How and When Should Your Company Explore Business Model Innovation? CONTENTS

SLOANSELECT COLLECTION SPRING 2012 A SPECIAL COLLECTION OF PERSPECTIVES FROM LEADING THINKERS ON THE TOPIC OF BUSINESS MODEL INNOVATION How and When Should Your Company Explore Business Model Innovation? CONTENTS

SLOANSELECT COLLECTION SPRING 2012

Insights on Business Model Innovation

1 Creating Value Through Business Model Innovation By Raphael Amit and Christoph Zott | Spring 2012

10 How to Identify New Business Models By Joseph V. Sinfield, Edward Calder, Bernard McConnell and Steve Colson | Winter 2012

16 The Business Models Investors Prefer By Peter Weill, Thomas W. Malone and Thomas G. Apel | Summer 2011

19 What to Do Against Disruptive Business Models (When and How to Play Two Games at Once) By Constantinos C. Markides and Daniel Oyon | Summer 2010

27 Foundations for Growth: How To Identify and Build Disruptive New Businesses By Clayton M. Christensen, Mark W. Johnson and Darrell K. Rigby | Spring 2002

Please note that gray areas reflect artwork that has been intentionally removed. The substantive content of the article appears as originally published.

REPRINT NUMBER INS0512

SLOANSELECT COLLECTION • “INSIGHTS ON BUSINESS MODEL INNOVATION” • MIT SLOAN MANAGEMENT REVIEW i Strategy in Changing MarketBUSINESSS : new MODEL BuS ineINNOVATIONSS ModelS creating Value through Business model Innovation Could your company benefit from a new business model? Consider these six questions. By Raphael amit aNd ChRistoph Zott The leading quesTion What do executives Companies often make substantial efforts to innovate their processes and products to need to know achieve revenue growth and to maintain or improve profit margins. innovations to improve pro- about busi- cesses and products, however, are often expensive and time-consuming, requiring a considerable ness model upfront investment in everything from research and development to specialized resources, new innovation? plants and equipment, and even entire new business units. Yet future returns on these investments Findings are always uncertain. Hesitant to make such big bets, more companies now are turning toward busi- Business model ness model innovation as an alternative or complement to product or process innovation. innovation can con- sist of adding new a recent global survey of more than 4,000 senior managers by the economist intelligence Unit activities, linking activities in novel found that the majority (54%) favored new business models over new products and services as a ways or changing which party per- source of future competitive advantage. eiU ana- forms an activity. lysts concluded that “the overall message is clear: the growing popularity of e-reading devices Novelty, lock-in, how companies do business will often be as, or such as the Kindle is stimulating business complementarities model changes in book publishing. and efficiency are more, important than what they do.”1 and in a sim- four major business ilar global study conducted by iBm, in which over model value drivers. Within organiza- 750 corporate and public sector leaders were inter- tions, business viewed on the subject of innovation, researchers model choices often go unchallenged found that “competitive pressures have pushed for a long time. business model innovation much higher than expected on Ceos’ priority lists.”2 However, this level of interest may not have been too surprising given that the iBm study also found that companies whose operating margins had grown faster than their competitors’ over the previous five years were twice as likely to emphasize business model innovation, as opposed to product or process innovation.3 one Ceo explained why his company’s focus on business model innovation had grown:

In the operations area, much of the innovations and cost savings that could be achieved have already been achieved. Our greatest focus is on business model innovation, which is where the greatest benefits lie. It’s not enough to make a dif- ference on product quality or delivery readiness or production scale. It’s important to innovate in areas where our competition does not act.4

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Business model innovation can also help com- We define a company’s business model as a system panies stay ahead in the product innovation game, of interconnected and interdependent activities that where as one Ceo from another study explained, determines the way the company “does business” with “you’re always one innovation away from getting its customers, partners and vendors. in other words, a wiped out by a new competing innovation that business model is a bundle of specific activities — an eliminates the need for your product.”5 a good activity system — conducted to satisfy the perceived product that is embedded in an innovative business needs of the market, along with the specification of model, however, is less easily shunted aside. some- which parties (a company or its partners) conduct one might come up with a better mp3 player than which activities, and how these activities are linked to apple’s tomorrow, but few of the hundreds of mil- each other. We started our research into business lions of consumers with ipods and itunes accounts models a decade ago by making in-depth inquiries will be open to switching brands. into the business models of 59 e-business companies Business model innovation matters to manag- in europe and the U.s. that had undertaken initial ers, entrepreneurs and academic researchers for public offerings.7 (see “about the Research.”) Later, several reasons. first, it represents an often under- we developed a unique data set containing detailed in- utilized source of future value. second, competitors formation about the business models of 190 might find it more difficult to imitate or replicate entrepreneurial companies listed on U.s. or european an entire novel activity system than a single novel public exchanges between 1996 and 2000. We supple- product or process. since it is often relatively easier mented these data on companies’ business models to undermine and erode the returns of product or with another manually collected data set on business process innovation, innovation at the level of the strategy, establishing empirically that a company’s business model can sometimes translate into a sus- product market strategy and its business model are tainable performance advantage. third, because distinct constructs that affect corporate perfor- business model innovation can be such a poten- mance.8 more recently, we have developed cases on tially powerful competitive tool, managers must be business model choice and evolution.9 attuned to the possibility of competitors’ efforts in Building on this work, we focus in this article on this area.6 Competitive threats often come from business model innovation in the context of estab- outside their traditional industry boundaries. lished companies. However, these ideas are equally applicable to innovators of entirely new business abouT The ReseaRch models and to managers of companies who need to the ideas presented in this article are anchored in the authors’ decade-long research adapt their business model incrementally with the ob- program on business models. We started this research with in-depth inquiries into jective of achieving business model innovation new to the business models of 59 e-business companies in europe and the u.s. that had their organization. even under conditions of resource undertaken initial public offerings. under our guidance, several research analysts investigated each company, using approximately 50 open-ended questions. the scarcity, organizations do not need to renounce inno- analysts wrote up the answers to the questions using information gathered from vation as a way of enhancing their performance multiple data sources (such as IPo prospectuses), which we then took to develop an prospects. Rather, managers should consider the op- inductive theory on the sources of value creation in e-business. portunities offered by business model innovation to In our subsequent work, we shifted attention from value creation to value appropria- tion by linking some of the value drivers of business models (notably, novelty and complement, if not substitute for, innovation in prod- efficiency) to company performance. to test our hypotheses, we developed a unique ucts or processes. Business model innovation can data set containing detailed information about the business models of 190 entrepre- allow managers to resolve the apparent trade-off be- neurial companies listed on u.s. or european public exchanges between 1996 and tween innovation costs and benefits by addressing 2000. We measured each business model design theme as a variable at a particular how they do business, for example, by involving part- point in time, and we regressed these variables on a range of performance measures. We also supplemented these data on companies’ business models with a manually col- ners in new value-creating activity systems. lected data set on business strategy, establishing empirically that a company’s product market strategy and its business model are distinct constructs that affect performance. Business model more recently, we developed cases on business model choice and evolution. these innovation in practice cases have given us additional insights that have led to further conceptual advances. Building on these advances in this article, we focus for the first time squarely on busi- to illustrate the power of business model innovation, ness model innovation in the context of established companies rather than start-ups. consider two cases: apple and HtC, the taiwan-

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based mobile device manufacturer. aPPle’s PeRFoRMance, beFoRe and for most of its history, apple was fo- aFTeR business Model changes In recent years, apple’s revenues, profit and stock price change have reflected its cused on the production of innovative successful business model innovations. hardware and software, mostly personal computers. By creating the ipod Apple Net Income ($ millions) and the associated itunes, a legal on- $25,000

line music download service, apple 01/27/10 introduced a radical innovation of its $20,000 Apple introduces iPad business model. apple was the first computer company to include music $15,000 distribution as an activity, linking it to 01/09/07 10/23/01 Apple introduces the development of the ipod hardware $10,000 Apple introduces iPhone iTunes/iPod and software. By adding this new activ- business model ity to its business model, which links $5,000 the music label owners with end users, apple transformed music distribu- 0 ‘90 ‘93 ‘96 ‘99 ‘02 ‘05 ‘08 ‘11 tion. Rather than growing by simply bringing innovative new hardware to % Change in Stock Price* 5,000% the market, apple transformed its Apple business model to encompass an on- 4,000% going relationship with its customers,

similar to the “razor and blade” model 3,000% of companies such as Gillette. this en- * Compared to January 31, 1990 base of: abled apple, and its business model 2,000% $8.50 for Apple and partners, to extract ongoing value S&P index of 329.08 from the use of the apple hardware 1,000%

and software. in this way, apple ex- S&P panded the locus of its innovation 0 from the product space to the business model — and its revenues, profit and stock price logical innovations. Yet HtC’s business model has change have reflected that successful business model remained centered on hardware design and product innovation. (see “apple’s performance, Before and innovation. in effect, HtC sells great razors, but no after Business model Changes.”) razor blades: its business model allows it to benefit such performance can be hard for even some only from the sale of its innovative, state-of-the-art otherwise high-performing companies to match if smart phones and tablets, but not from their use. they rely solely on product innovation. HtC has Comparing the performance of HtC and apple been a very innovative, profitable and growing origi- stock in the past two years highlights the fact that in nal equipment manufacturer since its founding in the fast-moving technology market space, product 1997. initially, HtC manufactured handsets for mi- innovation without business model innovation may crosoft-powered mobile phones for companies such not always provide enough competitive advantage. as palm, Hp and t-mobile. in 2006, it changed its (see “the stock price of HtC vs. apple,” p. 44.) product-market strategy from being a contract in contrast to apple, HtC has not been involved in oem manufacturer to selling its own HtC-branded the creation or delivery of mobile content or services, smart phones to wireless network operators and the and its devices function on third-party operating sys- general public through various distribution chan- tems such as Google’s, generating revenues for HtC nels. HtC has excelled in many ways, recording only from the hardware sales. apple, on the other many firsts in the smart phone product market space hand, benefits from economies of scope due to the in- and winning numerous awards for its many techno- teroperability of its software base (ios, itunes, app

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store, iCloud) for its various products including its allowed taco Bell to realize economies of scale and computers (imacs), tablets (ipads), phones (iphones) improvements in efficiency and quality control, as and mp3 players (ipods). in addition, apple benefits well as to increase space for customers within the from direct ownership of its distribution channels restaurants.12 other companies might wish to (online app store, brick-and-mortar apple retail change their business models in similar incremental stores). further, apple’s business model enables it to ways or follow a business model innovator in their derive revenue from app store sales of third-party ap- industry in order to achieve competitive parity. plications, from itune songs, and from at&t for the Business model innovation can occur in a num- use of its iphone for voice and data. ber of ways: 1. By adding novel activities, for example, through how to innovate in forward or backward integration; we refer to this Business model design form of business model innovation as new activ- an innovative business model can either create a ity system “content.”13 new market or allow a company to create and ex- 2. By linking activities in novel ways; we refer to this ploit new opportunities in existing markets. Dell, form of business model innovation as new activ- for example, implemented a customer-driven, ity system “structure.” build-to-order business model that replaced the 3. By changing one or more parties that perform traditional build-to-stock model of selling com- any of the activities; we refer to this form of busi- puters through retail stores.10 ness model innovation as new activity system Changes to business model design, however, can “governance.” be subtle; even when they might not have the poten- Content, structure and governance are the three tial to disrupt an industry, they can still yield design elements that characterize a company’s important benefits to the innovator. Consider taco business model.14 (see “six Questions about Busi- Bell, the restaurant chain offering mexican-style fast ness model innovation.”) Change one or more of food, which in the late 1980s decided to turn the res- these elements enough and you’ve changed the taurant’s kitchens into heating and assembly units. model. Consider the following. most chopping, cooking and clean-up activities were The content of an activity system refers to the selec- transferred to corporate headquarters. the food was tion of activities to be performed. for example, sent precooked in plastic bags to restaurants, where Colombia’s largest bank, Bancolombia, adopted ac- it could be heated, assembled and served.11 this in- tivities beyond those of a typical retail bank. the cremental business model innovation was not perceived market need for these activities was the de- game-changing for the fast food industry, but it mand for microcredit among the more than 60% of Colombians who did not have access to banking ser- The sTocK PRice oF hTc vs. aPPle vices. to perform these new activities — an comparing the performance of Htc and apple stock during the past two years innovation in the content of its business model — the highlights the potential benefits of successful business model innovation. bank needed to train its top management, hire and

% Change in Stock Price* train new staff and link the new activities to its exist- 5,000% ing system (platforms, applications and channels).15 Apple another example of business model innovation fo- 4,000% cused on content is iBm.16 after a severe financial crisis in the early 1990s, the company shifted its focus 3,000% from being a supplier of hardware to becoming a ser- * Compared to base of: $8.50 for Apple and S&P index of vice provider. Drawing on know-how built over 2,000% 329.08 (both on January 31, 1990) and 37.99 TWD for HTC HTC decades, iBm launched a range of new activities in (on March 29, 2002). consulting, it maintenance and other services. the 1,000% transformation was substantial: By 2009, more than S&P 0 half of iBm’s $96 billion in revenues came from these ‘90 ‘93 ‘96 ‘99 ‘02 ‘05 ‘08 ‘11 activities, which had barely existed 15 years earlier.

