of how cost accounting data can be used for strategic planning.

In his review of the evolution of management accounting, Kaplan (1984) says about traditional cost accounting and management control systems:

Virtually all of the practices employed by firms today and explicated in leading cost accounting textbooks had been developed by 1925. During the last 60 years there has been little innovation in the design and implementation of cost accounting and management control systems

(1984: 390).

Since the modern strategic planning frameworks were not developed until the 1970s and 80s (see for example Abell and Hammond, 1979; Porter, 1985), it is possible that the difficulties experi- enced by analysts in using accounting data for strategic planning are due to Kaplan's 'accounting lag' (Kaplan, 1986). The present paper argues that the inappropriateness of traditional cost accounting data for value chain analysis is due in part to the incompatibility of their respective approaches to cost accumulation. Instead of trying to use a universal accounting system for all purposes, strategic planning requires a system designed specifically to facilitate strategic cost analysis.

Management Accounting

How does management accounting differ from cost accounting? The definition of the former given by Horngren (1981: 5) is:

The distinguishing feature of management accounting is its emphasis on the planning and control purposes (of accounting systems).

There are two types of planning decision: routine and strategic (including special decisions) (Horngren, 1981: 5-6). An 'effective accounting system' provides information for these purposes and for 'external reporting to. . .outside parties' (Horngren, 1981: 5). In common with other textbooks in this field, there is no explicit discussion of strategic decisions and their data requirements.

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Accounting Data for Value Chain Analysis 177

Commenting on the relationship between man- agement accounting and cost accounting and on

the former's inability to live up to its name,

Simmonds (1981) says:

Yet, despite management accounting's name, proclaiming its metamorphosis from cost account- ing, the tendency to place analysis of recorded costs to the fore still outweighs the embryonic and generally abstruse efforts to analyse managerial decision making and design accounting infor- mation to improve managerial decisions

(1981: 1).

One reason why this metamorphosis is proving

so difficult could be that accounting information for some popular strategic planning frameworks

(Haspeslagh, 1982) cannot be directly extracted from systems designed for external reporting and routine decision making. The fact that data

for strategic planning are different from those required for other internal purposes is not

explicitly discussed by authors of texts on cost and management accounting.

While accounting texts have been silent on this

issue, there have been warnings about the need to manage the interface between short-range budgets and long-range (strategic) plans (Shank et al., 1973) and to identify the specific information requirements of each phase of the strategic

decision making process (Gordon et al., 1978). To these, the authors of the present article would

add the warning that traditional cost accounting data are poorly adapted to strategic decision making.

Summary

While organizations capture and record account- ing data once, it subsequently serves two entirely different purposes. One is to satisfy the require- ments of legal entity accounting, the other is to provide management with the relevant data for

decision making and control. Cost accounting currently provides data for both of these purposes.

While financial accounting can be used for

expressing how the results of strategies will appear to outsiders after the event, it is not an appropriate vehicle either for assessing the economic value of a given strategy or for choosing between competing strategies.

Traditional cost accounting, initially developed to measure 'true costs' and bereft of significant

innovation for the last 60 years, is not able to

furnish the data required by the modern strategic planning frameworks of the 70s and 80s.

The growing number of management account-

ing textbooks testifies to the new emphasis on a

user orientation to accounting data. However, none specifically discusses how accounting data

can be used to support the more recent approaches to strategic planning.

Traditional accounting systems are not just

unhelpful for value chain analysis (Porter, 1985; 39 and 61), they can also get in the way of it (Porter, 1985: 63).

THE VALUE CHAIN APPROACH TO STRATEGIC PLANNING

The value chain approach to planning is explained

in Porter (1985). In this and subsequent sections we are only concerned with those aspects that

affect the requirements for accounting data. The approach is based on a number of propositions.

While the majority are not unique individually, together they lead to a unique framework for strategic planning.

Porter argues that firm profitability is a function

of industry attractiveness and the firm's relative position within it. Strong relative positions imply that the firm has a competitive advantage that can be sustained against attacks by competitors and evolution of the industry. Competitive advantage comes from creating value for buyers that exceeds the costs of generating it. There are three sources of competitive advantage, known collectively as generic strategies. They are low cost, differentiation and focus. Competitive advantage is created by the performance of discrete activities such as design, production, marketing, and delivery. Each of these contributes

to the chosen generic strategy. Value chain analysis is a method for decomposing the firm into strategically important activities and under- standing their impact on cost behavior and differentiation.

