Value chains and value networks

1 Introduction

Organisations make profits by carrying out activities in ways that add value – doing things for customers that the customers cannot, or do not want to, do for themselves. This chapter looks at how that value creation is organised, starting inside the organisation and working outwards:

• Porter’s value chain – the activities inside one organisation

• Value analysis – using the chain to decide where value is really created

• Supply chains – the flow of materials from suppliers through to customers

• Value networks – value created by many co-operating organisations

• Value creation in ecosystems, networks and platforms – the way much of the modern economy now organises value creation, and a named requirement of the 2027 syllabus

The final sections matter particularly for the exam: two-sided platforms, network effects and ecosystem thinking now shape the business models of many of the world’s most valuable companies, and the syllabus asks you to analyse them and their impact on strategy.

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2 Porter’s value chain

Porter’s value chain groups all the activities an organisation carries out into nine categories: five primary activities (the sequence that physically creates and delivers the product and looks after the customer) and four support (secondary) activities that make the primary activities possible. Every activity has costs; a successful business organises and performs its activities so that customers willingly pay more than the total cost – the difference being profit, or margin.

For each activity there are real choices about how it is performed – and those choices are where strategy becomes concrete:

2.1 How activities add value

Suppose an organisation’s activities cost $10m in total and customers pay $14m. Porter almost treats the $4m margin as a piece of magic to be explained: why do customers hand over more than the activities cost? The only logical reason is that the organisation is doing something customers value but cannot or will not do for themselves:

• Know-how – customers could be given all the resources and still could not design the car’s suspension or engine; they are paying for expertise, not metal.

• Economies of scale – a supplier producing in huge volumes has unit costs each individual customer could never match. A customer wanting one-tenth of a factory’s output could not build a one-tenth-size factory at one-tenth of the cost – fixed costs do not shrink proportionately – so paying the supplier, including the supplier’s profit, is still cheaper.

• Risk transfer – customers pay specialists to shoulder risks they do not want. Licensed asbestos-removal contractors are paid less for lifting material into skips than for carrying the safety and legal risk of doing it properly.

• Location – the supplier may operate in a low-cost area while customers are in a high-cost one.

• Flexibility – buying in converts what would be the customer’s fixed costs into variable costs.

As always, competitive success then comes through one of Porter’s generic strategies – cost leadership or differentiation, each with or without focus (Chapter 10). The value chain is the tool for delivering the chosen strategy: a cost leader interrogates every activity for savings; a differentiator asks which activities create the superior value customers will pay extra for. Either way, management must understand the basic rationale of why customers pay the organisation a margin – and protect it. Cut an activity customers really value and the margin goes with it.

2.2 Linkages

Porter also emphasised the linkages between activities: the chain hangs together, and changing one activity changes others. Spending more on technology development to design a more reliable product can cut the cost of after-sales service. Spending more on training can make operations cheaper through right-first-time working. Moving head office out of an expensive capital city cuts infrastructure costs but may affect sales, marketing and outbound logistics. Strategic cost management means understanding these linkages, not cutting each activity in isolation.

2.3 Service industries

Although originally formulated for manufacturers, the value chain applies to service industries too. Some elements shrink in importance (inbound logistics, for a bank) while others grow: employees in service businesses are customer-facing, so human resource management can have a decisive effect on the value the customer perceives.

2.4 Value analysis

Used properly, the value chain supports value analysis – a systematic look at where value is created and where cost is incurred, so that the two can be compared activity by activity:

1. Map the organisation’s activities and attribute costs to each

2. Identify which activities create the value customers actually pay for (and which merely add cost)

3. Consider each activity’s configuration: perform it differently, spend more on it, spend less, outsource it, or eliminate it

4. Check the linkages, so that a saving in one activity does not destroy value in another

5. Repeat the exercise across the wider network – suppliers’ and distributors’ activities can be reconfigured too

Value analysis feeds directly into strategy integration (Chapter 10): when individual strategic choices are being assembled into a coherent whole, the value chain shows whether they reinforce or undermine each other.

3 The supply chain and supply chain management

Manufacturing organisations ultimately make profits by buying materials, processing them and selling the results. The arrangement of that flow is the supply chain, and managing it well means simultaneously achieving good customer service and low cost. Supply chain management involves:

• Integrating and managing the sourcing, flow and control of materials

• Covering the whole flow, from suppliers’ suppliers through to customers

• Co-ordinating potentially many suppliers and many customers

• Synchronising material receipts, processing and despatches

• Using IT throughout: customer orders automatically generate component lists, work schedules and supplier orders, allowing varied product specifications to be made efficiently without long identical production runs

Supply chains are described by a river analogy – picture materials floating downstream, through the organisation and on to customers:

• Upstream – everything that happens before inputs reach the organisation: the ore is mined, smelted, rolled into steel, delivered. For the organisation itself, the upstream chain covers procurement and inbound logistics.

• Downstream – everything from the organisation to the final customer: outbound logistics, marketing and sales, and service. (Interpret the terms flexibly – sometimes goods flow directly from supplier to customer, with the organisation acting purely as co-ordinator.)

Finally, supply chains can be driven in two directions:

4 From value chains to value networks

The value chain is essentially internal – how one organisation arranges its own activities. But no business is an island. Most sit inside a value network (or value system): what is ultimately supplied to, and paid for by, the final customer depends on activities carried out by many suppliers, logistics companies and distributors as well as by the organisation itself.

Two points follow:

• Every party must make a profit. The network as a whole must deliver enough value, efficiently enough, for the customer’s payment to fund a margin for everyone in it. An organisation that squeezes its suppliers to destruction weakens its own network.

