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Deloitte Research
A competitive strategy studyby Deloitte Consulting and Deloitte & Touche
Deconstructing the formula for
BUSINESS MODEL INNOVATIONUncovering value-creating opportunities in familiar places
CONTENTS
Deconstructing the Formula forBusiness Model Innovation ................................................... 1
About the Study .................................................................... 4
Context:Finding Opportunities in Familiar Places .............................................. 6
Innovating Around the Who:Redefining Customer Segments,Creating New Segments, or Changing the Buyer ................................... 9
Innovating Around the What:Offering Customers What They Really Want ....................................... 14
Innovating Around the How:Developing Unique Capabilities and Operational Structures ............... 16
Creating a Sustainable Business Model ................................ 17
Putting Business Model Innovation to Work ......................... 20
About Deloitte Consulting and Deloitte & Touche ................... 25
About Deloitte Research ...................................................... 25
Case Studies
Harley-Davidson: From Competing on Motorcycle
Performance to Selling the Rebel Lifestyle .................................... 8
WellPoint: From Near Death to Industry Leadership
Via Business Model Innovation ................................................. 11
Paychex: Bringing Big-Company Payroll
Services to Mom-and-Pop Operators .......................................... 18
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Deconstructing the Formula forBusiness Model Innovation
The creation of new business models that would redefine
industries was the boardroom game of the late 1990s’ dot-com
boom. For many companies today, however, it appears to be an
anachronism. Amid economic uncertainty and dot-com carnage,
executives are battening down the hatches – slashing payrolls,
winnowing product and service lines, scaling back R&D programs,
and pressuring sales managers to redouble their efforts. Cost-
cutting and streamlining are back in vogue.
Yet if creating significant shareholder value is still the goal,
the search for new business models that can rewrite the rules of
an industry shouldn’t end. Combined with our extensive
experience helping clients with business model strategy, our new
study on some of the most successful business models of the past
40 years shows that such opportunities exist regardless of the state
of the economy. In fact, companies such as Corning, WellPoint
Health Networks, and Charles Schwab demonstrate that economic
uncertainty is actually a fertile time for spawning entirely new
business models.
That was one of the key findings of our extensive research
over the last year on business model innovation (BMI). We
analyzed hundreds of publicly held companies across a wide range
of industries and selected 16 of the most impressive business
model innovators that redefined their business and generated
extraordinary shareholder value. We discovered that multibillion-
dollar opportunities were there for the taking by large, lumbering
companies as well as by agile start-ups. In fact, established
companies were responsible for more than half of the innovative
business models that we examined (several of the 16 companies
launched more than one innovative business model). These
organizations – General Electric, WellPoint, Enron and Corning
among them – overthrew cultural inertia and exploited enormous
advantages in generating billions for their shareholders.
In deconstructing the formula for business model
innovation, our overarching question was this: What are the
patterns for creating enormous shareholder wealth through
business model innovation? By that term, we refer to companies
that introduce an entirely new approach to business, one that
diverges from industry norms in terms of “who” is targeted as
customers, “what” is offered to those customers, and “how” that
offering is provided.1 We wanted to understand how companies
were able to generate enormous returns for their shareholders by
expanding their focus for differentiation beyond product
innovation. Finally, we wanted to understand how business model
innovation created sustainable advantages for the innovators.
Our findings shattered many of the popular preconceptions
about business model innovation. In addition to finding that
business model innovation happens in both good times and bad,
our research and experience challenges today’s nostrum that
revolutionary companies succeed by being first to understand and
act upon a new technology, regulatory shift, socio-demographic
change or other significant discontinuity. In fact, we found
something else: While some companies capitalized on such trends,
most simply targeted customers whose needs had existed for
some time but who, as a market segment, were considered
undesirable or even unprofitable by the pack.
The case of Paychex illustrates this vividly. In 1970, B. Thomas
Golisano was a sales manager for a regional payroll processing
company in Rochester, N.Y., that served large companies. He
couldn’t convince his superiors that small companies – less than
50 employees2 – were an untapped but lucrative market. While it
took Golisano four years to turn a profit, his business model today
is irrefutable.3 Paychex, whose customers have an average of 14
employees, is a highly profitable company with revenues of nearly
$900 million and a market value of $15 billion.4
22
As Paychex and others like Southwest, WellPoint, and America
Online show, the opportunity was there for all to see – and seize –
for some time. In other words, creating blockbuster new business
models does not require an ability to predict the future – it
requires an ability to redefine the present. However, simple as
this may sound, doing so requires identifying and overturning
long-held industry norms – beliefs that have shaped existing
companies’ decisions regarding the who, what, and how of
business and that blind most managers from seeing unexploited
blockbuster opportunities. The Paychex scenario – in which the
industry incumbents dismissed a market segment as undesirable
– was repeated in many of the companies we explored.
Business model innovation does not require star-gazing; it
also usually doesn’t require leading-edge product or service
innovation. In fact, none of the 16 companies analyzed invented
what could truly be considered a breakthrough product or service.
In many cases, the business model innovators essentially left the
prevailing product/service offering of an industry unchanged.
Instead, they altered the existing structure of the industry in ways
that were unfathomable to the incumbents.
Just as important, business model innovation requires going
far beyond identifying an unserved or underserved market
segment – i.e., changing just the who component. Every one of
the 16 companies we studied also carefully designed and built the
what (the product/service offering and the customer’s experience
with it) and the how (the operations, supplier relationships, and
other activities that deliver that customer experience) in ways that
economically produced extraordinary customer value. The
innovators also captured sustainable competitive advantages in
one or more ways, including creating economies of scale, being far
ahead on the learning curve, having loyal customers, and
possessing hard-to-duplicate resources. Further, the innovators
preyed upon the inherent constraints of the incumbents –
disadvantages that included commitments to existing supply
chains and fears of disrupting existing channel relationships.
SOURCE: DELOITTE CONSULTING
The Business Model Innovation framework is a structured approach to evaluating and introducing innovation to individual businesses.
WHO
• Segment• Needs• Perception
• Channels• Product/Services• Total Experience
• Resources• Activities• Partners
WHAT HOW
• External Factors• Internal Capabilities
• Innovator Advantages• Incumbent Disadvantages
CONTEXT SUSTAINABILITY
FRAMEWORK FOR BUSINESS MODEL INNOVATION
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LEVERAGEABLEBusinessContext
SPECIFICCustomer Focus
SUSTAINABLEFactors
PRECISECustomerOffering
UNIQUEBusiness
Capabilities
WHO WHAT HOW
PC industry focusedon build-to-stock
ExperiencedPC buyers
Incumbent channelconstraints & build-to-order expertise
Self-servicePC solutions
Build to order,direct channel
Deregulation andvolatile energy
prices
Commercial endusers of energy
Long-termcustomer contracts
Turnkey energyoutsourcing
Risk forecasting,solution packaging
Online access forinformation
Lifelong, averagenet-worth investor
Incumbentsunwilling to sell
competing products
Multi-channel,multi-product access
Integratedchannels
Deregulation andairlines’ focus on
business travelers
Cost-sensitivetraveler
Incumbents commit-ment to higher cost
business modelNo-frills travel Point-to-point
resources
Small businessesunderserved by
outsourcing industrySmall
businesses
Incumbents unableto profitably serve
small business
Small-biz focusedpayroll outsourcing
Brand, low-costoperations
Japanese lead inmotorcycle technology
Rebel imageexecutives
Business modelbuilt aroundrebel brand
Branded motorcyclerebel lifestyle
Brand, Harleyowner groups
Individuals andsmall business
Tailored healthcaresolutions
Incumbents unableto become
customer-centric
Customer-centricorganization
Virtually-integratedcustomer direct
Self-servicemulti-channel brokerage
Low-cost air travel
Small businesspayroll outsourcing
Lifestyle provider
Payer industryfocused on
large groupsCustomized health insurer
This is our formula for successful business model innovation.
In this study, we explore the formula through the experiences of
the 21 innovative business models. Based on our research and
consulting experience, we discuss the implications for established
companies looking for the next great opportunity or trying to
protect their current model from attacks. Finally, we present a three-
step approach for identifying, evaluating, and bringing to market
promising new business models.
