This is the twelfth in a series of essays that addresses management topics. The first ten explored “hot button” issues; the next ten satirize management “buzzwords.” I base these essays on countless provocative lectures and irreverent discussions as a nutty professor of Business Administration.
In a previous essay, I examined the buzzwords “system” and “synergy.” They’re not really buzzwords, they have important meanings when used properly. I just hate the way they have become abstract, vacuous substitutes for economic concepts that managers, especially new managers learning the ropes, need to know. I continue this examination by looking at the terms “value,” “value-added,” and “value-chain.” I address them here because all five terms are related. In fact, one set is the more basic form of the other.
Let’s start with the word value. Most people seem to have a better understanding of this term than the managers I’m concerned about. So I’ll keep the context confined to business, and the production of goods and services that people buy.
Think like a consumer. Think about something that is physically close to you at the moment; your computer, your eyeglasses, your fuzzy-wuzzy widdle puppy, anything at all that you bought. If I asked you “what is its value,” what would your answer be? Remember, I didn’t ask you what you paid for it, I asked you to estimate its value. Right off the bat you can see that I’m suggesting there’s a difference between price and value, especially when it comes to little Sparky there.
Let’s start over.
Theory suggests that we can view any production process as a system. As we discussed previously, a system is a collection of parts/subsystems that collectively and interdependently consume resources, and transform them into outputs. Let’s look at business in general. Let’s specify “resources” as labor, capital, equipment, time, and information. The five types of resources can all be measured in one way – by what they cost. Note that word. There are labor costs, equipment costs, information costs, and “time is money.” Make no mistake about it, money costs money. How much of your money goes to just paying interest charges on borrowed money?
Also, no system is perfectly efficient. It is impossible for any system to transform all consumed resources into valued outputs. Every system produces waste: scrap or defective goods, wasted time, excessive turnover, deteriorated equipment, etc. Here, then, “outputs” refers to valued goods and services. The business system, then, is everything needed to transform five resources into valued outputs.
I’m not trying to be sarcastic, but if you’re confused you are probably thinking too hard. Next comes the tricky part. Enter the term “value-added.” For a business to survive, it means that the overall economic value of the output of its production system (or “value-chain,”) should exceed the overall economic value of the resources consumed. The difference, quite simply, is “value-added.” (I am saving a discussion of the term “Economic Value-Added” for another essay, because it differs in important ways.)
But how can that be? If no system is perfectly efficient, but is always less than 100% efficient, how is it possible for the value of the output to be greater than the value of the input? Doesn’t that mean greater than 100% efficiency?
No. All you have to do is understand the difference between cost, price, and value. Remember a moment ago I asked you to place a value on something you bought? If you have a marketing or “demand-side” mentality, you feel that the value of something is determined by what people are willing to pay for it — period. It has nothing to do with production costs or efficiencies. True, if a company can not, on average and over the long term, charge prices that exceed its overall costs of production, it will go out of business. Conversely, if the firm can contain costs and charge “what the market will bear,” then very nice profits are possible. The firm has added great value simply by exploiting the difference between production costs and market valuation. Anything that increases this margin, is “value-adding.” Anything that decreases this margin, is “value-destroying.” Managers obsess on locating and improving these marginalities.
Now let’s get back to Sparky the wonder-puppy. If you were the owner of the kennel where you bought Sparky, what production/resource costs would you be glad to incur, just because they allowed you to charge a price that more than covers their costs? If the pup is a pure-bred, then advertising may be value-adding if pure-bred Sparkies are hard to find. Conversely, what costs do nothing to allow you to increase prices and in fact, would allow you to lower prices if the costs were eliminated? Do Sparky pups fed only expensive bottled water imported from France fetch a higher price? What costs simply represent a wasteful inefficiency, such as dog food that the rats got into? Then again, what wastes are only natural, to be expected by the laws of systems theory? Not every morsel of dog food ends up being metabolized (transformed) into dog — see the difference between a natural inefficiency and one that managers can control?.
I hope that is a suitable primer of a few terms that have earned a permanent place in the economic lexicon of business. I’ll throw in one more term as lagniappe (that’s Cajun for freebie.) The term is Supply Chain. A Supply Chain is a Value-Added Chain. The only difference is where the boundaries of the system are perceived to be. The way the term is typically used, a supply chain considers production activities that exist outside the boundaries of your own organization, acting either as suppliers to it or immediate downstream customers of it. It is an important term because many organizations construct their entire business strategies around a supply chain strategy. In business terms, you should no longer view your organization as “the” system. Your organization is a sub-system in a larger competitive entity called a supply chain. In many industries now, supply chains compete, not individual firms that exist as subsystems within them. Now that makes value-chain analysis really interesting!
Finally, I would like to acknowledge my wonderdog Chloe, who boldly slept beside me as I searched for a simple way to explain all this. The first draft was a wreck.
