A Framework for Business Model Innovation Article · January 2004 1 author: B. Mahadevan 1 A framework for Business Model Innovation B. Mahadevan Indian Institute of Management Bangalore Bannerghatta Road, Bangalore, 560 076 INDIA. E-mail: [email protected] Ph: (91 - 80) - 699 3275 Abstract Innovation as a key enabler of value creation has been the subject matter for study by several strategy researchers in the past few decades. However, the notion of business model innovation has not been distinctly established in the previous studies. This paper seeks to fulfill this objective. We develop a framework for business model innovation using a two-fold process. On the one hand, we explore theoretical foundations of creating and sustaining competitive advantage of firms and deduce factors that play an important role in the process. On the other hand, we study 18 successful business models from a variety of sectors of industry in the US and identify key success factors. The study identifies several useful implications for practice. Our framework suggests that incumbent firms and start-ups differ vastly in their approach towards business model innovation. Moreover, the success of a business model innovation hinges closely on the degree of differentiation and the degree of sustainability that the business model innovation provides to the innovating firm. Keywords: Innovation, Business Model, Framework, Empirical Study I. INTRODUCTION To be successful businesses need to constantly engage in value creation for both the shareholders and the customers. Innovation has been recognised as one potential lever for value creation. Despite this simple truth, business leaders have often grappled with the issue of value creation over several years. Recently, innovation has been the subject matter of discussion by several researchers both in popular press and scholarly journals [1,2,3]. Alternative forms of innovation have been identified in the literature. These include market, product, process innovations [4] and technological innovation [5]. Earlier research on sources of innovation has generally classified innovations into Administrative Vs Technical or Product Vs Process. However, in our understanding, recently several firms have seldom deployed radical innovations in technology, product or the business processes to create value. This has renewed the interest in the subject and raises the fundamental question “what are successful companies leveraging on?” We show that these firms deploy business model innovation (BMI), a framework that creates a strategic positioning for a firm. BMI enables a firm to uniquely deploy available alternatives with respect to product, technology, process and markets with a view to create new value propositions and appropriate value arising out of the competitive advantage. We show in this paper that business model innovation is the current source for value creation and develop a framework for the same. Before we proceed further, we define the term value creation. By value creation, we mean the sum of all values that can be appropriated by participants in business transactions [6]. This research adds a few dimensions to the existing body of knowledge in the area. First, the notion of BMI has neither been explicitly recognised nor defined in the past. We provide a formal definition for BMI and develop a framework for the BMI process. Furthermore, we link the theoretical foundations pertaining to value creation to various components of a business model and show how in practice these ideas have found expression in the business models. Finally, we identify some implications for practice and identify areas that require further research. II. COMPONENTS OF A BUSINESS MODEL The term business model has been used widely among the practising community and consultants in a loose fashion. It is often linked to the revenue model or the operating model of the firm and is used to indicate how robust is the revenue potential of the business idea. Hamel [7] suggested that the high capitalisation of silicon valley firms could be due to the business model than the talent of the entrepreneurs. Kim and Mauborgne [8] took a narrower view of a business model. They defined business model with the objective of arriving at a pricing structure for the product. Amit and Zott [9] noted that the perspective of business model is absent in the academic literature. They define business model as a careful design of content, structure and governance of transactions so that it creates value. Venkatraman and Henderson [10] defined business model as a strategy pertaining to customer interaction, asset configuration and knowledge leverage. Mahadevan [11] defined a business model for an Internet based E Commerce using three components: value stream, revenue stream and logistic stream. Value stream is nothing but a list of tangible value propositions that a customer is likely to derive from the business. On the other hand, logistic stream will focus on various elements pertaining to asset control and configuring the supply chain. All the above definitions point to three important 2 ingredients of a