# A Deep Dive into Value Equations: Understanding Business Dynamics
Written on
Chapter 1: The Evolution of Business Strategy
In 2013, a former colleague of mine took the helm as CEO of a leading food distribution company in an emerging market. The business thrived, serving thousands of small food outlets nationwide. Fast forward to 2021, and I unexpectedly crossed paths with her at a networking event. She revealed that she had departed the company in 2018, a time when it was already facing challenges, eventually leading to its bankruptcy in 2019.
According to her, the decline was precipitated by the rise of large retail chains. In 2013, these chains were relatively small and even relied on her company for supplies. However, by 2018, they had grown significantly stronger and more aggressive.
They began to eliminate small stores from the market, depriving distributors of their core clientele. Subsequently, these retail giants established their own distribution networks and opted to work directly with manufacturers, cutting out the middlemen. This led to many distributors shuttering their operations, while others were forced into niche markets.
Despite her attempts to pivot the business and adapt the model, my colleague faced resistance from the board and ultimately decided to leave. "It was a remarkable company," she lamented, "but it became obsolete overnight."
The relentless nature of value equations in business is starkly illustrated by the following analogy:
When you purchase a paper cup of coffee, you may not realize that the coffee, cup, and plastic lid represent the culmination of three extensive value chains. The paper cup originated from a tree (though it's worth noting that paper cups aren't solely made of paper), the coffee began its journey in regions like Colombia or Ecuador, and the plastic lid was derived from oil.
These products embarked on a long journey to reach you, involving numerous companies that dealt with raw materials, created intermediary goods, and managed transportation.
As products flowed down these value chains—from suppliers to end customers—money moved in the opposite direction. Your payment for the coffee initiated a cash flow that traveled back through the value chain, with each link taking its share.
The Value Equations Explained
Every link in the value chain adds some degree of value to what it receives from its predecessor. The greater the value addition, the higher the markup. Conversely, if a link contributes little value, it risks being marginalized or forced to lower its prices, as was the case with that distributor.
The market demand for value is finite. For instance, customers require a specific number of coffee cups daily and do not need multiples of that amount. Thus, cafes need a set quantity of cups, coffee, and so forth. Increasing the value produced by one player necessitates diminishing it for another. However, solutions do exist, which will be explored further below.
Each link must generate value and retain a portion of it, often referred to as gross margin or profit. The more value captured, the more profitable the link becomes, but this can also render its offerings less appealing to subsequent links in the chain.
Let's break down these equations one by one.
Equation #1: The Consumer's Choice
I tend to be quite conservative with my clothing purchases. Despite my wife's objections, I consistently buy the same brand and model of jeans, opting to order them directly from the manufacturer's website. By doing this, I inadvertently deny several entities—distributors, logistics firms, and retail chains—their share of the revenue. Yet, as a consumer, I remain indifferent.
A few years ago, a car manufacturer decided to enable customers to order vehicles directly from its website. This shift transformed dealerships into mere order collection points, infuriating the dealers who could no longer upsell insurance, repairs, or accessories.
In a lengthy value chain, businesses must strive to maximize the value they deliver to protect their position and profit margins.
Equation #2: The Impact of Consumer Behavior
European consumers tend to be conservative as well; they are less likely to buy new products if their current ones are still functional. For example, they typically replace smartphones every 40 months, while Americans do so every 24 months.
By multiplying the number of smartphone users in a country by the rate of new purchases, you can calculate the annual demand for the market. In mature, saturated markets, this demand remains relatively stable, meaning that for one player to sell more, others must sell less—a classic zero-sum game.
However, some companies disrupt this equilibrium by expanding or altering the demand itself. The introduction of the first iPhone is a prime example. At the time, most people already owned phones, yet Apple managed to shift the market dynamics:
- Some switched from traditional cell phones to smartphones.
- Others acquired their first mobile devices.
- A significant number transitioned to Apple from competing brands.
- Many ceased purchasing cell phones altogether, leading to a dramatic decrease in demand for that segment.
Thus, Apple didn’t merely outperform rivals like Nokia or BlackBerry; it fundamentally changed the demand landscape.
The most innovative companies don’t just seek to outperform competitors; they aim to expand the market. Such innovations allow them to outpace rivals while simultaneously broadening their market share, effectively tilting the balance in their favor.
Equation #3: Value Perception in Consumer Decisions
Consumers make purchases based on the perceived value they receive compared to the cost incurred—not just in monetary terms. For instance, consider the decision between:
- Buying a completed house for $300,000.
- Purchasing land and materials and hiring a contractor to build a house, incurring $250,000, but with a year-long wait and potential contractor disputes.
Your choice ultimately hinges on which option you believe offers greater value for your investment.
Companies must create value for the subsequent links in the chain. The more value they generate, the higher the potential price they can command. However, they also need to ensure profitability to sustain and enhance their capacity to create value in the future.
For instance, Apple incurs a cost of $501 to produce an iPhone 14 Pro Max, selling it at a base price of $1,099, leading to a markup of 119%. The company maintains high pricing not merely for shareholder gain, but also to fund ongoing research and development.
Business leaders face a complex dilemma: capturing maximum value to satisfy shareholders while also ensuring their offerings remain attractive to consumers. The more value a business captures, the less appealing its products may appear, leading to potential price sensitivity among customers.
There’s no universal solution to this challenge, but leaders must consider whether they want to prioritize capturing more value at the risk of limiting their customer base or adopt an alternative approach.
Chapter 2: Case Studies in Value Dynamics
This video, titled "Solutions to Problems 7-13 (A Modern Approach Chapter 7) | Introductory Econometrics 30," delves into the practical applications of value equations and their implications in real-world scenarios.
The second video, "Solutions to Problems (Chapter 13 A Modern Approach) | Introductory Econometrics 55," further explores these concepts, providing valuable insights into strategic decision-making in business.