Value creation and pricing (updated)

It is commonly accepted that Internet has brought the possibilities for SME and micro societies to compete on new basis with larger competitors. The technology brought the possibility to open virtual stores either to communicate or sell to consumers worldwide. Like bigger firms, small retailers understood that going on line would automatically affect their volumes of sales, but in reality only few succeeded because they missed the real opportunities the media.

I will use the definition of value creation proposed by T.Jelassi and A.Enders in the book Strategy for e-business (2005; page 97-102) in a synthetic way before discussing the divers aspect of the concept.

In the book the authors state that the ability of a firm to create value is a required condition to reach and sustain its profitability. Nowadays, environment has become even more turbulent, it has become even more important to understand how value is created within a company, and how it is captured under the form of profits.

Jelassi (2005) proposes the following definition to value created: it is the difference between the value perceived by the customer and the cost to produce it.

Perceived value can take form as following:

- The product or service itself

- The speed of delivery

- The brand or reputation

- Convenience and easiness of use of a service

- Variety of choice, etc,..

The term of perceived value is used because the same feature may not lead to the same interest for every customers. For example, one hour photo processing may not represent the same value for a customer who lives near the store and another who lives 50 km, or if one hour relates speed to poor quality for him.

To be successful on the market place the value created must fulfil two requirements:

- Must be positive : costs must be lower than the benefit it provides. This does not refer to a accounting profitability approach but rather a safe line that should not be crossed, for example to avoid situations in which huge costs could generate poor customer’s benefits.

- Must be higher than the value created by competitors. A competitor could produce the same benefit decreasing its cost; or it might improve the benefit without increasing the cost.

Jelassi points many firms were bankrupted after Internet booming in the early 2000s as they were more focussed on the acquisition of new customers, and the growth of their revenues, choosing the way of lowering both costs and prices.

Internet and e-business strategies made cost reductions easier, and many firms chose this approach to implement their online deployment; this often lead to consider low pricing as the principal value proposed to customers. This trend is characterised as “the myth of lower cost and price” by Kim et al (2004), as they are no limitations to how much costs and prices can be reduced. This does not suggest no effort should be done in lowering costs, but more efforts should be allocated to create other forms of values to differentiate, as the role of value is to be turned into benefits for the company. SMEs cannot afford to be cost leaders betting on volumes and economies of scale; and they do not have the resources to resist successive price decreases or price wars. Therefore, to create value that is superior to competitors, SMEs should emphasis on extracting differentiated value at a the lowest possible cost, in a way that allows flexibility of proposals. Doing so, SMEs can either minimize the effects of price decrease by offering more, or focus on other proposals that maintain a satisfactory level of margin.

According to Jelassi (2005), the process of value creation itself does not tell anything about how it is distributed between the producer and the consumer of a service; it is the selling price that determines how the value created is divided, splitting in too entities :

- The producer surplus: the difference between the cost of producing/buying and the selling price of the service.

- The consumer surplus: the difference between the consumer willingness to pay and the price he actually paid.

Consumers generally look for products/services that offer the greatest surplus, but the price that they are actually willing to pay can be difficult to estimate.

From my own experience, pricing have always been a source of discussions between shop owners and/or salesmen; should the same price be applied on and off line? What should be the answer to a client asking for a discount, relating to a very low price seen on line? Answers always come under the form of objectives of margins based on accounting principles. J.Hogan (Journal of Business Strategy , 2006) identified that as an old twentieth century way to price, and as the first trap to avoid in an environment of global economy and expanding Internet market places. Pricing should be done in accordance with the value of the product/service, not the benefits it is expected to generate. The article, based on a study of 1000 companies, shows many examples of firms that increased their margins following that rule; actual examples show that products or services can be sometimes priced five times the price set by “accounters”.

Nevertheless, two factors influence the distribution of created value between consumer and producer:

- The structure or context of the industry: If competition is intense, as it has been the case for the past years in the photo industry, the balance should weight on the side of customers. As the actors are looking for market shares they either propose low prices or highly valuable bundles of products/services to protect their price.

- The relative level of value generated by the company: When a company manages to generate more value than its competitors, it owns the potential to generate more profits (Jelassi 2005).

Jelassi (2005) proposes one way to improve creativity in the process of value creation. Firms should be looking outside their traditional framework to find sources of value creation, meaning outside the standard business practices of the industry or “outside of the box”. I will use the value curve provide in Jelassi’s book to compare online and in store print ordering in terms of consumers benefits.

