OPERATIONS MANAGEMENT

Goods, Services and Value Chains

CHAPTER 2

Value Chains
DAVID A. COLLIER AND JAMES R. EVANS

Operations Management, 2e/Ch. 2 Value Chains 2007 Thomson South-Western

Chapter 2 Learning Objectives

1. To define value and three ways to increase it, to describe a value chain using inputoutput or pre- or post service diagrams, and to distinguish between a value chain and supply chain. 2. To describe the role of operations, vertical integration, and outsourcing in designing and managing value chains, and to apply break-even analysis to simple outsourcing decisions.
Operations Management, 2e/Ch. 2 Value Chains 2007 Thomson South-Western

Chapter 2 Learning Objectives

3. To describe the nature of a multinational enterprise and value chains in a global environment, to explain the advantages and disadvantages of off shoring decisions, to identify difficulties associated with managing global value chains, and to recognize the role of local culture in managing nondomestic operations.

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Chapter 2 Value Chains

Given the chapters three lead in discussions

What is your opinion of companies that move operations to other countries with cheaper labor rates? In the long run, do you think that such decisions help or hurt business competitiveness and national economies? Should governments influence or legislate such decisions?
You might want to discuss Question # 22 on page 66!
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Chapter 2 Value Chains

Value and Supply Chains The underlying purpose of every organization

is to provide value to its customer and stakeholders.

Value is 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.
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Chapter 2 Value Chains

Value and Supply 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.
Operations Management, 2e/Ch. 2 Value Chains 2007 Thomson South-Western

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.
Operations Management, 2e/Ch. 2 Value Chains 2007 Thomson South-Western

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).
Operations Management, 2e/Ch. 2 Value Chains 2007 Thomson South-Western

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.
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Exhibit 2.1 The Value Chain

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

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

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Exhibit 2.3 Pre- and Postservice View of the Value Chain

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Chapter 2 Value Chains

Pre- and Post-service Value Chain Example Ford Motor Company found that the total value of owning a Ford vehicle averaged across all market segments for service and the vehicle was allocated according to a customer survey as follows:

the vehicle (i.e., product features and performance) itself accounted for 52 percent of total value, the sales process for 21 percent, and
the maintenance and repair service processes for 27 percent.
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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.

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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.

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Chapter 2 Value Chains Buhrke Industries, In. Value Chain

Buhrke Industries Inc., located in Arlington Heights, Illinois, provides stamped metal parts to many industries, including automotive, appliance, computer, electronics, hardware, house wares, power tools, medical, and telecommunications.
Buhrke objective is to be a customers best total-value producer with on-time delivery, fewer rejects and highquality stampings. However, the company goes beyond manufacturing goods; it prides itself in providing the best service available as part of its customer value chain.
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Exhibit 2.4 The Value Chain at Buhrke Industries

Source: Buhrke Industries company web site

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Chapter 2 Value Chains

Buhrke Industries, In. 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.
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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.
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Chapter 2 Value Chains

Value and Supply Chains A value chain is broader in scope than a supply chain, and encompasses all pre- and postproduction 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.
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Exhibit 2.3 Pre- and Postservice View of the Value Chain

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Chapter 2 Value Chains

Procter & Gambles Supply Chain Structure

A model of a supply chain developed by Procter & Gamble. P&Gs 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 and 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.

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Exhibit 2.5 Procter & Gambles Conceptual Model of a Supply Chain for Paper Products

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

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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.

Outsourcing is the process of having suppliers provide goods and services that were previously provided internally.

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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. Offshoring is the building, acquiring, or moving of process capabilities from a domestic location to another country location while maintaining ownership and control.
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Exhibit 2.7 Four Degrees of Offshoring Scenarios

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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.
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Chapter 2 Value Chains

The U.S. has experienced three waves of outsourcing:

The first wave involved the exodus of goodsproducing 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.
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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.

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Chapter 2 Value Chains

Letters of Credit Processes Help Make Value Chains Work The flow of information is an important aspect of value chain design. Information must move as fast or faster than the physical goods. For example, global buyers and sellers depend on a "letter of credit" to settle their payments. The paper-based process used for about four centuries requires banks to coordinate with one another and exchange documents, often across oceans, and has numerous drawbacks: The cost of processing trade documentation is more than 5% of the total annual value of world trade. Banks reject half of all "letters of credit" transactions because of incorrect information from the buyer or seller. The cost of processing a simple global transaction is about $400. Each transaction requires up to 24 forms to be accurately completed.

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Chapter 2 Value Chains

Letters of Credit Processes Help Make Value Chains Work Internet-based platforms are leading to vast improvements in letter of credit value chains. TradeCard Inc., for example, allows the buyer to connect the flow of physical goods and the flow of electronic funds and trade documents.

