Value Chain Analysis and Life Cycle Costing

What is a value chain Analysis

To conduct a value chain analysis, the company begins by identifying each part of its production process and identifying where steps can be eliminated or improvements can be made. These improvements can result in either cost savings or improved productive capacity. The end result is that customers derive the most benefit from the product for the cheapest cost, which improves the company's bottom line in the long run.

Value is the amount that buyers are willing to pay for what a firm provides them and is measured by total revenue

Value chain analysis relies on the basic economic principle of advantage — companies are best served by operating in sectors where they have a relative productive advantage compared to their competitors. Simultaneously, companies should ask themselves where they can deliver the best value to their customers.

 

What is a value chain?

To understand how to conduct a value chain analysis, a business must first know what its value chain is. A value chain is the full range of activities — including design, production, marketing and distribution — businesses go through to bring a product or service from conception to delivery. For companies that produce goods, the value chain starts with the raw materials used to make their products, and consists of everything that is added to it before it is sold to consumers.

The process of actually organizing all of these activities so they can be properly analyzed is called value chain management. The goal of value chain management is to ensure that those in charge of each stage of the value chain are communicating with one another, to help make sure the product is getting in the hands of customers as seamlessly (Good condition) and as quickly as possible.

Value Chain Analysis

With growing competition the organisations are becoming customer driven where customer satisfaction is priority.

Value chain analysis is a strategic management tool to assess and review various business functions in which usefulness is added to product or services.

An enterprise converts inputs into outputs where value is added to inputs to convert them into outputs .

The chain of activities that is performed to add value to inputs in order to arrive at the final outputs is referred to as value chain.

The concept was originally identified and defined by Porter.

Competitive Advantage A competitive advantage is an advantage over competitors gained by offering consumers

greater value, either by means of lower prices or by providing greater benefits and service that justifies higher prices.

Competitive advantage is a business concept describing qualities that allow an organization to overtake its competitors. These attributes may include access to natural resources, such as high grade ores or inexpensive power, highly skilled personnel, geographic location, high entry barriers, etc. New technologies, such as robotics and information technology, can also provide competitive advantage, whether as a part of the product itself, as an advantage to the making of the product, or as a competitive aid in the business process (for example, better identification and understanding of customers).

Competitive advantage cannot be understood by looking at a firm as a whole," Porter wrote. "It stems from the many discrete activities a firm performs in designing, producing, marketing, delivering and supporting its product. Each of these activities can contribute to a firm's relative cost position and create a basis for differentiation.Porter suggests that activities within an organization add value to the service and products that the company produces, and that all of these activities should be run at optimum level if the organization is to gain any real competitive advantage. If they are run efficiently, the value obtained should exceed the costs of running them — for example, customers should return to the company and transact freely and willingly.

Essential Requirements

If an enterprise wishes to enjoy competitive advantage it must carry out its activities in a cost effective way.

Such an enterprise needs to have a value chain where…

There are minimum number of activities

All activities are effective

All activities are performed at a relatively low cost.

Porter Value Chain

Porter classified the full value chain into nine interrelated primary and support activities.

Primary activities are performed to satisfy external demands.

Support activities are performed to serve the needs of internal customers.

Primary ActivitiesInbound logistics: This refers to everything involved in receiving, storing and distributing the raw materials used in the production process.

Location of distribution facilities,

Warehouse layout and designs

Operations: This is the stage where raw products are turned into the final product.

e.g. Efficient plant operations

Incorporation of appropriate process technology

Efficient plant layout and workflow design

Outbound logistics: This is the distribution of the final product to consumers. Effective shipping processes to provide quick delivery and minimize damages

Shipping of goods in large lot sizes to minimize transportation costs.

Marketing and sales: This stage involves activities like advertising, promotions, sales-force organization, selecting distribution channels, pricing, and managing customer relationships of the final product to ensure it is targeted to the correct consumer groups.

Innovative approaches to promotion and advertising

Proper identification of customer segments and needs

Service: This refers to the activities that are needed to maintain the product's performanceafter it has been sold out. This stage includes things like installation, training, maintenance, repair, warranty and after-sales services.

Quick response to customer needs and emergencies

Quality of service personnel and ongoing training

Primary activities Each of the categories may be vital to competitive advantage depending on the industry.

For a distributer, inbound and outbound logistics are the most critical.

For a service firm providing the services on its premises such as restaurant or retailer.

For a bank engaged in corporate lending , marketing and sales are a key to competitive advantage through the effectiveness of the calling officer and the way in which loans are packaged and priced.

However all the categories of primary activities will be present to some degree and play some role in competitive advantage.

Support activities

These are support activities .

These activities ensure the efficient performance of the primary activities.

