Business Models Innovation

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Deloitte Research A competitive strategy study by Deloitte Consulting and Deloitte & Touche Deconstructing the formula for BUSINESS MODEL INNOVATION Uncovering value-creating opportunities in familiar places

Transcript of Business Models Innovation

Page 1: Business Models Innovation

Deloitte Research

A competitive strategy studyby Deloitte Consulting and Deloitte & Touche

Deconstructing the formula for

BUSINESS MODEL INNOVATIONUncovering value-creating opportunities in familiar places

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CONTENTS

Deconstructing the Formula forBusiness Model Innovation ................................................... 1

About the Study .................................................................... 4

Context:Finding Opportunities in Familiar Places .............................................. 6

Innovating Around the Who:Redefining Customer Segments,Creating New Segments, or Changing the Buyer ................................... 9

Innovating Around the What:Offering Customers What They Really Want ....................................... 14

Innovating Around the How:Developing Unique Capabilities and Operational Structures ............... 16

Creating a Sustainable Business Model ................................ 17

Putting Business Model Innovation to Work ......................... 20

About Deloitte Consulting and Deloitte & Touche ................... 25

About Deloitte Research ...................................................... 25

Case Studies

Harley-Davidson: From Competing on Motorcycle

Performance to Selling the Rebel Lifestyle .................................... 8

WellPoint: From Near Death to Industry Leadership

Via Business Model Innovation ................................................. 11

Paychex: Bringing Big-Company Payroll

Services to Mom-and-Pop Operators .......................................... 18

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Deconstructing the Formula forBusiness Model Innovation

The creation of new business models that would redefine

industries was the boardroom game of the late 1990s’ dot-com

boom. For many companies today, however, it appears to be an

anachronism. Amid economic uncertainty and dot-com carnage,

executives are battening down the hatches – slashing payrolls,

winnowing product and service lines, scaling back R&D programs,

and pressuring sales managers to redouble their efforts. Cost-

cutting and streamlining are back in vogue.

Yet if creating significant shareholder value is still the goal,

the search for new business models that can rewrite the rules of

an industry shouldn’t end. Combined with our extensive

experience helping clients with business model strategy, our new

study on some of the most successful business models of the past

40 years shows that such opportunities exist regardless of the state

of the economy. In fact, companies such as Corning, WellPoint

Health Networks, and Charles Schwab demonstrate that economic

uncertainty is actually a fertile time for spawning entirely new

business models.

That was one of the key findings of our extensive research

over the last year on business model innovation (BMI). We

analyzed hundreds of publicly held companies across a wide range

of industries and selected 16 of the most impressive business

model innovators that redefined their business and generated

extraordinary shareholder value. We discovered that multibillion-

dollar opportunities were there for the taking by large, lumbering

companies as well as by agile start-ups. In fact, established

companies were responsible for more than half of the innovative

business models that we examined (several of the 16 companies

launched more than one innovative business model). These

organizations – General Electric, WellPoint, Enron and Corning

among them – overthrew cultural inertia and exploited enormous

advantages in generating billions for their shareholders.

In deconstructing the formula for business model

innovation, our overarching question was this: What are the

patterns for creating enormous shareholder wealth through

business model innovation? By that term, we refer to companies

that introduce an entirely new approach to business, one that

diverges from industry norms in terms of “who” is targeted as

customers, “what” is offered to those customers, and “how” that

offering is provided.1 We wanted to understand how companies

were able to generate enormous returns for their shareholders by

expanding their focus for differentiation beyond product

innovation. Finally, we wanted to understand how business model

innovation created sustainable advantages for the innovators.

Our findings shattered many of the popular preconceptions

about business model innovation. In addition to finding that

business model innovation happens in both good times and bad,

our research and experience challenges today’s nostrum that

revolutionary companies succeed by being first to understand and

act upon a new technology, regulatory shift, socio-demographic

change or other significant discontinuity. In fact, we found

something else: While some companies capitalized on such trends,

most simply targeted customers whose needs had existed for

some time but who, as a market segment, were considered

undesirable or even unprofitable by the pack.

The case of Paychex illustrates this vividly. In 1970, B. Thomas

Golisano was a sales manager for a regional payroll processing

company in Rochester, N.Y., that served large companies. He

couldn’t convince his superiors that small companies – less than

50 employees2 – were an untapped but lucrative market. While it

took Golisano four years to turn a profit, his business model today

is irrefutable.3 Paychex, whose customers have an average of 14

employees, is a highly profitable company with revenues of nearly

$900 million and a market value of $15 billion.4

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As Paychex and others like Southwest, WellPoint, and America

Online show, the opportunity was there for all to see – and seize –

for some time. In other words, creating blockbuster new business

models does not require an ability to predict the future – it

requires an ability to redefine the present. However, simple as

this may sound, doing so requires identifying and overturning

long-held industry norms – beliefs that have shaped existing

companies’ decisions regarding the who, what, and how of

business and that blind most managers from seeing unexploited

blockbuster opportunities. The Paychex scenario – in which the

industry incumbents dismissed a market segment as undesirable

– was repeated in many of the companies we explored.

Business model innovation does not require star-gazing; it

also usually doesn’t require leading-edge product or service

innovation. In fact, none of the 16 companies analyzed invented

what could truly be considered a breakthrough product or service.

In many cases, the business model innovators essentially left the

prevailing product/service offering of an industry unchanged.

Instead, they altered the existing structure of the industry in ways

that were unfathomable to the incumbents.

Just as important, business model innovation requires going

far beyond identifying an unserved or underserved market

segment – i.e., changing just the who component. Every one of

the 16 companies we studied also carefully designed and built the

what (the product/service offering and the customer’s experience

with it) and the how (the operations, supplier relationships, and

other activities that deliver that customer experience) in ways that

economically produced extraordinary customer value. The

innovators also captured sustainable competitive advantages in

one or more ways, including creating economies of scale, being far

ahead on the learning curve, having loyal customers, and

possessing hard-to-duplicate resources. Further, the innovators

preyed upon the inherent constraints of the incumbents –

disadvantages that included commitments to existing supply

chains and fears of disrupting existing channel relationships.

SOURCE: DELOITTE CONSULTING

The Business Model Innovation framework is a structured approach to evaluating and introducing innovation to individual businesses.

WHO

• Segment• Needs• Perception

• Channels• Product/Services• Total Experience

• Resources• Activities• Partners

WHAT HOW

• External Factors• Internal Capabilities

• Innovator Advantages• Incumbent Disadvantages

CONTEXT SUSTAINABILITY

FRAMEWORK FOR BUSINESS MODEL INNOVATION

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LEVERAGEABLEBusinessContext

SPECIFICCustomer Focus

SUSTAINABLEFactors

PRECISECustomerOffering

UNIQUEBusiness

Capabilities

WHO WHAT HOW

PC industry focusedon build-to-stock

ExperiencedPC buyers

Incumbent channelconstraints & build-to-order expertise

Self-servicePC solutions

Build to order,direct channel

Deregulation andvolatile energy

prices

Commercial endusers of energy

Long-termcustomer contracts

Turnkey energyoutsourcing

Risk forecasting,solution packaging

Online access forinformation

Lifelong, averagenet-worth investor

Incumbentsunwilling to sell

competing products

Multi-channel,multi-product access

Integratedchannels

Deregulation andairlines’ focus on

business travelers

Cost-sensitivetraveler

Incumbents commit-ment to higher cost

business modelNo-frills travel Point-to-point

resources

Small businessesunderserved by

outsourcing industrySmall

businesses

Incumbents unableto profitably serve

small business

Small-biz focusedpayroll outsourcing

Brand, low-costoperations

Japanese lead inmotorcycle technology

Rebel imageexecutives

Business modelbuilt aroundrebel brand

Branded motorcyclerebel lifestyle

Brand, Harleyowner groups

Individuals andsmall business

Tailored healthcaresolutions

Incumbents unableto become

customer-centric

Customer-centricorganization

Virtually-integratedcustomer direct

Self-servicemulti-channel brokerage

Low-cost air travel

Small businesspayroll outsourcing

Lifestyle provider

Payer industryfocused on

large groupsCustomized health insurer

This is our formula for successful business model innovation.

