CHAPTER 15

Business Model Overview

Technology changes of the sort we have examined at length represent one strand of innovation—a better mousetrap, as it were. But for technological innovation to make its way to people in the marketplace, a second factor is required: a business model. That is, there must be an organization of resources that facilitates an exchange of value, often monetary, in order that technology artifacts can find users.

For most of the mass production era, business models have involved capital-intensive factories or collections of infrastructure that generated products or services consumed by paying customers. With information goods in a digital era not necessarily requiring the same capital intensiveness, business models have proliferated: One professor who has studied Internet commerce has organized dozens of examples into nine families.*¹ Thus, (1) packaging the right technology into the right market offering (product, service, or hybrid), (2) creating a compelling exchange proposition, and (3) organizing resources to make the trades happen requires additional types and layers of innovation, capital, and management. The better mousetrap, in short, requires a mousetrap store, collective, foundation, or other arrangement to connect the product with people's needs.

Definition

While the term “business model” is widely used,* I follow the definition of my previous coauthor, Henning Kagermann, the former chief executive of the German software company SAP. A business model, he and his coauthors state, consists of four interlocking elements that, taken together, create and deliver value.

1. Customer value proposition, including target customer, the customer's job to be done, and the offering that satisfies the problem or fulfills the need.
2. Profit formula, including the revenue model, cost structure, margin model, and resource velocity (lead times, turns, etc.).
3. Key resources to deliver the customer value proposition profitably, potentially including people, equipment, technologies, partnerships, brand, and so on.
4. Key processes also include rules, metrics, and norms of behavior that make repeated delivery of the customer value proposition repeatable and scalable.²

Let us expand on each of these dimensions.

The customer value proposition gets much of management's attention insofar as it's front and center at the nexus of provider and customer. Kagermann and his coauthors rightly focus on the customer as a person (potentially a person in an organizational role) with a job to do or need to be filled. This orientation can help prevent against infatuation with a technology for its own sake, a “push” orientation toward innovation.

Profit formulas have become problematic in the age of “free” as a viable price point for many digital goods. Linux and Wikipedia have business models even though they lack profit formulas. Similarly, Microsoft and the New York Times Company have been forced to reinvent their business models by the presence of free alternatives. Even in traditional for-profit businesses, the scale of digital business can alter the business model landscape. Google is estimated to deliver 34,000 search results per second; Facebook reached a half billion users in six years. Radio took 38 years to ship 50 million units; the iPod took 3 years to hit the same milestone. Each of these four technologies has a distinctive set of profit formulas to fit its context.

In addition, profit formulas typically include a time scale: are key processes enacted in tenths of a second (Google), in days (luxury resorts), in decades (life insurance)? Charles Fine's notion of “clockspeed”³ has been redefined in the past decade by such developments as smartphone app marketplaces, Twitter feeds, and real-time status updates for social gaming at Sony, Microsoft, and Facebook. The speed of technology-driven change—which futurist and inventor Ray Kurzweil insists is getting faster*—stress-tests many organizations: Lucent, Sun Microsystems, and Motorola merely begin a list of companies dragged down in the vortex of rapid change.

Key resources are changing. Intellectual property, brand, and other intangibles matter in new ways (compare Amazon's patent portfolio to Xerox's), yet physical infrastructure is also scaling to new levels. For example, as we discussed, AT&T's wireless data traffic increased 5,000% in four years; few businesses have ever had to address that kind of growth at a national level. Leadership remains a scarce resource, as comparisons of Yahoo! and Google, or Microsoft pre- and post-Bill Gates's retirement show.

Key processes encompass a wide range of activities. Formal policies, informal cultural practices, operational choices, and measurement and incentive systems can each be a critical element in a venture's success. Note that repetition is listed as a goal: One-hit wonders are too often the norm in technology-driven businesses. Similarly, in an age of network effects, global reach, and cheap media, scale has become a strategic dimension in ways it might not have been in industries where growth occurred at a less frenetic pace.

Changing Minds, Changing Models

Even when the need is clear, however, changing a business model can be difficult. General Motors' template for labor costs, model changeovers, and brand management dates to the 1960s and did not adapt to new dynamics of competition, healthcare cost explosion, and consumer behavior; the company had to declare bankruptcy and rethink every aspect of its business after 2008. The music industry's bundling of songs into LP records worked for a few decades, but the model failed in the digital era, leaving the labels' economics and practices out of step with the market. Established air carriers' inattention to the low end of the market and to their own cost structures left them vulnerable to a new wave of budget airlines, such as EasyJet, Ryan Air, and Southwest.⁴ American Airlines used to be a star in the industry because of its pioneering use of information technology with the Sabre reservations system, but the company has struggled to turn a profit in recent years and finally declared bankruptcy in 2011.

