scm and vca

scm and vca - Transcript

JMAR Volume Four Fall 1992

Strategic Cost Management The Value Chain Perspective
John K Shank Vijay Govindarajan Dartmouth College
Abstract The value chain concept has been discussed in the strategy literature for more than a decade now As a generic concept for organizing our thinking about strategic positioning its significance is widely accepted But empirical examples of the power of the concept tor shaping cost analysis have not yet reached the literature This paper reports a disguised field study in which a value chain is constructed The insights for cost management which emerge are contrasted with those which are suggested by two traditional analysis techniques a 2x2 growth share matrix and conventional cost analysis The purpose of the paper is to extend our knowledge about how to construct and use value chains in managerial accounting The authors believe the concept is powerful and deserves far more empirical study as a way to make the strategic perspective more explicit in managerial cost analysis While accounting systems do contain useful data for cost analysis they often get in the way of strategic cost analysis Porter 1985 page 63

One of the major themes In strategic cost management SCM concerns the focus of cost management efforts Stated ln question form How do we organize our thinking about cost management In the SCM framework managing costs effectively requires a broad focus external to the firm Porter 19851 has called this the value chain The Value chain for any firm in any business is the linked set of value creating activities all the way from basic raw material sources through to the ultimate end use product delivered into the final consumers hands This focus is exiemcd to the firm seeing each firm in the context of the overall chain of value creating activities of which it is very probably only a part We are aware of no firms which span the entire value chain in which they operate A firm such as Chevron in petroleum spans wide segments of the value chain in which it operates from oil exploration to service stations but it does not span the entire chain Fifty percent of the crude oil it refines comes from other producers and more than one third of the oil it refines is sold through other retail outlets Also Chevron is not in the auto business at all the major user of gasoline More narrowly a firm such as Maxus Energy is only in the oil exploration and production business The Limited Stores are big downstream in retail outlets but own no manufacturing facilities Reebok Is a famous shoe brand but the firm owns very few retail outlets Reebok does however own its factories Though the value chain concept has been around for more than 10 years the strategic power of this concept has not been well articulated Based on an extensive literature search we were not able to find even one complete empirically derived value chain for a firm There is a clear need

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to begin to document real world examples of how the value chain framework provides strategic Insights that are unlikely to emerge from other frameworks We believe it is important to begin to bring this perspective into the domain of managerial accounting This paper is an attempt to begin to fill this need

STRATEGIC POWER OF THE VALUE CHAIN ANALYSIS THE BASICS
Whether or not a firm can develop and sustain differentiation and or cost advantage depends fundamentally on the configuration of its value chain relative to the value chain configuration of each of its competitors We believe Porter 1985 is correct when he argues that competitive advantage in the marketplace ultimately derives from providing better customer value for equivalent cost or equivalent customer value for a lower cost From this perspective value chain analysis is essential to determine exactly where In the firm s segment of the chain from design to distribution customer value can be enhanced or costs lowered As argued by Shank 19891 Ignoring linkages upstream from the firm as well as downstream is just too restrictive a perspective Danger of Ignoring Value Chain Linkages The value chain framework is a method for breaking down the chain of activities that runs from basic raw materials to end use customers into strategically relevant segments In order to understand the behavior of costs and the sources of differentiation As noted earlier a firm is typically only a part of the larger set of activities in the value creation and delivery system Since no two firms of which we are aware even in the same industry compete in exactly the same set of markets with exactly the same set of suppliers the overall value chain for each firm is unique Suppliers not only produce and deliver Inputs used in a firm s value activities but they importantly influence the firm s cost differentiation position For example developments by steel mini mills lowered the operating costs of wire products users who are the customers of the customers of the mini mill 2 stages down the value chain Similarly customer s actions can have a significant Impact on the firm s value activities For example when printing press manufacturers create a new press of 3 meters width the profitability of paper mills is affected because paper machine widths must match some multiple of printing press width Mill profit is affected by customer actions even though the paper mill is 2 stages upstream from the printer who is a customer of the press manufacturer As we will discuss more fully below gaining and sustaining competitive advantage requires that a firm understand the entire value creation and delivery system no just the portion of the value chain In which it participates Suppliers and customers and suppliers suppliers and customers customers have profit margins that are important to identify in understanding a firm s cost differentiation positioning since the end use customers ultimately pay for all the profit margins along the entire value chain The center column of Exhibit 1 presents a conceptual value chain for the paper industry The distinct value activities such as timber growing

