Sergio Caredda
What is a Business Model? With this post I clarify the different perspectives of this foundational element for business capacity to innovate.
I have recently started endeavour in trying to define the essential elements of the design fabric of an organisation. Business Models are a crucial element of this definition, together with Strategy, Operating Models and Organisation Models. With this post I want to try to uncover, a bit more in detail, what the concept of Business Model is, what are the critical theories of Modelling present, and how these relate to the other elements.
- May 3rd, 2020: Updated References and corrected a few typos.
- Aug 25, 2024: Updated References to new release of Organisation Evolution Framework.
Business Models: The origins.
A look at the Google Ngram viewer for the term “Business Model”, shows that its usage is pretty recent, with a steady climb around the first dot.com bubble, where the wording “Business Model” was sometimes even abused, as many newcomers filled the market with IPOs, presenting ideas of businesses rather than demonstrated economic results.
- Business Models: The origins.
- What are Business Models for?
- What about companies that do not know about their Business Model?
- Theories of Business Models
- Peter Drucker and his Theory of the Business
- Business Model as an Information Architecture
- Business Model as a “Narrative”
- Gary Hamel’s Business Model: driving wealth potential.
- Chesbrough Business Model Definition
- The Business Model Framework by Richardson
- Business Model as an Information Theory
- The Four Block Model
- The 9-Point Strategy Framework
- The Business Model Canvas
- The Dynamic Capabilities Framework
- Design a Winning Business Model
- The Business Model Database
- The Clayton Christensen Institute Business Model Theory
- Business Model as System of Consequences
- How to use Business Models
- Organisational Consistency
- Business Model Innovation
- Testing Market Assumptions
- Conclusion
- Business Model within the Organisation Evolution Framework
- Comments and Feedbacks
- References
We have already seen why the concept of the Business Model is so important, but this does not mean that there is still confusion about what it really means. A Business Model is “A term of Art” (Lewis, 2014). Which means that like art itself, it’s one of those things many people feel they can recognise when they see it (especially a particularly clever or terrible one) but can’t quite define. (Ovans, 2015)
Some authors trace the concept of Business Model to a definition inferred from Peter F. Drucker “Theory of the Business “: assumptions about what a company gets paid for. (Drucker, 1994). In reality, Drucker never used the term “Business Model”, and his theory of the business is a set of assumptions about what a company should or should not do, more in line with Michael Porter’s definition of Strategy (Porter, 1996). In strategic management, the standard unit of research is the business unit, the industry in which a business unit is competing and the corporation which is the legal entity of most business units (Bettis, 1998). Based on these units of analysis, researchers try to evaluate why individual companies have higher profits than other, comparable companies. Which is why another possible “ancestor” of the concept of Business Model can be traced in the work of Kenneth Andrew, who for the first time distinguished between Business and Corporate Strategy (Andrews, 1971).
Again it is essential to make sure we distinguish Business Models from Strategy and Tactics, as there is often much confusion. The three are, for sure interrelated, but it is essential to capture the difference.
Whereas business models refer to the logic of the company—how it operates and creates and captures value for stakeholders in a competitive marketplace—strategy is the plan to create a unique and valuable position involving a distinctive set of activities.Ramon Casadesus-Masanell, How to Design a Winning Business Model, (Casadesus-Masanell and Ricart, 2011)
Thus, a Business Model is genuinely a “System of Choices” and “System of Consequences” on which Strategy can be based. Which also leads to a necessary consequence: While every organisation has a business model, not every organisation has a strategy—a plan of action for contingencies that may arise. However, not many leaders fully grasp this, which comes to very important (and often unwelcome) consequences.
What are Business Models for?
In a special issue of the journal Long Range Planning, Charles Baden-Fuller and Mary Morgan say that business models can serve three different purposes (Baden-Fuller and Morgan, 2010).
- They can describe different kinds and types of businesses. This is critical if we are trying to study them analytically.
- They can be short-hand descriptions of how firms operate – the primary value here is that you can use the business model to ensure that you have strategic fit across activities.
- They can be role models – you can use them to describe how you want your organisation to function.
- Steve Blank has added a fourth idea that a Business Model is just a set of hypotheses about the market.
- They can be identified with the map or the topography of the organisation as defined by Naomi Stanford (Stanford, 2011b).
- Often you will also find the concept of “Business Model” limited to revenue streams as a proxy for value creation (Healy, 2016).
What about companies that do not know about their Business Model?
As I investigated this topic, I found out a fascinating statistic. The same Charles Baden-Fuller, interviewed about the unique issues of Long Range Planning on the subject of Business Models, stated in 2010 that more than 2/3 of companies had not articulated their business model (see video below).
