Value Chain Analysis for Assessing Competitive Advantage

Statements on Management Accounting

PRACTICE OF MANAGEMENT ACCOUNTING

TITLE

CREDITS

This statement was approved for issuance as a Special thanks are due to Randoif Holst, SMAC Statement on Management Accounting by the Manager, Management Accounting Guidelines, for his Management Accounting Committee (MAC) of the continuing project supervision and to the members of Institute of Management Accountants (IMA). IMA appre- the focus group (including MAC members Dennis Daly ciates the support of The Society of Management and Thomas Huff) for contributing to the improvement Accountants of Canada (SMAC) in helping create this of the final document. SMA and extends appreciation to Joseph G. San Miguel, of the Naval Postgraduate School, who drafted the manuscript.

Published by Copyright © 1996 Institute of Management Accountants Institute of Management Accountants 10 Paragon Drive All rights reserved Montvale, NJ 07645-1760 www.imanet.org Statements on Management Accounting

PRACTICE OF MANAGEMENT ACCOUNTING

Value Chain Analysis for Assessing Competitive Advantage

TABLE OF CONTENTS

I. Rationale ...... 1 Exhibits II. Scope ...... 1 Exhibit 1: The Value Chain ...... 3 III. The Value Chain Defined ...... 1 Exhibit 2: Competitive Advantage Through IV. Competitive Advantage and Low Cost and/or Differentiation . . .4 Customer Value ...... 2 Exhibit 3: Process Cost Drivers ...... 8 V. The Role of the Management Exhibit 4: Competitor Cost Analysis ...... 10 Accountant ...... 4 Exhibit 5: Value Chain for Crown, Cork VI. The Value Chain Approach for and Seal Company ...... 12 Assessing Competitive Advantage ...... 5 Exhibit 6: Vertical Linkages in the Production Internal Cost Analysis ...... 5 of Plastic Food Containers ...... 13 Internal Differentiation Analysis ...... 10 Exhibit 7: Value Chain Differences: The Vertical Linkage Analysis ...... 13 Telecommunications Industry . . . .16 VII. Strategic Frameworks for Exhibit 8: How Tetra-Pak Reconfigured Value Chain Analysis ...... 17 the Value Chain ...... 21 Industry Structure Analysis ...... 18 Exhibit 9: How IKEA Reconfigured the Core Competencies Analysis ...... 19 Furniture Industry ...... 22 Segmentation Analysis ...... 22 Exhibit 10: Approaches to Defining Segmentation Variables ...... 24 VIII. Limitations of Value Chain Analysis . . . .26 Exhibit 11: Segmenting the British IX. Organizational and Managerial Frozen Food Industry ...... 25 Accounting Challenges ...... 27 Exhibit A-1: Value Chain vs. Conventional X. Conclusion ...... 28 Management Accounting ...... 30 Appendix – Value Chain Analysis vs. Conventional Management Accounting Bibliography PRACTICE OF MANAGEMENT ACCOUNTING

I. RATIONALE G appreciate the organizational and managerial Competitive advantage for a company means not accounting challenges. just matching or surpassing what competitors can do, but discovering what customers want and III. THE VALUE CHAIN DEFINED then profitably satisfying, and even exceeding, The idea of a value chain was first suggested by their expectations. As barriers to interregional Michael Porter (1985) to depict how customer and international trade have diminished and as value accumulates along a chain of activities access to goods and services has grown, that lead to an end product or service. customers can locate and acquire the best of what they want, at an acceptable price, wherever Porter describes the value chain as the internal it is in the world. Under growing competition and, processes or activities a company performs “to hence, rising customer expectations, a company’s design, produce, market, deliver and support its penalty for complacency becomes even greater. product.” He further states that “a firm’s value chain and the way it performs individual activities A strategic tool to measure the importance of are a reflection of its history, its strategy, its the customer’s perceived value is value chain approach to implementing its strategy, and the analysis. By enabling companies to determine underlying economics of the activities themselves.” the strategic advantages and disadvantages of their activities and value-creating processes in Porter describes two major categories of busi- the marketplace, value chain analysis becomes ness activities: primary activities and support essential for assessing competitive advantage. activities. Primary activities are directly involved in transforming inputs into outputs and in delivery II. SCOPE and after-sales support. These are generally also This guideline is addressed to managers, and the line activities of the organization. They more specifically to management accountants, include: who may lead efforts to implement value chain analysis in their organizations. G inbound logistics—material handling and warehousing; The concepts, tools and techniques presented G operations—transforming inputs into the final apply to all organizations that produce and sell a product; product or provide a service. G outbound logistics—order processing and distribution; This guideline will help readers to: G marketing and sales—communication, pricing and channel management; and G link value chain analysis to organizational G service—installation, repair and parts. goals, strategies and objectives; G broaden management awareness about value chain analysis; G understand the value chain approach for assessing competitive advantage; G comprehend useful strategic frameworks for value chain analysis; and

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Support activities support primary activities and IV.COMPETITIVE ADVANTAGE other support activities. They are handled by the AND CUSTOMER VALUE organization’s staff functions and include: In order to survive and prosper in an industry, firms must meet two criteria: they must supply G procurement—purchasing of raw materials, what customers want to buy, and they must supplies and other consumable items as well survive competition. A firm’s overall competitive as assets; advantage derives from the difference between G technology developmen—know-how, procedures the value it offers to customers and its cost of and technological inputs needed in every value creating that customer value. chain activity; G human resource management—selection, Competitive advantage in regard to products and promotion and placement; appraisal; rewards; services takes two possible forms. The first is an management development; and labor/employee offering or differentiation advantage. If customers relations; and perceive a product or service as superior, they G firm infrastructure—general management, become more willing to pay a premium price planning, finance, accounting, legal, government relative to the price they will pay for competing affairs and quality management. offerings. The second is a relative low-cost advantage, which customers gain when a John Shank and V. Govindarajan (1993) describe company’s total costs undercut those of its the value chain in broader terms than does average competitor. Porter. They state that “the value chain for any firm is the value-creating activities all the way from basic raw material sources from component Differentiation Advantage suppliers through to the ultimate end-use product A differentiation advantage occurs when customers delivered into the final consumers hands.” This perceive that a business unit’s product offering description views the firm as part of an overall (defined to include all attributes relevant to the chain of value-creating processes. buying decision) is of higher quality, incurs fewer risks and/or outperforms competing product According to Shank and Govindarajan, the industry offerings. For example, differentiation may include value chain starts with the value-creating a firm’s ability to deliver goods and services in a processes of suppliers, who provide the basic timely manner, to produce better quality, to offer raw materials and components. It continues with the customer a wider range of goods and services, the value-creating processes of different classes and other factors that provide unique customer of buyers or end-use consumers, and culminates value. in the disposal and recycling of materials. Once a company has successfully differentiated The industry value chain and the value chain its offering, management may exploit the advan- activities within the firm are compared in Exhibit 1. tage in one of two ways: increase price until it just offsets the improvement in customer benefits, thus maintaining current market share; or price below the “full premium” level in order to build market share.

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EXHIBIT 1: THE VALUE CHAIN EXHIBIT 1. THE VALUE CHAIN

Industry Value Chain Activities Value Chain within the Firm

Primary Support Activities Activities

R&D Supplier Value Chain Procurement

n Design

e Chai Firm Z XY Value Chain Technology

e Valu Development th Production ughout Distribution Human Thro Value Chain Resource ins Management arg

it M Marketing rof Buyer for P Value Chain Firm ys Infrastructure r Pa Distribution

onsume Disposal/ Recycle se C Value Chain End-U Service

Low-Cost Advantage Many sources of cost advantage exist: access A firm enjoys a relative cost advantage if its total to low-cost raw materials; innovative process costs are lower than the market average. ThisSource:technolog y; low-cost access to distribution relative cost advantage enables a business to channels or customers: and superior operating do one of two things: price its product or service management. A company might also gain a lower than its competitors in order to gain market relative cost advantage by exploiting economies share and still maintain current profitability; of scale in some markets. or match the price of competing products or services and increase its profitability. The relationship between low-cost advantage and differentiation advantage is illustrated in Exhibit 2.

