Working paper WP no 713 IESE November, 2007 University of Navarra COMPETING THROUGH BUSINESS MODELS Ramon Casadesus-Masanell Joan E Ricart IESE Business School-University of Navarra Avda. Pearson, 21-08034 Barcelona, Spain TeL. (+34)93 253 42 00 Fax: (+34)93 2534343 amino del Cerro del Aguila, 3(Ctra. de Castilla, km 5, 180)-28023 Madrid, Spain. TeL. (+34)91 357 08 09 Fax: (+34)91 3572913 Copyright@ 2007 IESE Business School
IESE Business School-University of Navarra - 1 COMPETING THROUGH BUSINESS MODELS Ramon Casadesus-Masanell Joan E. Ricart IESE Business School – University of Navarra Avda. Pearson, 21 – 08034 Barcelona, Spain. Tel.: (+34) 93 253 42 00 Fax: (+34) 93 253 43 43 Camino del Cerro del Águila, 3 (Ctra. de Castilla, km 5,180) – 28023 Madrid, Spain. Tel.: (+34) 91 357 08 09 Fax: (+34) 91 357 29 13 Copyright © 2007 IESE Business School. Working Paper WP no 713 November, 2007
COMPETING THROUGH BUSINESS MODELS Ramon Casadesus-Masanell Joan e ricart Abstract In this article a business model is defined as a companys choice of policies and assets, governance structure of those policies and assets, and their consequences, whether flexible rigid. We also provide a way to represent such business models to highlight dynamic loops and to facilitate an understanding of the interaction with other business models. Furthermore, we develop some tests to evaluate the business model both in isolation as well as in interaction with other business models from different organizations, such as competitors, complementary organizations, suppliers, partners, and others Professor, General Management, Harvard Business School Professor, General Management, IESE Keywords: Business model, Interaction, Competitive Strategy, Competitive Dynamics
IESE Business School-University of Navarra COMPETING THROUGH BUSINESS MODELS Ramon Casadesus-Masanell1 Joan E. Ricart2 Abstract In this article a business model is defined as a company’s choice of policies and assets, the governance structure of those policies and assets, and their consequences, whether flexible or rigid. We also provide a way to represent such business models to highlight dynamic loops and to facilitate an understanding of the interaction with other business models. Furthermore, we develop some tests to evaluate the business model both in isolation as well as in interaction with other business models from different organizations, such as competitors, complementary organizations, suppliers, partners, and others. 1 Professor, General Management, Harvard Business School 2 Professor, General Management, IESE Keywords: Business model, Interaction, Competitive Strategy, Competitive Dynamics
COMPETING THROUGH BUSINESS MODELS Business model innovation is becoming one of the main forces driving strategic renewal efforts of businesses around the world. IBM,s 2006 "Global CEo Study, for example, shows that top management in a broad range of industries are actively seeking guidance on how to innovate in their business models to improve their ability to both create and capture value. While the expression"business model"has been a part of business jargon for a long time, there is no widely accepted definition of what it really means. Its origins can be traced back to the writings of Peter Drucker (1954), but the notion has only gained prominence among both academics and practitioners in the last decade or so. This is not to say that organizations did not have or use business models prior to this recent wave of interest, but rather that, because business models of industry players were for the most part similar, the business model did not receive the attention that it does today. Advances in information and communication technologies have driven the recent interest in business model design and business model innovation. Many of the so-called"e-businesses constitute new business models(Evans and Wurster, 1997; Varian and Shapiro, 1999). Shafer Smith, and Linder(2005) present twelve recent definitions of business model and find that eight are related to e-business of course, not all business model innovations are It-driven; other forces such as globalization and deregulation have also resulted in new business models and fuelled the interest in this area New strategies for the bottom of the pyramid in emerging markets (Ricart et al., 2004)have also steered researchers and practitioners towards the systematic study of business models. Most academics working in this area agree that, for companies to be effective in such "different environments, they need to develop novel business models(Prahalad and Hart, 2002; London and Hart, 2003). In fact, socially motivated enterprises that aim to reach the bottom of th pyramid constitute an important source of business model innovations(Hart and Christensen, 2002; Prahalad, 2005) It is certainly not controversial to state that, in order for organizations to thrive, managers must have a good understanding of how business models work. Nevertheless, the academic community has so far offered little insight on this issue. In truth little is understood about what constitutes a superior business model, or even what a business model really is. This chapter attempts to remedy this state of affairs. We thank Giambattista Dagnino, Pankaj Ghemawat, Costas Markides, Jan Rivkin, and seminar participants at IESE's "Brown Bag"Seminar series and the 2007 Meetings of the Academy of Management (Philadelphia). Casadesus-Masanell is grateful to the HBs Division of Research and IESe Business Schools Public-Private Sector Research Center
