A value-creation perspective
A Business Model (BM) indicates how an organization creates, delivers and captures value. Novel BMs can be a source of competitive advantage, and even disrupt an industry. In fact, BMs may have a more strategic implication than other forms of innovation like novel technology, Exhibit 1.
A business model is different from strategy. The former relates to value creation while the latter is about how to position competitively. Industries are equally prone to disruption by both new business and technologies. The intent of this brief is to highlight a few BMs that have been used to create a sustainable advantage with little or no novel technology. These cases highlight the fact that technological innovation is not a necessary condition for industry disruption; in fact, incumbents who are leaders in their respective industries need to be proactively looking for new business models that serve their customers better.
A firm can be thought of as an entity that buys inputs, transforms it into a product or service, and sells it to another entity or person. BMs can be broadly categorized based on the stage of their usage: while buying inputs, while transforming to a product / service or while selling. At the conversion stage, BMs include planned obsolescence, automation, and risk tuning. At the selling stage, a number of BMs have been employed including freemium, platform as a service, and disintermediation. At the buying stage, example BMs include sustainable sourcing and geography-specific sourcing. A broader list of BMs is given in Exhibit 2, and we elaborate on some of these BMs in this article.
Business Models at the Transform Stage
BMs at the “Transform” stage have lately cross pollinated across industries, resulting in major shifts in industry structures:
• Planned obsolescence: this model was popularized by GM in the 1930s, with their regular schedule for releasing new car models, sometimes with no major technology improvements but only different styling. This has been very successfully used in other industries including IT (the “Win-Tel” monopoly of Microsoft and Intel), cell phones (Apple), printers (HP) and is still used by the automobile industry. Then there are players that do the exact opposite – create a timeless design – and are doing just fine, like luxury cars (Rolls Royce) and watches (Patek Philippe); but the timeless approach won’t work well for most high volume, mid/low market segments.
• IP only: many companies in the electronics industry have gotten big based on the IP-only approach – e.g. ARM, Qualcomm, Tessera. They don’t actually make the end-products, rather preferring to develop and then license out the IP. This IP impacts a variety of everyday devices, including mobile phones, computers, audio systems, video game consoles, and TVs. Also there are patent assertion entities like Acacia that buy up patents from small-scale inventors and go after large companies for infringing on these patents.
• Automation – as a business model automation is being applied to areas like asset management - especially since research has shown that a majority of fund managers have worse returns than a market index. Robo-advisors are being offered as low-cost alternatives to fund managers, with comparable returns. Companies like Wealthfront, Betterment and Vanguard are active players in this space.
• Risk tuning – passing more risk to the buyer while increasing the returns is essentially what peer-to-peer lending platforms like Lending Club started out as. In addition, being online-only enabled them to pass cost savings from not having branches / stores. Performance over the past few years has been so good for these instruments that now even institutional investors are putting in huge sums as an alternative to savings accounts given the depressed interest rates.
• Cost leadership – companies like Walmart and Southwest have used cost leadership as the primary business model, and have put in place a number of strategies that work together to push the cost envelope. This means working across the buy-transform-sell processes, including optimizing supply chain, store footprints, pricing, and organization. Given the high growth in online retail, maintaining cost leadership will involve a new set of tactics by Walmart.
• Platforms – this model involves establishing a platform and allowing other entities and individuals to create useful products that work on this platform – this creates a symbiotic relationship that makes the platform even bigger and richer. Facebook, Salesforce, and app stores (Google, Apple) are examples – they allow developers to make software that can be sold on the platforms, pulling in even more users and pulling in revenues for both the platform and the developer. Zynga (a game developer) piggybacked on the Facebook platform and was able to scale up users rapidly – in return Facebook got more than 10% of its revenue from its relationship with Zynga.
• Increasing asset utilization: a recent wave of startups have aimed to identify and make available under-used assets, like office space (Liquidspace), lodging (Airbnb), and cars (Turo). Airbnb is already a top-5 lodging player in the US and could be the biggest in a few years. This has put significant pressure on the pricing tactics used by hotels, especially during peak times.
• On-demand services: the model is to create a base of service providers (usually individuals) and connect them with consumers; such a model allows for freelancers to work on their own schedule, and consumers to get help as needed. As companies like Uber have shown, this can put significant pressure on existing industries (Taxis, Limos). Such a model also exists with services like household help (Taskrabbit, Postmates), food delivery (Grubhub), and software development (Upwork). This model can also be leveraged by large companies in specific industries (e.g. fulfillment centers, fast food chains, last mile delivery).
