Business.model.magreta.doc [605259]

Why Business Models Matter
by Joan Magretta
Reprint r0205f

HBR Case Study r0205a
A Pain in the (Supply) Chain
John Butman
HBR at Large r0205b
How Resilience Works
Diane L. Coutu
Different Voice r0205c
Turning an Industry Inside Out:A Conversation with Robert Redford
Change the Way You Persuade r0205d
Gary A. Williams and Robert B. Miller
HBR Spotlight: Practical Strategy
Divestiture: Strategy’s Missing Link r0205e
Lee Dranikoff, Tim Koller, and Antoon Schneider
Why Business Models Matter r0205f
Joan Magretta
Disruptive Change: When Trying Harder r0205g
Is Part of the Problem
Clark Gilbert and Joseph L. Bower
Tool Kit r0205h
Read a Plant – Fast
R. Eugene Goodson
The Entrepreneur r0205j
A Test for the Fainthearted
Walter Kuemmerle
May 2002

Copyright © 2002 by Harvard Business School Publishing Corporation. All rights reserved. 3“Business model ” was one of the great buzzwords
of the Internet boom, routinely invoked, as the
writer Michael Lewis put it,“to glorify all manner
of half-baked plans.” A company didn’t need a strategy,or a special competence, or even any customers – all itneeded was a Web-based business model that promisedwild profits in some distant, ill-defined future.Many people – investors, entrepreneurs, and executives alike –bought the fantasy and got burned.And as the inevitablecounterreaction played out, the concept of the businessmodel fell out of fashion nearly as quickly as the .com appendage itself.
That’s a shame.For while it’s true that a lot of capital
was raised to fund flawed business models, the fault liesnot with the concept of the business model but with itsdistortion and misuse.A good business model remains Why
BusinessModelsMatter
by Joan MagrettaA good business model begins
with an insight into humanmotivations and ends in a richstream of profits.

essential to every successful organization, whether it’s a
new venture or an established player.But before managerscan apply the concept, they need a simple working defini-tion that clears up the fuzziness associated with the term.
Telling a Good Story
The word “model” conjures up images of white boardscovered with arcane mathematical formulas.Businessmodels, though, are anything but arcane.They are, atheart, stories – stories that explain how enterprises work.A good business model answers Peter Drucker’s age-oldquestions: Who is the customer? And what does the cus-tomer value? It also answers the fundamental questionsevery manager must ask: How do we make money in thisbusiness? What is the underlying economic logic that ex-plains how we can deliver value to customers at an ap-propriate cost?
Consider the story behind one of the most successful
business models of all time: that of the traveler’s check.During a European vacation in 1892, J.C. Fargo, the presi-dent of American Express, had a hard time translating hisletters of credit into cash.“The moment I got off thebeaten path, ” he said on his return, “they were no moreuse than so much wet wrapping paper.If the president ofAmerican Express has that sort of trouble, just think whatordinary travelers face.Something has got to be doneabout it.”
1What American Express did was to create the
traveler’s check – and from that innovation evolved a ro-bust business model with all the elements of a good story:precisely delineated characters, plausible motivations,and a plot that turns on an insight about value.
The story was straightforward for customers.In ex-
change for a small fee, travelers could buy both peace ofmind (the checks were insured against loss and theft) andconvenience (they were very widely accepted).Merchantsalso played a key role in the tale.They accepted the checksbecause they trusted the American Express name, whichwas like a universal letter of credit, and because, by accept-ing them, they attracted more customers.The more othermerchants accepted the checks, the stronger any individ-ual merchant’s motivation became not to be left out.
As for American Express, it had discovered a riskless
business, because customers always paid cash for thechecks.Therein lies the twist to the plot, the underlyingeconomic logic that turned what would have been an un-remarkable operation into a money machine.The twistwas float. In most businesses, costs precede revenues: Be-
fore anyone can buy your product, you’ve got to build itand pay for it.The traveler’s check turned the normalcycle of debt and risk on its head.Because people paid forthe checks before (often long before) they used them,American Express was getting something banks had longenjoyed – the equivalent of an interest-free loan from itscustomers.Moreover, some of the checks were nevercashed, giving the company an extra windfall.
As this story shows, a successful business model repre-
sents a better way than the existing alternatives.It mayoffer more value to a discrete group of customers.Or itmay completely replace the old way of doing things andbecome the standard for the next generation of entrepre-neurs to beat.Nobody today would head off on vacationarmed with a suitcase full of letters of credit.Fargo’s busi-ness model changed the rules of the game, in this case, theeconomics of travel.By eliminating the fear of beingrobbed and the hours spent trying to get cash in a strangecity, the checks removed a significant barrier to travel,helping many more people to take many more trips.Likeall really powerful business models, this one didn’t justshift existing revenues among companies; it created new,incremental demand.Traveler’s checks remained the preferred method for taking money abroad for decades,until a new technology – the automated teller machine –granted travelers even greater convenience.