IESE Business School-University of Navarra COMPETING THROUGH BUSINESS MODELS∗ Business model innovation is becoming one of the main forces driving strategic renewal efforts of businesses around the world. IBM’s 2006 “Global CEO Study,” for example, shows that top management in a broad range of industries are actively seeking guidance on how to innovate in their business models to improve their ability to both create and capture value. While the expression “business model” has been a part of business jargon for a long time, there is no widely accepted definition of what it really means. Its origins can be traced back to the writings of Peter Drucker (1954), but the notion has only gained prominence among both academics and practitioners in the last decade or so. This is not to say that organizations did not have or use business models prior to this recent wave of interest, but rather that, because business models of industry players were for the most part similar, the business model did not receive the attention that it does today. Advances in information and communication technologies have driven the recent interest in business model design and business model innovation. Many of the so-called “e-businesses” constitute new business models (Evans and Wurster, 1997; Varian and Shapiro, 1999). Shafer, Smith, and Linder (2005) present twelve recent definitions of business model and find that eight are related to e-business. Of course, not all business model innovations are IT-driven; other forces such as globalization and deregulation have also resulted in new business models and fuelled the interest in this area. New strategies for the bottom of the pyramid in emerging markets (Ricart et al., 2004) have also steered researchers and practitioners towards the systematic study of business models. Most academics working in this area agree that, for companies to be effective in such “different” environments, they need to develop novel business models (Prahalad and Hart, 2002; London and Hart, 2003). In fact, socially motivated enterprises that aim to reach the bottom of the pyramid constitute an important source of business model innovations (Hart and Christensen, 2002; Prahalad, 2005). It is certainly not controversial to state that, in order for organizations to thrive, managers must have a good understanding of how business models work. Nevertheless, the academic community has so far offered little insight on this issue. In truth little is understood about what constitutes a superior business model, or even what a business model really is. This chapter attempts to remedy this state of affairs. ∗ We thank Giambattista Dagnino, Pankaj Ghemawat, Costas Markides, Jan Rivkin, and seminar participants at IESE’s “Brown Bag” Seminar series and the 2007 Meetings of the Academy of Management (Philadelphia). Casadesus-Masanell is grateful to the HBS Division of Research and IESE Business School's Public-Private Sector Research Center
What Is a Business model? Although there is no generally accepted definition of business model, practitioners and academics often talk loosely of a business model as"the way the company operates. " While we share this view to an extent, we must provide a more specific definition to make progress. To this end, we review existing work and base our definition on earlier notions Magretta (2002) defines business models as"stories that explain how enterprises work. "This author goes back to Peter Drucker and defines"a good business model"as the one that provides answers to the following questions Who is the customer and what does the costumer value? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost? Magretta's implicit idea is that the term "business model"refers to the logic by which the organization eams money. While not formal, Magretta's approach highlights two fundamental questions that any business model should answer: one related to the value provided to the client and the other to the organizations ability to capture value in the process of serving customers While Magretta's definition is broad and imprecise, Amit and Zott's(2001)is narrow (as it focuses on e-businesses) but precise. These authors review the contributions of several theories including virtual markets, Schumpeterian innovation, value-chain analysis, the resource-based view of the company, dynamic capabilities, transaction cost economics, and strategic networks. they point out, every theory contributes elements to the notion but none, by itself, completely explains the nature of business models. Amit and Zott analyze a sample of U.s. and European e-business models to highlight the drivers of value creation and present the following integrated definition: a business model depicts the content, structure, and governance of transactions designed so as to create value through the exploitation of business opportunities (page 511). Transaction content refers to the goods or information being exchanged, as well as to the resources and capabilities required. Transaction structure refers to the parties that participate, their links, and the way they choose to operate. Finally, transaction governance refers to the way flows of information, resources, and goods are controlled by the relevant parties, the legal form of organization, and the incentives to the participants. As mentioned above, Shafer, Smith, and Linder (2005) uncovered twelve definitions published from 1998 to 2002, and they developed an affinity diagram to identify four major categories common to all or most definitions: strategic choices, creating value, capturing value, and the value network. Therefore, consistent with the intuitive view of the concept, a business model is defined by strategic choices, sometimes made by a network of organizations, that explain value creation and value capture. From this we conclude that an important component of business models are the specific choices made by management on how the organization must operate. For example, choices regarding things such as compensation practices, procurement contracts, location of facilities, employed, extent of vertical integration, or sales and marketing initiatives are, for the part, choices made by management that define "the way the company operates