3 PRACTICE OF MANAGEMENT ACCOUNTING EXHIBIT 2: COMPETITIVE ADVANTAGE THROUGH LOW COST AND/OR DIFFERENTIATION EXHIBIT 2. COMPETITIVE ADVANTAGE THROUGH LOW COST AND/OR DIFFERENTIATION

Superior Differentiation Differentiation Advantage with Cost Advantage Relative Differentiation Position

Stuck–in–the–Middle Low-Cost Advantage

Inferior

Inferior Superior

Source: Shank and Govindarajan, 1993. Relative Cost Position

Superior relative cost position offers equivalent distribution channel; profit variance analysis; customer value for a lower price. Superior relative and financial analysis. differentiation position offers Source:better Sh customerank, and Govindarajan, 1993. value for an equivalent price. Today, management accountants must also bring skills in activity-based costing, benchmarking, Organizations that fail to gain competitive re-engineering, target costing, life-cycle costing, advantage through low cost or superior differen- economic value analysis, total quality manage- tiation, or both, are “stuck-in-the-middle.” For ment and value chain analysis. The Appendix instance, several American bicycle makers, contrasts traditional management accounting including Schwinn, Huffy, Murray and Columbia, with the requirements of value chain analysis. found themselves in this position during the 1980s. These companies lacked a cost advantage Value chain analysis is a team effort. and failed to foresee the emerging mountain Management accountants need to collaborate bike market. By contrast, Cannondale captured with engineering, production, marketing, distribu- market share after introducing its large-diameter tion and service professionals to focus on the frame bicycle. strengths, weaknesses, opportunities and threats identified in the value chain analysis results. V. THE ROLE OF THE MANAGEMENT ACCOUNTANT By championing the use of value chain analysis, The management accountant is traditionally con- the management accountant enhances the sidered the resident expert on cost analysis; firm’s value and demonstrates the value of the cost estimation; cost behavior; standard cost- finance staff to the firm’s growth and survival. ing; profitability analysis by product, customer or

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VI.THE VALUE CHAIN The value chain approach for assessing com- APPROACH FOR ASSESSING petitive advantage is an integral part of the COMPETITIVE ADVANTAGE strategic planning process. Like strategic Most corporations define their mission as one of planning, value chain analysis is a continuous creating products or services. For these organi- process of gathering, evaluating and com– zations, the products or services generated are municating information for business decision- more important than any single step within their making. By stimulating strategic thinking, value chain. In contrast, other companies are the analysis helps managers envision the acutely aware of the strategic importance of company’s future and implement decisions to individual activities within their value chain. They gain competitive advantage. thrive by concentrating on the particular activities that allow them to capture maximum value for their customers and themselves. Internal Cost Analysis Organizations use the value chain approach to These firms use the value chain approach to bet- identify sources of profitability and to understand ter understand which segments, distribution the cost of their internal processes or activities. channels, price points, product differentiation, The principal steps of internal cost analysis are: selling propositions and value chain configura- tions will yield them the greatest competitive G identify the firm’s value-creating processes; advantage. G determine the portion of the total cost of the product or service attributable to each value- The way that the value chain approach helps creating process; organizations assess competitive advantage is G identify the cost drivers for each process; through the following types of analysis: G identify the links between processes; and G evaluate the opportunities for achieving G internal cost analysis—to determine the relative cost advantage. sources of profitability and the relative cost positions of internal value-creating processes; Identify the firm’s value-creating processes. G internal differentiation analysis—to understand To identify its value-creating processes, a firm the sources of differentiation (including the cost) must de-emphasize its functional structure. within internal value-creating processes; and Most large businesses still organize themselves G vertical linkage analysis—to understand the as cost, revenue, profit and investment centres. relationships and associated costs among These and other organizational sub-units, such external suppliers and customers in order to as departments, functions, divisions or separate maximize the value delivered to customers and companies, that are frequently used for control to minimize cost. purposes are not very useful for identifying value- creating processes. Adopting a process perspec- These types of analysis are not mutually exclusive. tive requires a horizontal view of the organization, Rather, firms begin by focusing on their internal beginning with product inputs and ending with operations and gradually widen their focus to outputs and customers. consider their competitive position within their industry.

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Processes are structured and measured sets of United Airlines has failed to match American’s activities designed to produce a specified output installed base of terminals in travel agencies. for a particular customer or market. Emphasizing process means focusing not on what work is done Determine the portion of the total cost of but on how work is done within the organization. the product or service attributable to each value-creating process. While an organization’s hierarchical structure The next step of internal cost analysis is to trace typically lays out responsibilities and reporting or assign costs and assets to each value-creating relationships, its process structure shows how process identified. Although firms maintain internal the organization delivers customer value. While reports and cost accounting information, this it is not possible to measure or improve hierar- information may not align with their processes. chical structure in any absolute sense, processes Companies might have to reclassify their data or lend themselves to such measures as cost, conduct cost studies to assign costs and assets time, output quality and customer satisfaction. to each process. Rather than conduct a detailed cost study, an organization might use rough esti- Because processes normally cut across func- mates to assign costs to their value-creating tional areas, defining process boundaries is not processes. always a straightforward task. People associated with a particular business process may view it in A full-cost approach provides the best estimate different ways. For example, the new product of life-cycle costs for evaluating the strategic development process could start with marketing cost advantage of a firm’s value-creating surveys or with delivery of product requirements process. Without adopting this approach, a firm from marketing to development engineering. The risks sacrificing product development costs to process could end with the release of product short-term profits. specifications or with shipment of the first order. Process boundaries should be defined independ- For example, the savings in factory labor that an ently of the way in which activities are organized. organization gains through using flexible manufacturing systems, robotics and computer- Selecting the appropriate activity category may integrated manufacturing might be offset by the be anything but straightforward. The key is to high cost of computer software programmers. classify value activities according to their true The information systems support costs should contribution to the firm’s competitive advantage. be allocated to the value-creating processes For example, if order processing is important to that benefit from the new systems as part of a firm’s customer interactions, then this activity the full cost. should be classified under marketing. For estimating the full cost of each value-creating Management at American Airlines, for example, activity, the full utilization of the capacity of handed its marketing unit the task of developing the activity or its practical capacity is normally and implementing the carrier’s SABRE computer- used. Facility managers and equipment vendors ized reservation system. The result: a significant are useful sources of capacity estimates. If competitive advantage that left the other airlines estimates of full capacity vary widely, a firm scrambling to copy the system. Even mighty could perform the analysis with the resulting

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costs to assess the sensitivity of the analysis to Structural cost drivers consist of organizational the different capacity measures. When costs factors that determine the economic structure vary dramatically, companies should seek more driving the cost of a firm’s products. These cost information for a more realistic long-term drivers reflect a firm’s long-term decisions, which estimate of capacity.1 position the firm in its industry and marketplace. Structural cost drivers may change. Although many of the processes identified may be instrumental for achieving competitive advan- For example, large pharmaceutical companies tage, various value-creating processes may have enjoy economies of scale that lower their unit differing effects on a firm’s costs or products. costs for expensive R&D. Elsewhere, Texas Companies selling pencils, pens or paper clips, Instruments has exploited the experience curve in for example, are unlikely to concern themselves lowering its life-cycle product cost. However, bigger with after-sales service. But customer support is not necessarily better, as evidenced by the is a vital part of the competitive strategy for success of steel companies’ mini-mill strategy. makers of computers or high-speed copiers. Executional cost drivers capture a firm’s opera- Identify the cost drivers for each process. tional decisions on how best to employ its The next step of internal cost analysis is to identify resources to achieve its goals and objectives. the factor or cost determinants for each value- These cost drivers are determined by manage- creating process. By understanding what factors ment policy, style and culture. How well a firm drive costs, a firm can assign priorities among its executes its use of human and physical cost improvement initiatives. In order to determine resources will determine its level of success or its relative cost advantage, a firm should also failure. For example, worker empowerment and know the cost factors of its competitors.2 flattened organizations are helping many firms in their continuous improvement efforts. While management accounting systems may contain the total cost of each value-creating Few structural and executional cost drivers can process, they may not reveal the causes or factors be operationalized under existing management for the significant individual costs. Using single accounting systems in the cost analysis of the output or volume measures (e.g., units, labor hours, value chain. However, these cost drivers do offer sales dollars) to assign costs is often misleading. an important reminder of the strategic decisions Multiple cost drivers usually provide more useful that firms need to make, or at least acknowl- information. Exhibit 3 illustrates examples of edge, in designing their value-generating systems. structural and executional cost drivers. Increasingly, companies are using activity-based costing to understand the resources/costs consumed by the activities and processes used in delivering their products and services. 1 The reader should refer to IMA’s Statement on Management Accounting, “Measuring the Cost of Capacity,” for additional information regarding the various approaches used for measuring capacity.

