Value Adding:

Easy to say.  Not so easy to translate into practice.  The difficulty—confusion between cost, monetary outlay, and value.

In the finance world, cost is synonymous with monetary outlay—the amount of money you need to buy something.  Your value must exceed this market-based value or you wouldn’t do it.  The concept of adding value fits uneasily within this world because there is no measure of value beyond the market-based measure.

In economics, the distinction is easier to make and illustrate.  If purchasing a new car today means you cannot afford an overseas vacation next summer, then the real (i.e., economic) cost of the car is the envisaged value of the vacation that you will no longer be able to enjoy.

The value-based way of thinking always requires knowledge of what the foregone alternative is.  And the cost is always in the mind of the decision-maker—it is never quantifiable because the foregone alternative by definition never comes to fruition.  To be sure, there are often after-the-fact market-based indicators that value exceeds cost.  Someone may offer you more for the car than you paid for it, for example, and this is one indicator even if you decide not to sell.  A company expansion announcement may be followed by a rising share price—another after-the-fact market-based indicator that value is being added.

The most profit you can extract from any deal is the difference in value (in your customer's mind) between the alternative you are presenting him with and his next best alternative.

As Nalebuff and Brandenburger say in their buzzword-titled, but otherwise excellent book, Co‑opetition: “Your added value is the size of the pie when you are in the game minus the size of the pie when you are out of the game.”  If the car customer values the envisaged vacation nearly as much as he values the new car, then you can bet the dealer makes little profit on the sale.

There is always the most potential for value adding at the start of projects, when lots of alternatives are available.  Value subtracting, and value  protection are the flip side of the value-adding coin, and here the reverse is the case.  You are most vulnerable and exposed to value losses after capital has been sunk—when your alternatives are more limited.  Be warned!

Try Nalebuff and Brandenburger’s simple rule on this example:  You have a $500 million investment that is ready to go except for an uncompleted bridge.  Completion of the bridge is held up by (say) environmentalists. 

Œ What is the value to you of the investment with the bridge?

� What is the value to you of the investment without this bridge?

Ü The difference is how much your protagonists can potentially extract from you in return for removing the obstruction.

There are lots of strategies that can help get you out of this predicament, or avoid getting you into it in the first place.  I mention several mining-related examples in my book Mining Economics and Strategy.  Of course, every case is unique, and unique responses have less chance of being anticipated by the other side.  If you are in such a situation, please give me a call.  _ICR