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Beacons for Business Model Innovation

How applying two pattern recognition tools can empower companies to pick and develop breakthrough winners in their innovation portfolio.
by Geoff Tuff and Stephen Wunker

Business Model Innovation is a hot topic in management thinking these days, even though there seems to be little agreement about what it looks like and even less about how to discover it. But there is no reason for Business Model Innovation to feel mysterious or hard to achieve. By using analytic tools that provide better decision-making insights, executives can vastly improve their innovation success rateand ensure their business model investments generate bigger returns.

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Tupelo, Mississippi has seen its share of people upending tradition. Not only is this small Southern town the birthplace of music revolutionary Elvis Presley, it is also ground zero for a new movement that seeks to transform a totally different fieldhow we care for our elders. Rejecting traditional models of senior livingones that feature a large medical staff tending to hundreds of patients in an institutionalized settinga Tupelo doctor created the first Green House senior home. These facilities contain no more than a dozen residents. The residents interact with each other in a large common area, play a role in decision-making, and are cared for by a single multi-tasking nurses aide. As the name suggests, the place feels like a house, not a hospital or a nursing home. Residents found the Green House experience so compelling that the concept has now been replicated more than 50 times. The radical approach to care is mirrored by an equally unique economic model that slashes staffing and overhead costs. Due to the small scale of the facility and the fact that there is just one multitasking worker, total staff time is 30 minutes less per resident-day, even while nursing care time (what matters most to the residents) is 1.5 hours more. Green Houses are a new business model founded on a total rethinking of the customer experience of elder residents. By contrast, Business Model Innovation in the newspaper industry seems to have lost touch with the customer and has instead become a euphemism for cost cutting. Even leading

institutions such as the Tribune Company, owner of The Chicago Tribune and other newspapers, seem to have been doing little new except for cutting journalists and putting articles online. Taking an inward-looking view, many in this industry seem to think that the simultaneous implosion of advertising and circulation can be addressed by thinner papers carrying more wire service stories, rather than through innovations in areas such as syndicating content and creating focused reader communities. A customer-focused view might have looked at the many touchpoints newspapers can have in peoples lives and communities. There is little reason, for example, that newspapers could not have dominated the online classified industry rather than ceding it to upstarts such as Monster.com and eBay. It is not a shock that newspapers have largely failed to create new business models. The promise of Business Model Innovationto create new product and service categories that make money in new ways and achieve accelerated growthgenerates enthusiasm but comes with a big catch: it requires true integrative change across many functions of a company, from finance and operations to manufacturing, marketing and sales. It requires new skills, new behaviors and the courage from leaders to think, act and lead differently. Executives can increase their odds of success by using a rigorous set of decision-making and pattern recognition tools. In this article, we will briefly touch on two critical

BEACONS FOR BUSINESS MODEL INNOVATION

diagnostic tools, the Ten Types of Innovation and Economic Value Estimation. By taking advantage of the insights these tools offer, corporate leaders can analyze which Business Model Innovation projects offer the most value for customers, allowing them to pick the winners and shut down the losers.

and Product System innovation (see Exhibit 1 below). This should not be surprising: new product ideas are easy to dream up and just as easy to kill in the average companys stage-gate process. If they are lucky enough to make it through to market launch, many product-focused innovators find themselves vulnerable to competitors. This challenge is becoming only more daunting as competition heats up in all corners of the world, especially in emerging markets where patent law may be less effective and mastery of complex distribution systems can matter more than having the best product on the shelf. By contrast, the most successful innovations we studied share two important traits. First, they focus on shifts in the revenue model and the customer experience. And second, they employ multiple types of innovationfrequently six or moremaking them genuinely new and different business

The Ten Types of Innovation : Meshing Inventive Revenue Models with New Customer Experiences

In examining more than 5,000 innovations successful and not over the past 15 years, we have been able to classify innovation activities into Ten Types of Innovation. Sadly, most of these innovations have not been successful (defined as returning their cost of capital), achieving in aggregate an abysmal success rate of 4.5 percent. Why? The vast majority of them and especially the failed attempts have been centered on Product

Exhibit 1: The Ten Types of Innovation The most successful business model innovations combine new ways of making money with new, great customer experiences.
Biggest opportunities are anchored here Most companies focus here Finance
Business model Networking

Process
Enabling process Core process

Offering
Product performance Product system Service

Delivery
Channel Brand Customer experience

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models. These are breakthrough innovations that deliver unique value to customers and are integrative in nature (across company functions) and thus hard to replicate. In our research, only 2 percent of the initiatives demonstrated these attributes and yet they delivered 90 percent of the cumulative value of all the innovations studied.