2. The reader should refer to IMA’s Statement on Management Accounting, “Developing Comprehensive Competitive Intelligence,” for additional information regarding the acquisition of competitive cost information.

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EXHIBIT 3: PROCESS COST DRIVERS EXHIBIT 3. PROCESS COST DRIVERS

STRUCTURAL COST DRIVERS

Scale How big an investment to make in manufacturing, R&D, marketing and other resources?

Scope What is the degree of vertical integration— horizontal integration is more related to scale?

Experience or learning How often has the firm already done this?

Technology What process technologies are used within each step of the firm’s value chain?

Complexity How wide a line of products or services to offer to customers?

EXECUTIONAL COST DRIVERS

Workforce involvement or participation Is the workforce involved in decisions and improvements in performance?

Total quality management Are the workforce and managers committed to total quality in processes and products?

Capacity utilization What are the scale choices on maximum plant construction?

Plant layout efficiency How efficient, against current norms, is the plant’s layout?

Product configuration Is the design or formulation of the product effective?

Linkages with suppliers and customers Is the linkage with suppliers and customers exploited, according to the firm’s value chain?

Source: Riley, 1987.

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Identify the links among processes. efficient at insignificant activities, but to better While individual value activities are considered meet customer demands. separate and discrete, they are not necessarily independent. Most activities within a value chain Using the value chain approach, a company goes are interdependent. Firms must not overlook beyond simple across-the-board cuts and value chain linkages among interdependent attempts to lower cost and improve efficiency activities that may impact their total cost. within each value-creating process. For instance, a company might negotiate lower costs of For example, cost improvement programs in one process inputs such as wages or purchases, or value chain process may lower or increase costs evaluate make-or-buy options. and/or revenues in other processes. Transfers of goods and services from one value chain Reducing process input costs often means nego- process to another increases cost. Eliminating tiating lower wages (as with Chrysler and the these transfers reduces the costs of purchasing, U.S. airlines during the mid-1980s) or moving invoicing and other recordkeeping functions. production to countries with cheaper labor costs. Suppliers might be willing to drop their prices if Tandem Computers eliminated its costs of the company negotiates long-term contracts, an purchase orders, invoicing and other functions by approach used by Levi-Strauss in contracting jointly developing a detailed bar code process with its textile suppliers. Companies also use with its suppliers. By improving its upstream buyer-seller partnerships to gain advantages in cost, design and engineering processes for the quality, time, flexibility, delivery and technology.3 Taurus, Ford saved on downstream production and customer service costs. Using fewer floppy United Parcel Service (UPS) outsourced its drives and motherboards in its PCs has enabled customer service centers. In the process, the IBM to halve its delivered cost in two years. company consolidated 65 customer service centers representing 5,000 jobs down to As sources of competitive advantage, these rela- between eight and 10 service centers run by tionships or linkages among activities can be as contractors. UPS service center employees important as the activities themselves. Such earn $10 to $12 an hour versus the $6.50 to linkages may also offer sustainable competitive $8 an hour paid to contractors. advantage, because their subtle, complex nature makes them difficult for competitors to imitate. Some processes may offer more opportunities for improvement than others. In order to get the Evaluate the opportunities for achieving most out of its cost reduction programs, a com- relative cost advantage. pany should prioritize its value-creating process- In many organizations, cost reductions are made es. Under the 80:20 rule, 20 per cent of the across the board (e.g., “eliminate 10 per cent value-creating processes often accounts for 80 from every department”). Because these firms per cent of total costs. do not reduce their costs strategically, this effort usually fails. More often than not, across-the- board cost reduction misconstrues the underlying 3 For more information on buyer-seller partnerships, the reader should refer to The Society of Management Accountants problem. The point is not to become more of Canada’s Management Accounting Guideline #32, “Building Buyer-Seller Partnerships.”

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EXHIBIT 4: COMPETITOR COST ANALYSIS EXHIBIT 4. COMPETITOR COST ANALYSIS

Independent Specialty Cost Cost Auto Repair Brake Repair Drivers Reduction

100% 79% 21%

Material Purchasing scale Material More efficient distribution 9% Less-skilled labor Labor Labor Lower compensation More specialization Variable Shop & productivity 7% and SG&A Variable Shop and SG&A Scale offset by larger advertising expenses 0% Fixed Shop Fixed Shop and SG&A Higher utilization of and SG&A equipment & facilities 5%

An example of the value chain approach to Internal Differentiation Analysis achieving a relative cost advantage is illustrated The value chain approach is also used by organ- in Exhibit 4. This exhibit compares a specialtySource: Riley,izations 1987. to identify opportunities for creating brake repair firm with an independent auto repair and sustaining superior differentiation. In this firm. By focusing on cost drivers such as scale, situation, the primary focus is on the customer’s skill levels, wages and capacity utilization, the perceived value of the products and services. specialty brake shop was able to reduce its costs by 21 per cent. Its largest percentage cost As with internal cost analysis, internal differenti- reduction was in material cost. ation analysis requires firms to first identify their value-creating processes and primary cost drivers. Companies can use comparisons with best They are then ready to perform a differentiation practices, benchmarking and business process analysis using the following guidelines: redesign to reduce their costs. The cost of quality emphasizes that eliminating process and material G identify the customers’ value-creating processes; waste leads to significant cost savings and G evaluate differentiation strategies for enhancing customer satisfaction. customer value; and G determine the best sustainable differentiation strategies.

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Identify the customers’ value-creating this unique service to a customer also enabled processes. P&G to improve its on-time delivery of ordered To pursue a superior differentiation strategy, a merchandise; firm’s processes must enhance those of its G service and support—tailored to end-user and customers. Thus, a firm should carefully study channel member sophistication and urgency of the value-creating processes of its customers. need. For several decades, superior service Exhibit 5 presents such an analysis for Crown, capabilities and high vendor switching costs Cork and Seal Company (CCS), a metal can maker, produced by proprietary architecture and soft- and its customers in the late 1970s. The metal ware enabled IBM to build and maintain a container industry was characterized by low commanding leadership position in the main- growth, low profits and intense competition. CCS frame computer industry. Until open systems succeeded with a differentiation strategy, which appeared in the mid-1980s, risk-averse cus- is usually very difficult to accomplish in a tomers were reluctant to make large capital commodity-type business. Two different groups and conversion outlays for mainframe computer of customers—food and beverage canners— systems without the manufacturer’s strong accounted for 80 per cent of the metal containers assurance of reliability; produced. G brand or image positioning—that lends greater appeal to the company’s offerings on critical Evaluate differentiation strategies for selection criteria. For many years, this quality enhancing customer value. image has allowed the American Express Co. The key to successful differentiation under the to command a significant price premium in the value-chain approach is to identify the value-creat- highly competitive financial services market— ing processes that distinguish a firm’s products or a premium that reflects, in its words, the services from those of its competitors. In making “privilege of membership”; and this distinction, customer value is emphasized. G price—including both net purchase price and cost savings available to the customer through The ways customer value can be enhanced the use of the product and service. through differentiation include: Determine the best sustainable differentia- G product features—that are esthetically appeal- tion strategies. ing or functionally superior. For example, the For a firm to achieve superior differentiation, it Mercedes-Benz automobile accomplished this must utilize the best mix of resources in creating feat so well for years that its name became value for its customers. In order to prioritize synonymous with the highest level of quality— its processes as sources of differentiation, a people would describe a product as the company must determine what attributes of “Mercedes-Benz” of its category; each process enhance customer value. G marketing channels—that provide desired levels of responsiveness, convenience, variety The more unique a firm’s resources and skills, and information. By placing its order-entry com- the more sustainable is its differentiation advan- puters in Wal-Mart’s stores, Procter & Gamble tage over competitors. significantly reduced the overall order-entry and processing costs for both firms. Providing