2 - IESE Business School-University of Navarra What Is a Business Model? Although there is no generally accepted definition of business model, practitioners and academics often talk loosely of a business model as “the way the company operates.” While we share this view to an extent, we must provide a more specific definition to make progress. To this end, we review existing work and base our definition on earlier notions. Magretta (2002) defines business models as “stories that explain how enterprises work.” This author goes back to Peter Drucker and defines “a good business model” as the one that provides answers to the following questions: • Who is the customer and what does the costumer value? • What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost? Magretta’s implicit idea is that the term “business model” refers to the logic by which the organization earns money. While not formal, Magretta’s approach highlights two fundamental questions that any business model should answer: one related to the value provided to the client and the other to the organization’s ability to capture value in the process of serving customers. While Magretta’s definition is broad and imprecise, Amit and Zott’s (2001) is narrow (as it focuses on e-businesses) but precise. These authors review the contributions of several theories including virtual markets, Schumpeterian innovation, value-chain analysis, the resource-based view of the company, dynamic capabilities, transaction cost economics, and strategic networks. As they point out, every theory contributes elements to the notion but none, by itself, completely explains the nature of business models. Amit and Zott analyze a sample of U.S. and European e-business models to highlight the drivers of value creation and present the following integrated definition: “A business model depicts the content, structure, and governance of transactions designed so as to create value through the exploitation of business opportunities” (page 511). Transaction content refers to the goods or information being exchanged, as well as to the resources and capabilities required. Transaction structure refers to the parties that participate, their links, and the way they choose to operate. Finally, transaction governance refers to the way flows of information, resources, and goods are controlled by the relevant parties, the legal form of organization, and the incentives to the participants. As mentioned above, Shafer, Smith, and Linder (2005) uncovered twelve definitions published from 1998 to 2002, and they developed an affinity diagram to identify four major categories common to all or most definitions: strategic choices, creating value, capturing value, and the value network. Therefore, consistent with the intuitive view of the concept, a business model is defined by strategic choices, sometimes made by a network of organizations, that explain value creation and value capture. From this we conclude that an important component of business models are the specific choices made by management on how the organization must operate. For example, choices regarding things such as compensation practices, procurement contracts, location of facilities, assets employed, extent of vertical integration, or sales and marketing initiatives are, for the most part, choices made by management that define “the way the company operates
Choices, however, are not the sole constituent of business models. As all authors highlight choices must be connected to value creation and value capture, or to alternative goals the company may want to pursue. And just as causes have effects in the physical world, management choices have consequences. For example, the provision of high-powered incentives (a choice) has implications regarding the willingness to exert effort or to cooperate with coworkers (consequences). Likewise, pricing policies (choices) have obvious implications regarding sales volume, and this, in turn, affects the economies of scale and bargaining power enjoyed by the company (two consequences). because consequences (such as low cost or culture of frugality) are usually employed to describe the way the company operates, me include them in our definition of a business model In summary, a business model consists of: (1)a set choices and (2) the set of consequences arising from those choices For the purposes of illustration, and somewhat loosely, think of a company as a machine. Of course, real organizations are different from machines in many important respects but, as will become clear below, the comparison is useful. In this analogy, a business model refers to how the machine is assembled ("choices"on how the machine is put together and how the different elements work together ("consequences"of the choices). A machine may be constructed in an almost infinite number of ways, with different levels of redundancy, specific mechanisms, quality of components, and so on. Furthermore, different machine configurations have different direct consequences, and this affects the overall level of efficiency (speed, input efficiency, noise, quality of output, etc. It is useful to distinguish different types of choices and consequences. There are three types of hoices: policies, assets, and governance of those policies and assets. Consequences, on the other hand, are classified into either flexible or rigid Figure 1 Elements of a Business model Choices Assets Governance Business model Flexible In this model, the element "Policies"refers to courses of action adopted by the company regarding all aspects of its operation. Examples of policies include opposing the emergence of unions, locating plants in rural areas, encouraging employees to fly tourist class, providing high-powered monetary incentives, or flying to secondary airports. "Assets"(physical) refers to tangible resources such as manufacturing facilities or a satellite system for communicating Indeed, for-profit organizations are often referred to as "money-making machines