In this study, we explore the formula through the experiences of

the 21 innovative business models. Based on our research and

consulting experience, we discuss the implications for established

companies looking for the next great opportunity or trying to

protect their current model from attacks. Finally, we present a three-

step approach for identifying, evaluating, and bringing to market

promising new business models.

Energy outsourcing provider

SELECT BUSINESS MODEL INNOVATIONS

SOURCE: DELOITTE CONSULTING

SUPERIORSHAREHOLDER

VALUE

From our research, companies that wish to compete and

succeed on the basis of business model innovation must focus

on three core issues:

Context: The external factors and internal capabilities that

can be exploited.

Innovation dimensions: How to redefine the basic

dimensions of business – who to serve, what to offer, and

how to operate – in new and profitable ways.

Sustainability: How to create a winning business model that

is hard to imitate.

TSR: 52% MV: $70B

TSR: 17.5% MV: $34B

TSR: 26.2% MV: $21B

TSR: 35.9% MV: $15B

TSR: 32% MV: $15B

TSR: 35% MV: $16B

TSR: 25.5% MV: $7B

NOTE: MV = Market Value (as of 7/31/01)TSR = Total Shareholder Return (Five-year annualized rate, including dividends, as of 7/31/01)

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About the Study

Deloitte Consulting launched its formal study of business model

innovation in November 2000. Despite volumes of research and

writings on the topic in the last 20 years, we found little in-depth

analysis regarding what factors and design patterns enable and

sustain profitable business model innovation.

We weren’t interested in studying business model

innovation per se – only the kind that generates superior

financial results. As a result, we began by identifying companies

from a range of industries that outperformed their peers in

generating shareholder value and compared their business

models to the pack.5

Identifying Top Performers

To identify the most successful business model innovators, we

first had to uncover the top-performing companies (whether

or not their performance was based on business model

innovation), and then evaluate the basis of their performance

(whether or not they were business model innovators). Our

screen for the top-performing companies was based on four

indicators used by Holt Value Associates, a financial consulting

firm, to evaluate corporate performance:

Total shareholder returns (TSR): Share price

appreciation plus dividends over the last three (or five)

fiscal years.

Cash flow return on investment (CFROI): The ratio of

gross cash flow to gross investments translated into an

internal rate of return. This recognizes the finite economic

life of depreciating assets and residual value of non-

depreciating assets.

Premium: The sum of current market values of debt and

equity, including the value of minority interest, divided by

current inflation-adjusted net assets plus three years of

capitalized R&D.

Percent future: The percentage of total market value that

the stock market assigns to the company’s expected

future investment. This was determined by subtracting

the portion attributed to the present value of existing

assets and investments from the market value of debt and

equity, then dividing by the total market value of debt

and equity.

Out of all U.S. public companies, 169 emerged as

significantly outperforming their peers, representing a wide

range of industries including beverage, drugstore, food

processing, retail, utilities, natural gas, financial services,

computers, manufacturing, and telecom. Business model

innovation was not the lever for superior performance for the

majority of these companies For example, in the drugstore

industry, the top-performer (Walgreen) simply executed better

than others without changing the segment’s long-existing

model. Quaker Oats and McGraw-Hill outperformed their rivals

through product leadership. And Amgen’s product innovation

was the reason it topped the list of pharmaceutical companies.

Identifying Successful Business Model Innovators

After extensive discussions with industry experts within and

outside Deloitte Consulting, 16 companies emerged from the

list of 169 top performers as those that successfully launched

21 business model innovations (several launched more than

one new business model). The list of business model innovators

features 10 start-ups (Amazon, America Online, Cisco, Dell, IMS,

Paychex, Schwab, Southwest Airlines, Starbucks, and Wal-Mart)

and 11 established companies who have significantly

transformed their business models (AOL/Time Warner,

Columbia, Corning, Enron’s three evolutions, General Electric,

Harley-Davidson, Schwab, Wal-Mart, and WellPoint). (See table

on following page.)

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Understanding the Patterns of Successful BusinessModel Innovation

With these 21 cases in hand, we then embarked on an extensive

examination of public information about them (books,

newspaper and magazine articles, regulatory filings, corporate

annual reports, Web site documents, etc.). We also interviewed

numerous executives and Deloitte consultants with expertise

on these companies. In pouring through this material, we

sought to understand three aspects of business model

innovation:

Context of their innovation: The conditions that enabled

or drove their success (regulatory, technology, socio-

economic, industry, etc.).

Elements of business model innovation: The innovation

levers they used to change the prevailing who, what, and

how, and create substantial new customer value.

Sustainability factors: How they were able to avoid being

copied by competitors or start-ups.

We conducted extensive analysis to identify the factors

behind the context, elements, and sustainability of superior

business model innovation. For example, to examine the context,

we identified 14 external factors (e.g., regulatory changes,

socioeconomic shifts) and eight internal factors (e.g.,

entrepreneurial culture, strong brand equity, new executive

leadership, risk of insolvency). We then identified the innovation

levers used in the who (users, needs, customer views), what

(channels, offerings, support), and how (assets, processes,

relationships).

Finally, we explored the elements of sustainability – the

factors the business model innovators had at their disposal (e.g.,

first-mover, brand equity) and the handicaps of incumbents in

pursuing the new business models (e.g., cultural inertia, fear of

disrupting existing distribution channels).

By identifying such factors, we were able to understand which

innovations occurred in what context and why they have been

sustainable, ultimately forming the basis of our findings.

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Top Performing Company Business Model Innovation Year introduced

Amazon

AOL1

Cisco

Dell

IMS

Paychex

Schwab 1

Southwest

Starbucks

Wal-Mart 1

Online retailer

Online content provider

Innovation acquirer

Virtually-integrated customer direct model

Health care information aggregator

Small business payroll outsourcing

Discount brokerage

Low-cost air travel

Multi-channel experience retailer

Mass discounter

1995

1993

1993

1984

1954

1970

1971

1971

1971

1962

Star

t ups

Tran

sform

atio

ns

SOURCE: DELOITTE CONSULTING

Vertically-integrated conglomerate

Specialty clothing mass merchandiser

Alliance-based market maker

Energy trader

Energy outsourcing provider

Bandwidth trader

Bundled product/service solution provider

Lifestyle provider

Self-service multi-channel brokerage

One-stop mass merchandiser

Customized health insurer

2000

1985

1990

1988

1992

2000

1990

1987

1992

1987

1986

AOL 2

Columbia

Corning

Enron 1

Enron 2

Enron 3

GE

Harley Davidson

Schwab 2

Wal-Mart 2

WellPoint

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Context: Finding Opportunitiesin Familiar Places

In our research, we first wanted to understand what context enables

business model innovation. What environmental forces were in

play in each of the cases? To what degree was innovation success

driven by an ability to exploit emerging socio-economic trends?