Energy outsourcing provider
SELECT BUSINESS MODEL INNOVATIONS
SOURCE: DELOITTE CONSULTING
SUPERIORSHAREHOLDER
VALUE
From our research, companies that wish to compete and
succeed on the basis of business model innovation must focus
on three core issues:
Context: The external factors and internal capabilities that
can be exploited.
Innovation dimensions: How to redefine the basic
dimensions of business – who to serve, what to offer, and
how to operate – in new and profitable ways.
Sustainability: How to create a winning business model that
is hard to imitate.
TSR: 52% MV: $70B
TSR: 17.5% MV: $34B
TSR: 26.2% MV: $21B
TSR: 35.9% MV: $15B
TSR: 32% MV: $15B
TSR: 35% MV: $16B
TSR: 25.5% MV: $7B
NOTE: MV = Market Value (as of 7/31/01)TSR = Total Shareholder Return (Five-year annualized rate, including dividends, as of 7/31/01)
4
About the Study
Deloitte Consulting launched its formal study of business model
innovation in November 2000. Despite volumes of research and
writings on the topic in the last 20 years, we found little in-depth
analysis regarding what factors and design patterns enable and
sustain profitable business model innovation.
We weren’t interested in studying business model
innovation per se – only the kind that generates superior
financial results. As a result, we began by identifying companies
from a range of industries that outperformed their peers in
generating shareholder value and compared their business
models to the pack.5
Identifying Top Performers
To identify the most successful business model innovators, we
first had to uncover the top-performing companies (whether
or not their performance was based on business model
innovation), and then evaluate the basis of their performance
(whether or not they were business model innovators). Our
screen for the top-performing companies was based on four
indicators used by Holt Value Associates, a financial consulting
firm, to evaluate corporate performance:
Total shareholder returns (TSR): Share price
appreciation plus dividends over the last three (or five)
fiscal years.
Cash flow return on investment (CFROI): The ratio of
gross cash flow to gross investments translated into an
internal rate of return. This recognizes the finite economic
life of depreciating assets and residual value of non-
depreciating assets.
Premium: The sum of current market values of debt and
equity, including the value of minority interest, divided by
current inflation-adjusted net assets plus three years of
capitalized R&D.
Percent future: The percentage of total market value that
the stock market assigns to the company’s expected
future investment. This was determined by subtracting
the portion attributed to the present value of existing
assets and investments from the market value of debt and
equity, then dividing by the total market value of debt
and equity.
Out of all U.S. public companies, 169 emerged as
significantly outperforming their peers, representing a wide
range of industries including beverage, drugstore, food
processing, retail, utilities, natural gas, financial services,
computers, manufacturing, and telecom. Business model
innovation was not the lever for superior performance for the
majority of these companies For example, in the drugstore
industry, the top-performer (Walgreen) simply executed better
than others without changing the segment’s long-existing
model. Quaker Oats and McGraw-Hill outperformed their rivals
through product leadership. And Amgen’s product innovation
was the reason it topped the list of pharmaceutical companies.
Identifying Successful Business Model Innovators
After extensive discussions with industry experts within and
outside Deloitte Consulting, 16 companies emerged from the
list of 169 top performers as those that successfully launched
21 business model innovations (several launched more than
one new business model). The list of business model innovators
features 10 start-ups (Amazon, America Online, Cisco, Dell, IMS,
Paychex, Schwab, Southwest Airlines, Starbucks, and Wal-Mart)
and 11 established companies who have significantly
transformed their business models (AOL/Time Warner,
Columbia, Corning, Enron’s three evolutions, General Electric,
Harley-Davidson, Schwab, Wal-Mart, and WellPoint). (See table
on following page.)
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Understanding the Patterns of Successful BusinessModel Innovation
With these 21 cases in hand, we then embarked on an extensive
examination of public information about them (books,
newspaper and magazine articles, regulatory filings, corporate
annual reports, Web site documents, etc.). We also interviewed
numerous executives and Deloitte consultants with expertise
on these companies. In pouring through this material, we
sought to understand three aspects of business model
innovation:
Context of their innovation: The conditions that enabled
or drove their success (regulatory, technology, socio-
economic, industry, etc.).
Elements of business model innovation: The innovation
levers they used to change the prevailing who, what, and
how, and create substantial new customer value.
Sustainability factors: How they were able to avoid being
copied by competitors or start-ups.
We conducted extensive analysis to identify the factors
behind the context, elements, and sustainability of superior
business model innovation. For example, to examine the context,
we identified 14 external factors (e.g., regulatory changes,
socioeconomic shifts) and eight internal factors (e.g.,
entrepreneurial culture, strong brand equity, new executive
leadership, risk of insolvency). We then identified the innovation
levers used in the who (users, needs, customer views), what
(channels, offerings, support), and how (assets, processes,
relationships).
Finally, we explored the elements of sustainability – the
factors the business model innovators had at their disposal (e.g.,
first-mover, brand equity) and the handicaps of incumbents in
pursuing the new business models (e.g., cultural inertia, fear of
disrupting existing distribution channels).
By identifying such factors, we were able to understand which
innovations occurred in what context and why they have been
sustainable, ultimately forming the basis of our findings.
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Top Performing Company Business Model Innovation Year introduced
Amazon
AOL1
Cisco
Dell
IMS
Paychex
Schwab 1
Southwest
Starbucks
Wal-Mart 1
Online retailer
Online content provider
Innovation acquirer
Virtually-integrated customer direct model
Health care information aggregator
Small business payroll outsourcing
Discount brokerage
Low-cost air travel
Multi-channel experience retailer
Mass discounter
1995
1993
1993
1984
1954
1970
1971
1971
1971
1962
Star
t ups
Tran
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SOURCE: DELOITTE CONSULTING
Vertically-integrated conglomerate
Specialty clothing mass merchandiser
Alliance-based market maker
Energy trader
Energy outsourcing provider
Bandwidth trader
Bundled product/service solution provider
Lifestyle provider
Self-service multi-channel brokerage
One-stop mass merchandiser
Customized health insurer
2000
1985
1990
1988
1992
2000
1990
1987
1992
1987
1986
AOL 2
Columbia
Corning
Enron 1
Enron 2
Enron 3
GE
Harley Davidson
Schwab 2
Wal-Mart 2
WellPoint
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Context: Finding Opportunitiesin Familiar Places
In our research, we first wanted to understand what context enables
business model innovation. What environmental forces were in
play in each of the cases? To what degree was innovation success
driven by an ability to exploit emerging socio-economic trends?
Was the innovation opportunity largely driven by regulatory
changes that redefined markets or opened up new ones? Were
innovations largely the response to emerging technologies that
enabled new and better ways to serve the existing market?
Given all the discussion about looking for discontinuities in
the marketplace, it’s no surprise that several of the business model
innovators did in fact capitalize on shifts in the macro- and micro-
economic environment. Amazon, Schwab, and Paychex exploited
new or emerging technologies to serve entirely new segments.
To our surprise, however, the major contextual driver behind
the innovation success cases we examined was not a new
technology, regulation, or socioeconomic change – it was the
existence of an unmet or overlooked customer need. A good
example of this is Southwest Airlines. The company started
operations in Texas in 1971 to serve an enormous but underserved
market: short-distance travelers who couldn’t justify the high fares
charged by traditional national carriers when comparing those
fares to alternatives like bus, car, or train travel. While regulatory
factors were an issue in Southwest’s case, they were a hindrance –
not an enabler – of innovation, initially preventing the company
from expanding its business outside of its home state.
Consider Starbucks. The Seattle-based company tapped into
American consumers’ long-existing but relatively unmet lifestyle
need for affordable luxuries, and a meeting place where people
could relax, chat and participate in a café community experience
like Europeans had done for decades.
We found that even the most technologically sophisticated
companies generated superior shareholder value by focusing on
unmet and overlooked customer needs – not by focusing on
technology. Dell, for example is known for technology-enabled
supply chain sophistication that dramatically minimizes inventory,
costs, and cycle time. But when the company was launched out
of Michael Dell’s University of Texas dorm room in 1984, Dell’s
technological infrastructure was nothing like the Web-enabled
one for which it is famous. Indeed, Dell’s initial epiphany was
about recognizing the overlooked needs of a rapidly-growing
customer segment: technically sophisticated business and
personal PC users who found no value in dealing with PC stores’
inflated prices and often less than sophisticated sales personnel.