Creating a business model is, then, a lot like writing a
new story.At some level, all new stories are variations onold ones, reworkings of the universal themes underlyingall human experience.Similarly, all new business modelsare variations on the generic value chain underlying all businesses.Broadly speaking, this chain has two parts.Part one includes all the activities associated withmaking something: designing it, purchasing raw materi-als, manufacturing, and so on.Part two includes all the ac-tivities associated with selling something: finding andreaching customers, transacting a sale, distributing theproduct or delivering the service.A new business model’splot may turn on designing a new product for an unmetneed, as it did with the traveler’s check.Or it may turn ona process innovation, a better way of making or selling ordistributing an already proven product or service.
Think about the simple business that direct-marketing
pioneer Michael Bronner created in 1980 when he was ajunior at Boston University.Like his classmates, Bronnerhad occasionally bought books of discount coupons for
local stores and restaurants.Students paid a small fee forthe coupon books.But Bronner had a better idea.Yes, thebooks created value for students, but they had the poten-tial to create much more value for merchants, who stoodto gain by increasing their sales of pizza and haircuts.Bronner realized that the key to unlocking that potentialwas wider distribution – putting a coupon book in everystudent’s backpack.
That posed two problems.First, as Bronner well knew,
students were often strapped for cash.Giving the books
4 harvard business reviewHBR Spotlight: Practical Strategy
Joan Magretta is a management consultant and writer and
a past winner of HBR’s McKinsey Award. This article draws
on material from her latest book, What Management Is:
How It Works, and Why It’s Everyone’s Business (Free
Press, 2002).

away for free would solve that problem.Second, Bronner
needed to get the books to students at a cost that wouldn’teat up his profits.So he made a clever proposal to thedean of Boston University’s housing department: Bronnerwould assemble the coupon books anddeliver them in bulk to the housing de-
partment, and the department could dis-tribute them free to every dorm on cam-pus.This would make the departmentlook good in the eyes of the students, anotoriously tough crowd to please.Thedean agreed.
Now Bronner could make an even
more interesting proposal to neighbor-hood business owners.If they agreed topay a small fee to appear in the newbook, their coupons would be seen byall 14,000 residents of BU’s dorms.Bronner’s idea took off.Before long, hehad extended the concept to other cam-puses, then to downtown office build-ings.Eastern Exclusives, his first company, was born.Hisinnovation wasn’t the coupon book but his businessmodel; it worked because he had insight into the motiva-tions of three sets of characters: students, merchants, andschool administrators.
Tying Narrative to Numbers
The term “business model”first came into widespread usewith the advent of the personal computer and the spread-sheet.Before the spreadsheet, business planning usuallymeant producing a single, base-case forecast.At best, youdid a little sensitivity analysis around the projection.Thespreadsheet ushered in a much more analytic approach toplanning because every major line item could be pulledapart, its components and subcomponents analyzed andtested.You could ask what-if questions about the criticalassumptions on which your business depended – for ex-ample, what if customers are more price-sensitive than wethought? – and with a few keystrokes, you could see howany change would play out on every aspect of the whole.In other words, you could model the behavior of a busi-ness.
This was something new.Before the personal computer
changed the nature of business planning, most successfulbusiness models, like Fargo’s, were created more by acci-dent than by design and forethought.The business modelbecame clear only after the fact.By enabling companiesto tie their marketplace insights much more tightly to
the resulting ec onomics – to link their assumptions about
how people would behave to the numbers of a pro f orma
P&L – spreadsheets made it possible to model businessesbefore they were launched.
Of course, a spreadsheet is only as good as the assump-tions that go into it.Once an enterprise starts operating,the underlying assumptions of its model – about both motivations and economics – are subjected to continuoustesting in the marketplace.And success often hinges on
management’s ability to tweak, or evenoverhaul, the model on the fly.When Eu-roDisney opened its Paris theme park in1992, it borrowed the business model thathad worked so well in Disney’s U.S. parks.Europeans, the company thought, wouldspend roughly the same amount of timeand money per visit as Americans did onfood, rides, and souvenirs.
Each of Disney’s assumptions about
the revenue side of the business turnedout to be wrong.Europeans did not, forexample, graze all day long at the park’svarious restaurants the way Americansdid.Instead, they all expected to beseated at precisely the same lunch or din-ner hour, which overloaded the facilities
and created long lines of frustrated patrons.Because ofthose miscalculations, EuroDisney was something of a dis-aster in its early years.It became a success only after adozen or so of the key elements in its business modelwere changed, one by one.