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Exhibit Value Chain in the Paper Product Industry I

i

Silvaculture and Timber Fanning

CQ b

Logging and Chipping
U

o a U

Competitor

Pulp Manufacturing
Q
0

ompeti

Paper Manufacturing

I

mpetitc

1

d

Converting Operations
Competitor E

0

Distribution

1

3

End Use Customer

d

logging pulp manufacture paper manufacture conversion and distribution are the building blocks by which this industry creates a product valuable to buyers It is possible to quantify the economic value created at each stage by identifying the costs revenues and assets for each activity What we argue is that every hypothetical firm shown on the left or right side in Exhibit 1 A B C D E F and G must construct a value chain for the total paper industry breaking the total value in the chain into its fundamental sources of economic value Such an analysis has potential strategic implications for every competitor in each segment of this industry Value Chain Insights for DifTerent Competitors If competitor A the most fully integrated company in the exhibit calculates the Return on Assets at each stage of the chain by adjusting all transfer prices to competitive market levels it could highlight potential areas where the firm could more economically buy from the outside

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Instead of making strategic choice of make or buy For example most of the fully integrated forest product companies still use independent loggers to cut their trees on the way to their mills With a complete value chain competitors B C D E F and G might be able to identify possibilities to forward or backward integrate into areas which can enhance their performance Westvaco for example recently stopped manufacturing envelope paper although it still owns a large envelope converter Champion International on the other hand has sold its envelope converting business but still produces envelope paper Both choices although apparently inconsistent could be plausible given the specific strategies of Westvaco and Champion Each value activity has a set of unique cost drivers that explain variations in costs in that activity Shank 1989 Thus each value activity has its unique sources of competitive advantage Companies are likely to face a different set of competitors at each stage Some of these competitors would be more fully integrated companies and some of them would be more narrowly focussed specialists For instance firm D in Exhibit 1 faces competition from firms A C and G in the paper mill stage Yet firms A C and G bring very different competitive advantage to this stage of the value chain vis a vis firm D It is possible for firm D to compete effectively with firms A C and G only by understanding the total value chain and the cost drivers that regulate each activity For example if lack of scope vertical integration is an Important structural driver of paper mill cost A has a significant advantage and D a significant disadvantage in this marketplace Since each firm illustrated in Exhibit 1 is both a buyer and a seller somewhere within the chain calculating the profit and ROA earned at each stage can help in understanding the relative power of buyers versus sellers at that stage For example comparing the returns for firm E versus F can help identify the relative power within the chain of the converting stage for which E is a supplier but F is a buyer This then could help the firms in identifying ways to exploit their linkages with their suppliers as well as with their customers to reduce costs or enhance differentiation or both

Value Chain versus Value Added Analysis The value chain concept can be contrasted with the internal focus that is often adopted in management accounting as alluded to in the quote at the outset of this paper Management accounting as explained In leading textbooks usually takes a value added perspective starting with payments to suppliers purchases and stopping with charges to customers sales The key theme is to maximize the difference the value added between purchases and sales under the assumption that this is the only way a firm can influence profits We argue that the value chain not value added is the more meaningful way to explore strategic issues Value added analysis in which the firm focuses only on its own operations in looking for profit enhancement opportunities can be quite misleading in two ways The value added concept starts too late Starting cost analysis with purchases misses all the opportunities for exploiting linkages with the

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firm s suppliers The word exploit does not imply that the relationship with the supplier is a zero sum game Quite the contrary it implies that the lirik should be managed so that both the ftrm and its supplier can benefit For instance when bulk chocolate began to be delivered in liquid form in tank cars instead of ten pound molded bars an industrial chocolate firm i e the supplier eliminated the cost of molding bars and packing them and a confectionery producer saved the cost of unpacking and melting Porter 1985 In addition to starting too late the value added analysis has another major flaw it stops too soon Stopping cost analysis at sales misses all the opportunities for exploiting linksiges with the firm s customers Here again we contend that the relationship with the customer need not be a zero sum game but one in which both parties can gain For instance some container producers have constructed manufacturing facilities next to beer breweries and deliver the containers through overhead conveyers directly onto the customers assembly line This results in significant cost reductions for both the container producers and their customers by expediting the transport of empty containers which are bulky and heavy Hergert and Morris 1989 The value chain framework highlights how a firm s products fit into the buyer s value chain For instance under the value chain framework it is readily apparent what percentage the firm s product costs are in the buyer s total costs The fact that paper constitutes over 40 percent of the total costs of a magazine is signiflcant in encouraging the paper mill and the publisher to work together in cost reduction activities The San Francisco Chronicle recently adopted JIT for paper delivery to its printing plant a program only possible with close supplier cooperation Since the valueadded concept ignores activities after the product leaves the firm it often does not highlight the degree of buyer power Emphasizing the Interdependence of Linked Activities Along a Value Chain Value chain analysis explicitly recognizes the fact that the individual value activities within a flrm are not independent but rather are interdependent For instance at McDonalds the timing of promotional campaigns one value activity signiflcantly influences capacity utilization in production another value activity These linked activities must be coordinated if the full effect of the promotion is to be realized As another example Japanese VCR producers were able to reduce retail prices from 1 300 in 1977 to 298 by 1984 by emphasizing the impact of an early step in the chain product design on a later step production by drastically reducing the number of parts in VCRs Hergert and Morris 19891 It is common to hear of conventional approaches to cost reduction which emphasize acrossthe board cuts However by recognizing interlinkages the value chain analysis highlights the possibility that deliberately increasing costs in one value activity can bring about a reduction in total costs The expense incurred by P G to place its order entry computers directly in Walmart stores significantly reduces overall order entry and processing costs for both firms