This is alarming. It also raises the point that every organisation has a business model, whether you have consciously thought about it or not (Kastelle, 2010).
Most enterprises haven’t fully come to grips with how to compete through business models.Ramon Casadesus-Masanell, How to Design a Winning Business Model, (Casadesus-Masanell and Ricart, 2011)
Theories of Business Models
Let’s now see the main concepts of Business Models and how these have been framed in recent years.
Peter Drucker and his Theory of the Business
“what to do” is increasingly becoming the central challenge facing managements, especially those of big companies that have enjoyed long-term success.Peter Drucker, The Theory of the Business (Drucker, 1994)
Drucker’s theory of assumptions is fascinating. He uses these to explain how “smart” companies fail to keep up with changing market conditions, precisely because of these assumptions. According to Drucker, the Theory of the Business is composed of Three Parts:
- First, there are assumptions about the environment of the organisation: society and its structure, the market, the customer, and technology.
- Second, there are assumptions about the specific mission of the organisation.
- Third, there are assumptions about the core competencies needed to accomplish the organisation’s mission.
The assumptions about the environment define what an organisation is paid for. The assumptions about mission define what an organisation considers to be meaningful results; in other words, they point to how it envisions itself making a difference in the economy and in the society at large. Finally, the assumptions about core competencies define where an organisation must excel in order to maintain leadership. (Drucker, 1994)
He also described the specifications to validate the Theory of the Business. And established four criteria:
- The assumptions about the environment must fit reality.
- The assumptions in all three areas must fit one another.
- The Theory of the Business must be known and understood throughout the organisation.
- The Theory of the Business has to be continuously tested.
Some theories of the business are so powerful that they last for a long time. But eventually every one becomes obsolete.Peter Drucker, The Theory of the Business (Drucker, 1994)
But what should you do when the theory starts displaying signs of being obsolete? It is then time to ask again, which assumptions about the environment, mission, and core competencies reflect reality most accurately. Drucker identified an action of Preventive Care that should be done, focused on two specific preventive measures:
- Abandonment: Every three years, an organisation should challenge every product, every service, every policy, every distribution channel with the question, If we were not in it already, would we be going into it now? By questioning accepted routines, the organisation forces itself to think about its theory.
- Study non-customers. I.e. study what goes on outside the business. This is based on the idea that the first signs of fundamental change rarely appear within one’s own organisation or among one’s own customers.
Both actions are focused on identifying threats to the current theory and bring-in decisive actions as needed. A key Leadership role according to Drucker.
Business Model as an Information Architecture
What is interesting to note is that the origins of the wording “Business Model” actually derives from Information Management. There are multiple instances of the usage of the term already in the Seventies and often refer to a similarity with the architecture of an information system used in the context of a business. Mainly many ICT experts were studying ways to “model” a business into an information system.
Interesting, therefore, the definition of what a Business Model’s Purpose can be, deriving from a study which was focused on how to represent businesses in a mark-up language (Eriksson and Penker, 2000):
- To better understand the critical mechanisms of an existing business. …
- To act as a basis for improving the current business structure and operations.
- To show the structure of an innovated business.
- To experiment with a new business concept or to copy or study an idea used by a competitive company (e.g. benchmarking on the model level).
- To identify outsourcing opportunities.
We can recognise many of these purposes in the other definitions and models we have seen. Although the original linkage with information technology is somewhat lost, there is one particular definition of Business Model that landed in 1998 by Paul Timmers, that still refers to this relationship with information systems. He defines a Business Model as an architecture for the product, service and information flow, including a
description of various business actors and their roles; and a description of the potential benefits for the various business actors; and a description of the sources of revenues. (Timmers, 1998). Interesting to point out how the importance of “information flows” which was at the origin of the usage of this term was lost for some time but comes back in the underlying significance of data and information in today’s economy.
Business Model as a “Narrative”
In a 2002 article on HBR, Joan Magretta supports in many ways Drucker’s view. A good business model answers the age-old questions, ‘Who is the customer? And what does the customer value?’ It also solves the fundamental problems every manager must ask: How do we make money in this business? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost? (Magretta, 2002). In a way, they constitute the foundational narrative of an enterprise.
They are, at heart, stories—stories that explain how enterprises work.Joan Magretta, Why Business Models Matter, (Magretta, 2002)
In framing these stories, you establish the value the business generates. Creating a business model is, then, a lot like writing a new account. A successful business model represents a better way than existing alternatives. The author identifies two components for each business model, as she sees these being all variations on the generic value chain underlying all businesses:
- Part one includes all the activities associated with making something: designing it, purchasing raw materials, manufacturing, and so on.
