Business Model Innovation – The What, Why, and How
In the last couple of decades, we’ve seen a dramatic increase in the popularity of business model innovation – and for good reason.
Technology has made it easier than ever to adopt a wide variety of novel business models effectively. At the same time, increased pace of innovation and global competition has made differentiation more important than ever.
In addition, with the havoc caused by COVID-19, we’re already seeing that even though many businesses are battling for survival, there are also winners. Those winners usually possess very robust business models, which further outlines the importance of business model innovation in times like this.
In this article, we’ll look into what exactly it is, why it is so important, as well as how one can make it happen with the help of quite a few examples.
The Definition of Business Model Innovation
One of the common mistakes people make when it comes to business models is that they simply look at them very narrowly as just the pricing model for their products and services.
While it certainly is a key part of the business model, the term is actually defined as the way an “organization creates, delivers and captures value”.
Business model is the way an organization creates, delivers and captures value.
Successful business models thus take a very holistic approach by integrate these different aspects of the business into a well-organized and thought out system.
Business model innovation, then is simply a novel way to put these pieces together to hopefully create a system that produces more value for both customers and the organization itself.
A good business model, like any other system, is after all much more than just the sum of its parts.
Why Is Business Model Innovation So Important?
Without realizing it, a business that doesn’t explicitly focus on their business model as a whole often ends up compromising their initial strengths.
For example, many businesses start to gradually drift apart from the true needs of their customers unless they specifically focus on avoiding that. Some might focus too heavily on just optimizing the delivery of their products and sacrifice their ability to create value.
There are many reasons for these phenomena. Perhaps management focuses too heavily on what the competition is doing, or perhaps there’s pressure from shareholders to optimize for short-term profit.
Regardless, there are countless industries where the true interests of the customers and those of the service providers have become opposite.
The healthcare sector is a prime example of this: a private hospital has strong incentives for wanting you to be chronically sick so that you’d keep coming back regularly and they could charge you for each visit. You naturally want the hospital to take good care of you, but ideally, you’d just want to stay healthy and not have to go to the doctors’ in the first place.
So, even if the individual doctors are doing their best to take care of you, the business simply isn’t very likely to invest in keeping you healthy because that’s the worst thing that could happen to their business.
Contrast that with business models like flexible subscription services where the provider has to constantly create value to keep the customer. The longer they are able to keep their customers happy, the more profit these businesses make, which creates very strong incentives for aligning shareholder and customer value.
Business model innovation is simply put probably the most important tool for building a business that creates maximal value for all stakeholders: customers, shareholders, employees, and the society at large.
This obviously leads to a wide variety of benefits:
- Increased value creation will lead to increased growth, even for otherwise stagnant businesses
- As business model innovation often requires new operating models and is thus often very difficult for established competitors to copy
- …which can lead to an extend period of competitive advantage
- The right kind of business model also helps overcome objections to sales and create positive brand recognition
- As mentioned, some business models can make the business much more robust towards market cycles and unexpected “black swan” events, such as the recent COVID-19 crisis
To conclude, business model innovation is a flexible tool for building a great business irrespective of the industry. That’s why you’ll see most of the fastest growing and most disruptive businesses including business model innovation as a key part of their “innovation mix”.
Examples of Business Model Innovation
Before we get into the part where we look at how to actually do business model innovation, let’s first take a look at a few examples of business model innovation to get a better picture of what it can look like in practice.
Subscription models are a powerful way to turn one-off purchases to a more predictable, and over time larger, stream of revenue while ensuring that the customer keeps getting value and is also able to better afford higher-end services due to the purchase occurring over time.
Subscription models are equally applicable for both B2B and B2C businesses.
On the B2B side, Software as a Service (SaaS) products like Microsoft Office 365 and Infrastructure as a Service (IaaS) offerings like Amazon Web Services are great examples of this approach.
