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Creating Customer Value is Not Enough

by Brian Viard

April 1, 2015

Taxi-vector

Creating customer value is not the only thing that goes into determining the price you can charge for your services.

A recent wave of taxi driver strikes across China signals a possible end to the ready supply of cheap labor in China. Tens of thousands of taxi drivers across multiple cities and provinces have struck. In addition to being a potential bellwether of rising labor costs, the strikes also highlight a key strategy concept: the idea of value capture and how it differs from value creation.

An immediate trigger of the strikes is the increasing use of smartphone apps (which I described previously) that allow passengers to avoid official taxis and take private cars. But this is a symptom not a cause. Taxi rates have increased very slowly in most Chinese cities and the drivers themselves receive a small portion of the revenues. A recent report in the China Daily about the Nanjing taxi strike provides some numbers: out of the total revenues generated by the average taxi ride, 25% goes to fuel while the taxi company receives 58% and the taxi driver only 17%. While the taxi company may pay for insurance and license fees, this still leaves them with a lot more than the driver who also has to pay for maintenance and repairs.

Why does the driver get so much less than the taxi company? This is where a strategy concept called value chain analysis is useful. Let me illustrate this with an example from my childhood. One summer when I was in high school a family friend hired me to plant a flower garden and paid me $20 for the afternoon’s work. She designed the garden and charged the household $200 not including the cost of the flowers. After an afternoon of toiling in the hot sun, I earned $20 while our family friend earned $180 and didn’t have to leave her air-conditioned house.

Why did she make so much more than me? The value chain for providing the flower garden required three main activities: identifying the need, designing and planting. Our family friend delivered the first two and I delivered the last. She earned much more because the activities she performed were scarcer. Any high school kid in reasonable shape could dig up the garden and plant the flowers according to her diagram. She, on the other hand, had the skills to design a beautiful garden and the relationships to know that the household wanted a flower garden. If I had attempted to negotiate higher pay, she would probably have refused because she could easily replace me with another high school student. There is no way I could have replaced her because I didn’t know the customer or how to design a flower garden.

My predicament illustrates the important difference between value creation and value capture. Any product or service creates value for those who buy it. The garden created value of at least $200 because that is what the customer paid.[1] Once value is created, the question is who captures it. In this case I captured 10% and our family friend 90%—in line with the relative scarcity of our inputs as value chain analysis would predict.

Let’s return to the taxi drivers and apply value chain analysis. A taxi ride creates value of at least as much as the passenger pays for it. To deliver a ride requires a car, fuel, maintenance, driving and coordinating between the driver and passenger. Value chain analysis predicts that the scarcer parts of this value chain will capture more value. Car manufacturers, fuel producers and repair shops probably capture little. These markets are all fairly competitive (or regulated at low prices in the case of fuel) in China so these inputs probably earn little margin on their contribution to a taxi ride.

This leaves the drivers and the taxi companies. Why do the taxi companies capture so much more value than drivers? Unfortunately for drivers, it is because the companies’ contribution is scarcer. Local governments usually authorize only a few taxi companies to issue drivers’ licenses in their cities.[2] For example, in Beijing a dozen large taxi companies control almost all of Beijing’s taxi licenses.[3] This gives them tremendous power in the value chain. Drivers, in contrast, are plentiful. While driving is by no means easy it is a widespread skill that many can provide. The fact that private cars coordinated by smartphone apps have proliferated so quickly is evidence that drivers’ skills are not that scarce.

Value chain analysis is a useful tool for firms to determine how much value they can extract and therefore how much profit they will make. Many internet companies create tremendous value but capture almost none of it. For example, I often use travel sites to identify flights or hotels that I want to book and then go to the airline or hotel site directly to book. When this happens the travel site has created great value for me but captured none of it. It could try to charge me for use of its site but the problem is that its service is not scarce enough—there are plenty of travel sites I can use.

It is important to apply value chain analysis to your own career. If your employer can easily replace you with someone else, then you are unlikely to earn a high salary. If, on the other hand, you offer skills that few others can then you should be well paid.

How should a company or an individual determine their contribution to the value chain? Perform the following thought experiment: remove yourself from the chain and see how much total value drops. This is the most you can expect to capture. The problem for a taxi driver is that the drop in value is imperceptible because there are plenty of other drivers to fill their seat. The same is true for the travel sites I use. In contrast, our family friend was in a great position because if she removed herself from the value chain virtually, the entire value evaporated.

What should you do if you perform this exercise and find that your added value is low? Find a way to make your skills scarcer. A taxi driver can learn the city roads better than other drivers or develop a better idea of where to find profitable rides. Travel sites can collect data on my preferences to present me with better travel options or more appealing advertising. This is not easy but the alternative is relegating yourself to a small chunk of the value chain.

 

Update: LeTV announced recently that it plans to design and manufacture an electric car in China. Since LeTV operates an online video platform, this raises questions as to what competitive advantage the company might bring to electric car manufacturing—an issue I discussed earlier with Wisco’s move into pig farming.


[1] The value created may be more than this. It equals the maximum that the customer was willing to pay. There is a separate value chain analysis that could be performed to determine how much of this total value our family friend captured and why. This will depend on how unique her skills and relationship are relative to others who might have replaced her.

[2] The taxi company has is an entitled rather than earned positional advantage.

[3] There are more than 200 taxi companies but only a dozen of them are large.

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