BUSINESS

Why do some companies’ profit margins exceed their competitors? How does one company

garner a competitive advantage against its peers? The answers to these questions may line

in value chain analysis. Value chain analysis is the process of looking at the activities that

go into changing the inputs for a product or service into an output that is valued by the

customer.

Porter Analysis

In 1985, Michael Porter, a Harvard Business School professor, introduced a basic value

chain model in his book Competitive Advantage. He identified several key steps comon

among all value chain analyses and determined that there are primary and supporting

activities that when performed at the most optimal levels will create value for their

customers such that the value offered to the customer exceeds the cost of creating that

value resulting in higher profit. Porter’s framework groups activities into primary and support

categories

The primary activities focus on taking the inputs, converting them into outputs and delivering

the output to the customer. The support activities play an auxiliary role to the primary

activities. When a company is efficient in combining these activities to deliver a superior

product or service, then the customer is willing to pay more for the product than the cost to

make and deliver the product which results in a higher profit margin.

Let’s work through an example of an asset management firm. The goal of the client is to

achieve the highest possible return on investment within the guidelines and restrictions set

forth by the client. The firm’s primary activities include:

 Investment team (portfolio managers, analysts)- making the investment decisions,

 Operations and Traders- ensuring the investments are in line with the guidelines set

forth by the client and the trades are at the best execution price,

 Marketing and Sales- procuring the clients, and

 Service (Client Relationship Management-) providing all the touch points to the

client.

Support activities include:

 Technology- designing a trading and client module that is efficient and effectively

allows the team to provide the highest level of service and make the best investment

decisions,

 Human Resources- finds and retains the highest level of talent at the firm,

 Infrastructure- includes the lawyers and risk managers whose oversight is crucial to

ensuring the client’s guidelines are followed, the investment risk is controlled and the

firm is operating within the regulations established by the SEC.

What Does it All Mean?

When a firm takes into account its value chain it needs to consider its value proposition, or

what sets it apart from its competitors. Value chain analysis is designed to improve profits

by creating a product or service that is so superior that customers are willing to pay more

than the cost to create it. But improving a value chain for the sake of improvement should

not be the end goal. Rather, a company should decide why it wants to improve its value

chain in the context of its competitive advantage- how would the company like to

differentiate itself amongst its peers. Two common competitive advantage strategies include

low cost provider or specialization/differentiation of product or service.

 Low Cost Provider-value chain analysis focuses on costs and how a company can

reduce those costs.

 Specialization-value chain analysis focuses on the activities that create a unique

product or differentiation in service.

Let’s go back to our asset management example. After the value chain is identified, then the

asset manager should determine its competitive advantage and pursue activities that go

towards reaching those goals. In this case, the asset manager wants to pursue a strategy of

differentiation by delivering a product that has steady, top quartile returns over three years.

Based on the drivers of uniqueness Porter identified, the firm needs to focus on its policies

and decisions and learning to differentiate itself in terms of performance. By focusing on

these drivers, the two primary activities of Investment Team and Operations and Traders

along with all the identified support activities can manage a product that achieves its

differentiated competitive advantage.

The Bottom Line

Value chain analysis is an extremely useful management tool which identifies the activities

that go into creating a superior product or service that is highly valued by customers. The

outcome of creating this highly valued product is that customers are willing to pay a

premium, which exceeds its costs thereby delivering higher profit. The usefulness of this

model created by Michael Porter is mostly seen in its ability to breakdown work product into

various activity groups to strategically focus the management on what are truly useful

activities and what creates value. It also concentrates a company to determine a vision-a

competitive advantage strategy- which will drive future products and services. Supporting

activities are further validated in the process creating an understanding that these

sometimes overlooked activities are integral to the value chain and value proposition for a

company.