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Why Business Models Matter by joan Magretta wu harvard business review Reprint ro205F

Why Business Models Matter by Joan Magretta Reprint r0205f

Harvard Business review WeMay 2002 HBR CASE STUDY RO205A A Pain in the( Supply)Chain John Butman HBR AT LARGE RO205B How Resilience Works Diane l. coutu DIFFERENT VOICE RO205C Turning an Industry Inside Out: A Conversation with robert Redford Change the way you persuade RO205D Gary A. Williams and Robert B. miller HBR SPOTLIGHT: PRACTICAL STRATEGY Divestiture: Strategy's Missing Link RO205E Lee dranikoff, Tim Koller, and Antoon Schneider Why Business Models Matter RO205F Joan Magretta Disruptive Change: When Trying Harder RO205G Is Part of the problem Clark Gilbert and Joseph L. Bower TOOL KIT RO205H Read a plant -Fast R. Eugene Goodson THE ENTREPRENEUR RO205) A Test for the fainthearted Walter Kuemmerle

HBR Case Study r0205a A Pain in the (Supply) Chain John Butman HBR at Large r0205b How Resilience Works Diane L. Coutu Different Voice r0205c Turning an Industry Inside Out: A Conversation with Robert Redford Change the Way You Persuade r0205d Gary A. Williams and Robert B. Miller HBR Spotlight: Practical Strategy Divestiture: Strategy’s Missing Link r0205e Lee Dranikoff, Tim Koller, and Antoon Schneider Why Business Models Matter r0205f Joan Magretta Disruptive Change: When Trying Harder r0205g Is Part of the Problem Clark Gilbert and Joseph L. Bower Tool Kit r0205h Read a Plant – Fast R. Eugene Goodson The Entrepreneur r0205j A Test for the Fainthearted Walter Kuemmerle May 2002

a good business model begins with an insight into human motivations and ends in a rich stream of profits y Business“B= USINESS MODEL was one of the great buzzwords Internet boom, routinely invoked, as the writer Michael Lewis put it, "to glorify all manner Models of half-baked plans. A company didn't need a strategy, or a special competence, or even any customers-all it needed was a Web-based business model that promised wild profits in some distant, ill-defined future. Many Matter people -investors, entrepreneurs, and executives alike bought the fantasy and got burned. and as the inevitable counterreaction played out, the concept of the business modelfelloutoffashionnearlyasquicklyasthe.com appendage itself. by Joan Magretta That's a shame. For while it's true that a lot of capital was raised to fund flawed business models, the fault lies not with the concept of the business model but with its distortion and misuse. A good business model remains Copyright o 2002 by Harvard Business School Publishing Corporation. All rights reserved

Copyright © 2002 by Harvard Business School Publishing Corporation. All rights reserved. 3 “Business model” was one of the great buzzwords of the Internet boom, routinely invoked, as the writer Michael Lewis put it,“to glorify all manner of half-baked plans.” A company didn’t need a strategy, or a special competence, or even any customers – all it needed was a Web-based business model that promised wild profits in some distant, ill-defined future.Many people – investors, entrepreneurs, and executives alike – bought the fantasy and got burned.And as the inevitable counterreaction played out, the concept of the business model fell out of fashion nearly as quickly as the .com appendage itself. That’s a shame.For while it’s true that a lot of capital was raised to fund flawed business models, the fault lies not with the concept of the business model but with its distortion and misuse.A good business model remains Why Business Models Matter by Joan Magretta A good business model begins with an insight into human motivations and ends in a rich stream of profits