The value chain is not a collection of indepen-

dent activities. Complex interdependencies pro- vide opportunities for optimization and problems of coordination between activities within the

chain, with the value chains of buyers and suppliers, and with the value chains of other

strategic business units (SBUs) within the same corporation.

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178 M. Hergert and D. Morris

As a framework for strategic planning, value

chain analysis has several distinctive character-

istics. These are (1) an emphasis on identifying

the source of sustainable competitive advantage;

(2) an insistence on the importance of complex

linkages and interrelationships; and (3) the

identification of generic strategies which must

be pursued consciously and coherently in the different value creating activities. The following paragraphs explain these characteristics.

The first difference between value chain plan-

ning and other approaches (e.g. portfolio models and PIMS-see Abell and Hammond, 1979) is the emphasis on identifying the source of competitive advantage. The roots of this approach

are in microeconomics. The firm is viewed as a

collection of discrete but related production functions (activities), where some of them are

not freely traded in external markets. These non-

traded activities will generate rents for the firms

able to perform them and also create entry

barriers or cost disadvantages for other firms. Firms perform a variety of tasks in transforming

raw materials and primary goods into final products. Although necessary, most of these activities do not distinguish a firm from its rivals. Competitive advantage must be based on those activities in which a firm has proprietary access to scarce resources (e.g. skills, patents, assets, distribution networks, etc.). The first step in

strategy formulation is to identify which activities are the actual or potential source of such rents. This is the part of the firm which must be managed most closely.

The second distinguishing characteristic is the emphasis on complex linkages and interrelation- ships. These are of several types: internal linkages within the value chain (such as relationships between sequential tasks in the flow of value

added), interrelationships between one business unit and another (often referred to as synergies in diversified firms), and vertical linkages between a business unit and its suppliers and buyers (similar to vertical integration). These linkages and interrelationships are important for creating competitive advantage as they provide opportun- ities for joint optimization and problems of coordination. These are explained and illustrated in the following paragraphs.

Internal linkages reflect the impact of one activity on another. For example, product devel- opment can reduce the costs of production by

reducing the number of parts. Between 1977 and

1984 Japanese manufacturers halved the number of parts in videocassette recorders and reduced prices from $1300 to $298.

Interrelationships between SBUs of a firm occur when a value creating activity is shared by several business units. Sharing increases throughput, reduces unit costs and can improve the pattern of capacity utilization. For example, Honda is a diversified firm operating in markets such as automobiles, lawn mowers and motor- cycles. An important strategic component in all these markets is engine technology. Its skills in engine technology have enabled Honda to attain a leadership position in many of its markets. The danger of applying a narrowly defined SBU planning approach to a company such as Honda is that no single SBU is likely to take responsibility for the maintenance of Honda's leadership in engine technology. This technology is an impor- tant interrelationship between SBUs for Honda. By focusing on interrelationships, value chain analysis is likely to signal this fact to management. Other planning approaches tend to assume away inter-business unit dependencies once the SBUs have been determined.

Lastly, vertical linkages describe the way in which a firm's value chain is related to the value chains of its suppliers and buyers. Firms producing canned beer consume enormous quantities of cans. These are too bulky to transport far or stock in large numbers. Makers of cans have built plants next to their major clients and deliver the cans by overhead conveyor thus securing considerable savings for themselves and their customers.

The third distinctive characteristic is the formu- lation of generic strategies: cost leadership, differentiation and focus. Cost leadership requires the firm to have lower costs than its rivals, differentiation to add more to buyer value than to its own costs and focus to pursue cost leadership or differentiation on a relatively narrow definition of the market. The choice of generic strategy and its successful implementation require a good knowledge of the cost structure of the firm and of its rivals.

ACCOUNTING DATA FOR VALUE CHAIN ANALYSIS

Value chain analysis is not easy to apply. The framework has extensive data requirements,

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Accounting Data for Value Chain Analysis 179

many of which relate to parts of the firm in

which data collection is likely to be minimal (e.g.

outbound logistics). In this section, some of the

key concepts in value chain planning will be

described and problems in obtaining the relevant

accounting numbers discussed. We start by

considering structural issues; that is to say the cost objectives for the accumulation of costs,

assets and revenues. Next we focus on the topic of linkages and interrelationships and examine

the extent to which accounting systems model these complex causal models of cost behavior. Then we turn to traditional budgeting mechanisms

and compare them with the value chain concept

of the cost of performing different activities. Porter's enumeration of the structural determi-

nants of these costs (Porter, 1985, chap. 3) is compared with the models of cost behavior discussed in leading accounting texts. Finally we point out some of the difficulties of performing value chain analysis in the absence of privileged access to internal data.

