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Creating Efficiency vs. Creating Value

2010 July 25

Do you want to get better at what you do best or do something else entirely?

That’s an important question and one that is not asked nearly enough. All too often the line between creating efficiency and creating value is blurred so much that we hardly even care to make the distinction.

There is, however, a difference and it’s an important one that requires some serious thinking about how you approach your business, especially as more of what we do becomes digitized.

Why Firms Exist

As I wrote in an earlier post about leveraging digital technology, if you want to think seriously about how businesses function there is no better place to start than Ronald Coase and his 1937 paper, The Nature of the Firm.

The major thrust of Coase’s view is that firms exist to minimize transaction costs. Anybody who has run a technology company in an up market knows exactly what he’s talking about.  It’s often much better to pay people a salary, even if they are idle some of the time, than to try to find freelancers whenever you need something done.

Moreover, firms have informational cost advantages. Having people on staff lets you create systems and methods that make things go faster and minimize errors. While some of this is formal, much of it is informal. Employees pass on information to each other, either explicitly or implicitly, during normal daily interactions.

Coase also mentions organizational costs as an offsetting factor. It takes time and energy to keep track of all those people running around doing different things. He posits that a successful firm must find a happy medium between minimizing transaction costs and not becoming so big that organizational costs become prohibitive.

Creating Value

The problem with Coase’s framework is that it speaks more to efficiency than to creation.

It explains why firms can be much more economical than a collection of individuals transacting with each other, but doesn’t tell us much about how some businesses like Apple and Google come up with really new and wonderful things while others, like Wal-Mart and Toyota, seem to be able to endlessly improve at doing the same thing.

Obviously, every successful company has to do some of both. Yet, it seems clear that a choice must be made to focus on one or the other. Moreover, as technological innovation seems to be more efficient than management innovation for driving down costs at the present moment, I would suggest that managers these days need to focus on creating value.

The Efficiency Trap

The problem with efficiency, it is that it is a slave to it’s own metrics. As I argued in an earlier post about crappy innovation, we don’t always want continual improvements along the same lines but will often  choose a product that is either cheaper or outperforms in another area. Clayton Christensen calls this Disruptive Innovation.

We once worried about how many calculations the chips in our personal computers could do per second, while now we value connectivity. We used to count megapixels in our digital cameras, but now we want them to be thin or to have a great lens or whatever.

This is never a smooth transition, but rather an inflection point. At some juncture people think that their pictures look good enough and stop wanting more megapixels, but care about other things like convenience, style, etc. At that point, new value needs to be created.

Christensen’s key insight is that companies that persist in creating efficiencies in areas that are no longer valued risk disaster. Either their products will become low margin commodities or their industry could disappear altogether.

Paradigm Shifts

Another way of looking at creating value is through the framework of paradigm shifts, a term coined by Thomas Kuhn in his classic, The Structure of Scientific Revolutions. In it, he describes 3 phases:

Pre-Paradigm Phase: When something new comes along, nobody is quite sure what to make of it. There are a lot of ideas and opinions, but no clear consensus. It could be argued that many aspects of digital technology, digital media especially, are pre-paradigm.

Normal Phase: At some point,, problems start getting solved and things start happening. A real consensus builds on the “right way of doing things.” It’s not perfect, of course, there are some anomalies that don’t quite fit, but generally everybody is happy.

Revolutionary Science: Eventually, the anomalies add up and they become real problems for the dominant paradigm. A new generation of thinkers comes along with novel approaches to old problems that make significant progress in areas long thought to be dead ends.

It seems clear that creating efficiencies is very effective when applied to existing paradigms, but not particularly good at creating new ones.

Networking Domains

In an earlier post, I pointed out that most great discoveries happen not from specialized expertise, but from synthesizing concepts from different domains. In his book Smart World, author Richard Ogle refers to this as “networking idea spaces.” Others refer to the process as Open Innovation.

Whatever you call it, it does appear that something important has changed. Ogle gives the example in his book of Xerox’s PARC research center, which developed important technologies like the graphical user interface (GUI) and the Ethernet, but failed to capitalize on them because it was poorly connected to the emerging personal computer movement.

Digital technology promises to make the shift toward value creation even more rapid and powerful. Through the web, the semantic web and other developments, creating value is becoming less about uncovering new information and more about matching problems with solutions.

Therefore maximizing connectivity between your organization and the rest the world is increasingly becoming key to superior performance. This is not only a technological issue, but touches how you recruit, train, partner and compete.

Old Tycoons – New Tycoons

Indeed, much has changed since the Industrial Revolution. The early tycoons such as Vanderbilt, Carnegie, Rockefeller and Ford made their mark by increasing efficiency through the introduction enormous economies of scale to cottage industries.

The new tycoons, such as Steve Jobs, the Google guys and Michael Bloomberg made their fortunes by doing something truly different. Even those with monopoly power or something like it, such as Bill Gates and the Walton clan, need to innovate (although much of Wal-mart’s innovation is admittedly in the supply chain and is focused on efficiency).

That’s why consolidation is no longer a grab for power, but a sign of a weakened industry that is unable to create value. Moreover, in some cases such as in the media business, acquisitions destroy value rather than create it. Most probably this is because, as Coase predicted, organizational size and informational flow are often in conflict.

As the future unfolds, it is not enough to do your job and do it well or even do it on a massive scale.  What’s imperative is to identify the job that people really want done.

– Greg

8 Responses leave one →
  1. July 26, 2010

    Another outstanding post Greg!