“The indirect channel was based on a marriage of the unknowing
buyer and the unknowledgeable seller,” explained the company’s
founder and CEO in his autobiography.6 “I knew that marriage
could not last… that customers would become even more
knowledgeable and demanding every year.”
Key TakeawayKey TakeawayThe greatest opportunities for business model
innovation are in established industries thought
to be "mature." In these industries, prevailing
norms obscure a hotbed of customer needs just
waiting to be addressed.
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Most of the 21 business model innovations came from what
many viewed as mature industries, not emerging technology
sectors where new entrants often create whole new industries
virtually overnight. While two of the 16 companies were
technology suppliers (Dell and Cisco), the majority were in
industries considered to be decidedly low-tech, mature, and
saturated with competition. Wal-Mart, for example, launched a
discount retailing business in 1962 in an industry that had been
dominated by companies such as F.W. Woolworth. Paychex started
its business in an industry controlled by Automatic Data Processing
Inc. (ADP). Few airline experts thought that upstart Southwest
Airlines would ever be more than a small regional carrier, especially
after watching the demise of bargain carriers such as People
Express. The predominant belief was that the largest, most
profitable carriers had to be national or international. Regional
airlines were considered to be small potatoes. But today,
Southwest’s market capitalization ($15 billion) is larger than the
combined market caps of American, United, and Continental.7 And
while Amazon and America Online sound like high-tech
companies, they have merely used technology to carve out a piece
of an established industry (retailing for Amazon and content for
AOL).
Industries that appear to be static provided some of the best
opportunities for business model innovation. In 18 of the 21 cases
studied, there was strong homogeneity among competitors’
business models prior to the innovation. In fact, most of the
business model innovations disrupted industries thought to be
mature, highly competitive, and therefore devoid of any great new
unexploited opportunities, at least until the innovator proved
otherwise.
Certainly, that was the case for Southwest Airlines. Looking at
the cutthroat competition and huge losses by airlines like Pan Am
and Texas Air, most potential entrants would have looked for
opportunities outside the industry. While earnings at the major
carriers have bounced up and down, Southwest has been
profitable since 1973.
Another thread that ran through many of the established
companies that launched successful new business models was the
presence of a strong perceived need to innovate, driven by
desperation or inspiration. Either survival was at stake (the case
at Schwab, WellPoint, Columbia, and Harley-Davidson) or the
company had a developed a culture that embraced innovation as
key to long-term success (a defining factor at AOL, Enron, and GE).
In addition, many business model innovators that were
established companies (firms such as Harley-Davidson, Columbia,
and Enron) created new wealth in part by leveraging their existing
brand equity or a strong, loyal customer base, or both. The ability
to leverage existing resources proved critical. Enron, for example,
capitalized on its financial capability in creating trading markets
for energy and bandwidth. Harley-Davidson’s strong brand among
motorcycle riders enabled it to shift its business model to
promoting the Harley lifestyle. Had Harley-Davidson launched its
new business model as an unknown start-up, it most likely would
have gained little traction. In combining groceries with general
merchandise in its second business model innovation, Wal-Mart
took advantage of its vaunted inventory management and
distribution capabilities, its vast and loyal customer base, and its
strong brand. Without that, it would have taken years for the
company to gain ground in the grocery business.
What does all of this say for the context of business model
innovation? It validates that regulatory, socioeconomic,
technological, and other environmental changes can indeed create
major opportunities. More importantly, though, our analysis of
context reveals that mature industries with well-established norms
about the who, what and how of business often hold the greatest
opportunities for business model innovation. Underneath the
complacent homogeneity in many industries is often a hotbed of
significant but unmet customer needs just waiting to be addressed.
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Harley-Davidson: From Competing onMotorcycle Performance to Selling theRebel Lifestyle
Nearly 20 years ago, Harley-Davidson Inc. was in danger of losing
its U.S. market to a rash of Japanese motorcycle manufacturers.
A financial crisis at Harley-Davidson and management buyout
of the company from its parent, AMF Inc., drove an entirely new
business model, which has spawned enormous marketplace and
Wall Street success. Today, with sales of about $3 billion, Harley-
Davidson is the largest seller of motorcycles in the United States
and is valued on Wall Street at more than $15 billion.8
But Harley-Davidson’s potential for success wasn’t nearly as
obvious back in the early 1980s. The context for Harley-Davidson’s
innovative business model was one of extreme distress.
Companies like Honda, Suzuki, Yamaha, and Kawasaki had
infiltrated the U.S. market with better-quality, higher-performing,
and lower-priced motorcycles. These companies used high-tech,
high-volume production operations, advertised heavily and
priced lower to gain market share. Internally, Harley-Davidson
struggled with poor labor relations and highly inefficient
manufacturing operations. Yet the company had several strong
capabilities to leverage: a brand that was an American icon, a
strong independent dealer network (which has grown to 1,300
worldwide), and an intensely loyal customer group.
In creating a new business model that would enable it to
differentiate itself from its fierce Japanese competitors, Harley-
Davidson management redefined all three aspects of the model.
It broadened the customer base (the who) beyond the hard-core
biker crowd to include leisure riders and weekend rebels. It
addressed this larger segment’s need for community, while
changing the basis of comparing motorcycle brands from one
of product versus product to one of lifestyle versus lifestyle. As a
lifestyle offering, competitors couldn’t compete against Harley-
Davidson on its home turf.
Harley-Davidson also wisely differentiated the value
experience (the what) on attributes other than the performance
of its bikes. These attributes included the sound of its bikes,
their look and feel, and, just as importantly, accessories, clothing,
and community events that had nothing to do with motorcycle
performance. Thus, the company repositioned itself from a
motorcycle to a lifestyle brand.
In changing the how, Harley-Davidson reinvigorated its
dealer relationships through cosponsoring community events,
which was the focus of an entire new Harley-Davidson division.
It also founded the world’s largest motorcycle club, the Harley-
Davidson Owners Group (appropriately called HOG, for short).
And it extended its brand to a range of Harley lifecycle
accessories for biking life, such as clothes. The company also
improved its quality and manufacturing operations’ efficiency.
How did Harley-Davidson sustain its initial business model
innovation? The company strengthened its chosen customer
segment (the who) by emphasizing the brand and lifestyle
aspects of buying a Harley-Davidson. It also maintained
ongoing contact with customers through the Harley-Davidson
communities and community events. Harley competed
effectively on the what of business model innovation through
its image-based branding campaigns. Technology and
performance-focused competitors couldn’t compete against
the Harley-Davidson lifestyle. In the how, Harley-Davidson
outran competitors in the United States through the strength
and loyalty of its dealer network and through economies of
scope; that is, the company leveraged its brand identity to sell
non-motorcycle products at steep margins.
Harley-Davidson’s highly profitable rebel lifestyle business
model is closely studied by others in both manufacturing and
consumer business circles. As a success, Harley-Davidson’s story
validates the power of customer-centric business model
innovation.
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Innovating Around the Who:Redefining Customer Segments, CreatingNew Segments, or Changing the Buyer
How could so many dominant, well-financed companies overlook
the new opportunities exploited by Wal-Mart, Schwab, WellPoint,
Southwest, and the other business model innovators? How did
they allow poorly-financed and often unsophisticated upstarts to
steal target portions of their market or dominate new markets?
In recognizing what others had missed, the business model
innovators either:
Redefined customer segments and targeted those with
underserved needs;
Created a new customer segment; or
Changed the decision maker within the existing customer
base.
WellPoint Health Networks demonstrates the power of redefining
an existing customer segment. The Thousand Oaks, Calif.-based
health insurer nearly went bankrupt in the mid-1980s as Blue Cross
of California. It began its dramatic recovery in the late 1980s
through business model innovation that refocused around two
customer groups that had largely been ignored. At the time of
WellPoint’s innovation, small businesses and individual customers
had been largely underserved by other health plans, which
optimized their products, processes, and channels to serve
corporations and other large group customers. To better pursue
these individuals and small businesses, WellPoint decided to create
units that were separate from operations catering to large groups.