In the course of this research we also discovered that it is very hard to innovate around revenue models and customer experience and not pull along other types of innovative change. For real Business Model Innovation, a company must assemble six or more types of innovation, with at least one innovation type coming from each of the four major categories (Finance, Process, Offering and

INSIDE THE BUSINESS MODEL INNOVATIONS AT THREE LEADERS

Dell revolutionizes the personal computer market. Dell was founded in 1984 on the premise that individualized computers could be sold directly to customers in order to better understand and meet consumer needs while responding more quickly to changes in the marketplace. This approach, combined with the introduction of relatively novel supply chain processes such as configure-to-order and just-in-time manufacturing, allowed the company to have substantially lower costs than its competitors. Dell rose from dormitory room start-up to global leadership in personal computer sales within just 15 years. Nestl Nespresso leverages brand awareness to open a boutique retail business. The Nespresso offering started with an innovative high-end productspecially designed machines and individual coffee capsules that enabled consumers to quickly produce a quality and individualized cup of espresso. It has since grown into an integrated customer experience. In addition to its 24-hour information and ordering service, Nespresso has opened a line of boutique retail outlets designed to provide Nespresso Club Members with an opportunity to learn about premium coffee, preparation techniques, and new Nespresso products. In addition to affording the company significant direct access to customers, the global network of 190 boutiques accounts for 30 percent of Nespresso sales. Plans are in place to open 30 new locations during 2010. HSBC First Direct creates a branchless bank. First Direct was founded in 1989 based on the insight that a significant number of bank clients did not use branch services and those that did reported relatively low customer satisfaction. In order to serve this market segment, First Direct offered a new approach to banking in the U.K.: customers could access all banking services over the telephone 24 hours a day, 7 days a week, 365 days a year. This was in stark contrast to traditional banks, which were generally open from 9 a.m. to 4 p.m. and closed for most of the weekend. First Direct has continued to lead in innovative services, such as being one of the first banks with online and mobile banking. As a result, it has attracted more than one million customers since inception.

BEACONS FOR BUSINESS MODEL INNOVATION

Delivery). Changing these fundamentals requires significant shifts across the business value chain. For example, it is a steep challenge to build a great, new customer experience without also innovating your offering, processes, partnerships and payment terms. These findings lead to a relatively basic condition for innovation success: if you want to be in the small minority of companies that have really created value from innovation, develop concepts that are anchored at the ends of the Ten Types spectrum and that contain possibilities for at least four other innovation Types as well. Sometimes, this will involve creating a thrilling experience for your customers and figuring out how to make money from it in novel ways think Apples iTunes or Nestls Nespresso. Other times, it will involve delivering at least an acceptable product-service package much more cost effectively than is possible using the accepted business models think Dell or Southwest Airlines.

accurate description of what they want. They may not have the language for it, they may be (unconsciously) motivated to obscure the truth, they may be basing their consideration on past experience, and they certainly cannot predict how their needs will evolve in the future. Increasingly, companies are tapping into the field of design-driven innovation for inspiration about how to explore their customers needs and desires. Especially when it comes to discovering what might lead to a thrilling customer experience, it is vital to use non-traditional research techniques. Video ethnography, field observation and in-depth interviews are the tools of cultural anthropologists who are behind some of todays most exciting customer discoveries. These tools provide insight into not just what customers say they want, but also their latent, emerging and wholly unmet needs. In order to tie insight to profitable opportunities, we like to borrow the Economic Value Estimation (EVE) tool pioneered by pricing strategist Tom Nagle. EVE is a simple framework which breaks down the economic value of an offer into its component parts and compares this value to a next-best competitive alternative (see Exhibit 2). By combining EVE with non-traditional research techniques (focused on generating new customer experiences), companies can begin to hypothesize what cost and value would be associated with any new offering. Establishing the EVE of a potential innovation can help set a threshold for when a project is worth pursuing.