- Part two includes all the activities associated with selling something: finding and reaching customers, transacting a sale, distributing the product or delivering the service.
So a new business model can focus on producing something new, or in a more efficient way, or rather at exploring alternative and better ways to sells (different channels, different distribution etc.).
Magretta links the birth of Business Models to how personal computing changed the nature of business planning. By enabling companies to tie their marketplace insights much more tightly to the resulting economics—to link their assumptions about how people would behave to the numbers of a pro forma P&L—spreadsheets made it possible to model businesses before they were launched. (Magretta, 2002). Yet, assumptions are again noted as the key driver of a successful model (as well as for most unsuccessful examples).
Business modeling is the managerial equivalent of the scientific method—you start with a hypothesis, which you then test in action and revise when necessary.Joan Magretta, Why Business Models Matter, (Magretta, 2002)
So how do you define if a business model works? According to Magretta, there are two simple tests. When business models don’t work, it’s because they fail either the narrative test (the story doesn’t make sense) or the numbers test (the P&L doesn’t add up). And its especially the narrative analysis that constitutes the most exciting aspect of this theory, as Magretta analysed a few of the failures of the first dot.com bubble.
Gary Hamel’s Business Model: driving wealth potential.
One of the authors that give the most extensive definition of Business Model is Gary Hamel. In his Leading the Revolution, Hamels spends a noticeable amount of time to the detail his idea of Business Model (Hamel, 2000).
He defines a business model as a “business concept that has been put into practice”. Extending this simplicity, he fashions a business model framework based on four main pillars:
- Core Strategy: contains the business mission, the product and market scope and calibration of the market to serve as the basis for differentiation.
- Strategic Resources: these are internal resources configured to practice the core strategy, and include Core Competencies Strategic Assets and Core Processes.
- Value Network: here we trace external partners of a business, including Suppliers, Partners and broader Coalitions.
- Customer Interface: it is where a business realises its benefits by exploiting the above three elements. An effective customer interface is built with five components: fulfilment and support, information and insight, relationship dynamics, and pricing structure.
Hamel also identifies three “bridges” that
- Configuration refers to the unique way in which competencies, assets, and processes are combined and interrelated in support of a particular strategy
- Customer Benefits refers to the specific bundle of benefits that are being offered to the customer
- Company boundaries encompass the decisions that have been made about what the firm does and what it contracts out to the value network.
Chesbrough Business Model Definition
One of the scholars more active in defining the concept of a Business Model is Henry Chesbrough from UC Berkeley. In a 2002 article focused on how Xerox corporation focused on its technology companies spinoffs, the author has developed a high-level view of what a Business Model represents.
His definition of Business Model is articulated in the following components (Chesbrough and Rosenbloom, 2002):
- articulate the value proposition, that is, the value created for users by the offering based on the technology;
- identify a market segment, that is, the users to whom the technology is useful and for what purpose;
- define the structure of the value chain within the firm required to create and distribute the offering;
- estimate the cost structure and profit potential of producing the offering, given the value proposition and value-chain structure chosen;
- describe the position of the firm within the value network linking suppliers and customers, including identification of potential complementors and competitors;
- formulate the competitive strategy by which the innovating firm will gain and hold an advantage over rivals.
His focus is on the intersection of the technology and economic domains in creating values, by linking the two domains above, which requires different types of understanding, which is why the authors affirm that Constructing business models in environments characterised by high complexity and ambiguity has much in common with Weick’s notion of sensemaking.
Which brings to one of the most important conclusions of the work of Chesbrough: the concept of Business Model Innovation being able to comparatively deliver the same if not more value than pure Technology innovation (Chesbrough, 2010) especially when we are facing areas where Open Innovation reigns (Rodet-Kroichvili, Cabaret and Picard, 2014).
The Business Model Framework by Richardson
James E. Richardson, from the University of Hawaii, provided a literature analysis and suggested a Framework in 2008, where he identified three dimensions that are common to the literature he analyzed.
Out of his analysis of existing literature, Richardson states that most authors identified several components in Business Model definition. The number of components varies from four to eight. A total of twenty-four different items are mentioned as components of a business model, with fifteen of these receiving multiple mentions. Of these, the most frequently included are the firm’s value offering or value proposition (11 mentions), profit/revenue/economic model (including revenue sources) (10 mentions), customer interface/relationship (8 mentions), partner network and roles (7 mentions), internal infrastructure/connected activities (6 mentions), and target markets/segments (5 mentions). (Richardson, 2008).
