“Salary in an organization is determined by the value of the decisions you make. If you’re decision is, ‘Do I empty this trash can?’, you get paid the salary of the janitorial staff. If you’re decision is, ‘Should we enter China or India as our next market?’ you get paid like a CEO. One of those decisions is valued at cents (the trashcan) the other in millions or billions (entering new markets).”
In other words, decisions determine everything. The higher the stakes of the decisions, the higher the pay. But why or why do we make decisions in the first place?
To generate value.
The more value an individual creates for the organization, the more of that value they get to keep for themselves in terms of pay. (Or compensation in terms of people paid with equity. But you get the point.) And workers/employees/owners create that value via decisions, which is the first theme of this website.
“Value” is why businesses, governments and really any organization exists. But this website doesn’t exist to serve the needs of governments or academics or non-profits; today I’m going to clearly define how businesses create value. Then we can use that definition for years to come.
Value Creation: A definition with a chart
Put simply, a business creates value by charging a price less than a customer’s “willingness to pay” for a good or service but higher than the costs to make and deliver the good or service. That’s a bit confusing. Fortunately, I have a chart to simplify things.That chart I learned in the core strategy class at my business school. So yes, this is Strategy 101 and I’m summarizing that lecture. That said, I’ve never seen this chart used in an actual business context, which is a shame. It’s simple. It’s elegant. And useful.
This chart isn’t quite economics per se, though it summarizes a lot of micro-economics graphs that show where to price a good. The line between strategy and economics is super blurry.
So let’s explain that above chart. Starting on the right. The “willingness to pay” (WTP, one of only two acronyms I’ll use today, I promise) is the hypothetical maximum price a customer would pay for a good. That’s the upper limit. Above that they won’t buy a good, below that they will. The price is what they actually pay for it. And “cost of goods” (COGS) is the term from accounting that means how much it cost you to make something. I’ll mainly call it “costs” today
The key insight of this diagram is the two terms on the left. This is the “value”. The first one is “consumer surplus”. The gap between what you actually have to pay and how much you would pay is the benefit you receive. The customer’s surplus from the transaction. The gap between the price and what it cost to make (and all the costs to run the business) becomes a company’s profit or net profit. (Or “producer surplus”. Or for an individual item the “gross profit”.) This is the value for a company and its owner and shareholders.
An Example of Value Creation: Buying Beer
For my real life example, I’m going to use craft beer, to show I’m a stereotypical male of my generation (Millennial). Maybe I would pay up to $10 for a six pack of craft beer. This is my WTP for craft beer. That’s the top line. (Numbers from here on are approximations to illustrate the point.)
The store I go to happens to sell a six pack of Golden Road for $9. This is the price. We now have our first “math” problem of the chart. (I put math in quotes because a lot b-school students think business math is complicated. Most financial statements are just addition and subtraction problems. That’s easy!) My consumer surplus is therefore $1. Great!
To keep this example simple, let’s assume the store paid $8 for the beer. This is their cost. Now we have our second equation, price minus cost. This gives us the store’s profit. Unlike the consumer surplus, which isn’t actually exchanged or stored, but a psychological value, the company keeps the profits. (Or again accounts for it as “gross profits” then subtracts the fixed costs of running the store. But I’m keeping it simple for now.)
Here’s that math in chart form:And that’s it! That’s the whole three part equation in real life. But now we get to play with it and generate some cool insights, that will directly tie to the themes of this blog.
The Good Side of the Chart: Creating Value
In business, the key to gaining a competitive advantage (a term for a later post) is to change the lines on this chart. Literally, if someone tells you strategy is complicated just say, “No, I only need to move one of three lines.” So how do you do that?
First, you can keep your costs and price flat flat, but increase the WTP of the customer. This means, you make a more attractive product for the customer. Get the customer to want to pay more or to raise their WTP. So let’s say every so often my store carries the craft beer Stone IPA. I’d pay $12 for a Stone IPA. But my store sells it also for $9, like Golden Road. In this scenario, my consumer surplus has gone from $1 to $3. That is creating value. (Presumably, the store will sell more Stone beer overall to make up for the higher price they could charge.)There are lots of different ways to increase the willingness to pay. You can make the product higher quality, better functioning, longer lasting or with better features. In services, you can offer faster services, better services or different types of services. Again, you increase WTP by making things better, in general. Or creating a new product people didn’t know they needed (the rarest type).
(Here are some good examples of boosting WTP. The iPhone took how much people were willing to pay for a cell phone and blew it through the roof because it was such a technological masterpiece. Google offered the best search engine, so it took over search. In-and-Out costs about the same as McDonald’s but crushes it on quality.)