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the structure of an activity system describes how six quesTions abouT business the activities are linked and in what sequence. Con- Model innovaTion Business model innovation can occur in a number of ways: by sider priceline.com. this online travel agency has adding new activities, by linking activities in novel ways — or by established links with airline companies, credit card changing one or more parties that perform any of the activities. companies and travelport’s Worldspan central res- 2 ervation system, among others. By introducing a What novel reverse market in which customers post desired activities could help 5 prices for sellers’ acceptance, priceline developed a satisfy those How will needs? value be fundamentally novel exchange mechanism through created for which these parties interact and by which items such 1 3 each What How could stakeholder? as airline tickets are sold. priceline was granted a customer the activities needs will the be linked in 6 business method patent on its innovative activity new business novel ways? What revenue system — a novel structure that continues to distin- model models can be address? 4 adopted to guish the company from other travel agencies. Who should complement perform the the governance of an activity system refers to who the business activities? model? performs the activities. franchising, for example, What novel governance represents one possible approach to innovative ac- arrangements can be found? tivity system governance. it can be the key to unlocking value, as when Japanese entrepreneur to- shifumi suzuki realized in the early 1970s that the interlinked value drivers of business models: nov- franchise system that had developed in the U.s. was elty, lock-in, complementarities and efficiency. an ideal response to the strict regulations imposed 1. Novelty captures the degree of business model in- by the Japanese government on retailing outlets, novation that is embodied by the activity system. which limited their size and restricted opening 2. Lock-in refers to those business model activities times. By franchising 7-eleven stores in Japan, that create switching costs or enhanced incen- suzuki adopted a novel type of activity system gov- tives for business model participants to stay and ernance (new to Japan, but not to the rest of the transact within the activity system. Consider for world) and managed to create value through profes- example nespresso, a division of nestlé Corpo- sional management and local adaptation.17 another ration. it introduced a new, low-cost espresso example of an innovative governance structure is maker that uses nespresso-produced coffee cap- the recent formation of a consortium of magazine sules. once a customer buys a nespresso publishers, including time, Hearst, meredith and machine, he or she needs to use nespresso coffee Condé nast, to develop an online magazine news- capsules — creating a lock-in that enables nestle stand using multiple digital formats. the resulting to profit from both the sale of the machine and company, next issue media, is jointly owned by in- the use of the machine by selling consumables dustry rivals and is a response by the rival publishers that machine owners must buy from nespresso. to declining print circulation (and hence print ad- Launching these products involved a radical re- vertising revenue) and the growth of digital media. design of the activity system, for example, by fighting for survival, the publishers are looking be- branching out into retailing activities. yond their otherwise fierce competition to their 3. Complementarities refer to the value-enhancing ef- common interest in inventing a new context for fect of the interdependencies among business magazines in the digital era. as ann moore, the for- model activities. Consider, for example, eBay, mer Ceo of time, stated, “it’s increasingly clear that which offers a platform to conduct sales over the finding the right digital business model is crucial for internet among individual buyers and sellers of the future of our business.”18 used and new products. a key requirement for the But how does a company increase the odds of platform to function properly is a payment mecha- developing the right business model for its situa- nism that allows buyers to make credit card tion? in our earlier work,19 we identified four major payments even when the seller does not have access

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to credit card services. paypal, the online payment interdependency between a company’s business company that eBay acquired, offers such a func- model and its revenue model. the revenue model re- tion, facilitating trades that could not otherwise be fers to the specific ways a business model enables completed. in other words, paypal has a value-en- revenue generation for the business and its partners.20 hancing effect on the eBay activity system. it is the way in which the organization appropriates 4. Efficiency refers to cost savings through the inter- some of the value that is created by the business model connections of the activity system. Consider for all its stakeholders. a revenue model complements Wal-mart, which not only championed the concept a business model design, just as a pricing strategy of discount retailing but also designed an activity complements a product design. Consider Better place, system that supports its low-cost strategy. an im- whose business model aims to provide electric vehicle portant activity within this system is logistics. over charging services. Like a mobile phone operator time, Wal-mart developed highly sophisticated whose business model centers on enabling the use of processes, such as cross-docking, unrivalled in the the mobile phone device through its network rather industry. these processes help the company to keep than on the handset device itself, Better place’s busi- its costs lower than its competitors, giving Wal- ness model centers on providing charging networks mart an important competitive advantage. and services rather than on the electric vehicle itself. our research suggests that the presence of each of it involves an innovative business model structure these value drivers enhances the value-creation po- with partners ranging from governments, vehicle tential of a business model. moreover, we find manufacturers, clean energy producers and others. important synergies among the value drivers. Com- Just as mobile phone operators charge customers plementarities, for example, can be more valuable variable or flat rates for telecommunication services, when supported by novel business model design. Better place intends to implement a revenue model as a function of customers’ car usage (miles driven), interdependencies in thus taking into account the interdependency be- Business models tween its business and revenue models.21 interdependencies in business models are created by the concepts of business and revenue model, al- entrepreneurs or managers in several ways: when though conceptually distinct, may be quite closely they choose the set of organizational activities they related and even inextricably intertwined. for exam- consider relevant to satisfying a perceived market ple, in the product world, Gillette uses its pricing need, when they design the links that weave activities strategy of selling inexpensive razors to make cus- together into a system and when they shape the gov- tomers buy its more expensive blades. a business ernance mechanisms that hold the system together. model lays the foundations for a company’s value Interdependence among business model design capture by codefining (along with the company’s elements. Content, structure and governance can be products and services) the overall “size of the value highly interdependent. take the san francisco, Cali- pie” (that is, the total value that is created), which can fornia-based peer-to-peer lending company prosper, be considered an upper limit to the company’s value for example. the venture aims at enabling direct, capture.22 the greater the total value created through small, unsecured loans between individual lenders the innovative business model, and the greater a and borrowers. early on, the founders made the con- company’s bargaining power, the greater the amount scious decision to let lenders choose the borrowers of value that the company can appropriate.23 to whom they wanted to lend their money. this was Caveats. as the Better place example suggests, a structural choice that settled the question of how business model innovators need to bear in mind that lending and borrowing activities were linked, but it identifying technologically or strategically distinct also constituted a decision about governance be- activities can be conceptually challenging, because cause it shifted the evaluation and selection activities the number of potential activities is often quite to the customers and away from the company. large.24 many seemingly inseparable activities can Interdependencies between business and reve- now be broken down even further, especially given nue models. managers also need to consider the ongoing advances in information and communica-

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tions technologies.25 (this, of course, represents not to illustrate how managers might productively only a conceptual challenge but also an opportunity and proactively use these questions, consider the for innovative managers to redesign the activity sys- business model of mcGraw-Hill’s book publishing tems of their organizations in novel ways.) business.27 in the U.s., general and trade books (in- What’s more, making changes to a company’s cluding consumer titles and celebrity author whole activity system rather than optimizing indi- books) represent about 55% of industry revenues, vidual activities (such as production) requires while academic and professional books generate systemic and holistic thinking, which can be de- the remainder. Until recently, only in business-to- manding. When responding to a crisis, operating in business and academic text segments have websites tough economic times or taking advantage of a new been a true marketing platform for digital content. opportunity, rethinking an entire business model While e-readers such as the kindle and the ipad are may not always be the first thing on a manager’s now rapidly gaining popularity, the time-consum- mind. this is particularly true when the level of ing and expensive book publishing process had not resistance to change is predicted to be high. as a re- changed in a material manner in many decades. sult, choices on business model design often go However, Google, amazon and other competing unchallenged for a long time. information and content providers have stimulated a growing customer interest in electronic formats. six Questions to ask Before publishers in the U.s. and europe are searching for launching a New model solutions to meet the emergent demand for creat- our research shows that in a highly interconnected ing and delivering digital content on portable world, especially one in which financial resources devices while preserving and enhancing value. are scarce, entrepreneurs and managers must look meeting the demand for digital content may re- beyond the product and process and focus on ways quire publishers to perform new activities (new to innovate their business model. a fresh business business model content). although it is unlikely that model can create and exploit opportunities for new the traditional hardback/paperback book will dis- revenue and profit streams in ways that counteract appear, it is expected that the demand for printed an aging model that has tied a company into a cycle publications will fall sharply. if printing and physi- of declining revenues and pressures on profit mar- cal distribution become less relevant in the process, gins.26 We suggest that managers ask themselves the the time it now takes to add a new title to a cata-

following six key questions as they consider busi- logue and to bookstore shelves will be reduced. a consortium of magazine ness model innovation: accordingly, designing, uploading and maintain- publishers is working to invent a new context for 1. What perceived needs can be satisfied through ing the most complete online catalogue may become magazines in the digital era. the new model design? 2. What novel activities are needed to satisfy these perceived needs? (business model content innovation) 3. How could the required activities be linked to each other in novel ways? (business model structure innovation) 4. Who should perform each of the activities that are part of the business model? should it be the company? a partner? the customer? What novel governance arrangements could enable this structure? (business model governance innovation) 5. How is value created through the novel business model for each of the participants? 6. What revenue model fits with the company’s business model to appropriate part of the total value it helps create?

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Determining whether mcGraw-Hill or another partner will carry out each of the activities of the new business model requires a careful consideration of trade- offs (new business model governance). for example, should the publisher’s content be delivered through a new mcGraw- Hill branded device, or by proprietary devices offered by such partners as amazon (with its kindle) or apple (with its ipad), thereby leveraging their existing position in the market? or should its content be delivered through internet- based platforms compatible with a broad range of devices, enabling global distribution? these are crucial governance decisions that a new publishing model will answer. publishers’ new business models will create value through the complementarities and interdependence among activities and through the enormous ef- a central new activity in publishers’ business models. ficiencies in the publishing process that the new in addition, to the extent that publishers decide to business models could generate. a number of alter- bypass traditional retail bookstores in their new native revenue models associated with these new business models, they will have to develop a new business models could be considered, such as single marketing activity targeting retail buyers. produc- subscription pricing independent of the number of tion will need to change as well. Creating content downloaded manuscripts, piecemeal pricing and/or with a digitally enabled streamlined process is an- value-based pricing for time-sensitive publications. other activity 21st-century publishers will probably need to incorporate into their new business models. taking a systemic View Linking the various activities to each other, se- addressing the six questions outlined above can help quencing these linkages and deciding how managers see their companies’ identities more clearly stakeholders will interact with one another in the in the context of the networks and ecosystems in new business models requires careful consideration which their organizations operate. Without a business (new business model structure). for example, the model perspective, a company is a mere participant in ways in which mcGraw-Hill decides to interact with a dizzying array of networks and passive entangle- multiple digital distribution partners such as apple ments. adopting the business model perspective can and amazon, through which mcGraw-Hill distrib- help executives purposefully structure the activity utes digital content to retail consumers, will affect systems of their companies; the purposeful design the breadth of the company’s access to the retail and structuring of business models is a key task for digital book market. the linkages among content general managers and entrepreneurs and can be an creators, including authors, editors, other publish- important source of innovation, helping the com- ing professionals and distributors, will constitute pany look beyond its traditional sets of partners, the heart of the new business model. these linkages competitors and customers. most importantly, per- must reflect alternatives available to authors — such haps, this approach encourages systemic and holistic as bypassing publishers altogether — as well as ap- thinking when considering innovation, instead of proaches adopted by competing publishers. isolated, individual choices. the message to execu-

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tives is clear: When you innovate, look at the forest, 10. e. Brynjolfsson and l. Hitt, “Intangible assets and the not the trees — and get the overall design of your economic Impact of computers,” in “transforming enterprise,” ed. W. dutton, B. Kahin, r. o’callaghan and a.W. activity system right before optimizing the details. Wyckoff (cambridge, massachusetts: mIt Press, 2004), 27-48. Raphael Amit is the Robert B. Goergen Professor 11. see l. applegate, l. schlesinger and d. delong, “taco of Entrepreneurial Management at the Wharton Bell, Inc.: 1983-94,” case no. 9-398-129 (Boston: Harvard School of the University of Pennsylvania in Philadel- Business school, 2001). phia, Pennsylvania. Christoph Zott is a professor J. santos, B. spector and l. Van der Heyden, “toward of entrepreneurship at IESE Business School in 12. a theory of Business model Innovation Within Incumbent Barcelona, Spain. Comment on this article at http:// firms,” working paper 2009/16/efe/st/tom, Insead, sloanreview.mit.edu/x/53310, or contact the authors fontainebleau, france, 2009. at smrfeedback.mit.edu. 13. We note in this context that although the “what” of the business model may change (i.e., what activities are aCKNoWledGmeNts included), the “what” of the customer offering (i.e., what product or service the customer buys) may or may not raphael amit acknowledges support from the robert B. remain unchanged. Goergen chair in entrepreneurship at the Wharton school. christoph zott acknowledges financial support 14. amit and zott, “Value creation.” from the Iese research division and from the ministry of 15. s. Banerjea, r. Kahn, c. Petit and J. White, “dare to science and Innovation of spain (grant eco 2009-12852). be different: Why Banking Innovation matters now,” ex- Both authors gratefully acknowledge the financial support ecutive brief, IBm Institute for Business Value, somers, of the Wharton-Insead alliance center for Global re- new york, 2006. search & development and also thank yuliya snihur, cesar Guzman-concha and sylvie Beauvais for valuable 16. H. chesbrough, “open Business models” (Boston: research assistance. Harvard Business review Press, 2006). 17. K. nagayama and P. Weill, “7-eleven Japan co. ltd.: reinventing the retail Business model,” cIsr WP 338 ReFeReNCes and mIt sloan WP no. 4485-04 (cambridge, massachu- 1. “Business 2010: embracing the challenge of change,” setts: mIt sloan school of management, January 2004). white paper, economist Intelligence unit, new york, feb- 18. B. stelter, “Group of magazine Publishers Is said to ruary 2005, p. 9. Be Building an online newsstand,” new york times, 2. G. Pohle and m. chapman, “IBm’s Global ceo report nov. 25, 2009, sec. B, p. 3; also see www.nextissue.com. 2006: Business model Innovation matters,” strategy & 19. amit and zott, “Value creation.” leadership 34, no. 5 (2006): 34-40. 20. Ibid. 3. Ibid., 36. 21. www.betterplace.com. 4. Ibid. 22. a. Brandenburger and H.W. stuart, Jr., “Value-Based 5. “Business 2010,” economist Intelligence unit, 10. Business strategy,” Journal of economics and manage- 6. r. casadesus-masanell and J.e. ricart, “competing ment strategy 5, no. 1 (march 1996): 5-24. through Business models,” working paper 713, Iese 23. c. zott and r. amit, “Business model design and Business school, Barcelona, spain, november 2007. the Performance of entrepreneurial firms,” organization 7. r. amit and c. zott, “Value creation in e-Business,” science 18, no. 2 (2007): 181-199. strategic management Journal 22, no. 6-7 (June-July 24. m.e. Porter, “competitive advantage: creating and 2001): 493-520. sustaining superior Performance” (new york: the free 8. c. zott and r. amit, “the fit Between Product market Press, 1985). strategy and Business model: Implications for firm Per- 25. f. santos, “toward an entrepreneurial theory of formance,” strategic management Journal 29, no. 1 Boundaries: the scalability of firms in nascent markets,” (January 2008): 1-26. unpublished manuscript. 9. c. loch, c. zott, a. Guttman, P. Jokela and d. nahmias, 26. zott and amit, “Business model design”; zott and “fricso (a): How to translate a new technology into a amit, “fit Between Product market strategy and Busi- Business (model),” case no. 608-025-1 (fontainebleau, ness model.” france: Insead, 2008); c. loch, c. zott, a. Guttman, P. 27. the mcGraw-Hill companies are active in the financial Jokela and d. nahmias, “fricso (B): designing the new services, education and business information markets Business model,” case no. 608-026-1 (fontainebleau, through leading brands such as standard & Poor’s, france: Insead, 2008); c. loch, c. zott, a. Guttman, P. mcGraw-Hill education and J.d. Power and associates. Jokela and d. nahmias, “fricso (c): executing the new Business (model),” case no. 608-027-1 (fontainebleau, france: Insead, 2008); and c. zott, B. Biren and I. Ban- Reprint 53310. For ordering information, see page 8. cerek “Webraska: evolving with the Wireless market,” Copyright © Massachusetts Institute of Technology, 2012. case no. 802-008-1 (fontainebleau, france: Insead, 2003). All rights reserved.

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A12-MI1-003 Zott.indd 49 3/6/12 9:49 AM BUSINESS MODEL INNOVATIONINNOVATION How to Identify New Business Models THE LEADING Systematically exploring alternative approaches to value creation QUESTION can allow companies to find new opportunities for growth. How can your company BY JOSEPH V. SINFIELD, EDWARD CALDER, BERNARD MCCONNELL AND STEVE COLSON explore business model innovation?