His framework proposal is organized around the concept of Value: The three major components of the framework--the value proposition, the value creation and delivery system, and value capture reflect the logic of strategic thinking about value.
Within the framework, the author has embedded most elements identified in the literature, providing a holistic framework of reference, that he then applied to one specific case: Walmart.
The model is simple and effective, however does not necessarily guide the user in a full identification of the different elements, resulting it into a more descriptive tool rather than an actionable framework.
Business Model as an Information Theory
Jonas Hedman and Thomas Kalling have also researched the literature on Business Models in 2002 and have come up with a framework that is heavily focused on information flows within the organization (Headman is an expert in Informatics).
They have identified seven key components: (1) customers, (2) competitors (3) offering, (4) activities and organisation,(5) resources, and (6) supply of factor and production inputs. These components are all cross-sectional and can be studied at a given point in time. To make this model complete, they have also included a longitudinal process component (7) that they called “Scope of Management”, to cover the dynamics of the business model over time and the cognitive and cultural constraints that managers have to cope with. (Hedman and Kalling, 2003)
The authors are very careful in utilizing the model through a time perspective: yes a Business Model can be analyzed in one point in time, but it is through its development over time that consistency can be assessed. And by focusing on what they defined “Scope of Management”, they create room for a focus on IT solutions as a critical enabler for Business Model value creation (as opposed to past theories focused more on external factors).
The Four Block Model
In 2008 Clay Christensen and Mark Johnson presented their views on the concept of Business Models. For them, a business model consists of four interlocking elements that, taken together, create and deliver value (Christensen, Johnson and Kagermann, 2008).
- Customer Value Proposition (CVP) – A successful company is one that has found a way to create value for customers—that is, a way to help customers get an important job done. And formalising this aspect is crucial
- Profit Formula is the blueprint that defines how the company creates value for itself while providing value to the customer. By embedding this aspect into the model, the authors clarify that the Profit Formula is only one aspect of the Business Model.
- Key Resources are assets such as the people, technology, products, facilities, equipment, channels, and brand required to deliver the value proposition to the targeted customer. The focus here is on the key elements that create value for the customer and the company, and the way those elements interact.
- Key Processes are operational and managerial processes that allow them to deliver value in a way they can successfully repeat and increase in scale.
One of the most interesting aspects of this model is that it is dynamic. Through several cases, the authors point out that Business Models need to evolve, as the market and competitors continuously challenge them.
Successful new businesses typically revise their business models four times or so on the road to profitability.Clay Christensen et al., Reinventing your Business Model, (Christensen, Johnson and Kagermann, 2008).
Which also links to one of the main concepts that Christensen developed: introducing a better business model into an existing market is the definition of a Disruptive Innovation (Ovans, 2015).
In thinking about the Business Model as a reinvention wheel, we need to consider also what can be standing in the way in developing a better Business Model. The authors identify the fact that often rules, norms and metrics exists in an organisation that is deeply rooted to protect the status quo, and become the first line of defence against any new model’s taking root in an existing enterprise. For example, the bases for individual’s rewards and incentives are a formidable aspect that can hinder change.
Mark Johnson has further refined the model in a recent book (Johnson, 2018), and several examples of business models in action are presented online.
He particularly showed a list of basic forms that can be adapted and implemented as business models for your own organisation.
In the table on the side, you can see a list adapted from the work of Johnson.
These are of course “paradigms”, and should be used with attention. It is not about “copying” a business model but instead thinking about how it operates within one market and using it to occupy a “white space” in the market.
Just to be sure, no short-cuts about just copying an already implemented model here, rather a way to learn from others, mainly if the model is then applied to a different industry or situation. The list also includes some example brands, but it is essential to remember that these companies are not static, and their models have been evolving over time.
The 9-Point Strategy Framework
Geoffrey Moore has presented in a recent book what he defines as The 9-Point Strategy Framework.
The basic idea is that each company should be defining in detail its relationship with the market by creating a Target Market Initiative, which employs the nine tactics identified by the framework.
It’s interesting to see that these elements (although listed under a “strategy” heading), would closely match the definitions of Business Model we have seen before, which is why I list this model in this section.
One of the advice that Moore gives is to ensure you enlist external perspectives to analyse and develop these themes. He shares the view that an inside-out perspective often does not allow to grasp the real potential of innovation and growth.
Also, for each element of the Strategy, its “next kin” should be likewise identified.
The Business Model Canvas
Firmly in the “a business model is a set of assumptions or hypotheses” camp is Alex Osterwalder, who has developed the most comprehensive template on which to construct those hypotheses. His nine-part “business model canvas” (Osterwalder, 2013) is essentially an organised way to layout your assumptions about not only the key resources and key activities of your value chain, but also your value proposition, customer relationships, channels, customer segments, cost structures, and revenue streams — to see if you’ve missed anything important and to compare your model to others (Ovans, 2015).
