Value Concepts

Value Chain Analysis

Value Chain is the set of activities and resources of a firm to deliver

value as perceived by customers.
 Value Chain Analysis

• In a value chain analysis, one needs to examine whether each activity

in question adds value in the value chain.
• Along this logic, one should identify value-added activities from non-
value activities and reduce or eliminate non-value-added activities in
the value chain.
• Value-added activities are those activities that add value in the eyes of
the target customers.
• Non-value-added activities are those activities in which customers
have no perceived benefits. These non-value-added activities can
cause colossal cost to firms as well as financial burdens.
 Value Chain Analysis

• Non-value activities do not create value to customers, it is not to say

that these non-value activities should be entirely eliminated, There are
activities (e.g., controlling or planning activities) which are important
for the well-being of an organization (core activities) but may not be
prominent in the eyes of customers. These activities are necessary but at
an absolute minimum.
• On the other hand, there are some value added but not core activities of
the organization (e.g., help desk in telecom). These activities can be
managed by a third party at a lower cost. IT services, financial
transactions report, human recruitment, help desk, and manufacturing
are the popular areas being outsourced by large corporations.
Value-Added versus Core Activity Dimensions
 An Example on Value Chain Analysis
Gino Toys wants to know whether there is room for price reduction by 20%
for its toy products in face of the market consolidation. Gino Toys anticipates
the price reduction will force exits of its direct competitors. If Gino Toys
insists the current price level, it may lose 40% of sale volume. If it keeps up
with the new market price, it may gain further 5% growth. Gino Toys needs
to prepare for the new market reality and questions whether there is room for
operation improvement. Gino Toys hired an external consultant team to
conducts a value chain analysis. In particular, Gino Toys wants to:
(a) Identify non-value-added activities in the value chain and its cost impact
(b) Evaluate the cost, volume, and profit impact on the price change
(c) Explore potential room for cost improvement
a. Cost Allocation by Category of value-added versus
core activity dimensions
 b. Cost, Volume, and Profit impact on Price Change

Fixed cost in production = $5610 × 60% = $3366 K

Fixed cost in non-production = ($4168 K) × 85% = $3542.8 K
Variable cost per unit = ($9778 K − $3366 K − $3542.8 K)/922 K = $3.1
Unit contribution margin (UCM) = sale price – variable cost = ($12 − $3.1) =
$8.9
(i) Current profit level = $11,064 K − $9778 K = $1286 K

(ii) No price change (40% drop in sale vol.)

= (Sale Units × 60% × UCM) – Fixed cost
= (922 K x 0.6 x $8.9) − $6908.8 K = −$1985.3 K
b. Cost, Volume, and Profit impact on Price Change
(iii) Twenty percent drop in price with constant sale volume =
922 K × ($12× .8 − $3.1) − $6908.8 K = −$915.8 K (i.e., 2 months)
(iv) Twenty percent drop in price with 5% growth =
922 K × 1.05 × ($12× 0.8 − $3.1) − $6908.8 K = −$616.2 K (i.e., 2 months)
(v) Compute the full-year impact on (iii) = −$915.8 K × 6 = −$5494.8
K
(vi) Compute the full-year impact on (iv) = −$616.2 K × 6 = −$3697.2 K
 c. Cost Improvement
• the elimination of non-value-added and noncore activities improves the
profit level of Gino Toys by about $4.3 M ($721 K × 6).
• In addition, a cost reduction program on the non-value-added but core
activities may also further increase profit level, For example:
• 50% reduction in the non-value-added cost in core activities generates a
saving of $5.3 M, ($1.76 M × 50% × 6). It will help the firm a lot during the
bad time by recovering at least 75% of the original profit level (1.29 M × 6).
• In the longer-term, the firm should consider outsource of the noncore activities
to spare management time for other core activities.
• Also, the management can also think of strengthening the core activity
to improve market position, e.g., increasing investment in product
design.
• In order to survive, Gino Toys needs to reduce operating cost
within the value chain activities of its functional operation. This is
the horizontal value chain analysis. In another approach, Gino
Toys can search along its industry value chain and exercise
forward or backward integration of the industry value chain to
gain synergy from the vertical integration.
 Vertical Value Chain Analysis

