BUSINESS_MODELS
.pdfBUSINESS MODELS, BUSINESS STRATEGY, AND INNOVATION '
A Note
David J. Teece
Institute of Management, Innovation and Organization
Haas School of Business
University of California, Berkeley
Berkeley, California, 94720
November 17,2008
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1 I would like to thank Michael Akemann, John Blair, Hank Chesbrough, Doug Kidder, and Richard Rumelt for helpful insight into the issues discussed here.
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I.Introduction
Whenever a business is established, it either explicitly or implicitly employs a particular business model. A business model describes the design or architecture of the value creation, delivery, and capture mechanisms employed by the business enterprise. The essence of a business model is that it defines the manner by which the business enterprise delivers value to customers, entices customers to pay for value, and converts those payments to profit. Put differently, a business model reflects management's hypothesis about what customers want, how they want it, and how an enterprise can best meet those needs, and get paid for doing so.
Business model design involves assessments with respect to determining: (1) the identity of market segments to be targeted; (2) the benefit the enterprise will deliver to the customer; (3) the technologies and features that are to be embedded in the product and service; (4) how the revenue and cost structure of a business is to be 'designed' (and if necessary 'redesigned') to meet customer needs; (5) the way in which technologies are to be assembled and offered to the customer; and (6) the mechanisms and manner by which value is to be captured, and competitive advantage sustained.
In short, a business model defines the organizational and financial 'architecture' of a business (Chesbrough and Rosenbloom, 2002). The business model makes implicit assumptions about the behavior of revenues and costs, the nature of user needs, and likely competitor behavior. It outlines the logic required to earn a profit, if a profit is available to be earned. Once adopted the business model defines the way the enterprise 'goes to market.'
These design issues are even more basic than the fundamental question asked by business strategists - which is how does one build a sustainable competitive advantage. Nevertheless, the design of business models and the choice of strategies are interrelated. The purpose of this note
2 There does not seem to be any one definition of a business model. Amit and Zott define a business model as "the structure, content, and governance of transaction" between the focal firm and its exchange partners [e.g. customers, vendors, complementors] (Amit and Zott, 2001; Zott and Amit, 2008). For alternate definition see Chesbrough and Rosenbloom, 2002.)
is to understand the significance of business models and explore connections to business strategy and innovation management.
Business models have been integral to trading and to economic behavior since business first began. Early traders had to decide who would absorb the risk associated with shipping goods from A to В (would the trader ship on consignment; would the traders buy on their own account and take the risk of sale; would traders seek to buy some kind of insurance or self insure; and how would goods be shipped [own transport or third party shipping company] etc.)
Despite lineage going back to pre-classical times, business models have been catapulted into public consciousness only during the last decade or so. Driving factors include the growth of the internet and e-commerce, and the restructuring of the financial services industry in the US and elsewhere.
With the growth of the internet, businesses not only obtained a different channel of distribution, but in some industries (e.g. music) some companies (the recording companies) had to completely re-think their business models, in part because of the ubiquity of illegal digital downloading. In addition, internet companies themselves have to design new revenue models. Indeed, with the dotcom boom and bust during 1998-2001, many new companies came to the securities markets with zero or negative profits (and unprecedentedly low revenues) seeking high valuations, which the capital markets seemed, at least for a while, willing to provide. Promoters managed to persuade investors that traditional revenue and profitability models no longer applied - and that the dotcom companies would find new and larger sources of revenue, e.g. advertising. This turned out to be true only in only a few cases.
With the recent tumult in financial markets, many accepted business models in investment banking and in investment management have likewise been abandoned, or are in the process of being significantly modified. Common practices with respect to leverage and risk turned out to be unsustainable when confronted with significant declines in real estate related asset prices in many countries around the globe.
Good business models yield value propositions that are compelling to customers, achieve advantageous cost structures, and enable significant value capture by the enterprise. In short, "designing" a business correctly, and figuring out and then implementing a commercially viable architecture for revenue, costs and profits are critical to enterprise success. Superior technology and products, good people, and good governance and leadership are unlikely to produce sustainable profitability if the wrong business model is in place.
