Since I wrote The Lean Ratio the other day the comments and opinions have come in fast and furiously. The concept of what is value adding is an important one – at the heart of lean if you believe that lean is all about the elimination of waste and that waste can be defined as everything that does not add value in the eyes of the customers.
In particular, the question of the costs of selling and advertising are a point of contention. Advertising most certainly has value – but it is valuable to the company – not the customer. Same with the cost of selling. As a customer, I could care less how many more you sell and to who. The cost of all that is your problem. You, as the manufacturer, are worried about selling a lot of things and racking up big sales numbers. As the customer, I only care about the one I bought. The point is that because something has value for the company, that does not mean it has value for the customers.
Same thing holds for logistics. The company may need to spend money on it, but as a customer, it holds no value for me. I really don't care if you shipped it 9,000 miles or 900 feet. How far it came does not influence my assessment of the value of the product. Just because an expense is necessary for the company, it does not hold that the expense is value adding in the eyes of the customer.
You may need to spend money on regulatory compliance, but that does not make it value adding in the eyes of the customer. There are lots of things that may be necessary (at least necessary within the business model in which you operate), but necessary and value adding are not the same thing.
The difference is that your necessary – either for business model or for compliance with the law – expenses do not translate into higher prices because they do not make the deal any more attractive for a customer. While some of the commenters pointed out that many costs are necessary, and the business would be in trouble if it did not incur them, the real test is on the flip side. Will spending more on those areas logically result in the ability to command higher prices – sustained higher prices – not just a short term deal?
Will moving the plant further from the customers and increasing logistics costs enable you to raise prices to the customers? If the answer is no then the cost is not value adding because it did not result in a better value proposition for the customer.
Same with advertising. Sure, a slick advertising campaign can drive sales and prices once – but the second time the customer is going to buy or not based on the perception of value resulting from the first purchase. In the long term, all the advertising in the world will not allow a company to command higher prices than the product is worth. This is a harsh reality P&G is now facing. And it is the harsh reality GM has steadfastly refused to face as they were consistently outsold by Toyota, even though they outspent Toyota on advertising by almost 4:1. Wahl Clipper trashed the big guys in the consumer clipper market despite being out-advertised by as much as 8:1. Advertising does not create value – just the temporary illusion of it, at best.
There actually is a companion ratio to the one I described earlier. It is the relationship of value adding expenses to price – usually calculated by (Gross sales/Total Value Adding Expenses = VP).
When you track both of these:
Value Adding Expenses/Total Expenses = VC (or Value to Cost)
and
Gross Sales/Total Value Adding Expenses = VP (or Value to Price)
You get the whole picture. The lean strategy should be driven by optimizing these two ratios simultaneously. If you choose to convince yourself that advertising is a value adding expense – or like the guy I cited in the previous post, decide to call all payrolls value adding to avoid offending anyone, you will see soon enough that, while you are making the Value to Total Cost ratio look good you are degrading the Value to Price ratio every time you spend more in those areas. The two ratios provide a check on each other, which is why they should be tracked simultaeously.
The bottom line is that it is very important that the discussion be held within every company and that 'value adding' be well defined. Value adding expenses should be reduced very, very carefully because it is too easy to degrade customer value in the process – that is the trap too many companies that run to China fall into. Non-Value Adding expenses, should be cut with near reckless abandon. For that matter, in many companies, they should not be reducing overall expenses at all. Instead they should be shifting expenses from non-value adding activities to ones that genuinely enhance the value of the product and will enable them to command higher prices. That is the real lesson from Toyota's history. Their cars are not cheaper than their competitors – they are a better value. A greater percentage of the money paid goes into the car, while their same-cost competitors are squandering it on administrative nonsense, overblown advertising, global logistics and other waste.
Daran says
I agree on marketing and sales; they may add value for the company, but unlikely for the customer.
However, many consumers do not agree. For luxury goods/electronics, the value is partly in the utility of the item, but also in the public perception of the brand name.
For logistics, I do not care where my supplier sources his components, but I do care about prompt delivery (and no damaged boxes, and delivery to my office on the 6th floor rather than on ground level)
I rarely care about customer service (another cost center), unless something goes wrong with my order or I need the warranty, in which case I want it to be solved promptly (logistics again!) and in a friendly manner.
