How to Build Risk into Your Business Model

by Karan Girotra and Serguei Netessine

IN EARLY 2008 four entrepreneurs in Paris started MyFab, an internet-based furniture retailer that is doing more to change the industry than any other company since IKEA. Instead of building large stocks of furniture, as its competitors do, MyFab provides a catalog of potential designs. Customers vote on them, and the most popular ones are put into production and shipped to buyers directly from the manufacturing sites—with no retail outlets, inventories, complicated distribution, or logistics networks.

The engagement and social aspects of the voting attracted customers in droves, but they most loved the prices. By simplifying its supply chain and producing only what customers wanted, MyFab was able to offer products at significantly lower cost than established furniture retailers could. In just two years the company has grown to more than 100 employees; it now sells furniture and other products in four markets, including the United States.

MyFab did not identify new market segments, nor did it develop new products based on novel technology. In fact, its products are similar—often nearly identical—to those of its competitors. Like Dell, Zara, and Zipcar before it, MyFab has prospered by innovating its business model—the way it offers existing products or services that address existing customer needs using existing technologies. Very often this kind of innovation turns out to be more valuable and transformative than product- or technology-driven innovation, as readers of the work of Clay Christensen or INSEAD’s W. Chan Kim and Renée Mauborgne well know.

But there’s a perennial problem with business model innovation: Managers often find it harder to determine what changes to the model will work than whether a new product or technology will catch on. So what’s the secret? How can companies systematically innovate their business models? How can executives identify and quantify the value of their changes? We believe that the literature on business model innovation has overlooked a critical driver of value: where in the value chain the risks associated with creating, supplying, and consuming products and services reside. In designing their value chains, companies typically focus on three things: revenue (price, market size, and ancillary sales), cost structure (direct and indirect costs, economies of scale and scope), and resource velocity (the rate at which value is created from the applied resources, typically captured through lead times, throughput, inventory turns, and asset utilization). These factors are well understood, and improving them is the main focus of management literature. Less well understood is that these value drivers are themselves affected by sharp changes in, for example, demand and supply. In thinking through changes to the business model, therefore, it is essential to examine the major sources of risk to the model and how the model will handle them.

Thinking in these terms quickly demonstrates the potential for companies to create value by redesigning their business models to reduce their risks. It can also reveal unsuspected opportunities for creating value by adding risk—if the company is well-placed to manage it. In the following pages we draw on our experience studying and consulting to dozens of companies—startups and large corporations alike—to describe the various types of risk-driven business model innovations and discuss their advantages and disadvantages.

Reducing Risks

Often companies that have lowered their business model risk have done so by delaying production commitments, transferring risk to other parties, or improving the quality of their information.

Delaying production commitments

Speeding up the production process is the most obvious way to do this. It usually means producing in higher-cost locations, which goes against supply chain orthodoxy. But surprisingly often the gains from reducing demand uncertainty outweigh the added costs. This approach lies behind some very remarkable innovations.

Consider the famous Spanish clothing retailer Zara. Branded clothing companies have traditionally focused on managing costs by organizing their sourcing, production, and distribution as efficiently as possible. As a result, they may need as long as 12 to 18 months to design, produce, and deliver a new line of clothing. That means they have to make big bets on future consumer preferences and demand. Bearing this risk has consequences for the bottom line through inventory write-downs (if the clothes don’t sell) or for the top line through stock-outs (if people want more than you’ve made).

Zara reduced the likelihood of these consequences by designing a hyperfast supply chain that turns a new line around in two to four weeks—making it much easier to keep pace with consumer preferences. Of course, there is a price: The company makes most of its products in an expensive location (southern Europe), ships them to stores often (weekly), and uses an expensive mode of transportation (air). But Zara’s success demonstrates clearly that a focus on managing demand risks can trump a focus on costs.

Note that Zara did not discover anything new about the risks involved in retailing apparel. Everyone knows that customers are fickle and hard to read. Zara’s insight was simply that a faster cycle time meant that decisions about product specifications and quantities needn’t be made so far in advance, and fresher data would be available when the company did have to make commitments.