PRACTICE OF MANAGEMENT ACCOUNTING EXHIBIT 5: VALUE CHAIN FOR CROWN, CORK AND SEAL COMPANY

EXHIBIT 5. VALUE CHAIN FOR CROWN, CORK AND SEAL COMPANY 1 2

Crown, Cork & Seal3 Canners 4 5 Des Ser Inv Inv Inv Sup Manu vic & A ign ent ent ent Dis Dis Purc Purc Pro Mar pli Can Sup e & , E Sal ory ory ory lum tri tri es ces fac hasin hasin ket butio butio ngi nin Te por es Ho Ho Ho of inu sing turi ing nee chn g t Ste lding lding lding m g g n n ng ring ical el

High quality inputs. Speed and competence in maintaining customers’ canning lines. Quality of technical advice. Reliability of supply even during metal shortages. Fast, reliable order processing. Containers for specialized uses. Special designs of containers. Specially Speed and flexibility of strong or light containers. delivery.

Consistency of product. Ability to meet unexpected Quality of product. orders from customers Flexibility of at short notice. manufacturing.

1. Designing distinctive cans for customers may assist their own marketing activities. 2. Consistent can quality lowers customers’ canning costs by avoiding breakdowns and holdups on their canning lines. 3. By maintaining high stocks and offering speedy delivery, customers can economize on their own stockholding (they may even be able to move to a just-in-time system of can supply). 4. Efficient order processing can reduce customers’ ordering costs. 5. Capable and fast technical support can reduce the costs of breakdowns on canning lines.

Adapted from: “Crown, Cork and Seal Company and the Metal Container Industry,” and “Crown, Cork and Seal Company, Inc.” Havard Business School, 1978.

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CCS (Exhibit 5), for example, focused only on Vertical Linkage Analysis tin-plated steel can production, not aluminum; Linkages among value-creating processes do not produced for beverage and aerosol customers, not end with the activities within a firm. The greatest food processors; and invested in more can-forming competitive advantage may come out of linkages lines at its plants to reduce changeovers and between a firm’s value-creating activities and set-up wages. CCS was also willing to devote more those of its suppliers, channels or users. resources to customizing metal containers for customers and to increase its responsiveness to Vertical linkage analysis is a much broader appli- customers’ schedule and quality needs. cation of internal cost and differentiation analysis that includes all upstream and downstream The payoffs for effective differentiation, and the value-creating processes throughout the indus- penalties for not differentiating, are clear. In try.Vertical linkage analysis considers all links 1980, Purolator Courier was bigger than Federal from the source of raw materials to the disposal Express; today the reverse is true. In 1982, and/or recycling of the product. Exhibit 6 out- Dreyfus had more assets under management lines the vertical links involved in the production than Fidelity—a situation that had reversed itself of “fast food” containers. by the mid-90s.EXHIBIT 6: VERTICAL LINKAGES IN THE PRODUCTION OF EXHIBIT 6. VERTICALPLASTIC LINKAFOODGES CO NTAIIN THENERS PRODUCTION OF PLASTIC FOOD CONTAINERS

Natural gas producers

Ethane producers

Styrene producers

Polystyrene producers

Fast food carton producers

Fast food restaurants

Final consumers

Source: PRACTICE OF MANAGEMENT ACCOUNTING

Shank and Govindarajan (1993) state the Vertical linkage analysis includes the following importance of vertical linkages: steps:

...gaining and sustaining a competitive advan- G identify the industry’s value chain and assign tage requires that a firm understand the entire costs, revenues and assets to value-creating value delivery system, not just the portion of the processes; value chain in which it participates. Suppliers G diagnose the cost drivers for each value-creating and customers and suppliers’ suppliers and process; and customers’ customers have profit margins that G evaluate the opportunities for sustainable are important to identify in understanding a competitive advantage. firm’s cost/differentiation positioning, because the end-use customers ultimately pay for all Identify the industry’s value chain and the profit margins along the entire value chain. assign costs, revenues and assets to value-creating processes. Vertical linkage can reveal which activities are Because vertical linkages can be complex the most (and least) critical to competitive and intangible, they are often overlooked by advantage (or disadvantage). For example, Swiss organizations. For example, the petroleum watchmakers succeeded for years as relatively industry consists of numerous value-creating small, labor-intensive assemblers. Then came processes or activities, including exploration, the 1970s and the advent of low-cost, mass- production, refining, marketing and distribution. produced watches. The Swiss responded by These processes define the value chain for this restructuring their industry to gain economies of industry. One company may participate in all scale similar to those enjoyed by their new parts of this value chain; another firm may global competitors. participate in only a few. This diversity of operations and organizations makes it difficult to However, the Swiss failed to realize that their adopt a standard approach for identifying critical problem was not in manufacturing. This industry value chain processes. set of activities added only a small proportion of the value of their final product. Far more significant Few firms have information systems that can were downstream activities in output logistics, identify and analyze these subtle relationships. marketing, sales and service. Beyond being able For example, profitability and return on assets to make a watch cheaply, the Swiss had to lower are key measures of competitive advantage their costs of distribution and service. They throughout an industry’s value chain. It can be came up with the hugely successful Swatch, extremely difficult to obtain pertinent information which, besides being inexpensively priced, was for these measures, including operating costs, virtually indestructible and could be distributed revenues and assets for each process through- through numerous low-cost channels, from out the industry’s value chain. However, this department stores to discount houses. information is necessary to calculate a rate of return on assets for each value chain process.

Obtaining the replacement or current cost of physical assets used by a value-creating activity

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is a necessary but often-complex undertaking. Diagnose the cost drivers for each value- Historical or book values usually provide inade- creating process. quate measures of current investment. Plant Traditional management or cost accounting engineers, equipment vendors and independent systems often assign costs by using a single out- appraisal professionals may be consulted to put measure of operating activity, such as output help establish current asset values. Likewise, volume. For vertical linkage analysis, a single establishing prices for transferring goods and measure is inadequate to capture the underlying services among value chain processes requires cost categories. Direct labor-based measures an understanding of market or competitive- may be appropriate for labor-intensive activities; based rates. If at least one firm competes in operating hours may be appropriate for machine- each stage of value creation, then competitive based activities. The cost drivers illustrated market prices are available. If not, then a company in Exhibit 3 may be used to identify the factors must use judgment in determining a transfer that determine costs throughout the industry price that incorporates a normal profit margin value chain. on full costs. For long-term strategic decision- making, companies should use full cost under Evaluate the opportunities for sustainable conditions of full capacity for the value activity. competitive advantage. While several measures of capacity exist, the By nature, competitive advantage is relative. In best measure should represent the long-term an ideal world, a firm can gauge its competitive utilization of the value activity’s assets (some- position by knowing its competitor’s value chains times called “practical capacity”). and the rates of return on each. In reality, however, this may be rather difficult: the competitor’s Publicly available financial reports produced by internal cost, revenue and asset data for its firms throughout the industry value chain can processes are generally unavailable. Sufficient provide key financial information. Typically, this qualitative information usually exists on a firm’s information is neither in the proper format nor major value-creating processes and the strategies disaggregated enough to accommodate vertical for each. By understanding how other companies linkage analysis. Significant analysis, data compete in each process of the industry value manipulation and judgment may be necessary chain, a firm can use the qualitative analysis to to obtain the appropriate information for each seek out competitive niches even if financial value chain process. data are unavailable.

