VALUE CHAINS

1. OM2 CHAPTER 2 VALUE CHAINS DAVID A. COLLIER AND JAMES R. EVANS

2. Chapter 2 Learning Outcomes l e a r n i n g o u t c o m e s LO1Explain the concept of value and how it can be increased. LO2Describe a value chain and the two major perspectives that characterize it. LO3Describe a supply chain and how it differs from a value chain. LO4Discuss key value chain decisions. LO5Explain offshoring and the key issues associated with it. LO6Identify important issues associated with value chains in a global business environment.

3. Chapter 2 Value Chains t a time when more than 98% of all shoes sold in the United States are made in other countries, Allen-Edmonds Shoe Corp. is a lonely holdout against offshoring. Moving to China could have saved as much as 60 percent. However, John Stollenwerk, Chief Executive, will not compromise on quality, and believes that Allen-Edmonds can make better shoes, and serve customers faster, in the United States. An experiment in producing one model in Portugal resulted in lining that wasn’t quite right and stitching that wasn’t as fine. Stollenwerk noted “We could take out a few stitches and you’d never notice it – and then we could take out a few more. Pretty soon you’ve cheapened the product, and you don’t stand for what you’re about.” Instead, Allen-Edmonds invested more than $1 million to completely overhaul its manufacturing process into a leaner and more efficient system that could reduce 5 percent off the cost of each pair of shoes. One year after implementing its new production processes, productivity was up 30 percent, damages were down 14 percent, and order fulfillment neared 100 percent, enabling the company to serve customers better than ever. What do you think?What is your opinion of companies that move operations to other countries with cheaper labor rates? Should governments influence or legislate such decisions?

4. Chapter 2 Value Chains • Value Chains • The underlying purpose of every organization is to provide value to its customer and stakeholders. • Valueis the perception of the benefits associated with a good, service, or bundle of goods and services (i.e., the customer benefit package) in relation to what buyers are willing to pay for them.

5. Chapter 2 Value Chains • Value Chains • The decision to purchase a good or service, or a customer benefit package, is based on an assessment by the customer of the perceived benefits in relation to its price. • The customer's cumulative judgment of the perceived benefits leads to either satisfaction or dissatisfaction.

6. Chapter 2 Value Chains One of the simplest functional forms of value is: Value = Perceived benefits/Price (cost) to the customer If the value ratio is high, the good or service is perceived favorably by customers, and the organization providing it is more likely to be successful. To increase value, an organization must: (a) increase perceived benefits while holding price or cost constant, (b) increase perceived benefits while reducing price or cost, or (c) decrease price or cost while holding perceived benefits constant.

7. Chapter 2 Value Chains • Value Chains • A value chain is a network of facilities and processes that describes the flow of goods, services, information, and financial transactions from suppliers through the facilities and processes that create goods and services and deliver them to customer. • A value chain is a “cradle-to-grave” model of the operations function (see Exhibit 2.1).

8. Chapter 2 Value Chains • Value Chains • The value chain begins with suppliers. Suppliers might be distributors, employment agencies, dealers, financing and leasing agents, information and Internet companies, field maintenance and repair services, architectural and engineering design firms, and contractors, as well as manufacturers of materials and components.

9. Exhibit 2.1 The Value Chain

10. Chapter 2 Value Chains • Value Chains • The inputs suppliers provide might be physical goods such as: • automobile engines or microprocessors provided to an assembly plant; • meat, fish, and vegetables provided to a restaurant; • trained employees provided to organizations by universities and technical schools; or • information such as computer specifications or a medical diagnosis.

11. Chapter 2 Value Chains • Value Chains • Inputs are transformed into value-added goods and services through processes or networks of work activities, which are supported by such resources as land, labor, money, and information. • The value chain outputs—goods and services—are delivered or provided to customers and targeted market segments.