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Calculationai Difficulties We do not wish to imply that constructing a value chain for a flrm is easy There are several thorny problems to confront calculating a value for intermediate products isolating key cost drivers identifying linkages across activities and computing supplier and customer margins The analysis starts by segmenting the chain into those components for which some flrm somewhere does make a market even if other firms do not This will catch the segments outlined in Exhibit 1 for the paper industry for example One could start the process by identifying every point in the chain at which an external market exists This gives a good first cut at identifying the value chain segments One can always find some narrow enough stage such that an external market does not exist An example would be the progress of a roll of paper from the last press section of a paper machine to the first dryer section on the same machine There is obviously no external market for paper halfway through a continuous flow paper machine Thus seeing the press section and the dryer section of the paper machine as separate stages in the value chain is probably not operational Part of the art of strategic analysis is deciding which stages in the value chain can meaningfully be decoupled conceptually and which cannot Unless some flrm somewhere has decoupled a stage by making a market at that stage one cannot independently assess the economic profit earned at that stage But the opportunities for meaningful analysis across a set of firms that have deflned differently what they make versus what they buy and what they sell are often very significant The fact that this is not always possible does not in our view negate the significance when it is possible Despite the calculationai problems we contend that every flrm should attempt to estimate its value chain Even the process of performing the value chain analysis in and by itself can be quite instructive In our experience we have found this exercise invaluable to managers by forcing them to carefully evaluate how their activities add value to the chain of customers who use their product service We present below a case study from our field research the name of the company and the flnancial data are disguised which we believe illustrates the strategic power of a value chain analysis NORTHAM PACKAGING COMPANY The Business Setting NorthAm Packaging Company produced 206 000 tons of coated paperboard in 1989 This paperboard was sold to consumer product firms processors who formed the paperboard into cartons then filled and sealed them for shipment to retail outlets NorthAm served two market segments In 1989 146 000 tons of the company s output went to commodity product flrms for whom the carton was Just a box For these firms price is the major purchase characteristic assuming normal quality and service The company had 40 percent market share in this segment These proces

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sors products were considered commodities because they did not have an ability to achieve a price premium for the brand name These processors were typically smaller in size NorthAm sold to over 300 customers in this segment Overall sales in this segment had declined 3 percent per year over the last five years but were believed to have stabilized in 1989 The second customer segment to whom NorthAm sold 60 000 tons of paperboard in 1989 was high quality differentiated processors for whom the carton was an important element of the marketing strategy NorthAm had a 15 percent market share in this segment These processors were typically larger in size NorthAm sold to only six customers in this segment This segment was growing at approximately 10 percent per year and was projected to grow even faster in the future The quality of the packaging material strength durability and printability was particularly important for this segment since the carton was a point of sale merchandising aid for the differentiated products NorthAm s market share in this segment had declined over time Customers attributed the decline to NorthAm s inability to consistently produce the high quality board this segment demands NorthAm was one of four major competitors in the coated paperboard industry Because of the scale technology and integration economies of these firms new entrants were effectively shut out Substitutes Plastic was the major substitution threat to the manufacturers of coated paperboard Shell Chemical and Hoover Intemationai now Johnson Controls had changed the consumer packaging industry overnight in 1965 when they combined to introduce the plastic resin pellet and the blow molding machine to manufacture plastic cartons At first the polyethylene pellets supplied by Shell Chemical were quite expensive But the blow molding machine was so easy to use that plastic made steady inroads into the consumer packaging industry However there were several reasons why coated paperboard continued to be used First although plastic was more economical when the price of plastic resin was low high plastic resin prices made coated board look good Guessing future levels of ethylene gas prices the basic driver of polyethylene price was a notoriously difficult task Second processors did not want to be at the total mercy of oil companies By using dual suppliers processors created a hedge against the volatile price of plastic resin For instance in 1988 a ftre in a Shell refinery in Louisiana destroyed 30 percent of the polyethylene pellet supply in the U S overnight and forced many processors who had largely converted to plastic back to coated board Third as new uses of the plastic resin were created industrial and consumer uses of plastic containers the input price was bound to go up Fourth since plastic was just a by product for the oil companies there was no real assurance of supply Finally environmental indignation over plastic jugs was heating up They were being outlawed in many states because of problems with burning them or dumping in landfills The most populous county in the U S Suffolk County on Long Island passed legislation in 1987 banning plastic cartons from its landfills