Reducing cycle time allows some companies to completely eliminate risks arising from demand uncertainty. Dell, for example, does not have to assemble a computer until the customer has ordered it, because it can turn the order around extremely fast. Again, a price must be paid: Like Zara, Dell must set up most of its production facilities close to its end customers (in the United States) and therefore cannot produce in low-cost locations for its main market. Similarly, Timbuk2, a popular bag manufacturer, can ship custom-designed orders to its customers in just two or three days—but its manufacturing has to be done in San Francisco rather than in China.

Rewriting your contracts

Another way to manage risk—especially asset-related risk—is to pass the exposure on to someone else. This usually involves altering your contracts with the other stakeholders in your value chain: employees, suppliers, and customers.

The customer-contact services provider LiveOps demonstrates how changing the terms of employment can radically alter a company’s risk profile. Traditional providers of contact services maintain a workforce of customer service agents at a call center. The volume of service requests is highly variable, meaning that sometimes this workforce is underutilized for a large portion of the workday, but at other times the call volume far exceeds its capacity and customers must tolerate long waits. The usual solution is to relocate the contact center to a low-cost location such as India.

LiveOps turned this model on its head. Instead of employing and training a large workforce, it maintains a pool of loosely affiliated freelancers. These are often stay-at-home parents who cannot take a job with fixed hours but are available many times during the day. The LiveOps computerized system allows them to work remotely in their free time. Agents log on to the system when they’re available, and customer calls are routed to them. Most important, LiveOps pays the agents only for the time that they are on support calls—meaning that the employees themselves bear the risk of their underutilization. They are willing to assume this risk in return for being able to make their own hours and work from home.

In the late 1990s Blockbuster handed off risk to suppliers: It revolutionized the highly competitive video rental industry by shifting away from fixed-price contracts (under which each VHS tape cost Blockbuster $60) and toward revenue sharing with the major movie studios. Under the old arrangement, the studios took little risk in terms of a mismatch between demand and supply: They received $60 for a tape no matter how many times it was rented. Blockbuster assumed all the risk of acquiring a dud and had to hedge its bets by buying fewer tapes.

Under the new arrangement, Blockbuster paid only $5 to $10 up front but shared about 50% of its revenues with the studios. This changed the studios’ information sharing, pricing, and marketing incentives, with the result that Blockbuster could stock more tapes, increasing the availability of hit movies. The company’s market share rose from 25% to 38%, and profits for the industry grew by up to 20%.

Gathering better data

Sometimes it isn’t possible to radically shorten the production process or alter your relationship with other stakeholders in your value chain. In that case, you can improve the quality of the information on which you base your commitments.

That is precisely what MyFab’s customer voting system does. The actual process of making and delivering furniture quickly has been greatly refined, so relocating doesn’t make as much competitive difference as it used to. The data MyFab gets through customer polling enable it to predict customer taste and demand levels more accurately than its competitors can, reducing its exposure to stock-outs and excess inventory.

Even when companies can reduce risk using the classic approaches, they should consider upgrading their information-gathering capabilities, because speeding up production or rewriting contracts often creates a new risk. This was a potential problem for LiveOps. Because its employees work from home and are independent contractors, it is much harder to verify that they are appropriately trained to answer calls. LiveOps mitigates this information risk by monitoring agents’ performance and routing calls first to the higher-ranked agents.

Adding Risk

Many people regard risk only as something to eliminate—an undesirable concomitant of managing the resources and capabilities needed to deliver a product or service. But as the economist Robert Merton has often pointed out, one can also argue that companies create value by being better at managing risk than their competitors are. The implication is that if you are better than others at managing a particular risk, you should take on more of that risk.

The history of innovation demonstrates that quite a few companies have made money by taking on more risk—typically by changing the terms of their contracts with suppliers or customers. More than 30 years ago Rolls-Royce, a manufacturer of aircraft engines, identified a major pain point in the industry: Maintaining airplane engines is rife with risk for the airlines. Engine breakdown can ground a plane for weeks while the airline pays for repair time and materials. Airlines, especially small ones, don’t always have the resources to adequately provide for such breakdowns.