Was the innovation opportunity largely driven by regulatory

changes that redefined markets or opened up new ones? Were

innovations largely the response to emerging technologies that

enabled new and better ways to serve the existing market?

Given all the discussion about looking for discontinuities in

the marketplace, it’s no surprise that several of the business model

innovators did in fact capitalize on shifts in the macro- and micro-

economic environment. Amazon, Schwab, and Paychex exploited

new or emerging technologies to serve entirely new segments.

To our surprise, however, the major contextual driver behind

the innovation success cases we examined was not a new

technology, regulation, or socioeconomic change – it was the

existence of an unmet or overlooked customer need. A good

example of this is Southwest Airlines. The company started

operations in Texas in 1971 to serve an enormous but underserved

market: short-distance travelers who couldn’t justify the high fares

charged by traditional national carriers when comparing those

fares to alternatives like bus, car, or train travel. While regulatory

factors were an issue in Southwest’s case, they were a hindrance –

not an enabler – of innovation, initially preventing the company

from expanding its business outside of its home state.

Consider Starbucks. The Seattle-based company tapped into

American consumers’ long-existing but relatively unmet lifestyle

need for affordable luxuries, and a meeting place where people

could relax, chat and participate in a café community experience

like Europeans had done for decades.

We found that even the most technologically sophisticated

companies generated superior shareholder value by focusing on

unmet and overlooked customer needs – not by focusing on

technology. Dell, for example is known for technology-enabled

supply chain sophistication that dramatically minimizes inventory,

costs, and cycle time. But when the company was launched out

of Michael Dell’s University of Texas dorm room in 1984, Dell’s

technological infrastructure was nothing like the Web-enabled

one for which it is famous. Indeed, Dell’s initial epiphany was

about recognizing the overlooked needs of a rapidly-growing

customer segment: technically sophisticated business and

personal PC users who found no value in dealing with PC stores’

inflated prices and often less than sophisticated sales personnel.

“The indirect channel was based on a marriage of the unknowing

buyer and the unknowledgeable seller,” explained the company’s

founder and CEO in his autobiography.6 “I knew that marriage

could not last… that customers would become even more

knowledgeable and demanding every year.”

Key TakeawayKey TakeawayThe greatest opportunities for business model

innovation are in established industries thought

to be "mature." In these industries, prevailing

norms obscure a hotbed of customer needs just

waiting to be addressed.

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Most of the 21 business model innovations came from what

many viewed as mature industries, not emerging technology

sectors where new entrants often create whole new industries

virtually overnight. While two of the 16 companies were

technology suppliers (Dell and Cisco), the majority were in

industries considered to be decidedly low-tech, mature, and

saturated with competition. Wal-Mart, for example, launched a

discount retailing business in 1962 in an industry that had been

dominated by companies such as F.W. Woolworth. Paychex started

its business in an industry controlled by Automatic Data Processing

Inc. (ADP). Few airline experts thought that upstart Southwest

Airlines would ever be more than a small regional carrier, especially

after watching the demise of bargain carriers such as People

Express. The predominant belief was that the largest, most

profitable carriers had to be national or international. Regional

airlines were considered to be small potatoes. But today,

Southwest’s market capitalization ($15 billion) is larger than the

combined market caps of American, United, and Continental.7 And

while Amazon and America Online sound like high-tech

companies, they have merely used technology to carve out a piece

of an established industry (retailing for Amazon and content for

AOL).

Industries that appear to be static provided some of the best

opportunities for business model innovation. In 18 of the 21 cases

studied, there was strong homogeneity among competitors’

business models prior to the innovation. In fact, most of the

business model innovations disrupted industries thought to be

mature, highly competitive, and therefore devoid of any great new

unexploited opportunities, at least until the innovator proved

otherwise.

Certainly, that was the case for Southwest Airlines. Looking at

the cutthroat competition and huge losses by airlines like Pan Am

and Texas Air, most potential entrants would have looked for

opportunities outside the industry. While earnings at the major

carriers have bounced up and down, Southwest has been

profitable since 1973.

Another thread that ran through many of the established

companies that launched successful new business models was the

presence of a strong perceived need to innovate, driven by

desperation or inspiration. Either survival was at stake (the case

at Schwab, WellPoint, Columbia, and Harley-Davidson) or the

company had a developed a culture that embraced innovation as

key to long-term success (a defining factor at AOL, Enron, and GE).

In addition, many business model innovators that were

established companies (firms such as Harley-Davidson, Columbia,

and Enron) created new wealth in part by leveraging their existing

brand equity or a strong, loyal customer base, or both. The ability

to leverage existing resources proved critical. Enron, for example,

capitalized on its financial capability in creating trading markets

for energy and bandwidth. Harley-Davidson’s strong brand among

motorcycle riders enabled it to shift its business model to

promoting the Harley lifestyle. Had Harley-Davidson launched its

new business model as an unknown start-up, it most likely would

have gained little traction. In combining groceries with general

merchandise in its second business model innovation, Wal-Mart

took advantage of its vaunted inventory management and

distribution capabilities, its vast and loyal customer base, and its

strong brand. Without that, it would have taken years for the

company to gain ground in the grocery business.

What does all of this say for the context of business model

innovation? It validates that regulatory, socioeconomic,

technological, and other environmental changes can indeed create

major opportunities. More importantly, though, our analysis of

context reveals that mature industries with well-established norms

about the who, what and how of business often hold the greatest

opportunities for business model innovation. Underneath the

complacent homogeneity in many industries is often a hotbed of

significant but unmet customer needs just waiting to be addressed.

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Harley-Davidson: From Competing onMotorcycle Performance to Selling theRebel Lifestyle

Nearly 20 years ago, Harley-Davidson Inc. was in danger of losing

its U.S. market to a rash of Japanese motorcycle manufacturers.

A financial crisis at Harley-Davidson and management buyout

of the company from its parent, AMF Inc., drove an entirely new

business model, which has spawned enormous marketplace and

Wall Street success. Today, with sales of about $3 billion, Harley-

Davidson is the largest seller of motorcycles in the United States

and is valued on Wall Street at more than $15 billion.8

But Harley-Davidson’s potential for success wasn’t nearly as

obvious back in the early 1980s. The context for Harley-Davidson’s

innovative business model was one of extreme distress.

Companies like Honda, Suzuki, Yamaha, and Kawasaki had

infiltrated the U.S. market with better-quality, higher-performing,

and lower-priced motorcycles. These companies used high-tech,

high-volume production operations, advertised heavily and

priced lower to gain market share. Internally, Harley-Davidson

struggled with poor labor relations and highly inefficient

manufacturing operations. Yet the company had several strong

capabilities to leverage: a brand that was an American icon, a

strong independent dealer network (which has grown to 1,300

worldwide), and an intensely loyal customer group.

In creating a new business model that would enable it to

differentiate itself from its fierce Japanese competitors, Harley-

Davidson management redefined all three aspects of the model.

It broadened the customer base (the who) beyond the hard-core

biker crowd to include leisure riders and weekend rebels. It

addressed this larger segment’s need for community, while

changing the basis of comparing motorcycle brands from one

of product versus product to one of lifestyle versus lifestyle. As a

lifestyle offering, competitors couldn’t compete against Harley-

Davidson on its home turf.

