Business Model Innovation
Entrepreneur Success Series
Resource Note # 4
In the last edition of SATTVA, we discussed the concept of innovation and its ten different types. Business Model which is also described by some as Profit Model or Revenue Model is one of the most important types of innovations. Hence, we decided to include Business Model Innovation as a special component of Entrepreneur Success Series. We begin with a brief overview of the concept of Business Models.
1. Business Model
Business model refers to the logic of the firm, the way it operates and how it creates value for its stakeholders. Magretta (2002) defines business models as ̳stories that explain how enterprises work. Business models describe, as a system, how the pieces of a business fit together.‘ A business model articulates the logic and demonstrates how a business creates and delivers values to customers. Business model also outlines the architecture of revenues, costs, and profits associated with the business.
Founded in 1841 in Italy, Nuovo Pignone’s product portfolio till 1990 was characterized by machineries and equipment for the oil industry, chemical-oil and nuclear industry; pressure equipment and heat exchange; control valves, fuel dispensers and measurement of gas; industrial control systems and information systems for network services. In June 1994 General Electric (GE) acquired Nuovo Pignone. Till then Nuovo’s business model was manufacturing oriented. In 1997 GE decided to reshape Nuovo‘s business model, enhancing the service function. At that time the service function was considered as a ―necessary evil‖.
It was realized that, from a revenue point of view, the service business was a business with a 50% margin, against the 20% on machines. In those years, in the oil and gas industry big companies were trying to scrap all non-core activities like maintenance. The top management of Nuovo Pignone understood this new opportunity. What followed was a new business model transforming Nuovo Pignone from being a traditional product oriented organization focused on selling machines, to a company providing complete solutions to Up-Stream, Mid-Stream, Down-Stream and Distribution customers.
(Source: Casprini, E. (2013-14). Business Model Innovation: Drivers, Processes and Capabilities.Ph.D Thesis, ScuolaSuperioreSant’ Anna di StudiUniversitari e di perfezionamento. Available: http://www.phdmanagement.sssup.it/documenti/awarded/casprini_thesis.pdf)
According to Casadesus-Masanell and Ricart (2009), business models comprise two different sets of elements: (a) the concrete choices made by management on how the organization must operate, and (b) the consequences of the choices. They explain the concepts of choices and consequence with the example of Ryanair, the low cost European Airline.
In the early 90s, Ryanair‘s top management considered four alternative plans of action to comeout from near bankruptcy: (1) become the Southwest of Europe, (2) add business class, (3)become a ―feeder‖ airline operating from Shannon‘s airport, or (4) exit the industry. Each of thefirst three options entailed a different business model, a different logic of the firm, the way it operates and how it creates value for its stakeholders. ̳Becoming the Southwest of Europe‘ waschosen as a strategy as opposed to adding business class or operating as a feeder airline. The resulting new Ryanair, with its new logic, new way to operate, and new way to create value for its stakeholders, worked with a new business model.
Important choices in Ryanair‘s business model include: flying to secondary airports, lowest ticketprices, low commissions to travel agents, standardized fleet of Boeing 737s, treating all passengers equally, high-powered incentives, no meals, nothing free, spartan headquarters, and no unions.
According to Casadesus-Masanell and Ricart, while evaluating a business model one should look for ‘virtuous cycles.’ In the case of Ryanair, examples of virtuous cycles are:
Virtuous cycle 1: lowest fares – large volume – bargaining power with suppliers – [low fixed cost] – lowest fares -…
Virtuous cycle 2: lowest fares – large volume – high aircraft utilization – [low fixed cost/passenger] – lowest fares – …
Virtuous cycle 3: lowest fares – low quality service expected – no meals – low variable cost – lowest fares – …
2. Building Blocks of Business Model
Alexander Osterwalder and Yves Pigneur outline nine building blocks of business models. They propose a business model canvas as shown in Exhibit 1.
(i) Customer Segments: For whom are we creating value? Who are our most important customers? What are their defining characteristics?
(ii) Value Propositions: Which customer needs are we satisfying? Which of our customer‘sproblems are we trying to solve? What benefits are we offering? What bundles of products & services are we offering to each customer segment?
(iii) Channels: How do we raise awareness about our company‘s products & services? How dowe help customers to evaluate our value proposition? How do we allow customers to purchase specific products & services? How do we deliver a value proposition? How do we provide after sales support?
(iv) Customer Relationships: What type of relationship does each of our segments expect from us such as personal assistance, self – service, automated services, communities, co-creation etc?