FINDINGS ORGANIZATIONS TRADITIONALLY pursue growth via one or more of three broad paths: Create a template that allows you to •They invest heavily in product development so they can produce new and better offerings. examine alternative answers to key •They develop deep consumer insights in order to offer new and better ways to satisfy customers’ needs. business model • They concentrate on strategy formulation to grow by acquisition or by moving into new or adja- questions. Use the template cent markets. to systematically Each of these paths usually involves devoting considerable time and resources to developing a corre- consider alternative approaches to value sponding organizational competency. For example, to build product capability, companies typically invest creation. in in-house research and development departments and/or technology-sourcing expertise. Establishing Be clear upfront about what you customer insight capability often requires creating in-house market research units and implementing don’t want to robust feedback links between the sales force and the developers of product or service lines. And creat- change about the way you do ing a strategy capability generally involves setting up dedicated corporate strategy units and merger and business. acquisition groups or engaging consultants. Recently, a fourth path has emerged, one By systematically that we might label “business model experi- examining alternative business models, the mentation”: the pursuit of growth through the tool manufacturer methodical examination of alternative business Kennametal was able to develop new service- models. At its heart, business model experimen- based offerings. tation is a means to explore alternative value creation approaches quickly, inexpensively and, to the extent possible, through “thought experi- ments.” The process sheds new light on potential competitors and lowers the risk of taking the wrong or a lesser-potential road — all for an initial investment that is typically quite small relative to what can be gained. Research conducted in the last 10 years has established a link between business model innovation and value creation.1 To our minds, this research points to the need for organizations to build a competency in business model innovation — that is, in the process of exploring possible business model alternatives that can be pursued to commercialize any given idea prior to going out into the market and expend-

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ing resources. However, few organizations have you can’t address with your current business successfully conceived and executed a business model? The answers to these questions form the es- model different from their current one, fewer still sence of business model experimentation. have done it more than once and only a handful ABOUT THE have put in place a methodical approach to business Starting the Process RESEARCH model innovation. The first step in the business model exploration pro- The approach to business model experimentation pre- Our goal is to demonstrate how an organization’s cess is to create a template to examine possible sented in this article stems ability to methodically and routinely examine mul- alternative answers to the questions above. (See “A from over four years of field tiple business model alternatives — in other words, Business Model Development Template.”) The ques- work carried out with more by treating the business model as a variable and not a tions that help to shape a business model represent a than 20 companies — in- constant — can serve as a critical enabler of growth, series of decisions, each of which has a set of possible cluding Kennametal, Infineum, Johnson & allowing executives to anticipate, adjust to and capi- outcomes. Our template lays out various possible Johnson, P&G and talize on new technologies or customer insights. The outcomes within the business model structure. Se- Medtronic — in an array of approach we describe is based on research over the lecting one possibility from each category and then industries, including con- last two decades into mechanisms of reliable, me- linking them together forms one potential new way sumer packaged goods, chemicals, medical devices, thodical business model generation as well as our to proceed. And, of course, selecting different com- pharmaceuticals and finan- own work helping companies2 build the capability to binations creates other possible outcomes. cial services. This work create repeatable growth through business model To see how this works, consider how an airline entailed in-depth, interview- experimentation. (See “About the Research.”) might use the template to generate alternative busi- based primary market ness models. Currently, airlines serve a range of research with existing and potential customers; exten- What Is a Business Model? customers with the same basic model. For example, sive working team idea At a conceptual level, a business model includes all as- regardless of whether the customer is going on vaca- formulation and prioritiza- pects of a company’s approach to developing a tion with her family, traveling on business or tion activities, and in-market profitable offering and delivering it to its target cus- responding to an emergency, airlines use the standard assumption testing and business piloting. Our pur- tomers. A review of the relevant literature reveals that pay-per-seat model with which we are all familiar. pose was to understand the more than 40 different components — such as target Minor levels of customization exist — for example, range of alternatives avail- customer, type of offering and pricing approach — larger seats and priority boarding for those who pay able for companies to have been included in various definitions of business for them — but the core model is the same for all. optimize the value captured through commercialization models put forward over the past few decades, with To explore business model innovation, an airline of their innovative offerings. much of the variation stemming from differences be- could start by picking a specific customer group and The specific company ex- tween the industries and circumstances in which a then beginning to explore potential options other amples presented in this definition has been applied.3 than its current model. Answers to the question “How article highlight two distinct For our purposes, we will explore the concept of a does the customer gain access to the offering?” (which approaches to employing the proposed business business model by addressing several core questions is essentially the same as asking “How will we sell it?”) model innovation process. that the majority of business model researchers deal could include “Through travel agents” or “Through These two cases represent within their models: online websites” or “Through self-service kiosks” or starting points at opposite •Who is the target customer? “As part of partnerships.” As for where on the value ends of the value chain — one driven by an •What need is met for the customer? chain the airline might operate, it could be the service understanding of unsatis- • What offering will we provide to address that provider, but it might also be a wholesaler selling off fied customer needs, the need? excess capacity to reduce unprofitable flights. Various other driven by the pursuit •How does the customer gain access to that offering? profit models would likely start with the traditional of applications for a set of •What role will our business play in providing the pay-per-seat but might expand to include subscrip- technical solutions. This demonstrates the broad ap- offering? tion models. The offering itself might be a premium plicability of the approach. •How will our business earn a profit? seat, a low-cost seat or maybe even fractional owner- In any working business model, the answers to ship of a plane or chartered use of an aircraft. We these questions are fixed. But what if they weren’t? experimented with “What we sell” for an airline to What if you considered each of them as a variable? show how changing just one variable can result in a What new opportunities could you capture that substantially different business. (See “Generating

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New Business Models by Changing One Variable.”) A BUSINESS MODEL DEVELOPMENT TEMPLATE Working out what elements should be in a busi- The questions that help to shape a business model represent a series of ness model — and then examining different decisions, each of which has a set of possible outcomes. This template lays out various possible outcomes within the business model structure. combinations of them — can be a rapid and robust way to explore the possibilities of business model in- What Who should customer What How will Where novation. This process has the potential, for instance, be our need offering the customer should we How will target should we will satisfy access our operate in we earn to uncover combinations that are common in other customer? fill? that need? offering? the chain? a profit? industries but not in your own. In fact, deliberately What How Value Chain How We Customer Job We Sell We Sell Role Profit applying analogies from other industries (for exam- 1 1 1 1 1 1 ple, what if a company became the NetJets of What How Value Chain How We agricultural equipment or the Dell of automobiles?) Customer Job We Sell We Sell Role Profit 2 2 2 2 2 2 can be highly fruitful. It may also highlight links that How How We create a “systemic” level of competitive advantage in Customer Job 3 3 We Sell Profit the business concept — much as Apple did with the 3 3 agreements it made with record labels to distribute songs through its iTunes online music site. Alterna- GENERATING NEW BUSINESS MODELS tively, the business model innovation process can BY CHANGING ONE VARIABLE uncover opportunities to more comprehensively ful- Changing even just one variable — in this case, “What is sold” for an airline fill a customer need than any current competitors do. business — can result in a substantially different business model. A quick run-through of simple combinations of Customer How It Value Chain Profit What high-level strategic questions can produce a wide Type Need Is Sold Role Model Is Sold range of potential business models. But each of the Obtain Through Premium, Incumbent Casual Service Carrier like Traveler Ground Travel ... Select Seat questions could be examined in more detail in a Transport Agent Provider on Plane American Airlines systematic way to yield deeper insight into some Reserve Online Low-cost, Discount specific aspect of the business. For example, rather Business via General Carrier like Traveler Hotel Broker ... Rooms Provider Seating on Southwest than brainstorming various alternatives for the Website Plane

“What we sell” category, a company could break the Fractional Fractional Emergency Facilitate Fee for Ownership category down into its constituent parts and ask a Traveler Air Travel ... Ownership Seat of Plane Company series of additional questions such as: like NetJets •Should we sell a product or a service? Chartered ...... Aircraft Charter •Should it be standard or customizable? Usage Service •Will its benefits be tangible or intangible? •Will we sell a generic or branded offering? •Should it be a durable or a consumable? sumer will need to purchase new ones frequently. We have often found it useful to visualize such Such realizations dramatically reduce the number choices as switches, or levers, which can be flipped of options that must be explored. one way or the other. (See “Exploring Offering Op- What’s more, there are likely only a handful of tions in More Depth,” p. 88.) You could engage in a ways that any of these questions can be practically ad- similar exercise to systematically explore potential dressed while remaining consistent with the mission variations in the way a customer might gain access to of the organization and its “goals and bounds”4 — an offering or the way a customer might pay for it. that is, what the organization is willing, and not willing, to do. Some answers form a more natural Narrowing the Choices path to making the business more efficient or better Despite what one might think, these choices are not able to deliver the existing value proposition. Some infinite. In working through possible combinations will lead to models that are more feasible to imple- of variables, it becomes clear that some are inher- ment than others, given the company’s existing ently interrelated. For example, if the offering is a competencies and its ability to develop new ones. durable good like a car, it is unlikely that the con- In fact, it is possible to use this approach to delib-

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erately align the exploration of alternative business The company then identified three high-potential models with wider corporate goals by “locking in” combinations. For example, one was small “job one or more variables as you go about your experi- shops” that had unmet training needs. The next mentation. To see how this might work, let’s take a step was to focus on developing the offering and look at two cases in more depth. In the first, a tool determine how the company would deliver it. manufacturer explores opportunities to enter new For each possibility, the team methodically re- lines of business spurred by market trends; in the viewed a list of levers for the remaining business second, a maker of petroleum additives seeks to model components — for example, “What we sell” identify new ways to employ its core competencies. and “How we profit” — and articulated multiple options for each lever. By examining more than 30 Exploring New Customer Needs different levers in multiple combinations, they sys- Kennametal is a tool manufacturer based in La- tematically generated an expansive list of possible trobe, Pennsylvania. Faced with an evolving business model options. Conceptualizing the differ- manufacturing environment, a changing customer ent components of a business model as levers forced base and increasing global competition, Ken- the team to consider new combinations they likely nametal embarked on a business model would have otherwise overlooked. For example, Ken- experimentation initiative to diversify its revenue nametal has traditionally been a product-centered stream by identifying two to three new businesses company that provides service as part of product in adjacent markets that would leverage core assets. sales. However, by looking at its service capabilities A small team kicked off the initiative with a research and examining the options for some “How we profit” effort focused on developing a more comprehen- levers, the company was able to consider a number of sive understanding of potential customers’ interesting fee-for-service business models. In doing frustrations, desires and challenges, in order to so, Kennametal was essentially exploring ways to populate both the target customer and possible monetize the latent wealth of knowledge contained needs categories of the business model template. in the organization’s experience, people and knowl- The research involved a combination of qualitative, edge-management systems. quantitative and observational activities.5 With more than 30 levers, there were literally Since the goal was to create diversified revenue thousands of possible permutations and, therefore, streams, Kennametal chose to prioritize needs the last step in the process was to identify the most based on the classic measures of their profit poten- attractive ones. The team focused on the possibili- tial: importance to the customer, the customer’s ties that would generate the greatest customer level of dissatisfaction with the offerings currently satisfaction, would be the hardest for competitors on the market and the degree to which the need had to copy and were the most feasible to pilot. This not already been targeted by other internal efforts. process ensured not only that a wide range of options were considered but that the opportunities EXPLORING OFFERING OPTIONS IN MORE DEPTH selected were well matched to customers’ needs, Rather than just brainstorming various alternatives for the “What we sell” question were competitively robust and leveraged existing that is part of a business model, a company could more systematically examine its resources appropriately. options by asking a series of additional questions, such as whether what it sells is a The initiative required a minimal amount of product or service, whether that product or service is standard or customizable, etc. time from a small, multifunctional team over an What We Sell eight-week period — truly a low-risk way to home in on new growth options. In this way, Kennametal Type Features Benefit Brand Lifetime used the business model innovation process to Product Custom Tangible Generic Consumable move beyond incremental improvements in its businesses and generate three new opportunities to pursue in adjacent markets. In particular, two of these initiatives formed the foundation of new ser- Service Off-the-Shelf Intangible Branded Durable vice-based offerings for Kennametal.

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Using Core Competencies to Create INCORPORATING GOALS AND BOUNDARIES INTO New Businesses at Infineum BUSINESS MODEL EXPERIMENTATION Infineum, an enterprise based in Oxfordshire, United In this excerpt from its business model generation template, Infineum built its goals and boundaries into the business model experimentation process by divid- Kingdom, with about 1,600 employees that conducts ing entries into three groups: “desirable,” “discussable” and “unthinkable.” business in more than 70 countries, is another or- Customer ganization that has used the business model Type and What Is Value Chain Profit experimentation process. Infineum is one of the lead- Position Need Sold Role Model ing formulators, manufacturers and marketers of B2B – Two Enhance Value Chain Steps or Customer Product Element Product petroleum additives for the fuel and lubricant indus- More From Process Solution Integrator Sales End User Efficiency try, and its customers are oil and fuel marketers. Desirable Improve Infineum’s goal in the business model experimenta- Customer Product tion process was to leverage its product technology Performance and know-how and create a list of profitable new op- Facilitate portunities that fit with its core competencies. B2B – Customer IP Licensing/ Upstream Close to Royalties End User Product Sale Supplier Since Infineum wished to hold to a strong inter- Design Discussable personal sales model in any initiative it pursued, we Integrated Product/ Value Chain Fee locked down the “How we sell” switch and did not Service Element Partner for R&D consider alternative sales methods. In addition, the Solution company’s goals and boundaries were built into the Manufacture process by dividing entries under each category into Business-to- Pure End Service Refiner Brokering Consumer Product three groups: “desirable,” “discussable” and “unthink- Unthinkable able.” (See “Incorporating Goals and Boundaries into (out of bounds) Financial Trader or Business Model Experimentation.”) End User Solution End Provider Distribution Given those requirements, within each category each option was considered according to its overall merits. Infineum identified a number of new oppor- yearly) for work resulting in meeting R&D targets. tunities, two of which we will now describe in more This fee was charged on the basis of value to the OEM detail. Both went from inception to commercializa- in meeting technical challenges, rather than bearing tion within 18 months, a time frame that is unusual in any relationship to the cost of the R&D, and as such an industry as asset-intensive as petrochemicals. can be considered as the direct monetization of the value of the R&D work. The second element involved Rethinking what we sell. The first example in- licensing the necessary know-how to the OEM and volves additives for the lubrication of high-precision charging royalties linked to the OEM’s use of that instruments like cameras and robotics. Identifying a know-how, based on the OEM’s unit sales. Revenue commercialization opportunity for this market pre- from these elements, together with the sales price of sented two special challenges to Infineum’s existing additives sold to the OEM, created three distinct in- business model. First, the amount of lubricant re- come streams, which led to a viable business model quired per instrument is extremely small, so selling for Infineum that was also acceptable to the OEM. the product by the ton, as Infineum usually did, was not appropriate. Second, Infineum was working Changing places. The second example shows closely with one particular original equipment man- what can happen when you look at different roles ufacturer, which wanted to treat the offerings as a your company might play in the industry value trade secret, whereas Infineum would have normally chain. Infineum normally sold diesel and heavy- sought patent protection for its intellectual property. fuel-oil additives to refineries, with a value To address these challenges, a new business model proposition based on a combination of high levels was devised having two key new elements in the “What of technical performance, lowering costs and a re- we sell” and “How we profit” categories. The first ele- sponsive supply chain to deal with fuel-specific ment was to charge a regular fee (typically, twice requirements. In the new business opportunity, ad-

