The concept of Value Chains were introduced by Michael Porter in his book Competitive Advantage in 1985:
“The value chain disaggregates a firm into its strategically-relevant activities in order to understand the behavior of costs and the existing potential sources of (competitive) differentiation.”
In other words, the value chain is the connected activities (or capabilities) that are executed by an organization to create and deliver value.
Economic value creation is the process of adding economic value to a business incrementally. Economic value creation is the sum of the value created by each business unit within a given economic system or value chain. Value-addition happens in two phases:
- creating a new value; and
- maximizing the economic value created.
For instance, an organization creates a new value by providing a new product or service according to an unmet demand. The organization then maximizes the value creation by matching the end customer’s needs with the product or service which produces the highest economic profit. Value-addition at a company level is captured through the concept of value chain efficiency. In other words, getting the most bang for the buck.
In order to build a proper model of a business and create a more accurate value chain, we need to take a step back and think of the business as a closed system. We need to ask ourselves three questions:
- What is the state of the business? The activities which make up the business and the costs that are associated with each one are interconnected.
- What are the inputs that make up each activity? Input costs determine the price of the product. The relationship between inputs and prices affect demand and therefore sales, which in turn, influence costs and profits.
- What are the outputs? What are the products that are produced? Depending on the end-consumer, demand may also be influenced by competitive forces and government regulation.
The value chain provides a structure to model and frame that thinking, and informs how we can visualize and map it.
More on that in a following deep dive into Wardley (Value Chain) Mapping, coming up!