(v) Revenue Streams: What type of transaction revenue (one – time payment) do we expect? What type of recurring revenue do we expect? How do customers prefer to pay (asset purchase, usage fee, subscription fee, licensing, renting / leasing, brokerage, advertising etc)?
(vi) Key Resources: What type of key resources do we need (physical, intellectual, informational, human, financial) to create, deliver, communicate & capture value?
(vii) Key Activities: What key activities do we need to create, deliver, communicate & capture value?
(viii) Key Partnerships: Who are our key partners for acquisition of key resources? Who are our key partners for performance of key activities?
(ix) Cost Structure: What are our most important fixed and variable costs? Which key resources are most expensive? Which key activities are most expensive?
3. Business Model Innovation
According to Chesbrough (2010) companies commercialize new ideas and technologies through their business models. The same idea or technology taken to market through two different business models may yield two different economic outcomes. Hence it is important for companies to develop the capability to innovate their business models. However, companies have many more processes, and a much stronger shared sense of how to innovate technology, than they do about how to innovate business models.
Business model innovation can be described as “the search for new logic of the firm and new ways that redefine the value proposition, how it is delivered and how value is captured.” As compared to other types of innovation, business model innovation involves large-scale change efforts that are often difficult to imitate and hence can result into sustainable competitive advantage. Business-model innovations change the economics of the value chain, diversify revenue &/or profit streams, and/or modify delivery models.
As smart phones and mobile apps threaten the conventional industries, business-model innovation has become all the more urgent: established companies must reinvent their businesses before technology-driven upstarts do. But most big companies are reluctant to risk tampering with theircore business model until it‘s visibly under threat. Besides, too many fixed routines and cultural factors can get in the way. In a 2014 survey of 1500 senior executives conducted by Boston Consulting Group across the globe, 94% reported that their companies are engaged in business model innovation to some degree. But only 27% said that they were actively pursuing it.
4. Framework for Business Model Innovation
In every industry, at a given point in time, there are long held beliefs about key components of business model and the manner in which an organisation makes money. For example, according to de Jong and van Dijk (2015) of McKinsey, in telecommunications, customer retention and average revenue per user are seen as key to making money. Success in pharmaceuticals is believed to depend on the time needed to obtain approval from the regulators. Innovation in business model can take place by challenging such governing beliefs.de Jong and van Dijk suggest following steps to challenge the dominant beliefs.
4.1 Outline the dominant business model in your industry.
All core elements of a business model can be clubbed into four key categories: customer segments & value proposition, channels, key activities & resources and financials. Each element of the business model needs to be examined systematically by asking: what are the long-held core beliefs about them.
(i) Customer Segments and Value Proposition
Who are our most important customers? Will they continue to remain important in future? Are there any new untapped / underserved segments, which we can tap?
What benefits are we offering to the customers and at what price? Will customers continue to value these benefits in future? Will the customers continue to pay the price that we charge?
In 2010, when Mark Bertolini became CEO, Aetna had 22 million medical policyholders, making it the third-largest player in the highly conservative health insurance business in USA. The Fortune 100 company appeared to be in a strong position: It had grown even during the 2008–2009 recession, when millions of people lost their jobs and their employer-provided health insurance, and it was prospering in the wake of the 2010 U.S. Affordable Care Act, whichimposed significant industry reforms. By the end of Bertolini‘s first year at the helm, Aetna had achieved a 38% surge in year on- year net income. Yet Bertolini began to realize that despite its profitability, the business of health insurance in its current form would soon disappear, to be replaced by a whole new way of making money that focused on servicing health care‘s consumersand providers.
Historically Aetna‘s customers were mainly large organizations—corporations, governments, universities, and other employers. Typically one person or a small department in each chose thehealth plan or plans for the entire organization. Thus, one of Aetna‘s core competencies wasselling plans to those intermediaries, rather than to the ultimate consumers.
Benefits managers and policy brokers look for ways to demonstrate value to their organizations— which had come to mean offering employees something “new.” The process inevitably gave riseto policy features that few members used in a given year but that generated higher and higher premiums. It also resulted in one-size-fits-all plans, with individuals unable to choose the coverage that was best for them.
Bertolini recognized that the needs of his primary customers—benefits managers—were not as urgent as the needs of the insured. Indeed, catering to those middlemen was backfiring. Employers and consumers alike were starting to actively shop for health care services, and they were growing increasingly sensitive to price. The Affordable Care Act had drawn public attention to the enormous cost of health care and its impact on the global competitiveness of U.S. firms. Employers had begun to shift health care costs to their employees, offering plans with high deductibles and out-of-pocket expenses at the point of care.
