The gap between a firm’s costs and their customer’s willingness to pay represents a firm’s competitive advantage and profitability. To increase competitive advantage and profitability a company can either take actions (marketing, design, R&D) to try to increase the customer’s willingness to pay, or they can take actions to reduce costs.

While increasing the customer’s willingness to pay sounds like a simple enough concept, it is much more difficult to accomplish in practice than it is to talk about in theory. The structure of a company’s business model, its position in the market, or available capital and cash flow can seriously restrict a firm’s ability to engage in activities that could potentially increase the customer’s willingness to pay. Even when such resources do exist, there is never a guarantee that a tangible ROI with ever be captured.

For these reasons, many companies choose to focus on reducing cost. A company’s cost’s when properly understood and assessed represent the piece of the competitive advantage equation that can be controlled by the firm to a certain degree. One good method for cost analysis is to examine the costs associated with each step of the firm’s value chain. Below is a generic value chain for a manufacturing firm and the steps a firm should take to apply the value chain to cost analysis:

Sourcing the Value Chain
  • Step 1: Identify the principal activities that make up the value chain.
  • Step 2: Allocate total costs to each function within the value chain.
  • Step 3: Identify cost drivers within each value function.
  • Step 4: Identify linkages. How will a change in one functional area affect another?
  • Step 5: Develop strategies for cost reduction
The nice thing about applying the value chain to cost savings is that it helps keep cost reduction strategies consistent across the organization. When you look at any one of the functions on the above value chain in a vacuum, Goods Inventories for instance, it is easy to develop cost savings strategies that are very effective within that value function but detract from the organizational strategy’s consistency. Obviously any cost savings strategy is going to require trade-offs at different levels of the value chain, but looking at cost savings through a value chain lens can help mangers to make these trade offs in the areas that reduce costs most significantly with the smallest effect on the value added by the function or the organizational strategy as a whole.

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