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ditives are mixed into the fuel after it has left the Colson is a company coach at Open Water Develop- refinery, typically when it is on board a ship in the ment Ltd. and a former general manager of growth initiatives at petroleum-additive maker Infineum in port of delivery. Here, the main emphasis is on high the United Kingdom. Comment on this article at levels of responsiveness and very short lead times to http://sloanreview.mit.edu/x/53214, or contact the minimize the turnaround time of vessels in port. authors at [email protected]. In this business model, Infineum was operating further along the supply chain than usual, with a very REFERENCES different value proposition. In this case, in order to 1. See T.W. Malone, P. Weill, R.K. Lai, V.T. D’Ursio, G. Her- gain access to the distribution channel, Infineum man, T.G. Apel and S.L. Woerner, “Do Some Business Models Perform Better Than Others? “Working paper partnered with a transportation service provider fa- 4615-06, MIT Sloan School of Management, (Cambridge, miliar with operating further along the supply chain Massachusetts, 2006) May 16; S.M. Shafer, H.J. Smith and J.C. Linder, “The Power of Business Models,” Busi- in this specific market. By holding inventory of prod- ness Horizons 48, no. 3, (2005): 199-207; E. Giesen, S.J. uct close to the partner’s supply points, Infineum was Berman, R. Bell and A. Blitz, “Three Ways to Successfully able to meet the challenge of very short lead times. Innovate Your Business Model,” Strategy & Leadership 35, no. 6 (2007): 27-33; and M.W. Johnson, C.M. Chris- Neither of these opportunities could have been tensen and H. Kagermann, “Reinventing Your Business captured and commercialized within Infineum’s nor- Model,” Harvard Business Review, 86, no. 12 December mal business models. They involved the development 2008: 51-59. In a study of 1,000 of the largest U.S. firms, for example, Malone et al. called attention to the link and of not only new value propositions but new ways to mapped out a comprehensive classification system that turn a profit and new ways to position the company can be employed both to categorize and to develop busi- within the industry value chain. So beyond improv- ness models. Shafer et al. described the benefits General Motors gained by employing business model innovation in ing business results by opening new avenues to the development of OnStar, and contrasted this success revenue, these initiatives stretched the organization’s story with the narrow and less innovative approach em- ability to think beyond its traditional competencies. ployed to define the business model for eToys in the late 1990s. Giesen et al. examined 35 financially successful enterprises and outlined three distinct paths to business The Bottom Line model innovation — industry, revenue and enterprise By engaging in business model experimentation with model innovation — that were at the core of their success. Further, Johnson et al. explored the stories of P&G, Tata, a small, focused team, companies can accomplish Hilti and Dow Corning to emphasize the financial and long- three important goals. First, they can understand the term competitive differentiation benefits that companies implications of different business models and make can achieve through business model innovation. clearer, better informed decisions about where and 2. Johnson et al., “Reinventing Your Business Model.” how they want to compete. Second, they can identify 3. Shafer et al., “The Power of Business Models”; and the business models that will create the most value for M. Morris, M. Schindehutte and J. Allen, “The Entrepre- neur’s Business Model: Toward a Unified Perspective,” customers and themselves and appropriately leverage Journal of Business Research 58, no. 6 (June 2005): 726- their existing resources. And third, they can use busi- 735. ness model innovation to extract the maximum 4. J.V. Sinfield and S.D. Anthony, “Constraining Innova- potential from other growth-focused activities — tion: How Developing and Continually Refining Your their technical R&D, customer insight and strategic Organization’s Goals and Bounds Can Help Guide Growth,” Strategy & Innovation 4, no. 6 (November-De- development efforts. Given the high potential of cember 2006): 1, 6-9. business model innovation and how few companies 5. For more on conducting research into discovering such have mastered it, we see business model experimen- needs see, for example, C.M. Christensen and M.E. tation as a potent source of competitive advantage. Raynor, “The Innovator’s Solution: Creating and Sustaining Successful Growth” (Cambridge, Massachusetts: Harvard Business Press, 2003); and S.D. Anthony and J.V. Sinfield, Joseph V. Sinfield is an associate professor of civil “Product for Hire: Master the Innovation Life Cycle With a engineering at Purdue University in West Lafayette, Jobs-to-be-done Perspective of Markets,” Marketing Indiana, and a senior partner at the innovation and Management 16, no. 2 (March-April, 2007): 18-24. strategy consulting firm Innosight. Edward Calder, a principal at Innosight, is based in the firm’s Lexing- ton, Massachusetts, headquarters. Bernard McCon- Reprint 53214. nell is vice president of WIDIA Products Group at Copyright © Massachusetts Institute of Technology, 2012. Kennametal, based in Latrobe, Pennsylvania. Steve All rights reserved.

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[STRATEGY] Financial assets, which include cash as well as securities like stocks, bonds and in- The Business Models surance policies that give their owners rights to potential future cash flows; Investors Prefer Physical assets, which include durable items such as computers, as well as nondu- New research suggests that the stock market rable items such as food; particularly values business models based on Intangible assets, which include intel- innovation and intellectual property. lectual property such as patents and copyrights, as well as other intangible assets BY PETER WEILL, THOMAS W. MALONE AND THOMAS G. APEL like knowledge, goodwill and brand value; Human assets, which include people’s time and effort. People of course cannot be Why are investors so bullish on companies like Apple and Disney? Is it financial metrics, great legally bought and sold, but their time and management, industry prowess, good investor relations or good timing? Probably all of these. knowledge can be “rented out” for a fee. But something else may be at work, too. In research we conducted at the MIT Sloan School of The four ways companies manage as- Management, we found that the stock market consistently values certain types of business mod- sets rights to generate revenue are as: els more highly than others. Specifically, we found that in recent years, investors have favored Creators, which sell ownership of prod- business models focusing on licensing intellectual property (such as Walt Disney’s business ucts they have created by transforming or model) and a certain kind of highly innovative manufacturing (such as Apple’s). assembling raw materials or components. We developed a framework that includes 14 types of business models. (Surprisingly, we Ford, 3M and Intel are examples of this found there is no universally accepted definition of the important concept of a business model.) type of company; Then, using data from Compustat, we classified all the more than 10,000 companies that are Distributors such as Wal-Mart or publicly traded on U.S. exchanges within the framework by identifying the percentage of each Amazon.com’s retail business, which sell company’s revenue generated through each of the 14 business models; we used a combination ownership of products they bought but of manual classification and a custom-developed rule-based software program. By classifying did not substantially change, except by companies’ revenue into these 14 business models, a new picture emerged of not only individ- transporting, repackaging or marketing; ual companies, but businesses more generally. The individual classifications were then (Continued on page 18) aggregated to construct an index for each business model. Those indices THE BUSINESS MODEL FRAMEWORK then allowed us to compare total stock Our business model framework defines the types of assets a company sells and the rights market returns — as measured by it grants customers to use those assets. We classified all of the companies listed on U.S. changes in stock price plus dividends exchanges into the framework by identifying the percentage of their revenues generated — for different business models in the through one or more of the business models. Share of Total U.S. markets over a 12-year period, Asset Type Revenue of from 1997 through 2009. The results U.S.-Listed Firms Financial Physical Intangible Human provide insight into investor treat- Manufacturer ment of various business models. In Creator N/A* particular, the findings underscore the 0% 57% 0% 57% Financial Wholesale/ importance of innovation and intel- Distributor Trader Retail N/A* lectual property in the U.S. economy. Asset <1% 14% ~0% 14% Rights Our business model framework is Financial Physical IP Contractor Landlord Landlord Landlord Landlord based on defining the types of assets a 8% 10% 2% 8% 28% company sells and the rights it grants Financial Physical customers to use those assets. We de- Broker Broker Broker fine four asset types and four ways <1% <1% 0% ~0% 1% Share of Total companies manage asset rights to gen- Revenue of 9% 81% 2% 8% 100% U.S.-Listed Firms erate revenue. The four asset types are: * not a legal business model

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The Business Models Investors Prefer (Continued from page 17) Landlords, which sell only the right to RELATED RESEARCH from physical assets. Manufacturing — use assets for a specified period of time; T.W. Malone, P. Weill, R.K. Lai, creating physical assets — generated about V.T. D’Urso, G. Herman, T.G. Marriott, Hertz, Accenture and Citigroup Apel and S.L. Woerner, “Do 57% of all company revenues. Manufac- Some Business Models Perform are examples of the landlord model. We in- Better than Others?” working turers are generally highly valued by cluded in this category companies that paper 4615-06, MIT Sloan School investors, with manufacturers who inno- of Management, Cambridge, employ licenses or subscriptions to sell lim- Massachusetts, May 18, 2006, vate even more highly valued. http://seeit.mit.edu. ited rights to use their intellectual property Twenty-eight percent of all company (IP) assets — companies such as Microsoft (65% of revenue in 1984 but only 30% in revenues derives from landlord type trans- and The New York Times; 2009) to licensing intellectual property (15% actions but with major differences in total Brokers, which receive a fee for matching of revenue in 1984 but 63% in 2009), with stock market returns. Financial and physical buyers and sellers without ever taking own- clear investor buy-in for this strategic shift. landlords were the poorest performing of ership or custody of the product; examples Disney stock outperformed the S&P 500 the common business models, while IP include Charles Schwab, eBay and realtors. stock index over the last five years and beat landlords were the second-highest perform- One of the advantages of this framework that index by more than 20% in the two-year ing. Contractors — a model that includes is that we can compare companies that have period ending December 31, 2010. consulting firms and other businesses that similar business models and thus require Business models provide a cross-indus- primarily “rent out” human assets — had similar capabilities but operate in different try lens for analyzing how a company is performance in the middle of the pack. industries. For example, a physical landlord managed and the resulting stock market Innovative manufacturers — which we can sell the use of a broad range of assets in- total return. The differences in the stock define as those who invest more than their cluding hotel rooms, plane seats, software, market total return of companies deriving industry average in research and develop- information or rental cars. We can also as- revenue from different business models are ment — are the top performers in the sess what business models investors prefer at striking — with returns for different types market. Apple is an example of an innova- different times and how a company’s busi- of business models ranging from about tive manufacturer. Apple’s business model ness model has changed over time. For 145% to 240% over the 12 years we studied. in 2008 was 86% manufacturer, 7% con- example, Disney has dramatically shifted its An interesting picture emerges: tractor and 7% IP landlord, and the results business model over the last 20 years from Eighty-one percent of total revenue from — products like the iPhone, iPhone apps, renting physical assets like theme parks companies listed on U.S. exchanges comes iPad, MacBook Air, iTunes — have paid big dividends. This is a powerful combination MARKET PERFORMANCE OF THE from an investor perspective. MOST COMMON BUSINESS MODELS Returning to Disney, we see that the Stock market total returns for different types of business models ranged from about 145% to 240% over the 12 years studied. company’s shift in business models over time has played directly into the sentiment Percent Change in Value 240% of investors. Disney has reduced revenues from one of the least valued business mod- 200% els, physical landlord, while increasing its reliance on one of the most valued busi- 160% ness models, IP landlord. And Disney has

120% also retained innovative manufacturing, the more highly valued part of the manu- Contractor 80% Financial Landlord facturing business model. IP Landlord Manufacturer 40% Manufacturer/Innovator Key Questions for Company Manufacturer/Non-Innovator Physical Landlord Leaders to Answer 0% Wholesale/Retail Distributor All Issues Of course, the business models that inves- S&P 500 EWI -40% tors value most today may not be the ones 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 they will favor 10 years from now. But the concept of business model provides a Note: The S&P 500 EWI is the equal weighted index for regular stocks including dividends. The MIT Business Models indices outperform the S&P 500 EWI mostly due to a larger concentration of small-cap companies. fundamental tool for analyzing many

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important strategic decisions. For example, companies can use our framework to help decide when to dispose of one business unit, when to invest in another one and where to look for potential acquisitions. In making these decisions, the framework helps you analyze your business, not just in the context of your own industry, but also in the context of companies in very different industries that have similar business models. We suggest that leaders should consider the following key questions: What are our business models today, and how have they changed over the last 10 years? How do our business models compare with those of our traditional and nontra- ditional competitors? How can we adjust our overall business model to include more revenue from the models that are most highly valued today (such as IP landlord and innovative manufacturer) or that we believe will be most highly valued in the future? To make any change in our business model, what competencies do we need to further develop, and what strategic experi- ments can we do today to test new business models for tomorrow?

Peter Weill is a senior research scientist and chairman of the Center for Information Sys- tems Research at the MIT Sloan School of Management. Thomas W. Malone is the Pat- rick J. McGovern Professor of Management and the founding director of the MIT Center for Collective Intelligence at the MIT Sloan School of Management. Thomas G. Apel is a research affiliate with the Center for Informa- tion Systems Research. The research team also included George Herman, Stephanie L. Woerner, Steve Kahl, Richard K. Lai, Victoria T. D’Urso and more than 20 MIT undergradu- ate, graduate and postgraduate students. This research was funded by the National Sci- ence Foundation (grant number IIS-0085725), the MIT Center for Collective Intelligence and the MIT Center for Information Systems Research. Comment on this article at http:// sloanreview.mit.edu/x/52402, or contact the authors at [email protected].

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THE LEADING QUESTION What to Do Against Should companies adopt a second business Disruptive Business model in their main market?

FINDINGS Responding to a dis- Models (When and How ruption by adopting a second business model in the same market can be an to Play Two Games at Once) effective strategy. Your second business model should Fighting against a disruptive business model by rolling out a be different from your existing one second business model is one option for companies to consider. and different from that of the disrupter. But to make that work, you need to avoid the trap of getting stuck Keep the two separate enough to in the middle. avoid conflicts, but BY CONSTANTINOS C. MARKIDES AND DANIEL OYON leverage potential synergies.

INCREASINGLY, ESTABLISHED companies in industries as diverse as airlines, media and banking are seeing their markets invaded by new and disruptive business models. The success of invaders such as easyJet, Netflix and ING Direct in capturing market share has encouraged established corporations to respond by adopting the new business models alongside their established ones. Yet, despite the best of inten- tions and the investment of significant resources, most companies are unsuccessful in their efforts to compete with two business models at once. According to Michael Porter and other strategy theorists, managing two different business models in the same industry at the same time is challenging because the two models (and their underlying value chains) can conflict with each other.1 For example, airlines selling tickets through the Internet to fight back against their low-cost competitors risk alienating existing distributors (the travel agents). Similarly, established newspaper companies that offer “free” newspapers to respond to new entrants risk cannibal- izing their existing customer George Clooney pitches base. By attempting to com- Nestlé’s Nespresso pete with themselves, Porter products, a new unit designed to reach argued, companies risk affluent coffee drinkers.

