Value Creation and Capture: Competitive Strategy

IES461
SMN-678-E
November 2010
Value Creation and Capture

Competitive Strategy
DILBERT © (2010) Scott Adams. Used By permission of UNIVERSAL UCLICK. All rights reserved
1. Introduction
This note introduces the basic concepts of value creation and value capture, which are used
as the building blocks for many other concepts, tools and frameworks in competitive
strategy. Defining these concepts allows us to think and talk more precisely about
competitive strategy. They also allow us to make progress in our understanding of what
strategies might actually work, and which are doomed to fail.
The “Value Creation and Capture” framework introduced in this note includes the definition
of value creation, the description of three broad value creation strategies and the
definition of value capture (both in a simple two-party example and in a more complete
value chain setting). On the way there, we will define some other concepts such as
willingness to pay and the productivity frontier, aimed at establishing common language
and understanding of the building blocks of competitive strategy.
This technical note was prepared by Bryan S. Ly, MBA 2011, and Professor Govert Vroom. November 2010.
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Last edited: 3/14/13

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to Dec 2019.
SMN-678-E Value Creation and Capture
2. Competitive Strategy
In “What is Strategy?” Michael Porter (1995) emphasized that strategy is not about doing
things better – strategy is about doing things differently. The essence of strategy is making
hard choices and trade-offs. While that concept seems rather basic and trivial, many
companies fall into the trap of trying to be all things to all people. Instead, a firm must
deliberately select a different set of activities to deliver a unique value mix. It must provide
greater value to its customers, deliver value at a lower cost, or both. To do so, a firm must
develop a competitive strategy that establishes a profitable and sustainable competitive
advantage against the competitive forces within an industry (Porter, 1980).
A competitive advantage is generated by the activities involved in creating, producing,

selling, and delivering a product or service. Operational effectiveness means performing
these activities better than rivals (e.g., faster, cheaper or more efficiently). While operational
effectiveness is necessary, it is often not sufficient in sustaining a competitive advantage.
Since competitors can easily emulate operational best practices, competition based on
operational effectiveness alone is mutually destructive. Instead, both operational
effectiveness and strategy are essential to superior performance. A competitive strategy
attempts to achieve a sustainable competitive advantage by performing different activities
from rivals. There are three key principles that underlie strategic formulation:
1. Strategy requires making trade-offs and choosing what not to do.
2. Strategy involves creating a unique and profitable strategy by intentionally choosing

a different set of activities.
3. Strategy involves alignment and fit of a firm’s activities.
The choice of what to do and what not to do is referred to as the company’s scope. The scope
of a firm includes three elements: product scope, customer scope and geographic scope. The
choice of scope directly affects the activities the firm has to do, although the firm still needs
to determine how to do these. Competitive activities are often incompatible and gains in one
area can be achieved only at the expense of another area. For example, configuring activities
for a low-cost strategy is different from how to configure activities to deliver superior
customer benefits. Typically, a firm can only gain a competitive advantage if its activities
combine and interact to reinforce one another. A strategic fit among many activities makes it
difficult for competitors to imitate an array of interlocked and reinforcing activities. The
success of a strategy depends on doing many things well and integrating among them.
With the above in mind, strategy is about achieving a sustainable competitive advantage
over the competition. We say that a firm possesses a competitive advantage when it creates
and captures more value than its competitors. In the remainder of this technical note, we will
first discuss strategies to create value and then focus on how firms can ensure that they
capture at least part of the value created.
2 IESE Business School-University of Navarra
to Dec 2019.
Value Creation and Capture SMN-678-E
3. Value Creation
The first step in the process is value creation. To begin, consider a simplified scenario of an
industry with only one firm and one buyer, illustrated in the figure below. In this scenario, the
definition of value created consists of two ingredients: the willingness to pay of the buyer and
the cost of the firm. The value created by the chain of players is defined as follows:
value created = willingness to pay – cost