As a direct result of these changes, WellPoint had grown solidly to
$7.5 billion in revenue by 1999, with CFROI and TSR well above
industry averages. (See sidebar on WellPoint.)
Several innovators created enormous wealth by developing
entirely new markets. Schwab virtually created a whole new
segment of investors: do-it-yourselfers whose desire for low-cost,
no-frills securities trading went underserved. In 1975, Schwab
quickly followed the deregulation of securities brokering and
commissions pricing by targeting the unmet needs of stock buyers
who didn’t value the premium advisory services of companies like
Merrill Lynch and Dean Witter. After brokerage deregulation,
leading brokerage houses actually considered raising commissions
to further solidify their premium brand positions. Schwab, a
struggling second-tier brokerage house, had little to lose in
pursuing the opposite strategy – serving the newly viable no-frills
segment by unbundling stock-trading advice from securities
transactions and offering the bare-bones transaction processing
service at a discounted commission price. As a result, Schwab
shifted customers’ perceptions about their trading alternatives
from one of brand versus brand to premium versus discount. In
Schwab’s first five years as a publicly traded company (1987-1992),
its total shareholder returns were the highest in the industry and
double those of Merrill Lynch, the largest U.S. brokerage.
Key TakeawayKey Takeaway Successful innovators look beyond industry
norms and tap into huge unmet needs by
redefining a customer segment, creating a new
segment, or changing the decision-maker.
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Paychex, a provider of payroll outsourcing services, also
created a new market and a new business model to serve it. Since
its 1970 launch as a new business dedicated to the small business
segment, Paychex has expanded dramatically, growing to nearly a
billion dollars in annual revenue while keeping its focus on small
businesses. (The average Paychex customer has 14 employees.9)
Paychex continues to capture value with its business model,
earning a five-year average annual growth in total shareholder
returns of more than 50 percent – nearly double that of ADP’s. In
addition, Paychex’s after-tax return on sales is a whopping
29 percent.10
Columbia Sportswear created a new segment of outdoors-
wear buyers. Founded in 1938, Columbia transformed itself from
a regional hat distributor to one of the largest distributors of
clothes and shoes for outdoor activities such as fishing, hiking,
hunting, and golf. At the beginning of the 1990s, the outdoor gear
industry was dominated by branded manufacturers that
competed on quality to serve a niche market: hardcore outdoors
enthusiasts. At the same time, manufacturers that competed on
cost dominated the mass-market outdoor clothing industry with
very limited branding. Recognizing a consumer shift in interest
toward more active lifestyles, Columbia identified a new segment
that bridged the two existing segments: a mass-market segment
for branded outdoor wear at affordable prices. By mid-2001, with
sales of $615 million and a market premium that’s more than
double the industry average, Columbia has become a pacesetter
at mass-producing technically legitimate outdoor wear in the
apparel industry.
In the early 1990s, America Online tapped a relatively new and
underserved segment of online computer users – technologically
unsophisticated newbies who needed simple interfaces and
navigation. Ten years ago, AOL had far fewer online subscribers
than CompuServe, which had been around since 1969 and over
the years had developed a steadily growing and highly profitable
business catering to mature and sophisticated online computer
users. CompuServe’s motto – “the information service you won’t
outgrow” – spoke volumes about its scant interest in attracting
novice computer users. America Online, however, catered to the
newbies by focusing on what CEO Steve Case called the 3 Cs:
communication (e-mail and chat room sessions), community
(letting subscribers interact with other subscribers), and clarity
(making the service easy to use). CompuServe, with its deep
offerings in online content, saw CompuServe as “nutritional” and
AOL as “junk food.” But CompuServe’s management ignored a key
fact: “America loves junk food,” as the author of a book on AOL
put it.11
Companies like GE demonstrate the rewards of rethinking the
target buyer. The industrial and services giant understood that
most manufacturing customers were not one-time buyers
ordering on spec but rather ongoing purchasers looking for
broader solutions. As a result, GE redefined the target buyer from
the engineering or procurement head to senior executives buying
an end-to-end solution. The company then applied this concept
of service provider to the majority of its manufacturing businesses.
GE’s business model continues to capture significant shareholder
value, earning a five-year annual total shareholder return
(1996 – 2001) of more than 30 percent – second highest among
its peer group within the manufacturing industry.
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WellPoint: From Near Death to IndustryLeadership Via Business Model Innovation
Few companies better demonstrate the power of rethinking
the who, what, and how of business model innovation –
rejecting the industry norms – than WellPoint Health Networks
Inc.. Near bankruptcy 15 years ago as Blue Cross of California,
the company has since made a stunning reversal, becoming
the best-performing U.S. health insurer, a highly profitable
business with 2001 revenues in excess of $12 billion, and a star
on Wall Street. But to make the shift, the company had to
eschew a number of long-held industry beliefs, particularly
about the viability of certain market segments and the need
for economies of scale in back-office operations.
The context for WellPoint’s business model innovation was
a dire one. In the 1980s, for-profit health maintenance
organizations (HMOs) were proliferating, siphoning off many
profitable customers – i.e., healthy consumers requiring little
medical care. Health plans looked indistinguishable except in
price, where Blue Cross of California was at a disadvantage. In
the midst of this, the company was suffering from spiraling
medical costs, a “well-deserved reputation for poor service,” and
a “bloated bureaucracy,” as the Los Angeles Times put it.12
By 1986, when the company brought in Leonard D.
Schaeffer as CEO, the organization was hemorrhaging $160
million in annual losses. “The company was insolvent – they
just hadn’t shut it down,” said Schaeffer, who had been president
at a Minnesota health insurer, Group Health Inc., but had spent
most of his career in government, as the first head of the federal
government’s Health Care Financing Administration and
budget director for the State of Illinois.
Almost immediately, he slashed the Blue Cross
organization’s payroll of 6,600 nearly in half and sold the
headquarters building for $90 million. But that wasn’t enough.
“Things were in terrible shape and every couple of weeks they
would get worse,” he remembered in an interview at WellPoint’s
Thousand Oaks headquarters just north of Los Angeles. “No
matter where we tried to make progress, there always was a
‘hand from the grave’ that came out and pulled us back in.”
With the organization staring death in the face, Schaeffer
questioned many of the norms that had gotten it in trouble.
The first was if large-group customers – big companies,
universities, government institutions, and the like – were indeed
the only profitable segment. “Individual insurance is considered
by ‘true’ insurance people to be a non-insurable event,”
Schaeffer explained, meaning that pooling risk is far more
difficult than it is in a large company with thousands of
employees. Small businesses, with much higher failure rates
than large companies and therefore much higher receivables
risks, were considered undesirable as well. “Small groups were
[insured] in case the small group eventually became a big
group,” he said.
At first, Schaeffer wasn’t certain that the company could
profitably serve individuals and small groups. But he knew it
wasn’t possible under any circumstances through the
company’s existing organizational structure, one in which
technology and paper intensive claims processing, customer
service, and other back-office operations were combined for
all customers for economies of scale.
On the way to transforming the organization, which by
1999 was able to go public as WellPoint Health Networks,
Schaeffer redefined the who of the industry by carefully carving
out operations to serve three separate customer segments –
individuals, small groups, and large groups. “We had to break
this huge mess into manageable chunks,” he explained. A
general manager over each customer segment was given strict
profit-and-loss responsibility, as well as all the operations
necessary to conduct business – marketing, sales, product
development, claims processing, customer service, and finance.
As a result, WellPoint broke its massive claims processing
factory into three pieces, each serving its own customer
segment. The industry considered that heresy.
The first chunk to be created was the individual segment,
one in which the company was losing $45 million a year in
insuring 65,000 people. This segment turned out to be much
12
different than the other two because the person receiving
and paying for health services was one and the same, unlike
the small- and large-group segment in which employers pick
up most of the tab. Marketing to and serving individuals were
far different than they were for corporate accounts.