business model: a need to understand the customer requirements, linking it to various operational choices to be made and activities (transactions) of the business and the need to include supply chain elements in the definition. based on the premise that innovation creates disequilibrium in the market paving the way for new value creation opportunities. McGrath et al. [19] argued that heterogeneity of a firm is likely to delay appropriation of rents in competitive markets by the competitors. Perhaps the closest definition for a business model stems from Markides [12]. According to Markides, every firm needs to position itself appropriately in a three dimensional strategic map comprised of who, what and why. The “who” element addresses the target group for the business. By appropriate identification of customers and their needs, it sets the stage for building the other components of the business model. Once the right target is identified, firms need to decide the exact nature of the value proposition that it needs to provide to the targeted segment. It may call for deciding the breadth and the depth of the offering, the level of interface required with the customer and the mode of offering. The “what” aspect of a business model addresses these issues. Once these components of the business model are established, the value delivery system could be configured. The “how” dimension of the business model addresses these issues. Configuring the operational aspects of the business would mean deciding on the type of product and process technology to be adopted, decisions on asset configuration, the extent and nature of interactions with other supply chain elements and overall operating system design. Therefore, degree of differentiation is an important element of innovation. Further, degree of differentiation is a good measure of assessing the value creation capability of an innovation. By degree of differentiation, we mean distinctiveness in the offering. Clearly, the “who”, “what” and “how” form the core elements of a business model. We see this definition of the business model to be broad. Further, it encompasses multiple perspectives suggested by other definitions. Therefore, in this study, we adopt this definition. Consequently, we define business model innovation as a strategic initiative to configure or reconfigure various elements pertaining to the three dimensions of the business model to enhance value creation potential of the firm and sustain it over a longer time. III. VALUE CREATION AND VALUE APPROPRIATION FROM AN INNOVATION The nature of innovation in firms has been broadly classified into three [13]: Administrative Vs Technical [14], Product Vs Process [15] and Radical Vs Incremental [16]. Technical innovation pertains to products, services and production process technology. On the other hand, administrative innovation involves organization structure and administrative processes. However, the notion of business model innovation has not been explicitly discussed in any of the previous studies. A set of highly homogenous firms in a sector of an industry has very little opportunity for value creation. The notion of creating value through innovation has well been articulated in the seminal works of Schumpeter [17,18]. Schumpeterian innovation-based competition is Firms operating in all sectors of industry go through a cycle of initial value creation (through innovation), value shrinkage (when competitors imitate the innovation) and value migration (identifying the next lever for value creation). Slywitsky [20] identified value migration paths in several sectors of industry and concluded that in order to be profitable, firms need to migrate their value propositions from time to time. Kim and Mauborgne [3] observed a similar phenomenon and proposed drawing value curves to identify when to start the next cycle of innovation. Rumelt [21] has shown that intra-industry differences in profits are greater than inter-industry differences, strongly suggesting the importance of firm-specific factors and the relative unimportance of industry effects. Clearly, one of the important firm-specific factors is the propensity to innovate. The variability in the propensity to innovate explains why firms experience persistent profitability to varying degrees. These studies lead to the proposition that in every firm innovation is a persistent activity required to remain competitive. However, persistent innovation is a necessary but not a sufficient condition for sustaining the profitability. Teece {5] argued that innovation and value appropriation might not go together. While innovation undoubtedly throws up opportunities for value creation, there are other factors that determine who benefits from the innovation. Similarly, McGrath et al. [19] argued that firms must establish distinctive competitive advantage before they could appropriate value out of an innovation. If they did not, rival firms appropriate the value. According to resource-based view (RBV), there are several resources in a firm that share properties such as scarce, unique, inimitable, durable, idiosyncratic, nontradeable, intangible and non-substitutable making them difficult to imitate [22,23,24]. These difficult-to-imitate resources may include a firm’s strategic assets such as its brand name, buyer-seller trust and other unique methods of marshalling the resources at its disposal. Ghemmawat [4] identified size and access as important factors in sustaining the competitive advantage. Lieberman and Montgomery [25] identified three mechanisms for enhancing first mover advantage. 