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Cost Structure One way to understand NorthAm s position Is to analyze and discuss the process flow from basic raw material sources through to the ultimate end use product delivered into the final customers hands However in order to keep this paper to manageable length we focus our discussion on the paper mill extrusion and conversion stages of the chain which relate to NorthAm The timber logging chipping and pulp mill stages are deemphasized because they are not critical to the issues addressed here Obviously the full value chain would consider these stages as well Step 1 Paperboard Manu cturlng The Mill NorthAm s primary manufacturing facility bought pulp on the open market for 319 per ton and converted the pulp into uncoated paperboard at an additional cost of 105 per ton The 105 is an average actual full cost figure We believe the analysis should use full cost since the focus is long run We use average actual cost as the best proxy for future cost The company sold some of the uncoated board to outside customers at an average price of 483 per ton plus freight to the customer On these shipments the mill earns a profit of 59 483 319 105 as shown in E Xhibit 2 But the major customer for the uncoated board was NorthAm s own plastic extruding plant Step 2 Adding the Plastic Coating Extrusion The uncoated board was then trucked to a nearby coating plant at an average cost of 3 per ton Polyethylene coating was applied to both sides of the board by two extruders at an average full cost of 91 per ton At this stage the product cost is 518 319 flO5 3 i 91 But using market price to value the transfer the economic cost is 577 483 3 91 Coated board was currently sold in the market for an average price of 605 plus freight On these shipments the extruding plant earns an economic proilt of 28 per ton 605 577 as shown in Exhibit 2 The uncoated board from the mill is valued here at the external market price in order to measure segment profit Step 3 Carton Conversion After extrusion the coated board is shipped to NorthAm s carton converting plant at an average freight cost of 35 per ton In the first stage of the converting operation rolls of coated paperboard are spliced together to form a long continuous web Next each particular processor s name logo and design is printed on one side Then the carton container blanks are stamped out and stacked on shipping pallets for loading The total cost of the conversion operation averaged 234 per ton The converting plant also paid an average of 10 per ton for freight to the end use customers Industiy statistics showed that one ton of board yielded an average of 14 400 containers All carton conversion costs are shown in Exhibit 2 Step 4 The Filling Piants Processors of Consumer Products The blank cartons containers were setup filled and then sealed in the processor s factory The processors delivered their products to convenience

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Journal of Management Accounting Research Fall 1992

stores and supermarkets Without recycling the cycle was complete when consumers purchased the products and eventually threw away the disposable cartons The processors who produced an undlfferentiated product usually paid 08 per carton The other costs of such processors were on average product cost 75 per carton and converting distribution and shrinkage 12 per carton They sold a carton of the commodity product for an average of 1 04 to supermarkets Their profit per carton was 09 1 O4 O8 75 12 This converts to 1 296 per ton of coated paperboard 14 400 cartons ton x 09 as shown in Exhibit 2 The differentiated processors on the other hand had a very different cost structure Their average container cost was 07 product cost 64 per carton converting distribution and shrinkage 11 per carton national selling and advertising 25 percent of the 1 42 per carton wholesale price to supermarkets or 36 per carton The branded processor thus earned a profit per carton of 24 1 42 07 64 11 36 This converts to 3 456 per ton of paperboard 24x14 400 as shown in Exhibit 2 It is an anomaly of this industry that the higher quality differentiated carton actually sells for less than the commodity carton 07 versus 08 This is because of substantial quantity discounts in the difierentlated segment In this segment 60 000 tons are spread over 6 customers whereas 146 000 tons are spread over 300 customers in the commodity segment Step 5 The Retailer The Supermarkets A typical supermarket sells the undifferentiated product for 1 16 and the branded product for 1 89 The entire value chain all 5 steps is summarized in Exhibit 2 This exhibit shows only gross margin for the supermarket without an allocation of store operating expenses Such an allocation is not relevant for the purposes of this example The first three steps in the chain relate to NorthAm The final two steps relate to the processors of consumer products and the supermarkets to whom they sell The assets invested at each stage of the process were estimated as follows We valued assets using current replacement cost and assuming full utilization of the item This included allocation of common assets based on full utilization where several products were involved Current Replacement Value of Assets Per Ton of Paperboard when operating at practical capacity Paperboard Mill 2 800 Extruding Plant 190 Carton Converter 830 Commodity Processor 5 400 Differentiated Processor lower investment per ton because of scale economies 2 890 Supermarket 1 800 This five step value chain approach to cost reporting is very unusual in management accounting but we believe the inferences it suggests as shown later justify this framework Parenthetically we might note that in generating the cost and asset numbers for processors and supermarkets we followed multiple ap

