In the recent article, What Is Your Organizational Value, we explored the mounting pressure to increase productivity. Do more with less, that is today’s business mantra. The phenomenon is all about cost containment, but perhaps it is also about losing entitled employees and keeping those that add value. Value is created anytime an action is taken for which the benefits exceed the costs, or anytime an action is “prevented” for which the costs exceed the benefits. This applies to so many aspects of business that no further explanation is needed. Obviously, those employees that are not adding value will be replaced with available talent that is willing to do so. But all of these productivity gains being fully realized? Are we capturing all of the value we are asking to be created? More companies are balancing their focus between value creation (revenues) and value capture (profits).
The Relationship Between Creating Value and Capturing Value
Borrowing from the neoclassical economic theory of profit maximization, let’s analyze value creation from the perspective of the theory of the firm. The theory of the firm is actually a collection of theories related to predicting the nature of a company or corporation, including its existence, behavior, structure, and relationship to the market.
A firm creates value by producing and delivering goods/services at a cost that is lower than what the consumer is willing to pay for that good/service. This value creation can be divided into two components: “producer surplus” (profits) and “consumer surplus.” The firm is owned by its shareholders, who capture any residual profits (“producer surplus”) that remain after the shareholders have paid for all the other resources used for producing the good/service. Typically, the residual profits are generated by the firm’s superiority relative to competitors. In addition, the firm creates value that flows to consumers in the form of “consumer surplus.” Consumers enjoy this surplus to the extent that the price they pay for the firm’s product is less than their maximum willingness to pay. The total economic value created by the firm at any point in time is equal to the sum of the producer and consumer surplus.1
Who Else Benefits?
Workers can certainly create value for their company, but can they capture some of it for themselves? Not necessarily. Unless the worker is in sales and paid on commissions or has variable compensation bonus money tied to performance – their value delta is probably not flowing back to them – at least directly. Studies show that even CEOs capture less than one percent of the value they create for their companies. In fact, one of the problems encountered when examining value creation is that the value creation “agent” often captures little if any of the extra value being created. The reason this is problematic can be summed up in one word, “incentive”.
Why create value beyond expectations if there is no incentive to do so? Consider this example. An employee discovers a technique to produce the company’s best selling product twice as fast as it could be made previously. He shares his findings with his boss and his coworkers. Instead of capturing value from his innovation, the employee’s innovation backfires from his perspective. Now his boss requires twice as much output and keeps the surplus value being delivered. Human nature often means that there is no incentive to create more value unless one can capture some of the value that is created. In other words, people will create more value if they can capture some of the surplus they create – becoming one of the stakeholders that captured value is distributed amongst.
But we need more value created, so now what?
Competition drives the need to innovate and create more value. Businesses that create the most value will survive or do better than their rivals. Rest assured, however; business rivals will make darn sure that consumers capture most of that surplus value. This is why “competition” and “information” (which drives competition on the buying side) are so important for market efficiency. In highly competitive markets, businesses must increase profits through value creation because trying to capture more value without creating more will make many customers go to competitors. It fact, it is competition that forces the close link between capturing value and creating value. One thing is for certain. You can’t capture value without creating it, but you can capture more value while creating less.
Create – Capture – Share
In the strategic management literature, there is much debate and arguably some confusion about the concept of value creation. Strategic management researchers have often taken a narrow view, equating value creation with returns to shareholders1 As discussed earlier, customers are another the primary beneficiaries – due to competition. It is time to expand the scope of value capture to include other stakeholders, with returns potentially captured by employees and suppliers as well.
Incentives drive behavior. We know that value is created anytime an action is taken for which the benefits exceed the costs, but it is also created also anytime an action is “prevented” for which the costs exceed the benefits. Incentives to improve aspects of production (e.g. waste, quantity, quality, production methods) and sales (e.g. up-selling and cross-divisional selling), finance management (e.g. A/R control, billing, interest management), job safety (e.g. maintenance management, standards and reporting) as well as other operational functions… all lead to the creation of value. Methods to reward performance in value creation by sharing in its capture will benefit all. The customer wins initially in terms of better products and services while employees and suppliers are more than motivated as a result of receiving a part of the reward.