Understanding the Basic Concepts of the Value System
Entrepreneur Success Series
Resource Note # 12
In continuation of the Entrepreneur Series, the focus moves to the means by which an entrepreneur can deliver the Value promised by business idea. The primary vehicle for delivering this Value is the Value Chain of an organisation and hence an understanding of the concepts and principles of the Value Chain would be beneficial for an entrepreneur. Once an understanding of the basic concept of the Value System is established, then it becomes easier to construct the Value System and determine how Value can be captured across the Value System.
A Market comprises of all the people (consumers) who have a need and who have the means to pay for fulfilling the need. Value is a two-way exchange of the needs of the customer as met by an organisation, and they payment of money in exchange by the customer. This section details a comprehensive understanding of Value and is applicable for both products and services.
The needs of the consumers are normally made up of multiple parameters that should be present in the product. An indicative (but not exhaustive) list of parameters could be:
- Functionality – Fitness for use, Reliability, Durability, Serviceability
- Cost – or competitive price
- Delivery – as required
- Features – multiple functionality in a product
- Innovation – ability to continuously enhance the product and features
1.1 Order-Winning and Market-Entry Parameters
Normally, it is unrealistic for a consumer to expect all the parameters in equal measure in a product. There is naturally a setting-off process – if you want less price then you may have to compromise on say features. If none of the parameters is to be compromised then the price would be pitched high (this is seen in high-end niche segments).
Thus the consumer tends to prioritise the various parameters of a product according to their primary need. This leads to sub-segments of the market. If one were to take motor-cycles as an example, one sub-segment may value power the highest, another sub-segment may look at styling, a third at fuel economy and so on. A motor-cycle manufacturer may decide to offer power as the highest value, aiming at the sub-segment that desires power. This parameter ‘power’ is termed as the order winning parameter for that segment and hence the order-winning parameter for the manufacturer. Thus different manufacturers may focus on offering different order winning parameters; at time maybe two order winning parameters. It is extremely rare to find many order-winning parameters unless it is a high-end niche.
While one or two parameters may be order-winning, it does not mean an organisation can neglect the other parameters. As an example, the manufacturer who offers power as order-winning, cannot ignore fuel economy or smooth drive. These will have to be offered at a minimum acceptable level for the consumer to even consider buying the product. Those parameters offered at minimum acceptable level of performance are termed as ‘market-entry parameters’. If a minimum level is not offered in the product, there will be no market for the product.
The total Value offered by the entrepreneur comprises the order-winning and market-entry parameters. An entrepreneur needs to list all the parameters in the product that his market requires, then identify those which will be offered as order-winning with the rest being market entry, and then they can proceed to design and make the product. Their performance on the order-winning parameters have to be superior to that of the competition in order to attract customers. The remaining market-entry parameters must be offered as meeting expectations adequately and not necessarily in a superior manner.
The tangible parameters of Value (e.g. features, quality, etc) are the outcome of the Value Chain. However there are some experience (subjective) aspects of Value which are enhanced by the Marketing function e.g. Brand Image.
1.2 Value density
It is a concept that captures how different needs are met in a product. A smart-phone has a high value density as it meets multiple needs like calling, surfing, mailing, photographing and so on. This is different from order-winning concept. Going back to the motor-cycle example, the need is basically personal movement but different parameters are emphasised as order-winning (e.g. power, fuel economy). One could say the Value density is one need per product. For a cell phone (as illustrated above) the Value Density can be said to be four per product. Some more examples:
- Malls lay out multiple value offerings – shopping, entertainment, dining
- ATMs meet the need for cash as also other transactions like depositing money, etc
- A pharmacy is not only for drugs, but a comprehensive source of health information.
There are two alternate paradigms in the Value density concept that govern Value exchange (i.e. money).