HBR Spotlight: Practical Strategy essential to every successful organization, whether it,'s a and pay for it. The traveler's check turned the normal venture or an established player. But before managers cycle of debt and risk on its head. Because people paid can apply the concept, they need a simple working defini- the checks before(often long before)they used them tion that clears up the fuzziness associated with the term. American Express was getting something banks had long enjoyed - the equivalent of an interest-free loan from its Telling a Good Story customers. Moreover, some of the checks were never cashed, giving the company an extra windfall The word"model "conjures up images of white boards As this story shows, a successful business model repre- covered with arcane mathematical formulas. Business sents a better way than the existing alternatives. It may models, though, are anything but arcane. They are, at offer more value to a discrete group of customers. Or it heart,stories-stories that explain how enterprises work. may completely replace the old way of doing things and A good business model answers Peter Drucker's age-old become the standard for the next generation of entrepre- uestions: Who is the customer? And what does the cus- neurs to beat. Nobody today would head off on vacation tomer value? It also answers the fundamental questions armed with a suitcase full of letters of credit.Fargo's busi- every manager must ask: How do we make money in this ness model changed the rules of the game, in this case, the business? What is the underlying economic logic that ex- economics of travel. By eliminating the fear of being plains how we can deliver value to customers at an ap- robbed and the hours spent trying to get cash in a strange propriate cost? city, the checks removed a significant barrier to travel Consider the story behind one of the most successful helping many more people to take many more trips. Like business models of all time: that of the travelers check. all really powerful business models, this one didn't just During a European vacation in 1892, J.C. Fargo, the presi- shift existing revenues among companies; it created new, dent of American Express, had a hard time translating his incremental demand. Traveler's checks remained the letters of credit into cash. "The moment I got off the preferred method for taking money abroad for decades, beaten path, he said on his return, "they were no more until a new technology-the automated teller machi use than so much wet wrapping paper. If the president of granted travelers even greater convenience. American Express has that sort of trouble, just think what Creating a business model is, then, a lot like writing a ordinary travelers face. Something has got to be done new story. At some level, all new stories are variations on about it. "What American Express did was to create the old ones, reworkings of the universal themes underlying traveler's check-and from that innovation evolved a ro all human experience. Similarly, all new business model bust business model with all the elements of a good story: are variations on the generic value chain underlying precisely delineated characters, plausible motivations, all businesses. Broadly speaking, this chain has two and a plot that turns on an insight about value. parts. Part one includes all the activities associated with The story was straightforward for customers. In ex- making something: designing it, purchasing raw materi- change for a small fee, travelers could buy both peace of als, manufacturing, and so on. Part two includes all the ac- mind(the checks were insured against loss and theft)and tivities associated with selling something: finding and convenience(they were very widely accepted). Merchants reaching customers, transacting a sale, distributing the also played a key role in the tale. They accepted the checks product or delivering the service. A new business model's because they trusted the American Express name, which plot may turn on designing a new product for an unmet was like a universal letter of credit, and because, by accept- need, as it did with the traveler's check Or it may turn on ing them, they attracted more customers. The more other a process innovation, a better way of making or selling or merchants accepted the checks, the stronger any individ- distributing an already proven product or service. ual merchant's motivation became not to be left out Think about the simple business that direct-marketing As for American Express, it had discovered a riskless pioneer Michael Bronner created in 1980 when he was a business,because customers always paid cash for the junior at Boston University. Like his classmates, Bronner checks. Therein lies the twist to the plot, the underlying had occasionally bought books of discount coupons for economic logic that turned what would have been an un- local stores and restaurants. Students paid a small fee for remarkable operation into a money machine. The twist the coupon books. But Bronner had a better idea. Yes, the as float. In most businesses, costs precede revenues: Be-I books created value for students, but they had the poten- fore anyone can buy your product, you've got to build it tial to create much more value for merchants, who stood to gain by increasing their sales of pizza and haircuts Joan Magretta is a management consultant and writer and Bronner realized that the key to unlocking that potential a past winner of HBR's McKinsey Award. This article draws was wider distribution-putting a coupon book in every on material from her latest book, What Management Is: student,'s backpack. How It Works, and Why It's Everyone,'s Business(Free That posed two problems. First, as Bronner well knew, Press, 2002). students were often strapped for cash. Giving the book HARVARD BUSINESS REVIEW

essential to every successful organization, whether it’s a new venture or an established player.But before managers can apply the concept, they need a simple working defini￾tion that clears up the fuzziness associated with the term. Telling a Good Story The word “model” conjures up images of white boards covered with arcane mathematical formulas.Business models, though, are anything but arcane.They are, at heart, stories – stories that explain how enterprises work. A good business model answers Peter Drucker’s age-old questions: Who is the customer? And what does the cus￾tomer value? It also answers the fundamental questions every manager must ask: How do we make money in this business? What is the underlying economic logic that ex￾plains how we can deliver value to customers at an ap￾propriate cost? Consider the story behind one of the most successful business models of all time: that of the traveler’s check. During a European vacation in 1892, J.C. Fargo, the presi￾dent of American Express, had a hard time translating his letters of credit into cash.“The moment I got off the beaten path,” he said on his return, “they were no more use than so much wet wrapping paper.If the president of American Express has that sort of trouble, just think what ordinary travelers face.Something has got to be done about it.”1 What American Express did was to create the traveler’s check – and from that innovation evolved a ro￾bust business model with all the elements of a good story: precisely delineated characters, plausible motivations, and a plot that turns on an insight about value. The story was straightforward for customers.In ex￾change for a small fee, travelers could buy both peace of mind (the checks were insured against loss and theft) and convenience (they were very widely accepted).Merchants also played a key role in the tale.They accepted the checks because they trusted the American Express name, which was like a universal letter of credit, and because, by accept￾ing them, they attracted more customers.The more other merchants accepted the checks, the stronger any individ￾ual merchant’s motivation became not to be left out. As for American Express, it had discovered a riskless business, because customers always paid cash for the checks.Therein lies the twist to the plot, the underlying economic logic that turned what would have been an un￾remarkable operation into a money machine.The twist was float. In most businesses, costs precede revenues: Be￾fore anyone can buy your product, you’ve got to build it and pay for it.The traveler’s check turned the normal cycle of debt and risk on its head.Because people paid for the checks before (often long before) they used them, American Express was getting something banks had long enjoyed – the equivalent of an interest-free loan from its customers.Moreover, some of the checks were never cashed, giving the company an extra windfall. As this story shows, a successful business model repre￾sents a better way than the existing alternatives.It may offer more value to a discrete group of customers.Or it may completely replace the old way of doing things and become the standard for the next generation of entrepre￾neurs to beat.Nobody today would head off on vacation armed with a suitcase full of letters of credit.Fargo’s busi￾ness model changed the rules of the game, in this case, the economics of travel.By eliminating the fear of being robbed and the hours spent trying to get cash in a strange city, the checks removed a significant barrier to travel, helping many more people to take many more trips.Like all really powerful business models, this one didn’t just shift existing revenues among companies; it created new, incremental demand.Traveler’s checks remained the preferred method for taking money abroad for decades, until a new technology – the automated teller machine – granted travelers even greater convenience. Creating a business model is, then, a lot like writing a new story.At some level, all new stories are variations on old ones, reworkings of the universal themes underlying all human experience.Similarly, all new business models are variations on the generic value chain underlying all businesses.Broadly speaking, this chain has two parts.Part one includes all the activities associated with making something: designing it, purchasing raw materi￾als, manufacturing, and so on.Part two includes all the ac￾tivities associated with selling something: finding and reaching customers, transacting a sale, distributing the product or delivering the service.A new business model’s plot may turn on designing a new product for an unmet need, as it did with the traveler’s check.Or it may turn on a process innovation, a better way of making or selling or distributing an already proven product or service. Think about the simple business that direct-marketing pioneer Michael Bronner created in 1980 when he was a junior at Boston University.Like his classmates, Bronner had occasionally bought books of discount coupons for local stores and restaurants.Students paid a small fee for the coupon books.But Bronner had a better idea.Yes, the books created value for students, but they had the poten￾tial to create much more value for merchants, who stood to gain by increasing their sales of pizza and haircuts. Bronner realized that the key to unlocking that potential was wider distribution – putting a coupon book in every student’s backpack. That posed two problems.First, as Bronner well knew, students were often strapped for cash.Giving the books 4 harvard business review HBR Spotlight: Practical Strategy Joan Magretta is a management consultant and writer and a past winner of HBR’s McKinsey Award. This article draws on material from her latest book, What Management Is: How It Works, and Why It’s Everyone’s Business (Free Press, 2002)

