Most people would not call what we do to store passwords encryption as it is not reversible. It's a cryptographic hash.
Also the diagram has some specific numbers which correspond to the orignal unix DES based system which nobody should be using any more for many reasons but mainly only 8 chars ASCII passwords. The principals however remain the same.
We want to protext the system also in the event of data from the shadow file is leaked ans to a limited extent from the system adminstrator. It should be impossible to recover the plain text password from what we store, anyone trying to brute force the passwords should need to this one password at a time and not all together. Brute forcing passwords should be a slow process. It should not be practical to precompute rainbow tables for even a faily modest collection of passwords. We should still be able to verify a given plain text matches the stored record and it should be extremely unlikely another password will accidentally match.
We do this with a special kind of cryptographic hash function and with the help a random salt. The salt (originally 12 bits nowadays more) makes attaxking passwords together and building rainbow tables very difficult. And the hash function should be slow so a single password brute force is impractical.
Since the original implementation we also add that speed should be paramaterized so we can increase compute difficulty as computers become faster. This was missing in the original unix implementation.
Also we want to support long passwords and we want the hash function to preserve as much of the entropy in the password as possible (unlike the infamous LanMan). The hash function should be preimage and collision resistant (unlike the LanMan). Some may want to add diverse charset support which many now use to increase password entropy.