Harley-Davidson also wisely differentiated the value

experience (the what) on attributes other than the performance

of its bikes. These attributes included the sound of its bikes,

their look and feel, and, just as importantly, accessories, clothing,

and community events that had nothing to do with motorcycle

performance. Thus, the company repositioned itself from a

motorcycle to a lifestyle brand.

In changing the how, Harley-Davidson reinvigorated its

dealer relationships through cosponsoring community events,

which was the focus of an entire new Harley-Davidson division.

It also founded the world’s largest motorcycle club, the Harley-

Davidson Owners Group (appropriately called HOG, for short).

And it extended its brand to a range of Harley lifecycle

accessories for biking life, such as clothes. The company also

improved its quality and manufacturing operations’ efficiency.

How did Harley-Davidson sustain its initial business model

innovation? The company strengthened its chosen customer

segment (the who) by emphasizing the brand and lifestyle

aspects of buying a Harley-Davidson. It also maintained

ongoing contact with customers through the Harley-Davidson

communities and community events. Harley competed

effectively on the what of business model innovation through

its image-based branding campaigns. Technology and

performance-focused competitors couldn’t compete against

the Harley-Davidson lifestyle. In the how, Harley-Davidson

outran competitors in the United States through the strength

and loyalty of its dealer network and through economies of

scope; that is, the company leveraged its brand identity to sell

non-motorcycle products at steep margins.

Harley-Davidson’s highly profitable rebel lifestyle business

model is closely studied by others in both manufacturing and

consumer business circles. As a success, Harley-Davidson’s story

validates the power of customer-centric business model

innovation.

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Innovating Around the Who:Redefining Customer Segments, CreatingNew Segments, or Changing the Buyer

How could so many dominant, well-financed companies overlook

the new opportunities exploited by Wal-Mart, Schwab, WellPoint,

Southwest, and the other business model innovators? How did

they allow poorly-financed and often unsophisticated upstarts to

steal target portions of their market or dominate new markets?

In recognizing what others had missed, the business model

innovators either:

Redefined customer segments and targeted those with

underserved needs;

Created a new customer segment; or

Changed the decision maker within the existing customer

base.

WellPoint Health Networks demonstrates the power of redefining

an existing customer segment. The Thousand Oaks, Calif.-based

health insurer nearly went bankrupt in the mid-1980s as Blue Cross

of California. It began its dramatic recovery in the late 1980s

through business model innovation that refocused around two

customer groups that had largely been ignored. At the time of

WellPoint’s innovation, small businesses and individual customers

had been largely underserved by other health plans, which

optimized their products, processes, and channels to serve

corporations and other large group customers. To better pursue

these individuals and small businesses, WellPoint decided to create

units that were separate from operations catering to large groups.

As a direct result of these changes, WellPoint had grown solidly to

$7.5 billion in revenue by 1999, with CFROI and TSR well above

industry averages. (See sidebar on WellPoint.)

Several innovators created enormous wealth by developing

entirely new markets. Schwab virtually created a whole new

segment of investors: do-it-yourselfers whose desire for low-cost,

no-frills securities trading went underserved. In 1975, Schwab

quickly followed the deregulation of securities brokering and

commissions pricing by targeting the unmet needs of stock buyers

who didn’t value the premium advisory services of companies like

Merrill Lynch and Dean Witter. After brokerage deregulation,

leading brokerage houses actually considered raising commissions

to further solidify their premium brand positions. Schwab, a

struggling second-tier brokerage house, had little to lose in

pursuing the opposite strategy – serving the newly viable no-frills

segment by unbundling stock-trading advice from securities

transactions and offering the bare-bones transaction processing

service at a discounted commission price. As a result, Schwab

shifted customers’ perceptions about their trading alternatives

from one of brand versus brand to premium versus discount. In

Schwab’s first five years as a publicly traded company (1987-1992),

its total shareholder returns were the highest in the industry and

double those of Merrill Lynch, the largest U.S. brokerage.

Key TakeawayKey Takeaway Successful innovators look beyond industry

norms and tap into huge unmet needs by

redefining a customer segment, creating a new

segment, or changing the decision-maker.

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Paychex, a provider of payroll outsourcing services, also

created a new market and a new business model to serve it. Since

its 1970 launch as a new business dedicated to the small business

segment, Paychex has expanded dramatically, growing to nearly a

billion dollars in annual revenue while keeping its focus on small

businesses. (The average Paychex customer has 14 employees.9)

Paychex continues to capture value with its business model,

earning a five-year average annual growth in total shareholder

returns of more than 50 percent – nearly double that of ADP’s. In

addition, Paychex’s after-tax return on sales is a whopping

29 percent.10

Columbia Sportswear created a new segment of outdoors-

wear buyers. Founded in 1938, Columbia transformed itself from

a regional hat distributor to one of the largest distributors of

clothes and shoes for outdoor activities such as fishing, hiking,

hunting, and golf. At the beginning of the 1990s, the outdoor gear

industry was dominated by branded manufacturers that

competed on quality to serve a niche market: hardcore outdoors

enthusiasts. At the same time, manufacturers that competed on

cost dominated the mass-market outdoor clothing industry with

very limited branding. Recognizing a consumer shift in interest

toward more active lifestyles, Columbia identified a new segment

that bridged the two existing segments: a mass-market segment

for branded outdoor wear at affordable prices. By mid-2001, with

sales of $615 million and a market premium that’s more than

double the industry average, Columbia has become a pacesetter

at mass-producing technically legitimate outdoor wear in the

apparel industry.

In the early 1990s, America Online tapped a relatively new and

underserved segment of online computer users – technologically

unsophisticated newbies who needed simple interfaces and

navigation. Ten years ago, AOL had far fewer online subscribers

than CompuServe, which had been around since 1969 and over

the years had developed a steadily growing and highly profitable

business catering to mature and sophisticated online computer

users. CompuServe’s motto – “the information service you won’t

outgrow” – spoke volumes about its scant interest in attracting

novice computer users. America Online, however, catered to the

newbies by focusing on what CEO Steve Case called the 3 Cs:

communication (e-mail and chat room sessions), community

(letting subscribers interact with other subscribers), and clarity

(making the service easy to use). CompuServe, with its deep

offerings in online content, saw CompuServe as “nutritional” and

AOL as “junk food.” But CompuServe’s management ignored a key

fact: “America loves junk food,” as the author of a book on AOL

put it.11

Companies like GE demonstrate the rewards of rethinking the

target buyer. The industrial and services giant understood that

most manufacturing customers were not one-time buyers

ordering on spec but rather ongoing purchasers looking for

broader solutions. As a result, GE redefined the target buyer from

the engineering or procurement head to senior executives buying

an end-to-end solution. The company then applied this concept

of service provider to the majority of its manufacturing businesses.

GE’s business model continues to capture significant shareholder

value, earning a five-year annual total shareholder return

(1996 – 2001) of more than 30 percent – second highest among

its peer group within the manufacturing industry.

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WellPoint: From Near Death to IndustryLeadership Via Business Model Innovation

Few companies better demonstrate the power of rethinking

the who, what, and how of business model innovation –

rejecting the industry norms – than WellPoint Health Networks

Inc.. Near bankruptcy 15 years ago as Blue Cross of California,

the company has since made a stunning reversal, becoming

the best-performing U.S. health insurer, a highly profitable

business with 2001 revenues in excess of $12 billion, and a star

on Wall Street. But to make the shift, the company had to

eschew a number of long-held industry beliefs, particularly

about the viability of certain market segments and the need

for economies of scale in back-office operations.