Where businesses previously used to buy the new version of Office products perhaps every five to ten years, now the same companies pay a comparable, albeit slightly lower, amount every year for their Office 365 subscriptions. However, for that increase in price, they get constant updates so that everyone’s always on the latest versions, as well as many more value-added services that customers used to have to purchase from someone else, like Microsoft Teams, plus the added flexibility of canceling unused licenses and upgrading or downgrading certain users to appropriate plans. It’s quite obvious that this is a deal where everyone wins.
On the consumer side, Dollar Shave Club is a great example of a subscription business that simply makes sense. The consumer gets great products more conveniently and affordably than they would from traditional brands in regular stores, and the company again gets a very predicable revenue stream, while cutting out the middlemen.
Subscription businesses tend to have quite distinct, straightforward value chains but do require some capabilities that many product businesses might not be very strong at, such as delivery and customer support.
Freemium is a portmanteau of the words free and premium. It refers to business models where a company offers a free version of their product, typically with certain limitations, in order to attract users and eventually upgrade them to paying “premium customers”.
For businesses with a good product, high gross margins and high customer acquisition costs, such as most content and software businesses, this can be a very powerful model, especially in crowded markets.
For example, at Viima, virtually all of our paying customers have first signed up for the free version of our product, seen the value that it can provide them, and then ultimately became paying customers as their use of the tool grew.
This obviously drives our customer acquisition costs down and allows us to offer our customers a better product at a price more affordable than the competition, which allows us to also serve businesses that the competition isn’t interested in serving, which leads to fast growth, while still maintaining solid margins that we can use to reinvest in the business, further accelerating our Flywheel of Growth.
The Freemium model is quite common for B2B software products that tend to have bottom-up adoption like Slack and Zoom, but also for many B2C services, such as Spotify and Apple iCloud.
The downside is that without strong value creation, freemium models might make it difficult for the business to capture enough value.
In essence, platforms are places that aggregate and/or facilitate supply and demand meeting. Platforms are characterized by their distributed approach to creating value.
In practice that means that they’re basically either matchmakers or marketplaces, but still come in many shapes and forms. They typically earn money by either taking a commission of the transactions, or by charging the supply side for the value-added services they provide.
These days you mostly hear the term being used for digital platforms, but the business model far predates online services. Shopping malls and classified ads in newspapers are just a couple of examples of traditional platform business models.
Digital platforms, however, have made the business model much more lucrative. Platforms, such as ones mentioned above, used to be very local but now it’s possible to create global platforms with tremendous economies of scale and minimal costs for getting started.
We’re all familiar with the examples: YouTube, Airbnb, Uber, Alibaba, the App Store, and the list goes on. While it probably isn’t a good idea to try to compete with these giants directly, there are still many niches where platform business models could create plenty of value.
The challenge with platform business models is that it’s often really hard to get platforms off the ground and achieve a critical mass where they become self-sustaining.
Both consumer and industrial goods manufacturers have traditionally relied on a, often complicated, supply chain of wholesalers and retailers to sell their goods.
Before the Internet, that allowed them to have a much larger geographical reach and thus benefit from economies of scale.
However, with the rise of e-commerce, we’ve seen a rapid rise in the popularity of the Direct-to-Consumer business model in many categories of consumer goods.
This approach provides the manufacturer with higher margins as the middlemen are removed, gives them much more control over the brand, customer experience and relationship, and provides them with more data, that is also of higher quality, on demand and customer preferences.
We’ve seen a wide variety of success stories in this area, for example Tesla in electric vehicles, Warby Parker in eyeglasses, Casper in mattresses, and the aforementioned Dollar Shave Club.
While not yet as common, the same approach is also gaining some traction on the B2B side of things with companies like Berlin Packaging.
Ads, affiliates & sponsorships
For as long as there have been content and communication channels, there’s been advertising in one form or the other, and that hasn’t changed recently.
With the explosion of content, we’ve seen a dramatic increase in content, which has made the traditional business model of monetizing content with advertising and sponsorships harder since there’s so much more competition for people’s attention.