There is another way to increase value for customers: you lower the price, while keeping WTP flat. This increases the consumer surplus. This is also creating value. In the beer example, assume I walk into liquor store, intent on buying beer, and I see a sale for $7 per six pack. I’m used to paying $9, and would pay up to $10, so my consumer surplus went from $1 to $3. Yay me! Same surplus; different method.So how do you lower prices? Well, you either cut into your own margin or you figure out how to lower costs. Many companies enter a market because they figured out a way to make a core product cheaper than it is currently being sold. In the beer example, domestic light beers are the best example. By scaling up production, they can produce beer cheaper than craft beer makers. I could get a whole twelve or even eighteen pack for price of one craft beer six pack. If a beer company can identify a way to make beer cheaper, it can lower prices and increase consumer WTP (and market share).
(Here are some good examples here: McDonalds, Taco Bell, and Wal-Mart. Or generic drugs. Lowering prices isn’t as sexy as increasing WTP, often relying on supply chain improvements or offshoring/outsourcing, but can definitely create value for customers.)
So figure out how to offer more value and increase willingness to pay, or figure out how to lower costs and therefore lower prices. That’s how you create value. I’d summarize 90% of value creation like this:
Increase Quality —> Increases WTP
Increase Variety —> Increases WTP
Increase Speed —> Increases WTP
Decrease Costs —> Decreases Price
The Bad Side of the Chart: Capturing Value
If you’re sharp, you noticed that I showed how to move two lines on the chart, while keeping the others still. What if, as a company, instead of lowering prices, you raised them? While keeping your COGS and WTP steady? Well your profit would jump.
The term for this is “value capture”.
So let’s say—and this could never happen in America with its strong anti-trust regulations—a single company or say handful of companies captured a dominant market position and began to work together. (Again impossible, but conveniently most cell phone plans cost about the same and offer the same services. Again, coincidence.) Let’s use the beer example. Since customers are willing to pay $10 for the beer above, what if all the stores worked together to all charge exactly $10 for all craft beer? Well, now my consumer surplus is $0. But the company, whose costs haven’t changed is now making a profit of $2.Or, let’s say there were only two makers of alcoholic beverages in the entire world. And they conspired together to increase the prices they charge retailers. So they still sell the beer for $9.90 to stores, and stores have to sell it at $10. Well, now the beer producers have captured nearly 95% of the value and customers don’t have any.
That’s how monopolies work. Or oligopolies. They don’t create value for anyone per se, but figure out a way to capture value from someone else. In other word, they are “part of the cost of doing business”, which usually means they capture value without adding value.
To be clear, lowering prices as the result of innovation that lowers costs is NOT value capture. Even if the value isn’t passed to consumers, it’s still passed to shareholders. Instead, when prices move simply because a company has figured out how to raise prices without moving their costs or by increasing the customers willingness to pay, they have figured out a way to capture value, and passed the costs on to the rest of the people in the chain.
The Ugly Side of the Chart: Capturing Market Share by Destroying Value
There is an even darker version than just capturing value where a company charges a price below what it costs to make a good. At that point, the company is offering a tremendous consumer surplus to customers. But why would they do this? It seemingly destroys value for themselves. Well it could be used to gain market dominance, at which point the company can raise prices again, devastating consumer surplus. A company cannot survive indefinitely if it loses money overall on acquiring market share.
Here’s an example of that with the craft beer, showing a company pricing below costs. Moreover, overall value is destroyed because the previous surplus of a total $2 is down to $1 (consumer surplus plus producer surplus). Short term there could be reasons for this, but fundamentally it is unsustainable. In our current climate, a lot of companies have current pricing that causes them to lose money. Some who have lost money for years. There are also companies loading up on debt to fuel M&A that are regional and/or national oligopolies. The question I have for each of them is this chart. What is your strategy? Are you creating value, capturing value or capturing market share?
In many cases, the end goal of the market share is to achieve market dominance, at which point the companies can charge whatever prices they want. That is indeed ugly, for consumers.
Every business conversation should strive to get back to this chart
I have a working theory that most good things in the economy come from value creation. Companies that create value have better future growth. Value creation grows the economy without inflating it into a bubble. I also believe that companies that learn to create value have better relationships and more success with their customers. Some of these beliefs economists have proven; others the evidence is mixed.
Yet, I have never seen this chart in a business context. I also rarely see it in a entertainment press context either. I hope to remedy that.
I thought about providing some examples of value creation versus capture in today’s article, but it would have been too long and, honestly, that’s the purpose of this website. MoviePass, Disney, Youtube, Amazon Studios/Prime/Video, Hulu, Comcast, AT&T and Apple. I’ll look at all their business models and pass judgement at some point.
In the meantime, ask yourself: is your company creating value, capturing it, or capturing market share?