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Spotlight

100 Harvard Business Review January–February 2011

SPOTLIGHT ON BUSINESS MODEL INNOVATION

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Joan E. Ricart (ricart@iese. edu) is the Carl Schroder Professor of Strategic Man- agement and Economics at IESE Business School in Barcelona.

Ramon Casadesus- Masanell (casadesus@ gmail.com) is an associate professor at Harvard Busi- ness School in Boston.

How to Design A Winning Business Model Smart companies’ business models generate cycles that, over time, make them operate more eff ectively. by Ramon Casadesus-Masanell and Joan E. Ricart

STRATEGY HAS been the primary building block of competitiveness over the past three decades, but in the future, the quest for sustainable advantage may well begin with the business model. While the convergence of information and communication technologies in the 1990s resulted in a short-lived fascination with business models, forces such as de- regulation, technological change, globalization, and sustainability have rekindled interest in the concept today. Since 2006, the IBM Institute for Business Value’s biannual Global CEO Study has reported that senior executives across industries regard develop- ing innovative business models as a major priority. A 2009 follow-up study reveals that seven out of 10 companies are engaging in business-model innova- tion, and an incredible 98% are modifying their busi- ness models to some extent. Business model innova- tion is undoubtedly here to stay.

That isn’t surprising. The pressure to crack open markets in developing countries, particularly those at the middle and bottom of the pyramid, is driving a surge in business-model innovation. The economic slowdown in the developed world is forcing compa- nies to modify their business models or create new ones. In addition, the rise of new technology-based and low-cost rivals is threatening incumbents, re- shaping industries, and redistributing profi ts. Indeed,

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January–February 2011 Harvard Business Review 101

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the ways by which companies create and capture value through their business models is undergoing a radical transformation worldwide.

Yet most enterprises haven’t fully come to grips with how to compete through business models. Our studies over the past seven years show that much of the problem lies in companies’ unwavering focus on creating innovative models and evaluating their ef- fi cacy in isolation—just as engineers test new tech- nologies or products. However, the success or fail- ure of a company’s business model depends largely on how it interacts with models of other players in the industry. (Almost any business model will per- form brilliantly if a company is lucky enough to be the only one in a market.) Because companies build them without thinking about the competition, they routinely deploy doomed business models.

Our research also shows that when enterprises compete using business models that diff er from one another, the outcomes are diffi cult to predict. One business model may appear superior to others when analyzed in isolation but create less value than the others when interactions are considered. Or rivals may end up becoming partners in value creation. Appraising models in a stand-alone fashion leads to faulty assessments of their strengths and weak- nesses and bad decision making. This is a big reason why so many new business models fail.

Three Characteristics of a Good Business Model How can you tell if a business model will be eff ective? A good one will meet three criteria.

Is it aligned with company goals? The choices made while designing a busi- ness model should deliver consequences that enable an organization to achieve its goals. This may seem obvious until you consider a counterexample. In the 1970s, Xerox set up Xerox PARC, which spawned technological innovations such as laser printing, Ethernet, the graphical user interface, and very large scale integration for semiconductors. However, Xerox PARC was notoriously unable to spawn new businesses or capture value from its inno- vations for the parent due to a distressing lack of alignment with Xerox’s goals.

Is it self-reinforcing? The choices that executives make while creating a business model should comple- ment one another; there must be internal consistency. If, ceteris paribus, a low-cost airline were to decide to provide a level of comfort comparable to that off ered by a full-fare carrier such as British Airways, the change would require reducing the number of seats on each plane and off er- ing food and coff ee. These choices would undermine the airline’s low-cost structure and wreck its profi ts. When there’s a lack of reinforcement, it’s possible to refi ne the business model by abandoning some choices and making new ones.

Is it robust? A good business model should be able to sustain its eff ectiveness over time by fend- ing off four threats, identifi ed by Pankaj Ghemawat. They are imitation (can com- petitors replicate your business model?); holdup (can customers, suppliers, or other players capture the value you create by fl exing their bargaining power?); slack (organizational complacency); and sub- stitution (can new products decrease the value customers perceive in your products or services?). Although the period of eff ec- tiveness may be shorter nowadays than it once was, robustness is still a critical parameter.