IESE Business School-University of Navarra - 3 Choices, however, are not the sole constituent of business models. As all authors highlight, choices must be connected to value creation and value capture, or to alternative goals the company may want to pursue. And just as causes have effects in the physical world, management choices have consequences. For example, the provision of high-powered incentives (a choice) has implications regarding the willingness to exert effort or to cooperate with coworkers (consequences). Likewise, pricing policies (choices) have obvious implications regarding sales volume, and this, in turn, affects the economies of scale and bargaining power enjoyed by the company (two consequences). Because consequences (such as low cost or a culture of frugality) are usually employed to describe “the way the company operates,” we include them in our definition of a business model. In summary, a business model consists of: (1) a set choices and (2) the set of consequences arising from those choices. For the purposes of illustration, and somewhat loosely, think of a company as a machine.1 Of course, real organizations are different from machines in many important respects but, as will become clear below, the comparison is useful. In this analogy, a business model refers to how the machine is assembled (“choices” on how the machine is put together) and how the different elements work together (“consequences” of the choices). A machine may be constructed in an almost infinite number of ways, with different levels of redundancy, specific mechanisms, quality of components, and so on. Furthermore, different machine configurations have different direct consequences, and this affects the overall level of efficiency (speed, input efficiency, noise, quality of output, etc.). It is useful to distinguish different types of choices and consequences. There are three types of choices: policies, assets, and governance of those policies and assets. Consequences, on the other hand, are classified into either flexible or rigid. Figure 1 Elements of a Business Model In this model, the element “Policies” refers to courses of action adopted by the company regarding all aspects of its operation. Examples of policies include opposing the emergence of unions, locating plants in rural areas, encouraging employees to fly tourist class, providing high-powered monetary incentives, or flying to secondary airports. “Assets” (physical) refers to tangible resources such as manufacturing facilities or a satellite system for communicating 1 Indeed, for-profit organizations are often referred to as “money-making machines.“ Business Model Choices Consequences Policies Assets Governance Flexible Rigid
between offices. The element "govenance"refers to the structure of contractual arrangements that confer decision rights regarding policies or assets. For example, a given business model may contain as a"choice"the use of certain assets such as a fleet of trucks. The fleet can be owned by the company or leased from a third party. As literature on transaction cost economics shows(see, for example, Williamson, 1980), seemingly innocuous differences in governance of assets and policies may have dramatic effects on the effectiveness of a given business model. A consequence is flexible if it is sensitive to the choices that generate it. For example, large volume is a consequence of a policy of low prices. If the policy changes to high prices, volume is likely to fall rapidly. In contrast, a rigid consequence is one that does not change rapidly with the choices that generate it. For example, a"culture of frugality"is a consequence that changes only slowly with the choices that generate it. Perhaps a more tangible example is an installed base of PCs"which is (partly) a consequence of prices set by Intel and Microsoft for the microprocessor and the operating system, respectively. As prices change the installed base changes slowly: it is a rigid consequence. Clearly, no consequence is purely flexible or purely rigid. All consequences are somewhere in between; it is a matter of degree Business Model Representations A useful way to represent business models is by means of a causal-loop diagram(Baum and Singh, 1994): choices and consequences linked by arrows representing causality. However, except possibly for the simplest organizations, such a representation rapidly becomes highly complex and often intractable. In principle, one could make the effort of listing every choice made by management (although this would take a very long time). More difficult, perhaps, is to list the set of all consequences of those choices and to spell out exactly how choices (and different combinations of choices) deliver those consequences, and how exactly consequences (and different combinations of consequences) enable choices. In most businesses there are large numbers of choices and consequences. An analysis and evaluation of an organizations business model that takes into consideration every choice and every consequence is just impractical: nothing meaningful can be concluded by considering choices and consequences in full richness of detail To overcome this issue, we work with representations of business models (or models of business models). A business model representation consists of (i) choices (generally a subset of all choices), (i) consequences (generally a subset of all consequences), and (ii)theories Notice the third element: theories. Theories are suppositions on how choices and consequences are related. For example, a theory may be that as r&D expenses increase, products with innovative features are brought to market. In the causal loop diagram, we would have an arrow from"high R&D expenses"to "innovative products. In many cases theories are commonly accepted relationships open to little discussion. Other times, however,theories"are controversial. In the 1960s, Sam Walton believed that large volumes of merchandise would be Notice that intangible assets such as experience, brand equity, or even the value of patents are consequences generally rigid), not choices. Notice that disciplines such as economics, sociology, or psychology are, for the most part, devoted to generating theories. For example, there is a large body of economic literature devoted to understanding how incentives affect performance. These theories are distilled in our business model representation by use of a simple arrow (or a few arrows)connecting choices and consequences. Disciplines look at the arrows with great care, but have little concern bout how arrows interact with one another and contribute to making the whole of a business model