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HOW TO paying a significant straddling cost: damaging their We have also found that competing successfully INTEGRATE existing brands and diluting their organizations’ with two different and conflicting business models SEPARATE UNITS cultures for innovation and differentiation.2 involves more than creating a separate unit. Several Companies operating with His view was that a company could find itself years ago, we studied the experiences of 68 compa- two business models use a variety of integrating mech- “stuck in the middle” if it tried to compete with nies that faced the challenge of competing with anisms to exploit synergies both low-cost and differentiation strategies.3 dual business models.8 Our main finding was that between the models. only a handful of companies that created separate Appoint a common gen- The Case for Separate Units units were successful in playing two games. Many 1 eral manager overseeing both the established and The primary solution proposed to solve this prob- had created separate units and still failed, suggest- the new business lem is to keep the two business models (and their ing that separation in itself was not enough to Allow different cultures underlying value chains) separate in two distinct ensure success. 2 to emerge but unite the organizations. That is the “innovator’s solution” If separation is not sufficient, what else should parent with the separate unit by a strong shared vi- that Clayton Christensen proposed and that has companies do? From 2007 to 2009, we studied 65 sion been supported by others.4 Even Porter has ac- companies that attempted to compete with dual Put in place targeted cepted this organizational solution.5 The rationale business models in their markets (see “About the 3but limited integrating for this approach is straightforward: Managers at Research”). By comparing the experiences of the mechanisms the established company who feel that the new businesses that did so successfully with those that Nurture strongly shared 4 values that unite the business model is growing at their expense would failed, we have identified five key questions that people in the two busi- want to constrain or even kill it. By keeping the two companies need to consider if they are to improve nesses business models separate, you prevent the compa- the odds of success in competing with dual busi- Appoint an active and ny’s existing processes and culture from suffocating ness models in the same industry. 5 credible integrator the new business model. The new unit can develop Emphasize “soft” le- 6 vers such as a strong its own strategy, culture and processes without in- Question #1: Should I enter the market space sense of direction, strong terference from the parent company. created by the new business model? values and a feeling of “we are in this together” Sensible as this argument seems, the separation Despite popular perception, the markets that get cre- solution is not without problems and risks. Perhaps ated by new business models are not necessarily Develop incentives that 7 encourage cooperation the biggest problem is that you can’t exploit the more attractive than existing markets. Nor are the between the two units synergies between the established company and the new customers who are attracted to the new business Integrate the activities separate unit.6 In recognition of the need to exploit models the kinds of customers that established cor- 8 that cannot be done the synergies, some academics have suggested an porations should necessarily pursue. For example, well if they become independent alternative: the creation of separate business units consider the huge market that Internet brokerage Allow the unit to bor- that are linked by a number of integrating mecha- created in the United States. There’s no question that 9 row brand name, nisms. Several studies have now identified a number it’s a big and growing market. But is it a market that physical assets, expertise and useful processes of integrating mechanisms that successful compa- all established brokers ought to go after? Probably nies have put in place to exploit synergies (see “How not. Consider Edward D. Jones & Co. L.P., one of the Let an independent 10 executive from out- to Integrate Separate Units”).7 leading companies in the U.S. retail-brokerage inside the business unit dustry. As John Bachmann, a former partner, secure an internal cham- pion to manage the unit Why Separation May commented: “You will not buy securities over the In- and provide oversight Not Be Enough ternet at Edward Jones. That’s going to be true as far Give the unit opera- Although the idea of creating separate business as I can see into the future.… If you aren’t interested 11 tional autonomy but units has received a lot of attention, this approach in a relationship and you just want a transaction, exercise strong central strategic control by itself does not ensure success. In fact, there then you could go to E*Trade Financial Corp. if you 9 Allow the unit to dif- are many examples of companies that have pursued want a good price. We just aren’t in that business.” 12 ferentiate itself by this strategy and failed (such as British Airways The decision to enter the market space that a adopting a few of its own value chain activities but with its Go Fly subsidiary and KLM with its new business model has created is not (and should exploit synergies by ensur- Buzz subsidiary) while other companies, such as not be) automatic. Before jumping in, an estab- ing that some value chain activities are shared with Nintendo and Mercedes, have succeeded in playing lished company needs to assess the “attractiveness” the parent two games without creating separate units. of the new market and whether it’s a market worth

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competing in. Whether or not the new market is at- newly created market that a new business model tractive will depend not only on its size and growth has created, the second question is: “Can I serve the rate but also on the business’s competences and the new customers with my existing business model or likelihood it would succeed in the new market. do I need a new one?” The answer is subjective, and Appearances can be deceiving. Established corpo- companies from the same industry facing the same rations should approach the decision the same way disruption have answered in totally different ways. they approach the decision to diversify into another However, the importance of asking (and answer- market. They must assess not only if the new mar- ing) this question cannot be overemphasized. It can ket is attractive in general but whether, given their save an established business an enormous amount own bundle of core competences, it is attractive to of money and time. them. That involves asking whether their competences can be applied in the new market in a unique ABOUT THE RESEARCH 10 way. The corporate graveyard is littered with com- We spent two years (2007-2009) exploring the question: “How could a companies that moved into what appeared to be pany compete successfully with two business models in the same industry?” attractive markets, only to discover that the markets We started by identifying 80 companies whose industries had been invaded by were filled with mines. a disruptive business model in the last 15 years. Fifteen of these companies chose to ignore the market space created by the new business model, while Many established companies assume that the 65 chose to enter it. These 65 companies formed the basis for our analysis. new markets are just extensions of the old market. For each, we prepared a detailed case study based primarily on archival data, For example, how different can the low end of the industry publications and other public sources. The cases emphasized the main airline market and the established airline market differences between the established company’s primary business model and be? Aren’t they simply two segments of the same the disruptive business model that invaded its market. They also described in detail how the established company attempted to adopt the disruptive busi- market? The answer is emphatically no! The fact is ness model and how successful it was in doing so. Some corporations had that the new markets are substantially different entered the new market space using their existing business model, while from the established markets — they are made up others chose to develop a new one. of different customers looking for different value Based on this initial analysis, we identified 23 companies that had entered the new market space successfully and 42 that entered and failed. We then attributes. As a result, they require different key attempted to identify consistent themes that differentiated the successes success factors and draw on different skills. For an from the failures. Once the initial “results” were compiled, we arranged for established company, moving into a newly created field trips and detailed interviews with nine companies (Nestlé, Edward Jones, market represents a risky diversification move and Edipresse, Circle Health, Waitrose, Guardian Media, Shire Pharma, Reuters and Tesco). The purpose was to communicate our initial findings and receive feed- should be evaluated as such. back from senior executives. That doesn’t mean that established corporations During 2009, the research was further refined in an iterative process of applica- can ignore an invading business model — they can’t. tion, testing and adaptation. Feedback from our academic colleagues, classroom But they don’t necessarily have to adopt it. One po- discussions and further interviews with executives at our sample companies tential response is to invest in the existing company to allowed us to identify the five key questions that this article discusses. make the traditional business strategy more competitive relative to the new business model. Alternatively, Consider Internet banking and the new markets the established company can counterattack the busi- it has created in retail banking. Should an estab- ness model innovators by introducing a new business lished bank try to serve the new market by adding model of its own — a “disrupt the disrupter” strategy. online distribution to its existing business model? There are several options available to a company to Or does Internet banking require an alternative respond to an invading business model; adopting the business model? Most established banks have new model is just one of them.11 (See “What to Do treated Internet banking as just another distribu- When Your Business Model Is Disrupted.” p. 29.) tion method. But the Dutch bank ING Groep N.V. has taken a distinctly different approach. In creating Question #2: If I do enter the new market space, a separate unit called ING Direct and allowing it to can I do it with my existing business model or develop its own business model and culture, ING will I need a new one? has concluded that Internet banking is more than If an established corporation decides to exploit the just another distribution channel, something that

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requires its own dedicated business model. company, similar products, different organizational Companies are being asked to make similar deci- decisions on the same challenge! sions in other industries. Consider the emergence of The issue of whether a new set of customers is price-sensitive customers in the auto industry. To another segment or a different market is so subjec- tap into the low end of the market, established car- tive that some companies treat it both ways. In the makers are weighing whether to sell new brands to United Kingdom, Waitrose Ltd. treats home distri- the low end using their existing business model or bution of groceries as both a segment and a market. develop a separate business model. With the excep- On the one hand, it offers home delivery through tion of India’s Tata Motors Ltd., most car companies its existing supermarkets. On the other hand, a new have chosen to stay with the existing business model. unit called Ocado Ltd. caters to the needs of online Airlines are weighing a similar issue: Should they customers using a targeted business model. develop separate business models to serve price- Why does a company decide to treat new custom- conscious consumers (as Southwest Airlines and ers as a totally different market rather than as another easyJet have done), or can they cater to this market segment of the existing market? Two important con- segment by offering cheap seats and no frills on their siderations are the size of the new market and its existing planes? Many airlines (including Continen- growth potential. The bigger the new market, the tal, BA, KLM and United) began with the former, more likely the company is to be aggressive and to at- but now most are shifting to the latter. tack it as a separate market. Another compelling In making this decision, the question is: Do the reason to approach it as a different market is that the new customers represent an entirely different mar- new market is so strategically distinct from the exist- ket requiring a different set of value chain activities, ing market that the business model doesn’t apply. Still or are they just another segment that can be served another reason may be that serving both established with the existing business model? The way most and new customers with one business model may be banks approached Internet banking suggests that so difficult that another solution is necessary.12 they looked at the new customers as just another However, the most important factor is top man- segment that could be served with their existing agement’s attitude toward the newly created market. Nintendo developed the Wii specifically to target business models. On the other hand, banks like A recent academic study found that new markets families, a strategy that caught the disrupters (Sony ING (with ING Direct) and HSBC (with First Di- are made up of two types of customers: customers and Microsoft) by surprise. rect); airlines like Singapore Airlines (with SilkAir) of the established companies that desert it for the and Qantas (with Jetstar); and various companies new value proposition, and new customers entering including Tata Motors (with the Nano) and Dow the market for the first time.13 Therefore, the ques- Corning (with Xiameter) have all looked at price- tion that all established companies need to answer conscious customers not just as another segment is: Is my goal to limit the cannibalization of my ex- but as a fundamentally different market that re- isting market or to exploit the new one? If the goal is quired a dedicated business model. to pursue the new opportunity aggressively (rather Obviously, there is no “right” way to look at the than defend against the threat), the company will new customers — a lot depends on how aggressive likely choose to approach it as a new market that re- a company wants to be. Consider Nestlé S.A. To quires its own business model.14 reach affluent coffee drinkers, Nestlé created a new unit called Nespresso and gave it the freedom to de- Question #3: If I need a new business model to velop its own business model. Nespresso operates exploit the new market, should I simply adopt more like a luxury-goods manufacturer than a the invading business model that’s disrupting high-volume consumer goods company. Nestlé has my market? since developed a new line of coffee makers for dis- Once a corporation decides to enter a new market cerning coffee drinkers at the low end of the using a new business model, it faces a make-or-break spectrum. But rather than create another business issue: exactly what business model to adopt. The model, it manages the new line (called Dolce Gusto) temptation is to mimic the business model of the as part of the established Nescafé division. Same disrupters — after all, if that business model worked

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for them, surely it will work for us. Our research WHAT TO DO WHEN YOUR suggests that this is a trap. By adopting the same BUSINESS MODEL IS DISRUPTED Although many companies respond to disrupters by launching a business model as the invader, established compa- new business model, that is not the only option. nies end up competing with their disrupters ESTABLISHED head-on. They try to beat them at their own game COMPANY DISRUPTER RESPONSE by being better than them. Unfortunately, this strat- Continental Southwest Airlines Set up a separate subsidiary egy almost always falls short. Airlines called Continental Lite to com- Established companies that succeed in entering pete in the low-cost market the new markets do so by developing radically dif- Nestlé Starbucks Created a new division called Nespresso to create and com- ferent business models — different from the one pete in the “home” market that the disrupters are using and different from the Edward Internet brokerage Decided not to enter this market one it employs in its established market. They fol- Jones with a dedicated business model low the same logic that disrupters used to attack Edipresse Free newspapers Launched its own free daily paper them. The disrupters succeeded in attacking the SMH Seiko and Timex Formed a separate unit to main market because they used a disruptive busi- launch Swatch ness model. If the established corporations want to British easyJet Created a separate unit called have the same success, they also need to utilize a Airways Go Fly to compete in the low- disruptive business model to enter the market that cost market the disruptive business model has created. In a AXA Index trading Acquired Rosenberg Group and Investment moved into quantitative funda- sense, they need to “disrupt the disrupter,” as Nin- Managers mental equity management with tendo did in response to Sony and Microsoft in the a hybrid business model video games console market. Instead of targeting Guardian Online news Set up an Internet business to Media provide its content online for free teenagers and young men as Sony and Microsoft Group did, Nintendo developed the Wii specifically to tar- Waitrose Online distribution Set up an online distribution arm get families. Instead of emphasizing functionality, (Waitrose Direct) and created a new company called Ocado to speed and superior graphics (as the PlayStation and compete in this market Xbox did), the Wii stressed ease of use and simplic- Nintendo Sony, Microsoft Developed the Wii and targeted ity. It was a strategy that caught the disrupters (Sony a different customer segment and Microsoft) by surprise and catapulted Nin- Estée Lauder Body Shop Developed the brand Origins tendo to industry leadership. to move into the natural cosmetics area; acquired To appreciate why established companies need to Aveda to move into adopt a business model that is different from the one herbal-based cosmetics that the disrupters use, we need to remember, as Christensen pointed out, that the new markets cre- Enterprise, which began more than 50 years ated by the invading disruptive business model are ago as Executive Leasing, entered a young market different from the established market.15 That has a se- that was dominated by Hertz and Avis. Rather rious implication for established companies: Moving than compete with Hertz and Avis for business into these markets represents a fundamental new travelers, Enterprise targeted the replacement market entry and to succeed, businesses need to abide market (for example, customers whose cars were by the cardinal rules of successful market entry. being repaired). Rather than operating out of air- The most important rule is to adopt a strategy ports, it located its offices in downtowns. Instead that breaks the rules of the game in that market.16 of using travel agents, it used insurance compa- There are many high-profile examples that support nies and body shop mechanics. And instead of this generalization, including Canon’s success in requiring the customer to pick up the car, Enter- entering the copier market, IKEA’s entry in the fur- prise brought the car to the customer. In short, niture retail business, Southwest’s entry in the Enterprise built a business model that was funda- airline market and Enterprise’s entry in the car mentally different from the ones utilized by its rental market. established competitors.

