Why you Should Treat Business Model Innovation as a Fully Established Discipline

By: Innovation Management

While most companies focus their innovation efforts on new products, others like Amazon and Netflix are disrupting industries with business model innovation –a cheaper, easier and more powerful form of innovation. InnovationManagement.se spoke about business model innovation with professors Netessine and Girotra, authors of the new book “The risk-driven business model”

Blockbuster’s failure to adapt its business model in the Netflix age proved to be a cautionary tale, while Amazon’s wild success is due to their mastery of regularly reinventing their business model to adapt to changing circumstances. The new book reveals the two kinds of critical risks to consider (Incentive Alignment Risk, when incentive structures are out of synch with a company’s interests; and Information Risk, when the business model depends on making decisions without sufficient information). The authors also outline key examples, from Nintendo (which missed out on $1 billion in potential sales of Wii because its compensation systems were aligned for bottom-line performance vs. future top-line growth) to crowd-funding platform Kickstarter (which reduces information risk in the development of new products by incentivizing customers to pre-purchase them before they’re even developed). The authors argue that every business – of any scale – needs to treat business model innovation as a fully established discipline.

1. Why is business model innovation so important?

It is becoming increasingly evident that traditional innovation approaches through new technologies and new products alone often don’t work. Pharmaceutical companies, for instance, have seen returns on such innovation to be elusive even though they often spend as much as 30% of their revenues on R&D. And spending so much without a clear return simply cannot work in the long term. This is why companies are turning to other types of innovation, especially those that do not involve first investing billions in R&D and then praying for the result.

With business model innovation this is possible. Both established companies (that were once startups) like Dell and Zara and young startups like AirBnB and Uber show that this is attainable. Moreover, we are seeing more companies (like Alibaba and TenCent) from the emerging markets that find it harder to compete with the West on new technologies but do well using inventive business models.

Right now is the renaissance period of business model innovation for several reasons. First, technological advances (smartphones, broadband, etc.) have made many new business models such as those of Uber and AirBnB possible. At the same time, technology innovators are realizing that they need business models to best profit from their innovations. For example Tesla has put together a fairly innovative dealership, re-purchase and switching station-based business model.

Second, while in the past business model innovations had to be local for years, because of global convergence it is now possible for business model innovators to scale fast globally (again Uber is a great example —present in over 70 cities around the world)—this gives business model innovators “internet scale”, something that only internet companies had in the past. Finally, investors are more aware of how business models can be significant game-changers that carry lower risk than technology or product innovation. Together, this is the perfect storm.

2. Why have companies like Amazon and Netflix become so successful?

The key is constant re-evaluation of the business model – what we call the business model audit . Most companies constantly evaluate and audit financial statements, for instance, but very few repeatedly analyze deficiencies in their current business models. Amazon and Netflix are two rare examples of companies that disrupt themselves rather than get disrupted by others. Take Amazon, for instance. Early on, cash-strapped company gets distributors and publishers to carry most of its books, rather than stocking the inventory itself. But very quickly, Amazon realizes that channel partners are not that good at fulfilling individual book orders which damages Amazon’s reputation so the company takes 180 degrees turn and heavily invests in warehouses to internalize fulfillment.

In 2001, the firm evolves further and starts hosting Internet stores for companies like Toys “R” Us, Target and Borders, and performs all other customer service duties on their behalf. In 2006 it goes even further and offers its fulfillment capabilities to anyone who wishes to transfer inventory to Amazon. It now pivots to same-day delivery and it is even looking into some exotic options like drone deliveries. And all of this is just on the fulfillment side: quite a voyage for what once was a virtual storefront!

3. How can your company be the next Amazon, instead of the next Blockbuster?

The first order of business is to establish business model audit as a regular exercise for top management of the company. Unlike traditional product or technology innovation, Business Model Innovation cannot be relegated to the R&D department. By its nature, Business Model Innovation can and often does involve many functional areas and therefore everyone must participate. The key to the Audit is identifying inefficiencies that are creeping up over time because technology changes, consumer tastes change, world evolves and what once was an efficient business model becomes obsolete and inefficient.

Once inefficiencies (or risks) are identified, companies can apply this framework which relies on changing how their decisions are made . Here startups are inherently in a more advantageous position because they are not bound by any existing business model but established companies must first break their own mold. This is impossible without commitment from the top– and direct support from the CEO.

New business models often require assigning people different responsibilities, redesigning the spheres of control and redrawing organizational boundaries. This is a tall order for most companies, which is why many innovations happen only when the organization is in a dire state. Creating the sense of urgency as well as culture for constant business model innovation is the job for top executives, NOT for techies from the R&D department. The biggest challenge is resistance from the beneficiaries of the current order– both external and internal ones. Internally it is power players in the organization who are threatened by change. Externally, you find incumbents with traditional models – it may be the dealerships against Tesla, taxi drivers against Uber, etc.

4. What are the kinds of critical risks to consider?

New business models can improve performance by reducing costs, increasing revenues or changing the way the business model bears risk. Of the three approaches, most industries have already made many efforts to reduce costs or increase revenues, so the possibility of further gains is limited. On the other hand, when it comes to changing the way a model bears risk, we have a lot more room for gains. Think of companies like Uber, AirBnb and Alibaba amongst many others—they have all created marketplaces by reducing the risk in micro-transactions.

There are two major sources of risk. One is what we call informational risk: many decisions in an organization are made without proper information. Think of a company like Timbuk2, which produces custom-made bags on demand vs. Samsonite producing lots of look-alike products without knowing what exactly the consumer wants. The second type of risk is what we call incentive alignment: think of early solar panel companies that tried hard-selling expensive, unproven technology to consumers vs. today’s dominant business model of FirstSolar when it leases solar panels and bundles in maintenance and other things so that consumers only pay for electricity that they generate. Both inefficiencies can be reversed by strategically changing:

• What decisions are made;
• When decisions are made;
• Who makes the decisions, and
• Why decisions are made.

By following this “4W” framework for Business Model Innovation, rethinking these critical decisions and ways in which they are made, any business or organization can advance its goals, exceed expectations and better compete in today’s marketplace.