Infrastructure -

Human Resource Management

Technology Department

Procurement.

The support activities help the primary functions and comprise the following:

Procurement: It refers to the function of purchasing inputs used in the firms value chain, not to the purchase input themselves. This is how the raw materials , supplies and the other consumable items for the product are obtained as well as assets such as machinery ,laboratory equipment, office equipment and buildings. For e.g. chocolate manufacturing and electric utilities for example procurement of cocoa beans and fuel respectively is by far the most important determinant of cost position.

Development of collaborative “win-win” relationships with suppliers

Analysis and selection of alternate sources of inputs to minimize dependence on one supplier

Technology development: Technology can be used across the board in the development of a product, including in the research and development stage, in how new products are developed and designed, and process automation.

Positive collaborative relationships between R&D and other departments

Excellent professional qualifications of personnel

Human resource management: It consists of activities involved in hiring,training, development, compensation and retaining the proper employees to help design, build and market the product. It supports both individual primary and support activities (hiring of engineers) and the entire value chain(Labour negotiations)

Quality relations with trade unions

Reward and incentive programs to motivate all employees

Firm infrastructure: This refers to an organization's structure and its management, planning, accounting, finance, quality-control mechanisms, legal and government affairs. Infrastructure unlike other support activities, usually supports the entire chain and not individual activities.

Effective planning systems

Excellent relationships with diverse stakeholder groups

Effective information technology to integrate value-creating activities

Value Created and Captured by a company – Cost of Creating that Value = Margin

Activity types

Within each category of primary and support activities, there are three activity types that play a different role in competitive advantage.

Direct activities- Activities directly involved in creating value for the buyer , such as assembly, parts matching, sales force operation, advertising, product design, recruiting etc.

Indirect – Activities that make it possible to perform direct activities on a continuing basis, such as maintenance, scheduling, operation of facilities, sales force administration, research administration, vendor record keeping etc.

Quality assurance- Activities that ensure the quality of other activities, such as monitoring, inspecting, testing, reviewing, checking, adjusting and reworking.

Project life cycle costing

It includes the cost associated with acquiring, using and disposing of physical asset.

It also includes the feasibility study , research and design, maintenance and replacement cost of the physical asset.

It is a technique which takes into account of the total cost of owning a physical asset or making a product during its economic life.

In this light product life cycle costs are incurred for products or services from their design stage through development to eventual withdrawl from the market.

Components of project cost

Acquisition cost : Cost of research, design and testing and purchase of capital equipment.

Transportation of handling cost of equipment

Maintenance cost

Operations cost such as energy cost and other utility cost.

Training cost such as training for maintenance of training and operation.

Inventory cost – cost of holding spare parts and ware housing.

Project Life Cycle Cost

Broadly it is divided into three categories

Initial Cost – Capital cost and set up cost . The asset can be in house or can be procured from supplier.

Operating cost – Apart from the operation and maintenance it includes some support costs like material handling, quality control and energy cost.

It also includes the following :

Cost of loss of production in down time , Cost of producing poor quality output, Cost of low utilization.

Disposal Cost

Disposal cost

Disposal cost may be significant as the asset must be dismantled and removed and the site made good for other use.

This cost can be offset by the disposal value of the asset.

Optimisation of project life cycle cost

To optimize life cycle cost it is necessary to do the following:

Assess the desired capacity of capital asset and their cost

Quantify the other life cycle cost apart from purchase cost

Optimise the trade-off between acquisition cost operation cost and disposal cost over the economic life of the asset.

Example : Computers sold with a one year guarantee . In this case it might be worth increasing manufacturing cost by 2% in order to improve the reliability of computer’s performance so that cost of repairs are less in the time of guarantee.

Understanding the calculations

XYZ ltd is about to replace its old boiler requirement either by a coal fired system or by an oil fired system. Finance cost is 15% per annum.

Other estimated cost

Initial Cost of Boiler : Rs.70000 for Coal and Rs.100000 for oil fired.

Annual operating cost of boiler : Rs60000 for Coal and Rs.45000 for oil.

If the company expected the new boiler system to work for at least 15 years which system should be chosen.

The present value annuity factor @ 15% is 5.847

Assignment

S ltd is about to replace its boiler equipment. Following three type of boiler systems are considered for replacement. The associated cost are given also. The new boiler system will have economic life of 10 years. The finance cost of the firm is 15% p.a. Which system should be chosen? (Present value Annuity factor @15% for 10 years: 5.019)

Boiler System Coal Fired Gas Fired Oil firedCost of Boiler 55000 74000 67000

Annual Fuel cost 27000 23000 25000Annual labour cost 8000 nil nil

Annual maintenance Cost 4000 3000 3000Annual Electricity Cost 1000 1000 1000