Examples of Value Chain Analysis | Cost Accounting

The following points highlight the four main examples of value chain analysis. The examples are: 1. Value Chain, Tomato Ketchup Industry 2. Value Chain, 30 GB Version of Apple’s Fifth-Generation IPod 3. Value Chain, Pharmaceutical Industry 4. Value Chain, Book Publishing Industry.

Example # 1. Value Chain, Tomato Ketchup Industry:

Let us take a simple example of tomato ketchup industry. The value chain begins with the production of tomatoes and ends with delivery of the ketchup to final customers.

A firm has a choice to be engaged in one of the activities or to integrate all or a few activities in the value chain within the firm. Integration of all or a few activities within the firm is known as vertical integration.

It is to the benefit of all the players in the value chain if together they can increase the total value created in the system. Understanding the value chain of the industry and the relationship between each activity is important to achieve the objective of increas­ing the value created by the system.

A change in the process of performing an activity might affect one or more activities in the value chain. E.g., when bulk chocolate began to be delivered in liquid form in tank cars instead ten pound moulded bars, an industrial chocolate firm (i.e. the supplier) eliminated the cost of moulding bars and packing them and a confectionary producer saved the cost of unpacking and melting.

Each individual player in the value chain aims to increase its share in the total value created in the system. How the value is shared depends on the relative bargaining power of the players. Relative bargaining powers of different players are shaped by forces that are beyond the control of any individual player. E.g., State regulation on contract farming determines the bargaining power of farmers.

Relative bargaining powers of players in the value chain change over time. E.g., if one of the players gains market power, its bargaining power increases while those of others reduce. E.g., Microsoft has a much stronger bar­gaining power than other players in the value chain. In fact, firms always leverage on its market power to increase its share in value created in the value chain.

However, the rela­tionship between all the players is sustainable only if all the players earn return on invest­ment at least equal to its cost of capital. E.g., unless the farmers earn a return at least equal to what they can earn by cultivating the next best crop, they will not grow tomatoes.

In this example, value in the system can be increased by increasing the productivity of tomatoes on two counts- first, it will reduce the cost of delivering value to customers because of reduction in the cost of raw material per unit, and second, it will earn a pre­mium from the end users by offering high-quality product consistently.

Value may also be increased by improving the packaging, which will increase the shelf-life and make the handling convenient for the end user. The name of the brand vendor, say Malaika Limited (ML) appears on the product. ML holds the intellectual property right of the formula, and is responsible for system integration, cost management, and marketing of the product. It may not get engaged in cultivation of tomatoes.

However, ML may provide technical support to farmers to increase the productivity and may guarantee a minimum yearly payment to them so that they do not shift to the production of other crops when in any particular year the production of tomatoes is poor due to climatic reasons.

If the manufac­turing process is simple and the economy of scale is achieved at a low scale of operation, ML may not engage in manufacturing activity also, because competition in manufactur­ing is likely to be high and consequently margin and its share in the value created in the system would be lower as compared to the same in other activities.

Packaging is a specialized activity and it takes time to build competencies. Moreover, innovation is the key for success in the packaging industry. Therefore, ML may decide to outsource packaging to a large firm (say Tetra Pack) in the packaging industry. The share of the packaging firm in the value created by the system depends on its positioning in the packaging industry and its contribution to value creation through innovation.

ML may directly supply to indus­trial customers like hotels, large restaurants, clubs, and factory canteens. ML’s ketchup may reach retail customers through ‘mom-pop’ stores via distributors and through super­markets such as Food Bazar and Spencer. The distributors’ share in the value depends on their relative bargaining power vis-a-vis ML.

Similarly, the share of supermarkets depends on their relative bargaining power vis-a-vis ML. The share of supermarkets is likely to be higher than that of distributors because the bargaining power of these stores is higher than that of distributors of FMCG products.

Value chains for most industries are much more complex than that of our simple tomato ketchup business. For some industries, it may not be linear like an assembly line. Mapping value chain of the industry benefits every firm in the industry.

Each linkage in the value chain has a unique set of cost drivers and unique com­petitive advantage. E.g., the set of cost drivers in farming activities is unique and differ­ent from manufacturing, packaging, and retailing activities. The competition depends on various factors such as entry and exit barriers, bargaining power of suppliers and customers, and rivalry among firms engaged in that activity.

The intensity of competi­tion might also be different for different activities. E.g., the competition in manufac­turing might be higher than the competition in the packaging activity. The choice of a firm as to the portfolio of activities in the value chain depends on the attractiveness of the activity and core competencies. It also depends on the nature of the industry. E.g., if the industry offers economy of scope, the firms in the industry are expected to be vertically integrated.

Over a period, the value chain in an industry may get reconfigured or the value may migrate from one activity to another. E.g., with the introduction of large-scale retail­ing in farm produce, the value chain has been reconfigured with the elimination of the middleman.

Similarly, in the FMCG industry, with the advent of supermarkets, a part of the value has migrated from the brand vendor to retail stores. Strategy formulation requires understanding of the current distribution of value and visualization of possible reconfiguration of the value chain or migration of value from one activity to another in future.

Example # 2. Value Chain, 30 GB Version of Apple’s Fifth-Generation IPod:

In electronic goods industry, companies that manufactured most products in-house, such as IBM and HP, as well as start-up companies that never had manufacturing capabilities have outsourced production and even product development to global network of contract manufacturers (CM) and original design manufacturers (ODM). Even vertically integrated Japanese and Korean firms rely on outside suppliers for key parts, equipment, and some final assembly.

The lead firm is the firm whose brand appears on the product and who bears the primary responsibility for conceiving, coordinating, and marketing new product. The lead firm innovates new products and transforms others’ innovations into products use­ful to and usable by customers. It holds the intellectual property right.