Structural Issues

The different dimensions in which it is necessary

to accumulate costs, assets and revenues are shown in Figure 1.

Defining the Strategic Business Unit

The first step in applying value chain analysis is to determine the boundaries of the segments of

STRATEGIC BUSINESS UNIT

l ~~~FIRM INFRASTRUCTURE _

SUPPORT HUMAN RESOURCE MANAGEMENT

ACTIVITIES TECHNOLOGY DEVELOPMENT II II

\ ~~~~PROCUREMENT

PRODUCTS INBOUND OPERATIONS OUTBOUND MARKETING SERVIC \ LOGISTICS LOGISTICS & SALES

PRIMARY ACTIVITIES

Figure 1. Dimensions for data accumulation

the business to be analysed. This requires dividing the firm into strategic business units in a manner appropriate for strategic decision making. Once the SBUs have been defined, the planner can begin to divide the business into individual activities for further study.

The justification for SBU analysis is that different kinds of businesses have different sources of competitive advantage and thus need to be managed differently (Porter, 1985: 23).

The guiding principle in applying SBU planning is to determine what subunits of the total firm can be considered autonomous for strategic decision making. Autonomy in this context means that decisions about one SBU can be made in relative isolation from decisions about other SBUs. The planner is therefore seeking a vantage point for decision making which will allow him to manage the most critical shared resources. In establishing SBUs, the planner will look inside the firm for shared costs and technologies and outside for shared markets, distribution, and customers. These two perspectives may not lead to the same definition of SBUs.

A great deal of judgement is required in interpreting the information from these two perspectives and, when they conflict, in choosing which should dominate. Value chain planning recognizes this dilemma by placing considerable emphasis on understanding the interrelationships that exist between business units because of shared resources. Porter (1985) provides numer- ous examples of how the existence of inter-

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180 M. Hergert and D. Morris

relationships can provide a competitive advantage to the multi-product firm.

During the last 15 years, there has been a growing awareness of the importance of business relatedness within corporate portfolios. Rumelt (1974) identified eight strategic profiles of firms, ranging from single business to conglomerate corporations. His findings indicate that horizon- tally integrated firms were more profitable than companies comprised of unrelated business units. Other research indicates that pure conglomerates often sell at a discount relative to the value which would be placed on its subsidiaries if they were traded as independent firms. This is consistent with the fact that conglomerates seem to be valued at consistently lower price/earnings multiples than the stock market as a whole. Using the ideas of value chain analysis, this implies that conglomer- ates are unable to exploit potential linkages to create competitive advantage. The diversity of businesses in a conglomerate makes it difficult to lower costs or enhance differentiation through coordinated action across SBU boundaries. Gen- eral Electric is a good example of a firm which is redeploying its assets in order to exploit potential linkages. Under the leadership of Jack Welch, General Electric has divested 190 subsidiaries and made over 90 acquisitions, in order to create a more complimentary set of business units. Likewise, many conglomerates (ITT, Borden, Fuqua, Scoville) are spinning off business units unrelated to their core business.

Value chain analysis provides a framework for establishing clusters of businesses (Heany and Weiss, 1983) based on an underlying set of skills. Porter (1985) provides a comprehensive discussion of the sources of synergy through SBU interrelationships as well as the managerial impediments to achieving these synergies in practice. Unfortunately, understanding such interrelationships and implementing effective strategies to exploit them is extremely complex. Organizational boundaries tend to create impedi- ments to coordination across business lines (Lawrence and Lorsch, 1967; Kilmann, 1983).

While the problem of defining SBUs is not unique to value chain analysis, it is more difficult because of the need to achieve a high degree of coordination across SBUs.

As the previous discussion suggests, it is unlikely that the actual organization structure of multi-product firms corresponds with the

definition of SBUs adopted by the strategic planner. Kilmann (1983: 348) suggests that the current organization structure is likely to be the one most out of alignment with the desired state. Dynamic environments, proactive stances to strategy and a preference for only changing structures in the last resort, all contribute to misalignments.

Consequently the basic structural unit of analysis required for value chain analysis often has no clearly delineated organizational counter- part and is therefore likely to cut across organi- zational boundaries. Since accounting systems accumulate costs around products and organi- zational units (Garrison, 1982), there is no general method for mapping accounting data built up around these dimensions onto SBUs defined by value chain analysis.