3 Clearly, while innovation could trigger the process of value creation, the value that accrues to the innovating firm is dependant on its ability to sustain the innovation. Inimitability of resources, preferential access to resources, lock-in and switching costs determine the degree of sustainability of an innovating firm. The greater the degree of sustainability, the greater are the chances of appropriating value from the innovation. We argue that unless firms are able to exploit value creating and value appropriation opportunities fully, the innovation is neither successful nor logically complete. Therefore, the elements of a successful business model innovation would have factors that enable firms to both value creation and value appropriation. The development of a framework for BMI will be on this basis. However, before we develop the framework, we provide additional insights on the basis of an empirical analysis of several business models that we have observed in practice. IV. BUSINESS MODEL INNOVATION: AN EMPIRICAL ANALYSIS We present our overall analysis of 18 business models of 15 companies operating in the US. While 10 business models were those pertaining to start-ups (including Amazon, Cisco, Dell, Wal-Mart, Southwest Airlines, Charles Schwab and AOL), the remaining were those of incumbent firms (including GE, Corning, and Harley Davidson). The term start-up has a slightly different connotation in the paper. In this paper, we have made an attempt to analyse multiple business models of the same company. For instance, we analyse two versions of WalMart and two versions of Charles Schwab. In such cases, while analyzing the first version, we treat the company as a start-up and while we anlayse the subsequent versions, the same company is treated as an incumbent. We have clarified this in the revised version. The results used in this paper consist of the findings from a partial list of business models taken up for the study. For more details on the study, readers are referred to Deloitte research [26]. The business models were selected on the basis of an initial short-listing of companies using financial analysis data. From a shortlist of top performers in each segment, 16 companies were selected for detailed analysis. Using a structured approach for data collection each of these cases were classified on the basis of over 60 factors for preliminary analysis. Further analysis involved use of BMI conceptual framework to fit these cases, pattern synthesis and empirical generalisation. The study was aimed at understanding three main questions: (a) What are the internal and external drivers that cause or enable companies to innovate their business model? (b) How do companies configure various elements in the business model? Are there any discernable patterns in the strategies adopted? (c) How could companies ensure that their business models are sustainable over a period of time? We present some of our key findings pertaining to these below. A. Context for innovation Our analysis shows a pattern in the process that drives a business model innovation (Figure 1). First, firms experience value shrinkage due to existing market conditions. Homogeneity of business models in the sector of the industry and changing customer needs contributed much to the value shrinkage phenomenon. Except AOL all other firms were experiencing high degree of homogeneity of business models with that of the competition. Similarly, existing business models were not addressing the changing customer needs. For example, prior to Charles Schwab’s introduction of a “self-service multi-channel brokerage” model during early 1990s, there was none to address the needs of the investor community that was becoming increasingly diverse. Starbucks, on the other hand, responded to the growing demand for “café community”, a relatively unmet lifestyle need for high-quality yet affordable luxuries (such as gourmet ice cream, tennis shoes etc.). Figure 1 An analysis of the context for Business Model Innovation Competition issues Technology issues Value Shrinkage New Value Creation Strategies Changing customer needs Regulatory/ Economy issues Firm level issues Firms in our sample have gainfully exploited opportunities that enabled them to create dis-equilibrium in the market. Southwest Airlines and Charles Schwab responded to the changes in the regulatory framework and came with new business models in the respective sectors. Firms such as Amazon, Dell and Cisco could exploit new technology options for value creation. Similarly, Owens Corning made significant advances in optical fibre technology to grow into a diversified hightech manufacturer from a mere