To remain a major player, Bertolini realized, Aetna would have to develop products and services that directly targeted the affordability needs of end consumers. This was the heart of the powerful case for innovation. It required a strategic shift over time from being strictly a B2B company to becoming a B2C company as well.
(Source: Bertolini, M., Duncan, D. S. and Waldeck, A. (December, 2015). ‘Knowing When to Reinvent.’ Harvard Business Review.) ______________________________________________________________________________
How are we delivering the products & services? How do we provide after sales support? How are we communicating the value to our customers? Can we change the value delivery&/or value communication methods in such a way that will improve our market performance? ______________________________________________________________________________
When Dell introduced its build-to-order model, it kept selling computers (i.e. it did not change the customer engagement/value proposition or unit of business), but it changed the channel. This was a big change in the way the computers were sold. This model also changed the monetization: customer would order and pay for a computer before Dell even built it. A consequence of it was to be able to manage the inventory in a more efficient manner, reducing the costs of obsolescence, and that turned in to an advantage in the computer makers industry.
(iii) Key Resources, Activities & Partnerships
What type of key resources & activities do we need (physical, intellectual, informational, human, financial) to create, deliver, communicate & capture value? How these key resources are changing with time?
Who are our key partners for acquisition of key resources? Who are our key partners for performance of key activities? Are these partners most effective & efficient options?
As discussed in example 1, addition of the service component to the existing offering at Nuovo Pignone, was done in two ways. First, a new, ad hoc, division dedicated to the service function was opened. First, 120 salesmen were hired. Second, some ̳trusted‘ people were identified and involved in helping shape the attitudes of Nuovo Pignone‘s employees towards services.
The company began to provide new service packages: Basic Service, Upgrades & Rejuvenation and Gold Service. The Basic Service includes selling only the parts every time a client needs them (i.e. it was the traditional service model, as existing at the time of acquisition by GE). The Upgrades & Rejuvenations includes the replacement of product or components in order to improve the performance. As per the contract, the client pays an annual fee while Nuovo Pignone guarantees specific performance. Under the Gold Service, long term service agreement contracts were developed. The idea of providing long term service agreements was linked to the development of the LNG plants. Facing a new (and highly uncertain) technology, the clients were sceptical about the adoption of LNG plants. Hence, Nuovo Pignone came up with a revenue model that postponed the payment to the satisfaction of the clients: ̳first try it and if it works thenyou pay‘. This approach turned to be successful. Big clients such as Exxon and Chevron that were unaware of the capabilities of Nuovo Pignone, were reassured by this approach: the fact that GEwas investing into the oil and gas industry and was providing ̳no risk‘ contracts, reassured them.Acquiring the trust of clients was crucial in the transition phase. Huge investments were made in learning (e.g. the Service Field Academy) and other assets. Presence of Nuovo Pignone at global level was strengthened: In 2000, 90% of employees were in Italy. The company needed to be present and visible also in markets such as US, Latin American and Middle East.
In 2012, due to the strategic envisioning of the holding, GE created General Electric Oil and Gas division and integrated Nuovo Pignone in it. Today GE Nuovo Pignone is an advanced technology equipment and services company that serves all segments of the oil and gas industry from extraction to transportation to end use. The Nuovo Pignone headquarter was moved from Florence to London in 2014. This shift has been perceived as the “natural” end of a process.(Source: Adapted from Casprini, E. (2013-14).Op.cit.)
(iv) Financials: Revenue Streams & Cost Structure
What type of transaction revenue (one-time payment) do we expect? What type of recurring revenue do we expect? How do customers prefer to pay (asset purchase, usage fee, subscription fee, licensing, renting / leasing, brokerage, advertising etc)?
What are our most important fixed and variable costs? Which key resources are most expensive? Which key activities are most expensive? ______________________________________________________________________________
The dominant belief in telecommunications industry has been that value is best captured through economies of scale—the more telephone minutes sold, the lower the unit cost. As a result, the larger the mobile-phone plan, the lower the cost per minute. Reliance Industries of India seems to be challenging this belief. While launching its 4G services under the brand name “JIO” the company has started to offer free voice calls by focusing its economic model on making money from data usage and from its investments in a huge data network and storage capacity. Such plans eliminate confusion among customers and increase their satisfaction. Probably the new plan is based on the realization that unlimited use of voice and texting units comes at no additional cost to itself, so it can compete against emerging voice-over-IP competitors.