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That suggests that if an established player (1) Nespresso) or should the name be totally different has decided to enter the market space that the in- (as BA did with Go Fly)? vading disruptive business model has created on Equity. Should the unit be a wholly owned sub- the periphery of the main market; and (2) has de- sidiary of the parent or should the parent own only cided to use a business model that is different from a certain percentage of the equity? the one it’s using in the established market, then it Value chain activities. Which value chain activi- should design a business model that is fundamen- ties should the unit develop on its own and which tally different from the one the disrupters employ. should it share with the parent? Frequently, compa- Although that will not guarantee success, it will in- nies allow the new unit to develop its own dedicated crease the probability that the established company customer-facing activities while sharing back-office will compete with its disrupters successfully. functions with the parent. That, however, may not always be the best solution, so companies should ex- Question #4: If I develop a new business model, amine this on a case-by-case basis. how separate should it be organizationally Organizational environment. Should the unit from the existing business model? be allowed to develop its own culture, values, pro- Once an established company has decided to enter cesses, incentives and people, or should some of the newly created market space by using its own these be shared with the parent? Many organiza- disruptive business model, it must determine how tions allow a unit to develop its own culture while separate the new and established business models having some common shared values. But that also should be. We found that asking “Should we sepa- needs to be considered on a case-by-case basis. rate the new business model or should we keep the Obviously, there are no “right” answers. Contrary two together?” is the wrong way to approach it. A to what many academics have proposed, separate units more useful question is, “Which activities do I op- don’t need to have their own names or their own dis- erate separately and which can I operate together?” tinct value chain activities. We know of many The logic for this approach is straightforward. companies that did not do this and yet succeeded in Proponents of running two separate operations operating two different and conflicting strategies at the point to the benefits of keeping the two business same time. The trick is to find the company-specific models apart, the most important being that it al- answers that enable the corporation to separate the lows the new unit to develop its own strategy, unit but not isolate it. In that way, it succeeds in balanc- culture and processes without interference from ing unit independence while helping it with the skills, the parent. It permits the new unit to manage its knowledge and competences of the parent company. business without being swayed by people who might worry about cannibalization threats and Question #5: Once I create a separate unit, what channel conflicts. While these benefits are real, sep- are the unique challenges of pursuing two busi- aration is by no means cost-free. Perhaps the biggest ness models at once? cost is not being able to exploit synergies between In addition to deciding which activities to separate the two businesses. We think there has to be a bal- and which to keep the same, the business must also ance: separate enough to avoid conflicts but not so decide how to manage the separate unit to exploit separate as to prevent exploitation of synergies. potential synergies and achieve true ambidexterity. That balance can be only achieved if the corpora- Several academics have explored this issue and, as a tion thinks creatively about what activities to result, we now have a long list of ideas and sugges- separate and what not to.17 tions on what companies ought to be doing.18 This decision on the appropriate degree of sepa- In an earlier research project, we explored this ration must be made for at least five areas: issue ourselves.19 Specifically, we examined 42 com- Location. Should the separate unit be located panies that had created a separate unit to compete in close to the parent company or somewhere else? the new market. Of these, 10 were successful, while 32 Name. Should the separate unit adopt a name failed. We compared the two groups on three dimen- similar to the parent name (as Nestlé did with sions: (1) the amount of strategic, financial and

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operational autonomy given to the unit (measured on a scale of 1 to 5, with high scores implying that decision-making autonomy was granted to the unit) (2) differences in the culture, budgetary and investment policies, evaluation systems and rewards relative to the parent (measured on a scale of 1 to 6 with high scores implying that these policies were very different) (3) whether the new unit was managed by a new CEO and (4) whether the new CEO came from outside the company or was transferred internally. We found that successful companies gave much more operational and financial autonomy to the Estee Lauder responded separate units than unsuccessful companies. They to The Body Shop’s entry into the market by also allowed the units to develop their own cul- developing Origins, their tures and budgetary systems, and to have their own natural cosmetic line. own CEOs. These are all policies consistent with That suggests that to develop an organization the notion that the new units need freedom to op- that’s capable of competing with dual business erate as they see fit. However, we also found that models (what we call an “ambidextrous organiza- autonomy did not come at the expense of syner- tion”), we must first ask and answer the question: gies: The parent still kept close watch over the “What kind of culture, structures, incentives and strategy of the unit; cooperation between the unit people do we need to put in place in our organiza- and the parent was encouraged through common tion to promote and encourage ambidextrous incentive and reward systems; and the CEO tended behaviors on the part of our employees?” There to be transferred from inside the organization to are many possible answers. Every company aspir- facilitate closer cooperation and active exploita- ing to manage two business models at the same tion of synergies. time must ask the question and find the answers Our results and those of other researchers sug- that are appropriate for its own specific context gest that there are many tactics that companies can and circumstances. use to manage the two business models effectively.

But rather than prescribing a laundry list of steps Constantinos C. Markides is the Robert P. Bauman companies can take, we prefer to suggest a way of Professor of Strategic Leadership at London thinking that managers can apply to their specific Business School. Daniel Oyon is a professor of management at HEC, Université de Lausanne, circumstances. in Switzerland. Comment on this article or contact One of the most fundamental principles of the authors at [email protected]. management is that the underlying organizational 20 environment creates the behaviors in a company. REFERENCES By “organizational environment,” we mean four 1. M.E. Porter, “Competitive Strategy” (New York: Free things: the culture of the company, which includes Press, 1980); and M.E. Porter, “What Is Strategy?” Har- its norms, values and unquestioned assumptions; vard Business Review 74 (November-December 1996): its structure, comprising not only its formal hierar- 61-78. chy but also its physical setup as well as its systems 2. Porter, “What Is Strategy?” (information, recruitment, market research and 3. Porter, “Competitive Strategy.” the like); the incentives, both monetary and non- 4. J.L. Bower, and C.M. Christensen, “Disruptive Technolo- gies: Catching the Wave,” Harvard Business Review 73 monetary ones; and finally, the people, including (January-February 1995): 43-53; R.A. Burgelman and L.R. their skills, mind-sets and attitudes. These four el- Sayles, “Inside Corporate Innovation” (New York: Free ements create the organizational environment that Press, 1985); C.M. Christensen, “The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail” (Bos- supports and promotes the behaviors that we want ton: Harvard Business School Press, 1997); A.C. Cooper in a company. and C.G. Smith, “How Established Firms Respond to

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Threatening Technologies,” Academy of Management Ex- 11. Charitou and Markides, “Responses to Disruptive ecutive 6, no. 2 (1992): 55-70; and C. Gilbert and J.L. Bower, Strategic Innovation.” “Disruptive Change: When Trying Harder Is Part of the Prob- 12. C. Markides and C. Charitou, “Competing with Dual lem,” Harvard Business Review 80 (May 2002): 94-104. Business Models: A Contingency Approach,” Academy 5. Despite arguing that most companies that attempt to of Management Executive 18, no. 3 (2004): 22-36. compete with dual strategies will likely fail, Porter has 13. C. Gilbert, “The Disruption Opportunity,” MIT Sloan also proposed that “companies seeking growth through Management Review 44, no. 4 (summer 2003): 27-32. broadening within their industry can best contain the risks to strategy by creating stand-alone units, each with its 14. Other factors that need to be considered in making this own brand name and tailored activities.” See Porter, decision are discussed in M.W. Johnson, C.M. Christensen “What Is Strategy?,” 77. and H. Kagermann, “Reinventing Your Business Model,” Harvard Business Review 86 (December 2008): 50-59. 6. For example, J.D. Day, P.Y. Mang, A. Richter and J. Rob- erts, “The Innovative Organization: Why New Ventures 15. Christensen, “Innovator’s Dilemma.” Need More Than a Room of Their Own,” McKinsey Quar- 16. D.B. Audretsch, “Innovation and Industry Evolution” terly 2 (2001): 21 argue that: “the simple injunction to (Cambridge: MIT Press, 1995); P.A. Geroski, “Market Dy- cordon off new businesses is too narrow. Although ven- namics and Entry” (Oxford, United Kingdom: Basil Blackwell, tures do need space to develop, strict separation can 1991); P.A. Geroski, “What Do We Know about Entry?” Inter- prevent them from obtaining invaluable resources and rob national Journal of Industrial Organization13, no. 4 (1995): their parents of the vitality they can generate.” Similarly, 421-440; and C. Markides, “Strategic Innovation,” Sloan M. Iansiti, F.W. McFarlan and G. Westerman, “Leveraging Management Review 38, no. 3 (spring 1997): 9-23. the Incumbent’s Advantage,” MIT Sloan Management Re- view 44, no. 4 (summer 2003): 58-64 reported that: 1 7. The same point is made by P. Gulati and J. Garino, “spinoffs often enable faster action early on but they later “Get the Right Mix of Bricks and Clicks,” Harvard Busi- have difficulty achieving true staying power in the market. ness Review 78 (May-June 2000): 107-114. They argue: Even worse, by launching a spinoff, a company often cre- “Instead of focusing on an either-or choice — Should we ates conditions that make future integration very difficult.” develop our Internet channel in-house or launch a spin-off? — executives should be asking, ‘What degree of integra- 7. A variant of the idea of creating separate units that are tion makes sense for our company?’” (ibid., 108) The linked by a variety of integrating mechanisms (spatial sep- same point is raised in C. Smith and A. Cooper, “Entry Into aration) is the idea of temporal separation. See J.A. Threatening Young Industries: Challenges and Pitfalls,” Nickerson and T.R. Zenger, “Being Efficiently Fickle: A Dy- chap. 14 in “Building the Strategically-Responsive Organi- namic Theory of Organizational Choice,” Organization zation” (New York: Wiley, 1994). Science 13, no. 5 (September-October 2002): 547-566; P. Puranam, H. Singh and M. Zollo, “Organizing for Innova- 18. Gilbert and Bower, “Disruptive Change”; S. Ghoshal tion: Managing the Coordination-Autonomy Dilemma in and L. Gratton, “Integrating the Enterprise,” MIT Sloan Technology Acquisitions,” Academy of Management Management Review 44, no. 1 (fall 2002): 31-38; C. Gib- Journal 49 (2006): 263-280; and N. Siggelkow and D. son and J. Birkinshaw, “The Antecedents, Consequences Levinthal, “Temporarily Divide to Conquer: Centralized, and Mediating Role of Organizational Ambidexterity,” Decentralized and Reintegrated Organizational Ap- Academy of Management Journal 47, no. 2 (2004): 209- proaches to Exploration and Adaptation,” Organization 226; V. Govindarajan and C. Trimble, “Ten Rules for Science 14, no. 6 (November-December 2003): 650-669. Strategic Innovators: From Idea to Execution” (Boston: The idea behind this proposal is that the same unit or Harvard Business Press, 2005); and M.L. Tushman and company can undertake two seemingly incompatible C.A. O’Reilly III, “Ambidextrous Organizations: Managing activities (such as exploitation and exploration) but at Evolutionary and Revolutionary Change,” California Man- different times. For instance, Siggelkow and Levinthal agement Review 38, no. 4 (1996): 8-29. showed through simulations of adaptation on rugged 19. Markides and Charitou, “Competing with Dual Busi- landscape that there are advantages to organizational ness Models.” forms that are initially decentralized but eventually central- 20. The notion that the underlying “structure” of the sys- ized. Similarly, Puranam, Singh and Zollo argued that a tem creates the behaviors in that system has been the company needs to synchronize the shift in organizational subject of a huge literature in the systems dynamics field. emphasis (from exploitation to exploration) with stages of See for example, J.W. Forrester, “Principles of Systems,” technological development — for example, structural 2nd ed. (Portland, Oregon: Productivity Press, 1968); and forms that emphasize autonomy tend to outperform A. Van Ackere, E. Larsen and J. Morecroft, “Systems structural forms that emphasize coordination during ex- Thinking and Business Process Redesign,” European ploration-intensive stages of development. Management Journal 11, no. 4 (1993): 412-423. For a 8. C.D. Charitou and C.C. Markides, “Responses to Dis- more managerial angle, see C.A. Bartlett and S. Ghoshal, ruptive Strategic Innovation,” MIT Sloan Management “Rebuilding Behavioral Context: Turn Process Reengi- Review 44, no. 2 (winter 2003): 55-63. neering into People Rejuvenation,” Sloan Management Review 37, no. 1 (fall 1995): 11-23. 9. E. Kelly, “Edward Jones and Me,” Fortune, June 12, 2000, 145. 10. C. Markides, “To Diversify or Not to Diversify,” Har- Reprint 51413. vard Business Review 75 (November-December 1997): Copyright © Massachusetts Institute of Technology, 2010. 93-99. All rights reserved.

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Foundations for Growth How To Identify and Build Disruptive New Businesses

Many companies any companies proudly think of themselves as inno- believe in the concept vative. The great majority of them, however, are adept at producing only sustaining innovations — of disruptive innovation M products or services that meet the demands of exist- but are skeptical about ing customers in established markets. Few companies have making it work. Here’s introduced genuinely disruptive innovations, the kind that result in the creation of entirely new markets and business a blueprint to help models. And yet the motivation to pursue such innovations managers understand if should be urgent. In almost any industry you care to examine, the conditions are right the most dramatic stories of growth and success were launched from a platform of disruptive innovation.1 for disruption—and Most managers understand that significant, new, sustain- how to pull it off again able growth comes from creating new markets and ways of and again. competing. But few of them make such investments. Why? Because when times are good and core businesses are growing robustly, starting new generations of growth ventures seems Clayton M. Christensen, unnecessary; when times are bad and mature businesses are Mark W. Johnson and under attack, investments to create new growth businesses Darrell K. Rigby can’t send enough profit to the bottom line quickly enough to satisfy investor pressure for a fast turnaround. The second problem is virtually insurmountable, so senior managers must rethink their reluctance to start new ventures in good times. After all, business units that are growing robustly today will become mature, and thus vulnerable, in the future. The only way a corporation can maintain its growth is by launching new growth businesses when the core units are strong. Our research indicates that if senior managers pursue this path — and if the growth businesses they start or acquire are truly disruptive — companies will find it less difficult and risky than many have supposed to create wave after wave of new growth. For more than a decade, we have studied innovative successes and failures at large and small companies. (To have a truer sense of whether a disruptive strategy may work in the future, it’s at least as important to understand what hasn’t worked as what has.) We studied

Clayton M. Christensen is a professor at Harvard Business School, Mark W. Johnson is the CEO of Innosight in Woburn, Massachusetts, and Darrell K. Rigby is a director of Bain & Company in Boston. Contact them at [email protected], [email protected] and [email protected].

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simple, it can be done. The key is to think through the issues rigorously and with a clear view of the obstacles and opportunities.

Distinguishing Sustaining From Disruptive Innovations The dichotomy between sustaining and disruptive innovations has been discussed in various contexts since Clayton Christensen first wrote about it in 1993. For the purposes of this article, it’s important to bear in mind the following essential elements of the theory: 1. The pace of technological progress in almost every industry outstrips the ability of customers in any given tier of the market to make effective use of the improved versions of a product. Technologies that aren’t good enough to address customers’ needs at one point typically improve to provide more than enough performance for those same customers at a later point. 2. Companies earn attractive profit margins when they stretch their products upmarket, targeting customers in a more demanding tier who are not yet satisfied by existing offerings. A down-market move toward customers who are already satisfied by available products yields profit margins that aren’t nearly as attrac- some ventures through the lens of history while tracking other tive. As a result, powerful “asymmetries of motivation” grow out initiatives in real time. As a result, we have devised two sets of of disruptive technological change. Whenever entrants are litmus tests that senior managers can use to shape business motivated to attack less profitable customers in less attractive plans to improve their chances of success. Our research suggests tiers of the market, established businesses will always be moti- that any proposal must pass at least one set of tests if project vated to move toward more profitable customers. investments are to have a chance of paying off. 3. Innovations that help incumbent companies earn higher Following an exploration of the litmus tests, we test our margins by selling better products to their best customers are ideas in a detailed example that asks whether Xerox could dis- sustaining, not disruptive. Sustaining innovations comprise both rupt Hewlett-Packard’s ink-jet printer business. We conclude simple, incremental engineering improvements as well as break- by outlining the process any company will need to institute if it through leaps up the trajectory of performance improvement. wants to create an engine capable of building new disruptive 4. Industry incumbents aren’t always the first to market with businesses over and over again. Although the task is far from a sustaining innovation, but they almost always end up on top.