When managers operate consciously from a model of
how the entire business system will work, every decision,initiative, and measurement provides valuable feedback.Profits are important not only for their own sake but alsobecause they tell you whether your model is working.Ifyou fail to achieve the results you expected, you reexam-ine your model, as EuroDisney did.Business modeling is,in this sense, the managerial equivalent of the scientificmethod – you start with a hypothesis, which you then testin action and revise when necessary.
Two Critical Tests
When business models don’t work, it’s because they fail ei-ther the narrative test (the story doesn’t make sense) orthe numbers test (the P&L doesn’t add up).The businessmodel of on-line grocers, for instance, failed the numberstest.The grocery industry has very thin margins to beginwith, and on-line merchants like Webvan incurred newcosts for marketing, service, delivery, and technology.Since customers weren’t willing to pay significantly morefor groceries bought on-line than in stores, there was noway the math could work.Internet grocers had plenty ofcompany.Many ventures in the first wave of electroniccommerce failed simply because the basic business mathwas flawed.
Other business models failed the narrative test.Con-
sider the rapid rise and fall of Priceline Webhouse Club.This was an offshoot of Priceline.com, the company that
may 2002 5Why Business Models Matter
Business modeling
is the managerialequivalent of thescientific method –you start with a hypothesis, whichyou then test in action and revisewhen necessary.

introduced name-your-own pricing to the purchase of air-
line tickets.Wall Street’s early enthusiasm encouragedCEO Jay Walker to extend his concept to groceries andgasoline.
Here’s the story Walker tried to tell.Via the Web, mil-
lions of consumers would tell him how much they wantedto pay for, say, a jar of peanut butter.Consumers could specify the price butnot the brand, so they might end upwith Jif or they might end up withSkippy.Webhouse would then aggre-gate the bids and go to companies likeP&G and Bestfoods and try to make a deal: Take 50 cents off the price of your peanut butter, and we’ll ordera million jars this week.Webhousewanted to be a power broker for indi-vidual consumers: Representing mil-lions of shoppers, it would negotiate discounts and thenpass on the savings to its customers, taking a fee in theprocess.
What was wrong with the story? It assumed that com-
panies like P&G, Kimberly-Clark, and Exxon wanted toplay this game.Think about that for a minute.Big con-sumer companies have spent decades and billions of dol-lars building brand loyalty.The Webhouse model teachesconsumers to buy on price alone.So why would the man-ufacturers want to help Webhouse undermine both theirprices and the brand identities they’d worked so hard tobuild? They wouldn’t.The story just didn’t make sense.Tobe a power broker, Webhouse needed a huge base of loyalcustomers.To get those customers, it first needed to de-liver discounts.Since the consumer product companiesrefused to play, Webhouse had to pay for those discountsout of its own pocket.A few hundred million dollars later,in October 2000, it ran out of cash – and out of investorswho still believed the story.
In case anyone thinks that Internet entrepreneurs have
a monopoly on flawed business models, think again.Wetend to forget about ideas that don’t pan out, but businesshistory is littered with them.In the 1980s, the one-stopfinancial supermarket was a business model that firedthe imagination of many executives – but Sears, to citeone example, discovered that its customers just didn’t getthe connection between power tools and annuities.In the1990s, Silicon Graphics invested hundreds of millions ofdollars in interactive television, but it was unable to findreal customers who were as enchanted by the technologyas the engineers who invented it.Ultimately, models likethese fail because they are built on faulty assumptionsabout customer behavior.They are solutions in search of
a problem.
The irony about the slipshod use of the concept of
business models is that when used correctly, it actuallyforces managers to think rigorously about their busi-nesses.A business model’s great strength as a planningtool is that it focuses attention on how all the elements ofthe system fit into a working whole.It’s no surprise that,even during the Internet boom, executives who graspedthe basics of business model thinking were in a better po-sition to lead the winners.Meg Whitman, for example,
joined eBay in its early days becauseshe was struck by what she describedas “the emotional connection betweeneBay users and the site.”
2The way peo-
ple behaved was an early indicator ofthe potential power of the eBay brand.Whitman also realized that eBay, un-like many Internet businesses thatwere being created, simply “couldn’tbe done off-line.”In other words, Whit-man – a seasoned executive – saw acompelling, coherent narrative with
the potential to be translated into a profitable business.
