Understanding value creation
Value creation is the increase in value from transforming raw inputs to the final output. You can think of value creation as the extra benefit that is derived from the transformation of raw inputs to final products. As you transform the products, the customer’s willingness to pay for the goods increase. The greater the customer’s willingness to pay, the greater the value that has been created.
Example of value creation 1: Manufactured products
It is easiest to imagine value creation when thinking of manufactured products – you can visibly see the products moving through the firm. A good example of value creation is processed foods. Cutting up the vegetables, cooking them together, and packaging the final product make the materials more valuable than they originally were. Customers are willing to pay a higher price for the processed product than they would for the original raw ingredients.
The same of course is also true with other manufactured products. The value of a finished car is greater than the value of the raw materials that went into it. The value for a table or chair is greater than the original wood. With each of these examples, by transforming the raw materials or ingredients, companies are able to create a product that customers are willing to pay a higher price for than the cost of the original components.
Example of value creation 2: Services
Beyond processed products, value is also created in the service industry. This can be less easy to visualize since one of the primary inputs is labor. However, the same principle still applies – value is created as customers are willing to pay a higher price than the cost of inputs. So for a haircut, value is created in the process of cutting our hair.
Thinking beyond value creation: Value capture
While value creation is an important component of successful businesses, it is also important that the company is ‘capturing’ at least a portion of the value that it is creating. While there may be a huge value created in transforming some raw materials to the final product (i.e., with the customer’s willingness to pay far exceeding the input costs), if customers are able to bargain down the price – they may be the ones that end up appropriating the majority of the value. It is possible to be in a situation where as a company you make little to no money despite creating huge value, because it is your customers that end up capturing the value created, with your firm only having minimal margins.