Surviving or Thriving? - Business model innovation - Six questions

Most large companies have survived the recession of the past five years surprisingly well. According to a recent Wall Street Journal analysis, S&P 500 firms cumulatively have higher revenues, higher profits, and higher employees in 2011 than they had in 2007, before the recession started. Interestingly, most of the 1.1 million jobs they added, however, were added oversees. But overall, it seems like everybody has done their homework of optimizing processes, carefully watching costs, and executing well.

In the meantime, a few companies ran away with it. Apple’s net income was generally under $1 billion (and sometimes negative) for fifteen years, between 1990 and 2004. In the last seven years, that curve exploded, to a 2011 net income of over $25.9 billion. Not surprisingly, it is now the most valuable company in the world, and its stock price has appreciated close to 5,000% over the last twenty years. You can’t do that with tweaking your processes and watching your costs. You have to pretty fundamentally change your strategy.

A recent article in the MIT Sloan Management Review argues that Apple is reaping the benefits of some smart changes in its business model that it implemented starting in 2001, with the introduction of the iPod. This article, “Creating Value Through Business Model Innovation,” by Raphael Amit (a Wharton professor) and Christopher Zott (an IESE professor), is part of a series of articles in the MIT SMR Spring 2012 issue around the topic of strategy in changing markets. I highly recommend it.

I have written before on this blog that business model innovation seems to be a “topic du jour” in strategy literature. This is definitely one of the more insightful articles on this topic. Amit and Zott offer two interesting frameworks.

First, there are three key design elements to a business model. Business model innovation can incur:

• By adding novel activities (“content”). Examples: Forward integration or backward integration in general, IBM getting into consulting services, Apple getting into music distribution, eBay buying PayPal, etc. If you go way back into business history, this also gets to the famous shaver and blades examples – or coffee machines and coffee packages to be more up-to-date.
• By linking activities in novel ways (“structure”). The example that the authors mention here is Priceline, which links hotels and airlines with credit card companies and reservation systems in a novel way. Or Apple linking software developers with end users through its App Store.
• By changing one or more parties that perform any of the activities (“governance”). Examples here: Franchising was a way for 7Eleven Japan to get around very strict Japanese retailing regulations. Or several magazine companies in the US have formed a joint venture called Next Issue Media to capture online opportunities more effectively. I think there could actually be a number of interesting examples where companies let end-users take over some of the activities (e.g. product configuration, assembly, customer service, etc.), rather than specialized service providers.

All of that makes sense. But this broad framework of content, structure and governance could also include a bank that decides to sell funeral benefits insurance through its branch network. This could be broadly categorized as a business model innovating using the criteria above, but it will hardly revamp the bank’s entire business, nor will it propel the bank’s share price to a 5000% increase. So clearly, some business model innovations have more of a fundamental impact than others. How can you evaluate that, and how can a strategist zero in on those that really matter? Here is where the author’s second framework comes in.

The value drivers of business model innovation are:

• Novelty: To what extent are the activities performed, and the combination of activities, truly innovative?
• Lock-in: To what extent does the business model create switching costs or enhance incentives for participants to stay and transact within the system?
• Complementarities: To what extent are the various linked activities value enhancing to each other? For example: PayPal services provide a significant value added to eBay sellers/buyers, and the volume of eBay transactions provides a significant degree of critical mass to establish PayPal as a payment platform.
• Efficiency: To what degree can cost savings be achieved through interconnections of activities?

There is some interesting material, and a few examples, on each of these points in the article. Interestingly, a number of other articles pick up on these various points. An excellent example of how to actually measure “lock-in” effects can be found in an earlier MIT SMR article (Why Dominant Companies are Vulnerable, link). And a recent Harvard Business Review article (When One Business Model Isn’t Enough, link) provides details on the topic of complementarities. It describes how Chile’s airline LAN operates three quite distinct business models (long-haul passenger business, domestic low-cost airline, and international cargo operations), discusses to what extent these businesses are complementary, and reviews what is important to managing this system of activities effectively.

I believe that understanding these value drivers is really critical to effectively design a strategy in today’s economy. Porter’s five forces framework captured the essence of strategy in the 80s, when most companies produced widgets for a stable, national market. In today’s economy characterized by services, heavy software/IT elements, close cooperation among multiple players, global competition, and rapid changes in the market environment, somebody will at some point come up with a framework that rivals Porter’s in relevance. I’m not sure that the four points above is necessarily that framework. But I’m sure it will be linked to some extent to strategically designing a business system around key value drivers.