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They have more resources and more at stake than new entrants, too expensive or too complicated. It’s much easier to target a powerful combination whenever the incumbents are moti- potential customers who aren’t buying at all than to steal cus- vated to win. tomers from an entrenched competitor. Strategies that disrupt 5. In contrast to sustaining innovations, disruptive innova- by creating new market applications for entirely new customers tions appeal to customers who are unattractive to the incum- should meet the following three litmus tests. bents. Although disruptive innovations typically involve simple adaptations of known technologies, entrants almost always beat Test #1: Does the innovation target customers who in the past incumbents at this game because established companies lack the haven’t been able to “do it themselves” for lack of money or skills? motivation to win. In the day-to-day internal competition for Many of the most successful disruptive growth businesses have resources and attention within large companies, projects that given people direct access to products or services that had target large, obvious markets invariably get priority over disrup- been too expensive or too complex for the mainstream. For tive ones. And yet every major, attractive market that exists today example, until the late 1970s computer jobs had to be was at its inception small and poorly defined — just as the major processed by specialists in the corporate mainframe-computer growth markets of tomorrow are small and poorly defined today. center. Today, ordinary people with PCs can handle problems 6. Companies that want to create new growth businesses should that are far more complex than the ones mainframes used to therefore seek disruptive opportunities because industry leaders solve. Disruption pulled new users into the computer market will not be motivated to pursue them. This approach applies to by the millions, as the PC allowed people to compute conven- venture-backed startups, cash-rich giants and everything in iently for themselves. between. According to our research, the probability of creating a If an idea can’t be shaped to pass this litmus test, the chances successful, new growth business is 10 times greater if the innova- for creating a new growth business diminish considerably. The tors pursue a disruptive strategy rather than a sustaining one.2 innovation may succeed in satisfying some customers, but it won’t create significant new growth. Take online retail banking. Two Strategies for Creating New Disruptive There just isn’t a large population of nonconsumers who can be Growth Businesses pulled into the market for bank accounts by Internet banking. All ideas for new products and businesses emerge from innova- Most low-income customers, and even most teenagers, have tors’ minds only partially formed. Middle managers then oversee bank accounts that offer easy access to basic services. Because it the shaping of these ideas into full-fledged business plans in an can’t meet this litmus test, online banking can be only a sus- effort to obtain funding from senior management. They typically taining innovation that helps retail banks serve a segment of hesitate to throw their weight behind new product concepts their existing customer base a bit more profitably and effec- whose market is not assured, fearing that their reputation for tively. New entrants are unlikely to be able to use the technology good judgment may be compromised. As a consequence, the nor- to disrupt established banks (unless they can conceive a strategy mal corporate process for shaping and funding ideas turns them that passes the second set of litmus tests). into sustaining innovations that target large, obvious markets.3 In contrast, online retail stock brokers such as E*Trade and Many of the ideas that end up as sustaining innovations Charles Schwab did have the potential to create a new disruptive could just as readily have been shaped into disruptive business growth market because they could enable a new set of cus- plans, given a distinctly different process and managers who tomers — day traders — to speculate; in addition, they made understood how to use it. To that end, we have developed two trading so simple and inexpensive that people of relatively low general strategies for turning ideas into plans for disruptive net worth could begin to manage their own portfolios without growth businesses. The first requires the creation of a new mar- the help of professionals. Because these companies were initially ket that can serve as a base for disruption; the second is based competing against nonconsumption rather than Merrill Lynch, on disruption of the prevailing business model from the low they could create a new wave of disruptive growth. Online retail end. The success of each strategy is predicated on managers’ banks, in contrast, could attract new accounts only by compet- ability to shape ideas that conform to a set of litmus tests. ing against established banks.

Creating a New Market as a Base for Disruption Test #2: Is the innovation aimed at customers who will welcome a Companies seeking to create disruptive growth should first simple product? search for ways to compete against nonconsumption: people’s If the innovation enables a new population of customers to inability to use available products or services because they are consume for themselves, it can more easily be shaped to pass the

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second litmus test: The disruptive product must be technologi- Test #3: Will the innovation help customers do more easily and effec- cally straightforward, targeted at customers who will be happy tively what they are already trying to do? with a simple product. This test requires innovators to keep in mind one essential fact: Established companies almost always trip up on this test. At a fundamental level, the things that people want to accom- Because corporate funding processes compel disruptive innova- plish in their lives don’t change quickly. Because of this stability, tors to quantify the magnitude and certitude of the opportunity, if an idea for a new growth business is predicated on customers potential disruptions are force-fit into obvious, measurable, wanting to do something that hadn’t been a priority in the past, existing market applications. That leads corporate managers to it stands little chance of success. hope for growth from improbable sources; more seriously, it pits Let’s illustrate this test by exploring the potential for digital innovators’ disruptive technology against a sustaining technol- imaging to disrupt the market for photographic film. How do ogy already in use by entrenched competitors. The disruptive most people use photographic film? When they’ve finished

If an idea for a new growth business is predicated on customers wanting to do something that hadn’t been a priority in the past, it stands little chance of success.

product’s performance must then surpass technologies on the shooting a roll, they drop off the film at the developer’s, fre- sustaining trajectory, which is equivalent to killing off the prod- quently ordering double prints so that copies of the best shots uct. Cramming disruptions into established markets is very will be readily available to send to friends or relatives. When expensive and always fails. the prints are ready, people bring them home, flip through Successful disruptive innovators always target customers who them, put them back into the envelope, and put the envelope welcome simple products. Apple marketed its Apple II as a toy for into a box or drawer. Less than 5% of all images are viewed children, while Xerox was misguidedly determined to use the more than once, and people rarely go back to mount the best same technology to automate the office. Palm’s Pilot was a simple photos into an album. organizer, whereas Apple (having become the industry incum- The digital-imaging companies approached amateur pho- bent) positioned its Newton as a handheld computer. Today, NTT tographers with interesting propositions: “If you’ll just take the DoCoMo and its Japanese competitors have signed up 40 million time to learn how to use this software, you can edit out the red- profitable subscribers for their wireless Internet-access systems by eye in all those flash pictures” and “You can now keep all your making it easy for teenagers to download ring tones and wallpa- pictures neatly arranged in online photo albums.” But the vast per and by providing simple games to help young commuters kill majority of digital camera owners do neither of these things. time. Their European and American counterparts, in contrast, are They weren’t priorities before, and they aren’t now. Digital cam- struggling to provide the bandwidth and screen size that will era users do send more images to more people over the Internet enable existing customers to do the same things on a phone that — the new technology lets people do more easily what they they do today on a computer; and because wireless access isn’t as were trying to do in ordering double prints from film. And the good as wireline access for these applications, they have no prof- recipients of the images typically view them once, close the box itable customers.4 Similarly, voice recognition technology is tak- and put the pictures into an envelope on the hard drive. ing off in applications involving simple phrases, but IBM’s Despite its disruptive potential, digital imaging hasn’t cre- ViaVoice product is designed to replace keyboard word process- ated the major wave of new growth that digital film and cam- ing and leaves users deeply dissatisfied. era companies so desperately need. The reason is that those It is important to note that in each of those cases, the tar- companies have violated the first two litmus tests. They’ve con- geted application, product and customer set were not fore- centrated on making products that can deliver images as sharp ordained by the technology. The divergent targets resulted from as those caught on photographic film. This has led them to vio- differences in the idea-shaping processes used by established late test #2 by making devices that are not technologically sim- companies and new entrants. ple. Because the technology they are using to capture sharper

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images is expensive, they have also violated test #1: The equip- Test #1: Are prevailing products more than good enough? ment isn’t cheap enough to appeal to existing camera owners, If available products aren’t yet good enough, a disruptive inno- most of whom are satisfied with the pictures they get from vation whose performance is even lower will not gain any trac- photographic film. These companies have, in other words, tion in the market. Mobile telephone networks probably fall into spent billions of dollars searching for growth in the wrong the category of “not yet good enough” to be disrupted with this place. Had they instead built their cameras with cheap sensors, strategy; many pharmaceutical products also fit this description. whose sharpness is more than adequate for images viewed on For example, synthetic insulin that is free of impurities couldn’t computer screens, they could have hit price points low enough disrupt the market for insulin made from a pig’s pancreas

Having barely enough cash forces a venture’s managers to flounder around with actual customers, rather than in the corporate treasury, for ways to get money.

to have competed against nonconsumption — selling “fun,” (which contains some impurities) because neither is effective not cameras, to teenagers and children, who use the Internet enough to counteract the long-term effects of Type 2 diabetes. with extraordinary creativity. Managers who are shaping a disruptive strategy can determine Digital cameras ultimately will displace photographic film. when a product’s performance has overshot what customers can Whether that happens after a brutal, feature-for-feature fight use by examining rigorously, market tier by market tier, the involving sustaining technology — or after a huge new growth extent to which customers are willing to pay premium prices for market is created among a new set of customers who have further improvements in the functionality, reliability or conve- found new ways and reasons for “consuming” images — nience of a product or service. If companies can sustain price depends on whether the companies in this space shape their increases in a given tier when they introduce an improvement strategies to create disruptive growth or allow the default set- in one of these areas, customers are not yet overserved and that tings of sustaining strategy to determine their targets. tier cannot be disrupted. Online commodity exchanges illustrate the point. In the late 1990s, hundreds of millions of dol- Disrupting the Business Model From the Low End lars were invested to create exchanges for commodities such as Some ideas for innovative products simply can’t be shaped to pass steel; their objective was to disrupt traditional distribution the first set of tests. That doesn’t mean they should automatically enterprises. The vast majority of the world’s steel, however, is be ruled out as the basis for new growth businesses. A quite dif- not purchased at the lowest price the buyer can find. Steel buy- ferent strategy — disrupting the industry leader’s business model ers quite consistently pay premium prices to be assured of reli- — also harnesses the power of asymmetric motivation. able supplies from their distributors. The prevalence of the A proposal that cannot compete against nonconsumption price premiums indicates that buyers are not yet overserved on necessarily aims at the same markets dominated by industry the dimension of reliability and thus the market could not be leaders. To succeed, this second strategy must meet two litmus disrupted by the online exchanges.5 tests. First, it must target the least-demanding tiers of a market in which prevailing products are so good they “overserve” cus- Test #2: Can you create a different business model? tomers. In other words, there must be less demanding cus- If the low end of a market is overserved and thus open to dis- tomers who would happily buy a good-enough product that is ruption, the second test requires managers to craft a new busi- cheaper than those currently available. Second, the product ness model; the business must be able to earn attractive returns must be made and marketed within a disruptive business at prices that can steal business at the low end. A disruptive model, one that enables the entrant to compete profitably while business model consists of a cost structure, operating processes pricing at deep discounts. Managers who shape a strategy to and a distribution system in which profit margins are thinner conform to these litmus tests can successfully create a new but net asset turns are higher. It creates the asymmetric motiva- growth business within an existing market. tion needed for disruptive success.

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Business model disruption has occurred several times in If a hopeful entrant can’t define a business model with high- retailing. For example, full-service department stores had a enough asset turns to earn attractive returns on low margins, it model that enabled them to turn inventories three times per won’t be able to attract the repeated capital investments required year with gross margins of 40%. They therefore earned 40% to sustain the upmarket march inherent in building a business. three times each year, for a 120% annual return on capital As we have reviewed business plans requesting corporate funds invested in inventory (ROCII). Discount retailers such as Wal- for new product development, we have been dismayed to see Mart and Kmart attacked the low end of the market — nation- how few of the plans’ developers have devised business models ally branded hard goods such as paint, hardware, kitchen that can sustain a disruptive enterprise. Most seem content to utensils, toys and sporting goods that were so commonplace wrap their plans in their existing business structure, counte- they could sell themselves. The low end of this market was over- nancing the loss of hundreds of millions of dollars under the flag served by department stores; customers did not need well- of disruption. That’s not disruption — it’s bad business! trained salespeople to help them get what they needed. The The strategy of business-model disruption isn’t as common discounters’ business model enabled them to make money at as the strategy of competing against nonconsumption, but it gross margins of about 23%. Their stocking policies and oper- can be very effective, as it has been repeatedly in retailing. Steel ating processes enabled them to turn inventories more than five minimills such as Nucor have used this strategy to beat the inte- times annually, so that they also earned close to 120% annual grated steel companies like Bethlehem, and online travel agen- ROCII. They did not accept lower levels of profitability; they cies are using it to disrupt full-service agencies. just earned acceptable profit through a different formula. Executives who are shaping a low-end disruptive business- For good reasons, full-service retailers ceded the low end of model strategy need to be sure it is unattractive to every power- the market to the discounters. Here’s why: The critical resource- ful incumbent. The failure of online drug retailers such as allocation decision that retailing managers make is assignment PlanetRx.com to do this reconnaissance led to their demise. of floor space. At the time discount retailers attacked the low Their online business models probably were disruptive in rela- end of their merchandise mix, managers of full-service stores tion to drugstore chains. But to the giant mail-order pharmacy could have defended the branded hard-goods businesses, which Merck-Medco, the Internet was a sustaining technology. The the discounters were attacking with prices that were 20% below Internet helped Medco make more money in the way it was those of department stores. But competing against the discoun- already structured to make money; and because Medco had far ters by matching their prices would have sent margins plum- more resources to throw at the opportunity than startups did, it meting to 23%, and, given the three-times-per-year inventory outdistanced the startups and drove them from the market. turns inherent in their business model, ROCII would have dropped to about 70%. Their other option was to allocate more Using the Litmus Tests To Shape a Disruptive Strategy: floor space to higher-margin cosmetics and high-fashion Xerox Versus Hewlett-Packard apparel, where gross margins easily could exceed 50% and To get a sense of how managers might use the litmus tests to ROCII would be 150%. Clearly, it made sense for the full-service shape an idea into a disruptive business plan, let’s examine department stores to get out of the tiers of the market that the whether Xerox could disrupt Hewlett-Packard’s ink-jet printing discounters were motivated to enter. Discount retailers subse- business. We don’t actually know if Xerox has considered this quently were motivated to move further upmarket into the lowest- possibility, and we use the companies’ names only to make the margin tiers of clothing, home furnishings and cosmetics. As they example more vivid. We’ve based it solely on information from did so, the full-service stores’ formula for profit maximization public sources. continued to motivate them to run away from rather than fight Xerox reportedly has developed outstanding ink-jet printing the discounters. technology. What can the company do with it? It could attempt to This is the sort of asymmetry of motivation that managers leapfrog ahead of Hewlett-Packard by producing the best ink-jet need to create if they hope to build a successful new growth printer on the market. In taking that approach, Xerox would be business within the same market served by industry leaders. To fighting a battle of sustaining technology against a company with do that, managers must start by asking: How much lower does superior resources and more at stake. H-P would win that fight. our price need to be to penetrate the lowest tier of the market? Could Xerox craft a disruptive strategy for this technology? We’ll What do our costs need to be to generate profits at that price use the litmus tests for the disruptive business model strategy first. level? How could we change our asset turns and operating To assess whether a low-end strategy is viable, Xerox’s man- processes to achieve attractive returns? agers should examine whether customers in each tier of the