Business models are less a strategy than a way of understanding the world and optimizing an entity's place in that world. As a cognitive “operating system,” as it were, business models must be widely understood and internalized by both employees or others inside the organization and by customers or other outsiders. For example, the Zappos culture, and its maniacal focus on customer service, is inextricably connected to the business's margin structure, which is premised on minimal discounting.

Similarly, Apple's App Store model provides an illustration where an idea rapidly took hold, enabling Apple to create a textbook example of a two-sided platform. (See Chapter 5.) No technologies were considered breakthrough: iTunes had conditioned people to download content and established a micropayment storefront, and the iPhone was well established (in the United States particularly) at the device level. But the business model change in how software was innovated and delivered to customers generated an entirely new industry, altering standard assumptions about channels, pricing, and developers.⁵

Henry Chesbrough, a business school professor now at the University of California, Berkeley, has studied business models for more than a decade. When looking at the path of technologies to market, he contends that these cognitive frameworks turn out to be as important as, if not more important than, the content of the technology itself. Nowhere is this more true than in the case of new (or what Harvard professor Clayton Christensen has elsewhere called “disruptive”) technologies: “[T]he technological management literature shows that firms have great difficulty managing innovations that fall outside of their previous experience, where their earlier beliefs and practices do not apply.” Chesbrough continues by noting that “Authors do not agree … whether the roots of that difficulty lie in characteristics of the technology itself, the management processes employed to manage it, or the means used to access the surrounding resources.”⁶

Disruptive Innovation

In each of the five industries discussed in subsequent chapters, at least part of the upheaval has been caused by one of Christensen's disruptive innovations. His model, which is nearly 15 years old, continues to explain parts of the technology and business landscape particularly effectively, so it is worth revisiting.

In normal times, innovations can accumulate gradually. Christensen calls this “sustaining” innovation, where the basic parameters are perhaps enhanced by a new flavor, or new packaging, or improved performance.⁷ Eventually in technology markets particularly, improvements eventually can outrun the capacity of the market to exploit them (for example, the overwhelming functionality of Microsoft Word, or 3-gigahertz Intel processors for people who do word processing and e-mail, not video transcoding). This tendency toward overshoot can be accentuated by so-called lead-user analysis, taking the point of view of “power users” as representative. Sustaining innovation is also a prime candidate for the trap of focus groups, which routinely both assert that they would pay for a new feature and deny the attractiveness of features that prove to be popular in the marketplace.

Sometimes, at the same time that sustaining innovation outruns market requirements, a new offering appears in the market. Disruptive innovations “fail” when compared head to head with an incumbent: Portable ultrasound machines lack the resolution and flexibility of conventional hospital-grade units, for example. But the disruptive innovation addresses a related set of user needs, without the heavy overhead and often at a radically low price: The portable ultrasound may cost only 5% of the incumbent. ING Direct introduced online banking that began with only simple savings accounts, limited physical branch structure, and extensive self-service technologies: It “failed” on complex products, in-person customer service, and certain types of convenience and reassurance. But the low infrastructure costs allowed ING Direct to pay well-above-market interest rates, making competition difficult for providers with expensive asset bases and complex processes to administer.

The combination of ease of use, low cost, and new competitive bases often allows the disruptive innovation to gather rapid market share growth, as in the case of MP3 audio files relative to physical compact discs: Audio fidelity may have been lower, but price, convenience, selection, and speed of distribution (given Napster and similar peer-to-peer services) were all superior.

A further factor in disruptive innovation relates to scale. What start out as niche markets are unappealing to large organizations, which (1) may already market a competing incumbent product and “know” nobody would want the less powerful offering, (2) resist both distraction from “core competences” and resource drains from proven winners, and (3) set high thresholds for return on investment and market size. Under a previous leadership team, managers at one large consumer products company stated that projected markets smaller than $100 million simply weren't worth pursuing.