12. Examples of Goods-Producing and Service-Providing Value Chains (slide 1) Exhibit 2.2

13. Examples of Goods-Producing and Service-Providing Value Chains (slide 2) Exhibit 2.2

14. Exhibit 2.3 Pre- and Postservice View of the Value Chain

15. Chapter 2 Value Chains • A Service View of a Business • Nestle once defined its business from a physical good viewpoint as "selling coffee machines." Using service management thinking, they redefined their business from a service perspective where the coffee machine is more of a peripheral good. • They decided to lease coffee machines and provide daily replenishment of the coffee and maintenance of the machine for a contracted service fee. This "primary leasing service" was offered to organizations that sold more than 50 cups of coffee per day.

16. Chapter 2 Value Chains • A Service View of a Business • The results were greatly increased Nestle coffee sales, new revenue opportunities, and much stronger profits. • Nestle's service vision of their business required a completely new service and logistical value chain capability.

17. Chapter 2 Value Chains • Buhrke Industries, Inc. Value Chain • Buhrke Industries Inc., located in Arlington Heights, Illinois, provides stamped metal parts to many industries, including automotive, appliance, computer, electronics, hardware, housewares, power tools, medical, and telecommunications. • Buhrke’s objective is to be a customer’s best total-value producer with on-time delivery, fewer rejects, and high-quality stampings. However, the company goes beyond manufacturing goods; it prides itself in providing the best service available as part of its customer value chain.

18. Exhibit 2.4 The Value Chain at Buhrke Industries Source: Buhrke Industries company web site

19. Chapter 2 Value Chains • Buhrke Industries, Inc. Value Chain • Service is more than delivering a product on-time. It's also partnering with customers by providing personalized service for fast, accurate response; customized engineering designs to meet customer needs; preventive maintenance systems to ensure high machine uptime; experienced, highly trained, long-term employees; and troubleshooting by a knowledgeable sales staff.

20. Chapter 2 Value Chains • Value and Supply Chains • A supply chain is the portion of the value chain that focuses primarily on the physical movement of goods and materials, and supporting flows of information and financial transactions through the supply, production, and distribution processes. • Many organizations use the terms “value chain” and “supply chain” interchangeably; however, we differentiate these two terms in this book.

21. Chapter 2 Value Chains • Value and Supply Chains • A value chain is broader in scope than a supply chain, and encompasses all pre- and post- production services (see Exhibit 2.3) to create and deliver the entire customer benefit package. • A value chain views an organization from the customer's perspective—the integration of goods and services to create value—while a supply chain is more internally-focused on the creation of physical goods.

22. Exhibit 2.3 Pre- and Postservice View of the Value Chain

23. Chapter 2 Value Chains Procter & Gamble’s Supply Chain Structure A model of a supply chain developed by Procter & Gamble—P&G’s “Ultimate Supply System”—is shown in Exhibit 2.5. The supply chain focus is on understanding the impact of tightly coupling supply chain partners to integrate information, physical material, product flow, and financial activities to increase sales, reduce costs, increase cash flow, and provide the right product at the right time at the right price to customers.

24. Source: Wegryn, Glenn W., and Siprelle, Andrew J., “Combined Use of Optimization and Simulation Technologies to design an Optional Logistics Network,” http://www.simulationdynamics.com/PDFs/Papers/CLM%20P&G%Opt&Sim.pdf Procter & Gamble’s Conceptual Model of a Supply Chain for Paper Products Exhibit 2.5

25. Chapter 2 Value Chains • Value Chain Design and Management • Outsourcing is the opposite of vertical integration in the sense that the organization is shedding (not acquiring) a part of its organization.

26. Chapter 2 Value Chains • Value Chain Design and Management • Vertical integration refers to the process of acquiring and consolidating elements of a value chain to achieve more control. • Outsourcingis the process of having suppliers provide goods and services that were previously provided internally.

27. Chapter 2 Value Chains • Value Chain Design and Management • Backward integration refers to acquiring capabilities at the front-end of the supply chain (for instance, suppliers), while forward integration refers to acquiring capabilities toward the back-end of the supply chain (for instance, distribution or even customers). • Companies must decide whether to integrate backward (acquiring suppliers) or forward (acquiring distributors), or both.