The context for WellPoint’s business model innovation was

a dire one. In the 1980s, for-profit health maintenance

organizations (HMOs) were proliferating, siphoning off many

profitable customers – i.e., healthy consumers requiring little

medical care. Health plans looked indistinguishable except in

price, where Blue Cross of California was at a disadvantage. In

the midst of this, the company was suffering from spiraling

medical costs, a “well-deserved reputation for poor service,” and

a “bloated bureaucracy,” as the Los Angeles Times put it.12

By 1986, when the company brought in Leonard D.

Schaeffer as CEO, the organization was hemorrhaging $160

million in annual losses. “The company was insolvent – they

just hadn’t shut it down,” said Schaeffer, who had been president

at a Minnesota health insurer, Group Health Inc., but had spent

most of his career in government, as the first head of the federal

government’s Health Care Financing Administration and

budget director for the State of Illinois.

Almost immediately, he slashed the Blue Cross

organization’s payroll of 6,600 nearly in half and sold the

headquarters building for $90 million. But that wasn’t enough.

“Things were in terrible shape and every couple of weeks they

would get worse,” he remembered in an interview at WellPoint’s

Thousand Oaks headquarters just north of Los Angeles. “No

matter where we tried to make progress, there always was a

‘hand from the grave’ that came out and pulled us back in.”

With the organization staring death in the face, Schaeffer

questioned many of the norms that had gotten it in trouble.

The first was if large-group customers – big companies,

universities, government institutions, and the like – were indeed

the only profitable segment. “Individual insurance is considered

by ‘true’ insurance people to be a non-insurable event,”

Schaeffer explained, meaning that pooling risk is far more

difficult than it is in a large company with thousands of

employees. Small businesses, with much higher failure rates

than large companies and therefore much higher receivables

risks, were considered undesirable as well. “Small groups were

[insured] in case the small group eventually became a big

group,” he said.

At first, Schaeffer wasn’t certain that the company could

profitably serve individuals and small groups. But he knew it

wasn’t possible under any circumstances through the

company’s existing organizational structure, one in which

technology and paper intensive claims processing, customer

service, and other back-office operations were combined for

all customers for economies of scale.

On the way to transforming the organization, which by

1999 was able to go public as WellPoint Health Networks,

Schaeffer redefined the who of the industry by carefully carving

out operations to serve three separate customer segments –

individuals, small groups, and large groups. “We had to break

this huge mess into manageable chunks,” he explained. A

general manager over each customer segment was given strict

profit-and-loss responsibility, as well as all the operations

necessary to conduct business – marketing, sales, product

development, claims processing, customer service, and finance.

As a result, WellPoint broke its massive claims processing

factory into three pieces, each serving its own customer

segment. The industry considered that heresy.

The first chunk to be created was the individual segment,

one in which the company was losing $45 million a year in

insuring 65,000 people. This segment turned out to be much

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different than the other two because the person receiving

and paying for health services was one and the same, unlike

the small- and large-group segment in which employers pick

up most of the tab. Marketing to and serving individuals were

far different than they were for corporate accounts.

Individuals often buy insurance through independent

brokers, not through the benefits consultants used by large

companies. They don’t have an HR department to iron out

problems. And they are bewildered by the complexities of

health insurance.

Because of such differences, WellPoint realized that the

what (the insurance products and the channels employed)

and the how (delivery approaches for those products) had

to be different for each customer segment as well. At the

time, the prevailing norm around the what of the industry

was that HMOs were the ideal insurance product for

controlling escalating medical costs. HMOs restrict a patient’s

choice by stipulating which doctors and healthcare facilities

will be covered. But Schaeffer thought otherwise, feeling that

people would pay higher deductibles and co-payments for

more choice. “I believed very strongly that the HMO was not

the answer, and to organize around something that I felt was

transient, to say the least, just didn’t make any sense to me.”

By offering multiple health plans to small groups (HMO

and others) – even different health plans to different

employees of the same company – WellPoint hit a responsive

chord during the economic boom of the 1990s. “We’re the

company that believes in choice, and that notion of choice is

very powerful because satisfaction correlates with whether

you chose or were forced to go into a health plan,” Schaeffer

said. Today, for example, the company offers small-business

employees nine different health plans. Less than a third of

the company’s members are in HMOs.

By separating the operations for each customer segment,

WellPoint has dramatically improved its ability to understand

the important needs of each segment, and to create new

health insurance plans or features to meet those needs. “The

key is to get to know those customers well enough to identify

product attributes that others don’t identify, and then build those

attributes into products,” Schaeffer explained. “They are very small

changes, but they’re very powerful.” For example, WellPoint lets

Ford Motor Co., a major account, pay according to the car-maker’s

cash-flow schedules. WellPoint knows when that’s going to be,

and prices it to account for the time-value of money.

On the other hand, the payment rules for small groups are

much stricter. Since a high percentage of small businesses fold

annually, those that don’t pay WellPoint within 30 days are

automatically cancelled. “Treating the receivables of small

businesses like large businesses has gotten other health insurers

in huge trouble in recent years,” Schaeffer said.

WellPoint has been able to deliver attractive health plans

profitably in its three segments through carefully thinking about

the how. First, each customer segment has its own dedicated

operations, including claims processing and customer service.

WellPoint’s business model innovation, in effect, was to create three

separate business models, each serving a different customer

segment. This shifted spending in the company from 80 percent

at the corporate level and 20 percent in the line businesses to

10 percent corporate/90 percent line.

In the small-group sector, WellPoint can offer a range of health

plans because it has standardized the nine plans. “We know from

our customers that these plans work for them and if we need to

make changes, our customers will drive that, not industry opinion,”

Schaeffer said. Second, the company uses actuaries to price its

policies, which most HMOs didn’t use 15 years ago. “I was stunned

to find out that the people who manufactured product in these

kinds of companies didn’t know anything about costs,” Schaeffer

said. “We have more actuarial discipline than most insurance

companies.” Third, WellPoint’s contracts let it change prices more

frequently than most other plans. And fourth, the company has

one of the best databases in its industry on the cost of specific

medical procedures.13 Updated continually, the database lets

WellPoint increase or decrease premiums faster than most other

plans.

12

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The who, what, and how of the three business units are

further improved at the corporate level through several

mechanisms: a strict planning and budgeting process;

continual measurement of key performance indicators; strong

rewards (or penalties) for meeting or missing performance

targets; and the clout to negotiate big pricing concessions from

healthcare providers. Schaeffer referred to the planning and

budgeting process as “loose-tight” – loose in that the three

business units are not instructed by corporate on such issues

as marketing, but tight in that numbers promised must be met.

An information system built for Schaeffer and other WellPoint

corporate executives provides key performance metrics by the

day. “If the [business units] are missing their numbers, I know

about it the minute that they know about it,” he said. “And if

they’re not working on a way to fix it, they know they’re in

trouble.” Schaeffer is known for ruling with an iron fist. Poor

performers are fired fast. “You do not do 15 percent [annual

earnings growth] for seven years because you’re lucky,” he said,

alluding to the pressure he puts on managers to perform.

