Chapter 5

Developing an effective business model

The importance of a business model

How business models emerge

Components of an effective business model

The importance of a business model

A business model is a firm` s plan for how it competes, uses its

resources, structures its relationships, interfaces with customers and

creates value to sustain itself on the basis of the profit it earns.

Almost all firms partner with others to make their business model work.

Example:

Dell Inc. needs the cooperation of its suppliers, shippers, customers and

many others to make its business model possible. If Dell` s suppliers

were not willing to deliver up-to-date parts to the company on a just-in-

time basis, Dell would have higher inventory costs and wouldn` t be

able to ship its products and to have competitive prices. Dell works

closely with its suppliers and motivates them.

There is no standard business model, no rules that dictate how a firm in

a particular industry should compete.

It is dangerous for a company to assume that it can be successful by

simply copying the business model of another firm because it may be

difficult to determine what another firm` s business model is and a firm`s

business model is dependent on the resources and capabilities it

possesses.

The development of a firm` s business model follows the feasibility

analysis stage of launching a new venture but comes before the

completion of a business plan.

Having a business model is important because: It serves as an extension of feasibility analysis (it asks the question:

Does the business make sense?)

It focuses attention on how all the elements of a business fit together and constitute a working whole

It describes why the network of participants needed to make a business idea viable is willing to work together

Some business model are developed so that other competitors will not

be able to understand how the firm makes money.

Example:

Looking at Google` s Web site it is not obvious how the firm generates

income. It makes money through carefully placing discreet ads that run

alongside search results; licensing its search technology to portals such

as America Online; licensing its search technology to companies for

internal search engines. Google keeps its business model secret to

other firms from duplicating what it is doing.

Once the model is clearly determined, the entrepreneur should diagram

it on paper, examine it and ask the following questions:

Does my business model make sense?

Will the businesses I need as partners participate?

If I can get partners to participate, how motivated will they be?

If I get customers, how motivated will they be to do business with my firm?

Can I motivate my partners and customers at a sufficient scale to cover the overhead of my business and make a profit?

How distinct will my business be? Will it be easy for a larger competitor to steal my idea?

If the answers to each of these questions is not satisfactory, the

business model should be revised or abandoned.

A business model is viable only if the suppliers, partners and customers

will consider as being advantageous for them to work with this firm.

Example:

Web House Club was launched by Priceline.com founder in the fall of

1999and failed just a year later. Priceline.com allows customers to "bid“

for airline tickets, hotel rooms and home mortgages. Web House was

Established to imitate Priceline.com` s business model and extend it to

a grocery store items. Web House worked like this: A shopper got a

plastic card with a unique number and a magnetic strip from a local

grocery store and it was used to activate an account on the Web House

Internet site. The shopper could than make a bid for a supermarket item.

The shopper could specify the price but not the brand. In few seconds

he would learn whether a manufacturer was willing to accept the price. If

so, the shopper would pay the item at a participating store using the

Web House card. The item could be any brand. By aggregating

shoppers ` demands, Web House could go to manufacturers and

negotiate discounts. The firm could then pass along the discounts to

consumers and take a small fee for bringing buyers and sellers

together.

This business model did not work for Web House for several reasons: It assumed that manufacturers would be willing to participate. The

Web House business model taught customers to select products on the basis of price rather than brand identity. So why would any manufacturer want to help Web House do that?

The Web House business model assumed that millions of shoppers would take the time to sit down at the computers and bid on grocery store items. But how many people have time to sit down, log on their computer and interact with a Web site to save 50 cents on a box of cereals without being able to choose the brand?

The firm could not motivate its suppliers or customers to participate at a sufficient scale to support the overhead of the business. Web House was asking suppliers to act against their self-interest and was asking shoppers to take too much time to save too little money.

How business models emergeThe value chain explains how business models emerge and develop.

By studying a product` s or service `s value chain a firm can identify

ways to create additional value and assess whether it has the means to

do so.

Example:

Dell learned that it has customers who want technical support available

24-hour-per-day, seven days a week and these customers are willing to

pay extra to get it. Dell realized that it could add value to the value chain

for selling computers by developing the service segment to include 24-

hour-per-day, seven days a week technical support. This could work

only if Dell has enough trained personnel to offer 24/7 support.

Value chain analysis is also helpful in identifying opportunities for new

businesses and in understanding how business models emerge.

Most products and services are produced in a complex supply chain that

involves many firms rather than a single firm.

Because of this a value chain tends to be identified more with a product

or service, rather than a particular firm.

Entrepreneurs look at the value chain of a product or service to identify

where the value chain can be made more effective or where additional

value can be added.

This type of analysis may focus on: A single primary activity of the value chain (such as marketing and

sales).

The interface between one stage of the value chain and another, such as the interface between operations (which are the activities required to manufacture a product) and outbound logistics (which are the activities required to warehouse and ship it).