Why Business Models Matter away for free would solve that problem. Second, Bronner tions that go into it. Once an enterprise starts operatin needed to get the books to students at a cost that wouldn't the underlying assumptions of its model-about both eat up his profits. So he made a clever proposal to the motivations and economics-are subjected to continuous dean of Boston University,'s housing department: Bronner testing in the marketplace. And success often hinges on would assemble the coupon books and management's ability to tweak, or even partment, and the department could dis- Business modeling roDisney opened its paris theme park in tribute them free to every dorm on cam- is the managerial 1992, it borrowed the business model that pus. This would make the department had worked so well in Disneys U.S. parks. look good in the eyes of the students, a equivalent of the Europeans, the company thought, would notoriously tough crowd to please The scientific method- spend roughly the same amount of time Now Bronner could make an even you start with a food. rides, and souvenirs. hood business owners. If they agreed to hypothesis, which the revenue side of the business turned pay a small fee to appear in the new you then test in out to be wrong. Europeans did not, for book, their coupons would be seen by example, graze all day long at the park's all 14,000 residents of BU's dorms. action and revise various restaurants the way Americans Bronner's idea took off. Before long, he when necessary did. Instead, they all expected to b seated at precisely the same lunch or dir puses, then to downtown office build ner hour, which overloaded the facilities ngs. Eastern Exclusives, his first company, was born. His and created long lines of frustrated patrons. Because of innovation wasn't the coupon book but his business those miscalculations, Euro Disney was something of a dis- model; it worked because he had insight into the motiva- aster in its early years. It became a success only after a tions of three sets of characters students, merchants, and dozen or so of the key elements in its business model school administrators were changed, one by one. Tying Narrative to Numbers s When managers operate consciously from a model of how the entire business system will work, every decision, initiative, and measurement provides valuable feedback The term"business model" first came into widespread use Profits are important not only for their own sake but als with the advent of the personal computer and the spread- because they tell you whether your model is working. If sheet.Before the spreadsheet, business planning usually you fail to achieve the results you expected, you reexam- meant producing a single, base-case forecast. At best, you ine your model, as EuroDisney did Business modeling is did a little sensitivity analysis around the projection. The in this sense, the managerial equivalent of the scientific spreadsheet ushered in a much more analytic approach to method-you start with a hypothesis, which you then test planning because every major line item could be pulled in action and revise when necessary. apart, its components and subcomponents analyzed an tested. You could ask what-if questions about the critical assumptions on which your business depended-for ex.I Two Critical Tests ample, what if customers are more price-sensitive than we When business models don,t work,it's because they failei- thought?-and with a few keystrokes, you could see how ther the narrative test(the story doesn't make sense)or any change would play out on every aspect of the whole. the numbers test(the P&l doesn' t add up). the business In other words, you could model the behavior of a busi- model of on-line grocers, for instance, failed the numbers test. The grocery industry has very thin margins to begin This was something new. Before the personal computer with, and on-line merchants like Webvan incurred new changed the nature of business planning, most successful costs for marketing, service, delivery, and technology. dent than by design and forethought. The business model for groceries bought on-line than in stores, there i more business models, like Fargo,s, were created more by acci- Since customers weren,,t willing to pay significantly became clear only after the fact. By enabling companies way the math could work. Internet grocers had plenty of to tie their marketplace insights much more tightly to company. Many ventures in the first wave of electronic the resulting economics-to link their assumptions about commerce failed simply because the basic business math how people would behave to the numbers of a pro formawas flawed P&L--spreadsheets made it possible to model businesses Other business models failed the narrative test Con- before they were launched der the rapid rise and fall of Priceline Webhouse Club Of course, a spreadsheet is only as good as the assump- This was an offshoot of Priceline. com, the company that