Estimating the Economic Value of Innovative Business Models

Effective Business Model Innovation is the ability to discover new ways of making money. It is often developed by tying scalable revenue or margin opportunities to untapped sources of customer value or by creating value more cost-effectively than the competition. For decades, precepts of good marketing have taught us that offers should satisfy customer needs. The difficulty, of course, is that customers often cannot provide a full and

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Me-too or low-payback initiatives should be scrutinized early in the development process and either killed or reshaped. High-payback innovations will either leverage a higher absolute level of value than alternatives or a lower (though still acceptable) level of value using a much lower cost structure. Find the innovations within your portfolio which have the highest ratio of Total Economic Value to Reference Value (of course, for a breakthrough innovation creating a new market, a Reference Value will not exist and that in turn will magnify the innovations Economic Value). And out of those, the ones that combine multiple types of innovation at least six are your likely winners.

It is enlightening to examine a recent innovation in light of Economic Value Estimation. The leading African telecom company Celtel (now owned by Indias Bharti) launched a mobile commerce service targeting businessto-business payments, given that so many of these transactions occur in cash in the worlds least developed markets. Potential corporate customers were initially skeptical of paying Celtel transaction fees until the companys staff rode along with trucking fleets and discovered just how valuable mobile commerce could be. For example, during a typical eight-hour delivery run, three hours could be spent counting cash in very small bills, and cash could be counted eight times between the time it was paid and ultimately banked. There were huge inefficiencies to address. Even more compellingly, Celtel saw that distributors were losing substantial sales by taking their orders during the prior days delivery, and that mobile technology could empower them to accept orders in real time from handsets so they could adjust for demand swings as they happened. The company calculated that its services were worth 1 to 4 percent of the total

Exhibit 2: How EVE Pinpoints High-Value Innovations

Negative Differentiation Value Positive Differentiation Value

Differentiation Value: The value to the customer (both positive and negative) of any differences between your offering and the reference product

Total Economic Value Reference Value Reference Value: The price (adjusted for differences in units) of the customers best alternative

transaction value, depending upon its clients circumstances. Ethnography gave Celtel the power to price mobile commerce according to the value it created and provided insights into

Source: Thomas T. Nagle, John E. Hogan and Joseph Zale, The Strategy and Tactics of Pricing, Fifth Edition (Saddle River, N.J.: Prentice Hall), 20.

totally new directions for the service.

BEACONS FOR BUSINESS MODEL INNOVATION

Where to Start
Any company that wants to take action on Ten Types and EVE diagnostic work will need to start with two fundamental requirements for success: 1. Understand the basic operating parameters of your company to be able to determine what is economically and organizationally viable and what is not 2. Know the collection of revenue models that the business world has used over time and understand how these analogs mightand might notbe applied to your company Operating parameters. The first requirement for success is that you understand the basic operating parameters of your company to determine what is viable. To think about the hidden shackles that prevent business model change, untangle the web of business processes, supply chain partnerships and other relationships that enable a firm to succeed. These include the suppliers, sales channels, and even the types of customers to target. Which of these operating parameters would be threatened by a new business model? How could a new model start off the radar so key stakeholders were not threatened? Think through all of the companys competencies, rules and behaviors that facilitate the current model, and how these might need to change. For instance, will sales compensation

need to emphasize more teamwork than at present? Will the emphasis be on a different sort of buyerone with an office and not a cubicle? Proactively addressing these hurdles in focused pilots can reduce an organizations reluctance towards change while at the same time revealing unseen dependencies. Prototyping via pilots enables you to test the flexibility of your companya key need for Business Model Innovation. Because these approaches are not simply window dressing and checklists for one-off projects, they must become corporate capabilities that enable a company to sustain its position over time. Senior executives need to lead by example and embed flexibility into their company. Sometimes, the solution is not to invent a completely new way of doing business, but instead to do old things in new ways and discover fundamentally cheaper methods to deliver existing sources of value to your customers. Revenue models. The second requirement for success is to understand the types of revenue models that exist across the business landscape today. Through our retrospective look at past successful innovations, we have catalogued 20 different revenue models that are typically used by corporations today. These are shown in Exhibit 3 on pages 8 and 9. Knowing these models is necessary but not sufficient; to really unlock the potential behind alternate revenue models, first understand company and industry orthodoxies i.e., just the way things are done around