4 - IESE Business School-University of Navarra between offices.2 The element “governance” refers to the structure of contractual arrangements that confer decision rights regarding policies or assets. For example, a given business model may contain as a “choice” the use of certain assets such as a fleet of trucks. The fleet can be owned by the company or leased from a third party. As literature on transaction cost economics shows (see, for example, Williamson, 1980), seemingly innocuous differences in governance of assets and policies may have dramatic effects on the effectiveness of a given business model. A consequence is flexible if it is sensitive to the choices that generate it. For example, large volume is a consequence of a policy of low prices. If the policy changes to high prices, volume is likely to fall rapidly. In contrast, a rigid consequence is one that does not change rapidly with the choices that generate it. For example, a “culture of frugality” is a consequence that changes only slowly with the choices that generate it. Perhaps a more tangible example is an “installed base of PCs” which is (partly) a consequence of prices set by Intel and Microsoft for the microprocessor and the operating system, respectively. As prices change, the installed base changes slowly: it is a rigid consequence. Clearly, no consequence is purely flexible or purely rigid. All consequences are somewhere in between; it is a matter of degree. Business Model Representations A useful way to represent business models is by means of a causal-loop diagram (Baum and Singh, 1994): choices and consequences linked by arrows representing causality. However, except possibly for the simplest organizations, such a representation rapidly becomes highly complex and often intractable. In principle, one could make the effort of listing every choice made by management (although this would take a very long time). More difficult, perhaps, is to list the set of all consequences of those choices and to spell out exactly how choices (and different combinations of choices) deliver those consequences, and how exactly consequences (and different combinations of consequences) enable choices. In most businesses there are large numbers of choices and consequences. An analysis and evaluation of an organization’s business model that takes into consideration every choice and every consequence is just impractical: nothing meaningful can be concluded by considering choices and consequences in full richness of detail. To overcome this issue, we work with representations of business models (or models of business models). A business model representation consists of (i) choices (generally a subset of all choices), (ii) consequences (generally a subset of all consequences), and (iii) theories. Notice the third element: theories. Theories are suppositions on how choices and consequences are related. For example, a theory may be that as R&D expenses increase, products with innovative features are brought to market. In the causal loop diagram, we would have an arrow from “high R&D expenses” to “innovative products.” In many cases theories are commonly accepted relationships open to little discussion.3 Other times, however, “theories” are controversial. In the 1960s, Sam Walton believed that large volumes of merchandise would be 2 Notice that intangible assets such as experience, brand equity, or even the value of patents are consequences (generally rigid), not choices. 3 Notice that disciplines such as economics, sociology, or psychology are, for the most part, devoted to generating theories. For example, there is a large body of economic literature devoted to understanding how incentives affect performance. These theories are distilled in our business model representation by use of a simple arrow (or a few arrows) connecting choices and consequences. Disciplines look at the arrows with great care, but have little concern about how arrows interact with one another and contribute to making the whole of a business model
bought in rural areas if discount stores were located there. At the time, most people did not share this view. (See Bradley, Ghemawat, and Foley, 1994.) Notice also that theories do not appear in the definition of a business model. a business model is made up of choices and consequences, but these are the actual choices and actual consequences as they are truly related. The term business model" refers to the real relationships. a business model representation, on the other hand, refers to a model of the business model. a business model representation integrates theories of causality that are believed to be true by the business model designer or analyst. If later they fail to hold up, there will be a break in the logic leading to business model failure ( partial or complete As mentioned above, we do not include every choice and consequence in the business model representation. There are two main ways to move from the full, true detail of a business model to a simplified, tractable representation: aggregation and decomposability. In most instances, business model representations make simultaneous use of both approaches Aggregation. Aggregation works by bunching together detailed choices and consequences into larger constructs. For example, specific incentive contracts (which may be unique to every individual in the