II.Theoretical Foundation of Business Models
There is no place in economic theory for business models, and, there is not a single scientific paper in the mainstream economics journals that analyses or discusses business models. The absence of consideration of business models in economic theory probably stems from theoretical constructs that have markets solving the problems that (in the real world) business models are created to solve.
In a hypothetical Arrow-Debreu economy - with fully developed spot and forward markets, strong property rights, the costless transfer of information, and no innovation - business models don't have utility.3 In most theoretical models of market economies, one can capture value by
simply selling ones output in markets---------which are assumed to exist for everything. In this theoretical construct, there is no need or benefit from bundling products or using loss leader or razor/razor blade approaches to pricing, as rational informed customers will always perceive and pay for value. Put differently, with perfect (one-sided) markets for everything, and an absence of "public" goods, business models are quite simply redundant. Producers/suppliers can create and capture value simply through disposal of everything and anything in markets at market prices. There is no need to worry about the architecture of revenues and costs, or about mechanisms to capture value, the price system does it all, so one never has to contemplate the logic of the business as the simplifying assumptions of economic theory make such logic simple and self evident.
J As Arrow notes, "in a strictly technical and objective sense, the price system does not work. You simply cannot price certain things - (p.22) and "trust and similar values, loyalty and truth telling - are not commodities for which trade in the open market is technically possible or even meaningful . . . (p.23). "A firm . . . provides another major area within which price relations are held in partial obeyance ... (p.25).
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But the theoretical model of general equilibrium and perfect competition is a caricature of the real world. Intangible products are ubiquitous, two-sided markets are common, and customers don't just want products; they want solutions to their perceived needs. Accordingly, in the real world, entrepreneurs and managers must give close consideration to the design of business models . . .
even if they are dealing with the production of pure commodities.
It's also true that in a planned economy, just as in a perfectly competitive Arrow-Debreu economy, business models do not have a place. Planners do need to understand steps in the value chain; but in a supply driven system where consumers get what the system produces, business models aren't necessary either. There is no problem in capturing value because value doesn't have to be captured; the state decides what to produce and provides investment dollars.
Put differently, business models are features of market economics where there is consumer choice, transaction costs, and heterogeneity amongst consumers. Profit seeking firms endeavor to meet variegated consumer wants through the constant invention of new value propositions. New business models can represent a form of innovation, as indicated earlier; but they also are necessitated by technological innovation which creates both the need to bring discoveries to market and the opportunity to satisfy unrequited customer needs. Clearly, the business model "problem" is relevant in market based economies in which there is consumer sovereignty but in which markets are not perfectly competitive.
III.Examples of Business Models
There is a plethora of business model possibilities. Some will be much better adapted to the business ecosystem than others. Selecting, adjusting, and/or improving the business model is a complex art. The "problem" is likely to be highly situational. As noted, the creation of business models is a form of innovation itself.
A wide variety of business models are observed in the economy. Just a few archetypes/examples are described below. The literature has not yet provided an accepted taxonomy. There is no attempt to be comprehensive.
Sears Roebuck invented a new distribution channel: mail order catalogue shopping. The Sears catalogue was especially important to rural customers. Other mail order catalogues followed. A century later companies like Amazon.com took the concept on-line for books. Webvan likewise tried to pioneer on-line grocery shopping, but the initiative failed as it did not achieve anywhere near breakeven volume.
The "razor blade model" is another classic and quite generic case of a business model: price razors inexpensively, but aggressively markup the consumables (razor blades). Jet engines for commercial airlines are priced the same way. Manufacturers know that engines have a long life; maintenance and parts is where Rolls Royce and GE make their money in this business. Engines are sold relatively inexpensively; but parts (and service) involve considerable markups.