The first obstacle to using accounting data for value chain analysis therefore occurs when the firm is not organized around SBUs and consequently the accounting system does not recognize SBUs as a dimension for data accumu- lation.

Identifying Critical Activities

Having defined the boundaries of the SBU, the next step is to identify its component critical activities. A starting point for this analysis will be the generic value chain (see Porter, 1985: 37). However, it will be necessary to go well beyond the generic chain in order to apply the model.

Porter (1985: 39, 45) provides some guidance on how to do this. Critical activities are technolog- ically and strategically distinct and have one or more of the following characteristics: (1) they have different economics; (2) they have a high potential impact on differentiation; and (3) they represent a significant or growing proportion of cost.

A critical activity is therefore one which has a large impact on competitive advantage. This means that an activity becomes key if it creates a large potential for cost reduction or differen- tiation. Chester Barnard (1938) defined the most important competitive differences as 'critical factors'. The critical factors, as determined in the market place, should translate into key activities for creating value. The task facing the planner is to identify the cost and effect of changing the way an activity is performed.

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Accounting Data for Value Chain Analysis 181

There is no particular reason why the formal

grouping of responsibilities in the organization

structure should correspond to critical activities

as defined by Porter (1985). This should come

as no surprise. There is considerable diversity in

the prescriptions for organizational design (e.g. Kilmann, 1983. proposes minimizing misdirected

conversion costs) and in the structures adopted

by firms (Lawrence and Lorsch, 1972). In fact Porter specifically states that organizational

boundaries may not recognize and reflect critical

activities and advises that boundaries be redrawn

with this concept in mind (Porter, 1985: 55-61). This lack of correspondence between critical

activities and organizational boundaries is another

source of potential difficulty for the analyst. The organizational dimension of cost accumulation is

the responsibility center (Garrison, 1982: 438). The accounting system attempts to measure the

resources committed to each of these and to

evaluate the performance of the manager. This is accomplished through responsibility center budgets and control reports.

If neither theoretical models of organization

design nor the actual structures of firms is

consciously built around critical activities, existing cost accounting systems are unlikely to accumulate costs, assets and revenues for them.

Four possible differences between cost centers

and critical activities exist in theory and are

found in practice: (i) Some critical activities may not be recognized as such and their performance

is divided out among a number of functions. They therefore have no organizational counterpart (Porter, 1985; 41, 59). Examples would be management education (properly part of human resource management) and procurement (often spread across most cost centers, except for very conspicuous items). (ii) Critical activities are not contained within individual functions and

therefore spill over into related parts of the organization. (iii) A function contains more than one critical activity, but the cost centers into which the function has been subdivided do not

recognize this fact. (iv) The definitions of different functions do not distinguish between primary and support activities (Porter, 1985: 38-43).

The second obstacle to using cost accounting data for value chain analysis is that there is no obvious correspondence between critical activities as defined in the value chain and responsibility centers as defined in accounting systems.

Defining Products

The last structural dimension for the accumulation

of costs and revenues is the product. The costs

of each primary activity must be split down by product (or product group). Three difficulties are

encountered.

The first is that it may not be the physical product that creates value for buyers. An obvious

example would be IBM's initial dominance of

the personal computer market. Its products were

outclassed by many competitors in terms of

performance, quality and price. Nevertheless IBM's products dominated their market segments

because of software, service, advertising and

because IBM was going to stay around. If the physical product is not responsible for creating buyer value, or does not account for a major part of it, then the accounting system's accumulation of costs by product will be of little help.

The second is that traditional accounting

systems do not attempt to trace non-manufactur- ing costs to products. Thus manufacturing costs

are classified as product costs and non-manufac- turing as period costs (Garrison, 1982: 28-31, 62). The reason for this distinction is that the former are used for valuing inventories and

determining income and the latter are not. The value chain analyst must therefore con-

struct his own theoretical models of how resource

inputs to non-manufacturing primary activities are related to products and find ways of expressing this theoretical model in terms of data which are

available or can be obtained at an appropriate

cost. The experience of service industries, such as banks, in applying cost accounting to determine

the profitability of services, products and cus- tomers (Garrison, 1982: 30) shows that it can be done.