Whitman has remained attentive to the psychology
and the economics that draw collectors, bargain hunters,community seekers, and small-business people to eBay.Its auction model succeeds not just because the Internetlowers the cost of connecting vast numbers of buyers andsellers but also because eBay has made decisions aboutthe scope of its activities that result in an appropriate coststructure.After an auction, eBay leaves it to the sellersand buyers to work out the logistics of payment and ship-ping.The company never takes possession of the goods or carries any inventory.It incurs no transportation costs.It bears no credit risk.And it has none of the overheadthat would come with those activities.
What About Strategy?
Every viable organization is built on a sound businessmodel, whether or not its founders or its managers con-ceive of what they do in those terms.But a business modelisn’t the same thing as a strategy, even though many peo-ple use the terms interchangeably today.Business modelsdescribe, as a system, how the pieces of a business fit to-gether.But they don’t factor in one critical dimension ofperformance: competition.Sooner or later – and it is usu-ally sooner – every enterprise runs into competitors.Deal-ing with that reality is strategy’s job.
A competitive strategy explains how you will do better
than your rivals.And doing better, by definition, meansbeing different.Organizations achieve superior perfor-mance when they are unique, when they do something noother business does in ways that no other business can du-plicate.When you cut away the jargon, that’s what strat-egy is all about – how you are going to do better by beingdifferent.The logic is straightforward: When all compa-nies offer the same products and services to the same cus-tomers by performing the same kinds of activities, no
6 harvard business reviewHBR Spotlight: Practical Strategy
A business model
isn’t the same thingas a strategy, eventhough many peopleuse the terms inter-changeably today.

company will prosper.Customers will benefit, at least in
the short term, while head-to-head competition drivesprices down to a point where returns are inadequate.Itwas precisely this kind of competition – destructive com-petition, to use Michael Porter’s term – that did in manyInternet retailers, whether they were selling pet supplies,drugs, or toys.Too many fledgling companies rushed tomarket with identical business models and no strategiesto differentiate themselves in terms of which customersand markets to serve, what products and services to offer,and what kinds of value to create.
To see the distinction between a strategy and a business
model, you need only look at Wal-Mart.You might thinkthat the giant retailer’s success was aresult of pioneering a new businessmodel, but that’s not the case.WhenSam Walton opened his first Wal-Mart in 1962 in the hamlet of Rogers,Arkansas, the discount-retailing busi-ness model had been around for afew years.It had emerged in the mid-1950s, when a slew of industry pio-neers (now long forgotten) began toapply supermarket logic to the saleof general merchandise.Supermar-kets had been educating customerssince the 1930s about the value of giving up personal service in exchange for lower food prices, and the newbreed of retailers saw that they could adapt the basic storyline of the supermarket to clothing, appliances, and a hostof other consumer goods.The idea was to offer lowerprices than conventional department stores by slashingcosts.And so the basic business model for discount retail-ing took shape: First, strip away the department store’sphysical amenities such as the carpeting and the chande-liers.Second, configure the stores to handle large num-bers of shoppers efficiently.And third, put fewer sales-people on the floor and rely on customers to servethemselves.Do those things well, and you could offer lowprices and still make money.
Walton heard about the new discount stores, visited a
few, and liked their potential.In 1962, he decided to setout on his own, borrowing a lot of ideas for his early storesfrom Kmart and others.But it was what he chose to do differently – the ways he put his own stamp on the basicbusiness model – that made Wal-Mart so fabulously suc-cessful.His model was the same as Kmart’s, but his strat-egy was unique.
From the very start, for instance, Walton chose to serve
a different group of customers in a different set of mar-kets.The ten largest discounters in 1962, all gone today,focused on large metropolitan areas and cities like NewYork.Wal-Mart’s “key strategy, ” in Walton’s own words,“was to put good-sized stores into little one-horse townswhich everybody else was ignoring.”
3He sought out iso-
may 2002 7Why Business Models Matter
lated rural towns, like Rogers, with populations between
5,000 and 25,000.Being a small-town guy himself, Waltonknew the terrain well.The nearest city was probably afour-hour drive away.He rightly bet that if his stores couldmatch or beat the city prices, “people would shop athome.” And since Wal-Mart’s markets tended to be toosmall to support more than one large retailer, Walton wasable to preempt competitors and discourage them fromentering Wal-Mart’s territory.
Wal-Mart also took a different approach to merchan-
dising and pricing than its competitors did – that is, itpromised customers a different kind of value.While com-petitors relied heavily on private label goods, second-tier
brands, and price promotions, Wal-Mart promised national brands ateveryday low prices.To make thispromise more than a marketing slo-gan, the company pursued efficiencyand reduced costs through innova-tive practices in areas such as pur-chasing, logistics, and informationmanagement.