Osterwalder has built a very intuitive tool, which structures a business model into nine building blocks, namely, value proposition, key resources, activities and partners on the upstream side, customer relationships, channels and segments on the downstream side, and ultimately, the cost structure and revenue streams (Osterwalder, Pigneur and Clark, 2010). The Canvas (illustrated in the below figure) helps craft the Business Model itself, and build it as well in a kind of Narrative format.
Osterwalder has done a great job of promoting the idea and making it genuinely useful. This version of business models proves that it is a practical tool that you can use to figure out where your organisation should be heading (Kastelle, 2012a). And he has also created a very successful tool, which has probably actively contributed to the high spread of the BM concept.
For me there is something intuitive about the BMC approach. We all must simply empower everyone, to go out and seek increased value from new BM’s, often seen but not captured in its interpretation. We need to simply communicate this quickly, on one page and well that’s the real power of the Business Model Canvas, for any organization, large or small.Paul Hobcraft, A Business Model Canvas Set to Explode
An exciting aspect of the Business Model Canvas is that a version also exists to support not-for-profit organisations, jointly developed by Alex Osterwalder and Steve Blank (Blank, 2016). In this case, the tool is re-labelled as Mission Model Canvas: Mission Achievement and some further elements substitute revenues Streams are replaced:
- Customer Segments is changed to Beneficiaries
- Cost Structure is changed to Mission Cost/Budget
- Channel is changed to Deployment
- Customer Relationships is changed to Buy-in/Support
A truly interesting take.
The Dynamic Capabilities Framework
In an article appeared in 2008 David J. Teece connects the concept of Business Model with that of the Dynamic Capability Framework he has discussed in preceding work. “Dynamic capabilities and strategy combine to create and refine a defensible business model, which guides organisational transformation. Ideally, this leads to a level of profits adequate to allow the enterprise to sustain and enhance its capabilities and resources” (Teece, 2018). The image above, taken from the same article, shows a simplified version of the Dynamic Capabilities Framework, omitting feedback channels.
The reason why this model is attractive is that it puts at the core the interdependence between Business Model and Strategy. “Once in place, a business model shapes strategy inasmuch as it constrains some actions and facilitates others. By deter-mining costs and profitability, a business model impacts the very feasibility of a strategy. In the event of a conflict between strategy and the business model, it falls to top management to determine which of the two should change”.
The concept of Dynamic Capability is defined as “the firm’s ability to integrate, build, and reconfigure internal and external competences to address rapidly changing environments” (Teece, Pisano and Shuen, 1997). These refer to “the capacity of an organisation to purposefully create, extend, or modify its resource base” (Helfat and Peteraf, 2009). The underlying assumption of the dynamic capabilities framework is that core competency should be used to modify short-term competitive positions that can be used to build longer-term competitive advantage.
Three dynamic capabilities are necessary in order to meet new challenges. Organisations and their employees need the capability to learn quickly and to build strategic assets. New strategic assets, such as capability, technology, and customer feedback, have to be integrated within the company. Existing strategic assets have to be transformed or reconfigured.
Teece’s concept of dynamic capabilities essentially says that what matters for business is corporate agility: the capacity to (1) sense and shape opportunities and threats, (2) seize opportunities, and (3) maintain competitiveness through enhancing, combining, protecting, and, when necessary, reconfiguring the business enterprise’s intangible and tangible assets (transform).
The issue with the Teece model illustrates the point that Baden-Fuller and Morgan make about the different uses of the business model concept. Teece’s model is designed solely for description/classification (Baden-Fuller and Morgan, 2010). So you can run into approaches for business models that aren’t as practical (Kastelle, 2012a).
Design a Winning Business Model
In a 2011 article on HBR, Ramon Casadesus-Masanell presented an alternative view on how to design a winning business model.
In his view, a Business Model is primarily made up of choices that executives make about how the organisation should operate in terms of policies, assets and governance, and consequences in terms of flexibility or rigidity. Flexible consequence is one that responds quickly when the underlying choice changes. But most consequences are often rigid, because they are rooted in corporate culture, and it will take time to have them disappear even if underlying choices are modified.
The theory here is simple. The authors observe that many companies tend to create innovative business models in isolation, without thinking of the competition or market dynamics. “The success or failure of a company’s business model depends largely on how it interacts with models of other players in the industry.” Which also builds a second significant consequence: Business Models are dynamic. “The propensity to ignore the dynamic elements of business models results in many companies failing to use them to their full potential.”