The third difficulty concerns the use of standard product cost data as an estimate of the value added

to the product by manufacturing operations. If the plant contains several different manufacturing processes and technologies, it will be necessary

to go back to the raw accounting data on

individual operations, times and costs to deter- mine the value added by each of the distinct activities within the plant. If the product is not

responsible for buyer value, then it will be necessary to accumulate factory costs in another

dimension altogether, for example, average con- figuration for a mainframe computer.

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182 M. Hergert and D. Morris

Reworking factory accounting data is probably

easier than developing product cost data for non-

manufacturing areas. There are several reasons.

(i) The definition of cost centers, reflecting

different technologies and operations within the

factory, are likely either to correspond to critical

activities or be simply related to them. (ii) Factories are designed to cope with predeter-

mined patterns of work flow and all operations

are rigorously defined to reduce variability to

acceptable limits, thus making it easier to measure

where resources are going. (iii) Factories are

used to collecting shop floor data for production control and cost accounting, and therefore should be amenable to the collection of additional data

needed for value chain analysis.

The third obstacle to using cost accounting

data for value chain analysis concerns identifying

the constituents of buyer value and then accumu-

lating costs, revenues and assets around these

cost objectives. If the physical product does not create buyer value, traditional cost accounting

systems are very little help. Even if the physical product is important, since cost accounting

systems distinguish between product costs and period costs, the analyst will have to build a product costing system for the latter. Moreover, factory product costs, classified by direct labor, direct material and manufacturing overhead

(Garrison, 1982: 31, 35) do not distinguish between different value creating activities in the

plant. It will be necessary to work with raw disaggregated data in order to develop the costs of the different manufacturing activities.

SUB 1

INTERRELATIONSHIP

tSUPPIER_ __B e izttz

VERTICAL LINKAGE INTERNAL LINKAGE

Figure 2. Linkages and interrelationships

Linkages and Interrelationships

The cost of performing one activity will often be

influenced by the way in which others are

performed. Other activities within the same SBU, activities of buyers and suppliers and activities

performed by sister SBUs provide the potential

for joint optimization and problems of coordi-

nation. These relationships are shown in Figure

2.

The value chain approach to linkages has a

clear predecessor in the literature on vertical integration. Harrigan (1984, 1985) provides an excellent summary of the literature and theoretical

underpinnings of vertical integration strategies,

as well as an empirical application of a new

framework for the analysis of vertical integration.

Her work builds on the traditional view of vertical

integration as a means of avoiding transaction

costs (Williamson, 1971, 1975). Within the value

chain context, a vertical integration strategy

becomes appropriate if the benefits of extending the chain of activities for a firm (avoiding the

costs of using the market, enhanced value creation, improved security of throughput, better coordination of activities) are greater than the costs (reduced strategic flexibility, added over- heads, out-of-pocket costs).

The importance and difficulty of modelling

these different types of interdependency can be illustrated with an example of an internal linkage. A quality drive in a component factory may result in a substantial reduction in costs of

the field service organization and a substantial

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Accounting Data for Value Chain Analysis 183

increase in buyer value. While it is unreasonable

to expect an accounting system to quantify the

costs and benefits of this type of decision as a

matter of routine, it is legitimate to demand that

the system makes it relatively easy to extract the

data for these ad hoc strategic decisions.

Most accounting theories and methods assume

that organization subunits are independent (Kil- mann, 1983). They therefore do not attempt to capture and model the data necessary for jointly

optimizing the performance of two or more activities.

When interdependencies between activities of the same corporation are recognized, their effects

are mediated through allocations (for services) and transfer prices (for components or products). Apart from these crude tools, the analyst will

either have to turn to model building and statistical analysis to capture the effects of interdependencies, or to use an approach such

as Kilmann's (1983) for estimating misdirected conversion costs and generating optimal organi-

zational relationships.

The fourth obstacle to using accounting data for value chain analysis is that accounting systems assume independence of subunits, rarely collect the information for coordinating and optimizing different activities (Porter, 1985: 61) and when this is not the case, use rudimentary tools for modelling interdependencies.

Determining the Value of an Activity

Having defined SBUs, activities and products, the final step is to determine the value created

for buyers by the performance of each activity. If there are no markets for intermediate products, cost has to be used as a surrogate for value. The

process of estimating the cost of each activity has two parts. First it is necessary to understand the behavior of the different cost components that make up the total cost of)each activity. From an understanding of behavior the analyst then estimates what the total cost of the' activity will be under different circumstances.

This section starts with a discussion of the concept of value creation, then examines the determinants of cost behavior and finally con- siders to what extent budgets reflect the value of an activity.