The business model of discount re-
tailing has attracted many players
since it emerged in the 1950s.Mostof them have failed.A few, like Wal-
Mart and Target, have achieved superior performanceover the long haul because their strategies set them apart.Wal-Mart offers branded goods for less to a carefully cho-sen customer base.Target built a strategy around a dif-ferent kind of value – style and fashion.The losers in theindustry – the chronic underperformers like Kmart – arecompanies that tried to be all things to all people.Theyfailed to find distinctive ways to compete.
A Good Model Is Not Enough
There’s another, more recent story that sheds further lighton the relationship between business models and strate-gies.It’s the story of Dell Computer.Unlike Sam Walton,Michael Dell was a true business-model pioneer.Themodel he created is, by now, well known: While other personal-computer makers sold through resellers, Dellsold directly to end customers.That not only cut out acostly link from the value chain, it also gave Dell the infor-mation it needed to manage inventory better than any
other company in its industry.And because the pace of in-novation in the industry was intense, Dell’s inventory ad-vantage meant it could avoid the high cost of obsoles-cence that other computer makers had to bear.Armedwith its innovative business model, Dell has consistentlyoutperformed rivals for more than a decade.
In this case, Dell’s business model functioned much like
a strategy: It made Dell different in ways that were hardto copy.If Dell’s rivals tried to sell direct, they would dis-When a new model
changes the economicsof an industry and isdifficult to replicate,it can by itself create a strong competitive advantage.

rupt their existing distribution channels and alienate the
resellers on whom they relied.Trapped by their ownstrategies, they were damned if they copied Dell anddamned if they didn’t.When a new model changes theeconomics of an industry and is difficult to replicate, it canby itself create a strong competitive advantage.
What often gets lost in Dell’s story, though, is the role
that pure strategy has played in the company’s superiorperformance.While Dell’s direct business model laid outwhich value chain activities Dell would do (and which itwouldn’t do), the company still had crucial strategicchoices to make about which customers to serve andwhat kinds of products and services to offer.In the 1990s,for example, while other PC makers focused on comput-ers for the home market, Dell consciously chose to goafter large corporate accounts, which were far more prof-itable.Other PC makers offered low-end machines to lurein first-time buyers.Michael Dell wasn’t interested in this“no-margin” business.He staked out his territory sellingmore powerful, higher margin computers.
Then, because Dell sold direct and could analyze its cus-
tomers in depth, it began to notice that its average sellingprice to consumers was increasing while the industry’swas falling.Consumers who were buying their second orthird machines and who were looking for more powerand less hand-holding were coming to Dell – even thoughit wasn’t targeting them.Only in 1997, after it had a prof-
itable, billion-dollar consumer business, did Dell dedicatea group to serving the consumer segment.
Now that everyone in its industry is selling direct, Dell’s
strategy has shifted to deal with the new competitive re-alities.With a decade-long lead, Dell is by far the indus-try’s best executor of the direct-selling model – it is thelow-cost producer.So it is using its cost advantage in PCsto compete on price, to gain share, and to drive the weakerplayers out of the business.At the same time, the com-pany is relying on its core business model to pursue op-
8 harvard business reviewHBR Spotlight: Practical Strategy
portunities in new product markets, like servers, that have
greater profit potential than PCs.The underlying busi-ness model remains the same.The strategic choices aboutwhere to apply the model – which geographic markets,which segments, which customers, which products – arewhat change.
Clarity about its business model has helped Dell in an-
other way: as a basis for employee communication andmotivation.Because a business model tells a good story,it can be used to get everyone in the organization alignedaround the kind of value the company wants to create.Stories are easy to grasp and easy to r emember.They
help individuals to see their own jobs within the larger
context of what the company is trying to do and to tailortheir behavior accordingly.Used in this way, a good busi-ness model can become a powerful tool for improving execution.
• • •
Today, “business model” and “strategy” are among themost sloppily used terms in business; they are oftenstretched to mean everything – and end up meaning noth-ing.But as the experiences of companies like Dell andWal-Mart show, these are concepts with enormous prac-tical value.It’s true that any attempt to draw sharp bound-aries around abstract terms involves some arbitrarychoices.But unless we’re willing to draw the line some-where, these concepts will remain confusing and difficultto use.Definition brings clarity.And when it comes toconcepts that are so fundamental to performance, no or-ganization can afford fuzzy thinking.
1.James C.Collins and Jerry I.Porras, Built to Last (HarperCollins, 1994).
2.“Meg Whitman at eBay Inc.(A), ” HBS case no.9-400-035.
3.“Wal-Mart Stores, Inc., ” HBS case no.9-794-024.
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