A traditional Value Chain involves a linear sequence of activities—from conversion of raw materials into components which are assembled into products. The products are then distributed, marketed, sold, and serviced. Management plans and execute strategies and operations based on this sequence.
This set of activities worked well for organizations in the past. However, this linear progression does not encourage Innovation and provides little protection from the risk of being outperformed by rivals in today’s disruptive markets. Such a competitive environment calls for implementing more robust ways of managing Customer Demand and Value Creation.
An effective approach to deal with this challenge is the Value Grid Analysis Model. The Value Grid approach provides a perspective beyond traditional linear progression of activities, where organizations need to balance equilibrium between suppliers and manufacturers aside from concentrating only on reducing lead times. It outlines new opportunities and risks for organizations.
The Value Grid Analysis provides a number of routes to improve Performance and reduce risks. It encompasses the following 3 pathways—or dimensions:
- Vertical pathway – using traditional Value Chain, companies find opportunities upstream or downstream from adjacent tiers in the existing Value Chain.
- Horizontal pathway – companies look for opportunities from similar tiers in multiple (parallel) Value Chains.
- Diagonal pathway – explore opportunities to create value across multiple value chains and tiers.
The Value Grid Framework necessitates diverting leadership attention towards 3 key opportunity areas to create Competitive Advantage:
- Customer Demand
- Information Access
- Multi-tier Penetration
Let’s dive deeper into the 3 opportunity areas.
The first opportunity area to drive competitive advantage pertains to controlling internal and external customers’ demand. It warrants a company to manage customer demand upstream (suppliers and companies that supply to suppliers) as well as downstream (customers). By managing customer demand downstream, organizations control the decision makers responsible for the purchase decision. When companies are unable to control the decision makers, they look for levers across the Value Chain to influence decisions. These levers include direct advertisements to the end users, focusing on distributors, or incentivizing retailers to recommend a product. Organizations also try to influence upstream, e.g., their R&D units, to create products which can be used in conjunction with the existing product range to boost their efficacy and benefits for the end-users, ultimately influencing consumers’ decisions downstream.
The 2nd opportunity area involves linking information sharing to influence decision making. A few manufacturers prefer to partner with those suppliers who openly disclose the information (capabilities, flexibility, and pricing structures) of their 2nd-tier suppliers with them. This assists them in planning and helping the suppliers manage materials and prices better.
For instance, with increased tariff on imported steel and price of steel continuously going up, car manufacturers like Honda purchase steel in bulk and sell it to their suppliers at a reduced rate. This helps them keep the prices of their cars down and compete better.
Nonlinear thinking (Value Grid Model) enables the organizations to determine innovative solutions beyond the scope of traditional Value Chains. To manage excess demand organizations take on multiple Value Chain tiers to control demand and buyers’ power.
Leading manufacturers evaluate multiple value chain points for their participation in order to scale. They sell not only to Original Equipment Manufacturers but also in the aftermarket. Supplying to more than one Value Chain tier allows organizations to withstand pressure from OEMs to reduce costs, demand shifts, and offers attractive margins.
Interested in learning more about the 3 opportunity areas of the Value Grid Analysis Framework? You can download an editable PowerPoint on Value Grid Analysis here on the Flevy documents marketplace.
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Cost-based Pricing is fast becoming a relic of the past and being substituted by the concept of Target Costing. Target Costing is referred to as an organized process to determine the cost at which a proposed product must be developed so as to generate profits at the product’s anticipated selling price in future.
In highly competitive markets such as FMCG, construction, healthcare, and energy, prices are determined by market forces. Producers cannot effectively control selling prices. The only control, to some extent, is over costs, so management’s focus has to be on influencing every component of product, service, or operational costs.
Target Costing is a proactive Cost Planning, Cost Management, and Cost Reduction practice. Costs are planned and managed out of a product and business early in product life-cycle, rather than during the later stages. The fundamental objective of Target Costing is to make the business profitable in any competitive marketplace. Target Costing is widely used in several industries e.g. manufacturing, energy, healthcare, construction, and a host of others.
Some key features of Target Costing are:
- Seller is a price taker rather than a price maker.
- The target selling price incorporates desired profit margin.
- Product design, specifications, and customer expectations are built-in while formulating the total selling price.
- Cost reduction and effective cost management is the corner stone of management strategy.
- Target Cost has to be achieved through team collaboration during activities such as designing, purchasing, manufacturing, marketing, and other activities.
Target Costing presents the following advantages over other product pricing techniques:
- More value delivered to customer since the product is created keeping in mind the expectation of the customer.
- Approach to designing and manufacturing products is market driven.
- Competitive Advantage gained through process improvement and product innovation.
- Drastic Process Improvement, which creates economies of scale.
- New market opportunities converted into real savings to achieve the best value for money rather than to simply realize the lowest cost.
The Target Costing process comprises 3 main phases.
- Market-Driven Target Costing
- Product-Level Target Costing
- Component-Level Target Costing
Let’s discuss the 3 phases briefly.
1. Market-Driven Target Costing
In this phase, Selling Price is determined by analyzing the entire industry value chain and all functions of the firm. The focus of this costing phase is on analyzing market conditions and determining the company’s Profit Margin in order to identify the “Allowable Cost” of a product.
In this phase, the desired profit level is set on the basis of firm’s strategy and financial goals, and is deducted from Selling Price to obtain Allowable costs. Intensity of competition, nature of customers, similar product introduction by competitors, and level of customer sophistication are the key factors influencing Market-driven Target Costing.
2. Product-Level Target Costing
In this phase, Allowable Cost only gives a ball-park figure of cost saving to be achieved. It has to be translated into Achievable Target Cost. This type of costing concentrates on designing products that satisfy the company’s customers at the Allowable Cost. The cardinal rule of Product-level Target Costing is to never exceed the Target Cost.
The objective of this Target Costing phase is to create intense but realistic pressure on the product designers to reduce costs. Product Strategy (number of products in the line, frequency of redesign, degree of innovation) and product characteristics (complexity, magnitude of up-front investments, and duration of product development) are the key factors affecting Product-level Target Costing.
3. Component- Level Target Costing
The Component-level Target Costing settles the price at which a firm is willing to purchase the externally-acquired components being used in its product. This phase involves a cross-functional team that is tasked to reduce costs across all functions such as designing, purchasing, manufacturing, marketing, and other activities.
The components cost history serves as the starting point for estimating the new component-level target costs alongside optimal selection of suppliers. A supplier-focused strategy is the key factor that influences Component-level Target Costing.
Interested in learning more about how the Target Costing process works and its key steps? You can download an editable PowerPoint on Target Costing here on the Flevy documents marketplace.