specialty glass manufacturer. In several of the incumbent firms, firm level competencies enabled new value creation strategies. One prominent example in our sample was GE. B. Business Model components The business models were analysed using the three dimensional framework (who-what-how). The firms in our sample exhibit several features that may enable firms not only to create value but also sustain them for a longer 4 time. They have achieved this by gainfully exploiting several factors identified in the literature for sustaining competitive advantage. While the “who” segment of the business model has provided sufficient scope to create dis-equilibrium in the market through innovative practices, the “what” and the “how” components have enabled the firms to deploy strategies to sustain the competitive advantage. Earlier research emphasized that inimitability of the business model plays a fundamental role in sustaining the competitive advantage for a longer time. The empirical study confirms these as we see several features that provide inimitability. Prominent among them is the variety of customer engaging alternatives deployed in the “what” component of the business model. The sustainability of Paychex’s BMI was anchored on the advantageous customer access that it achieved through greater opportunities of engaging the customer with their business. Similarly, asset control strategies and branding strategies are likely to play a significant role in inducing switching costs and provide benefits of lock-in. Harley Davidson could leverage on its brand equity among its loyal customers to promote Harley Lifestyle. On the other hand, BMI in Corning involved leveraging the existing strengths in product development and technology research as well as developing new supply chain linkages to outsource execution. Asset control strategies such as achieving a dominant position on critical assets required for the innovation and acquiring/licensing IP with the partners were important elements of Corning’s strategy. C. Sustainability of the innovation Past research seem to converge on a set of factors for sustaining competitive advantage. The business model component of each firm in our sample exhibits a combination of several of these. Wal-Mart, for example, took advantage of its valuable inventory management and distribution capabilities while innovating its second business model. Based on the detailed analysis of the factors that provided sustainability, we have identified four generic categories under which these fall: (a) Size based: The strategies deployed in the business model components are mainly arising out of size advantages. (b) Complimentary physical assets based: The competitive advantages stem in this case from physical assets that are essential for benefiting from the innovation. (c) Relationship based: In this case, the firms move from a mere transactional interaction to one of a relational mode. Over time, deep and lasting relationships are formed with the customers. (d) Tacit knowledge assets based: In addition to physical resources and deep relationships, firms have accumulated valuable experiences pertaining to operating in a unique mode arising out of business model innovation. This forms the core of the tacit knowledge assets of the firm. As we can see, the extent of imitability of these strategies decreases as we go down the list. While replicating large scale assets are possible (although not worthwhile in several cases), tacit knowledge assets can neither be sourced in the market nor developed overnight. We make several observations based on the analysis. First, very few have made use of tacit knowledge assets based strategies for sustaining innovation. On the other hand, the strategies are size oriented and in some cases relationship oriented. Second, incumbent firms have been able to exploit several advantages arising out of size, learning experience, asset control, supply chain reconfiguration and other resource-based strengths. In contrast, start-up firms have been able to create business models that are highly distinctive. These firms have developed new modes of developing deep linkages with the customer and operate in areas that are hitherto unknown or untested by the competition. Starbucks, Amazon, and Southwest airlines are some of the examples in our sample that demonstrate this method of innovation and value appropriation. D. A framework for business model innovation A successful business model innovation requires three important ingredients; recognizing the need to migrate the business model to the next cycle as value shrinkage occurs, exploiting new value creation opportunities for crafting the next business model and sustaining the innovation sufficiently long to appropriate value ahead of the competition through careful choices of the business model components. The basic structure of business model innovation that we propose is ground on this premise (Figure 2). The process is repetitive as diffusion of innovation happens over time. The context drives one cycle of business model innovation. During this stage, firms experience value shrinkage as business