away for free would solve that problem.Second, Bronner needed to get the books to students at a cost that wouldn’t eat up his profits.So he made a clever proposal to the dean of Boston University’s housing department: Bronner would assemble the coupon books and deliver them in bulk to the housing de￾partment, and the department could dis￾tribute them free to every dorm on cam￾pus.This would make the department look good in the eyes of the students, a notoriously tough crowd to please.The dean agreed. Now Bronner could make an even more interesting proposal to neighbor￾hood business owners.If they agreed to pay a small fee to appear in the new book, their coupons would be seen by all 14,000 residents of BU’s dorms. Bronner’s idea took off.Before long, he had extended the concept to other cam￾puses, then to downtown office build￾ings.Eastern Exclusives, his first company, was born.His innovation wasn’t the coupon book but his business model; it worked because he had insight into the motiva￾tions of three sets of characters: students, merchants, and school administrators. Tying Narrative to Numbers The term “business model”first came into widespread use with the advent of the personal computer and the spread￾sheet.Before the spreadsheet, business planning usually meant producing a single, base-case forecast.At best, you did a little sensitivity analysis around the projection.The spreadsheet ushered in a much more analytic approach to planning because every major line item could be pulled apart, its components and subcomponents analyzed and tested.You could ask what-if questions about the critical assumptions on which your business depended – for ex￾ample, what if customers are more price-sensitive than we thought? – and with a few keystrokes, you could see how any change would play out on every aspect of the whole. In other words, you could model the behavior of a busi￾ness. This was something new.Before the personal computer changed the nature of business planning, most successful business models, like Fargo’s, were created more by acci￾dent than by design and forethought.The business model became clear only after the fact.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. Of course, a spreadsheet is only as good as the assump￾tions that go into it.Once an enterprise starts operating, the underlying assumptions of its model – about both motivations and economics – are subjected to continuous testing in the marketplace.And success often hinges on management’s ability to tweak, or even overhaul, the model on the fly.When Eu￾roDisney opened its Paris theme park in 1992,it borrowed the business model that had worked so well in Disney’s U.S. parks. Europeans, the company thought, would spend roughly the same amount of time and money per visit as Americans did on food, rides, and souvenirs. Each of Disney’s assumptions about the revenue side of the business turned out to be wrong.Europeans did not, for example, graze all day long at the park’s various restaurants the way Americans did.Instead, they all expected to be seated at precisely the same lunch or din￾ner hour, which overloaded the facilities and created long lines of frustrated patrons.Because of those miscalculations, EuroDisney was something of a dis￾aster in its early years.It became a success only after a dozen or so of the key elements in its business model were changed, one by one. When managers operate consciously from a model of how the entire business system will work, every decision, initiative, and measurement provides valuable feedback. Profits are important not only for their own sake but also because they tell you whether your model is working.If you fail to achieve the results you expected, you reexam￾ine your model, as EuroDisney did.Business modeling is, in this sense, the managerial equivalent of the scientific method – you start with a hypothesis, which you then test in action and revise when necessary. Two Critical Tests When business models don’t work, it’s because they fail ei￾ther the narrative test (the story doesn’t make sense) or the numbers test (the P&L doesn’t add up).The business model of on-line grocers, for instance, failed the numbers test.The grocery industry has very thin margins to begin with, and on-line merchants like Webvan incurred new costs for marketing, service, delivery, and technology. Since customers weren’t willing to pay significantly more for groceries bought on-line than in stores, there was no way the math could work.Internet grocers had plenty of company.Many ventures in the first wave of electronic commerce failed simply because the basic business math was flawed. Other business models failed the narrative test.Con￾sider the rapid rise and fall of Priceline Webhouse Club. This was an offshoot of Priceline.com, the company that may 2002 5 Why Business Models Matter 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

