Consulting for the Royal Hotel

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- What is the total value created in the transaction involving WizTech?

We estimate the total value created in the exchange described in the scenario as follows:

Firm cost (FC) is given in the case. The case states clearly that it cost $1,500 to WizTech to manage a cloud account. Supplier opportunity cost (SOC) is not given and I use an estimate of $1,000. Note that I found using supplier opportunity cost immediately, confusing for the students. What I now do is complete the analysis using firm cost, and alert the students that I will have to make one modification later. I then introduce the role of supplier opportunity cost later when the definitions are formalized and the students have some clarity in the analysis. I find that in this way the discussion flows better and at the end I can easily introduce the implications of using supplier opportunity cost rather than firm cost to define value created.

Note that talking about supplier opportunity cost is important for two reasons: 1) it shows that value can be appropriated by WizTech by eating into the supplier share; 2) more importantly, using the notion of supplier opportunity cost, it becomes apparent that the value created in the transaction is a product of the transformation process initiated by WizTech who takes resources that would be worth $1,000 (as per our estimate) in their next best use and creates something that its customers are willing to pay $5,000 for – value is created through this transformation process. Also note that supplier opportunity cost is a theoretical per unit measure that includes everything from financing, to managerial talent, to labor, to parts, etc. It is an estimated per unit average in this case.

Customer willingness to pay (CWP) in this example is based on the notion that we can quantify what the customer is willing to pay for a perfect substitute. This is why we have to make the simplifying assumption that the price for the former solution is given. This is of course not completely realistic because we could negotiate with the supplier, but the assumption is needed to simplify the analysis. Thus a perfect substitute is valued at $25,000 + ($2,100 x 5) = $35,500. From this sum we have to deduct what the customer would have to pay to run the WizTech solution over its life span: $6,000 x 5 = $30,000. Assuming that the two options are perfect substitutes (thus all information about value of the brand, faster or slower service because of proximity, and the like have already been embedded in willingness to pay calculations), the Royal Hotel’s CWP is $5,500 for WizTech’s solution.

At this point we can formally establish that the total value created in the transaction involving WizTech is $5,500 - $1,000 = $4,500. Note that when I do the analysis using firm cost I obtain a slightly different value ($5,500 - $1,500 = $4,000). For the reasons explained above I suggest that you do the same and reserve the introduction of the notion of SOC for later in the discussion.

- Of the total value created, who appropriates it and how much?

Appropriation of value is a different concept than value creation. A critical insight of this analysis is that creating value that the firm cannot appropriate is not a sensible strategy. When posed the questions, students need to first speculate about where price will fall. To bring further energy to the discussion I often ask a vocal student to be the Royal Hotel’s negotiator while I play WizTech. After rejecting any of the offers he or she puts forth and insisting that price be set at $5,500, it become clear that WizTech is in the dominant bargaining position. This is due to the fact that WizTech is unique and valuable and that without WizTech the total value created disappears (the notion of added value discussed in the next question).

Note that if the student walks away from the deal, due to pride or anger or any other non-rational reason, you should remind them that their duty is to maximize shareholders’ wealth and that his next best option is the former supplier. Thus, it is duty to accept the deal. Clearly this is a very short term strategy and point out that if WizTech is trying to break into the market they will be willing to compromise. Moreover, assuming perfect information and that WizTech knows Royal’s CWP precisely is another assumption. All this is correct, but you should ask students once again to keep the analysis simple and straightforward (they will see the value of doing this once we get to the C case!!).

After making the point that WizTech is clearly in the power position, I pick a number, typically the mid-point ($3,500) and ask the student to tell me what happens if price were to fall there. With a price established we can compute the amount of the total value created that is appropriated by each of the players. Not considering suppliers for the moment, we conclude that WizTech appropriates $2,000 in the form of extra profits, while the Royal Hotel appropriates $2,000 in the form of savings. If we had used SOC as the lower boundary of value creation ($1,000) then we would also know that the suppliers appropriated $500 in extra profits (i.e., $500 more than the minimum they would have been willing to accept to provide resources to WizTech).

It is worth pointing out once more before moving on that WizTech could have theoretically appropriated all $4,000 (i.e., the entirety of the total value created).

- Does WizTech have added value?

After I ask this question I formally define the term. Added value is, by definition, the value that would be lost were the firm not to partake in the exchange. That is, WizTech’s added value is measured as that portion of the value created in the transaction were WizTech decided not to take part. In other words, added value is the total amount of value that would be dissipated if WizTech did not exist or left this value system. Thus, we already see that added value depends on the configuration of the specific value system and existing competition (a critical point driven home by the B case).

Since WizTech is the only firm that can produce the cloud solution (the innovation that enables them to drive CWP), all the value created would be lost if WizTech decided not to participate. Thus, WizTech’s added value is the full $4,000 (if you chose not to use SOC yet; $4,500 otherwise).

- Is WizTech in a position of competitive advantage with respect to its competitors (i.e., Canon)?

Intuitively, we can already assert that WizTech has a competitive advantage because it has added value - it brings something