4.2 Dissect the most important long-held belief into its supporting notions.
How do notions about customer needs and interactions, technology, regulation, business economics, and ways of operating underpin the core belief? For instance, financial-services players assume that customers prefer automated, low-cost interfaces requiring scale. Because the IT underpinning financial services has major scale advantages, most of a provider‘s cost base isfixed. Furthermore, the appropriate level of risk management is possible only beyond a certain size of business.
4.3 Turn an underlying belief on its head.
Formulate a radical new assumption about the core elements of your business model. The assumptions may be such that no one wants to believe it currently in your industry. For instance, what if a financial-services provider‘s IT could be based almost entirely in the cloud, drastically reducing the minimum economic scale?
4.4 Sanity-test your reframe.
Not all the assumptions made will make sense. One of the ways of testing your new assumptions / beliefs is to look for evidence of its success in another industry. This may enhance your prospects of hitting on something that makes business sense. Business-model innovations, unlike product and service ones, travel well from industry to industry. For example hotel booking start up Airbnb inspires taxi aggregator Uber, which in turn inspires Peer by, an app for retailing. ______________________________________________________________________________
de Jong and van Dijk of McKinsey cite example of a big European maritime port that embarked on a large scale land-management program. The industry belief reframed by the port was that large liquid-bulk-load ships valued private access to storage tanks. The underlying assumption was that shipping companies wanted the ability to deliver their bulk loads anytime and therefore required entry to their tanks at close range.
In response to this perceived need, most maritime ports have developed jetties to which they provide individual shipping companies private access— essentially the equivalent of “ownership.” As a result of each company‘s varying schedules and traffic, many jetties ended up being mostly unused, but others weren‘t sufficient for peak times.
Seeing this problem, the port‘s management reframed the industry belief by asking if customers cared more about access on demand than exclusivity. The port now intends to help all customers use any jetty to access any fuel tank, by developing a common-carrier pipe connecting them. The maritime port is making more of underutilized jetties and storage tanks by shifting the business model so that shipping companies pay for access to jetties and storage rather than the exclusive use of them. This model seems similar to Airbnb, the hotel booking chain or taxi operator Uber. (Source: de Jong, M and van Dijk, M. (July 2015). ‘Disrupting beliefs: A new approach to business-model innovation.’ McKinsey Quarterly.)
4.5 Translate the reframed belief into your industry’s new business model.
Typically, once companies arrive at a reframe, the new mechanism for creating value suggests itself—a new way to interact with customers, organize your operating model, leverage your resources, or capture income. Companies then need to transition from their existing business model to the new one. While doing so companies need to be aware of barriers to business model innovation.
Novelty, complementarities and efficiency which are key aspects of business model innovation may often conflict with the more traditional configurations of firm assets, whose managers are likely to resist experiments that might threaten their on-going value to the company. A vice president of a field sales organization, for example, might take strong exception to experiments with online sales of the same products, whether they are successful or not.
According to Christensen (1997) there exists a conflict between the business model already established for the existing technology, and that which may be required to exploit the emerging, disruptive technology. Typically, the gross margins for the emerging one are initially far below those of the established technology. The end customers may differ, as may the necessary distribution channels. As the firm allocates its capital to the most profitable uses, the established technology generally gets disproportionately favoured and the disruptive technology starved of resources.
According to Chesbrough the success of established business models strongly influences the information that subsequently gets routed into or filtered out of corporate decision processes. But following it too slavishly can lead firms to risk missing potentially valuable uses of their technology when they do not fit obviously with their current business model.
Bertolini, M., Duncan, D. S. and Waldeck, A. (December, 2015). ̳Knowing When to Reinvent.‘Harvard Business Review
Casprini, E. (2013-14). Business Model Innovation: Drivers, Processes and Capabilities.Ph.D Thesis, ScuolaSuperioreSant’ Anna di StudiUniversitari e di perfezionamento. Available:http://www.phdmanagement.sssup.it/documenti/awarded/casprini_thesis.pdf
Chesbrough, H. (2010). ‘Business Model Innovation: Opportunities and Barriers.’Long RangePlanning, Vol 4.
Christensen, Clayton M. (1997). The innovator’s dilemma. Boston,Massachusetts, USA: Harvard Business School Press
de Jong, M, Marston, N and Roth, E. (April, 2015). ̳The eight essentials of innovation.‘
de Jong, M and van Dijk, M. (July, 2015). ‘Disrupting beliefs:A new approach to business-model innovation.’ McKinsey Quarterly.
Osterwalder, A. and Pigneur, Y. (2016). Business Model Generation. New Delhi: Wiley India.