Figure 1
Simplified buyer and firm scenario
Buyer
Product
Firm
The first part of the equation is willingness to pay. Willingness to pay is an abstract concept,
defined as the maximum price a buyer would pay for a firm’s product. Firms can increase the
price premium, or the customer’s willingness to pay, by differentiating themselves from
competitors. The term differentiated is commonly misused. While differentiation typically
implies “being different from competitors,” simply being different does not mean that a firm
is differentiated. In this note, the term differentiated is defined as the ability of a firm to
boost the willingness of customers to pay for its product and command a price premium
(Ghemawat, 1998). For example, BMW is able to achieve a higher customer willingness to
pay by differentiating itself from the competition through its focus on performance,
engineering and style1.
The second part of the equation is the firm’s costs in manufacturing the product. Costs
include all the associated expenses involved in creating, producing, selling and delivering a
product. As mentioned previously, costs can be reduced through improvements in operational
effectiveness. For example, firms can reduce costs through economies of scale and scope,
input costs, product design and efficiency.
1 Willingness to pay is a relatively abstract concept. In general, assessing the willingness to pay of consumer products is not easy.
Each individual customer has a personal preference and opinion. Some customers may value certain products or services more than
others and as a result, their willingness to pay is difficult to determine precisely. It is also important to recognize that willingness to
pay is not the same as price. In fact, the price a firm chooses does not usually affect a customer’s willingness to pay for a product.
IESE Business School-University of Navarra 3
to Dec 2019.
Figure 2
Value created by a firm
(¼)
Willingness to Pay
Buyer
Value Created
Firm
Cost
Having defined willingness to pay and cost, value created is simply defined as the difference
between the two.
3.1 Value Creation Strategies

Firms trying to implement value creation strategies must recognize that a common tension
exists between increasing willingness to pay and decreasing cost. In most instances, a firm
will incur higher costs to deliver a product with greater differentiation and, hence, higher
willingness to pay. Also, lowering costs often implies a trade-off in quality that will
negatively affect willingness to pay. Ultimately, the goal of a firm is to drive a larger wedge
between cost and the willingness to pay (Ghemawat, 2006).
In his 1980 book, Porter suggested that firms have to choose between the two so-called
“generic” strategies of low cost and differentiation. Built on his recognition of the tension
between increasing willingness to pay and decreasing cost, he argued that a firm pursuing
both at the same time would be “stuck in the middle.” Later research has shown that, while it
is true that there is a tension between willingness to pay and cost, it is still possible to
profitably try to achieve both goals at the same time. In other words, firms have the option
of competing on the basis of:
x Low cost
x Differentiation
x Dual advantage
Figure 3 illustrates the main strategies that a firm can employ. By employing a differentiation
strategy, a firm may increase the willingness to pay with only a small increase in cost
compared to an average industry competitor. By employing a low-cost strategy, a firm may
achieve large cost savings with only a small decrease in the customer’s willingness to pay.
Figure 3 also illustrates the possible competitive advantage of a firm with a dual competitive
strategy of low cost and high differentiation.
to Dec 2019.
Figure 3
Value creation strategies
WTP
$
Cost
Industry Average Differentiation Strategy Low-Cost Strategy Dual Advantage Strategy

Competitor
Willingness to Pay Cost
Figure 3 depicts the ideal situation of value creation strategies that actually work. It should be
stressed again, though, that the dual advantage strategy is particularly difficult to implement
because of the trade-offs that are normally present. More generally, if a firm increases
willingness to pay and cost by the same amount, no value is created. Similarly, if the firm
reduces cost but willingness to pay goes down by the same amount, no value is created.
3.2 Value Creation and the Productivity Frontier