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market are willing to pay price premiums for improvements in business model that was attractive to Xerox but unattractive to performance — faster printers that produce sharper images. At H-P. This might entail pricing ink cartridges for embedded the highest tiers, the answer is yes. It appears, however, that con- notebook printers at levels that would send H-P scurrying sumers in less demanding tiers are increasingly indifferent to upmarket, in search of the larger profits generated by higher- improvements. So the first litmus test is met: It does seem that performance stationary printers. In that scenario, Xerox would a set of customers would be willing to buy a “good enough” retain the motivation to go after H-P’s business, while H-P printer that is cheaper than prevailing products. would be less motivated to fight back. The next litmus test is whether Xerox could define a business model that would generate attractive returns at the discounted Making the Disruptive Strategy Work prices required to win business at the low end. The possibilities Once a viable disruptive growth strategy has been defined, it needs don’t look good. H-P and other printer companies already out- nourishment to survive in the corporate environment. Three source the fabrication and assembly of components to the lowest- classes of factors that affect what a company like Xerox can do cost sources in the world. They make all their money selling ink with the printer opportunity — its resources, processes and values cartridges. Xerox could enter the market by selling ink car- — need to be managed carefully.6 The meaning of the first two tridges at lower prices, but unless it could define processes that terms is straightforward. In this context, we use the term “values” would allow it to do so profitably, any lead it gained initially to mean the criteria that people employ when making both big would be unsustainable. A disruptive business-model strategy and small decisions — when giving priority to one set of activities that attacks the low end probably can’t succeed in this space. over another. Managers need to determine which resources, The managers would have to evaluate the potential for compet- processes and values to leverage to help the new business succeed. ing against nonconsumption instead. Is there a large, untapped population of computer users who Resources In addition to the technology, the key resources for don’t have the skills to operate current printers or the money to Xerox’s printer business would be management talent and cash. buy one? Probably not. Hewlett-Packard and its competitors Who should take the reins of the new venture? In situations like already competed successfully against nonconsumption when this, corporate executives often tap managers who have strong they launched their easy-to-use, inexpensive ink-jet printers to records of success in the mainstream business. Such choices can disrupt expensive laser printers. It might be possible, however, to be the kiss of death, however, because the kinds of challenges entice existing printer owners to buy more printers by enabling that will confront managers in building a new disruptive enter- consumption in a new context. This is where it gets interesting. prise are radically different from those that most would have Could Xerox use its technology to help customers do some- grappled with in the core business. The counterintuitive point thing more easily that they are already trying to do? Is there a is that managers whom corporate leaders have learned to trust low-performance product that people would happily buy? because of their success in the mainstream business probably Quite possibly. Documents created on notebook computers are cannot be counted on to lead a radical new venture. not easy to print. Notebook users have to find a stationary To choose the right managers to lead a new venture, it’s useful printer and either hook its cable to the computer or transfer the to construct a three-column chart. In the left column, list the chal- file to a desktop PC via floppy disk in order to get paper copies. lenges that the managers will confront as they build the new ven- If Xerox incorporated a simple, inexpensive printer into the ture. In the middle column, list the experiences the managers base or back of a notebook computer so that users on the go should already have had, to be certain they have the perspective to could get hard copies when they needed them, where they succeed. In the right column, list the backgrounds of candidates. needed them, the company could probably win customers even Thus in the left column, Xerox’s managers might note that if the printer wasn’t as good as a stationary ink jet. Only Xerox’s customers for the built-in printer probably would not know at engineers could determine whether the idea is technologically the outset what features they’d need or when or how they would feasible, but as a strategy, it would pass the litmus test. actually use the product. In the middle column, they would A key, again, is asymmetry of motivation. In this case, we specify a manager who had successfully and unsuccessfully would expect H-P to ignore the notebook-printer opportunity introduced new products in a fluid, emerging market. In the at the outset because of the other options competing for right column, they might evaluate the résumé of a product resources within H-P’s huge printer business, which needs large manager from Palm because some features of Palm’s products chunks of new revenue to sustain its growth. To create as much have been warmly embraced, while others have bombed.7 asymmetry as possible, Xerox would also want to develop a The other important resource, cash, must be managed in a

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way that avoids two common misconceptions. The first is that A key to nurturing a new growth business is recognizing access to deep corporate pockets is an advantage to a new when to leverage the parent corporation’s resources, processes growth business. It is not. Too much cash allows those running and values, and when to create new ones. In our experience, the a new venture to follow a flawed strategy for too long. Having CEO has to make this judgment because there are no simple barely enough forces the venture’s managers to flounder around rules to follow. There is strong evidence that without the CEO’s with actual customers, rather than in the corporate treasury, for intervention, the power of habitual ways of doing things will ways to get money. The right strategy for a disruptive business direct new ventures into the sustaining mode — and the core is never clear at the outset. Tight purse strings force managers business must be sustained, after all, even as the new one is nur- to uncover a viable strategy quickly — if one exists.8 tured. Whether the CEO is willing or able to make such judg- The second misconception is that the corporation needs to ment calls is another crucial litmus test of success. be patient — that it should be prepared to accept large losses for For this hypothetical business, Xerox’s CEO might want to sustained periods in order to reap the huge upside that eventu- emulate the former CEO of Teradyne, Alexander d’Arbeloff.

A lack of good ideas is not the problem. The problem is the absence of a robust, repeatable process for creating and nurturing new growth businesses.

ally comes from disruptive innovation. Let’s be clear: Senior Teradyne makes sophisticated integrated-circuit testing equip- managers should be patient about the new venture’s size but ment. In the mid-1990s, d’Arbeloff sensed that competitors were impatient for profits. The requirement to get very big very fast considering a scaled-down tester that would rely on inexpensive is lethal to new ventures. It takes time for new markets to semiconductor chips and off-the-shelf software. Such a product emerge: Customers have to discover where, when and why they could test simple circuits at the low end of the market, at a quar- are using a new product, and the new venture has to define a ter of the multimillion dollar cost of Teradyne’s machines. profitable business model. All new ventures lose money for a D’Arbeloff decided to get there first and set up a separate time at the outset, but corporate executives should expect the business unit to disrupt the market — and Teradyne itself. One managers of a new business to find a way to make profit within of the keys to the development of what became the successful a couple of years. Small but profitable ventures need to be given Integra tester business was flexibility to create appropriate time to establish the new market and grow to a substantial size.9 processes for annual budgets, sales projections and strategic The only way to guard against such impatience is by launch- planning, compared with the standards that would have been ing new growth ventures when the corporation doesn’t actually imposed if the project had been part of a mainstream division. need them. When companies wait until they need huge waves of The venture was, however, kept to very tight cost controls. growth in a hurry, their haste triggers a sequence of behaviors Moreover, d’Arbeloff kept the values guiding the project clear: that paradoxically make it impossible to grow.10 The product was to be simple and low-cost. The team developing it had to find a market that would welcome an inexpensive Processes and Values In any company, mainstream processes and tester with limited functionality. That focus paid off, as the ven- criteria for setting priorities (values) have been honed to sustain ture reached $150 million in annualized sales within 18 months the core business. Typically, key processes that work well in the of its release in 1998. core (such as strategic planning and product development) actually impede what needs to be done in an emerging business. Building an Innovation Engine And the criteria for setting priorities and making decisions that Ironically, successful disrupters often fall prey to disruption are inherent to the business model of the new enterprise often themselves. Digital Equipment was overtaken, literally, by must be very different from those that are useful in the main- Compaq, which is being overtaken by Dell. Oracle disrupted IBM stream. That is why disruptive enterprises often need to be and Cullinet but is now being disrupted by Microsoft. Many managed as independent business units. observers assume that an absence of good ideas is the reason for

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the fall of once-disruptive companies, and they try to focus their The process starts with training. Sales, marketing and engi- own companies on generating new ideas. But in our interviews neering employees have the great ideas in most companies. They with managers of companies that failed to capitalize on disrup- should be trained in the language of sustaining and disruptive tive opportunities, not once did anyone say, “We just never innovation and understand the litmus tests so that they know thought of it.” In fact, the executives had actively considered and what kinds of ideas they should channel into sustaining usually experimented with the disruptions that eventually dis- processes — and what kinds they should direct into disruptive placed them. A lack of good ideas is not the problem. The prob- channels. Capturing ideas for new growth businesses from peo- lem is the absence of a robust, repeatable process for creating and ple in direct contact with markets and technologies is far more nurturing new growth businesses. We have suggested how execu- productive than relying on analyst-laden business-development tives might shape and implement a strategy to create a single new departments. Front-line employees are also well positioned to disruptive growth business. To establish an organizational capa- scout for small acquisitions with disruptive potential. If the price bility to do it over and over again, senior executives should build is reasonable, it is often better to acquire a company whose strat- the components that go into an innovation engine. egy passes the litmus tests than to start from scratch internally.

Start Before You Need To The best time to invest for growth is, in Create Processes for Shaping Disruptive Business Plans Ideas with fact, when the company is growing. To build what will be a disruptive potential need a destination. Senior management respectable portfolio of growth businesses in five years, start now should therefore create a team at the corporate level that is — and add to the portfolio every year. Companies that build responsible for collecting disruptive-innovation ideas and while they are growing can shield their nascent high-potential molding them into propositions that fit the litmus tests. The businesses from Wall Street pressure, giving each one the time it members of this team have to understand the litmus tests at a needs to iterate toward a viable strategy and then to take off. deep level and use them repeatedly. Such experience will help the team develop a collective intuition about how to shape dis- Establish an Aggregate Project Plan An aggregate project plan is a ruptive business plans. We use the word intuition deliberately system to allocate resources toward strategic objectives. The here. While the process that molds ideas into sustaining inno- plan must be established before managers have considered the vations can be deliberate, data-driven and analytical, the merits of specific product proposals; it then can be used to help process for shaping disruptive businesses must be driven by company leaders systematically distribute resources to new intuitive understanding of the possibilities. growth businesses. To determine what percentage of available The only company in history we know of that has success- resources they should allocate to disruptive new ventures, exec- fully launched a series of disruptive growth businesses is Sony. utives must decide in advance the number of such businesses Between 1950 and 1980 Sony introduced 12 disruptions that the company needs to start or acquire each year in order to have created huge new growth markets and helped the company top- robustly growing businesses five and 10 years down the road, ple competitors that had been the leaders in the electronics when growth of the core business has slowed.11 By creating an industry. But the company’s last successful disruption was its aggregate plan, companies can keep sustaining proposals from Walkman, launched in 1979. Between 1980 and 1997, Sony con- competing with disruptive ideas for funding. Propositions for tinued to be technologically innovative, but every innovation new growth businesses compete only for the planned number during this period was sustaining. Sony’s PlayStation and Vaio of disruptive slots in the plan in a given year, and sustaining notebook computers, for example, are great products, but they ideas are matched against other sustaining possibilities. were late entrants targeted at well-established markets. How did the company’s ability to develop sustaining innovations come Train People To Distinguish Between Disruptive and Sustaining Ideas to squeeze out its ability to continue generating disruptive ones? In all companies, the processes that shape ideas into investment Before 1980, Sony founder Akio Morita and a small group of propositions have a predictable result: In order to pass the hur- trusted associates made every new product-launch decision. As a dles required to get funded, all ideas must be transformed into policy, they never did any market research — if a market did not proposals that sustain the mainstream business. These processes exist, they believed, it could not be analyzed. The group developed are extremely valuable in keeping the mainstream business an intuitive but practiced process for shaping and launching dis- healthy, but they are not capable of shaping ideas into disrup- ruptive businesses. In the early 1980s, Morita withdrew from tive business plans. As a result, companies need to create differ- active involvement in the company in order to focus on political ent processes for evaluating and shaping disruptive ideas. activities. The company began beefing up its marketing functions

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with M.B.A.s who favored the use of data-driven, analytical potential pitfalls and work to make the creation of disruptive new processes to assess market needs. Such processes can only identify businesses a corporate process — an organizational capability that and shape sustaining innovations — and as a consequence, Sony is constantly practiced — can start laying the groundwork for a lost its ability to continue launching disruptive businesses. company future blessed by continuous healthy growth. Because all corporations that hope to sustain growth need streams of sustaining innovations within business units and disruptive innovations in new units, we advocate the creation of REFERENCES a Sony-like group at the corporate level that develops a similar 1. See C.M. Christensen, “The Innovatorʼs Dilemma: When New practiced intuition about disruptive ventures. It’s not just the Technologies Cause Great Firms to Fail” (Boston: Harvard Business School Press, 1997). shaping processes that need to be different. The process for selecting managers needs to employ very different criteria from 2. Christensen, “The Innovatorʼs Dilemma,” 126. those used to promote managers within established businesses. 3. See J.L. Bower, “Managing the Resource Allocation Process” (Homewood, Illinois: Richard D. Irwin, 1972). The team should coach each new venture’s management on 4. J.L. Funk, “The Mobile Internet: How Japan Dialed Up and the West techniques like discovery-driven planning that can speed the Disconnected” (Hong Kong: ISI Publications, 2001). 12 emergence of a winning strategy. 5. Our choice of wording in this paragraph is important. When cus- The team must also be the visible and vocal advocate of new tomers cannot differentiate products from one another on any dimension that they can value, then price is often the customerʼs basis of growth businesses. It should define and articulate throughout choice. We would not say, however, that when a consumer buys the the company the technology or market scope governing disrup- lowest-priced alternative, the axis of competition is cost-based. The tive business plans. Twice a year or so, team members should right question to ask is whether customers will be willing to pay higher prices for further improvements in functionality, reliability or conve- hold refresher training sessions with sales, marketing and engi- nience. As long as customers reward improvements that have commen- neering people in each operating unit. The purpose of these ses- surately higher prices, we take it as evidence that the pace of sions is to provide updates on how previous ideas had been performance improvement has not yet overshot what customers can use. When the marginal utility that customers receive from additional shaped into plans for high-potential growth businesses and to improvements on all of these other dimensions approaches zero, then describe why other ideas could not pass the litmus tests. Such cost is truly the basis of competition. updates are critical because they can help innovators within the 6. We have published in greater detail elsewhere on the recommen- dations in this section. See, for example, C.M. Christensen and M. corporation refine their ability to recognize disruptive innova- Overdorf, “Meeting the Challenge of Disruptive Change,” Harvard tions when they encounter them. Business Review (March-April 2000): 66-76. Processes are not created in PowerPoint presentations; they 7. For a cogent account of how to recognize and train managers who are defined only when a group of people does something over are capable of succeeding in such situations, see M.W. McCall, “High Flyers” (Boston: Harvard Business School Press, 1996). and over again. And every process needs a home. This is why 8. For strong evidence, see A. Bhide, “The Origin and Evolution of New intuitive processes for creating disruptive growth businesses Businesses” (New York: Oxford University Press, 2000). need to be honed in a dedicated group. 9. New ventures that are successful and growing will, of course, continue to consume cash long after they begin to show profit. Our point is Not Just a Lucky Bet that the ventures should not be allowed to consume large amounts of profit. This is not short-sighted. It is a management mechanism that The structure of our proposed innovation engine is quite different forces the ventureʼs executives to iterate as quickly as possible toward from a conventionally managed corporate venture-capital organi- a viable strategy and business model. zation. The fundamental premise of venture capital is that creat- 10. For an exceptionally insightful — and frightening — analysis of this ing new businesses is intrinsically unpredictable; thus many bets problem, see “Stall Points: Barriers to Growth for the Large Corporate Enterprise” (Washington, D.C.: Corporate Strategy Board, 1998). must be placed in order to get a few that pay off. We are propos- 11. The concept of an aggregate project plan was first developed by S.C. ing that starting successful growth businesses isn’t as random and Wheelwright and K.B. Clark in “Revolutionizing Product Development” failure-fraught as it has appeared. It is complicated, to be sure. But (New York: Free Press, 1992). Their concept has been extended to the corporate resource-allocation process in a note by C.M. Christensen, it only appears random, we believe, because managers haven’t “Using Aggregate Project Planning To Link Strategy, Innovation and the understood the factors that lead to success or cause failure. Resource Allocation Process,” Harvard Business School note no. 9-301- Spending too much on the wrong strategy in an attempt to get big 041 (Boston: Harvard Business School Publishing Co., 2000). fast; putting people with inappropriate experience in charge; vio- 12. R.G. McGrath and I. MacMillan, “Discovery-Driven Planning” Harvard Business Review (July-August 1995): 44-54. lating the litmus tests; and launching growth initiatives in an ad hoc manner when it is already too late — these reasons for failure Reprint 4332 can be managed and avoided. Executives who understand the Copyright  Massachusetts Institute of Technology, 2002. All rights reserved.

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