Creating Value is Your Prime Directive

Executive Series #5

Preparing to drive a business into a high-performance state requires an understanding of some foundational concepts. I have presented several of these in previous articles:

1. Businesses as complex systems,
2. Businesses as dynamic systems, and
3. The Leadership Cycle, the rhythm of a business.

This article explores the concept of creating value, the prime directive of a business.

The Prime Directive

Some of you probably chuckle when I use the term prime directive. I first heard the term as a kid with my eyes locked on the latest episode of Star Trek. The term described an over-arching principle that must be followed regardless of the impact on other mission objectives.

When talking about businesses, the prime directive is always creating value.

What is Value?

What is value? The concept is somewhat abstract, but it is also straightforward and can be measured. Value is simply a measurement of the amount a given customer is willing to pay for a good or service at a particular moment in time. For example, if you sell a widget to a customer for $10, they have valued the widget at $10, or more. What makes the concept complicated is how a customer determines value.

Value is a Concept of Perception.

Value is a concept of perception. Each of your customers determines value separately. One customer may happily pay $10 for an item, while another won’t even consider a purchase unless it is less than $9. Many factors influence each customer’s perception of value; incredibly, most of these factors are subjective and emotional. We’ll discuss this complex subject in future articles, but for now just realize that:

1. Value is determined by the customer,
2. Each customer perceives value differently,
3. A customer’s perception of the value changes in time.

In summary, you can influence, but can’t control a customer’s perception of value.

How is Value Determined?

A customer perceives both tangible and intangible elements when they are determining value. Much of this valuation process is unconscious to the customer.

• Tangible Value Elements – Tangible elements are obvious if you sell a physical product. These include the materials used in manufacturing and the sophistication of the manufacturing process. However, services can also include tangible elements such as when a service technician performs work. Tangible elements are typically directly associated with costs. When you scale your business, your costs for the tangible elements will rise proportionately.  

• Intangible Value Elements – Intangible elements include things like your brand, product designs, intellectual property such as software, data, or patents, and even the customer’s memory of their last interaction with your company. Some intangible elements are impossible to see because they only exist with a specific customer’s mind. However, EVERY transaction between your company and each customer includes both elements. Intangible elements are highly leveraged when you scale. The costs associated with intangible value tend to be fixed, upfront costs, with little variable cost as you scale.

The value that a given individual assigns to an item at a moment in time is the result of the sum of all elements of value. Some elements add to the value (+), some elements add nothing to the value (0), and some elements detract from the value (-). We can call this concept the Value Equation.

The Value Equation is difficult, if not impossible, to determine on an individual transaction basis. However, as you aggregate all of your transactions, the picture becomes clearer at the product and service level and even clearer at the business level. Breaking down the Value Equation for your business into individual components will give you a powerful tool to drive profitability for your company.

How is Value Creation Measured?

Your inputs into designing, producing, inventorying, managing, warehousing, shipping, servicing, etc. a product or service each contribute elements of value. However, these elements do NOT correlate to a customer’s perception of the value of the product. You may incur costs to run your business, to buy materials, and sell the product, but to your customer, these costs have ZERO correlation to how they value your product. Understanding that costs DO NOT equal value is critical. However, knowing the cost contribution of each value element will help you understand their value-building power.

The total value you create as a business is the difference between the value of the products and services purchased by your customers (i.e., sales), less the total costs that you incur to deliver that value to those customers. In other words, Net Profit is a direct measure of the total value creation of a business. However, the Net Profit includes negative value elements. Driving these elements out of your business is the key to maximizing performance and value.

Other Value Measures

Other measures can help you understand the value contribution of individual elements of your business. These are:

• Product Gross Margins – Different companies measure this differently. This can refer to the difference between the sales price and the cost of materials of a product. Sometimes, direct costs, such as assembly labor, or the cost of service technicians are included. Tracking product margins helps you understand the relative contribution of value of specific products.
• Contribution Margins – This is also a term that is used differently across companies. The term generally refers to margins after all the direct variable costs to sell a product. In some companies, product gross margins and contribution margins would be the same. Contribution Margins can help you get a more complete picture of the value generated by a particular product or market segment.
• EBITDA Margins – The EBITDA, or Earnings Before Interest, Taxes, Depreciation & Amortization, is a great correlation to the value-creation engine of the business. It leaves out the effects of depreciation and amortization (which can confuse your understanding of performance). It also is the most widely used corollary to the valuation of the enterprise.
• EBIT Margins – The EBIT, or Earnings Before Interest & Taxes, is ultimately the closest direct measure of value creation for a business.

You should be more concerned with trends and trajectories, rather than specific numbers. If your margins as a percent of revenue are rising over time, you are headed in the right direction.

However, the numbers can be misleading. The more granular you get (i.e., when you look at product margins instead of EBITDA margins), or the shorter term you look, the numbers can be deceiving.

Conclusion

Your purpose is creating value, but only your customers can determine that value. Focusing on building value, as perceived by your customers, is the foundation of every great business. Shedding activities that have no value, or more significantly are of negative value to your customers, will drive the value-building power of your company and lead you towards high performance.

Copyright © 2021 Douglas C. Fergusson