HBR Spotlight: Practical Strategy introduced name-your-own pricing to the purchase of air- nesses. A business model's great strength as a planning line tickets. Wall Street's early enthusiasm encouraged tool is that it focuses attention on how all the elements of CEO Jay Walker to extend his concept to groceries and the system fit into a working whole It's no surprise that even during the Internet boom, executives who grasped Here's the story Walker tried to tell. Via the Web, mil- the basics of business model thinking were in a better pe ons of consumers would tell him how much they wanted sition to lead the winners. Meg whitman for example, to pay for, say, a jar of peanut butter joined eBay in its early days because Consumers could specify the price but A business model she was struck by what she described not the brand, so they might end up as"the emotional connection between with Jif or they might end up with isnt the same thing eBay users and the site. The way peo- Skippy. Webhouse would then aggre- ple behaved was an early indicator of gate the bids and go to companies like as a strategy, even the potential power of the e Bay brand. P&G and Bestfoods and try to make though many people like many Internet businesses that Whitman also realized that eBay, un- your peanut butter, and we'll order use the terms inter- were being created, simply "couldnt wanted to be a power broker for ind:- changeably today. a million jars this w eek. Webhouse be done off-line, In other words whit- man-a seasoned executive-saw vidual consumers: Representing mil compelling, coherent narrative with lions of shoppers, it would negotiate discounts and then the potential to be translated into a profitable business. ass on the savings to its customers, taking a fee in the Whitman has remained attentive to the psychology process. nd the economics that draw collectors, bargain hunters, What was wrong with the story? It assumed that com- community seekers, and small-business people to eBay panies like P&G, Kimberly-Clark, and Exxon wanted to Its auction model succeeds not just because the Internet play this game. Think about that for a minute. Big con- lowers the cost of connecting vast numbers of buyers and umer companies have spent decades and billions of dol- sellers but also because eBay has made decisions about lars building brand loyalty. The Webhouse model teaches the scope of its activities that result in an appropriate cost consumers to buy on price alone. So why would the man- structure. After an auction, eBay leaves it to the sellers facturers want to help Webhouse undermine both their and buyers to work out the logistics of payment and ship- prices and the brand identities they'd worked so hard to ping. The company never takes possession of the goods build?They wouldn't. The story just didnt make sense. To or carries any inventory. It incurs no transportation costs be a power broker, Webhouse needed a huge base of loyal It bears no credit risk. And it has none of the overhead customers. To get those customers, it first needed to de- that would come with those activities. liver discounts. Since the consumer product companies refused to play, We bouse had to pay for those discounts What About Strategy? in October 2000, it ran out of cash-and out of investors Every viable organization is built on a sound business who still believed the story. model, whether or not its founders or its managers con- In case anyone thinks that Internet entrepreneurs have ceive of what they do in those terms. But a business model a monopoly on flawed business models, think again. We isn,'t the same thing as a strategy, even though many peo- tend to forget about ideas that don't pan out, but business ple use the terms interchangeably today. Business models history is littered with them. In the 1980S, the one-stop describe, as a system, how the pieces of a business fit to- financial supermarket was a business model that fired gether. But they don't factor in one critical dimension of the imagination of many executives-but Sears, to cite performance: competition. Sooner or later-and it is usu- one example, discovered that its customers just didn, t get ally sooner-every enterprise runs into competitors.Deal- the connection between power tools and annuities In the ing with that reality is strategy,'s job 1990s, Silicon Graphics invested hundreds of millions A competitive strategy explains how you will do better dollars in interactive television, but it was unable to find than your rivals. And doing better, by definition, means real customers who were as enchanted by the technology being different. Organizations achieve superior perfor as the engineers who invented it. Ultimately, models like mance when they are unique, when they do somethingno hese fail because they are built on faulty assumptions other business does in ways that no other business can du about customer behavior. They are solutions in search of plicate. When you cut away the jargon, thats what strat- a problem. egy is all about-how you are going to do better by being The irony about the slipshod use of the concept of different. The logic is straightforward: When all compa- business models is that when used correctly, it actually nies offer the same products and services to the same cus- forces managers to think rigorously about their busi- tomers by performing the same kinds of activities, no HARVARD BUSINESS REVIEW

introduced name-your-own pricing to the purchase of air￾line tickets.Wall Street’s early enthusiasm encouraged CEO Jay Walker to extend his concept to groceries and gasoline. Here’s the story Walker tried to tell.Via the Web, mil￾lions of consumers would tell him how much they wanted to pay for, say, a jar of peanut butter. Consumers could specify the price but not the brand, so they might end up with Jif or they might end up with Skippy.Webhouse would then aggre￾gate the bids and go to companies like P&G and Bestfoods and try to make a deal: Take 50 cents off the price of your peanut butter, and we’ll order a million jars this week.Webhouse wanted to be a power broker for indi￾vidual consumers: Representing mil￾lions of shoppers, it would negotiate discounts and then pass on the savings to its customers, taking a fee in the process. What was wrong with the story? It assumed that com￾panies like P&G, Kimberly-Clark, and Exxon wanted to play this game.Think about that for a minute.Big con￾sumer companies have spent decades and billions of dol￾lars building brand loyalty.The Webhouse model teaches consumers to buy on price alone.So why would the man￾ufacturers want to help Webhouse undermine both their prices and the brand identities they’d worked so hard to build? They wouldn’t.The story just didn’t make sense.To be a power broker, Webhouse needed a huge base of loyal customers.To get those customers, it first needed to de￾liver discounts.Since the consumer product companies refused to play, Webhouse had to pay for those discounts out of its own pocket.A few hundred million dollars later, in October 2000, it ran out of cash – and out of investors who still believed the story. In case anyone thinks that Internet entrepreneurs have a monopoly on flawed business models, think again.We tend to forget about ideas that don’t pan out, but business history is littered with them.In the 1980s, the one-stop financial supermarket was a business model that fired the imagination of many executives – but Sears, to cite one example, discovered that its customers just didn’t get the connection between power tools and annuities.In the 1990s, Silicon Graphics invested hundreds of millions of dollars in interactive television, but it was unable to find real customers who were as enchanted by the technology as the engineers who invented it.Ultimately, models like these fail because they are built on faulty assumptions about customer behavior.They are solutions in search of a problem. The irony about the slipshod use of the concept of business models is that when used correctly, it actually forces managers to think rigorously about their busi￾nesses.A business model’s great strength as a planning tool is that it focuses attention on how all the elements of the system fit into a working whole.It’s no surprise that, even during the Internet boom, executives who grasped the basics of business model thinking were in a better po￾sition to lead the winners.Meg Whitman, for example, joined eBay in its early days because she was struck by what she described as “the emotional connection between eBay users and the site.”2 The way peo￾ple behaved was an early indicator of the potential power of the eBay brand. Whitman also realized that eBay, un￾like many Internet businesses that were being created, simply “couldn’t be done off-line.”In other words, Whit￾man – a seasoned executive – saw a compelling, coherent narrative with the potential to be translated into a profitable business. Whitman has remained attentive to the psychology and the economics that draw collectors, bargain hunters, community seekers, and small-business people to eBay. Its auction model succeeds not just because the Internet lowers the cost of connecting vast numbers of buyers and sellers but also because eBay has made decisions about the scope of its activities that result in an appropriate cost structure.After an auction, eBay leaves it to the sellers and buyers to work out the logistics of payment and ship￾ping.The company never takes possession of the goods or carries any inventory.It incurs no transportation costs. It bears no credit risk.And it has none of the overhead that would come with those activities. What About Strategy? Every viable organization is built on a sound business model, whether or not its founders or its managers con￾ceive of what they do in those terms.But a business model isn’t the same thing as a strategy, even though many peo￾ple use the terms interchangeably today.Business models describe, as a system, how the pieces of a business fit to￾gether.But they don’t factor in one critical dimension of performance: competition.Sooner or later – and it is usu￾ally sooner – every enterprise runs into competitors.Deal￾ing with that reality is strategy’s job. A competitive strategy explains how you will do better than your rivals.And doing better, by definition, means being different.Organizations achieve superior perfor￾mance when they are unique, when they do something no other business does in ways that no other business can du￾plicate.When you cut away the jargon, that’s what strat￾egy is all about – how you are going to do better by being different.The logic is straightforward: When all compa￾nies offer the same products and services to the same cus￾tomers by performing the same kinds of activities, no 6 harvard business review HBR Spotlight: Practical Strategy A business model isn’t the same thing as a strategy, even though many people use the terms inter￾changeably today