The authors identify three criteria that good business models have, notably because they tend to generate virtuous cycles of value creation. A good business model needs to answer the following three questions:
- Is it aligned with company goals?
- Is it self-reinforcing?
- Is it robust?
To be competitive with a business model, you have to ensure that the external market reacts in alignment. This can be achieved either by weakening your competitor’s cycles or by turning competitors into complements (Casadesus-Masanell and Ricart, 2011), which is a crucial element on Business Models based on Platforms.
The Business Model Database
Anders Sundelin maintains a website named The Business Model Database, which precisely focuses on maintaining an inventory of Business Models definitions. He defines a Business Model as an answer to two questions (Sundelin, 2008):
- How are values created, captured and by whom?
- How are values extracted, controlled and by whom?
He also identifies the key components he sees as standard in most Business Models definitions:
- Core capabilities (assets, capabilities, processes)
- Customer value propositions (products and services, offering, differentiation)
- Target customer (segments, scope, needs)
- Revenue model (pricing, ways of charging)
- Distribution channel (delivery, channels, promotion)
- Partnerships (suppliers, partners, value chain position)
- Cost structure (fixed and variable costs)
- Value Proposition (including all stakeholders)
- Control Mechanisms (used to protect the created values and profit streams)
Although his blog has not been updated for some time, he has produced a detailed and fascinating infographic that collects a very detailed view of the evolution of the Business Model concept based on his collection. You can see this in the image below.
I have not treated all models illustrated in this infographic on this post, mainly because for many I have not found durable pieces of evidence of usage (but I might be wrong, so feel free to send me feedback by commenting on this post).
The Clayton Christensen Institute Business Model Theory
The Clayton Christensen Institute proposed a Business Model Theory defined as:
The theory that determines an organization’s capabilities and priorities while predicting future success in the field or market.
This theory defines a business model as four interlocking elements that, when taken together, create and deliver value: value proposition, resources, processes, and profit formula/priorities.
According to this Theory, the first component of the business model is the value proposition, or the set of value propositions, a company offers to its customers. These are the promises an organization makes to fulfill customer needs or goals. Most businesses have multiple value propositions delivered to customers as products or services.
Resources are required to deliver value propositions. These are assets— people, technology, products, facilities, equipment, brands, and cash—both tangible and intangible.
As an organization works to deliver its value propositions repeatedly and effectively, processes emerge. These are the habitual ways of working together as people address repeated tasks successfully. Some processes are explicitly stated, documented, and followed. Others are unstated and executed as part of the unspoken culture. Examples include training, budgeting, planning, etc.
To cover all the costs associated with the resources and processes needed to deliver on the value propositions, as well as establish a margin to promote sustainability, organizations create a profit formula. This defines how the company will maintain viability and sustainability to support its cost structure over time.
The ways in which the four components reinforce one another makes the business model highly interconnected as resources and processes are replicated, repeated, improved and standardized. Thus, it’s more challenging to alter the longer it exists.
This theory insists on consistency across the elements identified. For example, if a proposed innovation creates friction with an exisiting established capability, it won’t gain internal traction. Similarly, if it threatens the existing Profit Formula, it won’t survive.
The institute also provides an interesting video explaining why the Business Model should be thoroughly understood.
Business Model as System of Consequences
IESE researchers Casadesus-Masanell and Ricart have conceptualized an approach by which a Business Model is defined as “a company’s choice of policies and assets, the governance structure of these policies and assets, and their consequences, whether flexible or rigid” (Casadesus-Masanell and Ricart, 2007).
This approach, rather than mapping specific components as in previous literature, focuses on the fabric of an organization, and looks at consequences. This way, the Business Model becomes, as I have stated above, a real System of Consequecences, connecting choices with results. The authors also include theories in their visual representation of a Business Model, defined as suppositions on how choices and consequences are related. Below an example that is part of their paper based on Ryanair’s analysis.
Central to this approach is the identification of Virtuous Cycles, which are reinforcing feedback loops that, at every iteration, strengthen the component of the model. In few words, consequences that reinforce the choice made.
What the authors propose is also a model for evaluating Business Models, based on two approaches: one in isolation (i.e. looking at one organization alone), and the other in interaction. Here a summary of the components seen:
- Analysis in Isolation
- Alignment to Goal - refers to the capability of the organization to align choices with its objectives.
- Reinforcement - refers to choices complementing each other.
- Virtuousness - refers to the presence of virtuous cycles.
- Robustness - refers to the ability of the Business Model to sustain its effectiveness over time.