• Content aggregation – what started off as a business model for newspapers and book publishers eventually spread to cable TV and now to the Digital world – e.g. streaming music (Spotify) and videos (Netflix). Spotify changed the business model from paying per song (iTunes) to paying monthly for ad-free listening – interestingly, any decline in traditional music sales was more than offset by increased streaming revenues to the artist / label. Netflix had previously helped bankrupt Blockbuster in DVD rentals, and now is taking on the TV industry by producing award-winning original content. Interestingly, the bigger value creation has been in content aggregation rather than content creation by individual entities – almost irrespective of the channel used (physical / digital); this value was mainly driven by scale and customer attraction / retention.
Business Models at the "Sell" Stage
A number of firms have distinguished themselves in value creation primarily by how they sell. A number of different BMs are possible in this regard:
• Platform as a service – much of the software and computing infrastructure is moving towards letting users pay periodically based on usage - e.g. Dropbox and Amazon Web Services (AWS). Services like AWS have been so popular that incumbents like IBM, Oracle and VM Ware are seeing decreasing market share and margins.
• Freemium – involves giving away a basic version that is free but charging for a feature-filled version, and used in a variety of industries like software (HR Block, Adobe), gaming (Angry Birds), IT (Box), and newspapers (NY Times). For companies like Box (cloud storage for enterprises), their products have low marginal costs, they maintain a high quality both in their free and paid version, and the free version is a way to convert free users to paying users and to attract other premium users. The newspaper industry has used this model in the last few years but the decline in print subscriptions and advertising revenue is still far greater than the additional revenues from their digital efforts.
• Lease – this model was popularized by Xerox to make its copiers more affordable. The renewables industry has adopted it for solar power – users pay a monthly fee to lease a system, and also reap the benefits of saving on their electricity bills. A modified version of leasing has been at play recently – e.g. Enlighted saves companies on its power bills by installing smart lighting; it gives away its hardware for free and recoups costs monthly from the customer based on the power saved.
• Razor & blade – starting with Gillette in the 1900s, this model has come a long way – an item is sold at or below cost in the hope that consumables for that item can be sold at a premium – this model is being used widely for gaming consoles (Microsoft, Sony), printers (HP), coffee pods (Green Mountain), e-book readers (Amazon Kindle), and mobile phones (AT&T, Verizon). Amazon Prime is a derivative of this model; customers pay a low upfront fee for a year of free 2-day shipping – more than 30% of US households have Prime, and the convenience prompts them to shop even more on Amazon.
• Disintermediation – with the rise of ecommerce, a number of business models for disintermediation are becoming more popular – e.g. direct to consumer (D2C) in consumer goods (Unilever), computers (Lenovo, Dell), cars (Tesla), and apparel / footwear (Under Armor, Nike). A handful of D2C apparel brands are getting good traction even though they are only sold online (Tobi). This model will negatively impact a number of traditional retailers, auto dealers, and malls unless they show a higher value proposition to consumers.
Business Models at the "Buy" Stage
There are many firms that use their buying model as the primary basis of value creation:
• Online to offline (O2O): the classic buy-side BM is that of a purchasing co-op, where individual members’ purchases are grouped together to create scale and drive deeper discounts from suppliers. Groupon in its early days followed a model of demand aggregation from individuals and enforced limited-time sign-ups, benefiting small businesses in off-peak times – this created value for all parties involved and made Groupon a leader in the O2O space. But slowly their model shifted to one of supply and demand aggregation with no time constraints; this increased value creation for Groupon but decreased value for small businesses.
• Sustainability: sourcing to improve sustainability has been around more as a corporate social responsibility rather than a business model. A few companies like Patagonia use it as their primary business model, and have created initiatives like the “1%” to pull in more corporate players. A number of retailers and food outlets are using organic foods as their primary BM, given that the organic market is growing at ~4X that of the overall food market (Whole Foods, Wegmans). Some companies focus on products free of chemicals and synthetics and has been a tough model to scale given recent controversies (e.g. The Honest Company).
• Geography: a geographic model is sometimes driven by the industry structure or from the need to portray a higher quality (e.g. made in America). Some companies like Chipotle have tried this model to emphasize local ingredients but at the expense of reduced purchasing scale and quality (as evidenced by an E. Coli outbreak at Chipotle).
In a company with multiple lines of business, each line might have its own model / value creation method – e.g. Apple embraces planned obsolescence for its hardware, platforms for its app store, and content aggregation for its music streaming services.
It is important for market leaders to experiment with business models actively. Else, there is always a threat of a competitor or a newcomer discovering the business model first and scaling up before market leaders can react in time.