Why Business Models Matter company will prosper. Customers will benefit, at least in lated rural towns, like Rogers, with populations between the short term, while head-to-head competition drives 5, 0oo and 25,000. Being a small-town guy himself,Walton prices down to a point where returns are inadequate. It knew the terrain well. The nearest city was probably a was precisely this kind of competition-destructive com- four-hour drive away. He rightly bet that if his stores could etition, to use Michael Porters term-that did in many match or beat the city prices, "people would shop at nternet retailers, whether they were selling pet supplies,I home. " And since Wal-Mart's markets tended to be too drugs,or toys. Too many fledgling companies rushed to small to support more than one large retailer, Walton was market with identical business models and no strategies able to preempt competitors and discourage them from to differentiate themselves in terms of which customers entering Wal-Marts territory. and markets to serve, what products and services to offer, Wal-Mart also took a different approach to merchan- and what kinds of value to create dising and pricing than its competitors did-that is, it To see the distinction between a strategy and a business promised customers a different kind of value. While com- that the giant retailer's success was a brands, and price promotions, Wal- result of pioneering a new business When a new mod Mart promised national brands at Sam walton opened his first Wal- changes the economics veryday low prices. To make this romise more than a marketing slo- Mart inin the hamlet of Rogers, of an industry and is gan, the company pursued efficiency ness model had been around for a difficult to replicate and reduced costs through innova- tive practices in areas such as pur- few years. It had emerged in the mid. it can by itself create chasing, logistics, and information 1950s, when a slew of industry pio- neers(now long forgotten) began to a strong competitive The business model of discount re. apply supermarket logic to the sale of general merchandise. Supermar- advantage. tailing has attracted many players since it emerged in the 1950s. Most kets had been educating customers of them have failed. a few like Wal- since the 1930s about the value of giving up personal Mart and Target, have achieved superior performance service in exchange for lower food prices, and the new over the long haul because their strategies set them apart. breed of retailers saw that they could adapt the basic story Wal-Mart offers branded goods for less to a carefully cho- line of the supermarket to clothing, appliances, and a host sen customer base. Target built a strategy around a dif- of other consumer goods. The idea was to offer lower ferent kind of value-style and fashion. The losers in the prices than conventional department stores by slashing industry-the chronic underperformers like Kmart-are costs And so the basic business model for discount retail- companies that tried to be all things to all people. They took shape: First, strip away the department store's failed to find distinctive ways to compete ohysical amenities such as the carpeting and the chande iers.Second,configure the stores to handle large num-I A Good Model Is Not Enoug bers of shoppers efficiently. And third, put fewer sales- people on the floor and rely on customers to serve There's another, more recent story that sheds further light themselves Do those things well, and you could offer low on the relationship between business models and strate- prices and still make money. gies It's the story of Dell Computer. Unlike Sam Walton, out on his own, borrowing a lot of ideas for his early stores personal-computer makers sold through resellers,Dell from Kmart and others. But it was what he chose to do sold directly to end customers. That not only cut out a differently-the ways he put his own stamp on the basic costly link from the value chain, it also gave Dell the infor business model-that made Wal-Mart so fabulously suc- mation it needed to manage inventory better than any cessful. His model was the same as Kmart's, but his strat- other company in its industry. And because the pace of in- novation in the industry was intense, Dell's inventory ad- From the very start, for instance, Walton chose to serve vantage meant it could avoid the high cost of obsoles- a different group of customers in a different set of mar- cence that other computer makers had to bear. Armed kets. The ten largest discounters in 1962, all gone today, with its innovative business model, Dell has consistently focused on large metropolitan areas and cities like New outperformed rivals for more than a decade York. Wal-Mart's "key strategy in Walton's own words, In this case, Dell's business model functioned much like "was to put good-sized stores into little one-horse towns a strategy: It made Dell different in ways that were hard which everybody else was ignoring,"He sought out iso- to copy. If Dell's rivals tried to sell direct, they would dis