Individuals often buy insurance through independent
brokers, not through the benefits consultants used by large
companies. They don’t have an HR department to iron out
problems. And they are bewildered by the complexities of
health insurance.
Because of such differences, WellPoint realized that the
what (the insurance products and the channels employed)
and the how (delivery approaches for those products) had
to be different for each customer segment as well. At the
time, the prevailing norm around the what of the industry
was that HMOs were the ideal insurance product for
controlling escalating medical costs. HMOs restrict a patient’s
choice by stipulating which doctors and healthcare facilities
will be covered. But Schaeffer thought otherwise, feeling that
people would pay higher deductibles and co-payments for
more choice. “I believed very strongly that the HMO was not
the answer, and to organize around something that I felt was
transient, to say the least, just didn’t make any sense to me.”
By offering multiple health plans to small groups (HMO
and others) – even different health plans to different
employees of the same company – WellPoint hit a responsive
chord during the economic boom of the 1990s. “We’re the
company that believes in choice, and that notion of choice is
very powerful because satisfaction correlates with whether
you chose or were forced to go into a health plan,” Schaeffer
said. Today, for example, the company offers small-business
employees nine different health plans. Less than a third of
the company’s members are in HMOs.
By separating the operations for each customer segment,
WellPoint has dramatically improved its ability to understand
the important needs of each segment, and to create new
health insurance plans or features to meet those needs. “The
key is to get to know those customers well enough to identify
product attributes that others don’t identify, and then build those
attributes into products,” Schaeffer explained. “They are very small
changes, but they’re very powerful.” For example, WellPoint lets
Ford Motor Co., a major account, pay according to the car-maker’s
cash-flow schedules. WellPoint knows when that’s going to be,
and prices it to account for the time-value of money.
On the other hand, the payment rules for small groups are
much stricter. Since a high percentage of small businesses fold
annually, those that don’t pay WellPoint within 30 days are
automatically cancelled. “Treating the receivables of small
businesses like large businesses has gotten other health insurers
in huge trouble in recent years,” Schaeffer said.
WellPoint has been able to deliver attractive health plans
profitably in its three segments through carefully thinking about
the how. First, each customer segment has its own dedicated
operations, including claims processing and customer service.
WellPoint’s business model innovation, in effect, was to create three
separate business models, each serving a different customer
segment. This shifted spending in the company from 80 percent
at the corporate level and 20 percent in the line businesses to
10 percent corporate/90 percent line.
In the small-group sector, WellPoint can offer a range of health
plans because it has standardized the nine plans. “We know from
our customers that these plans work for them and if we need to
make changes, our customers will drive that, not industry opinion,”
Schaeffer said. Second, the company uses actuaries to price its
policies, which most HMOs didn’t use 15 years ago. “I was stunned
to find out that the people who manufactured product in these
kinds of companies didn’t know anything about costs,” Schaeffer
said. “We have more actuarial discipline than most insurance
companies.” Third, WellPoint’s contracts let it change prices more
frequently than most other plans. And fourth, the company has
one of the best databases in its industry on the cost of specific
medical procedures.13 Updated continually, the database lets
WellPoint increase or decrease premiums faster than most other
plans.
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The who, what, and how of the three business units are
further improved at the corporate level through several
mechanisms: a strict planning and budgeting process;
continual measurement of key performance indicators; strong
rewards (or penalties) for meeting or missing performance
targets; and the clout to negotiate big pricing concessions from
healthcare providers. Schaeffer referred to the planning and
budgeting process as “loose-tight” – loose in that the three
business units are not instructed by corporate on such issues
as marketing, but tight in that numbers promised must be met.
An information system built for Schaeffer and other WellPoint
corporate executives provides key performance metrics by the
day. “If the [business units] are missing their numbers, I know
about it the minute that they know about it,” he said. “And if
they’re not working on a way to fix it, they know they’re in
trouble.” Schaeffer is known for ruling with an iron fist. Poor
performers are fired fast. “You do not do 15 percent [annual
earnings growth] for seven years because you’re lucky,” he said,
alluding to the pressure he puts on managers to perform.
How has WellPoint sustained its success? For one, many
competitors have huge costs tied up in serving all their
customers through a single organization; separating these
operations as WellPoint has would cost millions and risk
organizational havoc. The inability to make changes all the way
through the who, what, and how of their businesses has left
many would-be WellPoint imitators far behind. Secondly,
Schaeffer’s outsized skepticism about popular wisdom in the
industry has resulted in few bad acquisitions, errant product
introductions, or failed technology investments. For instance,
he declined to enter the Medicare HMO market in the mid-
1990s, even while competitors made big money at first. But
then the HMOs hit the wall when the government cut rates in
1997.
The impact of WellPoint’s moves has been spectacular. One
leading Wall Street analyst predicts the company’s operating
earnings will grow 21 percent this year to $714 million and
revenue 34 percent to more than $12 billion.14 And the company,
which was worth literally nothing 15 years ago, today has a
market cap of more than $6 billion.15 In addition, WellPoint has
earned Fortune magazine’s distinction as the best-managed
healthcare company the last three years. Furthermore, Schaeffer
was named one of Business Week magazine’s top 25 managers
across all industries last year.
The 56-year-old Schaeffer has accomplished all this while
continuing to thumb his nose at industry convention. This year,
he petitioned the U.S. Food & Drug Administration to make three
safe, non-sedating allergy medications available over the counter.
The move would benefit consumers, who would have OTC access
to safer, more effective drugs than currently available, at out-of-
pocket costs equal to or less than current prescription co-
payment. In addition, WellPoint would save about $90 million a
year, mitigating pressure on insurance premiums. It was the first
time an insurance company has asked the FDA to shift a drug to
OTC status.16
And remember the industry norm about the individual and
small-group businesses being undesirable? For several years,
WellPoint’s individual and small-group businesses have been its
most profitable – a compelling feat in an industry that still
gravitates toward large organizations. “Even in the 1990s, one
major insurer would tell you that only schlocky companies would
insure organizations of less than 350 employees,” he said. On
the contrary, catering to all three segments in good and bad
economic times has become critical to WellPoint’s success.
During economic downturns, the individual market grows as
people lose their jobs. In upswings, the small-business segment
(which in the past has produced the greatest number of new
jobs) and large-group segment boom.
“We like being diversified,” said Schaeffer, smiling broadly
like a doctor who has brought a patient back from the brink,
against all medical odds and medical conventions.
14
Innovating Around the What: Offering Customers What They Really Want
The leaders at business model innovation were extremely careful
about what they offered their customer segments, the second
element of the business model formula. They carefully tailored
the offering to their chosen segments. In some cases, they stripped
out features and functions from the industry-standard offering that
their chosen segments did not value and provided what they did
value at a lower cost. In other cases, they expanded the industry-
standard offering with attributes that customers embraced and
competitors overlooked. Other innovators drastically reduced the
price component of the what by making structural cost reductions
in the how.
The “what” includes not only the product and service offering
but also the channels through which customers become aware of
the company and its offering. Moreover, it includes customers’ total
experience in using the offering after the purchase. We refer to
this collectively as the “value experience.”
The business model innovators we studied took painstaking
care to match the design of the value experience to precisely fit
the needs of the customer group they were targeting. These
companies developed channels and levels of integration between
these channels that best corresponded to what their targeted
segment valued.
They also let their target customers’ needs dictate the
functionality and quality of the products and services offered –
often stripping down a more robust offering to only the features
and functions that the segment really needed and would pay for.
Consider the case of Southwest. To deliver low-cost fares to its
budget-conscious market, the airline skimped on meals, in-flight
entertainment, and other services it considered unnecessary for
cost-conscious travelers. In catering to the health insurance needs
of individuals and small businesses, WellPoint created health plans,
customer support, and marketing programs that were distinct from
those designed for large companies.
In tailoring the offering, business model innovators utilized multiple
levers, including:
Customizing the offering or allowing customers to configure
it themselves;
Letting customers access the offering through new channels;
and
Dramatically expanding the product/service selection.
