Advantages and Value

What comes first, advantages or value? How does causation run – does superior value result in advantages, or do advantages result in superior value? This is a sort of what comes first, the chicken or the egg?

Closer inspection of this question shows that the latter must be true. Superior value rests on the notion of offering higher benefit and utility to consumers than that offered by rivals. The source of this superior value must be found in advantages and capabilities that rivals do not possess. Advantages are simply the benefits that a firm enjoys when it uses and applies its resources in a way that rivals cannot easily emulate. This, in turn allows the firm to offer differentiated value that provides higher utility to consumers.

Advantages themselves result from developing and applying strength against weakness, or from finding and exploiting points of leverage that have gone unnoticed by rivals. Advantages are built up over time – by pursuing a set of coherent actions that guide a firm in marshaling and applying its resources in a particularly effective way. This is the role of strategy.

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Pricing and Elasticity

What would happen if your firm increased its prices by 5 percent? The fact that many firms cannot answer this question suggests they know too little about the responsiveness of customer demand to price changes – what economists know as the price elasticity of demand.

Often, one doesn’t need to know price elasticity precisely. Even a good approximation of a firm’s demand curve can allow for reasonable assumptions about how elastic or inelastic that demand is. Where the demand curve is believed to be inelastic, a firm can experiment by increasing prices slightly to validate the assumptions made.

Knowing the elasticity of demand can also allow a firm to avoid making a second error: discounting prices when demand is inelastic. Injudicious use of discounting in the face of inelastic demand makes little sense and erodes profits unnecessarily.

Process Improvement vs. Value Chain Improvement

Process improvements are about improving a firm’s production technology. A key aim of process improvements is to achieve an increase in the productivity of a firm’s inputs, principally labour and capital. This means that any level of output can be produced with fewer inputs, or more output can be produced with the same inputs. Process improvements impact a firm’s cost curves and, ultimately, its supply curve.

In contrast, value chain improvements can have impact more on a firm’s demand side. By choosing and tailoring the configuration of its value chains, a firm decides which value-creating activities to perform for which customers. This directly impacts the firm’s ability to generate revenue.

Because processes make up value chains, the difference between process improvement and value chain improvement is subtle, but profound. The former is tactical, the latter is strategic. Firm’s should avoid confusing one with the other.

Thinking at the Margin

A fundamental principle in economics is that rational people often make decisions by comparing marginal benefits and marginal costs. Rational decision makers will tend only to take action when the marginal benefit of a proposed action exceeds the marginal cost.

Two key implications of marginal thinking for businesses are the following:

  1. The costs of production, and firm profitability, is a result of choices. For example, choosing to make one more unit of a product is a marginal decision – as long as marginal revenue exceeds or equals marginal cost, making one additional unit is a reasonable course of action. Therefore, products and services do not have costs – it is the decisions associated with them that do.
  2. Competitive advantage may well rest on the degree to which a firm can provide value that exceeds a customer’s willingness to pay. Willingness to pay is a function of the marginal utility a customer perceives they will receive from consuming a product or service. As a firm increases the value it offers, consumers’ utility also increases, but at a decreasing rate. This decreasing marginal utility in turn results in a lower willingness to pay. Decreasing marginal utility among consumers is a key factor firms should consider when making value or performance improvements.

From the above, it can be seen that marginal thinking and decision-making impacts a firm on both the supply and demand sides. Decomposing marginal thinking into key demand and supply drivers can be instructive for strategy development and formulation.

A Zombie Idea: Value Improvement

If a firm is not creating and keeping customers, it’s not because the value offered must be improved, it’s because the value being offered is wrong. Firms spend huge amounts of resources and money on Lean and Six Sigma programs to help improve value. These firms should realize that value is designed, not improved. Lean and Six Sigma can help you create and deliver value efficiently and with minimal variation around a specified value target, but they are not the way to develop that target itself.

Only when a firm fully understands market need can it begin to innovate and design value. Designing value is not about designing a product or service. It is about designing benefit and utility for a customer (or customer group), where the benefit/utility perceived by the customer exceeds the price being asked. The product or service are merely the carriers of the value.

Marketing and innovation are the two fundamental business processes that drive value design. When a firm cannot design value that creates and keeps customers, it should look to these two fundamental processes, not to the shop floor.

Diversification

The main problem with diversifying a product line or a business is that strategic coherence can be lost.

A good strategy has an internal coherence – the result of design – where the sum of the whole is greater than the sum of the parts. In such a strategy, the policies and actions align and fit in such a way as to multiply their effect. The risk of diversification is that it can undo this coherence, leading a firm into businesses and processes with which it is unfamiliar, and thereby eroding its competitive advantage.

Diversification decisions must be made wisely. The fit and alignment of diversification initiatives with a firm’s sources of advantage should be explored and examined deeply. Where diversification entails moving resources out of the current sources of advantage and into unfamiliar territory, that may be a warning signal to reflect and consider.

Highly diversified firms may offer a wide variety of products and services. But they may also experience lower profits because they are not particularly good at anything. This is the danger to avoid. Diversification which is poorly thought-out may result in average performance at best, and mediocrity at worst.