- Analysis in Interaction
- Interdepence - this happens when consequences of are common to both companies models.
- Tactical Interaction - refers to organizations affecting each other by acting within the boundaries set by their business models.
- Strategic Interaction - refers to how changes in one company’s business model affect the working of another’s company’s business model.
These elements add a very interesting cut an view on how we can study and understand Business Models of existing organizations, but also open up for a more ecosystemic view.
How to use Business Models
Tim Kastelle has posed himself an interesting question. What can you actually do with a business model? (Kastelle, 2012b)
He has identified three things that can be done:
- Test Your Organisational Design for Consistency. Which is an interesting take considering the sequence where often Org Design and Business Model generation are not always in sync.
- Innovate the Business Model
- Test Your Market and Your Assumptions
Organisational Consistency
One of the critical issues in looking at business models is that they must be internally consistent (Kastelle, 2011). I have already written about consistency in more detail in a specific post; for sure, there is a need to ensure that consistency is achieved between the Business Model and all other organisation design elements.
Considering what we have already mentioned, i.e. that many companies are not even aware of what their Business Model is, ensuring that the Business Model is made explicit is a first step in understanding why some change programs fail. I suspect, for example, that a lot of the consolidated Patterns that Siobhan McHale mentions in her book The insiders’ Guide to Culture Change are a direct consequence of the Business Model of a company. We need, therefore, to ensure that this is explicit, also to ensure we cover the dynamic tension with strategy and tactics also already seen.
What this also means is that we cannot simply “copy” the Business Model of somebody else, and drop it entirely in our organisation. We need to reason in terms of Intentional Design also and above all for the Business Model, as it drives choices and consequences.
Business Model Innovation
We have seen already how Business Model Innovation is one of the critical drivers of innovation. But we need to be aware that, linked to the limited understanding that many managers have about the Business Model, we fail to exploit its potential. Business model innovation is currently underutilised. In part, this is because many organisations have not articulated what their business model is. Doing so is the first step to figuring out a genuinely novel way to create value for the people for whom you’re creating things. (Kastelle, 2010) And there is an absolutely stunning business case for it.
Rita McGrath says in “When Your Business Model is In Trouble,” is when innovations to your current offerings create smaller and smaller improvements (and Christensen would agree). You should also be worried, she says, when your own people have trouble thinking up new improvements at all or your customers are increasingly finding new alternatives. This creates a static Business Model perception, which eventually sclerotised the dynamic of change.
Which again points out to the fact that Intentional Design is required to drive innovation. Here is, however, where the distinction between Business Model and Strategy becomes again fuzzier. The issue is that when we think of incremental innovation of a Business Model, this can effectively happen thanks or because of strategic choices. But the potential of Business Model innovation is much more extensive.
Naomi Stanford proposes the development of adeptness as a critical capability for the organisation (Stanford, 2011a), and she cites the concept of Planned Abandonment suggested by Peter Drucker (Drucker, 1999), as he said that the time to abandon a product, service, policy, rule, or other organisational element is much earlier than when it begins to cause problems. As a rule, it is time to abandon when any of the three following conditions apply:
- The product, service, market, process, or whatever still has a few good years of life
- Its greatest virtue is that it is entirely written off. Ask instead ‘what is it producing?’
- An old and declining product, service, market, process, etc. is being maintained at the expense of new and growing products, services, markets, processes, etc.
“Drucker suggested that the leadership team should regularly ask a series of questions aimed at pinpointing areas for abandonment.” A key element to drive Business Model Innovation, as it continually puts in question the basis of the BM itself.
Business model innovation is a powerful form of innovation. So once you’ve described your business model (or that of your industry), start thinking about how you can change it (Kastelle, 2010).
Testing Market Assumptions
Steve Blank likes to say that a business model is just a set of hypotheses about the market (Blank, 2011). So you can use the business model to test your assumptions about what will work as you introduce new ideas (Kastelle, 2011).
This aspect can be embedded in the continuous cycle of innovation. Still, we need to consider the limit we have already mentioned, i.e. ensure we feel the limits of experimentation without market feedback. It’s therefore essential to test the Business Model almost like a scientist. Scientists are interested in finding the boundary conditions for rules – when do rules stop working? When testing business model hypotheses, you’re trying to figure out what is right in your particular case. So beware of absolute statements about what will or won’t work. (Kastelle, 2011)
A great reference model for this is what Steve Blank (2005) nicely describes ad Customer Discovery into his Customer Development process. “You need to leave guesswork behind and get “outside the building” in order to learn what the high-value customer problems are, what it is about your product that solves these problems, and who specifically are your customer and user.” (Blank, 2005)
Too many companies feel that when the business model is found (i.e. when the customer discovery is finished, looking at Blank’s theory), the work is done. The issue is that this is not the case: “an “initial business model” is just that: a starting point, based on a hypothesis and multiple assumptions” (Osterwalder and Pigneur, 2011). Which leads to the second step in the process identified by Blank: Customer validation.