How has WellPoint sustained its success? For one, many

competitors have huge costs tied up in serving all their

customers through a single organization; separating these

operations as WellPoint has would cost millions and risk

organizational havoc. The inability to make changes all the way

through the who, what, and how of their businesses has left

many would-be WellPoint imitators far behind. Secondly,

Schaeffer’s outsized skepticism about popular wisdom in the

industry has resulted in few bad acquisitions, errant product

introductions, or failed technology investments. For instance,

he declined to enter the Medicare HMO market in the mid-

1990s, even while competitors made big money at first. But

then the HMOs hit the wall when the government cut rates in

1997.

The impact of WellPoint’s moves has been spectacular. One

leading Wall Street analyst predicts the company’s operating

earnings will grow 21 percent this year to $714 million and

revenue 34 percent to more than $12 billion.14 And the company,

which was worth literally nothing 15 years ago, today has a

market cap of more than $6 billion.15 In addition, WellPoint has

earned Fortune magazine’s distinction as the best-managed

healthcare company the last three years. Furthermore, Schaeffer

was named one of Business Week magazine’s top 25 managers

across all industries last year.

The 56-year-old Schaeffer has accomplished all this while

continuing to thumb his nose at industry convention. This year,

he petitioned the U.S. Food & Drug Administration to make three

safe, non-sedating allergy medications available over the counter.

The move would benefit consumers, who would have OTC access

to safer, more effective drugs than currently available, at out-of-

pocket costs equal to or less than current prescription co-

payment. In addition, WellPoint would save about $90 million a

year, mitigating pressure on insurance premiums. It was the first

time an insurance company has asked the FDA to shift a drug to

OTC status.16

And remember the industry norm about the individual and

small-group businesses being undesirable? For several years,

WellPoint’s individual and small-group businesses have been its

most profitable – a compelling feat in an industry that still

gravitates toward large organizations. “Even in the 1990s, one

major insurer would tell you that only schlocky companies would

insure organizations of less than 350 employees,” he said. On

the contrary, catering to all three segments in good and bad

economic times has become critical to WellPoint’s success.

During economic downturns, the individual market grows as

people lose their jobs. In upswings, the small-business segment

(which in the past has produced the greatest number of new

jobs) and large-group segment boom.

“We like being diversified,” said Schaeffer, smiling broadly

like a doctor who has brought a patient back from the brink,

against all medical odds and medical conventions.

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Innovating Around the What: Offering Customers What They Really Want

The leaders at business model innovation were extremely careful

about what they offered their customer segments, the second

element of the business model formula. They carefully tailored

the offering to their chosen segments. In some cases, they stripped

out features and functions from the industry-standard offering that

their chosen segments did not value and provided what they did

value at a lower cost. In other cases, they expanded the industry-

standard offering with attributes that customers embraced and

competitors overlooked. Other innovators drastically reduced the

price component of the what by making structural cost reductions

in the how.

The “what” includes not only the product and service offering

but also the channels through which customers become aware of

the company and its offering. Moreover, it includes customers’ total

experience in using the offering after the purchase. We refer to

this collectively as the “value experience.”

The business model innovators we studied took painstaking

care to match the design of the value experience to precisely fit

the needs of the customer group they were targeting. These

companies developed channels and levels of integration between

these channels that best corresponded to what their targeted

segment valued.

They also let their target customers’ needs dictate the

functionality and quality of the products and services offered –

often stripping down a more robust offering to only the features

and functions that the segment really needed and would pay for.

Consider the case of Southwest. To deliver low-cost fares to its

budget-conscious market, the airline skimped on meals, in-flight

entertainment, and other services it considered unnecessary for

cost-conscious travelers. In catering to the health insurance needs

of individuals and small businesses, WellPoint created health plans,

customer support, and marketing programs that were distinct from

those designed for large companies.

In tailoring the offering, business model innovators utilized multiple

levers, including:

Customizing the offering or allowing customers to configure

it themselves;

Letting customers access the offering through new channels;

and

Dramatically expanding the product/service selection.

In targeting the small-company market, Paychex slashed the costs

of providing payroll services by creating highly standardized payroll

services. In doing so, Paychex brought a valuable offering to small

businesses – the outsourcing of complex payroll processes – that

previously had only been affordable for large corporations. Given

the company’s rapid growth, there’s no question that small

businesses need to outsource payroll as much as large businesses

do. In fact, small businesses on average spend 50 hours a year on

payroll issues, in part to comply with dozens of changing payroll

tax regulations.17

Innovators also created integrated solutions that enhanced

customer loyalty. Schwab, for example, added mutual funds and

financial products from other institutions, while opening other

channels for customers to transact their business, including stores

and the Web. In each case, customer-targeting decisions guided

business choices on what services and experiences to offer. The

innovators didn’t fall into the trap of trying to become all things to

all people, knowing that would put them on an unprofitable path.

14

Key TakeawayKey Takeaway Successful innovators precisely tailor their

offering to their segment's unique needs.

Sometimes this means stripping out features from

the industry-standard offering; other times it

means adding features that competitors missed.

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Other advantages were achieved through offering one-stop

shopping. This was the case in Wal-Mart’s second business model

innovation: its push in the late 1980s to combine grocery items

and general merchandise through its mainline stores, Sam’s Clubs

and super-centers. At the time, most grocery and general

merchandise stores were separate entities. Wal-Mart leveraged

the brand equity it had built over the years for everyday low prices

in general merchandising to steal share of the grocery market.

Through the new business model and relentless store openings,

the company’s market value exploded by 2001 to more than

$200 billion.

Cisco Systems’ business model success in the

telecommunications equipment industry came from a different

type of one-stop value experience. The company’s business model

brilliance came from truly understanding and catering to the

increasingly complex needs of corporate telecommunications

managers in the 1990s. In the late 1980s, more and more corporate

data was shifting from high-cost, proprietary computer networks

to lower-cost, Internet-based networks. A host of new and existing

telecommunications equipment and software suppliers were

chasing this huge market. For a corporate telecommunications

manager, betting on any one of these vendors was a highly risky

proposition. From a customer’s perspective, there is great risk that

either the technology of such a company will become obsolete, a

nonstandard, or that the vendor will go belly-up and not be able

to support its installed base. Cisco shaped its business model to

mitigate that risk by creating a one-stop shop for Internet

networking hardware, software, and services. It created a multi-

product, multi-technology portfolio through an aggressive

merger-and-acquisition strategy and as it grew, customers’ risks

in choosing Cisco continued to decrease.

Two other popular themes in the what of business model

innovation were information-enabled self-service and its close

cousin, the no-frills offering. Amazon and Dell pioneered self-

service-based business models in the book and personal computer

industries. In both cases, self-service was in many ways better than

the full-service options of the incumbents. No bookstore clerk in

the world can match Amazon’s reader reviews with as many

insights into as many books. And although the World Wide Web

hadn’t taken off when Dell started to gain critical mass in the early

1980s, the company later used the Internet to take its self-service

model to the next level. Dell offers its largest customers

customized Web pages in part so they can get the technical details

of their purchases up to the minute (a major source of value for

their IT departments, which must enforce corporate policies and

standards). Dell’s Web pages give customers a much greater sense

of their options in tailoring a PC to their liking – far beyond what

an order taker could explain over the phone or in a store. At $32

billion in revenue, Dell has become the world’s largest and most

efficient maker of PCs.