Moreover, the propensity to ignore the dynamic elements of business models results in many compa- nies failing to use them to their full potential. Few ex- ecutives realize that they can design business mod- els to generate winner-take-all eff ects that resemble the network externalities that high-tech companies such as Microsoft, eBay, and Facebook have created. Whereas network eff ects are an exogenous feature of technologies, winner-take-all eff ects can be trig- gered by companies if they make the right choices in developing their business models. Good business models create virtuous cycles that, over time, result in competitive advantage. Smart companies know how to strengthen their virtuous cycles, weaken those of rivals, and even use their virtuous cycles to turn competitors’ strengths into weaknesses.

“Isn’t that strategy?” we’re often asked. It isn’t— and unless managers learn to understand the dis- tinct realms of business models, strategy, and tactics, while taking into account how they interact, they will never fi nd the most eff ective ways to compete.

What Is a Business Model, Really? Everyone agrees that executives must know how business models work if their organizations are to thrive, yet there continues to be little agreement on an operating definition. Management writer Joan Magretta defi ned a business model as “the story that

102 Harvard Business Review January–February 2011

SPOTLIGHT ON BUSINESS MODEL INNOVATION

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explains how an enterprise works,” harking back to Peter Drucker, who described it as the answer to the questions: Who is your customer, what does the customer value, and how do you deliver value at an appropriate cost?

Other experts defi ne a business model by speci- fying the main characteristics of a good one. For ex- ample, Harvard Business School’s Clay Christensen suggests that a business model should consist of four elements: a customer value proposition, a profi t formula, key resources, and key processes. Such de- scriptions undoubtedly help executives evaluate business models, but they impose preconceptions about what they should look like and may constrain the development of radically diff erent ones.

Our studies suggest that one component of a busi- ness model must be the choices that executives make about how the organization should operate—choices such as compensation practices, procurement con- tracts, location of facilities, extent of vertical inte- gration, sales and marketing initiatives, and so on. Managerial choices, of course, have consequences. For instance, pricing (a choice) aff ects sales volume, which, in turn, shapes the company’s scale econo- mies and bargaining power (both consequences). These consequences infl uence the company’s logic of value creation and value capture, so they too must have a place in the defi nition. In its simplest concep- tualization, therefore, a business model consists of a set of managerial choices and the consequences of those choices.

Companies make three types of choices when cre- ating business models. Policy choices determine the actions an organization takes across all its operations (such as using nonunion workers, locating plants in rural areas, or encouraging employees to fl y coach class). Asset choices pertain to the tangible resources a company deploys (manufacturing facilities or sat- ellite communication systems, for instance). And

governance choices refer to how a company arranges decision-making rights over the other two (should we own or lease machinery?). Seemingly innocuous diff erences in the governance of policies and assets infl uence their eff ectiveness a great deal.

Consequences can be either flexible or rigid. A fl exible consequence is one that responds quickly when the underlying choice changes. For example, choosing to increase prices will immediately result in lower volumes. By contrast, a company’s culture of frugality—built over time through policies that oblige employees to fl y economy class, share hotel rooms, and work out of Spartan offi ces—is unlikely to disappear immediately even when those choices change, making it a rigid consequence. These dis- tinctions are important because they aff ect competi- tiveness. Unlike fl exible consequences, rigid ones are diffi cult to imitate because companies need time to build them.

Take, for instance, Ryanair, which switched in the early 1990s from a traditional business model to a low-cost one. The Irish airline eliminated all frills, cut costs, and slashed prices to unheard-of levels. The choices the company made included offering low fares, fl ying out of only secondary airports, ca- tering to only one class of passenger, charging for all additional services, serving no meals, making only short-haul fl ights, and utilizing a standardized fl eet of Boeing 737s. It also chose to use a nonunionized workforce, offer high-powered incentives to em- ployees, operate out of a lean headquarters, and so on. The consequences of those choices were high volumes, low variable and fi xed costs, a reputation for reasonable fares, and an aggressive management team, to name a few. (See “Ryanair’s Business Model Then and Now.”) The result is a business model that enables Ryanair to off er a decent level of service at a low cost without radically lowering customers’ will- ingness to pay for its tickets.