28. Chapter 2 Value Chains AutomobileSuppliers – Vanish or Rebound? Clips & Clamps Industries located in Plymouth, Michigan has been selling metal brackets for decades to the big three Detroit automobile manufacturers—General Motors, Ford, and Chrysler. But a few years ago, the firm decided it must become a tier-one supplier to Toyota, Honda, and Nissan if it was to survive the global economic downturn. Mr. Aznavirian, President and co-owner, said “You can’t sit around waiting for the Big Three to come back.” Mr. Aznavirian lead efforts to gain work from the Japanese firms by reducing equipment downtime, producing less scrap, and becoming a more efficient part of the global supply chain. --- Mr. Craig Fitzgerald, a consultant, noted that “more than half of North America’s 1,200 small auto suppliers will vanish into bankruptcies, mergers, and liquidations…. But some like Clips and Clamps will reinvent themselves and rebound.”

29. Chapter 2 Value Chains • The U.S. has experienced three waves of outsourcing: • The first wave involved the exodus of goods-producing jobs from the U.S. in many industries several decades ago. Gibson Guitars, for example, produces its Epiphone line in Korea. • The second wave involved simple service work, such as standard credit card processing, billing and other forms of transaction processing, keying information into computers, and writing simple software programs. Accenture, for example, does much of its bookkeeping operations in Costa Rica.

30. Chapter 2 Value Chains • The U.S. has experienced three waves of outsourcing: • The third, and current wave, involves skilled knowledge work, such as engineering design, graphic artists, architectural plans, call center customer service representatives, and computer chip design. For example, Massachusetts General Hospital uses radiologists located in Bangalore, India, to interpret CT scans.

31. Chapter 2 Value Chains Solved Problem Suppose that a manufacturer needs to produce a custom aluminum housing for a special customer order. Because it currently does not have the equipment necessary to make the housing, it would have to acquire machines and tooling at a fixed cost (net of salvage value after the project is completed) of $250,000. The variable cost of production is estimated to be $20 per unit. The company can outsource the housing to a metal fabricator at a cost of $35 per unit. The customer order is for 12,000 units. What should they do?

32. Chapter 2 Value Chains Solution VC1 = Variable cost/unit if produced = $20 VC2 = Variable cost/unit if outsourced = $35 FC = fixed costs associated with producing the part = $250,000 Q = quantity produced Using Equation 2.1 we obtain: Q = 250,000/($35 - $20) = 16,667 In this case, because the customer order is for only 12,000 units, which is less than the break-even point, the least cost decision is to outsource the component.

33. Chapter 2 Value Chains Value chain integration is the process of managing information, physical goods, and services to ensure their availability at the right place, at the right time, at the right cost, at the right quantity, and with the highest attention to quality.

34. Chapter 2 Value Chains • Value chain integration in services—where value is in • the form of low prices, convenience, and access to special • time-sensitive deals and travel packages—takes many • forms. Examples include: • Third-party integrators for the leisure and travel industry value chains include Orbitz, Expedia, Priceline, and Travelocity. • Many financial services use information networks provided by third-party information technology integrators, such as AT&T, Sprint, IBM, and Verizon, to coordinate their value chains. • Hospitals also use third-party integrators for both their information and physical goods, such as managing patient billing and hospital inventories.

35. Chapter 2 Value Chains Offshoring is the building, acquiring, or moving of process capabilities from a domestic location to another country location while maintaining ownership and control.

36. Extra Exhibit Four Degrees of Offshoring Scenarios

37. Chapter 2 Value Chains • According to one framework, foreign factories can be classified into one of six categories: • Offshore factories established to gain access to low wages and other ways to reduce costs, such as avoiding trade tariffs. An offshore factory is the way most multinational firms begin their venture into global markets and value chains. • Outpost factories established primarily to gain access to local employee skills and knowledge. Such skills and knowledge might include software programming or call center service management.