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Exhibit 3: 20 Sample Revenue Models from Successful Innovators TACTIC
Subscription Float Freemium Flexible Pricing

DEFINITION
Create predictable cash flows by charging customers up front (a one time or recurring fee) to have access to the product/service over time. Receive payment prior to building the offering use the cash to earn interest prior to making margins. Offer basic services for free, while charging a premium for advanced or special features. Vary prices for offering based on expected demand.

EXAMPLE
NETFLIX turned the video rental industry on its head with the implementation of a subscription model (no more late fees!). DELL chose to carry no inventory and only built each computer after it was ordered and paid for: earning interest instead of carrying inventory risk. SKYPE developed free Skype-to-Skype calls, but charged a premium for outgoing and incoming calls to landlines and mobiles. AMERICAN AIRLINES implemented Super Saver fares in 1977 that enabled variable pricing depending on demand patterns in an effort to fill seats during lesstraveled times. HEWLETT PACKARD subsidized the initial cost of printers and made its profits on high margin replacement ink cartridges and paper. SECOND LIFE, an online virtual world, auctioned off parcels of virtual land for player development; the winning bidder could pay with either US dollars or Lindens (the in-world currency). RADIOHEAD went direct to fans when it offered its album In Rainbows online and allowed fans to set the price they wanted to pay for the entire album. GOOGLEs AdSense charged sponsors to place links on users (free) search results pages; the revenue supported the majority of Googles operations. GROUPON, a bulk-buying website, chose to offer everything from yoga classes to teeth whitening to restaurant discounts but only one deal is available per day, starting promptly at midnight and ending at 11:59 p.m. or when it sells out ... whichever comes first. MORGAN STANLEYs costs for managing large sums of money were roughly the same as for small sums, but fees and thus profit escalated with larger transactions. BIC created the first low-cost ballpoint pens and obliterated the fountain pen market with its low margin product sold in immense quantities. AMWAY sold its beauty, wellness, and home products directly to its network of independent business owners who took on the responsibility of selling the products through personal referrals. APPLE typically priced its products well above the competitionnonetheless, customers purchased Apple products for their design, ease of use, and cachet. MONSANTO applied a yearly software licensing model to a batch of its seeds to ensure yearly revenues from growers.

Installed Base Auction

Offer a core product for slim margins or loss to drive demand, realize profit on follow-up products and services. Allow a market to set the price for goods and services.

User-Defined Ad-Supported Forced Scarcity

Invite customers to set a price they wish to pay.

Provides content / services for free to one party while selling listeners, viewers or eyeballs to another party. Limit the number of offerings available, by quantity or time frame, to drive up demand and price point.

Volume

Earn outsized margins on large-size products or transactions by keeping cost per unit fixed, regardless of unit size.

Cost Leadership Keep variable costs low and sell high volumes at low
prices.

Multi-Level Marketing Premium Licensing

Sell bulk or packaged goods to a sales force that turns around and sells it.

Price at a higher margin than competitors, usually for a superior product, offering, experience, service or brand. Grant permission to some other group or individual to use your offering in a defined way for a specified payment.

BEACONS FOR BUSINESS MODEL INNOVATION

TACTIC
Microtransactions Financing Switchboard Membership Predictive Analytics Metered Use

DEFINITION
Sell many items that cost close to a dollar or as low as one cent to create acceptable impulse purchases.