One of the support activities, such as human resource management.

If a product` s value chain (like a computer) can be strengthened in any

one of these areas, it may represent an opportunity for a new venture to

perform that activity.

There are examples of entrepreneurial firms that have enhanced the

value chain of an existing product or service by focusing on one of three

previously mentioned areas:

Firms founded to enhance a primary activity:

a). Outbound logistics: FedEx, UPS

the reason a new venture was started: to provide new ways to warehouse and move products effectively to the end users

b). Marketing and sales: Home depot, Wal-Mart

to provide new ways to market and sell products

c). Inbound logistics: Airborne Logistics, Excel

to provide efficient material management, warehousing and inventory control.

Firms founded to enhance a support activity:

a). Firm infrastructure: Boston Consulting Group

to provide management support

b). Human resource management: Administaff, Paychex

to provide payroll, tax, benefits administration and other human resource services

c). Technological development: EDS, Scient

to help firms integrate new technologies into existing business systems.

Firms founded to enhance the interface between one stage of the value chain and another:

a). Inbound logistics/operations: Ariba, Chem Connect

to help firms with the interface between inbound logistics and operations

b). Operations/outbound logistics: DHL Worldwide Express, UPS

to help firms with the interface between operations and outbound logistics

A firm can be formed to strengthen the value chain for a product, only if

a viable business model can be created to support it.

Example:

Michael Dell` s idea of selling computers directly to end users would not

have been possible if it were not low-cost shippers (such as UPS) and

manufacturers of components who were willing to sell their products to

him.

Components of an effective business model

An effective business model consists of the following components: Core strategy (how a firm competes) Strategic resources (how a firm acquires and uses its resources) Partnership network (how a firm structures its partnerships) Customer interface (how a firm interacts with its customers)

The core strategy describes how a firm competes relative to its

competitors and its elements are: the firm` s mission statement, the

product/marketing scope, the basis for differentiation.

Mission statement describes why the firm exists and what its business

model is. It is important that a firm` s mission not to be defined too

narrowly because the business model that merges may become too

singularly focused and resistant to change,

Example:

Xerox, The Document Company, has an implicit mission that focuses on

copiers and copying. This mission prevented the firm from seeing an

opportunity that might fit its business model. Xerox viewed itself as a

company that reproduces documents that already existed, causing the

firm to be a late entrant into the market for computer printers, which print

original documents stored electronically. This narrow focus allowed

Hewlett-Packard to gain control of the printer market.

A company` s product/market scope defines the products and markets

on which it will concentrate. The choice of a product has an important

impact on a firm` s business model.

Examples:

a). When Amazon.com was created, it was an online bookseller but has

evolved to sell other product lines, including CDs, DVDs, jewelry and

apparel.

b). Yahoo started as a company offering free Internet search services in

an attempt to generate enough traffic to sell advertising space on its

Web site. The business model worked until the e-commerce burst in

2000 and advertising revenues declined. Yahoo revised its business

model to include more subscription services to generate more income.

The markets on which a company focuses are an important element of

its core strategy.

Examples:

a). Because 80 percent of Dell` s customers are firms and government

agencies, Dell has built in his business model sophisticated forms of

customer support, such as “Premier Pages“ program which includes

Web pages for individual corporate customers. These pages allow

customers to search for products, place orders and configure products

online.

b). In contrast, Gateway` s business model is focused on individual

customers, small businesses and first-time computer buyers. It has

learned that most of first-time buyers want to see and touch a computer

before they purchase it, leading to the creation of gateway stores. It also

offered computer training. In early 2004, Gateway closed its stores,

indicating that it hadn` t the success with them that it had intended. The

failure suggests that Gateway` s business model will continue to evolve

to find a product/market scope through which it can generate value for

customers.

The basis for differentiation: it is important that a new venture

differentiates itself from its competitors in some way that is important to

its customers.

Firms choose one of two generic strategies (cost leadership and

differentiation) to position themselves in the market.

Firms using a differentiation strategy compete on the basis of providing

unique or different products .

Firms that have a cost leadership strategy strive to have the lowest cost

in the industry. It is difficult for a new venture to feature a cost

leadership strategy because it requires economies of scale that take

time to develop.

The strategy that a firm chooses affects its business model.

A cost leadership strategy requires a business model that is focused on

efficiency, cost minimization and large volume.

A differentiation strategy requires a business model focused on

developing products and services that are unique. These firms try to

create a brand loyalty.

Strategic resources

A firm is not able to implement a strategy without resources.

The resources a firm has affects its business model.

For a new venture, its strategic resources may initially be limited to the

competencies of its founders, the opportunity they have identified and

the unique way they plan to serve their market.

The most important resources a firm has are the core competencies and

the strategic assets.