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proaches we Interviewed NorthAm executives about their customers cost structures we visited several processors and supermarkets and Interviewed managers about their costs and investments The resulting numbers though not precise are reasonable enough estimates to draw meaningful inferences We turn now to the business decisions NorthAm was facing Strategic Options Which market segment should NorthAm emphasize Where should It Invest capital dollars The strategic positioning and capital spending decisions facing NorthAm as of 1989 would shape its future for many years to come On the choice of market segments NorthAm considered two specific alternatives The company could continue to emphasize the commodity processors whose total market had been declining 3 percent a year but who had always been their main customers Or they could try to aggressively build market share with differentiated processors whose market was growing at 10 percent or more and who would pay top dollar for board holding quantity discounts constant but who demanded a consistent high quality NorthAm recognized Its weaknesses vIs a vIs the differentiated segment Technologically obsolescent manufacturing Most of the plant and equipment had been bought in the 1960s Nagging problems with the quality of the board caused by lack of up to date machinery Limited extrusion capacity Lack of rotogravure printing in the conversion plant Their 15 percent market share in the differentiated segment reflected their status as largely a backup supplier Major capital investments a total of 61 5 million had to be made If NorthAm was serious about rebuilding market share In this fast growing segment Three specific new Investments would be About 43 million to upgrade its primary manufacturing facility to improve board strength printability and smoothness About 17 million to add a new extruder to compete in multilayered polymer coating applications Differentiated processors required multiple coatings to extend the shelf life of products and to hold difficult products liquids for example About 1 5 million to purchase a rotogravure printing press Currently NorthAm printed the cartons with fiexographic presses which use rubber printing rolls This method is Inexpensive but produces low quality images After the initial capital investment the rubber plates cost about 150 each with six needed for a standard six color process Although the quality was not as good as with rotogravure printing high quality printing had never been required by the commodity processors Rotogravure printing uses etched metal printing rolls and gives an extremety precise and high quality finish but It is expensive After the initial capital expense each etched metal printing plate costs 2 500 With a six color process 15 000 must be spent for only one run Once that

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run Is complete those etched cylinders will probably never be used again This completes the case study itself In the next section we compare the results of several different ways of analyzing the strategic options Conventional Analysis of the Strategic Options How should NorthAm s senior executives evaluate the marketing and investment options open to them Conventional capital expenditure requests using discounted cash flow analyses had been prepared to Justify the proposed investments These focussed solely on projected Value added for NorthAm Using assumptions recommended by the marketing group these DCF analyses showed acceptable returns for NorthAm for investing 61 5 million to build market share in the differentiated segment Exhibit 3 Exhibit 3 NorthAm Packaging Company Capital Investment Analysis DiHerentiated Segment Capital investments needed in year 0 Primary manufacturing 43 million Third extruder 17 million Rotogravure printing 1 5 miliion Total 61 5 million Annual Cash Flows Per Ton Revenue assumes a 10 price increase due to a better quality board 7 7 x 14 400 l iO9 Costs per Exhibit 2 319 105 3 91 35 234 10 797 Plus additional printing costs due to rotogravure printing 10 Proilt per ton 302 Total market differentiated segment 400 000 tons Projected market growth 14 Additional volume next year 400 000 x 14 56 000 Assume we can capture 50 of this additional volume 28 000 Plus a 5 increase in our share of the existing market 400 000 X 5 20 000 Additional Volume 48 000 tons We ignore additional growth beyond year 1 to be conservative Annual Cash Proilts 48 000 x 302 14 5 million After tax profits 40 tax rate 8 7 million Plus depreciation lax shield straight line depreciation for 10 years 6 15 million x 40 2 46 million Total annual cash flows 11 16 million Time horizon for the project 10 years Salvage value of the plant and equipment In year 10 after tax 3 million All cash flows are in real dollars inflation is not incorporated Internal Rate of Return Approx 13 after tax real return