EXAMPLE
KARTRIDER, on online multiplayer racing game, offered players virtual items in-game, including different types of vehicles and spray paint that added new functionality for nominal fees. GMAC provided profitable automotive leasing and financing options to give customers the ability to lease or own a General Motors vehicle. eBay collected fees for posting items and took a percentage of every item sold; in return it offered sellers centralized access to millions of buyers and collectors. SAMS CLUB collected an annual membership fee to provide members access to wholesale prices and bulk deals that could not be matched in traditional retail. GE AVIATION analyzed real-world airline engine maintenance data and precisely priced its leasing and service offering to be more cost-effective for airlines than owning their engines. BETTER PLACE, an electric car charging system, developed a model that sells mobility miles to drivers on a pay-as-you-go basis.

Capture revenue not directly from the sale of a product, but from structured payment plans and aftersale interest. Connect multiple sellers with multiple buyers; the more buyers and sellers who join, the more valuable the switchboard. Charge a time-based payment to permit access to locations, offerings, or services that non-members dont have. Model past performance data to predict future outcomes and price offerings accordingly.

Allow customers to pay for only what they use.

All company examples are used for illustrative purposes only.

here and then consider how analogous models from other industries might be put to use. As an example of industry orthodoxy, consider the Installed Base model represented by Hewlett-Packards approach to the printing business. HP built a formidable market position through selling printers at a small loss and attempting to lock users into buying its highly lucrative ink cartridges. Kodak, a latecomer to this industry, has had to play the game differently to gain traction. Rather than copy the HP model, Kodak reversed it. It sells printers at a healthy margin and provides the ink at relatively low prices. The model caters to customers who print extensively and understand that ink cartridge purchases can add up to cost serious money. As a result of this novel approach, inkjet printers have become one of Kodaks principal growth drivers.

Finding and using analogies across industriesto apply the business model of one industry to anothercan reveal exciting new opportunities. Analogies are a fantastic way to think beyond orthodoxies in one industry by imagining how borrowing from other industries can turn a companys model on its head. Consider the GE Aviation jet engine business model, in which the company has analyzed real-world airline engine maintenance data and priced its leasing and service offering to be more cost effective than customers owning their engines. This is a model increasingly followed by competitors and quite a different approach from the traditional one of productfollowed-by-parts-and-service. This predictive analytics modelwell known among retailers who mine consumer data to anticipate future spending behaviorscould very well have applicability in many other industries.

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Taking Action
THE CHALLENGE OF CONTINUOUS REINVENTION
Even successful business model innovators have trouble sustaining their innovations over time. Examining the shareholder return for three hugely successful Business Model innovators (Dell, Home Depot and Southwest) highlights how even companies with Innovation DNA can get complacent, wedded to tradition, and stymied when trying to create a second breakthrough.
Indexed Cumulative Total Shareholder Return
200 150 100 50 0 200

The best way to start tapping into the enormous value offered by Business Model Innovation is to take a look at what you have in your portfolio already. Using the Ten Types of Innovation and EVE models as pattern recognition tools, carve out the few initiatives which appear to have the characteristics of future winners. If there is nothing there, then focus your team on creating unique, unimagined customer experiences with revenue models that break your industrys conventional wisdom. Lest you get dragged down the route of incrementalism, start by looking for inspiration outsideseek insights, perspectives on your industry orthodoxies, and understanding of where the real value lies for your customer base, as well as for those who are not your customers yet. It is most important to focus on the demand

Dell

Cumulative Indexed TSR

150 100 50 0 200 150 100 50 0

Home Depot

side of this work and then wend backwards through the capability, asset, and cost implications. As with most breakthrough innovation, think about back-of-the-envelope cost calculations, not detailed economic

Soutwest Airlines

models, and always look for opportunities to take out pieces of the cost structure as you explore new user and revenue possibilities.