For intermediate transfers between processes, Value chains for three competitors in the rapidly competitive market prices, if available, should be changing telecommunications industry—AT&T, substituted for the internal transfer prices. For NYNEX and IBM—are listed in Exhibit 7, along with example, competitive market prices for a single the strategic differences for each firm (Hax and link in the value chain may be obtained from Majiuf, 1991). The strategic differences reflect vary- individual firms that operate only in that link of ing structural and executional cost drivers. In market- the chain. For long-term cost estimation, full ing, for instance, AT&T started with no organization costs should be used rather than marginal, but with significant name recognition. The regional variable or incremental costs. marketing scale of NYNEX and the worldwide marketing scale of IBM are important cost advantages.

PRACTICE OF MANAGEMENT ACCOUNTING EXHIBIT 7: VALUE CHAIN DIFFERENCES: THE TELECOMMUNICATIONS INDUSTRY EXHIBIT 7. VALUE CHAIN DIFFERENCES: THE TELECOMMNICATIONS INDUSTRY

Strategic Differences Value Chain Processes AT&TNYNEX IBM

Procurement Owns manufacturing Free to use any Owns Rolm, CPE branch (Western Electric) supplier it wants manufacturer

Technology Technological leadership Focus on software Strong R&D in Development through Bell Labs products computer hardware and software technologies

Operations National presence Regional monopoly Global presence High quality of equipment Innovative Leading computer through heavy capital equipment from technology expenditure outside suppliers Partnership with Similar communications High-quality MCI standards nationwide regional network Strongest national through heavy telecommunications capital investment network

Marketing New emphasis on Use of Bell logo Strong reputation and Sales marketing (still weak) Focus on top 1,000 for marketing High name recognition corporate customers excellence Long-term relationship Sales and Already sells to most with clients distribution centres major corporations Recruits computer close to customers Experienced sales executives force

Source: Hax and Majluf, 1991.

Finding innovative ways to perform value-creating and shipped the slabs to its large markets in the Source: Hax and Majluf, 1991. activities helps firms improve their overall perfor- Northeastern U.S. Only then did the company mance and achieve competitive advantage. In mix the concentrate with water, thus avoiding the order to thrive in the mature, highly competitive lengthy and costly shipment of water. meat packing industry, for example, Iowa Beef Processors built its plants near cattle ranches, Increased global competition forces firms to focus thus eliminating the high cost of shipping cattle on worldwide sustainable competitive advantage. to northern processing plants. In order to lower Porter (1990), one of a few strategists who have its costs, Tropicana froze slabs of orange juice systematically studied global competition, cites four concentrate near the orange groves in Florida major factors that influence national competitive

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advantage. These are: intensive activity, in low-wage Asian countries such as China, Thailand and the Philippines. G factor conditions—the nation’s position in factors of production, such as skilled labor or Taking a global view of the value chain is not infrastructure, necessary to compete in a without disadvantages. One possible negative given industry; factor is transportation between linked processes. G demand conditions—the nature of domestic Transportation consumes time and adds to demand for the industry’s product or service; costs. Shipments of electronic components G related and supporting industries—the presence between the Far East and North American or absence in the nation of supplier industries assembly plants may take at least a month. and related industries that are internationally Transporting components to local assembly competitive; and plants may save transport and inventory costs. G firm strategy, structure and rivalry—the conditions in the nation governing how companies are Scattering value-creating processes around the created, organized and managed, and the world can also lead to poor control, communica- nature of domestic rivalry. tion and coordination. Close proximity of R&D, engineering, production and marketing personnel Geographic scope can allow firms to gain may provide synergistic benefits in meeting substantial competitive advantages by sharing or customer needs. coordinating similar value activities in different places. The importance of this advantage is For example, to increase its worldwide tire pro- illustrated by the recent success of firms with a duction capacity to compete with Michelin, global scope, such as Canon (Japan), Caterpillar Japan’s Bridgestone acquired Firestone Tire & (U.S.), N.Y. Philips (Netherlands) and Siemens Rubber in the U.S. Muddled strategies, slow (West Germany). These firms sell and service their decision-making and poor communication products in practically every corner of the globe. between Tokyo and Akron, Ohio, led to major losses, layoffs and a sell-off of assets. Automakers like Ford or GM are even more global: they carry out many key value-creating activities— The North American Free Trade Agreement from engineering to manufacturing and sales—in among Canada, Mexico and the U.S. has intro- dozens of countries around the world. Japanese duced new relationships affecting value-chain auto companies are also globalizing rapidly, making analysis for suppliers and buyers alike. These huge investments in manufacturing facilities in, relationships require careful scrutiny. For example, for example, South Korea, Singapore and the U.S. lower labor costs in Mexico have motivated companies to locate their assembly and manu- Nike’s key value-creating processes are shoe facturing processes there. However, some firms design, manufacture of shoe components and have experienced costly productivity and quality final assembly. All major inputs to each process problems that more than offset their labor savings. are available in the U.S. However, Nike locates Each firm must balance the benefits/cost of a component manufacturing, requiring moderately multi-location decision. skilled labor and capital, in Taiwan and South Korea. It locates assembly operations, a labor-

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To properly evaluate the opportunities for com- Bargaining power of buyers petitive advantage in the global marketplace, The degree of buyer power generally depends on: firms need to consider such things as a country’s values, political climate, environmental concerns, G customer concentration (the higher the trade relations, tax laws, inflation rates and concentration of customers, the greater their currency fluctuations. The recent devaluation of negotiating leverage); the Mexican peso is an example of the risks of G the propensity for customers to integrate back- moving operations to uncertain economies. ward (the higher the propensity for backward integration, the greater the bargaining leverage); VII. STRATEGIC FRAMEWORKS G costs of switching suppliers (the lower the FOR VALUE CHAIN ANALYSIS switching costs, the greater the buyer’s lever- Value chain analysis requires a strategic framework age); and or focus for organizing internal and external infor- G the number of alternative suppliers (the greater mation, for analyzing information, and for summariz- the number, the greater the customer’s leverage). ing findings and recommendations. Because value chain analysis is still evolving, no uniform practices Bargaining power of suppliers have yet been established. However, borrowing Just as powerful buyers can squeeze profits by recent concepts from strategists and organization putting downward pressure on prices, suppliers experts, three useful strategic frameworks for value squeeze profits by increasing input costs. The chain analysis are: same factors that determine the power of buyers also determine the power of suppliers. The bar- G industry structure analysis; gaining power of suppliers and buyers relative to G core competencies; and the firm depends on the relationships between G segmentation analysis. their value chains. Bargaining power will be a function of relative strengths, in particular, value Industry Structure Analysis activities that depend on one another. Michael Porter (1980, 1985) developed the five forces model as a way to organize information Identifying the specific activities involved and the about an industry structure to evaluate its nature of their strengths and relationships can potential attractiveness. give important insights into the power balance between buyer and seller, and how it may be Under this model, the profitability of an industry altered for the firm’s benefit. or market measured by the long-term return on investment of the average firm depends largely Threat of substitute products or services on five factors that influence profitability. The potential for profit in an industry is deter- These are: mined by the maximum price that customers are willing to pay. This depends primarily on the G bargaining power of buyers; availability of substitutes. When few substitutes G bargaining power of suppliers; exist for a product—e.g., gasoline—consumers G threat of substitute products or services; are willing to pay a potentially high price. If close G threat of new entrants; and substitutes for a product exist, then there is a G intensity of competition. limit to what price customers are willing to pay.