models are highly homogeneous. They look for alternative paths that enable them identify new opportunities for configuring various elements of the business model. Through such an innovation the firm creates dis-equilibrium and customers perceive distinctiveness in the offerings. The operational details of the nature of innovation are evident in various choices made in the core elements of the business model. Various alternative choices are employed in the “who”, “what” and “how” components of the business model. As we noted in the empirical study, these choices impact the sustainability of the model over time. These choices enable the firm to develop idiosyncratic insights, resources and routines out of innovation. Diffusion of innovation is unavoidable. At best, it can be postponed to a later time. Therefore the context will once again drive the next cycle of innovation. 5 Competition Context for BMI Technology Core Elements of BMI Target Customers Who Value Propositions What Regulatory & Economy Value Delivery System Changing customer needs Figure 2 A framework for Business Model Innovation How Firm Level issues These include, for instance, cultural and mind-set inertia, fear of disrupting existing channels, fear of cannibalisation, inability to manage different operational modes and loyalty to large sunk costs (pertaining to earlier operations). The incumbent firms experience path dependence while they engage in the next business model innovation. Therefore, incumbent firms have a compelling reason to consolidate their existing linkages (of customers and supply chain partners) and seek to provide them new value perceptions or strengthen the existing value perceptions. Therefore, it is likely that incumbent firms will find the deterrence mode more useful whereas new firms (with low market share and aggressive growth projections) will often employ war mode innovation strategies. Such a separation of strategies is hardly surprising. On the other hand, it is indeed natural. Sustainability In our study, we find that incumbent firms have been able to exploit several advantages arising out of size, learning experience, asset control, supply chain reconfiguration and other resource based strengths. On the other hand, the business models were less distinctive. However, even when the business model was less distinctive, they have been able to appropriate sufficient value on account of high degree of sustainability. We characterise this as deterrence mode of innovation. The primary value driver in deterrence mode innovation is the ability to induce switching costs to existing customers. This stems largely from economies of scale, monopoly control over critical resources and a control on the eco-system. In contrast, start-up firms have been able to create business models that are highly distinctive. Start-up firms do not have rich endowment of resources as incumbent firms to provide them high degree of sustainability. Despite this they were able to appropriate value due to high degree of differentiation of their business model. We refer to this as war mode innovation. Essentially, war mode innovations work from the other side. They reduce the switching costs to competitors’ customers and trigger them to embrace the new offering. Furthermore, through significant transactional efficiency increases, increased economies of scope (often due to use of IT based strategies for providing the value proposition) and developing intimate relationships with the newly found customers they bring in an element of uniqueness and strengthen their value proposition. War mode innovation helps a firm not only to appropriate value, but also prevent the competition from imitating for a period of time (primarily arising out of substantial investments in new relationships and exploiting resources outside the firm). Furthermore, start-up firms have the benefit of not having many of the disadvantages that an incumbent firm faces. Figure 3 Alternative value migration path in a BMI process High Degree of Differentiation V. MANAGERIAL IMPLICATIONS Based on these findings we propose five categories of innovating firms on the basis of alternative value migration paths that these firms pursue when they engage in a business model innovation exercise (Figure 3). We use degree of differentiation and degree of sustainability as the two dimensions on which we identify these categories. The first two are deterrence mode innovators and war mode innovators. We have already characterised these two categories. Low Suc Inn cessfu (W ovato l ar mo rs de) d en Tr ters t Se Followers Im ita t ors ul ssf ors de) e o c c at Su nov ce m In ren r ete (D Degree of Sustainability High Trend setters deploy new strategies that are promisingly good innovation ideas. They portray high degree of differentiation. However, without the required endowment of physical and knowledge assets they fail in appropriating value over time. Several Internet start-ups in the last five years belong to this category. However, some of the trend setters evolve into war mode once they experience first mover advantage arising out certain strategic