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

Many companies have a well-defined process for creating new products, but very few have articulated a means for shaping new business models. Without a deliberate approach to the task, companies run several risks: the subtle re-direction of new business model efforts to look more like the core business, resistance by business functions impacted by

Years Since IPO

Note: TSR = (closing price opening price + dividends) / opening price; prices are adjusted for stock splits and special events Source: Yahoo Finance

10

BEACONS FOR BUSINESS MODEL INNOVATION

THREE BUSINESS MODELS TO WATCH

Skype for Business Leveraging the Freemium business model, Skype provides users with free voice and video calls made within its network. For businesses whose employees frequently Skype, the company has begun to sell premium services that integrate Skype into the central PBX phone system, allow easy distribution of credit to individual accounts for calls made to non-Skype phones, and facilitate both instant messaging and file sharing. Virgin HealthMiles Challenging the Pay for Performance business model orthodoxy, Richard Bransons Virgin Group has created a model it calls Pay for Prevention. Virgin HealthMiles backs corporate wellness programs through engaging employees in measurable activities such as pedometer wearing and biometric monitoring. The firms pay some participants reward points based on how effectively they are meeting fitness goals. Amazon Web Services Pity the poor businesses that fork out big money for computing power, bandwidth and other infrastructure which they then under-use. Amazon is using its vast IT resources to provide companies with Metered Use cloud-based technology such as servers, storage and database services.

the new model, an inability to rapidly iterate, and an overload of organizational change. Circumventing these barriers requires careful attention to process from the beginning. A cross-functional governing team of senior executives should establish a clear strategic mandate and set realistic success metrics. Then these executives should follow a model set by venture capitalists for how they interact with project leaders. Venture capitalists use frequent board meetings of their portfolio companies to focus on solving problems, not reviewing presentations. They expect firms to discover many unknowns, and early on they measure progress in terms of risk mitigation rather than rapid revenue growth. They prize flexibility. Moreover, they concentrate companies on just a small handful of issues

at a time, which minimizes the downside of fast change while maximizing the impact of lessons learned from the marketplace. Reasons abound for employees to resist altering the way the company operates. But with the right amount of rabid pull from deep customer insight, supported by illustrative analogies and deliberate process, every company can take advantage of this source of competitive advantage. This is not a drill. Most companies face competitive threats from upstarts or faster-moving competitors. The time for Business Model Innovation is now, before one of them forces your hand or steals the customers you thought you had.

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About

MONITOR GROUP

Monitor works with the worlds leading corporations, governments and social sector organizations to drive growth in ways that are most important to them. Monitor Group offers a range of servicesadvisory, capabilitybuilding and capital servicesdesigned to unlock the challenges of achieving sustained growth. Monitors innovation practice brings together an entrepreneurial, global team with expertise in a broad spectrum of disciplines. It includes innovation specialists at Doblin as well as a proprietary network of external technology and industry experts that supports our clients around the globe.

About Geoff Tuff

Geoff Tuff is a Senior Partner at Monitor and a leader of the firms Innovation and Sustainability practices. He has been at the firm since the early 1990s. Geoff has worked in a wide range of industries including pharmaceuticals, medical devices, consumer products, beverages, information services, financial services, telecommunications, metals, and both commodity and specialty chemicals. His work is focused entirely on helping companies grow organically through innovation and commercial excellence. Throughout his career, he has been instrumental in developing some of Monitors core methodologies related to driving top-line growth for clients, and he is currently an account manager for several of the firms leading clients. His writing frequently appears in the Monitor Perspectives series and has been published in journals such as Marketing Management. Geoff received his B.A. with honors from Dartmouth College, and also holds an MBA from Harvard Business School. He is based in the firms office in Cambridge, Massachusetts, and can be reached via e-mail at Geoffrey_Tuff@Monitor.com.

About Stephen Wunker

Stephen Wunker is Managing Director of New Markets Advisors. As a specialist in building innovation capabilities and creating new markets, he has focused on the healthcare, financial services, and telecom industries. He has published articles on innovation in a wide array of industry and general business publications, including Forbes and BusinessWeek. Steve has four patent filings for business model innovations. In addition to his consulting career, he has been a successful entrepreneur and corporate venturer in both developed and emerging markets. Steve received his B.A. with honors from Princeton University, a Masters in Public Administration from Columbia University, and an MBA from Harvard Business School. He can be reached via e-mail at swunker@newmarketsadvisors.com.

The authors wish to acknowledge the contributions of David Shear in the preparation of this article.
Copyright 2009, 2010 Monitor Company Group Limited Partnership. All rights reserved. Reproduction in whole or part is prohibited without permission.