Idea in Brief There has never been as much interest in business models as there is today; seven out of 10 companies are trying to create innovative business models, and 98% are modify- ing existing ones, according to a recent survey.

However, most companies still create and evaluate business models in isola- tion, without considering the implications of how they will interact with rivals’ business models. This narrow view dooms many to failure.

Moreover, companies often don’t realize that busi- ness models can be designed so that they generate virtu-

ous cycles—similar to the powerful eff ects high-tech fi rms such as Facebook, eBay, and Microsoft enjoy. These cycles, when aligned with company goals, reinforce competitive advantage.

By making the right choices, companies can strengthen their business models’ virtuous cycles, weaken those of rivals, and

even use the cycles to turn competitors into comple- mentary players.

This is neither strategy nor tactics; it’s using business models to gain competitive advantage. Indeed, com- panies fare poorly partly because they don’t recognize the diff erences between strategy, tactics, and busi- ness models.

Business Model

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A business model comprises choices and consequences.

HOW TO DESIGN A WINNING BUSINESS MODEL HBR.ORG

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How Business Models Generate Virtuous Cycles Not all business models work equally well, of course. Good ones share certain characteristics: They align with the company’s goals, are self-reinforcing, and are robust. (See the sidebar “Three Characteristics of a Good Business Model.”) Above all, successful business models generate virtuous cycles, or feed- back loops, that are self-reinforcing. This is the most powerful and neglected aspect of business models.

Our studies show that the competitive advan- tage of high-tech companies such as Apple, Micro- soft, and Intel stems largely from their accumulated assets—an installed base of iPods, Xboxes, or PCs, for instance. The leaders gathered those assets not by buying them but by making smart choices about pricing, royalties, product range, and so on. In other words, they’re consequences of business model choices. Any enterprise can make choices that allow it to build assets or resources—be they project man- agement skills, production experience, reputation, asset utilization, trust, or bargaining power—that make a diff erence in its sector.

The consequences enable further choices, and so on. This process generates virtuous cycles that con- tinuously strengthen the business model, creating a dynamic that’s similar to that of network eff ects. As the cycles spin, stocks of the company’s key as- sets (or resources) grow, enhancing the enterprise’s competitive advantage. Smart companies design business models to trigger virtuous cycles that, over time, expand both value creation and capture.

For example, Ryanair’s business model creates several virtuous cycles that maximize its profits through increasingly low costs and prices. (See the exhibit “Ryanair’s Key Virtuous Cycles.”) All of the cycles result in reduced costs, which allow for lower prices that grow sales and ultimately lead to increased profi ts. Its competitive advantage keeps growing as long as the virtuous cycles generated by its business model spin. Just as a fast-moving body is hard to stop because of kinetic energy, it’s tough to halt well-functioning virtuous cycles.

However, they don’t go on forever. They usually reach a limit and trigger counterbalancing cycles, or they slow down because of their interactions with

other business models. In fact, when interrupted, the synergies work in the opposite direction and erode competitive advantage. For example, one of Ryanair’s cycles could become vicious if its employ- ees unionized and demanded higher wages, and the airline could no longer off er the lowest fares. It would then lose volume, and aircraft utilization would fall. Since Ryanair’s investment in its fleet assumes a very high rate of utilization, this change would have a magnifi ed eff ect on profi tability.

It’s easy to see that virtuous cycles can be cre- ated by a low-cost, no-frills player, but a diff erentia- tor may also create virtuous cycles. Take the case of Irizar, a Spanish manufacturer of bodies for luxury motor coaches, which posted large losses after a series of ill-conceived moves in the 1980s. Irizar’s leadership changed twice in 1990 and morale hit an all-time low, prompting the new head of the compa- ny’s steering team, Koldo Saratxaga, to make ma