Invalid claim that value networks supercede or trump value chains

The Ricardian Vice

Now, now gents. Let's deal in reasoned logic and facts.

The term "Ricardian Vice" refers to the practice of basing policy on models even when they are demonstrably harmful. When policy makers allow themselves to become so entranced with the beauty of orthodox models, they close their eyes to what is actually happening in the world of business and IT. It is important to subject IT governance and policy to the light of experience and reason rather than dogmatic adherence to simplified assumptions.

Be careful not to succumb to the Ricardian Vice when unfamiliar ideas appear.

Dangers arise from the lack of rigor in organizational speculations, from the failure to appreciate the limited applications to highly artificial and arbitrary analysis. For example, reasoning in terms of abstract IT value chain models where all but a few variables are frozen. In these models, one could argue that one variable causes the other in a simple one-way fashion. This leads to the mistaken belief that one could easily deduce IT policy directly from this abstract model.

Value networks, and its more quantitative brethren System Dynamics, have been around since the 1960s. Jay W. Forrester provided one of the first systematic explorations of the complex dynamics underlying information and material flow in organizational systems. ( J.W. Forrester, Industrial Dynamics, 1961).

They are hardly fads.
- Each is taught at top business schools across the US (Harvard, MIT, Stanford, etc.) and Europe (London School of Economics, Norwegian School of Mgt, for example).
- They are in use by such industry notables as SAP, Oracle, Wal-Mart, McKinsey, Boeing, Dupont, General Motors, IBM, HP, to name a few.
- They have been successfully used to address such complex problems as global warming, manufacturing, finance, supply chain, parmacology, organizational resistance, TQM, improving professional sports teams, urban decay and so on.

Forrester set the stage for exploring the linkages across parts of the value chain from an operations standpoint. Among other things, he provided an early look at the root cause for dynamic distortions in value chains, which was later expanded and relabeled as the bullwhip effect; see, for example, H.L. Lee, V. Padmanabhan and S. Whang, "The Bullwhip Effect in Supply Chains," Sloan Management Review 38, spring 1997. He demonstrated that Value Chain thinking, in many scenarios, was harmful to the organization in the long term.

(There is a relation between Value Chains and Supply Chains. Porter was quite clear that primary activities deal with the physical creation and transfer of products (page 38 of Porter's "Competitive Advantage", for instance). How do you deal with manufacturing and transfering physical products without a supply chain?).

Porter's work (published in 1985, not 1990) is the key reference on value chains. Companies seek competitive advantage with value chains by managing an orderly flow of goods and services across supplier and customer relationships. In theory at least, reducing the lead time at each link in the chain allows companies to reduce inventory and deliver the end products using concepts such as just-intime manufacturing and supply, continuous replenishment and quick-response manufacturing. As the entire chain tightens, the organization becomes more competitive.

However, there is a catch: While it appears well suited for describing and understanding a traditional manufacturing organization, where tasks are long-linked and sequential, its underlying logic is less suitable to the analysis of service industries such as IT organizations. It obscures rather than illuminates the essence of value creation. There are no shortages of critiques, for example, Lowendahl (1992) and Armistead and Clark (1993).

So what is a Value Chain model?

For clarity's sake, a review is in order: Value Chains work by transforming inputs into products. They rely on long-linked technology where tasks are linear and interdependent. The end-product is the medium for transferring value between an organization and its customers.

The diagram on Service Strategies' p49 represents the actors in a Value Chain according Porter; Supplier, Business Unit and the owner of the Value Chain. Notice that Porter pays very little attention paid to Customers - no appearance, for example, in the index. There are oodles on suppliers.

The sequencing and arrow format of the value chain diagram underlines the sequential and linear nature of its primary activities. The assembly line mechanism is designed to produce standard products at low cost per unit by exploiting cost economies of scale. (Porter, 1985)

Customer value is defined either by the cost reductions that the product can provide in the customer's activities or by the performance improvements that the customer can gain by using the product. Technology development is performed to either reduce the cost of the product, particularly through process improvement, or to raise the price. (Porter, 1985)

According to Porter, "Competitive advantage cannot be understood by looking at a firm as a whole. Advantage stems from the many discrete activities a firm performs – designing, producing, marketing, delivering, and supporting products. Each of these activities can contribute to a firm's relative cost position and create a basis for differentiation."

Value chains are primarily concerned with overall efficiency and the cost of performing activities. Even those customer-facing activities such as sales, marketing and service are primarily driven by efficiency and cost concerns. This is how it creates value.

While Porter identified ten unique drivers of cost, the major driver is scale. The vertical integration is the primary means for value chains to reduce control costs due to uncertainty in supply and demand. Management policy is primarily concerned with issues such as process efficiency, process inputs and outputs, and the ability to respond to changes in supply and demand.

What about IT Value Chains or Value Chains for IT Services?

There are serious problems when applying the value chain framework to service organizations, IT or otherwise. There are no shortages of explanations (Stabell and Fjeldstad, "Configuring Value for Competitive Advantage", for example). When MIT published a similar critique last summer (2006), "Evolving from Value Chain to Value Grid", it was received as old news.

It was ITILv2 that erred when applying to Value Chains to the IT service organization.

To better understand why, begin with other service industries. In an insurance company, for example, what is received, what is produced, and what is shipped? Few executives would consider uninsured people as raw material from which to produce insured people. Nor would they describe the value creation process as a paper-transforming organization, manufacturing policies from blank paper. This mental model of a paper-flow-transformation-process misses the logic of important activities such as reinsurance to cover risk, actuarial calculations and customer relationship management.

Or take the example of a bank. A value chain would consider deposits as the 'raw material' that the bank's primary activities transform into loans, or postulate that all primary banking activities collapse into a single major activity named operations. In either case, the value chain model cannot deal explicitly with both lenders and borrowers as bank customers. Rather, the logic of banking is obscured by focusing attention on transaction-processing unit costs, with little attention to interest spread and risk management.

I'll leave to the ambitious reader to work out this logic in IT service organizations. While these organizations may acquire and provision hardware and software, hire unix administrators, build out raised floor space and such, what are they really creating for customers (value) and how?

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