A few firms supply high cost inputs like visual display, hard drive, and key integrated circuits. Firms provid­ing these inputs have proprietary knowledge, have capabilities to innovate rapidly, and have their own value chain. Firms providing low-cost inputs work with thin margin due to absence of any notable innovation and because their products face competition from close substitutes.

In the case of iPod, Apple is the lead firm. It has outsourced the entire manufacturing of the device. The total cost of the device comes to around US$143.12. Toshiba supplies the hard disk at US$73, which is 51% of the total cost. It captures value of US$19.45. Toshiba Matsushita supplies ‘display module’ at US$20.39, which is 14% of the total cost. It captures value of US$5.85. Broadcom supplies video/multimedia processor at US$8.36, which is around 6% of the total cost. It captures value of US$4.39.

Portal Player supplies ‘Portal Player CPU’ at US$4.94, which is 3% of the total cost. It captures value of US$2.31. These four firms together supply components which constitute almost 75% of the total cost, and they together capture value of US$32 approximately. The retail price of the device is US$299. The wholesale discount is 25%; the distributor retains 10%, and 15% goes to retailers. The wholesale price, which goes to Apple, is US$224. Thus, apple cap­tures value of US$80.

The calculations above explain why Apple outsources entire manufacturing of the device. The share of value in innovation and brand management activities is significantly higher than the value captured by any individual activity. Apple has conceived the prod­uct and protects it from competition through innovation and customer service, and there­fore, gets more than 50% of the total value created in the value chain.

Example # 3. Value Chain, Pharmaceutical Industry:

The Drug Development Plan:

Pills and serums are the end products of a long, complex discovery process. Discovery process may take 15 years. It starts with the identification of genes involved in a particular disease. Next stage is to identify and validate proteins—or targets—that different genes produce in different parts of the body. These are those targets that cause malfunctions in cells that become diseased.

In the third stage, research identifies small molecules that will be attached to the target protein and prevent it from causing the disease. After identifica­tion of these leads, the drug enters the testing phase. The leads are tested first on animals and then on humans.

Finally, the firm has to find ways of economically manufacturing the drug on a large scale and marketing it successfully to doctors and patients. (In some instances the problem may be the absence of proteins—such as a growth hormone, e.g. — in which case the challenge is to find ways to synthesis and deliver the missing proteins. But the ‘large molecule’ treatment account for only 10% of the industry.)

Inflection Points and Migration of Value:

The modern industry came into being in the early nineteenth century, when scientists realized that the herbs and potions people took to treat illness worked because they contained specific active ingredients. Several German companies began to systematically iso­late those ingredients, test them for efficacy, and sell them as pills. At that point, firms had to pursue vertical integration.

Second inflection point came during the 1960s. The genetic revolution began with Crick and Watson’s discoveries of DNA. In that era, basic research was most valuable.

The third inflection point came when scientists mapped the genes and the information was publicly available. Now the industry is awash in basic information about genes. Value has started to migrate downstream towards more mechanical task of identifying, testing, and manufacturing molecules.

In the present state of research and marketing, most leading pharmaceutical compa­nies prefer to be present in all activities in the value chain. The number of specialist firms engaged only in research is in decline. However, on cost considerations, most multina­tional pharmaceutical companies are coming out of manufacturing activity.

They offer contract for manufacturing to pharmaceutical companies located in emerging economies. Multinational companies join hands with local pharmaceutical companies in research and marketing to expand their business in emerging economies.

Many Indian firms like Bicon, Cadila Healthcare, Ipca Labs, Kopran, Lupin Laborato­ries, Nicholas Piramal, Orchid Chemicals & Pharmaceuticals, Sun Pharma, and Wockhardt manufacture drugs on contract from multinational pharmaceutical companies.

Similarly, India is becoming a hub for clinical research. The choice of location by multinational companies for contract manufacturing and contract research is based on skill sets available in different locations, cost drivers at different locations, and the regulatory environment.

The choice of portfolio of activities is driven by profit pools at different linkages in the value chain and the relationships between different activities and not so much on core competencies. The aim is to create higher value in the system by lowering the cost and to capture higher share in the total value created in the system.

Example # 4. Value Chain, Book Publishing Industry:

It is rarely that a publishing company is engaged in the first four activities which end with manufacturing of paper. Only a few publishers have their own printing press. Most publishers outsource the printing activity. Publisher is the lead player in the book publishing business. Its brand is printed on the book.

The publisher is responsible for acquiring manuscripts, getting them evaluated in terms of relevance and quality, developing accepted manuscripts, and then coordinating other activities to produce books. It is responsible for providing services to customers. Publishers usually do not outsource the activities relating to development of the manuscript because significant value is added to books at the development stage.

The total cost of publishing a book comes to 44% of the printed price. If the printed price is CU 100, the publisher gets CU 60 after allowing 40% discount to distributors. Total cost to the publisher (including expenses for activities undertaken internally) comes to CU 33 allocated as follows- Print­ing charges CU 10; royalty to the author CU 8; and expenses towards acquisition, review, and developing the manuscript and sales promotion and marketing CU 15. The publisher captures value of CU 27.

The printer captures CU 3 after payment of paper cost of CU 3 and meeting printing and binding cost of CU 4. The distributor retains 5% of the commission received from the publisher. It captures value of CU 1 after meeting expenses of CU 4. The retailer captures value of CU 17 after meeting expenses (including labour cost) of CU 18. Thus, the value created in the chain is CU 56 in a book priced CU 100.

The distribution of value explains why publishers prefer to focus on publishing only and not to take up other activities in the value chain. On the other hand, printers, who are specialists in printing books, want to move up to publishing activities. However, they face the entry barrier because established authors prefer to get their work pub­lished by respected publishers only. Moreover, getting space in the distribution channel is also difficult.