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Any price increase will then cause some customers A major difficulty in industry structure analysis to switch to substitutes. A thorough understand- lies in defining the specific industry. No industry ing of the value chains of buyers as they relate has clear boundaries either in terms of products to the firm’s product can help in assessing (and or geographical areas. For example, does one combating) the threat of substitution. analyze the industry environment of Ford as the “transportation equipment” industry, the “motor Threat of new entrants vehicles and equipment” industry or the If an industry is earning a return on invested “automobile” industry? capital above the cost of capital, that industry will act as a magnet to firms outside the industry. To overcome the difficulty of defining an industry, Unless the entry of new firms is barred, the rate the concept of substitutability can be applied to of profit must fall to the competitive level. Even a firm’s supply and demand chains. On the the mere threat of entry may be sufficient to demand side, if buyers are willing to substitute ensure that established firms constrain their one product for another—e.g., Toyotas for Fords— prices to the competitive level. then the manufacturers belong in a single industry. However, this guideline does not always Intensity of competition hold. For example, customers may be unwilling Markets experiencing rapid growth typically see to substitute Apple Macintosh computers for less intense competition. Rival companies can usu- Compaq computers, even though both manufac- ally satisfy profitability and growth without having turers belong to the same industry. On the to take market shares from their competitors. supply side, if two manufacturers can make each other’s products, then they belong to a The variety and nature of the value chains of single industry. competitors shape many of the characteristics of an industry. The relative importance of Porter’s model sometimes draws criticism for economies of scale versus economies of scope, neglecting the difficulty of obtaining and main- for example, depends on the kind(s) of technology taining the information required to perform an employed in competitors’ value chains. The industry structure analysis. While such an stability of the industry and of its competitive exercise may be time-consuming, it is essential situation also relates to what happens to the to obtain a detailed database in order to fully value chains of firms in the industry. The effective- understand an organization’s competitive ness of low cost versus differentiation strategies environment. Dismissing the task as too difficult depends on the nature of users’ value chains, is tempting, and may lead to inappropriate and on how competitors’ value chains interact decision-making. with those of both sellers and users. Core Competencies Analysis Since these five forces are ever-changing, Industry structure analysis is well suited to Porter’s framework needs to be employed as describing the what of competitiveness, i.e., what a dynamic analytical tool. This is because makes one firm or one industry more profitable competition is a dynamic process: equilibrium is than another. But understanding the particulars never reached and industry structures are of such advantages as low cost, quality, customer constantly being reformed. service and time to market may still leave the

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question of why largely unanswered. For example, new ways of using information technology for a wide why do some companies seem able to continually variety of end users. In contrast, using its core com- create new forms of competitive advantage while petence in information processing, Xerox devel- others seem able only to observe and follow? oped icons, pull-down menus and the computer Why are some firms net advantage creators and mouse, but failed to exploit the marketplace. others net advantage imitators? For assessing competitive advantage it is necessary not only to A core competence is identified by the following keep score of existing advantages—what they tests: are and who has them—but also to discover what it is that drives the process of advantage G Can it be leveraged?—does it provide potential creation. Industry structure analysis is much better access to a wide variety of markets? suited to the first task than to the second. G Does it enhance customer value?—does it make a significant contribution to the perceived Thus, industry structure analysis must be customer benefits of the end product? supplemented by an equally explicit core compe- G Can it be imitated?—does it reduce the threat tence focus. Organizations need to be viewed of imitation by competitors? not only as a portfolio of products or services, but also as a portfolio of core competencies. Applying the value chain approach to core competencies for competitive advantage includes Core competencies are created by superior the following steps: integration of technological, physical and human resources. They represent distinctive skills as G validate core competencies in current well as intangible, invisible, intellectual assets businesses; and cultural capabilities. Cultural capabilities G export or leverage core competencies to the refer to the ability to manage change, the ability value chains of other existing businesses; to learn and teamworking. Organizations should G use core competencies to reconfigure the be viewed as a bundle of a few core competen- value chains of existing businesses; and cies, each supported by several individual skills. G use core competencies to create new value chains.

Core competencies are the connective tissue Validate core competencies in current that holds together a portfolio of seemingly businesses. diverse businesses. They are the lingua franca that Core competencies should tie together the portfolio allows managers to translate insights and expe- of end products and help a firm excel in dominat- rience from one business setting into another. ing its industry. For example, Corning Glass’s core Core competence-based diversification reduces competence is its ability to melt specialty glass. risk and investment and increases the opportu- Pyrex, television bulbs, headlamps and optical nities for transferring learning and best practice wave guides are just a few of the products of this across business units. successful producer. Procter & Gamble’s R&D expertise and marketing/distribution skills pro- For instance, the New York Times stated that vide a significant competitive advantage in a wide Microsoft’s only factory asset is the human imag- range of mass consumer products (e.g., Ivory, ination. This company has excelled in inventing Tide, Folgers, Crisco, Pampers).

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Core competencies need to be continually and distribution system. Besides employing validated. In the early 1970s, Timex held half these core competencies in hotels, the company of the global market for watches with its core uses them in its other businesses, including competence in low-cost management of precision institutional food service, consumer food and manufacturing. By the mid-1970s, the watch restaurants, cruise ships and theme parks. industry moved to digital technology, making Timex’s core competence irrelevant. AT&T extended its core competence as an efficient processor of customer accounts by Export or leverage competencies to the entering the credit card business. Kimberly Clark’s value chains of other existing businesses. entry into disposable diapers extended its core The same set of core competencies can be competence in the design of paper products. exploited in multiple businesses by exporting core competencies to the value chains of other Use core competencies to reconfigure the existing businesses. value chains of existing businesses. While firms may manage their existing value For example, one of Honda’s core competencies chains better than their competitors, sophisticated is designing and producing small engines. By firms work harder on using their core competen- exporting this core competence to a wide variety cies to reconfigure the value chain to improve of business lines, the company seeks to have six payoffs. Otherwise, competitors may exploit Hondas in every garage: autos, motorcycles, opportunities. snowmobiles, lawnmowers, snow blowers, chain saws and power tools. Other Honda core compe- For example, Japanese watchmakers side- tencies are dealership management and shorter stepped traditional distribution channels in favor product development cycles. of mass merchandisers such as department store chains. By efficiently consolidating freight, Marriott Corp. has core competencies in food Emery Freight dominated the air freight industry service and hospitality skills, standardized hotel and was consistently a leader in profitability in operating procedures, and a shared procurement U.S. industry. Federal Express reconfigured the

EXHIBITEXHIBIT 8: HO 8.W HOTETW RA-PTETRA-PAKAK RECONFIG RECONFIGUREDURED THETHE V ALUEVALU CHAINE CHAIN

FILLING TRANSPORT RETAIL CUSTOMERS DISPLAY

Make container No refrigerated Low store handling Longer shelf life on site trucks

Tetra-Pak specialized No wasted space No need to No need to equipment in filling & packing refrigerate & less refrigerate & less space is required space is required

Source:

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air freight business by focusing on the overnight Use core competencies to create new delivery of small packages. value chains. With strong core competencies in its existing Tetra-Pak is an excellent example of a firm that businesses, an organization can seek new reconfigured the value chain in the packaging customers by developing new value chains. industry for dairy products and orange juice. Tetra-Pak designed a filling machine for its a For example, Federal Express (FedEx) transferred septic packages and changed the packaging its expertise in the delivery of small packages to industry. Exhibit 8 illustrates Tetra-Pak’s changes contract new business with L.L. Bean for to the value chain. overnight distribution. Disney has exported its people-moving skills to urban mass transit for Another example of a value chain reconfiguration Oakland, California. is IKEA, which grew from a small, Swedish mail- order furniture operation to one of the world’s The development of the corporate purchasing largest retailers of home furnishings (Normann & card is exporting the expertise of credit card Ramirez, 1993). As illustrated in Exhibit 9, IKEA companies, such as American Express and Visa, selected numerous factors to offer prices that are to process small purchase transactions for other 25-50 per cent lower than those of competitors. companies.

EXHIBIT 9: HOW IKEA RECONFIGURED THE FURNITURE INDUSTRY EXHIBIT 9. HOW IKEA RECONFIGURED THE FURNITURE INDUSTRY

Value Chain Major Choice

Design Simple, high quality, designed to lower cost

Parts Standard & common, global supplier network

Assembly By the customer

Transport/stocking Computerized system for suppliers & warehouses

Marketing Scandinavian image

Display Focus on designs, not pieces, to create value

Home delivery By the customer

SourSource:ce: No Norrmamannnn an andd Ramir Ramirez,ez, 19 1993.93.

