Classroom Companion: Business

 
Chapter 8 · Value Creation Models and Competitive Strategy

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8.2 
 Value Chain
Definition 8.1
The value chain can, in its simplest form, be represented as a linear chain consisting 
of three elements: logistics in (retrieval of raw material, components, or services), the 
production of goods, and logistics out (delivering goods to the market). In addition, 
there is a need for common activities such as management, buildings, inventory, stor-
age facilities, and research.
The value chain is illustrated in 
.
Fig. 
8.1
. The factory producing physical goods 
is a value chain. The actual chain modeling a factory may contain more elements 
in a series than the three basic elements in the definition (Porter included also mar-
keting and promotion and services in the chain).
The value chain is just a model by which it is easier to understand the economy 
and strategy of the classical industrial organization producing tangible goods. The 
value chain has been analyzed in depth by Michael Porter and other economists.
The logic behind the value chain is that the cost of a single item of a good can 
be computed as the sum of the cost of raw materials needed for each item (m), the 
cost of producing a single item (p), and the cost of shipping the item to the market 
(s). This sum is the direct cost (marginal cost) of the good. The total cost per item 
is then the sum of the direct costs and the cost of the common activities (A) per 
item. If the total production is n items, the common activities represent a cost of 
A/n per item. The total cost per item is then:
c
m
p
s
A n
=
+ + +
/ .
The major strategy of the chain is to reduce the cost per item. From the equation, 
it is obvious that this entails reducing the cost of raw materials, production, mar-
keting and sales, and the common cost. The marginal cost (or incremental cost) as 
n → ∞ is then:
Production
Logistics out
Logistics in
Common
activities
Final products
Raw materials
1
2
3
4
5
. Fig. 8.1 The value chain. (Authors’ own figure)