Business begins with value creation. It is the purpose of the institution: to create and deliver value in an efficient enough way that it will generate profit after cost.
Because value creation is the starting point for all businesses, successful or not, it’s a fundamental concept to understand. Here’s what is to come in this collection of wisdom about value creation:
- Definition of Value, and how it can be created
- Evolution of value creation through history, and in the future
- How value can be measured and managed
In the next Edition, we’ll pair this with research on Value Capture — join Evergreen to be sure you get the followup to this post.
How Value is Created (Value Defined)
In the broadest terms possible, value is created through work. This work could be mechanical (cutting a tree down and turning it into lumber) or creative (creating a logo or writing a paper). Of course, not all work is value-creating (sisyphysian tasks like moving rocks from one place to another, then back).
The purpose of a business is to create value (through work), sell or trade it to customers, and capture some of that value as profit. (Ok, Duh, yes, but we’re starting from the bottom here).
A Precise Definition of Value Creation
In his excellent book, The Origin of Wealth (graciously gifted to me by Nathan Bashaw), Eric Beinhocker offers a scientifically rigorous definition of the creation of economic value, based upon the work of the Economist Georgescu-Roegen:
A pattern of matter, energy, and/or information has economic value if the following three conditions are jointly met:
1) Irreversibility: All value-creating economic transformations and transactions are thermodynamically irreversible.
2) Entropy: All value-creating economic transformations and transactions reduce entropy locally within the economic system, while increasing entropy globally.
3) Fitness: All value-creating economic transformations and transactions produce artifacts and/or actions that are fit for human purposes.
For those who didn’t take a Thermodynamics course in college (myself included), substitute entropy for ‘disorder’ for a decent approximation. So in more normal-human words: Value is created through an irreversible process which gives a resource’s ‘order’ greater usefulness to other humans.
Under this definition, almost any activity can be value-producing, from opening a door for someone, to writing something, to turning the sun’s energy into power to run your ceiling fan.
Not All Value is Created Equal
As there are an enormous (and ever-increasing) set of possible ways to create value, how do we decide which type to pursue? Is each way of creating value as useful to us as another?
Peter Thiel doesn’t think so. In his incredibly useful book, Zero to One, he talks about the conditions of a successful business. All businesses must create value, but some types of value (and methods of value creation) are more useful than others. His book is summarized in this talk at Stanford:
Creating value by producing a commoditized product is not a pathway to success. Think about the substitutability of your product or service: Do customers have a wide array of other options? Do they have to make a purchase at all? Are you meaningfully distinct from your competitors?
If your industry is in competitive equilibrium, the death of your business wouldn’t matter to the world: some other undifferentiated competitor will always be ready to take your place.
This is the condition for most businesses — what they sell is not unique, but generally substitutable. If you want to create the kind of value that builds a lasting and successful business, Thiel says you must be unique:
All happy companies are different: each one earns a monopoly by solving a unique problem.
To solve that unique problem, you must develop unique skills or processes:
In the real world outside of economic theory, every business is successful exactly to the extent that it does something others cannot.
This set of ideas is really to lead-in to studying Competitive Advantage, the ‘how’ of developing and delivering on this unique value proposition. What does your business do that others can’t match?
Thanks to Victor Sowers and Itamar Goldminz for recommending this set of Peter Thiel’s ideas!
Note: Delivering a commoditized product with a radically improved cost structure is certainly a Low-Cost Competitive Advantage, and is a very worthwhile method of value creation.
Value Creation Chain (through an Organization)
For a visual way to consider value creation, let’s take a look at Porter’s Value Chain. The Harvard Business School Professor generalizes all business processes and shows each contributes to the organizations goal to create value for customers:
These ‘Primary Activities’ are the process alluded to in our first definition from Beinhocker, which do the ‘work’ to create the value that customers are paying for:
Inbound logistics — These are all the processes related to receiving, storing, and distributing inputs internally. Your supplier relationships are a key factor in creating value here.
Operations — These are the transformation activities that change inputs into outputs that are sold to customers. Here, your operational systems create value.
Outbound logistics — These activities deliver your product or service to your customer. These are things like collection, storage, and distribution systems, and they may be internal or external to your organization.
Marketing and sales — These are the processes you use to persuade clients to purchase from you instead of your competitors. The benefits you offer, and how well you communicate them, are sources of value here.
Service — These are the activities related to maintaining the value of your product or service to your customers, once it’s been purchased.
Any business will have some version of each of these activities, even if it’s just a one-person service company. This set of primary activities are the foundation for creating value as an organization.
The Evolution of Value Creation
Historic Value Creation
This infographic from Funders and Founders summarizes the long history of a wide variety of human attempts at value creation. I don’t consider it scientific or comprehensive (strictly speaking, I don’t think plunder count as value creation), but it is a quick way to get a sense of the evolution of the economy up until today. To see the full story, go to the site here.
Of course, there were lots of parallel types of value creation throughout history, these are just examples dominant in each era. Given where we’ve come from… where are we going next?
What Value Creation looks like in the Future
As we look at the changes in the way our economy has created value in the past 100 years, we’ve shifted from a focus on huge mechanical production during the industrial revolution to more creative and customized production through the information age. Software and related services dominate more and more of value creation.