Bill Waddell says
There are certainly many fads and people buy quite a bit based on the brand image, but I used the words ‘sustained’ and ‘long term’ very deliberately. Young people seem to be particularly susceptible to this with clothes and electronics. Ultimately, however, the fad wears off and the reality of value replaces the perception, and a business that drives its sales based on advertising and brand image, rather than soild product value will have short term success, at best.
Jason Morin says
“Same thing holds for logistics. The company may need to spend money on it, but as a customer, it holds no value for me. I really don’t care if you shipped it 9,000 miles or 900 feet. How far it came does not influence my assessment of the value of the product.”
Ah, but how quickly a customer receives the product DOES often influence their overall assessment of value. Some customers may even pay a higher price for a product, even one of slightly lower quality, if they know they can receive it faster.
No one disputes the fact that costs for logistics and marketing are necessary evils. All companies experience those costs in one form or another. But some companies have learned to convert those evils into a competitive advantage.
Louis English says
My friend, Jim VanPatten, has a little mantra he uses to sort out VA from NVA. You role play the end customer and in response to what is being suggested as VA say… “Yes, sounds good, give me some more of that (insert questionable VA) for my money.” If what you hear sounds absurd then it is NVA
Ron Pereira says
Great series of posts, Bill. They’ve really made me think.
I am still struggling with some of your points… especially on the value of effective advertising and brand awareness… but I’d like to reflect a bit before firing off with counter-arguments.
In any event, it’s been a pleasure reading your work this year. Keep up the good fight.
Merry Christmas!
Danie Vermeulen says
Again on the money, Bill. It always comes back to real value! Those customers who work out where they get the best real bang (value) for their buck will keep on coming back … and they’ll probably tell their friends.
Those companies who strive to supply more value at the same (or even less) cost will define the rules of the game and should be the winners in the long run … unless governments change the rules of course).
Merry Christmas!
Danie Vermeulen
CEO: Kaizen Institute New Zealand
Michael Horn says
Value is often created by perception and can be sustained by aggressive marketing and advertising. Two companies that come to mind who produce okay, but way overpriced merchandise, are Bose and Oreck. These companies pour inordinate amounts of advertising into the market and are perceived to be market leaders based on their promotional efforts. The consumer has continued to support these products because of perceived value and service, even though these products perform no better than other products sometimes half their price. Do not underestimate the power of perception, it is a value added process. It takes a tremendous effort to establish a reputation and once established is sustainable with more promotion investment. The excess margins of overpriced goods contribute to other consumer valued attributes by these companies, including long term replacement of failures, free next day shipping, free accessories, etc. The conclusion is that VC and VP are focused parameters that can help determine the overall value of a product(brand), however, how specific elements are included or not included in those equations becomes the issue.
Bruce Baker says
Bill,
Is your point that consumers are so rational and have such perfect knowledge that they are immune to having their perceptions of value or “worth” influenced by advertising?
Bill Waddell says
Bruce,
Of course consumers are not so rational and endowed with perfect knowledge – but the free market is very, very rational and it continually evolves toward perfect knowledge. If you want to sell something worth $1 and charge consumers $3 by propping it up artificially with clever advertising, then I will make a product worth the same $1 and take over your market by selling it for $2.
It is a failure to understand this that is currently killing the big brands. The estimates are that by the year 2012, over 50% of consumer purchases will be private labeled goods. That is because the name brands still believe they can create value with advertising. Walmart and Kroger are proving my point by undercutting the big brands with goods the consumers see as having equal value, but at a much lower price. The big brand guys all lost sight of the fact that, at the end of the day consumers want the maximum quality, utility and reliability relative to the price they have to pay – and advertising does not add to quality, utility or reliability.
How many more old guard American brands have to die after eroding the value of their products with Chinese manufacturing because they think that image is more important than substance?
Tom says
If you put items such as ‘advertising’ in your product catalogue, how many customers would come to you to buy those items? None I suspect. The customer does not ask for ‘One widget and $100 worth of advertising please’