Don't Just Create Value; Capture It

Don't Just Create Value; Capture It:

from HBR.org 
In my recent HBR article, The New Dynamics of Competition, I present a new analytical tool called Value Network Maps, which I explain below.

These Maps are an outgrowth of exciting new work by strategy scholars developing a mathematical model of firm strategy that I refer to as the Value Capture Model (VCM). The VCM calls our attention to three important truths of competitive strategy that other theories obscure. Business strategists ignore these truths at their peril. Value network maps are designed to ensure that your strategic thinking is complete.
The first truth is that, while value creation and value capture are crucial aspects of any strategic analysis, they are different and, as such, must be treated in distinct ways. As the exhibit below reveals, a Map analysis begins by looking at value creation. The center of the Map depicts the firm and the other agents (generally, a supply chain and its customers) who, jointly, contribute to a "pie" of economic value. These agents are called the "value network." This first step in a Map analysis requires managers to think deeply about how with whom they create value for the ultimate end-user. How much of this pie each agent actually captures is answered in the next two stages of the analysis, each corresponding to one of the remaining truths highlighted by the VCM.
The second truth is that competition is symmetric in its operation. This is something of a new idea in strategy. Since the mid-1800s all the way through Michael Porter, people have been encouraged to think of "competition" as a persistent driver of profit erosion - that is, as a threat. But the mathematics of the VCM vividly illustrate that competition works both on the firm and on those with whom the firm must transact in exactly the same way.
The Map captures the workings of competition in two locations. First, it surrounds the firm and its value network with a field labeled the "competitive periphery." The periphery is populated with those agents who generate competition either for the firm or for others in the firm's value network. Agents in a network are guaranteed a share of value commensurate with the intensity of competition for them. An agent's competition-guaranteed share is depicted in the Map as dark shaded slice of the value pie. This balanced view of competition both simplifies analysis (there are not five forces of competition, only one) and makes it comprehensive (by ensuring that the role of competitors for the firm is not ignored).
One of the interesting implications of this view of competition is that market share is not always the unalloyed "good" that many managers assume it to be. Why? Because, when a firm increases its market share it turns potential customers into actual customers. On the one hand, the firm's value network is expanded and more value is created. On the other, in joining the network, these customers leave the periphery, thereby reducing competition for the firm. Thus, while there may be more overall value up for grabs, the firm is guaranteed less of it by competition.
The third truth is that there are two essential ways a firm captures value — either through force of competition or through force of persuasion. This may be the most radical and far-reaching insight for competitive strategy yet to come out of the VCM. Once again, received wisdom in strategy suggests that value capture is entirely determined by competition. After all, prices are determined at the point where "the supply curve intersects the demand curve," right?
Fortunately, perhaps, the real world isn't quite so deterministic. Competition from the periphery for any agent (the firm, its suppliers, or its customers) does determine a minimum share that it must get of the value pie produced by its network, as illustrated by the Map. But competition rarely results in a complete allocation of value — that is, the shares guaranteed by competition do not typically add up to 100%. When they do not, a second avenue for value capture is opened up for the firm.
Imagine negotiating with one of your buyers. If there is a minimum price below which you can credibly walk away from the deal — because there are other deals you prefer to take below that price — then, that minimum is the amount guaranteed by competition. In symmetric fashion, your buyer may have a maximum he or she is willing to pay. Economists refer to these values as "reservation prices" (the VCM helps us understand how, exactly, those reservation prices are determined). Typically, your minimum does not equal your buyer's maximum, in which case the final price will be somewhere in-between.
In the VCM, we refer to all ways a firm captures value from its deals other than competition as persuasion and the portions of value created that are up for grabs through persuasion are shown in the map as the light shaded slices of the pie. In some industries, such as military contracting, this second source of value capture may be dominant.
Firms can be helped in their ability to persuade by a wide variety of factors. They may have superior bargaining skill (e.g., due to an extremely well-trained sales force). Industry norms (such as the structure of a bidding process) can also affect the relative ability of forms and the other agents in the network to negotiate a larger slice of the pie.
Relatedly, firms may forward integrate to a point in the supply chain at which they have "persuasive" advantages. For example, producers of products for mass retail markets can forward integrate into retail distribution. By doing so, they bypass negotiations with big distributors and, instead, deal with individual consumers. Big distributors typically have greater incentive to haggle over their share of the pie than do individual consumers. The latter can still walk away from prices that are not consistent with their alternatives (arising from competition for them), but within that range the firm can make take-it-or-leave-it offers such that the benefit of bargaining to the customer is below the cost of doing so.
To sum up, the Value Network Map shows how much value is up for grabs, the extended network of agents who interact with the firm to create that value, a periphery of agents who compete for those in the firm's value network and, finally, the shares of value guaranteed to the firm and its network partners by the competition from the periphery. The strategic significance of competitive versus persuasive factors is highlighted by comparing the shares guaranteed by competition to the total amount generated by the value network.

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