For the right kind of audiences, typically in very specific niches, it can still be a viable business model in itself and for other businesses with a sizeable following, it can become an additional secondary source of income.
For example, while Spotify generates the vast majority of its revenue and profits from its subscribers, advertising revenue does provide the company with a solid secondary revenue stream that can be used for investing in growth.
Loss leaders & add-on services
While there’s nothing new in selling professional services, we’ve seen many interesting novel business models built around them.
A great example of this is the business model of open source software companies like WordPress, Red Hat and Elastic. These companies have built very popular open source software products that they let other companies use completely for free.
When you give away great software for free, it tends to become extremely widely adopted, as has certainly been the case for the aforementioned three products. Without the open source model, these companies would never have been able to reach the kind of market share they’ve actually managed to get to.
Once their products have been adopted at scale, the open source companies are obviously well positioned to either sell professional services or offer hosting services for this large base of users.
The same basic logic of giving something away for free, or at a loss, and then sell additional products or services to that wider customer base is also known as a loss leader strategy. It has been widely adopted across many industries, such as retail where stores might offer a real bargain for certain attractive products to lure in more foot traffic.
In general, selling maintenance contracts and other add-on services has become a ubiquitous business model especially in B2B, but also for more expensive B2C products, such as cars.
Razor & blades
The razor and blades business model is actually just another form of the aforementioned loss leader strategy, but is specific to goods with a longer lifecycle.
The idea is that you provide a product, like the razor, at a very affordable price – typically at a loss – and then make the profits by continuously selling complementary, consumable items for it, just like the blades for the razor.
Interestingly, just like with so many other stories of innovation, the story of the business model being invented by Gillette when he first created disposable razor blades isn’t true. In reality, it was invented by the competitors that entered the market once Gillette’s patents expired.
Since then, the model has been adopted by many companies selling goods like film cameras, printers and Nespresso capsules.
While the aforementioned examples cover some of the innovative business model patterns that we’ve seen gain popularity in the recent years, there are many others as well: franchising, auctions, micropayments, pay-what-you-want, the list goes on.
The Business Model Navigator is a very convenient and easy-to-use tool for browsing these patterns.
There are literally countless ways you can combine the different business models together with different product and service offerings to try to maximize the value created by your products and services.
As a result, many of the most innovative businesses in their industries actually have hybrid business models that actually combine multiple of the aforementioned patterns in a way that is tailored for their specific business. This is true for both traditional businesses and startups alike.
One example of a successful hybrid model is the aforementioned Spotify. As mentioned, the freemium approach is the core of their business, but they also use ads as a way to both capture revenue from their free users, but also incentivize their users to upgrade to paid plans. Even though the ads obviously don’t directly provide value for their customers, they can get away with that because their free plan simply provides the users with so much value that ads are just a small nuisance in the grand scheme of things.
Another example of this is Peloton. They sell high-end exercise equipment like bikes and treadmills for home use, and couple that with a subscription service that provides exercise programs, virtual classes and many other engaging features to accompany the bike. According to the company, even though their devices are quite expensive, they aim to sell them at break-even and then make money with the subscriptions.
This obviously means that to make a profit, they need to ensure that their customers stay motivated and keep exercising, which is what ultimately keeps them fit and creates value.
How Do You Create Business Model Innovation?
The examples above have hopefully provided you with some inspiration on what kind of new business models might be possible.
However, if you’re looking to create a business model innovation for your business, here are a few tips that can help you find the right model for you.
1. Start with customer value
The first step, as with every innovation, is to start with customer value.
- What is “the job” that the customer wants done?
- What are the obstacles that currently prevent them from getting the job done?
- What are your customers now using to get the same job done, or why are they putting off doing it?
- How do they know if the job is done or not?
Once you have a clear answer to these questions, you’ll already be well on your way.
2. What are your strengths?
Every business should obviously build their business models to benefit from and take advantage of their own strengths and unique capabilities.