It is only when you start testing your model with customers that you will discover whether your hypothesis is right or wrong. Hence, the Customer Development process constitutes an iterative loop designed to fix the model’s shortcomings. This is what Eric Ries defines as Pivot.
Only after several iterations and pivots will you really “nail” the right business model. Then it’s time to scale. This is called Customer Creation which is when you start “creating end-user demand and drive that demand into the company’s sales channel.” (Blank, 2005). Only after this step, you will be able to focus on Company Building, the last stage of the process.
Unfortunately, too often, companies jump immediately to the last step and create the organisational framework before all the other aspects are aligned. Which can result in significant failures.
Conclusion
The journey through the many views of what precisely a Business Model is, may sound confusing in some ways because of the different perspectives. However, there is a consensus now on the importance of actively defining an explicit Business Model. I want to stress the word explicit because, as we have seen, every organisation has a business model, but few have really reasoned on it. Making it explicit makes it possible to build a consistent narrative of your organisation, clearly defining where this organisation sits within its network of relationships and the market.
A Business Model, therefore, needs to be unique for your organisation, as it will become the inner fabric, the architecture on the way you conduct business. Understanding it is not sufficient; we need to design it through a constant innovation process intentionally. Copying it is out of the question: we simply cannot: only an intimately unique model will have the potential of ensuring business success.
The challenge that exists ahead of us, in today’s VUCA environment, is how a Business Model should be addressed in the framework of platforms or ecosystems. I’ve on Purpose not treated these two fundamental concepts, because they question a broader topic than the Business Model itself from my point of view. But do pose the question of how do we treat the relationship between different Business Models.
The other big question is about the relationship of the Business Model with elements like Purpose. The link between the two comes from the mapping of the Value Proposition that is offered to the stakeholders (Customers, Shareholders, Employees, etc.). The underlying assumption is that value here is not just financial, and the challenge is how to ensure that “profit” and “social impact” are not seen as two separate value streams, but instead embedded into a unique Business Model (Osterwalder and Pigneur, 2011). This is where, for example, I see companies like Patagonia well placed. Their difference can be captured at the Business Model level, and not at the Organisational Model levels (like instead Laloux claims in his book).
This example should clarify once more the need to correctly identify the Business Model, and ensure this is widely known in the organisation. Again, an act of Intentional Design. Which then will lead the way to define the proper Strategy, Operating Model and choose the right Organisation Model to pursue.
Business Model within the Organisation Evolution Framework
The definition of “Business Model” provided is very ample, underlining the concept that what is interesting here is the offering that the organisation has and (implicitely) the identification of “customers” of the same organisation.
Per se this definition allows to intercept many different types of organisation, independently from their mission, purpose or objective. Both Profit and Not-For Profit organisations can be catered by the model, and the same applies also to public and governmental organisations.
There are many elements that underlie a Business Model, but the truly critical is the Value Proposition. The Business Model de facto connects the external market to the internal side of the organisation, and requires a clear Value Proposition to be present and articulated. Its absence is one of the main derailers for an organisation in terms of their effectiveness. When external customers do not understand the Value that an organisation offers, this can be the primary reason for its failure.
- Company Boundaries
- Network Structure
- Revenues Sources
- Cultural Paradigm
Here a list of some of the Visible Artefacts that can be identified to analyse the Business Model. There can be various others, but from my point of view these are the critical ones. Identifying Revenues Sources, for example, is the best way to identify customers and make hypothesis on the Value Proposition. Company Boundaries (including legal structures and governance models) are also critical in analysing a business model. Network Structure allows to identify how the organisation interacts with customers and suppliers and so on.
This article is part of a series where I examine the different components of Organization Design, analyse models and theories and propose a specific approach of Intentional Design.
Key Content Articles
- The Organization Evolution Framework
- Business Models: The Theory and the Practice
- Strategy. Frameworks: The Theory and the Practice
- Operating Models: The Theory and the Practice
- Organization Models: a Reasoned List between Old and New
- Leadership Models: The Theory and The Practice
- Purpose: The Theory and the Practice
- Corporate Culture: The Theory and the Practice
- Organization Ecosystem: The Theory and the Practice
- Building the Intentional Organization
- What is Organization Design?
- Consistency and Intentional Design: Building the Organization of the Future
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