Core competencies are capabilities that serve as a source of a firm` s

competitive advantage over its rivals.

Examples: Sony` s competence in miniaturization; Dell` s competence in

supply chain management.

A firm` s core competencies are important in both the short and the long

term.

In the short term they allow a firm to differentiate itself from its

competitors and create unique value.

Example:

Dell` s core competencies include supply chain management, efficient

assembly and serving customers, so its business model of providing

corporate customers computers that are price competitive, are

technologically up to date and have access to after-sale support makes

sense. If Dell suddenly starts assembling and selling musical

instruments, it will not be a successful strategy because it is outside its

core competencies.

In the long term, it is important to have core competencies to establish

strong positions in complementary markets.

Example:

Dell has taken its core competencies in assembly and sale of PCs and

has moved them into the market for computer servers and other

electronic devices.

Strategic assets include plant and equipment, location, brands, patents,

customer data, a qualified staff, distinct partnerships.

Firms try to combine core competencies and strategic assets to create

a sustainable competitive advantage.

Partnership network

New ventures do not have the resources to perform all the tasks

required to make their businesses work, so they rely on partners to

perform key roles.

In most cases, a firm does not want to do everything itself because most

tasks needed to build a product or deliver a service are not core to a

company` s competitive advantage.

Example:

Dell differentiates itself from its competitors through its expertise in

assembling computers but buys chips from Intel. Dell could manufacture

its own chips, but it does not have a core competence in this area. Dell

relies on UPS and Federal Express to deliver its products because it

does not have a core competence in this area.

Firms ` most partnerships are with suppliers that provide parts or

services.

A supply chain is the network of all the companies that participate in the

production of a product, from the acquisition of raw materials to the final

sale.

More and more, managers focus on supply chain management, which is

the coordination of the flow of all information, money and materials that

moves through a product` s supply chain.

The more efficiently a firm can manage its supply chain, the more

effectively its business model will perform.

Along with its suppliers, firms partner with other firms to make their

business model work.

These partnerships are in the form of strategic alliances, joint ventures,

networks, consortia, trade associations.

Example:

A survey made by PriceWaterhouseCoopers found that more than half

of America` s fast-growing companies have formed multiple

partnerships to support their business models. These partnerships have

resulted in more innovative products, more profit opportunities and high

growth rates.

Partnerships help firms focus on their core competencies, gain

economies of scale, share risk and cost, gain access to foreign markets,

speed to market, flexibility and neutralize competitors.

There are risks involved in partnerships, particularly if a single

partnership is a key component of a firm` s business model.

Many partnerships failed because of poor planning or the difficulties to

make cultures compatible, financial and organizational risks, risks of

becoming dependent on a partner, loss of decision autonomy.

Customer interface

The type of customer interaction depends on how a firm chooses to

compete.

Example:

Amazon.com sells books only over the Internet, while Barnes & Noble

sells both through its traditional bookstores and online. In the computer

industry there are several customer interface models. Dell sells only

online and over the phone, while Hewlett-Packard and IBM sell primarily

through retail stores.

The elements of a firm` s customer interface are: target market,

fulfillment and support, pricing model.

Target market is the limited group of individuals or businesses that it

tries to address.

The target market a firm selects affects everything it does (the strategic

assets it acquires, the partnerships it makes, the promotional

campaigns).

Fulfillment and support describe the way a firm` s product or service

goes to the market or how it reaches its customers.

It also refers to the channels a firm uses and the level of customer

support it provides.

Firms differ along these dimensions.

Example:

Suppose that a new venture developed a new cell phone technology.

The firm has several options regarding how to take its technology to the

market, such as: to license the technology to existing cell phone companies (such as

Nokia, Ericsson) to manufacture the cell phone itself and establish its own sales

channels

to partner with a cell phone company (such as Motorola) and sell through partnerships with the cell phone service providers.

The choice a firm makes about fulfillment and service has a dramatic

impact on the type of company that evolves and the business model it

develops.

Example:

If the firm licenses its technology, it would build a business model that

emphasizes research and development. If it decides to manufacture its

own cell phones, it would need to establish core competencies in the

areas of manufacturing and design and to form partnerships with cell

phone retailers.

The level of customer support a firm is willing to offer also impacts its

business model.

Some firms differentiate their products or services and provide extra

value to their customers through high levels of service and support.

Customer service can include delivery and installation, financing

arrangements, customer training, guarantees, repairs, convenient hours

of operation, convenient parking, information through Web sites.

Pricing structure

Pricing models vary depending on a firm` s target market and its pricinf

philosophy.

Example:

a). Some rental car companies charge a daily flat rate, while other charge so much per mile.

b). Some consultants charge a flat fee for performing a service, while others charge on hourly rate.

It is difficult for a new venture to differentiate themselves on price, which

is a common strategy for larger firms with more economies of scale.