For example, if you have plenty of data and when and how your products break, you’re obviously the party that’s best positioned to provide novel maintenance services, or maybe even insurance for these products.
3. What are your objectives for the business?
Some businesses want to focus on profitability, others want to grow as much as possible, and some simply want to do as good of a job as possible for their customers.
These goals ultimately matter a lot when you’re trying to design the perfect business model as different business models are better suited for different kinds of goals.
Some companies might simply want to find ways to expand their current business with minor tweaks to their model where others might be looking for bigger, more transformative kind of changes.
For example, if you’re looking to maximize growth, you should choose a business model where the customer gets almost all of the value and keep costs down to maximize adoption.
In the short term, you will take a financial hit compared to some of the other models, but this can make the business unattractive for competitors, thus providing you with a big competitive advantage in the long run. The Freemium and open source models are obvious examples of this approach.
4. Look for patterns by benchmarking leading innovators
As mentioned, the best business models are tailored to the needs of your customers, the characteristics of your industry, as well as your business objectives.
Thus, whenever you’re looking to design a new business model, it’s usually a good idea to benchmark what the most innovative companies in the world are currently doing.
You should obviously know where your competition is but remember that the point of business model innovation is to find a way that allows you to provide much more value than they do, either at a lower price or with better margins, maybe even both, so don’t just copy them!
Thus, the best benchmarks are often from very different industries.
As mentioned, the Business Model Navigator is a great resource for this benchmarking process. It’s a website that features 55 different business model patterns that you can try to apply for your own business, including most of the examples we presented above.
5. Put it all together to identify the right model
The next step is to combine your findings from steps 1, 2, 3 and 4. Find ways where you can create as much value for your customers as possible, that uses your strengths, and allows you to capture a fair share of that revenue as determined by your business objectives.
This is obviously the creative part, so it might take some time and effort to get this right, but remember that you can always look at the examples we’ve mentioned above.
You can use the matrix below to map your alternatives and compare them with your objectives.
To generalize, if you currently sell services, you typically want to scale the business to a larger audience and improve margins. For both goals, the way to achieve these goals is to productize the offering. If you succeed in this, you can provide most of the value at a fraction of the cost, which can naturally help you scale the business to a much wider customer base, but also improve the margins of delivering that value.
On the other hand, if you are selling products, you probably want to turn one off sales into a more predictable stream of revenue, as well as grow the amount of business you get from each customer. In this case, the solution is to either sell add-on services that help your customers make the most out of your products, or to look for ways that you could use to turn those one-off product sales into subscriptions with some service components.
6. Validate & iterate
As with any other kind of innovation, you typically don’t get business model innovation right the first time around either.
In the end, the only way to know if it works is by testing the business model in practice.
The challenging part with many business model innovations are that they often require drastic changes to your current operating model, which you obviously shouldn’t do unless you have strong evidence for the transition being worth it.
Thus, it’s crucially important that you validate the assumptions that you’ve done in the steps leading to this point, starting from your most critical assumption, and pilot that with a small subset of your customers.
Validating the business model at smaller scale obviously saves costs and resources, but has another key advantage: speed. Learning and moving fast is essential for innovation success.
Learning and moving fast is essential for innovation success.
Seemingly small tweaks in the business model can make or break even the most brilliant products, so if you have great offerings, be prepared to iterate the business model based on what you learn and don’t give up too easily.
For example, both Post-It notes and Nespresso machines didn’t see commercial success until their respective companies were able to figure out the right ways to package these products with the right business model.
It can sometimes take quite a few of those tweaks to figure out the right business model, even if your products are brilliant, which is why you need to learn, iterate, and move fast when your window of opportunity is still open.
To conclude, business model innovation is a powerful, yet still very underappreciated tool.
It’s one of those topics that is quite straightforward to get the hang of, and can thus help make a difference quite soon.
If you’re not seeing the business results you think you should be getting with your products and services, or you’re looking to take significant market share from entrenched competitors, give business model innovation a try.
This article was originally published in Viima’s blog.
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