“The key is to get to know those customers well

enough to identify product attributes that

others don’t identify, and then build those

attributes into products.”– Leonard Schaeffer, CEO of WellPoint

No-frills value experiences helped power Schwab’s first

business model incarnation, as well as Southwest’s. To undercut

stock trading fees of the incumbents, Schwab unbundled the

standard offering – trading plus investment advice. Southwest’s

offering was constructed to profitably undercut the prices of all

other carriers on its routes. This required stripping away on-board

services and the use of travel agents.

As these examples show, the changes the business model

innovators made in the what were not incremental improvements

to the norm. They were, in fact, structural changes. WellPoint

tailored products to meet the distinct needs of individuals and

small businesses, while cultivating the agents who could connect

with these customers. Southwest dramatically pared back the

services that flyers had been used to – food, movies, and so on –

to deliver low-cost air travel. Wal-Mart’s stores in essence were

giant warehouses with shopping carts – retail environments

designed to drastically reduce the cost of merchandising and

increase the flow-through of shoppers.

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Innovating Around the How:Developing Unique Capabilitiesand Operational Structures

After having a specific customer focus and offering that meets the

precise needs of that target segment, the third factor in business

model success involves developing unique capabilities and

operational structures to make the offering possible. Such

capabilities come in three forms: resources (such as intellectual,

physical, structures, and brand assets), activities (such as product

development, distribution, and manufacturing processes), and

partners (such as valued suppliers).

Dominant themes we witnessed across successful innovators

include:

Developing unique capabilities and control over the value

chain;

Optimizing provider operations to targeted segments;

Driving down costs either through

– making explicit trade-offs in what is provided to the

customer, or

– creating significant structural cost advantages.

The capabilities that the innovators used to deliver their value

experience were in all cases unique. That is, they couldn’t be easily

copied by established or start-up competitors. Take the example

of Dell Computer. In Dell’s case, the who was knowledgeable

buyers of PCs (especially large organizations) who didn’t need the

help of a dealer or other channel intermediary to get what they

wanted. Dell’s target segments are big institutions (they have the

greatest sales volume potential and the largest, most sophisticated

IT departments) and PC-savvy individuals who need little support.

Michael Dell decided that providing customizable PCs through

self-service was the way to go (the what), and that the way to

deliver that experience was by going direct and building to order.

As long as the direct model appeared to be a fraction of the market

(which it was until the 1990s), the established PC manufacturers

were reluctant to go around their dealers and face expulsion from

the channel. But as long as they sold through the intermediary,

they couldn’t hope to match Dell’s structural cost advantages in

tailoring PCs to customers’ specifications and selling direct to

customers, thereby reducing channel cost and minimizing

inventory obsolescence (the biggest risk of making and

distributing products and components with half-lives that can be

measured in months). To make sure it was competitive with

computer stores’ quick delivery (at least, for off-the-shelf products),

Dell located supplier operations near its assembly plants and

integrated with those suppliers virtually through its own computer

network. The efficiency of Dell’s how is still unmatched in the

computer industry.

In unbundling its one-size-fits-all health insurance offering,

WellPoint, the California-based health insurer, organized its

resources around distinct customer segments: large employer

groups, small businesses, and individuals. It created self-sufficient

business units with separate information systems for each

segment, which enabled each unit to maintain its own

membership and claims records, and more directly respond to

each segment’s needs. Each unit was given true profit-and-loss

responsibility.

The capabilities that Southwest built to deliver to budget-

conscious travelers a value experience featuring low-cost, on-time

flights are truly unique in the airline industry. First, its resources

are far different. Southwest’s flight network is point-to-point (city-

to-city), whereas the national airlines use hub-and-spoke systems.

Key TakeawayKey Takeaway Successful innovators develop unique capabilities

and operational structures, often creating cost

advantages that competitors can’t match.

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Southwest also focuses on short-haul routes and uses one type

of jet, the Boeing 737. In contrast to the major carriers that use an

assortment of jets, Southwest standardized on one model to

reduce maintenance costs, standardize processes, improve fleet

flexibility, and better ensure on-time arrivals and departures.

There’s no way that the national carriers operating different aircraft

and hub-and-spoke routes can compete with Southwest on price

and enjoy Southwest’s margins.

Second, its activities ran counter to the pack by shunning

premium services such as elaborate meals. Third, its partner

relationships with employees, airports, and others were atypical:

employee stock ownership; close relationships with under-utilized,

secondary airports; and a strong social contract with employees

built upon a history of no layoffs. That’s a far cry from the industry

norm, where downturns result in thousands of layoffs. “Nothing

kills your company’s culture like layoffs,” Southwest CEO Herb

Kelleher told Fortune magazine recently. “Nobody has ever been

furloughed here, and that is unprecedented in the airline industry.

It’s been a huge strength of ours. It’s certainly helped us negotiate

our union contracts.”18 For example, the company’s 10-year

contract with its pilots (three to four years is typical in the industry)

has helped it control costs.

Innovating around the how, as these cases illustrate,

frequently involves configuring activities, resources, and

partnerships in one or more ways that reduce costs. In some

instances, innovators reduced costs by eliminating elements of

the standard offering (e.g., Schwab removing investment advice

from stock trading), by reducing or aggregating steps in the value

chain (e.g., Dell), leveraging economies of scale (e.g., Wal-Mart),

by engineering operations to be low-cost (e.g., Southwest),

and/or by gaining control over critical assets or resources.

Importantly, in every case the choices regarding the how were

tightly linked to choices regarding the what, which in turned

depended upon who was being targeted. That is, the business

model innovators thought through all three aspects of their

business models in achieving significant advantages. The changes

were inextricably linked.

Creating a Sustainable Business Model

While a new business model may be innovative and create

significant customer value, it is not automatic that it will also

generate superior shareholder value. The hundreds of dot-coms

that have crumbled over the last year attest to that. Internet

shopping malls like buy.com and Value America came to realize

that their business models were barely profitable largely because

they were easy to imitate. Endless new entrants sparked cutthroat

competition, which quickly eroded any profit margins originally

captured.

The business model innovators we studied were successful

because they could defend their business models from the

inevitable attackers. The ability to sustain one’s business model

innovation depends on two factors: the extent to which the

innovator creates real advantages, and the existence of real or

psychological disadvantages among the innovator’s competition.

Innovator Advantages

In nearly every case, the innovators created significant advantages

and created enormous brand equity. AOL has become a

household word, while few teenagers would likely recognize the

name of CompuServe, an online service that has been around far

longer than AOL. Has any airline executive generated more

headlines than Herb Kelleher of Southwest? And do any

consumers or airline industry experts – even after the failure of

People Express – now doubt the viability of a discount carrier?

The logos and associated values of these modern corporate icons

are imprinted in the brains of their customers.

Another innovator advantage is an economic one – a superior

ability to deliver a product or service based on scale economies,

learning curve advantages, and locking in critical assets and

resources. The successful innovators created complex, hard-to-

copy business models. They tailored their operations to finely-

targeted customer segments, leveraged technology in often

ingenious ways, and created distinctive corporate cultures that

kept the machine the founders built constantly in tune.

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Paychex: Bringing Big-Company PayrollServices to Mom-and-Pop Operators

Opportunities for business model innovation are right in front

of every organization. But to pursue them, executives have to

rethink their core beliefs about the who, what, and how of their

business.

When managers do this, they can discover customer needs

that they’ve overlooked or misunderstood for some time. The

small-businesses payroll outsourcing model on which Paychex

is thriving today is a case in point. With superior performance

over its industry peers on total shareholder returns, market

value, real asset growth, and other measures, the company is

on strong footing today.