organization) may be bunched together into a choice called"high-powered ncentives. "This captures the idea that contracts typically impose high-powered incentives on the workforce. In the business model representation, instead of detailing every contract offered to every individual, we simply write one choice: high-powered incentives. This allows a simplified representation that enhances our understanding of the organization. One can think of aggregation as 'zooming out and looking at the (real) business model from the distance. As the analyst zooms out, details blur and larger objects (aggregations of details)become clear. If one keeps one's nose too close to every choice and consequence, it is impossible to see the larger picture and understand how the business model works On the other hand, if one looks at the business model from very far away, all the interesting details are lost. It is more of an art than a science to find the right distance from which to assess a given business model. How much to ' zoom out generally depends on the question the analyst is trying to address In what follows we use the expression "level of aggregation"to refer to the extent to which we zoom out from the full business model. a high level of aggregation refers to looking at the business model from a long distance. A low level of aggregation refers to being close to the details. As we point out below, high levels of aggregation are needed when analyzing nteraction between business models of different players (or competition through business models). y. Sometimes business models are decomposable in the sense that different groups of choices and consequences do not interact with one another and thus can be analyzed in isolation. In this case, depending on the question to be addressed, representing just a few parts of an organizations business model may be appropriate. Clearly, this simplifies the analyst,'s task considerably. For example, in the case of Ryanair developed below, there are few interactions between Ryanair's choices on related businesses such as car rentals or accommodation, or on ancillary business by others, and therefore Ryanair's operative choices related directly to the management of the airline. Given this, one can understand the working of Ryanair's model without needing to be absolutely comprehensive. SE Business School-University of Navarra-5
IESE Business School-University of Navarra - 5 bought in rural areas if discount stores were located there. At the time, most people did not share this view. (See Bradley, Ghemawat, and Foley, 1994.) Notice also that theories do not appear in the definition of a business model. A business model is made up of choices and consequences, but these are the actual choices and actual consequences as they are truly related. The term “business model” refers to the real relationships. A business model representation, on the other hand, refers to a model of the business model. A business model representation integrates theories of causality that are believed to be true by the business model designer or analyst. If later they fail to hold up, there will be a break in the logic leading to business model failure (partial or complete). As mentioned above, we do not include every choice and consequence in the business model representation. There are two main ways to move from the full, true detail of a business model to a simplified, tractable representation: aggregation and decomposability. In most instances, business model representations make simultaneous use of both approaches. Aggregation. Aggregation works by bunching together detailed choices and consequences into larger constructs. For example, specific incentive contracts (which may be unique to every individual in the organization) may be bunched together into a choice called “high-powered incentives.” This captures the idea that contracts typically impose high-powered incentives on the workforce. In the business model representation, instead of detailing every contract offered to every individual, we simply write one choice: high-powered incentives. This allows a simplified representation that enhances our understanding of the organization. One can think of aggregation as ’zooming out’ and looking at the (real) business model from the distance. As the analyst zooms out, details blur and larger objects (aggregations of details) become clear. If one keeps one’s nose too close to every choice and consequence, it is impossible to see the larger picture and understand how the business model works. On the other hand, if one looks at the business model from very far away, all the interesting details are lost. It is more of an art than a science to find the right distance from which to assess a given business model. How much to ‘zoom out’ generally depends on the question the analyst is trying to address. In what follows we use the expression “level of aggregation” to refer to the extent to which we zoom out from the full business model. A high level of aggregation refers to looking at the business model from a long distance. A low level of aggregation refers to being close to the details. As we point out below, high levels of aggregation are needed when analyzing interaction between business models of different players (or competition through business models). Decomposability. Sometimes business models are decomposable in the sense that different groups of choices and consequences do not interact with one another and thus can be analyzed in isolation. In this case, depending on the question to be addressed, representing just a few parts of an organization’s business model may be appropriate. Clearly, this simplifies the analyst’s task considerably. For example, in the case of Ryanair developed below, there are few interactions between Ryanair’s choices on related businesses such as car rentals or accommodation, or on ancillary business by others, and therefore Ryanair’s operative choices related directly to the management of the airline. Given this, one can understand the working of Ryanair’s model without needing to be absolutely comprehensive