Value Creation

A fundamental notion in value chain analysis is

that a product gains value (and costs) as it passes

through the vertical stream of production within

the firm (design, production, marketing, delivery,

service). When created value exceeds costs, a

profit is generated. This notion of value creation

derives from the economics of demand. Products

are viewed as a bundle of attributes (Lancaster,

1975) which can be configured in multiple ways

to appeal to segments of consumers having

diverse demand functions. This creates the

potential for differentiating a firm's product and

charging price premiums. As a result, a given

configuration of product attributes will uniquely appeal to a set of consumers (a market segment).

The necessary condition for supernormal profits

is that not all firms will be able to offer certain

combinations of product attributes which are highly valued by consumers, or that some firms

will be disadvantaged in their ability to offer

those combinations. The assumption behind this approach is that firms are unique on the supply side of markets. This means that the cost

structures of firms within the same markets are

not homogeneous.

A firm must therefore know which of its

activities is responsible for its competitive advan-

tage. It can do this only if it knows both the

cost and the perceived value of each activity.

Unfortunately, severe problems exist in trying to make these calculations. Apart from the problems

of determining costs, it will be difficult for a firm to know the value to the consumer of intermediate

activities. Value is defined as the willingness of

consumers to pay for the product at each stage of processing. If intermediate products are traded on external markets, it is possible for the firm to observe a market price for the goods at different

stages of processing. However, intermediate

markets for the outputs of each activity may not exist. The willingness to pay for activities internal to the firm will remain unobservable, and this will contribute to the uncertainty about where a firm's competitive advantage truly lies.

Cost Behavior

Each activity that a firm performs will have an underlying cost structure and behavior. Porter

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184 M. Hergert and D. Morris

calls the determinants of activity cost 'cost drivers'

and identifies ten categories (Porter, 1985:

62-118). Analysis of these drivers is important irrespective of which generic strategy the firm

has chosen as the source of its competitive

advantage. These drivers are summarized in

Table 1.

Of the ten cost drivers described by Porter, scale economies and learning are probably the

easiest to quantify. Nonetheless, economists have

tackled this problem with mixed success. Data

on scale economies and learning are not generally collected by a firm for its own operations and

are difficult to estimate for competitors (obvious

exceptions would be the aircraft and automobile industries). However, one motive for employing the value chain approach is the light it sheds

on achieving competitive advantage through performing activities better than competitors. Thus knowledge of the firm's cost drivers and

those of its competitors is important to using the

method successfully.

Table 1. Cost drivers. The following ten cost drivers determine the cost of an activity and its evolution through time

Cost drivers Definition

1. Economies and diseconomies Impact of scale on the costs of performing an activity. of scale Increasing complexity can lead to diseconomies.

2. Learning and spillover Reduction in cost of performing an activity due to experience. Learning from the experience of others is called spillover.

3. Pattern of capacity utilization High fixed costs and high change over costs provide opportunities for joint optimization of production, logistics and marketing.

4. Linkages The cost of an activity is related to how other activities are performed within the same value chain and in the chains of suppliers and buyers.

5. Interrelationships An SBU may be able to benefit from sharing scarce resources with another SBU within the same firm.

6. Integration Vertical integration may reduce transaction costs, but at the expense of flexibility and scale. Buying goods or services that

were sourced in-house is particularly difficult.

7. Timing There are circumstances in which it pays to be the first-mover. In others it is better to be a follower.

8. Discretionary policies Decisions by the firm, not related to the other cost drivers, influence the cost of an activity e.g. product specification, technology, etc.

9. Location The skills of the labor force, access to transportation, etc., all affect costs.

10. Institutional Government incentives, union power, regulations of all sorts, have a major impact on costs.

Modern cost and managerial accounting texts

discuss the learning curve and methods of

estimating it (e.g. Dopuch et al., 1974). They

also explain different ways of modelling cost

behavior (e.g. Kaplan, 1982; Shillinglaw, 1982). Typically these consist of time study, account

classification, high-low, multiple regression, and

visual estimation. Apart from time study, they

are essentially backward looking. They attempt to model past behavior. This is an important first step. However, value chain analysis suggests that

besides understanding cost structure and behavior in the past, management should use cost drivers

as a competitive weapon. By controlling and reconfiguring the value chain, successful firms

gain sustainable competitive advantage for the

future (Porter, 1985: 100-118). The distinction between modelling the past and mastering the

future can be illustrated by recent experiences of the American automobile industry. In response to the threat from Japanese automobiles, they have reconfigured their value chains and secured

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Accounting Data for Value Chain Analysis 185

substantial reductions in their break-even vol-

umes. This reconfiguration has changed the economics of their businesses and consequently made obsolete any statistical models they had developed.