Figure 3 shows the three value creation strategies that are available to firms. A firm’s ideal
strategy is a choice from the range of trade-offs found between cost and differentiation, not
a choice between mutually exclusive strategies. A depiction of the productivity frontier is a
helpful tool in visualizing this trade-off.
In “What is Strategy?” Porter described the productivity frontier as the sum of all existing
best industry practices at any given time. It is the maximum value that a firm delivering a
particular product can create at a given cost using the best available resources (e.g.,
technologies, skills, management techniques or inputs). This productivity frontier is
constantly shifting outward with the development and introduction of new and improved
technologies, new management techniques and new inputs.
Figure 4
Productivity frontier
to Dec 2019.
New entrants often discover and take advantage of new and promising strategic positions
through resourcefulness and insightfulness. Unencumbered by existing activities or
operational inertia, new entrants are flexible enough to recognize and exploit new ways of
competing, thereby shifting the productivity frontier outward (Grant, 2010). In contrast, these
unique strategic positions are often overlooked by incumbents, which are the set of existing
firms within an industry.
Example 1: Differentiation Strategy
For example, consider Neutrogena’s entry into the soap market (illustrated in Figure 5). As a
new entrant into the soap market, Neutrogena positioned its new offering as a differentiated
product from other traditional soap producers. Unlike traditional soaps, Neutrogena’s product
was formulated to be pH balanced, available only in drugstores, marketed to doctors and
advertised in medical journals. Furthermore, Neutrogena incurred additional costs by
employing a slower, more expensive manufacturing process in order to maintain a high level
of quality. By choosing to position its product differently and having its activities reinforce
this differentiation strategy, Neutrogena was able to develop a unique and premium position
in the market. Neutrogena’s differentiation strategy is represented as the second set of bars in
Figure 3 and as a position in the upper left corner in Figure 5.
Figure 5
Shifting the productivity frontier through a differentiation strategy
High
Neutrogena
Soap Market
D
ife
rn
ta
o
Productivity
Frontier
Low
High Relative Cost Position Low
Example 2: Low Cost Strategy
Now consider the case of the Vanguard Group. Vanguard chose its activities to reinforce a
consistent low cost approach to provide a predictable performance and reduce expenses. Its
offerings are the standard array of financial products available from many competitors.
However, through activities such as keeping trading levels low and minimizing overhead costs,
Vanguard developed a value chain superior to that of its competitors. Vanguard’s customers
received a consistent performance at an extremely low price, which allowed Vanguard to
become a successful player in the mutual fund industry. Vanguard’s low cost strategy is
represented in Figure 3 by the third set of bars and as a position in the bottom right corner in
Figure 6, in contrast to the upper left position occupied by Neutrogena in Figure 5.
to Dec 2019.
Figure 6
Shifting the productivity frontier through a low-cost strategy
High
Mutual Funds Industry
D
ife
rn
ta
o
Productivity
Frontier Vanguard
Low
Example 3: Dual Advantage Strategy
Dell is an excellent example of a company with a successful dual advantage strategy. With a
just-in-time inventory management system and a configure-to-order model, Dell was able to
significantly reduce inventory and component costs as compared to its rivals. Dell was,
however, still able to increase market share while maintaining prices equal to or higher than
those of its competitors – clear signs that Dell also commanded a superior willingness to pay.
As illustrated in Figure 7, Dell is pushing out the productivity frontier both in terms of
willingness to pay and in terms of relative cost position. Dell’s strategy corresponds to the
last set of bars in Figure 3 and a middle position in Figure 7.
Figure 7
Shifting the productivity frontier through a dual advantage strategy
High
Personal Computer Industry
Dell
D
ife
rn
ta
o
Productivity
Frontier
Low
The three main value creation strategies are often referred to as competitive positions. In
competitive strategy, competitive positioning refers to the choices a firm makes in the trade-
off between increasing the willingness to pay and decreasing cost. As explained above, it is
to Dec 2019.
important to recognize that the largest distance between willingness to pay and cost does not
necessarily occur at either extremes of low costs or high price premiums.
4. Value Capture
Once the value created is defined, the next step is to determine how much value each player
in the value chain will capture. Consider once again the case of a single buyer and single
firm. The division of value between these two players is determined by the price paid by the
buyer. The price is driven by a number of factors ranging from industry competition to firm
uniqueness. A non-differentiated firm in a competitive industry will have almost no
bargaining power and, therefore, will capture little value. In contrast, a differentiated firm in
a monopoly or oligopoly has considerable market power and will capture a significant
amount of value.
4.1 Value Creation and Capture in the Simple Two-Party Case

The figure below illustrates the division of value between the two players. The entire line
segment represents the value created by the vertical chain of players. The top portion of the
line segment represents the amount of value captured by the buyer, which is simply the
buyer’s willingness to pay for the product minus the price paid to the firm. The bottom
portion represents the amount captured by the firm, which is the price charged to the buyer
minus the cost to produce the product.
Figure 8
Division of value between buyer and firm
($)
Willingness to Pay
Buyer Buyer’s Share
Value Created Price
Firm Firm’s Share
Cost
Example of the Two-Party Case
As a simplified example, consider the concession market at Camp Nou, FC Barcelona’s

legendary stadium. The firm in this example is a concession booth selling beer (Cervecería
Messi) and the buyer is an average FC Barcelona fan (Barça fan) attending a match. Suppose
that for a bottle of beer, the buyer has a willingness to pay of 7 euros, while the firm can
procure the beer at a cost of 2 euros (assuming, for the sake of simplicity, that the retailer
does not incur any additional operating costs such as labor, rent or utilities). In this scenario,
the total value created by the Cervecería Messi is 5 euros, as shown in Figure 9.
to Dec 2019.
Figure 9
Total value created by Cervecería Messi
($)
¼7 Willingness to Pay
Barça Fan
Value Created ¼5 ? Price
Cervecería Messi
¼2 Cost
Let us now suppose that the beer retailer sets the price of the beer at 4 euros As illustrated in
Figure 10, this scenario would result in the Barça fan (the buyer) capturing 3 euros of the
value created and Cervecería Messi (the firm) capturing 2 euros of the value created. What
this illustration also shows is that the firm can create more value by employing the strategies
discussed earlier: increasing willingness to pay, lowering cost or both.
Figure 10
Division of value between Cervecería Messi and Barça fan
($)
Barça Fan ¼3 Buyer’s Share
Value Created ¼5 ? Price
Cervecería Messi ¼2 Firm’s Share
¼2 Cost
4.2 Value Creation and Capture in the Value Chain