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Another way to address these options would be through a simple 2x2 growth share matrix as originally introduced by the Boston Consulting Group IHenderson 1979 Exhibit 4 displays NorthAm s strategic options on this familiar portfolio grid using the dimensions of market growth a proxy for market attractiveness and market share NorthAm had historically emphasized the commodity segment Even though volume had been shrinking at 3 percent per year over the past five years the ftrm had maintained market share at 40 percent in this large segment 350 000 tons per year This segment appears to be the classic cash cow in the BCG terminology high market share with low growth The strategic inference from the BCG grid would be that NorthAm should harvest this commodity segment The firm on the other hand had a relatively modest 15 percent of the market in the differentiated package segment The overall market in this segment was growing at 10 percent per year with projections to grow even faster in the future NorthAm has a low market share in this high growth segment The strategic inference from the BCG grid would be that NorthAm should aggressively build market share in this segment by making the 61 5 million in new Investments Hiis was in fact the prevailing sentiment within NorthAm when we undertook the value chain analysis This point of view was supported by formal financial analysis using DCF techniques Exhibit 3 as indicated above A 13 percent real return certainly argues for investing 61 5 million to build share in the differentiated segment An alternative way of viewing NorthAm s problem using different input assumptions might yield different analytic inferences For instance value chain analysis as we will show later casts severe doubt on the assumption In Exhibit 3 that the differentiated segment will give NorthAm a 10 percent price increase
Exhibit 4 Boston Consulting Group Grid Htgh Build Differentiated Processor Segment Market Growth Divest Harvest Commodity Processor Segment High Relative Market Share Hold

Low

Low

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Strategic Analysis A Value Chain Perspective Organizing the information in the value chain framework Exhibit 2 provides a fundamentally different view of the marketing and investment options facing NorthAm Exhibits 5 through 7 summarize the inferences from the value chain framework Recapping the methodology we used in creating the value chain was as follows Identify Value Chain Stages We identified the mill extruder converter processor and supermarket as the key building blocks in the value chain A conventional management accounting system will tend to ignore the value created by the processors and supermarkets because they are beyond the scope of profitability to the firm Identify Strategic Options Since the value chain analysis was done to draw inferences about two strategically distinct market segments we prepared separate value chains for the commodity and differentiated processor segments Assign Costs and Revenues to Value Chain Steves After identifying the value chain activities and strategic options the next step was to assign operating costs and revenues to these activities Exhibit 2 All costs and revenues have been calculated for one ton of paperboard using estimated average actual full cost Estimated Market Value Transfer Prices NorthAm s converting operations have a true market price for sales to the processors But how can we approximate value for intermediate products Uncoated board is transferred internally from the mill to the extruder and coated board is transferred Internally from the extruder to the converter Since uncoated and coated paperboard are also traded in external markets we used the competitive market prices for the intermediate products Calculating profit per ton for each value activity based on the competitive market price as opposed to arbitrary accounting transfer prices helps to identify the fundamental sources of economic value and allows each stage to be evaluated independently Exhibit 5 summarizes the profit earned at each stage in the linked value chain Estimated Asset Ini stment We then estimated the assets per ton of board at each value activity using current replacement costs and assuming full utilization of capacity see earlier discussion Current replacement costs were estimated from discussions with plant engineers and equipment vendors Tons of production at full capacity were estimated from discussions with manufacturing management and equipment vendors With profit and assets we calculated Return on Assets for each value stage as summarized In Exhibit 6 Calculational Accuracy We should emphasize that the computations In Exhibits 2 3 5 and 6 do not involve the same level of precision that one is likely to encounter in audited financial statements In fact profit margins for processors and supermarkets are based on estimates that average away substantial continual day to day volatility in net prices As the analysis proceeds and particular activities become critical in answering strategic questions greater effort at precision can be made



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Exhibit 6 Profit Per Ton of Board Data U ken from Exhibit 2 Supermarket Processor Converter Extruder
MIU

NorthAm

Commodity Segment Differentiated Segment 6 768 1 728 3 456 1 296 124 268 28 355 28 211
59
59