Decomposability also allows the study of individual business units in multi-business organizations. For example, below we represent Microsoft's business model for operating systems and productivity applications for the PC (at a high level of aggregation). Microsoft is present in many other sectors such as videogame systems or operating systems for personal digital assistants. Although there are interactions between all of these businesses, these may not be central to the particular question being addressed by the analyst and may therefore be ignored In what follows, we will abuse language and refer to business model representations as, simply, business models. In doing this, we are assuming that the representation does a good job of portraying the organizations true business model An Example: Ryanair To illustrate our notion of a business model, consider Ryanair in 1999 as described in Rivkin's (2000) classic. Important choices in Ryanair's business model include: low fares, flying to secondary airports, all passengers treated equally, nothing is free, no meals, short-haul flights, standardized fleet of Boeing 737s, low commissions to travel agencies, non-unionized, high powered incentives, and Spartan headquarters. Consequences of those choices include: low variable and fixed costs, reputation for reasonable fares, combative management team, large olume, etc. Considering what we know about the industry, we can develop theories on how choices and consequences are related. For example, an arrow from low fares (choice) to high volume(consequence) reflects the theory that the demand function for flights is downward- sloping. We employ a causal loop diagram to represent Ryanair's business model (See Figure 2 Figure 2 Ryanair's Business Model No meals Low variable cost Nothing free Large Ancillary business Low fix cost Secondary airports west Reputation for High aircraft suppliers Standardized fleet of 737s o travel agencies Attracts combative team incentives
6 - IESE Business School-University of Navarra Decomposability also allows the study of individual business units in multi-business organizations. For example, below we represent Microsoft’s business model for operating systems and productivity applications for the PC (at a high level of aggregation). Microsoft is present in many other sectors such as videogame systems or operating systems for personal digital assistants. Although there are interactions between all of these businesses, these may not be central to the particular question being addressed by the analyst and may therefore be ignored. In what follows, we will abuse language and refer to business model representations as, simply, business models. In doing this, we are assuming that the representation does a good job of portraying the organization’s true business model. An Example: Ryanair To illustrate our notion of a business model, consider Ryanair in 1999 as described in Rivkin’s (2000) classic. Important choices in Ryanair’s business model include: low fares, flying to secondary airports, all passengers treated equally, nothing is free, no meals, short-haul flights, standardized fleet of Boeing 737s, low commissions to travel agencies, non-unionized, highpowered incentives, and Spartan headquarters. Consequences of those choices include: low variable and fixed costs, reputation for reasonable fares, combative management team, large volume, etc. Considering what we know about the industry, we can develop theories on how choices and consequences are related. For example, an arrow from low fares (choice) to high volume (consequence) reflects the theory that the demand function for flights is downwardsloping. We employ a causal loop diagram to represent Ryanair’s business model. (See Figure 2.) Figure 2 Ryanair’s Business Model Short haul flights No meals Nothing free All passengers treated equally Lowest fares Secondary airports Low commissions to travel agencies Non-unionized workforce High-powered incentives Spartan headquarters Standardized fleet of 737s Attracts young & pleasure travelers Reputation for “fair” fares Large volume Ancillary business. High aircraft utilization Bargaining power with suppliers Word of mouth advertising Attracts combative team Tough negotiators Low variable cost Low fix cost
Choices are in bold and underlined, rigid consequences are in boxes, and flexible consequences nor every consequence. We have made use of aggregation and decomposable ade by ryanair are plain text. Notice that the representation does not include every choice Figure 3 is a representation of Ryanair's business model with theories. To explicitly account for theories, we include a short text with the justification for each arrow. to keep the representations simple, however, in the rest of the paper we will place the arrows without explicit theories. Only when a theory is not obvious will it be written down because, as Figure 3 illustrates, when theories are explicitly accounted for, the diagram becomes harder to read. Figure 3 yanair's Business Model with Theories Absence c meals lowers cost Short haul Economies of scale Low vanable cost foung travelers are f Attracts abilty to 8noe, travel Large Sotmie_ Ancillary condary Secondary airports alka low D utilization air fares elate Bargaining po Standardized Excrement about lage noun depend fleet of 737s advertisi ing Low commissions Combative_ Attracts combative team-are lkely to act as Nonunionized uniore Incividuals selFeelect Spartan headquarters In summary, the causal loop diagram represents theories linking choices and consequences that allow us to conjecture that Ryanair is able to offer service at a very low cost without reducing too much the customers willingness to pay in the target segment We should point out that the absence of arrows also implicitly defines theories. For example, Ryanair's choices of a standardized fleet and the use of secondary airports are unrelated, even if they may reinforce one another by leading to low maintenance costs and rapid turnovers