As far as the ten cost drivers are concerned,

none can be easily estimated from routinely

available cost accounting data. Moreover, their

estimation is hindered by changes in organization structure, chart of accounts and accounting conventions.

Budgets and Value

The cost accounting equivalent to measuring the

value of an activity is the responsibility center

budget. It is unlikely that responsibility center budgets correctly measure the value (cost) of performing the related activities. There are two

main reasons: the first concerns the categories of expense charged to the budget; the second concerns the items of expense included in each category.

There has been considerable debate in the

literature over cost allocations (see for example Bodnar and Lusk, 1977; Zimmerman, 1979; Swieringa and Weick, 1981). Problems of not allocating costs include: excessive consumption by users, measurement of the efficiency of service departments, the choice between providing the service in-house or purchasing it, evaluating the

trade-off between quality and price (Kaplan, 1982: 353-356). Some of these problems are concerned with the measurement of expenses, others with providing management control data and motivating appropriate behavior. They may not be compatible (Bodnar and Lusk, 1977: 857).

Cost centers can be charged with three types of cost: those directly consumed by the center (e.g. salaries), those supplied by a support group (e.g. office space, computing facilities) and those related to being part of a wider organization (e.g. head office, central personnel).

In the experience of the authors, there is little uniformity of practice among firms as regards the treatment of indirect support and indirect general overhead. Determining the cost of an activity will therefore require substantial rework- ing of company figures.

The first set of adjustments makes sure that the responsibility center is charged for the

resources it consumes. These should be long run

average estimates, not short run marginal ones.

It will be necessary to exclude charges that do

not really belong, but have been included because

the proper critical activity has not been defined

for the purposes of cost accumulation (human resource management, for example). It will also

be necessary to replace the marginal cost of consuming a service (e.g. telex), by an estimate

of the long run average cost of providing it. There is also the 'charge in/charge out' problem. Work is frequently performed by one responsibility center for another. While a record may be kept

of the value of this work for the responsibility center as a whole, it is unusual to identify the precise activities within the centers rendering and receiving the service. Consequently the spending

report for the responsibility center can be correct, and that of its component activities wrong.

The general rule is that the entire costs of an

SBU should be charged to its primary and support activities if a shutdown or major expansion is being contemplated. If the organization chart

defines a responsibility center which is not important to the creation of sustainable competi- tive advantage, its costs will have to be distributed among the critical activities.

Having made sure that the budgets are charged with the right categories of expense, it is also necessary to examine the contents of each

category. The categories are defined in the chart of accounts. Each is an accumulation of a number

of elements. While these groups may be legitimate and useful for the purposes of cost accounting, they may lack the necessary degree of homogen- eity when viewed from the perspective of value chain analysis. The analyst should therefore check that the definitions contained in the chart of

accounts are appropriate. This is not a major obstacle, but it may cause

a great deal of tedious work if the chart of

accounts has not been defined correctly for value chain analysis.

The fifth obstacle to using cost accounting data

for value chain analysis is that the cost center budgets are likely to be a poor reflection of the economics of performing an activity. This is compounded by the inability of the cost accounts to quantify the cost drivers, and the likelihood that the accounting conventions used for internal

purposes have been mandated by external report- ing authorities (Kaplan, 1984: 409).

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186 M. Hergert and D. Morris

To remedy this situation, the choice of an

appropriate internal accounting system should depend not only on the choice of corporate strategy (Kaplan, 1986), but also on the choice of strategic planning framework.

Understanding Competitive Advantage

One of the motives for value chain analysis is to discover the firm's relative competitive position. This involves comparing the value chain of a firm

with those of its competitors. We have described some of the difficulties that

will be encountered in trying to develop the value chain of a firm, given access to internal data. Since a great deal of data will be inappropriate or missing, extensive interviews will be necessary both to interpret what is available and to fill the gaps. Developing value chains for competitors from external data and without the possibility of interviews is going to be even more difficult.

Table 2. Value chain concepts and their management accounting counterparts

Value chain Management accounting

1. Structure Strategic business unit If the firm is not organized into SBUs, then the accounting

system will not accumulate data in this dimension.