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In a recent agreement, Roadway Logistics Identify segmentation variables Systems, a unit of Roadway Services Inc., will and categories. manage and track all inbound and outbound There may be literally millions of ways to divide up shipments for Dell Computer Corp., including the market into segments. Typically, an analysis operations in Europe and Asia. The logistics considers between 5 to 10 segmentation variables. company will also handle transportation for These variables are evaluated on the basis of their service and repair needs. ability to identify segments for which different competitive strategies are (or should be) pursued. Segmentation Analysis Industries are sometimes collections of different The selection of the most useful segment-defining market segments. Vertically integrated industries variables is rarely obvious. Industries may be are good examples of a string of natural business- subdivided by product lines, type of customer, es from the source of raw material to the end use channels of distribution and region/geography. by the final consumer. Several firms in the paper The most common segmentation variables and steel industries are vertically integrated. Not all considered are type of customer and product firms in an industry participate in all segments. related, as illustrated in Exhibit 10.

If the nature and intensity of Porter’s five forces The first set of variables describes segments in or the core competencies vary for various terms of general characteristics unrelated to the segments of an industry, then the structural charac- product involved. Thus, a bakery might be con- teristics of different industry segments need to be cerned with geographic segments, focusing on examined. This analysis will reveal the competitive one or more regions or even neighborhoods. It advantages or disadvantages of different segments. might also divide its market into organizational A firm may use this information to decide to exit the types such as at-home customers, restaurants, segment, to enter a segment, reconfigure one or dining operations in schools, hospitals and so more segments, or embark on cost reduction/ on. Demographics can define segments repre- differentiation programs. senting strategic opportunities such as single parents, professional women and elderly people. Differences in structure and competition among segments may also mean differences in key The second category of segment variables success factors among segments. includes those that are related to the product. One of the most frequently employed is usage. A Using the value chain approach for segmentation bakery may employ a very different strategy in analysis, Grant (1991) recommends five steps: serving restaurants that are heavy users of bakery products than restaurants that use fewer G identify segmentation variables and categories; bakery products. Zenith made a niche for itself G construct a segmentation matrix; in the very competitive personal computer G analyze segment attractiveness; industry by focusing on government, which is G identify key success factors for each segment; the largest computer user. and G analyze attractiveness of broad versus narrow Segmenting by competitor is useful because it segment scope. frequently leads to a well-defined strategy and a

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EXHIBIT 10: APPROACHES TO DEFINING SEGMENTATION VARIABLES EXHIBIT 10. APPROACHES TO DEFINING SEGMENTATION VARIABLES

Customer Characteristics

Geographic – Small communities as markets for discount stores Type of organization – Computer needs of restaurants versus manufacturing firms versus banks versus retailers Size of firm – Large hospital versus medium versus small Lifestyle – Jaguar buyers tend to be more adventurous, less conservative than buyers of Mercedes-Benz and BMW Sex – The Virginia Slims cigarettes for women Age – Cereals for children versus adults Occupation – The paper copier needs of lawyers versus bankers versus dentists

Product-related Approaches

User type – Appliance buyer - home builder, remodeler, homeowner Usage – The heavy potato user - the fast-food outlets Benefits sought – Dessert eaters - those who are calorie-conscious versus those who are more concerned with convenience Price sensitivity – Price-sensitive Honda Civic buyer versus the luxury Mercedes-Benz buyer Competitor – Those computer users now committed to IBM Application – Professional users of chain saws versus the homeowner Brand loyalty – Those committed to IBM versus others

strong positioning statement. Thus, a targetSource: segments, a segmentation matrix can be customer group for the Toyota Cressida consists developed. Two or more dimensions may be of buyers of high-performance European cars used to partition an industry. such as the BMW. The Cressida is positioned against the BMW as offering comparable perfor- For example, restaurants could be divided into mance for a substantially lower cost. four dimensions: type of cuisine, price range, type of service (e.g., sit-down, buffet, cafeteria, Construct a segmentation matrix. take-out, fast food) and location. After customer- and product-related variables have been selected for identifying different

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EXHIBIT 11: SEGMENTING THE BRITISH FROZEN FOOD INDUSTRY EXHIBIT 11. SEGMENTING THE BRITISH FROZEN FOOD INDUSTRY

DISTRIBUTION CHANNELS

Supermarkets Independent Specialist Producers’ Retailers’ Grocery Freezer Brands Brands Retailers Stores Caterers

Vegetables P R O Fruits D U C Meat T Products

T Y Desserts P E S Convenience Ready Meals

Note: The above matrix identifies five categories of frozen food, and five distribution channels. While the basic distinction of customers is between retail and catering, within retailing there are three distinct categories of outlet: supermarkets, independent grocery stores, and specialist retailers of frozen food (”home freezer centres”). In addition, different market conditions exist for processors supplying frozen foods for sale under their own brand names as opposed to those supplying frozen foods for sale under the brand name of the retailer.

Source: Monopolies and Mergers Commission, Frozen Foods (HMSO, London 1976); and P. Geroski and T. Vlassopoulos, “The rise and fall of a market leader; Frozen foods in the UK,” London Business School, Case series 9, 1989. Source: Monopolies and Mergers Commission, Frozen Foods (HMSO, London 1976); and P. Geroski and T. Vlassopoulos, “The rise and fall of a market leader; Frozen foods in the UK,” A segmentation matrix for Londothe n BritishBusines sfrozen School, Casbee series used 9, to 19 89.evaluate the profitability of different foods industry is presented in Exhibit 11. Five segments. However, the competitive focus shifts types of product and five channels of distribution to an analysis of the different segments. are used to construct the two-dimensional segmentation matrix consisting of 25 potential For example, in the frozen foods industry seg- segments. However, not every cell in the matrix mentation, independent grocers and caterers may be relevant. Empty cells may represent may be willing to substitute fresh fruits and future opportunities for products or services. vegetables for frozen goods. Therefore, the threat of substitutes within the segments and Analyze segment attractiveness. from outside sources must be carefully examined. Competitive assessments using industry structure analysis or core competencies analysis can also

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In addition, the interrelationship among segments On the other hand, when the Toro Company must be carefully considered. For example, caterers broadened its distribution channels for its snow may purchase frozen food items from supermar- blowers and lawnmowers to include discount kets at bargain prices. Segments may be natural chains, it almost went bankrupt. Feeling buyers, sellers or substitutes for one another. betrayed, a number of Toro’s dealers dropped its products. In the automobile industry, the luxury car and sports car segments were high-priced, high-margin Taking a narrow segment focus may leave a firm products with less intense competition than vulnerable to competitors. For instance, by relying other automobile segments. The introduction of solely on its lemon-lime soft drink, 7-Up left itself high-quality, lower-priced Acura, Lexus and Infiniti at a competitive disadvantage to Coca-Cola and autos changed the competitive structure of Pepsi. Recently, Hallmark Cards Co. has begun these high-priced segments. to market its premium image greeting cards through discounters. Hurt by discounters, some Identify key success factors for each of Hallmark’s 9,000 independent specialty segment. shops have begun selling cards from Hallmark’s Quality, delivery, customer satisfaction, market competitors. share, profitability and return on investment are common measures of corporate success. In this In many industries, aggressive firms are moving regard, each segment must be assessed using toward multiple-segment strategies. Campbell the most appropriate key success factors. Cost Soup, for example, makes its nacho cheese and differentiation advantages should be high- soup spicier for Texas and California customers lighted by these measures. and offers a Creole soup for Southern markets and a red-bean soup for Hispanic areas. In New Examination of differences among segments in York, Campbell uses promotions linking buyers’ purchase criteria can reveal clear differ- Swanson frozen dinners with the New York ences in key success factors. Giants football team; in the Sierra mountains, skiers are treated to hot soup samples. Analyze attractiveness of broad versus Developing multiple strategies is costly and narrow segment scope. often must be justified by an enhanced A wide choice of segments for an industry aggregate impact. requires careful matching of a firm’s resources with the market. The competitive advantage of Some firms decide to avoid or abandon segments each segment may be identified in terms of low because of limited resources or because of uncer- cost and/or differentiation. tain attractiveness. For example, in the 1960s, IBM decided not to enter the mini-computer Sharing costs across different market segments segment. This allowed upstart Digital Equipment may provide a competitive advantage. For example, Corp. to dominate this segment of the computer Gillette broadened its shaving systems to industry. General Electric abandoned the computer include electric shavers through its 1970 acqui- industry completely. Under CEO Jack Welch, GE’s sition of Braun. Lipton recently entered the major segments must be first or second in market bottled iced-tea market. share, or risk being sold.