company will prosper.Customers will benefit, at least in the short term, while head-to-head competition drives prices down to a point where returns are inadequate.It was precisely this kind of competition – destructive com￾petition, to use Michael Porter’s term – that did in many Internet retailers, whether they were selling pet supplies, drugs, or toys.Too many fledgling companies rushed to market with identical business models and no strategies to differentiate themselves in terms of which customers and markets to serve, what products and services to offer, and what kinds of value to create. To see the distinction between a strategy and a business model, you need only look at Wal-Mart.You might think that the giant retailer’s success was a result of pioneering a new business model, but that’s not the case.When Sam Walton opened his first Wal￾Mart in 1962 in the hamlet of Rogers, Arkansas, the discount-retailing busi￾ness model had been around for a few years.It had emerged in the mid- 1950s, when a slew of industry pio￾neers (now long forgotten) began to apply supermarket logic to the sale of general merchandise.Supermar￾kets had been educating customers since the 1930s about the value of giving up personal service in exchange for lower food prices, and the new breed of retailers saw that they could adapt the basic story line of the supermarket to clothing, appliances, and a host of other consumer goods.The idea was to offer lower prices than conventional department stores by slashing costs.And so the basic business model for discount retail￾ing took shape: First, strip away the department store’s physical amenities such as the carpeting and the chande￾liers.Second, configure the stores to handle large num￾bers of shoppers efficiently.And third, put fewer sales￾people on the floor and rely on customers to serve themselves.Do those things well, and you could offer low prices and still make money. Walton heard about the new discount stores, visited a few, and liked their potential.In 1962, he decided to set out on his own, borrowing a lot of ideas for his early stores from Kmart and others.But it was what he chose to do differently – the ways he put his own stamp on the basic business model – that made Wal-Mart so fabulously suc￾cessful.His model was the same as Kmart’s, but his strat￾egy was unique. From the very start, for instance, Walton chose to serve a different group of customers in a different set of mar￾kets.The ten largest discounters in 1962, all gone today, focused on large metropolitan areas and cities like New York.Wal-Mart’s “key strategy,” in Walton’s own words, “was to put good-sized stores into little one-horse towns which everybody else was ignoring.”3 He sought out iso￾may 2002 7 Why Business Models Matter lated rural towns, like Rogers, with populations between 5,000 and 25,000.Being a small-town guy himself, Walton knew the terrain well.The nearest city was probably a four-hour drive away.He rightly bet that if his stores could match or beat the city prices, “people would shop at home.” And since Wal-Mart’s markets tended to be too small to support more than one large retailer, Walton was able to preempt competitors and discourage them from entering Wal-Mart’s territory. Wal-Mart also took a different approach to merchan￾dising and pricing than its competitors did – that is, it promised customers a different kind of value.While com￾petitors relied heavily on private label goods, second-tier brands, and price promotions, Wal￾Mart promised national brands at everyday low prices.To make this promise more than a marketing slo￾gan, the company pursued efficiency and reduced costs through innova￾tive practices in areas such as pur￾chasing, logistics, and information management. The business model of discount re￾tailing has attracted many players since it emerged in the 1950s.Most of them have failed.A few, like Wal￾Mart and Target, have achieved superior performance over the long haul because their strategies set them apart. Wal-Mart offers branded goods for less to a carefully cho￾sen customer base.Target built a strategy around a dif￾ferent kind of value – style and fashion.The losers in the industry – the chronic underperformers like Kmart – are companies that tried to be all things to all people.They failed to find distinctive ways to compete. A Good Model Is Not Enough There’s another, more recent story that sheds further light on the relationship between business models and strate￾gies.It’s the story of Dell Computer.Unlike Sam Walton, Michael Dell was a true business-model pioneer.The model he created is, by now, well known: While other personal-computer makers sold through resellers, Dell sold directly to end customers.That not only cut out a costly link from the value chain, it also gave Dell the infor￾mation it needed to manage inventory better than any other company in its industry.And because the pace of in￾novation in the industry was intense, Dell’s inventory ad￾vantage meant it could avoid the high cost of obsoles￾cence that other computer makers had to bear.Armed with its innovative business model, Dell has consistently outperformed rivals for more than a decade. In this case, Dell’s business model functioned much like a strategy: It made Dell different in ways that were hard to copy.If Dell’s rivals tried to sell direct, they would dis￾When a new model changes the economics of an industry and is difficult to replicate, it can by itself create a strong competitive advantage