In targeting the small-company market, Paychex slashed the costs
of providing payroll services by creating highly standardized payroll
services. In doing so, Paychex brought a valuable offering to small
businesses – the outsourcing of complex payroll processes – that
previously had only been affordable for large corporations. Given
the company’s rapid growth, there’s no question that small
businesses need to outsource payroll as much as large businesses
do. In fact, small businesses on average spend 50 hours a year on
payroll issues, in part to comply with dozens of changing payroll
tax regulations.17
Innovators also created integrated solutions that enhanced
customer loyalty. Schwab, for example, added mutual funds and
financial products from other institutions, while opening other
channels for customers to transact their business, including stores
and the Web. In each case, customer-targeting decisions guided
business choices on what services and experiences to offer. The
innovators didn’t fall into the trap of trying to become all things to
all people, knowing that would put them on an unprofitable path.
14
Key TakeawayKey Takeaway Successful innovators precisely tailor their
offering to their segment's unique needs.
Sometimes this means stripping out features from
the industry-standard offering; other times it
means adding features that competitors missed.
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Other advantages were achieved through offering one-stop
shopping. This was the case in Wal-Mart’s second business model
innovation: its push in the late 1980s to combine grocery items
and general merchandise through its mainline stores, Sam’s Clubs
and super-centers. At the time, most grocery and general
merchandise stores were separate entities. Wal-Mart leveraged
the brand equity it had built over the years for everyday low prices
in general merchandising to steal share of the grocery market.
Through the new business model and relentless store openings,
the company’s market value exploded by 2001 to more than
$200 billion.
Cisco Systems’ business model success in the
telecommunications equipment industry came from a different
type of one-stop value experience. The company’s business model
brilliance came from truly understanding and catering to the
increasingly complex needs of corporate telecommunications
managers in the 1990s. In the late 1980s, more and more corporate
data was shifting from high-cost, proprietary computer networks
to lower-cost, Internet-based networks. A host of new and existing
telecommunications equipment and software suppliers were
chasing this huge market. For a corporate telecommunications
manager, betting on any one of these vendors was a highly risky
proposition. From a customer’s perspective, there is great risk that
either the technology of such a company will become obsolete, a
nonstandard, or that the vendor will go belly-up and not be able
to support its installed base. Cisco shaped its business model to
mitigate that risk by creating a one-stop shop for Internet
networking hardware, software, and services. It created a multi-
product, multi-technology portfolio through an aggressive
merger-and-acquisition strategy and as it grew, customers’ risks
in choosing Cisco continued to decrease.
Two other popular themes in the what of business model
innovation were information-enabled self-service and its close
cousin, the no-frills offering. Amazon and Dell pioneered self-
service-based business models in the book and personal computer
industries. In both cases, self-service was in many ways better than
the full-service options of the incumbents. No bookstore clerk in
the world can match Amazon’s reader reviews with as many
insights into as many books. And although the World Wide Web
hadn’t taken off when Dell started to gain critical mass in the early
1980s, the company later used the Internet to take its self-service
model to the next level. Dell offers its largest customers
customized Web pages in part so they can get the technical details
of their purchases up to the minute (a major source of value for
their IT departments, which must enforce corporate policies and
standards). Dell’s Web pages give customers a much greater sense
of their options in tailoring a PC to their liking – far beyond what
an order taker could explain over the phone or in a store. At $32
billion in revenue, Dell has become the world’s largest and most
efficient maker of PCs.
“The key is to get to know those customers well
enough to identify product attributes that
others don’t identify, and then build those
attributes into products.”– Leonard Schaeffer, CEO of WellPoint
No-frills value experiences helped power Schwab’s first
business model incarnation, as well as Southwest’s. To undercut
stock trading fees of the incumbents, Schwab unbundled the
standard offering – trading plus investment advice. Southwest’s
offering was constructed to profitably undercut the prices of all
other carriers on its routes. This required stripping away on-board
services and the use of travel agents.
As these examples show, the changes the business model
innovators made in the what were not incremental improvements
to the norm. They were, in fact, structural changes. WellPoint
tailored products to meet the distinct needs of individuals and
small businesses, while cultivating the agents who could connect
with these customers. Southwest dramatically pared back the
services that flyers had been used to – food, movies, and so on –
to deliver low-cost air travel. Wal-Mart’s stores in essence were
giant warehouses with shopping carts – retail environments
designed to drastically reduce the cost of merchandising and
increase the flow-through of shoppers.
16
Innovating Around the How:Developing Unique Capabilitiesand Operational Structures
After having a specific customer focus and offering that meets the
precise needs of that target segment, the third factor in business
model success involves developing unique capabilities and
operational structures to make the offering possible. Such
capabilities come in three forms: resources (such as intellectual,
physical, structures, and brand assets), activities (such as product
development, distribution, and manufacturing processes), and
partners (such as valued suppliers).
Dominant themes we witnessed across successful innovators
include:
Developing unique capabilities and control over the value
chain;
Optimizing provider operations to targeted segments;
Driving down costs either through
– making explicit trade-offs in what is provided to the
customer, or
– creating significant structural cost advantages.
The capabilities that the innovators used to deliver their value
experience were in all cases unique. That is, they couldn’t be easily
copied by established or start-up competitors. Take the example
of Dell Computer. In Dell’s case, the who was knowledgeable
buyers of PCs (especially large organizations) who didn’t need the
help of a dealer or other channel intermediary to get what they
wanted. Dell’s target segments are big institutions (they have the
greatest sales volume potential and the largest, most sophisticated
IT departments) and PC-savvy individuals who need little support.
Michael Dell decided that providing customizable PCs through
self-service was the way to go (the what), and that the way to
deliver that experience was by going direct and building to order.
As long as the direct model appeared to be a fraction of the market
(which it was until the 1990s), the established PC manufacturers
were reluctant to go around their dealers and face expulsion from
the channel. But as long as they sold through the intermediary,
they couldn’t hope to match Dell’s structural cost advantages in
tailoring PCs to customers’ specifications and selling direct to
customers, thereby reducing channel cost and minimizing
inventory obsolescence (the biggest risk of making and
distributing products and components with half-lives that can be
measured in months). To make sure it was competitive with
computer stores’ quick delivery (at least, for off-the-shelf products),
Dell located supplier operations near its assembly plants and
integrated with those suppliers virtually through its own computer
network. The efficiency of Dell’s how is still unmatched in the
computer industry.
In unbundling its one-size-fits-all health insurance offering,
WellPoint, the California-based health insurer, organized its
resources around distinct customer segments: large employer
groups, small businesses, and individuals. It created self-sufficient
business units with separate information systems for each
segment, which enabled each unit to maintain its own
membership and claims records, and more directly respond to
each segment’s needs. Each unit was given true profit-and-loss
responsibility.
The capabilities that Southwest built to deliver to budget-
conscious travelers a value experience featuring low-cost, on-time
flights are truly unique in the airline industry. First, its resources
are far different. Southwest’s flight network is point-to-point (city-
to-city), whereas the national airlines use hub-and-spoke systems.
Key TakeawayKey Takeaway Successful innovators develop unique capabilities
and operational structures, often creating cost
advantages that competitors can’t match.
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Southwest also focuses on short-haul routes and uses one type
of jet, the Boeing 737. In contrast to the major carriers that use an
assortment of jets, Southwest standardized on one model to
reduce maintenance costs, standardize processes, improve fleet
flexibility, and better ensure on-time arrivals and departures.
There’s no way that the national carriers operating different aircraft
and hub-and-spoke routes can compete with Southwest on price
and enjoy Southwest’s margins.
Second, its activities ran counter to the pack by shunning
premium services such as elaborate meals. Third, its partner
relationships with employees, airports, and others were atypical:
employee stock ownership; close relationships with under-utilized,
secondary airports; and a strong social contract with employees
built upon a history of no layoffs. That’s a far cry from the industry
norm, where downturns result in thousands of layoffs. “Nothing
kills your company’s culture like layoffs,” Southwest CEO Herb
Kelleher told Fortune magazine recently. “Nobody has ever been
furloughed here, and that is unprecedented in the airline industry.
It’s been a huge strength of ours. It’s certainly helped us negotiate
our union contracts.”18 For example, the company’s 10-year
contract with its pilots (three to four years is typical in the industry)
has helped it control costs.