Total NorthAm of Profit

3 379 10 5

10 435 2 0

Exhibit 6 Return On Assets Per Ton of Paperboard Based on Current Replacement Cost and Full Capacity Utilization Differentiated Segment Commodity Segment Profit Assets ROA Pro it Assets ROA 6 768 1 800 376 1 728 1 800 96 Supermarket 2 890 120 5 400 24 3 456 Processor 1 296 124 830 15 268 830 32 Converter 190 15 15 28 Extruder 28 190 2 800 2 2 800 2 59 59 Mill 8 510 123 3 1 10 435 Total 3 379 11 020

New Insights Does the information based on value chain analysis lead to new insights We believe it does Dramatically different strategic insights emerge when one considers the value chain analysis summarized in Exhibit 7 Of the total profit of 3 379 per ton of paperboard created in the commodity processor segment NorthAm realized 355 10 5 percent of the total value In sharp contrast in the differentiated processor segment NorthAm s share of the total profit in the chain is only 2 percent The buyer power in the differentiated segment is extremely strong As we noted earlier the average customer In the differentiated segment is much larger than the average commodity segment customer Even though the carton is of higher quality and is much more a marketing tool in the differentiated segment volume discounts and overall buyer power hold unit prices below those for the commodity carton Thus NorthAm actually does more work here with more assets for a lower sales price on a per unit basis We should note that there is no particular reason ex ante to believe that 10 5 percent of the overall profit in the commodity segment Is a reasonable or unreasonable share for the carton manufacturer versus the processor or the retailer But whatever the share is for the

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Exhibit 7 NorthAm Packaging Company A Value Chain Perspective Differentiated Segment Commodity Segment of the of the Total Total Pront Pront ROA Pront Pront ROA
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28 124 3 456 6 768 10 435

25 1 2 33 65 100

15 15 120 376

268
1 296

I

L T J
1 728 3 379 49 100 96 Supermarket

carton manufacturer in the commodity segment the share should be higher in the differentiated segment where the carton is more expensive to make and is much more important as a polnt of sale marketing tooL Although NorthAm does not separate commodity end use carton stock from differentiated end use carton stock as it is produced the differentiated end use product must run slower to produce smoothness t hus yielding fewer tons per hour and higher cost per ton For the share of overall profit to drop from 10 5 percent to 2 percent is dramatic evidence of the lack of seller power for NorthAm in the higher value segment The 07 carton price ln the differentiated segment presumes a product which meets quality standards That is there is no way to charge more than 07 the prevailing price in this segment once the quality improvements are achieved NorthAm s Return on Assets ROAs in the commodity segment is 2 percent at the mill 15 percent at the extruder and 32 percent at the converter On the other hand in the differentiated segment the ROAs are 2 percent 15 percent and 15 percent for the mill extruder and converter respectively This further reinforces the unattractiveness of the differentiated segment From the BCG grid Exhibit 4 the differentiated processor segment looked extremely attractive But based on the value chain analysis this market looks much less attractive The differentiated processors have enormous leverage buyer power Why invest over 60 million to build market share in the differentiated segment where NorthAm is currently able to extract only 2 percent of the total value created in the chain This insight is neither apparent In the BCG type strategic analy

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sis nor In a conventional management accounting approach relying on DCF based project returns to NorthAm In fact the value chain analysis calls into question the sales volume and selling price assumptions used in the DCF analysis contained in Exhibit 3 Further conventional management accounting is of little help in quantifying buyer power since it ignores the total value created in the chain It is highly unlikely that NorthAm will be able to extract any more than 2 percent of the total value in the differentiated segment even after it matches its leading competitor s investment due to the buyers tremendous bargaining power unless the differentiated processors are willing to share some of their profit in order to entice an investment by NorthAm There are very few buyers in the differentiated segment fewer than ten versus more than 1 000 in the commodity segment Buyers are very large The average order size tends to be quite large Differentiators typically keep two or more sources of supply Poor service quality or uncompetitive prices are punished by cuts in order size Plastic has several attractive features as a packaging material break resistance design versatility eye appeal printability Plastic poses a more significant threat to coated board in the differentiated segment since this segment values more highly the marketing appeal of the package This substitution threat sets a cap on paperboard carton prices and a corresponding cap on investment returns once the overwhelming buyer power is factored into the analysis Overall the value chain perspective yields a much different picture of this industry It appears to be an industry where the closer one gets to the end use customer and the more one creates product differentiation the more money will be made Exhibit 7 NorthAm seems to lose on both counts They lack the ability to forward integrate into the processor and supermarket segments Further we have already argued that NorthAm lacks the product quality to successfully compete as a supplier to the differentiated processor segment What should they do NorthAm s position is similar to having failed to improve your hand in the draw in a poker game Do you put more money in the pot even if you know you have a bad hand Do you fold Or do you stay in as long as possible without adding much to the pot NorthAm instead of de emphasizing the commodity segment as would be recommended by the BCG type analysis needs to find ways to effectively compete in the commodity segment by being the low cost producer Here again the value chain framework can provide important insights NorthAm needs to understand the structural and executional drivers of cost behavior for the major cost items in the mill extruder and converter operations Shank 1989 NorthAm then needs to manage these drivers better than its competitors Staying in the commodity segment is the only logical choice for NorthAm TTie attractiveness of this option is further enhanced by possible significant growth in commodity carton demand in export markets Their manufacturing system