    I’ve been thinking about Coase recently because I think that one of the critical strategic issues for organisations to consider these days concerns the boundaries of the firm. We have technology now that makes these much more permeable than they’ve been in the past. Consequently, it puts some choices back on the table that we’ve been taking for granted for 40 years or so…
    Tim Kastelle´s last blog post ..Managing Different Creative Styles

    [Reply]

    Greg Reply:

    Tim,

    Yeah, between his ideas about the nature of the firm and his ideas about energy markets, I think we’ll be talking about Coase for a long time:-)

    – Greg

    [Reply]

  2. July 26, 2010

    Greg – another outstanding post. Thanks!
    I guess I’m going to have read some Coase… As you have probably guessed by now, I’m something of a Process bigot and your remarks on efficiency fall into that category in terms of Continuous Process Improvements. It’s mantra is: Think, Plan, Do, Measure and Repeat. And while the accent or focus during the “Thinking” stage is aimed primarily at improving efficiency, the really good practitioners also use the thinking time to reflect on a new or more innovative way of doing things, too.
    As you say, however, firms must both improve efficiency and innovate. Strangely enough, as an observation I would believe that many North America companies are focused on the innovate or die, while lacking a Process view of their operations. Is this true of Europe, too?
    Eric Goldman´s last blog post ..B2B Sales Lead Generation using SMM

    [Reply]

    Greg Reply:

    Eric,

    It’s a very good question. I would probably agree, but it’s tough to tell (it varies so much by country and by industry).

    I would say that it is usually the mark of a poor company when efficiency efforts are very visible (then it’s not really efficiency, but cutting corners).

    – Greg

    [Reply]

  3. August 23, 2010

    Greg,

    a fantastic post. When we look at US and Europe from our part of the world,the terms efficiency and value have very different connotation. Our companies have pegged on efficiency with high focus on PDCA cycle, with a major difference on value. Most innovation , coming from the west has a value , addressing decision and choice sensitivities of those geographies with a scalabality of low to high approach. In Asia, the companies have been forced to innovate to match the value scale (affordability) and choice sensitivities of the local populace. While IPOD may be popular in West, a low cost MP3 has a mass market here. Nokia learned to respond to these conditions and introduce products that served the local needs, but got locked up in the western philosophy of scalability. India and China have many examples where value scale are driving frugal engineering and disruptive innovation in a high efficieny environment.Most examples in India , combine both aspects of high efficiency and high value addressing mass appeal. Therefore feature rich mobile phones, supporting a wide range of applications are available at less than one third the prices of standard American and European companies.This is an example of bundled value approach , very different from the scalability of the west.Likewise a $2000 car and sub $100 refrigerator.Examples abound in services as well. Bharti Airtel , India’s leading mobile telephone company , has a stated position of “minutes factory”. The entire operations of the business revolves around 1 minute of telephone use.The Chinese and Indian markets have a blended model of efficiency and value , creating a bottom of the pyramid approach.Neither Apple nor Toyota is successful here, but Maruti Suzuki.

    [Reply]

    Greg Reply:

    Siddhartha,

    Thanks for an excellent analysis from an emerging markets perspective. Extremely interesting!

    – Greg

    [Reply]

  4. Gennady permalink
    December 20, 2013

    Greg,

    Perhaps I missed it, but how do you define value? If it’s not some ephemeral concept, but rather discounted future cash flows, then Coase is right on the money: reducing transaction costs creates value … Everything else being equal, if costs of managing, etc. are higher than reduction in transaction costs then “outsourcing” is preferable. A classical own vs rent problem … If bringing “contractors” in reduces transaction costs enough, than value IS created …

    Hence your example of Walmart is right on the money: efficiencies create value.

    As to innovation, there is a reason why large corporations apprehensive of Disruptive Innovation. Christensen explained this in his The Innovators Dilemma. And even if he did not, classical risk vs return explains it perfectly.

    Disruptive innovation is extremely risky way more than the risk that investors in established companies are willing to take. Hence, disruptive innovation is predominantly prerogative of start ups investors of which exhibit appetite for risk significantly higher than investors in established companies. Investors in start ups demand returns according to the risks they take 30%, 40%, 50% …

    So value can be created or destroyed in both established companies and start ups. These entities choose projects with risks corresponding to risk appetites of their investors. Hence, start ups focus on disruptive innovations and established companies on reducing transaction costs and other less risky projects.

    [Reply]

    Greg Reply:

    Gennady,

    You make some good points and as you acknowledge, I pointed out that creating efficiency does create some value, but mainly it reduces costs. However, as I also noted above, at this point technological improvements are more effective at creating efficiencies than management improvements, managers are probably better off focusing on creating new value, rather than simply focusing on doing the same thing at lower cost.

    I do think you should investigate the disruptive innovation issue further. Large firms certainly are pursuing disruptive innovations and are getting particularly successful at it. Christensen himself published an article about this a year or two ago and most large companies do have some kind of disruptive or open innovation program these days. Many also have internal VC’s and accelerators as well.

    Further, there is no reason to believe that disruptive innovation is inherently more risky than other types of innovation (e.g. incremental innovation, traditional R&D, etc.). Certainly, when Microsoft invests $9 billion per year on R&D it is taking a significant risk. A disruptive innovation simply pursues a different value proposition with a new business model. Sticking with an old business model can certainly be just as risky (e.g. Kodak, Blockbuster).

    In fact (and I’ll have a post out about this in a few weeks), cloud based technologies are presently disrupting business models across industries. Would it be more risky for incumbent firms to continue to pursue incremental improvements in installed solutions or to rethink their business model? Most of the companies I talk to are choosing the latter.

    – Greg

    [Reply]

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