Innovating around the how, as these cases illustrate,
frequently involves configuring activities, resources, and
partnerships in one or more ways that reduce costs. In some
instances, innovators reduced costs by eliminating elements of
the standard offering (e.g., Schwab removing investment advice
from stock trading), by reducing or aggregating steps in the value
chain (e.g., Dell), leveraging economies of scale (e.g., Wal-Mart),
by engineering operations to be low-cost (e.g., Southwest),
and/or by gaining control over critical assets or resources.
Importantly, in every case the choices regarding the how were
tightly linked to choices regarding the what, which in turned
depended upon who was being targeted. That is, the business
model innovators thought through all three aspects of their
business models in achieving significant advantages. The changes
were inextricably linked.
Creating a Sustainable Business Model
While a new business model may be innovative and create
significant customer value, it is not automatic that it will also
generate superior shareholder value. The hundreds of dot-coms
that have crumbled over the last year attest to that. Internet
shopping malls like buy.com and Value America came to realize
that their business models were barely profitable largely because
they were easy to imitate. Endless new entrants sparked cutthroat
competition, which quickly eroded any profit margins originally
captured.
The business model innovators we studied were successful
because they could defend their business models from the
inevitable attackers. The ability to sustain one’s business model
innovation depends on two factors: the extent to which the
innovator creates real advantages, and the existence of real or
psychological disadvantages among the innovator’s competition.
Innovator Advantages
In nearly every case, the innovators created significant advantages
and created enormous brand equity. AOL has become a
household word, while few teenagers would likely recognize the
name of CompuServe, an online service that has been around far
longer than AOL. Has any airline executive generated more
headlines than Herb Kelleher of Southwest? And do any
consumers or airline industry experts – even after the failure of
People Express – now doubt the viability of a discount carrier?
The logos and associated values of these modern corporate icons
are imprinted in the brains of their customers.
Another innovator advantage is an economic one – a superior
ability to deliver a product or service based on scale economies,
learning curve advantages, and locking in critical assets and
resources. The successful innovators created complex, hard-to-
copy business models. They tailored their operations to finely-
targeted customer segments, leveraged technology in often
ingenious ways, and created distinctive corporate cultures that
kept the machine the founders built constantly in tune.
181818
Paychex: Bringing Big-Company PayrollServices to Mom-and-Pop Operators
Opportunities for business model innovation are right in front
of every organization. But to pursue them, executives have to
rethink their core beliefs about the who, what, and how of their
business.
When managers do this, they can discover customer needs
that they’ve overlooked or misunderstood for some time. The
small-businesses payroll outsourcing model on which Paychex
is thriving today is a case in point. With superior performance
over its industry peers on total shareholder returns, market
value, real asset growth, and other measures, the company is
on strong footing today.
How did Paychex create its business model in 1970? Two
key factors allowed Paychex to come into being. First was the
development of technology for cost-effectively complying with
state and federal tax requirements. The second was the
opportunity to satisfy a large number of small businesses whose
needs were not being addressed by the leading incumbent,
Automated Data Processing Inc. (ADP). Had Paychex believed
that ADP controlled a mature market for payroll services, where
all the market opportunities were already uncovered and
adequately addressed, it never would have gotten off the
ground.
The Rochester, N.Y., company was founded by Tom
Golisano in late 1970 to serve a small-business segment
largely ignored by payroll giants such as ADP. Golisano, in
fact, had failed to convince his boss at a regional payroll
processor of the viability of the small-business niche before
launching Paychex.19
Paychex defined the who by looking closely at the payroll
needs of small businesses. Realizing that small-business
needs for efficient, affordable payroll processing were unmet,
it understood their needs better and redefined them. In the
process, Paychex successfully altered customer perspectives
on what their choices were. Paychex defined the what by
broadening customers’ choices and simplifying the offerings.
For instance, it provided a choice of customized solutions that
are typically available only for large companies.
Consistent with its definitions of who and what, Paychex
configured its how by engineering operations to serve its
targeted customer group and using information technology
to tightly integrate with customers’ systems. The sustainability
of Paychex’s business model innovation is undoubtedly
rooted in the advantageous customer access and customer
loyalty it has achieved as part of its first-mover advantages.
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Incumbent Disadvantages
Such advantages weren’t the only way for a business model
innovator to carve a chunk out of an existing market or to create
a new market. The incumbents in these industries frequently had
many disadvantages that gave the business model innovators
considerable time and leeway to pioneer a new approach. We
came across three real disadvantages most often: the potential
of a business model innovation to disrupt existing channels of
distribution, the fear of eroding the existing brand, and the
difficulty in managing multiple operational models.
Fear of channel disruption stops many incumbents from
creating new business models. Compaq, IBM, Hewlett-Packard,
Packard Bell, and the other PC makers who sold through channel
in the 1980s and 1990s were reluctant for many years to risk their
channel relationships by going direct. By the time they did, Dell
was already in motion, with the company building and perfecting
supply chain and assembly operations that are still unmatched
in the industry. Merrill Lynch and other full-service brokerages
let Schwab control the discount market for years, not wanting to
damage the relationships and goodwill they had built up with
their brokers.
An important part of Schwab’s success can be attributed to
its ability to capitalize on competitors’ fears, namely that copying
Schwab would erode their brand equity as premium brokerage
houses. They did not try to match Schwab’s discount model.
Similarly, in Southwest’s early years, few of the national airlines
wanted to pollute their premium brands by offering a discount
model to compete with Southwest’s regional play. Competitors
used to joke that Southwest and the long-defunct, no-frills airline
People Express stuffed passengers in like cattle.
In addition to these real constraints, psychological hurdles
handicapped incumbents as well. By far the biggest was the
inability of incumbents to think beyond the current business
norms of the industry. This myopia prevented incumbents in most
of the industries studied from seeing the unserved customer needs
in the market that could provide major opportunities for growth.
The competitors of over 80 percent of the business model
innovators studied shared this blindness. This myopia allowed
business model innovators to capture significant first-mover leads
before incumbents could figure out what hit them. These
disadvantages are formidable.
These examples suggest that before launching a new business
model, executives must rigorously identify the advantages their
organization can create – and the disadvantages of the existing
competition. In their excitement over a new business opportunity
and all the hard work in executing it, managers often forget the
importance of due diligence to understand the sustainability of
the innovation. The fall to earth of many once-meteoric companies
attests to this.
Key TakeawayKey TakeawaySuccessful innovators exploit key assets such as
brands, innovative cultures, scale economies, and
deep knowledge. They also prey on incumbents'
real and perceived constraints.
20
Putting Business ModelInnovation to Work
Given today’s economic uncertainty, executives understandably
may view business model innovation as a risky proposition.
However, our research shows how playing it safe can actually cause
companies to incur larger risks – the risk of watching someone
else redefine the who, what, and how of the industry. While it’s
hard to imagine today, most of the established players in the
industries that Wal-Mart, AOL, Schwab, Columbia, Dell, and
other innovators first entered grossly underestimated the
importance of the new business models. Business model
innovation can come from any place, any time. Schwab launched
discount brokerage services for the mass market amid a protracted
bear market. Similarly, Corning began its alliance-based path of
developing new product markets during a market recession.
The innovators don’t rest peacefully at night. They realize that
even the most lucrative breakthrough business models can run
their course or at least need continual tune-ups. Four of the
companies we studied – AOL, Schwab, Wal-Mart, and Enron – have
launched fundamental business model innovations more than
once in their lifetimes. Enron has actually introduced three business
model transformations, expanding its business model from energy
trading to include energy outsourcing and bandwidth trading.
While the other innovators in the study did not repeatedly
launch discrete new business models, they were by no means
standing still after launching their initial innovation. These
companies instituted ongoing incremental improvements to stay
ahead of the pack. For example, Dell was one of the first PC
companies to jump on the Internet. As of summer 2001, Dell sells
half of its products online and has become the largest PC maker in
the world, direct or indirect.20
In learning from these companies, it is clear to us that business
model innovation should be approached methodically and on a
consistent basis. A three-step approach can bring order to what
can easily become a chaotic process.