Newspapers have historically employed a business model in which the paper is sold quite inexpensively, usually at a nominal level insufficient to cover all costs. Newspaper publishers for decades looked to advertising revenue to cover costs plus provide a profit. In recent years, their business model has been undermined by websites like eBay and Craigslist that have siphoned off advertising revenues from job listings, classified ads, and real estate listings. Many newspapers have gone out of business.
In the early days
of photocopying Xerox used leasing as their revenue model: i.e. one couldn't
buy a Xerox photocopier even if one wanted to. Leasing was the modus operandi because Xerox had correctly figured out that supply would stimulate demand, i.e. give people easy access to a copy machine, and they would use it more than they themselves had anticipated, thereby end running barriers to purchase what at the time was regarded as an expensive machine. Later the business model morphed to selling and endeavoring to make money from the sale of toner and copy paper (the "razor blade model").
In the sports apparel business, sponsorship is a key component of today's business models. Nike, Adidas, Reebok, Canterbury, and others sponsor football and rugby clubs and teams, providing kit and sponsorship dollars as well as royalties streams from the sale of replica product. After building brand on field, these companies leverage this brand into off-field
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products, often with considerable success. On-field sponsorship is almost a sine qua non for brand authenticity. However, this model is readily imitated and its viability for any particular apparel company depends on the sponsor's ability to leverage on field sponsorships into off field sales. Relationships with clubs, teams, and team managers and owners become important in the mix. This model has now been in place for at least 50 years.
Another example from the United States is Southwest Airlines, where the founder surmised that most customers wanted direct flights, low costs, reliability, and good customer service, but didn't need frills. To achieve these goals, the airline eschews the hub-and-spoke model, does not belong to any alliances, and does not allow interlining of passengers and baggage. Nor does it sell tickets through travel agencies - all sales are direct. All aircraft are standardized on the Boeing 737s. This allows greater operating flexibility. Its business model was pioneering and quite distinct from the major carriers, and many have tried (without much success) to copy elements of the Southwest "model".
Consider performing artists. They have several business models they can employ. Their revenue sources might include: live productions, movies, sale of CDs through stores, online sale of music through virtual stores such as iTunes offered by Apple4. A star might decide to use concerts as the key revenue generator, or concerts may be used primarily to stimulate sales of recordings. The star could decide to spend less time performing at concerts, and more time in the recording studio. In short, there are multiple revenue streams available, each somewhat better adapted to each performer. The particular revenue model employed may depend upon the star's contextual talents and preferences.
Now consider the recording companies. The emergence of the Internet, Napster, and Napster clones required the recording companies to rethink their business models, and they have been doing so along several fronts. On one front, they are moving to greatly increase the royalty rate for Internet "broadcast" of their content. On another, they are moving to capture advertising revenues associated with that content. For instance, MySpace Music enables MySpace users to
4 The iTunes music store is an example of a business model innovation introduced by Apple. It was the first legal pay-as-you-go method for downloading music. Time Magazine hailed it as '"the coolest invention for 2003".
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listen to songs from Universal, Sony BMG, and Warner Music. There is free advertising supported streaming, with easy access to Amazon.com for purchases of music. Another example is Nokia's "Comes with Music (CWM). A CWM handset comes with "free", unlimited music downloads for a year. Nokia passes on a fee to the recording companies.
Clearly, Internet companies provide a rich array of new business models. Other examples include Flickr (www.flickr.com) which has been described (Shuen 2008) as "a poster child for Web 2.0. It offers users a way to share photos easily" (p.2). Shuen also notes that Flickr's friendly and easy-to-use web interface and its free photo management and storage service are great examples of a Web 2.0 "freemium" business model. "Freemium" (free and premium) has been described by Fred Wilson (quoted in Shuen) as:
"Give your service away for free, possibly ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc., then offer premium priced value added services or an enhanced version of your service to your customer base."
This business model has been used not only by Flickr but also by Adobe (PDF reader), Skype, and MySpace. According to Shuen, low cost on-line distribution and marketing and investment are associated with "revenue from multiple streams, including value-added premium services and customer acquisition: (p.5). The Flickr business model actually evolved from gaming to on-line photo sharing, harnessing user feedback generated through blogs.
