A Blog by Jonathan Low


Feb 25, 2013

Creating Efficiency versus Creating Value

Leaders spend a lot of time managing the tension between efficiency and value. Short term versus long, make versus buy, shareholders versus stakeholders. All of those competing interests are representative of the choices on the decision-making continuum.

They can, of course, be mutually supportive but as contemporary management practice has evolved, they often lead in very different directions.The goal should be identifying and then optimizing the congruences that may lead to competitive advantage. The challenge is overcoming the often fierce ideological  and institutional commitment to one objective rather than both.

Efficiency is often applied to ruthlessly reducing costs and 'friction' so that market dominance and the financial benefits that are thought to flow from them can be achieved quickly. This is believed to produce a form of value, most often represented by the return to shareholders who are, at least theoretically, the 'owners' of the enterprise.

Some will take offense and recoil in horror at the notion that any other interests may equal or even supersede those of investors. But the reality is that the tyranny of the shareholder era is largely over. There remain some extant examples, like the attempt by hedge fund managers like David Einhorn's Greenlight Capital to force Apple to distribute some of its cash. This highlights the sometimes disparate goals of investors vs. managers, money vs strategy.

The depredations associated with the financial crisis and the understanding that the economy is a complex web of public and private assets and initiatives that have created a boiling stew of tax advantages, subsidies, legislative favors, legal maneuvers, human and intellectual capital assets et al makes claims of primacy difficult to sustain.

Value can be associated with both the short term - primarily as a vehicle for extraction of same - or the long term, which usually implies investment for the future health of the enterprise, sometimes to the short term disadvantage of one stakeholder or another.

The point, as the following article explains, is not to take sides or declare one objective better, or more noble or important than another, but to impose the realization that most institutions can not do both simultaneously. Some can only do one or the other for extended periods of time. But some can blend the two. The goal should be defining what objectives are salient, creating a strategy to achieve those objectives, then transparently communicating both the objectives and strategy to stakeholders so that optimal decisions can be made about allocating capital by all involved. Efficiency is one way of achieving value and can also be responsible for destroying it, but is ultimately a means to an end. Determining that end and then realizing it is what managers and their advisers are paid to do. JL

Greg Satell comments in Digital Tonto:

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

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 Satell said...

Thanks for posting this Jonathan.

I just want to clarify one minor point. While you are correct that I'm not saying that one is more notable than the other, I do believe that creating efficiency is becoming more automated, so managers should focus more on creating value.

This isn't true in each and every case, but I do believe it is generally true.

- Greg

Jon Low said...

Greg - Thanks for the comment and for the body of thoughtful and prescient writing you have produced so consistently.

I appreciate the clarification. I agree that efficiency is not an end in itself and value should be the priority in most cases - Jon

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