Hi-Tec Sports USA, a California-based hiking shoe company, had to issue a purchase order to one of its global suppliers in China and then open a letter of credit with its bank. The process that could take as much as two weeks. Today, Hi-Tec uses TradeCard's system and the entire electronic process seldom takes more than one day. Hi-Tec figures they save 20 cents per shoe by doing an electronic letter of credit.

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Chapter 2 Value Chains

Rocky Shoes & Boots Company

Rocky Shoes & Boots (RS&B-www.rockyboots.com) headquartered in Nelsonville, Ohio, manufactures rugged leather shoes for hiking and camping. RS&B 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.
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Exhibit 2.6 Rocky Shoes & Boots Value Chain

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Chapter 2 Value Chains

Rocky Shoes & Boots Company The principal characteristics of this global value chain are described as follows: Leather is produced in Australia and then shipped to the Dominican Republic. 1. Outsoles are purchased in China and shipped to Puerto Rico. 2. Gor-Tex fabric waterproofing materials is made in the United States. 3. Shoe uppers are cut and stitched in the Dominican Republic, and then shipped to Puerto Rico. 4. Final shoe assembly is done at the Puerto Rico factory. 5. The finished boots are packed and shipped to the warehouse in Nelsonville, Ohio. 6. Customer orders a filed and shipped to individual stores and contract customers from Nelsonville.
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Exhibit 2.6 Rocky Shoes & Boots Value Chain

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Chapter 2 Value Chains

Rocky Shoes & Boots Company 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.
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Chapter 2 Value Chains

Rocky Shoes & Boots Company 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 RS&B said, "We've got to get there, or we're not going to be able to compete."

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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. According to one
framework, foreign factories can be classified into one of six categories:

1. 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.

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Chapter 2 Value Chains

According to one framework, foreign factories can Be classified into one of six categories:

2. 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.

3. Server factories established to supply specific

national or regional markets.

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Chapter 2 Value Chains

According to one framework, foreign factories can Be classified into one of six categories:

4. 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. 5. Contributor factories established to serve a local market and conduct activities like product design and customization. Primary manufacturing,
Operations Management, 2e/Ch. 2 Value Chains 2007 Thomson South-Western

accounting, engineering design, and marketing and sales processes often reside at contributor factories.
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Chapter 2 Value Chains

According to one framework, foreign factories can be classified into one of six categories:

6. 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."

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Chapter 2 Value Chains

James Womack, the co-author of "The Machine that Changes the World," states that
"Outsourcing production, in whole or part, makes the most sense if a manufactured product is stable, requires lots of labor, and doesn't need lots of technical support." He recommends a product-by-product analysis to determine what production is appropriate to move where instead of the argument that if everyone else is going to China, we should go. Wall Street Journal, October 6, 2004, p. B 1.
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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.

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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.
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Exhibit 2.8 Comparison of Work Forces in the United States, India, and China Value Chains in a Global Business Environment

Source: OSullivan, K., and Durfee, D., Offshoring by the Numbers, CFO Magazine, June 2004, p. 54.

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Exhibit 2.9 Example Issues to Consider When Making Offshore Decisions

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Exhibit 2.10 Offshore Candidates for Service and Information Work Activity

Source: Harris, R., Offshoring by the Numbers, CFO Magazine, June 2004, p. 58

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Chapter 2 Value Chains

Example of Offshoring Risk Protecting Intellectual Property

Schwinn Bicycle Company entered into a contract manufacturing agreement with one Taiwan manufacturing company. Within a decade, the Taiwan Company became Giant Manufacturing (www.giant-bicycle.com) and broke its supplier relationship with Schwinn. Giant started producing its own bicycle brand name and has opened up it's own U.S. subsidiary in the U.S.
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Exhibit 2.11 Example Advantages and Disadvantages of Global Offshoring and Outsourcing

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Exhibit 2.12 Example Countries Participating in Global Supply Chain Development

Source: Datz, T. Outsourcing World Tour, CIO Magazine, July 15, 2004, pp. 4256

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Chapter 2 Value Chains

Complex global value chains are more difficult to manage than small domestic value chains. Some of the many issues include the following: 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.
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Chapter 2 Value Chains

Some of the many issues include the following:

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.
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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.
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Exhibit 2.13 Example Cultural Differences that Impact Business

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Chapter 2 Value Chains Solved Problem #1 Outsourcing & Breakeven Analysis

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?
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Chapter 2 Value Chains Solved Problem #1 Outsourcing and Breakeven Analysis

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 only for 12,000 units, which is less than the break-even point,

the least cost decision is to outsource the component.

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