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A segment justifying a unique strategy must be or services with no external or competitive market of worthwhile size to support a business strategy. information, transfer prices must be estimated Furthermore, that business strategy needs to be on the basis of the best information available. effective with respect to the target segment in order to be cost effective. In general, it is costly Isolating cost drivers for each value-creating to develop a strategy for a segment. The question activity, identifying value chain linkages across usually is whether or not the effectiveness of the activities, and computing supplier and customer strategy will compensate for this added cost. profit margins present serious challenges. The use of full cost assumes that the full capacity of VIII. LIMITATIONS OF VALUE the value chain activity’s facilities is used to CHAIN ANALYSIS derive the costs. Plant and manufacturing Value chain analysis is neither an exact science personnel and vendors of equipment are good nor is it easy. It is more art than preparing sources for capacity information. They can also be precise accounting reports. There are several helpful in estimating the current or replacement limitations to the implementation and interpreta- cost of the assets. Independent companies, tion of value chain analysis. First, the internal such as Valuation Research Corp. in Milwaukee, data on costs, revenues and assets used for provide valuation services for assets. value chain analysis are derived from one period’s financial information. For long-term strategic Despite the calculational difficulties, experience decision-making, changes in cost structures, indicates that performing value chain analysis market prices and capital investments from one can yield firms invaluable information on their period to the next may alter the implications of competitive situation, cost structure, and link- value chain analysis. Organizations should ages with suppliers and customers. ensure that the value chain analysis is valid for future periods. Otherwise, the value chain analy- IX. ORGANIZATIONAL AND sis must be repeated under new conditions. MANAGERIAL ACCOUNTING CHALLENGES Identifying stages in an industry’s value chain is Value chain analysis offers an excellent opportunity limited by the ability to locate at least one firm to integrate strategic planning with management that participates in a specific stage. Breaking a accounting to guide the firm to growth and survival. value stage into two or more stages when an This change in focus for management accounting outside firm does not compete in these stages is necessary to maintain its critical role as the is strictly judgmental. information profession.

As discussed previously, finding the costs, The most significant challenge for senior man- revenues and assets for each value chain activity agement and management accountants is to sometimes presents serious difficulties. There is recognize that the traditional, functional, internally much experimentation underway that may provide oriented information system is inadequate for better approaches. Having at least one firm operate the firm engaged in global competition. in each value chain activity helps identify external prices for goods and services transferred Another challenge for management accountants between value chains. For intermediate products is to bring the importance of customer value to

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the forefront of managements’ strategic thinking. management accountant should ensure that the For many managers and firms, this requires a CEO is committed to value chain analysis and great deal of education and awareness. the organizational changes necessary for its Management accountants should take the initia- successful implementation. tive to bring the value chain message to major players in the firm. Seminars, articles, value For many service companies, Porter’s value chain chain examples and company-specific applica- model emphasizing manufacturing firms may tions are useful to illustrate the advantages of appear inappropriate. However, every organization value chain analysis. (banks, hospitals, airlines, professional firms) has a variety of primary and support value-creating Although value chain analysis requires expertise activities to which value chain analysis applies. in internal operations and information, it For example, a publishing company might have demands a great deal of external information. the following primary activities: information Management accountants must seek relevant acquisition, editorial, production, distribution, financial and non-financial information from sales and service. Support activities include new sources outside the organization. product and business development, technology assessment and development, human resource Management accountants must integrate data- management and firm infrastructure. If strategy bases and potential sources of timely information is seen as the pursuit of competitive advantage, on competitive forces confronting the business. the link between the formulation of service This calls for innovation and creativity in strategy and operational service delivery is vital. gathering and analyzing information for management decisions. X. CONCLUSION As a unifying theme, value chain analysis presents Designing internal and external information sys- organizations with an overarching tool for improving tems to assist managers in planning, monitoring their strategic planning and resource allocation. and improving value-creating processes is another The goal is to provide management with sufficient challenge facing management accountants. options to sustain its competitive advantage in an ever-changing business environment. Information technology is improving daily but existing information systems are slow to change. Analyzing costs and differentiation through the Management accountants should solicit support value chain is an essential component in the search from all senior managers for allocating for competitive advantage. The data problems resources to develop and improve value chain- are not insignificant and the answers will not oriented information systems. always be precise.

Value chain analysis requires the cooperation of Nevertheless, there will be considerable benefit all managers involved in value chain processes, in the debate that results from the process and including engineers, designers, production in the enhanced quantitative awareness of the managers, marketing managers and distribution external competitive arena and of the firm’s part managers. Leadership from the CEO is vital to in it. As so often in strategic planning, the successful cooperation of managers. The process is often as valuable as the outcome.

PRACTICE OF MANAGEMENT ACCOUNTING

APPENDIX: VALUE CHAIN ANALYSIS VS. CONVENTIONAL MANAGEMENT ACCOUNTING Information generated from the traditional management accounting systems, including cost accounting, is generally unsuitable for value chain analysis for a variety of reasons. Exhibit A-1 provides a comparison of value chain analysis and traditional management accounting.

Generally, traditional management accounting focuses on internal information. It often places excessive emphasis on manufacturing costs. It also assumes that cost reduction must be found in the “value-added” process, i.e., selling price less the cost of raw material.

Using a value added approach can be misleading, since there are many other purchased inputs such as engineering, maintenance, distribution and service. The value-added process starts too late because it ignores linkages with suppliers, and stops too early because it ignores linkages with customers.

The value chain approach encompasses external and internal data, uses appropriate cost drivers for all major value-creating processes, exploits linkages throughout the value chain, and provides continuous monitoring of a firm’s strategic competitive advantage.

PRACTICE OF MANAGEMENT ACCOUNTING

EXHIBIT A-1: VALUE CHAIN VS. CONVENTIONAL EXHIBIT A-1. VALUE CHAINMANA VS. GEMCONVENTIONALENT ACCOU MANAGEMENTNTING ACCOUNTING

Traditional Management Value Chain Analysis Accounting in the Strategic Framework

Focus Internal External

Perspective Value added Entire set of linked activities from suppliers to end-use customers

Cost Driver Single cost driver Multiple cost drivers Concept (cost is a function of volume) – Structural drivers (e.g., scale, pe experience, sco technology d complexity) an Application at the overall – Executional drivers (e.g., participative firm level (cost-volume- management, total quality management profit analysis) and plant layout) A set of unique cost drivers for each value activity

Cost “Across the board” cost View cost containment as a function of Containment reductions the cost drivers regulating each value Philosophy activity Exploit linkages with suppliers Exploit linkages with customers Exploit process linkages within the firm “Spend to save”

Insights for Somewhat limited Identify cost drivers at the individual Strategic activity level, and develop cost/ Decisions differentiation advantage either by controlling those drivers better than competitors or by reconfiguring the value chain (e.g., Federal Express in mail delivery, and MCI in long distance telephone) For each value activity, ask strategic questions pertaining to: – Make versus buy – Forward/backward integration Quantify and assess “supplier power” and “buyer power,” and exploit linkages with suppliers and buyers

Adapted from: Shank and Govindarajan, 1993.

PRACTICE OF MANAGEMENT ACCOUNTING

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