Scan andScope
Rethink andRedesign
Plan andImplement
Set BMI objectives
BMIFocus Areas
RankedBMI Opportunities
Value-CreatingBMI
SOURCE: DELOITTE CONSULTING
Define pathway
Understandindustry norms
Assess external factors
Assess internalcapabilities and constraints
Rethink the who,what and how
Assess ft-gap ofeach option
Assess sustainabilityof each option
Refine andcompare options
Build workplanand milestones
Prototype and evolve
Rapidly implement
PUTTING BUSINESS MODEL INNOVATION TO WORK
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The first step in this process involves scanning for
opportunities and determining when new business models should
be explored. What is the current context of the industry? What
key technology, regulatory, and socioeconomic trends could spell
major opportunities? Industry norms must be articulated around
target customers (who), offerings (what), and operating models
(how). What customer segments are considered undesirable? For
desirable customers, what is the prevailing belief about their core
needs?
Additionally, managers must understand the capabilities of
their organization that can be leveraged in a new business model.
Brands (which Harley-Davidson exploited in creating a lifestyle
business model), business processes (Wal-Mart took advantage of
its inventory management and distribution systems in its second
business model innovation), existing customer bases, and other
assets can provide important capabilities for new business models.
Which should managers reexamine first – the who, what, or
how of their industry? We believe that a company ’s core
capabilities (i.e., the how) needs to be determined by choices
around the who and the what – and not vice versa. Starting by
assessing one’s core capabilities – for example, first-class R&D or
distribution management – may lead managers to discover new
customers and products that can be easily served by existing
capabilities. However, we believe the best place to start is to
identify the target who – the significant, underserved customer
needs. Around that who, a unique offering and profitable
operating model must be built that other would-be competitors
cannot easily match or outdo.
The second step involves getting senior executives to
proactively challenge the norms around the who, what, and how
of their industry to identify new business opportunities. Why were
the segments identified in the first phase considered undesirable?
Could these segments become attractive by altering the value
experience? Could these needs be served better by creating a
new customer segment, redefining an existing segment, or
changing the buyer?
In looking at all the steps that customers take in purchasing
and using the offering – from search to replacement – what
attributes (e.g., variety, speed, ease of use) are most important to
each segment? For segments that appear to offer the greatest
customer and shareholder value, how can the value experience
be delivered most efficiently? What kinds of competitive
advantage could be created (scale, learning curve, etc.)? What
disadvantages are existing competitors likely to have in pursuing
the opportunity?
Managers then must assess how well the opportunities fit with
existing resources and how well the organization can sustain the
new business models in the face of competition. At the end of
this step, managers will have a range of business model
opportunities ranked by such criteria as size of potential
opportunity, degree of fit with corporate capabilities, and level of
sustainability.
22
The third step is to refine the design of the new business
models, plan their rollout, and then pilot them. A road map must
be developed for each opportunity, with major tasks, milestones,
and key success factors. It is at this stage that risk must be
evaluated. The key risks of business model innovation include
technology immaturity, customer reluctance to adopt a new
offering, organizational resistance, and the possible disruption of
existing business operations. Managers must develop strategies
to mitigate their primary risks. Critical go and no-go hurdles should
be created in advance. Managers must develop explicit
implementation plans, financial forecasts, and risk and
sustainability assessments.
There is not one ideal business model. Developing value
business models requires a measured approach and a significant
amount of “analytical heavy lifting” focused on rethinking industry
norms, identifying underserved customer segments, and deciding
where and how to apply the lessons learned from successful
innovators.
The dot-com collapse and economic uncertainties have
caused established companies to pause before they invest in the
next breakthrough business concept. Billions of dollars in
corporate R&D and venture funds have been lost because of
insufficient due diligence on promising-sounding new business
models. But the rising sea of red ink should not blind executives
to the substantial value created through business model
innovation over the last 40 years. If anything, the success of
outsiders like Wal-Mart, Schwab, AOL, and Starbucks demonstrates
how costly it can be to let others rethink the prevailing who, what,
and how of an industry.
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1 London Business School Professor Constantinos Markides in his1999 book “All the Right Moves” created the framework of the Who,What, and How to examine business models.
2 W. C. Symonds, “The Power of the Paycheck,” Business Week, May 24,1999, p. 71.
3 Golisano talked about the early days at Paychex Inc. in a Q&A withInc. magazine, “How to Build an Inc. 500 Company,” December 1, 1988.
4 Market value as of July 31, 2001.
5 Financial performance of the industry leaders was tracked througha HOLT value analysis conducted at the end of December 2000. Holtuses six metrics in its analysis: “premium current,” “percent future,”“cash flow return on investment,” “total shareholder returns,” “five-year real annual asset growth,” and “current market value.” For moreinformation about these measures, see sidebar “About the Study.”
6 M. Dell with C. Fredman, “Direct from Dell: Strategies ThatRevolutionized an Industry,” p. 12 (HarperBusiness, 1999).
7 H. Kelleher with K. Brooker, “The Chairman of the Board Looks Back,”Fortune, May 28, 2001, p. 63. Market value as of July 31, 2001.
8 Market value as of July 31, 2001.
9 Paychex press release of July 11, 2001, “ABA selects Paychex asprovider of new member benefit for payroll processing,”www.paychex.com/paychex/press/071101.html
10 W.C. Symonds, “The Power of the Paycheck.” Business Week, May 24,1999, p. 71.
11 K. Swisher, “aol.com”, (Times Business, 1999), pp. 86-87.
12 J. Peltz, “Behind Aetna Bid …,” Los Angeles Times, March 3, 2000,p. C-1.
13 R. Rundle, “Calling the Shots: California Health Plan Thrives, ButDoctors Claim Care Suffers,” The Wall Street Journal, May 31, 2000,Page A1.
14 So predicts John Szabo, an analyst at CIBC World Markets, accordingto a May 14, 2001 Business Week article by A. Weintraub, “Leonardthe Giant Killer?” p. 78.
15 Market value as of July 31, 2001.
16 A. Weintraub, “Leonard the Giant Killer?”, Business Week, May 14, 2001,p. 78.
17 According to a survey by International Communications Research,as cited in an Entrepreneur magazine article by M. Hogan,“Automation for the People,” January 1, 2000.
18 H. Kelleher as told to K. Brooker, “The Chairman of the Board LooksBack,” Fortune, May 28, 2001, pp. 63-76.
19 W.C. Symonds, “The Power of the Paycheck,” Business Week, May 24,1999, p. 71.
20 S. Perman, “Automate or Die,” eCompany Now, July 2001, pp. 60-67.
24
For Further Information, Please Contact
AMERICASANDREW GARBER
Tel: 404.631.3570
Email: [email protected]
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DELOITTE CONSULTING
BMI THOUGHT LEADERSHIP TEAM
©2001 Deloitte Consulting and Deloitte & Touche LLP. All rights reserved.ISBN 1-892383-90-X
DAVID ROSENBLUM
Tel: 213.688.5169
Email: [email protected]
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Tel: 213.688.4712
Email: [email protected]
DOUG TOMLINSON
Tel: 415.783.4161
Email: [email protected]
MUMTAZ AHMED
Tel: 415.783.5597
Email: [email protected]
Special thanks to those who contributed to this research: Professor B. Mahadevan (Indian Institute of Management), Rik Geiersbach,
Mathias Herzog, Donald Hicks, Mark Holmstrom, Alison Keiller, Mark Mullikin, Michele Parmelee, Stephanie Siegel, Steve Watkins, and
Sarah Wiley.
Recent Deloitte Research Thought Leadership:■ Collaborative Knowledge Networks: Driving Workforce Performance Through Web-Enabled Communities
■ Digital Loyalty Networks: eDifferentiated Customer and Supply Chain Management
■ Mobilizing the Enterprise: Unlocking the Real Value of Wireless
■ Strategic Flexibility in the Communications Industry: Making Billion-Dollar Bets in a World of Uncertainty
■ Strategic Flexibility in the Energy Industry: Competing in a Decade of Uncertainty: 2000-2010
Please visit www.dc.com for the latest Deloitte Research thought leadership or contact us at Tel: +1.212.492.3791
or e-mail: [email protected].
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