IESE Business School-University of Navarra - 7 Choices are in bold and underlined, rigid consequences are in boxes, and flexible consequences are plain text. Notice that the representation does not include every choice made by Ryanair nor every consequence. We have made use of aggregation and decomposability. Figure 3 is a representation of Ryanair’s business model with theories. To explicitly account for theories, we include a short text with the justification for each arrow. To keep the representations simple, however, in the rest of the paper we will place the arrows without explicit theories. Only when a theory is not obvious will it be written down because, as Figure 3 illustrates, when theories are explicitly accounted for, the diagram becomes harder to read. Figure 3 Ryanair’s Business Model with Theories In summary, the causal loop diagram represents theories linking choices and consequences that allow us to conjecture that Ryanair is able to offer service at a very low cost without reducing too much the customers’ willingness to pay in the target segment. We should point out that the absence of arrows also implicitly defines theories. For example, Ryanair’s choices of a standardized fleet and the use of secondary airports are unrelated, even if they may reinforce one another by leading to low maintenance costs and rapid turnovers
However, the assumption is that these choices are independent. For simplicity, in the diagram above, we do not spell out these "absent arrow"theories Virtuous Cycles- The Dynamics of Business Models By now, it should be apparent that our concept of a business model is intrinsically dynamic The relationship between choices and consequences occurs over time. Moreover, some"rigid consequences are stocks(such as an installed base or cumulative experience) that are built over time. An understanding of the functioning and evaluation of business models requires explic consideration of the dynamics between choices and consequences One of the most striking features of business models is that their dynamics often generate feedback loops. This happens when, in addition to choices yielding consequences, consequences enable choices. Feedback loops can be of two types: virtuous cycles and vicious cycles. Since these are symmetric, and the same principles therefore apply to both, we need to study one type of feedback loop and have chosen to focus on virtuous cycles. Virtuous cycles are feedback loops that, with every iteration, strengthen some components of the model at every iteration. For example, Honda historically set low prices for its motorcycles (a choice); the consequences were high volume and high cumulative output which allowed the company to move down the learning curve, and thus result in low cost. Low cost (a consequence), in turn, enabled Honda to profitably set low prices (a choice). As the cycle spun again and again, Honda kept lowering prices because (marginal)cost decreased. Using the representation diagram igure 4 Example of a Virtuous Cycle High Volume Low price cumulative Low cost virtuous cycles are feedback loops that, with every iteration, strengthen the value of the components of the model Once they get going, virtuous cycles take on a life of their own; just as a fast-moving body is hard to stop because it possesses kinetic energy, well-functioning virtuous cycles cannot easily be brought to a halt 4 See Christiansen and Pascale(1983) Kinetic energy is the energy that a body possesses by virtue of its movement
8 - IESE Business School-University of Navarra However, the assumption is that these choices are independent. For simplicity, in the diagram above, we do not spell out these “absent arrow” theories. Virtuous Cycles – The Dynamics of Business Models By now, it should be apparent that our concept of a business model is intrinsically dynamic. The relationship between choices and consequences occurs over time. Moreover, some “rigid” consequences are stocks (such as an installed base or cumulative experience) that are built over time. An understanding of the functioning and evaluation of business models requires explicit consideration of the dynamics between choices and consequences. One of the most striking features of business models is that their dynamics often generate feedback loops. This happens when, in addition to choices yielding consequences, consequences enable choices. Feedback loops can be of two types: virtuous cycles and vicious cycles. Since these are symmetric, and the same principles therefore apply to both, we need to study one type of feedback loop and have chosen to focus on virtuous cycles. Virtuous cycles are feedback loops that, with every iteration, strengthen some components of the model at every iteration. For example, Honda historically set low prices for its motorcycles (a choice); the consequences were high volume and high cumulative output which allowed the company to move down the learning curve, and thus result in low cost. Low cost (a consequence), in turn, enabled Honda to profitably set low prices (a choice). As the cycle spun again and again, Honda kept lowering prices because (marginal) cost decreased.4 Using the representation diagram: Figure 4 Example of a Virtuous Cycle Low price High Volume Large cumulative output Low cost Learning economies Virtuous cycles are feedback loops that, with every iteration, strengthen the value of the components of the model. Once they get going, virtuous cycles take on a life of their own; just as a fast-moving body is hard to stop because it possesses kinetic energy,5 well-functioning virtuous cycles cannot easily be brought to a halt. 4 See Christiansen and Pascale (1983). 5 Kinetic energy is the energy that a body possesses by virtue of its movement