HBR Spotlight: Practical Strategy rupt their existing distribution channels and alienate the portunities in new product markets, like servers, that have resellers on whom they relied. Trapped by their own greater profit potential than PCs. The underlying busi- trategies,they were damned if they copied Dell and ness model remains the same. The strategic choices about damned if they didn't When a new model changes the where to apply the model-which geographic markets, economics of an industry and is difficult to replicate, it can which segments, which customers, which products-are by itself create a strong competitive advantage What often gets lost in Dell's story, though, is the role Clarity about its business model has helped Dell in an- hat pure strategy has played in the company's superior other way: as a basis for employee communication and performance. While Dell's direct business model laid out motivation. Because a business model tells a good story, which value chain activities Dell would do(and which it it can be used to get everyone in the organization aligned wouldn't do), the company still had crucial strategic around the kind of value the company wants to create. choices to make about which customers to serve and Stories are easy to grasp and easy to remember.They what kinds of products and services to offer. In the 1990s, help individuals to see their own jobs within the larger for example, while other PC makers focused on comput- context of what the company is trying to do and to tailor rs for the home market, Dell consciously chose to go their behavior accordingly. Used in this way, a good busi- after large corporate accounts, which were far more prof- ness model can become a powerful tool for improving itable. Other PC makers offered low-end machines to lureexecution in first-time buyers. Michael Dell wasnt interested in this no-margin"business. He staked out his territory selling Today, "business model " and"strategy"are among the more powerful, higher margin computers. most sloppily used terms in business; they are often Then, because Dell sold direct and could analyze its cus- stretched to mean everything-and end up meaning noth- tomers in depth, it began to notice that its average selling ing. But as the experiences of companies like Dell and price to consumers was increasing while the industry's Wal-Mart show, these are concepts with enormous prac- was falling. Consumers who were buying their second or tical value It's true that any attempt to drawsharp bound- third machines and who were looking for more power aries around abstract terms involves some arbitrary and less hand-holding were coming to Dell-even though choices. But unless we're willing to draw the line some- it wasn't targeting them. Only in 1997, after it had a prof- where, these concepts will remain confusing and difficult itable, billion-dollar consumer business, did Dell dedicate to use Definition brings clarity. And when it comes to a group to serving the consumer segment. concepts that are so fundamental to performance, no or- Now that everyone in its industry is selling direct, Dell's ganization can afford fuzzy thinking. strategy has shifted to deal with the new competitive re- alities. With a decade-long lead, Dell is by far the indus- 1James C. Collins and Jerry L Porras, Built to Last (HarperCollins,1994. try's best executor of the direct-selling model-it is the 2. "Meg Whitman at eBay Inc(A)" HBS case no. g-400-035. low-cost producer. So it is using its cost advantage in PCs 3."Wa-Mart Stores, Inc. HBS case no.9-794024 compete on price, to gain share, and to drive the weaker players out of the business. At the same time, the com- Reprint RO205F pany is relying on its core business model to pursue op To place an order, call 1-800-988-0886 HARVARD BUSINESS REVIEW

rupt their existing distribution channels and alienate the resellers on whom they relied.Trapped by their own strategies, they were damned if they copied Dell and damned if they didn’t.When a new model changes the economics of an industry and is difficult to replicate, it can by itself create a strong competitive advantage. What often gets lost in Dell’s story, though, is the role that pure strategy has played in the company’s superior performance.While Dell’s direct business model laid out which value chain activities Dell would do (and which it wouldn’t do), the company still had crucial strategic choices to make about which customers to serve and what kinds of products and services to offer.In the 1990s, for example, while other PC makers focused on comput￾ers for the home market, Dell consciously chose to go after large corporate accounts, which were far more prof￾itable.Other PC makers offered low-end machines to lure in first-time buyers.Michael Dell wasn’t interested in this “no-margin” business.He staked out his territory selling more powerful, higher margin computers. Then, because Dell sold direct and could analyze its cus￾tomers in depth, it began to notice that its average selling price to consumers was increasing while the industry’s was falling.Consumers who were buying their second or third machines and who were looking for more power and less hand-holding were coming to Dell – even though it wasn’t targeting them.Only in 1997, after it had a prof￾itable, billion-dollar consumer business, did Dell dedicate a group to serving the consumer segment. Now that everyone in its industry is selling direct, Dell’s strategy has shifted to deal with the new competitive re￾alities.With a decade-long lead, Dell is by far the indus￾try’s best executor of the direct-selling model – it is the low-cost producer.So it is using its cost advantage in PCs to compete on price, to gain share, and to drive the weaker players out of the business.At the same time, the com￾pany is relying on its core business model to pursue op- 8 harvard business review HBR Spotlight: Practical Strategy portunities in new product markets, like servers, that have greater profit potential than PCs.The underlying busi￾ness model remains the same.The strategic choices about where to apply the model – which geographic markets, which segments, which customers, which products – are what change. Clarity about its business model has helped Dell in an￾other way: as a basis for employee communication and motivation.Because a business model tells a good story, it can be used to get everyone in the organization aligned around the kind of value the company wants to create. Stories are easy to grasp and easy to remember.They help individuals to see their own jobs within the larger context of what the company is trying to do and to tailor their behavior accordingly.Used in this way, a good busi￾ness model can become a powerful tool for improving execution. • • • Today, “business model” and “strategy” are among the most sloppily used terms in business; they are often stretched to mean everything – and end up meaning noth￾ing.But as the experiences of companies like Dell and Wal-Mart show, these are concepts with enormous prac￾tical value.It’s true that any attempt to draw sharp bound￾aries around abstract terms involves some arbitrary choices.But unless we’re willing to draw the line some￾where, these concepts will remain confusing and difficult to use.Definition brings clarity.And when it comes to concepts that are so fundamental to performance, no or￾ganization can afford fuzzy thinking. 1.James C.Collins and Jerry I.Porras, Built to Last (HarperCollins, 1994). 2.“Meg Whitman at eBay Inc.(A),” HBS case no.9-400-035. 3.“Wal-Mart Stores, Inc.,” HBS case no.9-794-024. Reprint r0205f To place an order, call 1-800-988-0886