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Journal of Managertient Accounting Research Fall 1992 Exhibit 8 Traditioiud Management Accounting Value Chain Analysis in the SCM Framework External Entire set of linked activities from raw material suppliers to ultimate end use customers Multiple cost drivers Structural drivers examples scale scofje experience technology complexity E ecutlonal drivers examples participative management total quality management plant layout Applied too often only at the overall firm level value activity has a set of unique cost drivers Cost containment is a function of the cost driver s regulating each value activity

Focus Perspective

Internal Value added

Cost Driver Concept

A single fundamental cost driver pervades the literature Cost is a function of volume

Cost Containment Philosophy

Cost reduction approached via responsibility centers or via product cost Issues

Exploit linkages with suppliers Ebcploit linkages with customers spend to save Insights for Strategic Decisions None are readily apparent This is a major reason why the strategic consulting firms typically throw away the conventional reports as they begin their cost analysis Identify cost drivers at the individual activity level develop cost differentiation advantage either by controlling those drivers better than comp etitors or by reconfiguring the value chain examples Federal Express in mail delivery MCI in long distance telephone For each value activity ask strategic questions pertaining to make versus buy forward backward integration Quantify and assess supplier power and buyer power exploit linkages with suppliers and buyers

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is geared to this market and their reputation has been n ade in this market Also they have a low investment base to support this business since most of the plant and equipment were bought before 1970 Major new investments are not required to compete here Looking at the economics of the mill extruder and converting operations NorthAm is currently destroying value rather than creating value by selling in the differentiated segment Also the profitability at the mill is well below satisfactory levels A cost driver analysis at the mill and extruder stages might go a long way in identiiying profit improvement opportunities Such analysis is beyond the scope of this paper

CONCLUSION
We have argued in this paper that the value chain need not be Just an abstract conceptual tool It can become a powerful tool of empirical analysis even though actual examples of value chains are not yet available in the published literature This paper presents a first attempt at a value chain for the coated paperboard carton business The value chain analysis in this situation yields insights which are much different from those suggested by more conventional analytic tools We contrasted the value chain perspective with the project analysis perspective via DCF analyses from conventional managerial accounting and the familiar BCG growth share matrix perspective The value chain analysis in this situation helps to examine and validate the implications which arise from the more conventional analyses The SCM value chain perspective thus extends our ability to achieve meaningful managerial cost analysis A summary of the key differences between value chain and traditional management accounting perspectives is shown in Exhibit 8 Since virtually no two companies compete in exactly the same set of value activities value chain analysis is a critical flrst step in understanding how a firm is positioned in its industry Building sustainable competitive advantage requires a knowledge of the full linked set of value activities of which the firm and its competitors are a part Once the value chain is fully articulated critical strategic decisions regarding make buy and forward backward integration become clearer Investment decisions can be viewed from the perspective of their impact on the overall chain and the ilrm s position within it For strategic decision making cost analysis today cannot afford to ignore this critical dimension The authors hope this paper will encourage more widespread attention to empirical estimation of value chains as a useful extension of modem strategic cost analysis

REFERENCES
Henderson B D Corporate Strategy Cambridge Mass Abt Books 1979 Hergert M and D Morris Accounting data for value chain analysis Strategic Management Joumal 10 1989 175 188 Porter M E Competitive Advantage Glenwood Illinois The Free Press 1985 Shank J K Strategic cost management New wine or just new bottles Journal of Management Accounting Reseawh Fall 1989 47 65 and Vijay Govindarajan Strategic Cost Analysis Homewood Illinois Richard D Irwin Inc 1989