Exhibit 4: The value curve applied to photo processing on line orders vs In store

Online photo services has changed the standard of value creation in the industry, bringing convenience, customers can make their choice using their usual interface and the time they need. Equipment in large bandwidth enables a fast transportation of the pictures through the network, while maintaining a satisfactory level of quality: quality depends on the size/weight of the files.

I assume here that print ordered on line were delivered home and executed by a virtual actor. The comparison is done with a store that processes prints internally within an hour. The difference in convenience relies on the fact that the client has to come twice to the shop, to leave and pick up the work. The difference that occurs in the selection range may come from the fact that in the photo industry unlike in others, variety of options remains wider in store (it could be size of print, number of copies, quality type of paper et etc etc). The level of customisation is difficult to reproduce for pure virtual players, as it requires a lot of investments for small returns in terms of volumes. The difference in pricing can be justified by taking in account all the value that is added the right side of the figure (speed of delivery, personalised advice).

Exhibit 5: The value curve applied to photo processing home delivery vs In store delivery

I assume here that the same store can provide on line services within one hour and deliver the picture both in store and home. Price in store has changed, even there is still a difference, because I have assumed that the store provides a service of prepaid pictures as it became common these days: payment are done in store downstream, and price is based on the quantity of prints bought. Therefore price per units decreases; this way of consuming pictures was inspired of the photocopy industry. Convenience has raised because the client can chose the interface, store or web site, and only has to come once to pick up the work in store, or can chose to be delivered home. Some clients prefer not to find their enlargement bent in their mailbox, while others may not enjoy queuing at the post office to get their pictures; queues are usually shorter in retail shops.

Regardless of the choice of the generic strategy the main purpose of understanding how value is created within a firm is to identify a strategic advantage that should be capitalized. The essence of a strategic advantage, in a synthesised definition, resides in its uniqueness that makes it hard to imitate. This could take form of processes to lower costs or to produce differentiators. For example the strategic advantage of photo retail shops against pure virtual laboratories could be identified as their physical presence that enables delivery in store. A virtual player could be trying to copy the system but it would require the building of an entire network of shops; this would be much more difficult than the opposite, many shops building a website to sell on line. Jelassi (page114-115) initially suggests there are two opposed views of extracting a strategic advantage trough value creation, the market based view (Porter,1986) and the resource based view or core competency (Barney, 1991); the author finally proposes that both theories are consistent and complimentary. A firm should survey both the structure of the competition within the industry and focus on its inside core capacities to develop and sustain its strategic advantage. I suggest this approach is particularly relevant in a digital environment that has become customer centric; the customer has become part of the value creation process and the core competency of retailers may become to develop and share this knowledge.

As mentioned previously, the consumer perceived value is a variable that relates to the consumer, it localisation and other factors. These factors cannot be omitted in the value creation process; furthermore, they became easy to identify using ICT technologies. Retailers are in direct contact with their customers. Knowledge of the clients used to be their strategic advantage and core competency allowing them to provide very personalised services. This knowledge was built on informal and implicit information base on the conversations with the clients. Shops passed one stage by integrating the use of computers to record their sales, leading to little more formal knowledge. On the other side, Internet has enabled a very deep knowledge by recording all transactions and traffic. Large companies which succeeded in implementing efficient ICT system have reached level of mass-customisation of exchanges (Tapscott), narrowing the distance with their final customers and competing in the field of the retailers.

R.Amit and C.Zott propose a model (exhibit) that highlights the four sources of value creation. This tool can help identifying in which areas retailers could be adding value.

Efficiency is generally related to areas where costs reductions can be achieved through economy of scales, speed of transactions and symmetry of information. The authors state that the more information flows in two ways between buyers and sellers, the more reactive are the actors of the chain.

Complementarities concern the additional products or services that can be bundled within a purchase. Different level of complementarities can be developed; for example the most obvious would be to propose bundles of photo print with frame , but it can also reside in the synergy of on line and offline print ordering.

Lock in refers to customers’ retention. The more customers are loyal and repeat transactions, the more they will contribute to value creation by giving chance to customize the service. This aspect is also related to network effect, as the more clients use the service the more chance the firm has to develop value and attract new users. Value perceived may come from the convenience, easiness of use of the service, the network effect itself, and the reliability of third parties such as payment services.

Novelty is related to the innovation’ contribution to the value creation. This could be technological innovations or new products, yet the best opportunities are to be found in the transactions processes. For example, it may be valuable to transfer the pictures stored in a came phone directly to a website, the transactions being billed monthly on the telephone invoice.