The Creation and Capture of Value

This was originally posted in October of 2015 using Posthaven before being moved to Substack. My plan is to start writing more posts like this again.

In order for a business to create value after cost it must create and distribute that value in the most efficient way possible. It can be considered the starting point for any and all businesses which leads to our first question to think about: how is that value created? Simply put, it is created through work. That work could be anything from administrative tasks (such as filling out the right paper work for customer orders), technical (deploying code to servers), and creative (marketing copy, product and/or logo design, etc.). The business can then create value through that work, sell or trade it to a customer base, and capture some of that value through profit. Based on this definition, we can begin to clearly see that businesses add value in more ways than just making a product and selling it. Every moving piece of that business should be moving towards the end goal of creating and capturing that value.

Now let’s start thinking about the types of value that can be created. First, let’s remember that not all types of value are created equal by any means. A value that is considered a commodity is easily replaceable in the minds of customers. For example, if your products aren’t distinguishable from your competitors, then that competitor will be primed to take your place should your business falter by any means. There are ways around this though; if your company is able to create a new and more efficient process for doing business or in possession of unique skills focused on the creation of value, then you will be able to more readily differentiate from those trying to eat your lunch. Having any of these things is a competitive advantage and should be fully utilized towards the goal of value creation.

Measuring value creation is important if only so that you understand what the value is that your business is making. The first method is by measuring revenue. Revenue tells you that the way your business creates value was worthwhile to your customer base since they are willing to pay for it. Notice how I didn’t say profit. Many businesses successfully create revenues but no profits (think Amazon), but many will not be able to do this for very long. A business needs a profit in order to survive and sooner or later a lack of making any profits will bring that business down, no matter how great the product or service. (Amazon has been able to successfully navigate this pasture by shrewdly reinvesting its revenues into future initiatives such as AWS.)

Then there is perceived and exchange value, which are interrelated. The exchange value is straightforward in that it is the amount of value exchanged between a buyer and seller for a product or service. For example, if you go to the store and purchase a pair of shoes, the price you pay for those shoes is the exchange value. The perceived value is defined by our perceptions of usefulness of the product or service. In economics there is a consumer surplus (C.S.); when the consumer surplus is greater than zero (C.S. > 0), then the customer is better off making a purchase than not. So value is created when the perceived value of a product or service has a certain degree of usefulness, consumer surplus is greater than zero (C.S. > 0) and that same value is then exchanged to the seller.

As we can see, it’s incredibly important for a business to create value. It won’t survive for very long if it doesn’t create value by differentiating itself in the marketplace or not making a profit in the long run. In order for a business to survive, it must capture a portion of that value it is creating. If businesses ultimately want to succeed, they must think clearly about how they are going to capture the value they are creating. Businesses that don’t do this may be leaving money on the table.

There are a number of different ways to capture value with some being more common than others. For instance, price based on value changes according to the offerings worth to the customer. What this means is businesses don’t set their prices based on what their competitors are doing. They might also discontinue the process of marking up prices based on production costs. Instead, what they are doing is looking at what their customers want and setting their prices accordingly. What is important is that the customers’ perception of value must be discovered. This is obviously different with each customer but there are different models of discovering this missing piece. An obvious example is auctioning, which doesn’t work with all business arrangements but is incredibly effective when it does. The most common example of an auction is with online advertising, where each buyer sets the price and the seller can choose whether or not to take that offer. Of course this is controlled less and less by human interaction and is guided more efficient using algorithms to guide the software. There are some downsides such as prices that may be less than satisfactory for the seller, but must be honored regardless.

Another model is known as demand-driven pricing; what this does is let the price change due to the fluctuations in demand for a product or service. The most common example to date is Uber and it’s constantly changing prices. Although there can be a large amount of complaints if the price is too high, there are reasons for it, and Uber acts on those reasons with a mechanical efficiency. The business is a money making machine. How it works is the company raises and lowers its prices based on demand for rides. Other factors that are taken could be day of the week, whether it is a holiday or not, weather, and even city, etc. Using these variables (and many, many others), the company can maximize its profitability by knowing how many cars to have on the road and in what location at any given time. Demand-driven pricing at its finest.

A further form of value capture model enables customers to set their own prices. Although this doesn’t take place in most industries, it is especially prevalent in the travel industry where buyers can decide what price they want to pay and sellers can take it or leave it. Unlike auctions though, this transaction is mostly kept between the buyers and sellers. Doing this lets the seller maintain their prices even if they are discounting for incremental sales.

Next up is for companies to capture value by using two-sided market forces to their advantage. Although the name may not ring a bell to most people, it is a model everyone has seen in action and is used efficiently by media companies. For example, many publications are free for the general public to take (think local periodicals in many major cities) and they make their money, in turn, by charging advertisers to place ads in their publications. The money is then used to subsidize the content that is created for the publications and the process is continued. Although Vice Media is a much larger entity now, when it was just a magazine, it was free to anyone (who could find it) and the vast amount of value was captured by charging advertisers (especially American Apparel). Of course they made money with subscriptions, but most people just searched high and low for a free copy.

Then there are those businesses that use what’s known as the “price carrier” in their offerings. This is the experience that businesses will hang a price tag on while customers may not be coming through the doors just for that in the first place; they may be coming for something else entirely. Think about it, we will sometimes purchase a product or service to gain access to something else the company is offering, but has no price tag on. Starbucks is a great example of this. The majority of their customers walk through their doors for a quick coffee before work in morning, but there are those people who come in just for the wi-fi. Using it isn’t for sale, but purchasing a coffee or pastry will give you access to it. So a good question to ask yourself is whether or not your business is hanging the price tag in the right place. What would happen if you moved it to something else?

One of the most prominent examples of value capture is called the razor-and-blades model, which was pioneered by Gillette. It’s a rather simple model: customers get the razor handle for free, but must purchase blades continuously since they get dull rather easily. And charging for the blades is where the value capture happens. This model was also utilized by technology companies who sold printers and printer ink replacement cartridges. The printers are always cheaply priced; the ink is not.

The final model to talk about is one we all know well since the phone carriers are incredibly efficient at using it; it is known as bundling. How it works is the price of the new phone is subsidized by any extra hardware, software, and data features we purchase with it. The phone is cheap; the options that are bundled with the purchase are where the value capture takes place. Car dealerships also excel at this too; when you go to purchase a car, the sales people will usually bundle in many products or services you may or may not even need since those add-ons are where the money is then made.

Both value creation and value capture are incredibly important to keep your business running smoothly over a long period of time; more so than your competitors. Both are equally important; both need to be studied rigorously for the best understanding of how the complement one another. Value creation is the work that a business needs in order to create value to offer to their current and potential customer base; capturing that value is what will keep customers happy and the business running smoothly. Combining the two will be what ultimately either keeps a business alive. And that is something to constantly been thinking about when focusing on your own business.