Building a Business Model and Strategy: How They Work Together Excerpted from Entrepreneur’s Toolkit: Tools and Techniques to Launch and Grow Your Business Harvard Business School Press Boston, Massachusetts ISBN-10: 1-4221-0533-4 ISBN-13: 978-1-4221-0533-7 5337BC Purchased by: Janet Le [email protected] on February 05, 2014 Copyright 2006 Harvard Business School Publishing Corporation All rights reserved Printed in the United States of America This chapter was originally published as chapter 4 of Entrepreneur’s Toolkit, copyright 2005 Harvard Business School Publishing Corporation. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior permission of the publisher. 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Purchased by: Janet Le [email protected] on February 05, 2014 4 Building a Business Model and Strategy How They Work Together Key Topics Covered in This Chapter • how the business model explains the way key components of the enterprise work together to make money • examples of two powerful business models • how strategy can confer competitive advantage • a five-step process for formulating strategy and aligning activities with it • why strategic thinking must be ongoing Purchased by: Janet Le [email protected] on February 05, 2014 fter you’ve identified a money-making opportunity and created a plan for addressing it, answer these three A important question: 1. How will our new business create value for customers? 2. How will it make a profit for us and our investors? 3. How will the business differentiate itself from competitors? An entrepreneur should be able to provide concise answers to anyone who asks these questions. If you don’t yet have the answers for your business, this chapter’s primer on business models and strat- egy will help you. Business executives, consultants, and the business media use the terms business model and strategy casually and generally without rigor. Many, when pressed, cannot define either term. Don’t be one of them. As an entrepreneur, you cannot afford fuzzy thinking about these important and very different concepts. As this chapter explains, a business model identifies your customers and describes how your business will profitably address their needs. Strategy, on the other hand, is about differentiating how your business satisfies customers. Both are required for success. Your Business Model The term business model first came into popular use in the late 1980s, after many people had gained experience with personal computers Purchased by: Janet Le [email protected] on February 05, 2014 Building a Business Model and Strategy 3 and spreadsheet software. Thanks to these digital innovations, entre- preneurs and analysts found that they could easily “model” the costs and revenues associated with any proposed business. After the model was set up, it took only a few keystrokes to observe the impact of in- dividual changes—for example, in unit price, profit margin, and supplier costs—on the bottom line. Pro forma financial statements were the primary documents of business modeling. By the time dot- com fever had become rampant, the term business model had become a popular buzzword. Still, most people were unable to articulate ex- actly what it meant. In the most basic sense, a business model describes how an en- terprise proposes to make money. Two Harvard Business School professors—Richard Hamermesh and Paul Marshall—have gone beyond this basic definition. They have defined business model as “a summation of the core business decisions and trade-offs employed by a company to earn a profit.” The decisions and trade-offs they refer to fall into four groups: • Revenue sources. This money comes from sales, service fees, advertising, and so forth. • Cost drivers. Examples are labor, goods purchased for resale, and energy. • Investment size. Every business needs a measurable level of in- vestment to get off the ground and, in the case of working cap- ital, to keep it operating. • Critical success factors. Depending on the business, a success factor might be the ability to roll out new products on a sus- tained basis, success in reaching some critical mass of business within a certain time, and so on.1 How would you describe your company or business concept in terms of these model elements? Have you nailed down your revenue sources and the factors that will drive costs for your business? Do you know which costs will be fixed and which will vary with sales vol- ume? Have you calculated the capital you’ll need to launch and op- erate the business? What factors are essential for success? Try to Purchased by: Janet Le [email protected] on February 05, 2014 4 Entrepreneur’s Toolkit answer each of these questions unambiguously, and do so before you approach any investors. Management consultant Joan Magretta has provided a useful in- troduction to business models in “Why Business Models Matter,” a 2002 Harvard Business Review article in which she views a business model as some variation of the value chain that supports every busi- ness. “Broadly speaking,” she writes, “this chain has two parts. Part one includes all the activities associated with making something: de- signing it, purchasing raw materials, manufacturing, and so on. Part two includes all the activities associated with selling something: find- ing and reaching customers, transacting a sale, distributing the prod- uct or delivering the service.”2 How would you describe your enterprise in terms of Magretta’s definition? Does your model tell a logical, sensible story? If you were to represent your model on a pro forma income statement with rea- sonable projections of revenues and expenses, would it be profitable? Some of today’s most powerful and profitable companies grew out of business models that were elegant and compelling in their logic and powerful in financial potential. Let’s consider two that are probably fa- miliar to you: Dell Computer and eBay. These examples will help you understand the concept of a business model and its importance. Example: Dell Michael Dell went into the personal computer business when Apple, IBM, and a handful of other producers were already established in the market. These manufacturers sold through resellers and maintained large inventories to accommodate the variety of PC features that cus- tomers had come to expect. Both practices were costly for the man- ufacturers, which had to give substantial discounts to resellers. At the same time they took heavy losses in finished-goods inventory when- ever the blistering pace of new product introductions made those in- ventories seem old-fashioned. By one estimate, PCs lost 2 percent of their value each day they sat in the finished-goods storeroom! Dell’s business model avoided both of these profit-sapping prob- lems. As everyone now knows, Dell identified his target market (fairly knowledgeable computer users who needed no hand-holding Purchased by: Janet Le [email protected] on February 05, 2014 Building a Business Model and Strategy 5 by store salesclerks) and sold directly to it, skipping middleman costs. At the same time he designed the business to avoid the cost of fin- ished-goods inventory. His solution was simple: Don’t have finished- goods inventory. For the most part, Dell built only machines for which the company had orders (and payments!), and it built those machines to order—a major competitive plus. Dell’s finished goods were not sitting in warehouses and losing value in anticipation of customer orders; they were in delivery trucks headed toward waiting customers. The business model facilitated this make-to-order arrangement through a fast and flexible supply chain of component makers and just-in-time assemblers. One of the more remarkable aspects of the Dell business model was its collection of payments in advance of filling customer orders. There was no 30- to 60-day accounts receivable to be financed with working capital. There were no uncollectibles. Instead, the company turned the traditional cash conversion cycle on its head, receiving customer pay- ments immediately and paying its own suppliers after 30 days. Example: eBay eBay, the online auction company, grew out of an even simpler model. Like a telephone company, eBay created an infrastructure that allowed people to communicate—for a modest fee—with each other. Its Web-based infrastructure of software, servers, and rules of behavior allows a community of buyers and sellers to meet and con- duct transactions for all manner of goods—from Elvis memorabilia to used Porsches. The company takes no part in the transactions, thereby avoiding many of the costs incurred by other businesses. As described by author David Bunnell, eBay “has no responsibility for goods offered at auction, for collecting buyer’s payments, or for ship- ping. Its only responsibilities are to maintain the integrity of the auc- tion process and the information linkages that make it feasible, and to bill and collect the fees it charges sellers.”3 As a mechanism for generating income, the eBay model is simple. It receives revenues from seller fees. Those revenues are reduced by the cost of building and maintaining the online infrastructure and by the usual marketing, product development, general, and administrative Purchased by: Janet Le [email protected] on February 05, 2014 6 Entrepreneur’s Toolkit costs that keep the operation running and that attract buyers and sell- ers to the site.