38. Chapter 2 Value Chains • Server factories established to supply specific national or regional markets. • Source factories, like offshore factories, established to gain access to low cost production but also have the expertise to design and produce a component part for the company's global value chain. • Contributor factories established to serve a local market and conduct activities like product design and customization. Primary manufacturing, accounting, engineering design, and marketing and sales processes often reside at contributor factories. • Lead factories established to innovate and create new processes, products, and technologies. Lead factories must have the skills and knowledge to design and manufacturer "the next generation of products."

39. Exhibit 2.6 Example Issues to Consider When Making Offshore Decisions

40. Chapter 2 Value Chains • Rocky Brands • Rocky Brands(www.rockyboots.com), • headquartered in Nelsonville, Ohio, manufactures • rugged leather shoes for hiking and camping. • The company began making boots in 1932 as the William Brooks Shoe Company with an average wage rate of 28 cents per hour. In the 1960s, Rocky Shoes & Boots were 100% "Made in America." In 1960, more than 95 percent of all shoes sold in America were made in America. • Timberland, Wolverine, and Rocky are popular brand names for this shoe market segment.

41. Exhibit 2.7 Rocky Brands Value Chain

42. Chapter 2 Value Chains • Rocky Brands • The principal characteristics of this global value chain • are described as follows: • Leather is produced in Australia and then shipped to the Dominican Republic. • Outsoles are purchased in China and shipped to Puerto Rico. • Gor-Tex fabric waterproofing materials are made in the United States. • Shoe uppers are cut and stitched in the Dominican Republic, and then shipped to Puerto Rico. • Final shoe assembly is done at the Puerto Rico factory. • The finished boots are packed and shipped to the warehouse in Nelsonville, Ohio. • Customer orders are filled and shipped to individual stores and contract customers from Nelsonville.

43. Rocky Brands Value Chain Exhibit 2.7

44. Chapter 2 Value Chains • Rocky Brands Global Challenges • Rocky profit margins are only about 2 percent on sales of over $100 million, while Timberland sales top $1 billion and have a 9 percent profit margin. • After seventy years in Nelsonville, the main factory closed in 2002. At that time, local labor costs were about $11 per hour without benefits, while in Puerto Rico the hourly rate was $6; in the Dominican Republic, $1.25; and in China, 40 cents.

45. Chapter 2 Value Chains • Rocky Brands Global Challenges • The price of boots continues to decline globally from roughly $95 a pair to $85, and is heading toward $75. • The grandson of the founder of Rocky Brands said, "We've got to get there, or we're not going to be able to compete."

46. Chapter 2 Value Chains • Issuesfor Managing Global Value Chains • Global supply chains face higher levels of risk and uncertainty, requiring more inventory and day-to-day monitoring to prevent product shortages. Workforce disruptions, such as labor strikes and government turmoil in foreign countries, can create inventory shortages and disrupting surges in orders.

47. Chapter 2 Value Chains • Transportation is more complex in global value chains. For example, tracing global shipments normally involves more than one mode of transportation and foreign company. • The transportation infrastructure may vary considerably in foreign countries. The coast of China, for example, enjoys much better transportation, distribution, and retail infrastructures than the vast interior of the country.

48. Chapter 2 Value Chains • Global purchasing can be a difficult process to manage when sources of supply, regional economies, and even governments change. Daily changes in international currencies necessitate careful planning and in the case of commodities, consideration of futures contracts. • International purchasing can lead to disputes and legal challenges relating to such things as price fixing and quality defects. • Privatizing companies and property is another form of major changes in global trade and regulatory issues.

49. Chapter 2 Value Chains TuneMan Case Study 1. Draw the “bricks and mortar” process stages by which traditional CDs are created, distributed, and sold in retail stores. How does each player in the value chain make money? (You can use the exhibits in the chapter to help you identify major stages in the value chain.) 2. Draw the process stages for creating and downloading music today. How does each player in this electronic/digital value chain make money? 3. Compare and contrast the approaches in the previous two questions. What’s changed? What’s new? Are there any advantages/disadvantages of each approach? 4. Compare the role of operations in each of these value chain structures and approaches.