• Shank and Govindarajan: They argue that value-added chain analysis

confines the study within the bounds of the firm without extending the
analysis to the backward linkages (supplier side) and forward linkages
(customer side) of the firm.
• Therefore, the potential synergetic effects of the intercompany
linkages cannot be materialized.
 Industry Value
Chain Configuration
• Toyota (TPS)
• BP and China Petroleum
• Banks
• Telecom providers
Comparison of Telephone
Industry Value Chains among
four market players
• Huawei: Strong in the upstream
value chain in both segments
(the telecom network and
consumer phone).
• Samsung: good presence in
upstream value chain of
network and phone business,
other electronic technologies,
“Android platform”
• Apple: platform system, apps,
and contents, led the market
with innovative technology
• Xiaomi: Its phones were of good
quality, reasonable features, and
good value price, Xiaomi
focused on cost-conscious
consumers
 Guides in Vertical Integration Analysis
The crux of the exercise is to ascertain incremental economic
benefits in the vertical integration process which strengthen the
long-term sustained competitive advantages.
 An Example on Vertical Integration
La Rose Bakery has a factory plant with a capacity to produce 4000 kg bakery products a day. A
utilization rate of 70% is employed currently to serve exclusively for a supermarket chain. Its
average net price for bakery items to the supermarket is $8 per kg and whose retail price is
$11.5/kg at the hand of ultimate consumers. La Rose also owns a flour mill to provide flour
exclusively for the plant. It has a production capacity of 3000 kg daily and current utilization rate
of 60%. The transfer price of flour raw materials to the factory plant is $1.9 per kg, using an arm’s
length price. La Rose wants to explore the feasibility to operate its own sale outlets and build a
new brand for the future franchise business. It plans to operate eight shops initially with an
average asset investment at $0.3 million per shop. It expects that annual operating (fixed) expense
for each shop is $0.3 million. With the new brand, the same product can be sold at $12.5 per kg.
La Rose expects to increase the output level to 90% of the capacity level. La Rose plans to put $1
million for the brand investment in the first year. Unit analysis on the current situation was
provided in table,
• Currently, La Rose’s average assets for the mill and factory plant are $1.3 million and $7
million, respectively. Industry benchmarks indicate that ROA for flour mill operation, factory
plant, and sale outlet businesses are 10%, 14%, and 20%, respectively.
• Comment on La Rose’s vertical integration and its proposal for operating sale outlet and
franchise business.
Unit Analysis
• Flour Mill
• Total annual output at full capacity = 3000 kg × 365 days = 1,095,000 kg
• Current output capacity = 1,095,000 kg × 60% = 657,000 kg
• Contribution margin per kg = ($1.9 − $1.58) = $0.32
• Fixed cost = 657,000 kg × ($0.1 + 0.15) = $164,250

• Factory Plant
• Total annual output at full capacity = 4000 kg × 365 days = 1,460,000 kg
• Current output capacity = 1,460,000 kg × 70% = 1,022,000 kg
• Contribution margin per kg = ($8 − $6) = $2
• Fixed cost = 1,022,000 kg × ($0.4 + 0.8) = $1,264,000
 Own Sale Outlets
• Total annual output at full capacity = 3000 kg × 365 days = 1,460,000 kg
• Current output capacity = 1,460,000 kg × 90% = 1,314,000 kg
• Contribution margin per kg = ($12.5 − $6) = $6.5
• Fixed cost = same as factory plant = $1,2264,000
• First-year brand investment (advertising) = $1 million
• Average outlet operating expenses = $0.3 million × 8 shops = $2,400,000
 Financial Performance
for Value Chain
• The dilemma of La Rose today
That it has no brand and has
difficulty for further growth.
• La Rose’s problem comes
from its single customer
whose high buyer’s power
would disallow the price to
increase and the output is
constrained at its request.
 Financial Performance
for Value Chain
• The Effect of Sale outlet
operation:
• La Rose can leverage its
production skills, logistic
flows, and experience of
customer taste to build its own
brand and sell bakery items in
its own shops.
• The direct sale approach lets
the firm acquire more market
information from customers,
enables the firm to build
brand, increases diversity of
product portfolio, and regains
sale autonomy.
 Present Value

The value of money in the future is not equivalent to the present value
of money today.
When dealing with future money (e.g., corporate forecast in a no. of
years), all future cash flow streams are required to discount to the
present value by a discount rate.
Imagine that there is a stream of cash flows to continue for 5 years, all
future cash flows (5 years) are required to be converted into the present
value (today as a common denominator) using the equation:
PV =1/(1 + r)n
Example: What is the present value of a cash flow stream in which an
annual $1000 will be received for 5 years starting 1 year from now? The
current interest rate is 10%p.a.
An interest rate of 10% is applied as discount rate for the PV. What is the
present value of $1 after 1 year, 2 years, and so on? We can easily
calculate the answer by the equation PV =1/(1 + r)n :
• PV of $1 in year 1 = 1/(1 + 10%) 1 = 0.909
• PV of $1 in year 2 = 1/(1 + r)2 = 0.826
 An Illustration of Present Value Concept
• La Rose Bakery asks a management consultant to prepare a corporate
cash flow forecast for 3 years. Assuming a discount rate (r) at 10%,
what should be the present value of these cash flows stream?
 Present Value
The net cash flow for each year from year 1 to year 3:
Year 1: $2 M + $1.2 M + $0.5 M − $2 M = $1.7 M
Year 2: $2.5 M − $4.5 M = −$2 M
Year 3: $4.5 M + $1.2 M = $5.7 M
Nominal Value = $5.4 M

PV = ($1.7 M × 0.909) − ($2 M × 0.826) + ($5.7 M × 0.751) = $4.17 M

PV = 77% of the nominal value. The reason is the large sum of nominal
money appears in year 3 which has a discount rate of 0.75.

Present value concept is an important topic for valuation when

involving a multiple period of time.