Now consider an entire value chain consisting of three main players: supplier, firm and
buyer. In this vertical chain, the firm acquires resources from a supplier and transforms these
resources into a product, which is subsequently sold to a buyer. Figure 11 illustrates this
vertical chain of activities.
to Dec 2019.
Figure 11
Simplified industry value chain
Buyer
Product
Firm
Resources
Supplier
In this scenario, the definition of value created by the entire value chain consists of two
ingredients: the willingness to pay of the buyer and the supplier cost. The value created by
the chain of players is defined as the first minus the second:
total value created = willingness to pay – supplier cost
Having already defined willingness to pay, supplier cost is simply the cost of producing the
resource or raw material.
The difference between they buyer’s willingness to pay and the supplier cost represents the
total value created by the value chain. Figure 12 illustrates the division of value among
the players. The entire line segment represents the value created by the vertical chain of
players. The top portion of the line segment represents the amount of value captured by the
buyer, which is simply the buyer’s willingness to pay for the product minus the price paid to
the firm. The middle portion represents the amount captured by the firm, which is the price
charged to the buyer minus the cost of resources paid to the supplier. Finally, the bottom
portion represents the amount of value captured by the supplier, which is the cost to the firm
minus the supplier cost.
Figure 12
Division of value in an industry value chain
($)
Willingness to Pay
Buyer
Buyer’s Share
Price
Total Value Firm’s Share

Firm
Created
Cost
Supplier’s Share
Supplier Supplier Cost
to Dec 2019.
In contrast with Figure 10 (the two-party example), Figure 12 highlights the fact that a firm
is typically caught in negotiations with both suppliers and buyers. The price the buyer pays
determines how much value the buyer captures, while the price the firm pays to the supplier
determines how much value the supplier captures. The remainder – if anything – is the value
captured by the firm.
Example of Value Creation and Capture in the Value Chain
Consider again the example of selling beer at Camp Nou, complicating things a little by
expanding the value chain. The supplier in this case is Estrella. It is also important to note that
the cost to the firm (or “cost of goods”) now refers to the price at which Cervecería Messi
purchases beer from Estrella. Suppose that it costs Estrella 1 euro to produce a bottle of beer. The
figure below shows that the total value created by the value chain is 6 euros and the supplier
now captures 1 euro of the total value created. The figure also illustrates that the amount of value
each player captures is dependent on the price they can set for their products (Estrella’s price to
Cervecería Messi; Cervecería Messi’s price to the fan) and, therefore, a function of each player’s
bargaining power.
Figure 13
Split of value over all parties involved
($)
Barça Fan
¼3 Buyer’s Share
¼4 Price
Total Value ¼2 Firm’s Share

Cervecería Messi ¼6
Created
¼2 Cost
¼1 Supplier’s Share
Estrella
¼1 Supplier Cost
5. Summary
Strategy is not about doing things better – strategy is about doing things differently. A firm
must deliberately select a different set of activities to deliver a unique value mix. It must
provide greater value to its customers, deliver value at a lower cost, or do both. How a firm
creates and captures this value is the fundamental question managers must ask.
This note introduced the fundamental concepts of value creation and capture as important
building blocks for competitive strategy. The main concepts are fairly simple:
x Firms can employ three distinct strategies to create value: differentiation, low-cost or
dual advantage.
to Dec 2019.
x To create a competitive advantage, a firm must create a larger wedge between

customer willingness to pay and cost as compared to rivals.
x To do so, a firm must deliberately select a different set of activities than its rivals.
These activities may affect the relative cost and relative willingness to pay.
The value creation and capture (VCC) framework as described in this note provides a solid
foundation for other competitive strategy topics. For example, VCC provides a way to help
analyze the attractiveness of industries based on how much value a firm can create and
capture within an industry based on the forces involved. The competitive dynamics of an
industry are also important determinants in the amount of value a firm can capture in the
industry. VCC is particularly useful for helping firms analyze the competitive forces that
affect value and identify opportunities and activities that could increase value, both created
and captured!
to Dec 2019.
Glossary
Competitive advantage – a firm possesses a competitive advantage when it creates and
captures more value than its rivals
Competitive positioning – the choices a firm makes in the trade-off between increasing the
willingness to pay and decreasing cost; the choice among the three value creation strategies
(low cost strategy, differentiation strategy and dual advantage strategy)
Differentiated – the ability of a firm to boost the willingness of customers to pay for its
product
Differentiation strategy – a strategy to significantly raise willingness to pay with only a