So, in the 1970s, Rolls-Royce started offering the airlines a very different service contract: “Power by the hour.” The airlines would pay Rolls-Royce for an engine’s flight hours rather than for repair time and materials. Of course, much of the risk reduction the airlines obtained was reflected in the price, but transferring the risk had a more profound effect: Rolls-Royce was motivated to improve its products and maintenance processes, because the fewer the problems and the quicker the fixes, the more the manufacturer got paid. The airlines could never have created value in this way, either on their own or by prodding Rolls-Royce, so the new contract triggered a completely new value creation dynamic. This movement, which is often referred to as servicization, has spilled over to other industries. For example, the German rail vehicle manufacturer Bombardier charges its customers for maintenance according to miles driven, and Caterpillar charges construction companies according to the amount of earth moved.

Sometimes trying to avoid a risk actually increases it, and you can better manage it by being willing to own more of it. Take the car rental business. The risk in this industry lies in underutilizing fixed assets—cars. Traditional companies rent in daily increments, so the customer has to pay for a day even if he needs the car for only a few hours. He must assume the risk of underutilized assets.

In 2000 Zipcar turned this model upside down. It realized that the ability to rent by the hour would encourage people to switch from taxis or limos to Zipcars. It could price its offering to improve on alternative short-distance transportation modes and still earn a much higher hourly rate than conventional car renters. (Zipcars cost about $8 an hour, whereas the prorated cost at a traditional company is $1 to $2.) The company’s annual revenues are approaching $200 million, demonstrating that returns on its new model outweigh the costs of maintaining a large fleet and multiple pick-up and drop-off locations.

Advantages and Challenges

The risk-driven innovation we describe has one important advantage over other forms of innovation: It’s much cheaper. Innovating products and technologies often involves generating a lot of ideas and then trimming the list down through discussion, voting, and prototyping. Multiple iterations of prototypes, customer feedback, and experimentation are necessary. Significant R&D expenditures are often involved.

Risk-driven innovation, however, can be approached in a systematic way and with few expenditures, and relatively clear and credible estimates can be made of the potential benefits and costs. A great deal of research has been done on the pricing of risk, and sound methods exist for putting a dollar value on contracts and real options that involve reducing, transferring, or adding risk. In fact, a recent article by Suzanne de Treville and Lenos Trigeorgis (“It May Be Cheaper to Manufacture at Home,” HBR, October 2010) described how real options analysis lets you put a dollar value on the benefits of moving production from distant but cheap locations to close-by but expensive ones.

In addition, you don’t need extensive experimentation and prototyping to identify very powerful innovations, because some of them have already been done and others can be quantified. Zipcar essentially reprised Rolls-Royce’s approach, and Zara’s innovation resembled Dell’s. The sidebar “The Next Big Thing?” points out that a startup in Israel is borrowing ideas from Zipcar and Rolls-Royce to introduce an electric car on a large scale (see “How to Jump-Start the Clean-Tech Economy,” by Mark W. Johnson and Josh Suskewicz, HBR, November 2009).

You might think that such innovations aren’t a sustainable form of competitive advantage. But experience shows that they actually can be, because copying someone else’s business model innovation often involves changing processes that are embedded in the culture of an organization—and substantially changing the cultural DNA is harder than adopting a new technology or design or entering a new market. It’s particularly challenging when the company being copied is a competitor. Other car companies took decades to become as good as Ford is at mass production. And although the famous Toyota Production System is well described in numerous books, and anyone can visit a Toyota factory, U.S. automakers still struggle to implement it as effectively as Toyota does. Meanwhile, companies in other industries prospered mightily from being the first to adopt mass production or TPS.

The lesson: If you really want to steal a march on your rivals, shift some of the focus that you now put on improving your products and services to thinking about how you, your suppliers, and your customers can manage the risks of the business you conduct together.

Originally published in May 2011. Reprint R1105G