Flickr has a multiple revenue stream business model. It collects subscription fees, charges advertising for contextual advertising, and receives sponsorship and revenue-sharing fees from partnerships with retail chains and complementary photo service companies. Flickr essentially gives away what amateur photographers want most: photo sharing, on-line storage, indexing and tagging. Yahoo bought Flickr in March 2005 for tens of millions.
A business model pioneered by one company in one space may be adopted by another company in another space. Outshouts Inc (www.outshouts.com), for example, has applied Flickr's
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multiple revenue streams model to on-line Web videos, allowing users to personalize and disseminate videos for business or consumer purposes.
While common with internet startups, the multiple revenue stream approach is by no means new. Besides theatrical releases, the studios who produce movies have long looked to revenues from licensing (toys, T-shirts, lunchboxes, backpacks), and more recently from video games, from soundtracks, and possibly from a sequel.
The above has focused on the impact of technology on value and its delivery. However technology can have an equally transformative effect on the cost side of the business model. New "cloud-based" computing models, for example, remove the need for small companies to invest up-front in expensive servers - instead they can buy server capacity in small slices, as needed, either based on their needs for the month. The size of the slices continues to shrink -services such as Amazon's EC2, for example, allows customers to buy a virtual server for a single transaction - measured in milliseconds - and return it to the pool when that transaction is done. This kind of innovation transforms previous "fixed plus variable" cost models into entirely variable cost models - greatly improving efficiency and reducing early-stage capital requirements. The following section systematically explores how new business can themselves
be viewed, and analyzed, as innovation
Business models must morph over time as changing markets and technologies dictate and/or allow. For instance, the business model that "investment banks" in the US employed disappeared in 2008. From at least the 1950s through the 1990s, the investment banking function itself usually generated most of the revenues; but by 2007 that figure was down to 16% for Goldman Sachs, one of the leading (if not the leading) investment bank. Revenues from trading and principal investment grew to 68%. Clearly, Goldman and other investment banks morphed their business models into something quite different - and more risky - than traditional investment banking. With (toxic) subprime mortgages becoming securitized and bled into the system, with help from Freddie and Fannie, and under pressure from Congress, the result turned out to be problematic. To survive, Goldman Sachs along with Morgan Stanley in September 2008 converted themselves into federally chartered commercial banks. These banks were the
last two independent investment banks left standing after the takeover of Bear Sterns by JP Morgan Chase, the bankruptcy of Lehman Brothers, and Merrill Lynch's absorption by Bank of America... abandoned their old business model for a source of stable funds. By accepting government regulation by the FDIC, the banks will need to maintain lower leverage, and accept lower risk and lower returns.
Other examples abound. Thus the Starbuck's European style coffeehouse can be copied in concept as Tully's has done - but the processes, operations, and capital required to do so are often not quite so readily available. Once established, Southwest Airlines non-hub approach to air travel through smaller regional airports was hard to imitate - protected by modest first mover advantages. IBM tried to imitate Dell's direct-to-consumer and direct-to-business approach to the sale of personal computers but with little success.
IV. |
Deep Truths About the Economy and Society |
Business models embody a gestalt of strategies and structures that represent provisional solutions to user/customer needs3. In any industry, particularly one that has been around for a while, standard solutions to customer needs become embedded in industry level business models. Technological change opens up better ways for satisfying those needs. The horse, then the railroad, auto and airplanes are all technological solutions to basic societal needs for transportation that displaced and complemented each other and formed the basis of competing business models for providing passenger transportation.
In designing commercially viable business models one needs to keep not only "deep truths" about customer desires, the nature of costs, and the capability of competitors in mind; one also needs to consider the relative merit of particular organizational and technological solutions to customer needs.
5 See Shirky (2008) for a similar perspective. A business model is provisional in the sense that it is likely overtime to be replaced by an improved model which takes advantage of technological or organizational innovation.
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