- Multiple values are packed in an offering for which money is exchanged in a single transaction; Then it is left to the customer to avail the value at no additional cost. E.g. Laptops and Smart phones are packed with features for which there is a one-time exchange of money. All the features may not have an immediate need, but they can cater to a latent need without additional money outflow. This is the value bundlingconcept.
- Multiple values are made available within one experience and operate on ‘pay per use’ i.e. money is paid for only those values which are availed e.g. in multiplexes, value exchange takes place separately for food, movies, shopping. They are not bundled into one entry fee. Similar is the case of TV entertainment providers, say Tata Sky.
An entrepreneur should examine the possibility of enhancing the value density of their offering and then decide whether it should be bundled or ‘pay-per-use’.
2. Value Chain
The Value offering of an organization is created through a set of processes that start with inputs and converts them to the value offering as outputs. Tangible value is obtained by moving raw materials through this conversion processesto the end product. Intangible value, like services, is delivered by moving products and ideas through the experience processesof the customer.
A simple conceptualization by Deming of the tangible conversion process is shown in Fig 1
Fig 1: Deming’s Conversion Process Cycle
The cycle starts with customers’ needs and the Value parameters they desire to meet the needs. The organisation produces the products in line with customer needs through a series of linked activities required to create value for the immediate customer. In return the customer provides cash to the organization in return for the value received.
Michael Porter classified the linked conversion processes as those line activities which are directly responsible for creating the value for the customer (Primary activities), and support activities which facilitate the line activities to deliver value (Secondary activities). The margin derived from these activities i.e. Value delivered measured as money less the costs incurred in the activities, was the true return for the organization. Porter’s model came to be known as the Generic Value Chainof the organization and is shown in Fig. 2.
Fig 2: Michal Porter’s Generic Value Chain
In Porter’s Value Chain, Inbound Logistics, Operations, Outbound Logistics, Marketing and Sales and Service are categorized as primary activities. Secondary activities include Procurement, Human Resource management, Technological Development and Infrastructure.
The organisation identifies those processes in the Value Chain which contributes to the Value parameter of the customer. For example, if delivery is the Value parameter (as in Domino’s Pizza), it is traced to the logistics and manufacturing process which are then strengthened, to make the organisation competitive on delivery. A consumer who values delivery as the CSF would then patronize that organization whose logistics activities are superior to that of competing organization. The Value Chain activities are also classified as order-winning and market-entry activities. This helps the organization identify where to build its competences and to make strategic decisions about investments, alliances and outsourcing in the Value Chain.
It is crucial for an entrepreneur to identify the Value Chain activities that are required for the end product offered by them. Those activities which contribute to order winning parameters must be strengthened and competencies built such that they are better than the competitor. This will ensure that the consumers will flock to them.
The Value Chain activities are not all carried out by the organisation. Some of the activities are transferred to outside parties. This is called Outsourcing – the contracting out of a business process to a third-party. For example, many organizations outsource their logistics needs to a third party logistics provider. Organizations resort to outsourcing for various reasons but primarily for reasons of ‘core competences’. If a process can be carried out more productively by another organization (as in the logistics example above), it can be outsourced, so that the total value offered by the organization can be improved. Other reasons could be to avoid certain overheads, prevent legal consequences, avoid owning and managing assets, capital requirement and so on. Generally, outsourcing results in better efficiency and profitability for the organization. It is normally expected that order-winning activities are not outsourced, but this is not necessarily the case. As an example, one of the order-winners for Amazon is speedy delivery which it manages through partnership relationship with logistics providers like DHL.
The opposite of outsourcing is insourcing, which is bringing processes into the organization through vertical integration. Reasons could be similar to outsourcing viz. greater efficiencies. Insourcing could be through backward integration (upstream activities) or forward integration (downstream activities).
Intermediation is the introduction of a third party to facilitate a process. This is different from Outsourcing in the sense that the third party does no value addition themselves but facilitates two parties to exchange value. For example, the e-commerce intermediation on the internet to bring buyers and suppliers together of a commodity, say steel. Intermediation does not add direct value to the product; rather it facilitates value addition.