• The configuration is a choice. Sell direct or through a distributor? Ship yourself or through a logistics partner – perhaps different answers for different products and regions? Reconfiguring the network (cutting out an intermediary, say, by selling online) can transform the economics of the whole chain.

5 Value creation in ecosystems

The 2027 syllabus goes a step beyond value networks, describing every organisation as inhabiting an ecosystem (Chapter 4 introduced the drivers of change within it). Two levels matter here:

• The wider ecosystem – the whole environment of markets, society, regulators and institutions in which the organisation adapts and evolves; it sets the ‘rules of the game’ and grants the organisation its permission to play.

• Industry (or business) ecosystems – smaller, more deliberate communities of organisations that choose to create value together around a shared offering: a smartphone maker with its app developers and accessory manufacturers; a games console with its game studios; a bank with the fintechs plugged into its interfaces.

In an ecosystem, value is created jointly: the offering customers actually buy (a smartphone that ‘does everything’) is assembled from contributions by many independent players. The strategic questions are then about roles and shares:

Distinguish value creation from value capture. An ecosystem may create enormous total value, but the share each participant captures depends on power within the system: orchestrators typically capture a disproportionate share (through fees, commissions and data), while complementors compete with each other and may capture little. Both questions – how much value does the ecosystem create, and how much of it will we capture – must be asked before joining or building one.

6 Networks and platforms

Many modern ecosystems are organised around a platform – a business whose product is not a good or service but a marketplace: it creates value by connecting two (or more) distinct groups and enabling transactions between them. Contrast the traditional ‘pipeline’ business:

6.1 Network effects

The engine of platform economics is the network effect: the platform becomes more valuable as more people use it.

Network effects have far-reaching strategic consequences:

• Winner-takes-most markets. Because the biggest network is the most valuable to join, platform markets tend to tip towards one or two dominant players. Being second is uncomfortable; being fifth is usually fatal.

• Growth before profit. Platforms rationally subsidise participation in the early years – free listings, discounted rides – because scale today is the source of profit tomorrow. Conventional profitability metrics can mislead; hence the scale, active-usage and engagement metrics of Chapter 17.

• Switching costs and multi-homing. Dominance is entrenched where users find it costly to leave (data, reputation and reviews are not portable) but is fragile where participants can cheaply ‘multi-home’ – drivers running two ride-hailing apps at once, say.

6.2 Technology enablers

Platforms and networks at today’s scale are possible only because of a cluster of technologies (covered in more depth in Chapters 15–17):

• Cloud computing – capacity on demand, so a platform can serve millions of users without owning data centres from day one.

• APIs (application programming interfaces) – standard connection points through which complementors plug their software into the platform; APIs are how an ecosystem physically assembles itself.

• Big data and analytics – matching algorithms (rider to driver, buyer to product), dynamic pricing and personalisation (Chapter 9).

• Mobile devices and digital payments – put the marketplace in every participant’s pocket and let strangers transact instantly.

• Trust systems – ratings, reviews and identity verification substitute for the trust that traditional intermediaries used to provide.

6.3 Creating a network or platform

Building a platform is not like launching a product, because at launch a platform is worthless: with no drivers there is nothing to attract riders, and with no riders nothing to attract drivers. Every platform faces this chicken-and-egg problem, and recognised seeding strategies exist for solving it:

• Subsidise one side. Decide which side is more price-sensitive or harder to attract and let it participate cheaply or free, charging the other side. Card networks charge merchants, not cardholders; job boards charge employers, not applicants.

• Seed the supply side yourself. Provide the initial content or inventory directly – a games console maker developing its own launch titles until independent studios arrive.

• Start in a narrow niche. Reach critical mass in one city, campus or category, prove the model, then replicate – far easier than being thinly spread everywhere.

• Convert an existing pipeline. A retailer that opens its established shop and customer base to third-party sellers starts with one side already built.

Once running, the orchestrator must govern the platform, and the governance choices are themselves strategic:

• Access: who may join each side, and on what verification

• Pricing: which side pays, and what commission (‘take rate’) the platform charges – squeeze complementors too hard and they defect or regulators intervene

• Quality and conduct rules: standards, review integrity, dispute resolution

• Data rights: who owns and may use the transaction data the platform generates

• Openness: an open platform grows faster; a closed (curated) one keeps quality and captures more value – Android versus iOS illustrates the trade-off

6.4 Stakeholder analysis in networks

Chapter 3 introduced stakeholder analysis and Mendelow’s power-interest matrix for a single organisation. The 2027 syllabus asks you to conduct stakeholder analysis in networks, where the cast list and the power dynamics are different:

• Both (or all) sides of the market are stakeholder groups in their own right, with opposed interests on pricing – every commission point is transferred between sides

• Complementors depend on the platform yet compete with it (platforms are regularly accused of copying their most successful complementors); their power depends on how easily they can multi-home

• The orchestrator holds structural power – it sets the rules and sees all the data – but its position rests on keeping enough participants on every side willing to stay

• Regulators and society take intense interest: competition authorities scrutinise dominance and self-preferencing; regulators examine gig-economy working conditions, content moderation and data use

• Traditional intermediaries being displaced (taxi firms, hotels, high-street retailers) are stakeholders too, and often lobby hard

The analytical tools still apply – assess each group’s power and interest – but power in a network derives from position: from whether a participant can credibly leave, from control of the rules and the data, and from network effects themselves. For an orchestrator, keeping key players ‘satisfied’ means keeping the ecosystem healthy enough that participation beats defection; for a pipeline firm, the analysis is usually about a handful of known counterparties instead.

7 Test your knowledge

Two short exercises close the chapter in the online notes: ten flashcards on the terms and frameworks above, and ten practice questions with worked feedback on every option. Work through the cards first, then the questions.