That firm has now revised its managers' earlier assumption and found billion-dollar markets for new, disruptive products that started below that $100 million threshold. New technologies with (initially) small markets usually require small organizations, with tolerance for ambiguity, lean infrastructures, and low resistance to change as the business model evolves.⁸

Disruptive Innovation as Paradigm Shift

Christensen's many examples of disruptive innovation hold much in common with the cognitive transition explained by Thomas Kuhn in his landmark book, The Structure of Scientific Revolutions.⁹ Kuhn's “normal” science parallels sustaining innovation; the breakthrough, or “paradigm shift” in Kuhn's model, occurs with a change in mind-set rather than a brilliant invention. HP's pricing of inkjet printers to lock users in to high-margin resupply purchases of ink in proprietary packaging is a classic business model innovation that originated with a lifetime view of customer profitability (as well as some historical reflection on King Gillette), not in a lab.

Kuhn's paradigm shift is a change in the collective mind of a community: “[D]uring [scientific] revolutions scientists see new and different things when looking with familiar instruments in places they have looked before…. [P]aradigm changes do cause scientists to see the world of their research-engagement differently.”¹⁰ The same thing happens in disruptive innovation. Facebook Photos disrupt Kodak's physical (and even digital) printing business because the problem shifts from having photos to sharing them. Unmanned aerial vehicles focus on delivering weapons and surveillance capability where they are needed instead of investing heavily in evasive maneuverability (and a pilot) as the key asset.

It is difficult to overemphasize the point that cognitive reframing of the customer value proposition and the profit formula, in particular, constitute critical elements of successful technology deployments. Online grocery, for example, was dismissed as impossible, given the low margins of traditional grocery and the high costs of personalized picking and delivery. But if compared instead to pizza delivery (characterized by 50% margins, higher with beverages and side dishes), online grocery potentially can work if the key processes are designed according to delivery-centric rather than selection-centric criteria.

Looking Ahead

Every enterprise, from a lemonade stand on up, has a business model. In rapidly changing technology-driven markets in particular, however, it is not always clear that a firm has the business model it needs. For all the billions of dollars spent on research and development, many patents and other innovations fail to make it to market. As we study the five industries highlighted in the coming chapters, it becomes clear that mind-set and preconceptions matter decisively in most disruptions: Time and again, competitive rules of engagement, margin structures, and customer behavior were taken as given or as an entitlement. (The music industry resisted attempts to unbundle music from the album format, for example, even though consumers wanted songs they liked rather than a collection that included too many songs they didn't.)

To make business model change real, in addition to labs full of PhD scientists, many companies need change agents, people with flexible outlooks who can see problems from multiple perspectives. They also need to devise market solutions every bit as innovative as the hardware, molecules, or user experience. Finally, these change agents must be capable of that most difficult of tasks: changing other people's minds.

Notes

1. Michael Rappa, “Business Models on the Web,” http://digitalenterprise.org/models/models.html.

2. Mark W. Johnson, Clayton M. Christensen, and Henning Kagermann, “Reinventing Your Business Model,” Harvard Business Review (December 2008): 51–59.

3. Charles Fine, Clockspeed: Winning Industry Control in the Age of Temporary Advantage (New York: Basic Books, 1999).

4. See Henning Kagermann, Hubert Oesterle, and John Jordan, IT-Driven Business Models (Hoboken, NJ: John Wiley & Sons, 2010).

5. See Dion Hinchcliffe, “The App Store: The New ‘Must-Have’ Digital Business Model,” ZD Net blog, January 21, 2010, www.zdnet.com/blog/hinchcliffe/the-app-store-the-new-must-have-digital-business-model/1172.

6. Henry Chesbrough and Richard S. Rosenbloom, “The Role of the Business Model in Capturing Value from Innovation: Evidence from Xerox Corporation's Technology Spinoff Companies,” Industrial and Corporate Change 11, no. 3 (2002): 529–555.

7. Clayton M. Christensen, The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail (Boston: Harvard Business School Press, 1997), p. xv.

8. Ibid., p. 121.

9. Thomas S. Kuhn, The Structure of Scientific Revolutions, 2nd ed. (Chicago: University of Chicago Press, 1970).

10. Ibid., p. 111.

*The nine families are advertising, affiliate, brokerage, community, infomediary, manufacturer (direct), merchant, subscription, and utility.

*A Google search on the phrase “business model” returned 6.8 million hits in late 2010.

*Kurzweil famously contends that the rate of change is itself accelerating. See www.kurzweilai.net/the-law-of-accelerating-returns.