Activities If the organization structure of the firm does not correspond to critical activities, accounting data will not be accumulated for activities.

Products A product costing system will have to be built for period costs. Summary product cost data for the plants must be abandoned in favor of raw disaggregated data. If the physical product does not create buyer value, costing systems will have to be built for plants and for non-manufacturing areas.

2. Relationships Linkages Accounting systems assume independence of subunits. Transfers

within of goods and services are modelled by transfer prices and vertical allocations. Neither are capable of serving as an appropriate

Interrelationships mechanism for joint optimization of two or more activities within the same SBU, between SBUs of the same firm, or between an SBU and its suppliers and buyers.

3. Budgets and value Cost drivers Accounting systems do not collect data on cost drivers, because

they are not part of either product or period costs. Deriving estimates of them from intertemporal studies is complicated by changes in structure, responsibilities and accounting systems.

Budgets Responsibility center budgets are unlikely to correspond to the cost of performing an activity. The categories of expense and the chart of accounts are likely to be wrong.

A certain amount of useful information about

competitors can be gleaned from trade journals, customers, suppliers and inferences drawn from the firm's own value chain. However, difficulties in making judgments about competitors' value chains should not be underestimated.

While making these competitive comparisons

will not be easy, value chain analysis is a considerable help. The concepts guide the search for data and provide a model for linking cause and effect.

SUMMARY AND CONCLUSIONS

The key concepts in value chain analysis and their management accounting counterparts are

shown in Table 2. Difficulties in using accounting data for value chain analysis arise from a lack of equivalence between them.

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Accounting Data for Value Chain Analysis 187

The degree to which management accounting

concepts correspond to the requirements of value chain analysis may appear disappointing. In this regard, Porter (1985: 63) comments:

While accounting systems do contain useful data for cost analysis, they often get in the way of strategic cost analysis.

Despite problems in obtaining accounting data for value chain analysis, the approach does provide insights into creating competitive advan- tage that are unlikely to emerge from other frameworks. Moreover, once the causes of the problems have been identified, much can be done to make strategic cost analysis easier. This section discusses the benefits of value chain analysis, suggests ways of improving the availability of accounting data and offers some general con- clusions.

Some of the benefits of value chain analysis will arise even if the firm is unable to estimate the precise value of the variables analyzed in the model. Even if the boundaries of SBUs, linkages between activities, cost drivers and value creation cannot be measured exactly, there may be considerable benefit to the firm in simply asking the right questions. Thus, it is the process of performing value chain analysis and not the exact numerical output which provides useful insights.

One of the strengths of value chain analysis is that it forces managers to think about which activities create profits, to choose a generic strategy for each product and to ask of each item of expenditure 'how does this add value to buyers?'.

The value chain approach is also attractive as

a planning model because of its intuitive appeal to operating managers. In our experience, they are keen to know whether the tasks they perform contribute to building sustainable competitive advantage.

Another benefit of the value chain approach is the emphasis it places on managing resources which cut across SBUs. These broadly defined resources are key technologies or skills which

affect the ability of the firm to compete in many different markets.

Against these benefits must be weighed the difficulties in using traditional cost and manage- ment accounting data for value chain analysis. Difficulties arise because of the dimensions

chosen for accumulating accounting data, because

of the inability of accounting systems to model

complex cost behavior and because of the failure

of responsibility center budgets either to identify

the factors driving costs or to measure all the

resources required in the long run for the

performance of particular activities. With the

exception of building a product costing system for period costs, there is little that can be done

to resolve either the structural difficulties of data

accumulation or the way cost behavior is reflected

in accounting systems. These obstacles to using traditional accounting data for value chain analysis

are inherent.

However, it is possible to make sure that the chart of accounts and cost center budgets are

compatible with the needs of value chain analysis.

At the very least this will involve giving more

visibility to those categories of expense which

require different treatment.

While performing value chain analysis obviously becomes easier with practice, the inherent prob-

lems of using traditional accounting data remain.

Firms intending to reappraise their strategic

plans on a regular basis, may wish to create

an accounting system for this purpose. While

transaction data would be captured once, it would

subsequently be used by three separate systems:

legal entity accounting, management accounting

and strategic cost analysis. There would be

different systems for different purposes.

This solution would serve two purposes: it would prevent management accounting data from being contaminated by external reporting

requirements; and it would also make value chain

analysis possible without recruiting an army of

analysts to rework the management accounting data.

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