The above aspects must be considered by an entrepreneur so that a judicious mix of Outsourcing and Insourcing will give a Value Chain that is aligned to give best and competitive Value to the customer.
3. Supply Chain
Porter’s Value Chain is drawn for the activities of a single organization. An organisation often outsources some activities and takes outputs from the outsourced companies as inputs for their own processes. The outsourced companies and the organisation together constitute what is called a Supply Chain.
As an illustration, normally an end product (say, the automobile) is made of a number of sub-assemblies like engine, transmission, steering, wiring harness and so on. Each sub-assembly requires technologically different processes. It is very rare to find one single organization having competence in all the processes and be vertically integrated to have all the processes under its ownership. Rather, the tendency is to disaggregate the key processes to organizations which have the best competence to produce the same. Thus engines are made by one organization with its own Value Chain, transmission by another and so on. All these sub-assemblies from various suppliers are then assembled as a car by one organisation. This is the situation in say Tata Motors, which only assembles the finally car from outsourced sub-assemblies.
So a string of ‘Value Chains’ of different suppliers link together to produce the car. This is the basic understanding of a Supply Chain– a series of organizations, with competences in different activities required to produce a product. Materials move through this chain, building up value on the journey from initial suppliers to final customers.
4. Demand Chain
The Supply Chain converts raw materials to the finished product. This finished product has to be moved through the distribution channel to meet the demand of the ultimate customer. The Marketing department identifies customer demand, the Supply Chain produces the product and it is reached to the customer by what is identified as the Demand Chain. The Demand Chain can therefore be understood as a set of organisations in the channel that moves the finished product to the final consumer. The Demand Chain has no manufacturing, though it could have service processes of packing and re-packing according to desired quantities. It is downstream to the Supply Chain.
5. The Value System
The Supply Chain and the Demand Chain together make up what Michael Porter defined as the Value System. The inter-relations of the 4 concepts – Value Chain, Supply Chain, Demand Chain, Value System – is summarized below:
- Value Chain is a set of activities, primary and secondary, that an organization carries out to provide value to its immediate customer.
- Supply Chain is a series of linked organizations (i.e. linked Value Chains) that converts raw material to finished products.
- Demand Chain is a series of linked organizations (i.e. linked Value Chains) in the channel that moves the end products to the final consumer.
- Value System is the linking together of individual Value Chains of both the Supply and Demand chain.
Fig. 3 captures schematically the composition of a Value System.
Normally, an entrepreneur comes up with a Business idea which may directly serve the end customer or may feed into another product that meets customer demands. This will define the position in the Value System that would be taken by the entrepreneur’s organization. If it is a supplier of parts to the end product, it would be upstream in the Supply Chain. If it assembles the end product, it would be the last organization in the Supply Chain. If it occupies a position in the distribution channel, it would be in the Demand Chain, with a retailer being the last organization in the Demand Chain
6. Operating the Value System
The challenge in any Value System is for all the organizations in the system to march in unison to the value parameter desired by the ultimate customer. This information has to percolate backwards from the ultimate customer to be adopted by every organisation in the Value System. This percolation is normally facilitated by IT systems like ERP. Each organization manages its own Value Chain as a part of the overall Value System. The Value it delivers to the succeeding organisation in the link is a building block of the final Value for the ultimate customer. The entrepreneur’s organisation must have core competences in those of its activities which contribute to the ultimate order-winning parameter. For example, if the end product is a Smart phone, then one of the order winning parameters would be the ability for innovating newer features and applications. An organisation in this Value System should thus have innovation competence in its outputs to support the ultimate order-winning parameters. This concept will allow an entrepreneur to decide what core competences to build in the organisation.
This above gives a fundamental understanding of the various facets of Value which are essential for an entrepreneur. How a Value System is actually constructed will be covered in the next edition of Sattva.
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