pursuits after the innovation is out in the market. Some strategies do not appropriate value as they are not outcomes of genuine innovation but of limited tinkering 6 of competitors’ ideas. They are neither good in differentiating nor in sustaining “so-called” innovation. We characterise them as imitators. Finally, there is a category of followers. Several other firms take time to copy the innovation by suitably adjusting the innovation to their operating system. These are defined as followers. Followers play an important role in diffusing the innovation over time and triggering the next cycle of innovation. VI. CONCLUSIONS Innovative practices enable organisations to discover new value creation opportunities. In the past, several types of innovation have been found to be useful. BMI is a metalevel activity that provides a basis for deploying available options in technology, product, markets, supply chain alternatives and assets to provide unique advantages to the firm. We provide a formal definition and description of the BMI process from an analysis of business models found in practice. Alternative migration paths proposed in this study require considerable research and empirical verification. We suspect that firms are likely to switch from one migration path to another over time. It is important to know what factors drives this phenomenon. ACKNOWLEDGEMENT The conceptual foundations of this paper were evolved during a collaborative research work the author did with concultants of Deloitte Consulting, L.L.P, USA as a part of an assignment during 2001 – 2002. The author wishes to place on record the support provided by Mr. Mumtaz Ahmed and Mr. Douglass Tomlinson of Deloitte Consulting by way of joint discussions and sharing of data for the purpose of developing a framework for Business Model Innovation. REFERENCES [1] Drucker, P., 1998, “The Discipline of Innovation,” Harvard Business Review, 76 (6). [2] Stringer, R., 2000, “How to Manage Radical Innovation,” California Management Review, 42 (4), 70 – 88. [3] Kim, W.C. and Mauborgne, R., 1997, “Value Innovation: The Strategic Logic of High Growth,” Harvard Business Review, 75 (1). [4] Ghemmawat, P., 1986, “Sustainable advantage”, Harvard Business Review, 64 (5), 53 – 58. [5] Teece, D.J. 1986, “Profiting from technological innovation: Implications for integration, collaboration, licensing and public policy”, Research Policy, 15, 285 – 305. [6] Brandenburger, A.M. and Stuart, H., 1996, “Valuebased business strategy”, Journal of Economics and Management Strategy, 5, 5 – 25. [7] Hamel, G., 1999, “Bringing silicon valley inside”, Harvard Business Review, 77 (5), 70 – 84. View publication stats [8] Kim, W.C. and Mauborgne, R., 2000, “Knowing a Winning Business Idea When You See One,” Harvard Business Review, 78 (5), [9] Amit, R. and Zott, C., 2001, “Value creation in Ebusiness”, Strategic Management Journal 22, 493 – 520. [10] Venkatraman, N. and Henderson, J.C., 1998, “Real strategies for virtual organizing”, Sloan Management Review, 40 (Fall), 33 – 48. [11] Mahadevan, B., 2000, “Business Models for Internet-based E-Commerce: An anatomy”, California Management Review, 42 (4), 55 – 69. [12] Markides, C., 2000, “All the Right Moves: A Guide to Crafting Breakthrough Strategy”, Harvard Business School Press, 169 – 178. [13] Damanpour, F., 1991, “Organisational innovation: A meta analysis of effects of determinants and moderators”, Academy of Management Review Journal, 34 (3), 555 – 590. [14] Damanpour, F. and Evan, W.M., 1984, “Organizational innovation and performance: The problem of organizational lag”, Administrative Science Quarterly, 29, 392 – 409. [15] Utterback, J.M and Abernathy, W.J., 1975, “A dynamic model of process and product innovation”, Omega, 3, 639 – 656. [16] Nord, W.R. and Tucker, S., 1987, “Implementing routine and radical innovation”, Lexington Books, Lexington, MA. [17] Schumpeter, J. 1950, “Capitalism, Socialism & Democracy”, Harper, NY. [18] Schumpeter, J. 1934, “The theory of economic development”, Harvard University Press, Cambridge, MA. [19] McGrath, R.G, Tsai, M-H., Venkatraman, S. and MacMillan, I.C., 1996, “Innovation, competitive advantage and rent: a model and test”, Management Science, 42 (3), 389 – 403. [20] Slywitsky, A., 1996, “Value Migration”, Harvard Business School Press. [21] Rumelt, R.P. 1991, “How much does industry matter”, Strategic Management Journal, 12, 167 – 185. [22] Amit, R. and Shoemaker, P.J.H., 1993, “Strategic Assets and organizational rent”, Strategic Management Journal, 14, (1), 33 – 46. [23] Barney, J.B., 1991, “Firm resources and sustained competitive advantage”, Journal of Management, 17, 99 – 120. [24] Peteraf, M.A., 1993, “The corner stones of competitive advantage: A resource based view”, Strategic Management Journal, 14 (3), 179 – 191. [25] Lieberman, M.B. & Montgomery, B., 1988, “First Mover Advantages”, Strategic Management Journal, 9, 41 – 58. [26] Deloitte Research, 2001, “Business Model Innovation: Deconstructing the formula for uncovering value-creating opportunities in familiar places”, A competitive strategy study by Deloitte Consulting and Deloitte & Touche.