small increase in costs
Dual advantage strategy – a strategy to simultaneously increase willingness to pay and

reduce costs
Incumbents – the set of existing firms within an industry
Low-cost strategy – a strategy to significantly reduce costs while only slightly decreasing
customer willingness to pay
Operational effectiveness – performing the activities involved in creating, producing, selling

and delivering a product or service better than rivals (faster, cheaper, more efficiently)
Productivity frontier – the sum of all existing best industry practices at any given time; the
maximum value that a firm delivering a particular product can create at a given cost using
the best available resources
Scope – choice of what to do and what not to do; scope includes three elements: product
scope, customer scope and geographic scope
Total value created – the difference between customer willingness to pay and supplier costs
Value created – the difference between customer willingness to pay and a firm’s cost to
produce the product
Willingness to pay – the maximum price a buyer would pay for a firm’s product.
to Dec 2019.
References
Brandenburger, A. M. and H. W. Stuart (1996), “Value-Based Business Strategy,” Journal of
Economics & Management Strategy, 5 (1), pp. 5-24.
Ghemawat, P. and J. W. Rivkin (1998), “Creating Competitive Advantage,” Harvard Business

School, 798-062.
Ghemawat, P. (2006), “Strategy and the Business Landscape,” New Jersey: Prentice Hall, 2nd
edition.
Grant, R. (2010), “Contemporary Strategy Analysis,” UK: John Wiley & Sons, 7th edition.
Porter, M. (1980), “Competitive Strategy,” New York: Free Press.
Porter, M. (1985), “Competitive Advantage: Creating and Sustaining Superior Performance,”

New York: Free Press.
Porter, M. (1995), “What is Strategy?,” Harvard Business Review, 74 (6), pp. 61-78.
to Dec 2019.

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IES461

Value Creation and Capture

Last edited: 3/14/13

A competitive advantage is generated by the activities involved in creating, producing,

1. Strategy requires making trade-offs and choosing what not to do.

2. Strategy involves creating a unique and profitable strategy by intentionally choosing

3. Strategy involves alignment and fit of a firm’s activities.

2 IESE Business School-University of Navarra

value created = willingness to pay – cost

IESE Business School-University of Navarra 3

3.1 Value Creation Strategies

4 IESE Business School-University of Navarra

Industry Average Differentiation Strategy Low-Cost Strategy Dual Advantage Strategy

Willingness to Pay Cost

3.2 Value Creation and the Productivity Frontier

IESE Business School-University of Navarra 5

Example 1: Differentiation Strategy

Example 2: Low Cost Strategy

6 IESE Business School-University of Navarra

Mutual Funds Industry

Example 3: Dual Advantage Strategy

IESE Business School-University of Navarra 7

4.1 Value Creation and Capture in the Simple Two-Party Case

Buyer Buyer’s Share

Value Created Price

Firm Firm’s Share

Example of the Two-Party Case

As a simplified example, consider the concession market at Camp Nou, FC Barcelona’s

8 IESE Business School-University of Navarra

Value Created ¼5 ? Price

Barça Fan ¼3 Buyer’s Share

Value Created ¼5 ? Price

Cervecería Messi ¼2 Firm’s Share

4.2 Value Creation and Capture in the Value Chain

IESE Business School-University of Navarra 9

total value created = willingness to pay – supplier cost

Total Value Firm’s Share

10 IESE Business School-University of Navarra

Example of Value Creation and Capture in the Value Chain

Total Value ¼2 Firm’s Share

IESE Business School-University of Navarra 11

x To create a competitive advantage, a firm must create a larger wedge between

12 IESE Business School-University of Navarra

Differentiation strategy – a strategy to significantly raise willingness to pay with only a

Dual advantage strategy – a strategy to simultaneously increase willingness to pay and

Incumbents – the set of existing firms within an industry

Operational effectiveness – performing the activities involved in creating, producing, selling

IESE Business School-University of Navarra 13

Ghemawat, P. and J. W. Rivkin (1998), “Creating Competitive Advantage,” Harvard Business

Porter, M. (1980), “Competitive Strategy,” New York: Free Press.

Porter, M. (1985), “Competitive Advantage: Creating and Sustaining Superior Performance,”

14 IESE Business School-University of Navarra

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