How did Paychex create its business model in 1970? Two

key factors allowed Paychex to come into being. First was the

development of technology for cost-effectively complying with

state and federal tax requirements. The second was the

opportunity to satisfy a large number of small businesses whose

needs were not being addressed by the leading incumbent,

Automated Data Processing Inc. (ADP). Had Paychex believed

that ADP controlled a mature market for payroll services, where

all the market opportunities were already uncovered and

adequately addressed, it never would have gotten off the

ground.

The Rochester, N.Y., company was founded by Tom

Golisano in late 1970 to serve a small-business segment

largely ignored by payroll giants such as ADP. Golisano, in

fact, had failed to convince his boss at a regional payroll

processor of the viability of the small-business niche before

launching Paychex.19

Paychex defined the who by looking closely at the payroll

needs of small businesses. Realizing that small-business

needs for efficient, affordable payroll processing were unmet,

it understood their needs better and redefined them. In the

process, Paychex successfully altered customer perspectives

on what their choices were. Paychex defined the what by

broadening customers’ choices and simplifying the offerings.

For instance, it provided a choice of customized solutions that

are typically available only for large companies.

Consistent with its definitions of who and what, Paychex

configured its how by engineering operations to serve its

targeted customer group and using information technology

to tightly integrate with customers’ systems. The sustainability

of Paychex’s business model innovation is undoubtedly

rooted in the advantageous customer access and customer

loyalty it has achieved as part of its first-mover advantages.

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Incumbent Disadvantages

Such advantages weren’t the only way for a business model

innovator to carve a chunk out of an existing market or to create

a new market. The incumbents in these industries frequently had

many disadvantages that gave the business model innovators

considerable time and leeway to pioneer a new approach. We

came across three real disadvantages most often: the potential

of a business model innovation to disrupt existing channels of

distribution, the fear of eroding the existing brand, and the

difficulty in managing multiple operational models.

Fear of channel disruption stops many incumbents from

creating new business models. Compaq, IBM, Hewlett-Packard,

Packard Bell, and the other PC makers who sold through channel

in the 1980s and 1990s were reluctant for many years to risk their

channel relationships by going direct. By the time they did, Dell

was already in motion, with the company building and perfecting

supply chain and assembly operations that are still unmatched

in the industry. Merrill Lynch and other full-service brokerages

let Schwab control the discount market for years, not wanting to

damage the relationships and goodwill they had built up with

their brokers.

An important part of Schwab’s success can be attributed to

its ability to capitalize on competitors’ fears, namely that copying

Schwab would erode their brand equity as premium brokerage

houses. They did not try to match Schwab’s discount model.

Similarly, in Southwest’s early years, few of the national airlines

wanted to pollute their premium brands by offering a discount

model to compete with Southwest’s regional play. Competitors

used to joke that Southwest and the long-defunct, no-frills airline

People Express stuffed passengers in like cattle.

In addition to these real constraints, psychological hurdles

handicapped incumbents as well. By far the biggest was the

inability of incumbents to think beyond the current business

norms of the industry. This myopia prevented incumbents in most

of the industries studied from seeing the unserved customer needs

in the market that could provide major opportunities for growth.

The competitors of over 80 percent of the business model

innovators studied shared this blindness. This myopia allowed

business model innovators to capture significant first-mover leads

before incumbents could figure out what hit them. These

disadvantages are formidable.

These examples suggest that before launching a new business

model, executives must rigorously identify the advantages their

organization can create – and the disadvantages of the existing

competition. In their excitement over a new business opportunity

and all the hard work in executing it, managers often forget the

importance of due diligence to understand the sustainability of

the innovation. The fall to earth of many once-meteoric companies

attests to this.

Key TakeawayKey TakeawaySuccessful innovators exploit key assets such as

brands, innovative cultures, scale economies, and

deep knowledge. They also prey on incumbents'

real and perceived constraints.

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Putting Business ModelInnovation to Work

Given today’s economic uncertainty, executives understandably

may view business model innovation as a risky proposition.

However, our research shows how playing it safe can actually cause

companies to incur larger risks – the risk of watching someone

else redefine the who, what, and how of the industry. While it’s

hard to imagine today, most of the established players in the

industries that Wal-Mart, AOL, Schwab, Columbia, Dell, and

other innovators first entered grossly underestimated the

importance of the new business models. Business model

innovation can come from any place, any time. Schwab launched

discount brokerage services for the mass market amid a protracted

bear market. Similarly, Corning began its alliance-based path of

developing new product markets during a market recession.

The innovators don’t rest peacefully at night. They realize that

even the most lucrative breakthrough business models can run

their course or at least need continual tune-ups. Four of the

companies we studied – AOL, Schwab, Wal-Mart, and Enron – have

launched fundamental business model innovations more than

once in their lifetimes. Enron has actually introduced three business

model transformations, expanding its business model from energy

trading to include energy outsourcing and bandwidth trading.

While the other innovators in the study did not repeatedly

launch discrete new business models, they were by no means

standing still after launching their initial innovation. These

companies instituted ongoing incremental improvements to stay

ahead of the pack. For example, Dell was one of the first PC

companies to jump on the Internet. As of summer 2001, Dell sells

half of its products online and has become the largest PC maker in

the world, direct or indirect.20

In learning from these companies, it is clear to us that business

model innovation should be approached methodically and on a

consistent basis. A three-step approach can bring order to what

can easily become a chaotic process.

Scan andScope

Rethink andRedesign

Plan andImplement

Set BMI objectives

BMIFocus Areas

RankedBMI Opportunities

Value-CreatingBMI

SOURCE: DELOITTE CONSULTING

Define pathway

Understandindustry norms

Assess external factors

Assess internalcapabilities and constraints

Rethink the who,what and how

Assess ft-gap ofeach option

Assess sustainabilityof each option

Refine andcompare options

Build workplanand milestones

Prototype and evolve

Rapidly implement

PUTTING BUSINESS MODEL INNOVATION TO WORK

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The first step in this process involves scanning for

opportunities and determining when new business models should

be explored. What is the current context of the industry? What

key technology, regulatory, and socioeconomic trends could spell

major opportunities? Industry norms must be articulated around

target customers (who), offerings (what), and operating models

(how). What customer segments are considered undesirable? For

desirable customers, what is the prevailing belief about their core

needs?

Additionally, managers must understand the capabilities of

their organization that can be leveraged in a new business model.

Brands (which Harley-Davidson exploited in creating a lifestyle

business model), business processes (Wal-Mart took advantage of

its inventory management and distribution systems in its second

business model innovation), existing customer bases, and other

assets can provide important capabilities for new business models.

Which should managers reexamine first – the who, what, or

how of their industry? We believe that a company ’s core

capabilities (i.e., the how) needs to be determined by choices

around the who and the what – and not vice versa. Starting by

assessing one’s core capabilities – for example, first-class R&D or

distribution management – may lead managers to discover new

customers and products that can be easily served by existing

capabilities. However, we believe the best place to start is to

identify the target who – the significant, underserved customer

needs. Around that who, a unique offering and profitable

operating model must be built that other would-be competitors

cannot easily match or outdo.

The second step involves getting senior executives to

proactively challenge the norms around the who, what, and how

of their industry to identify new business opportunities. Why were

the segments identified in the first phase considered undesirable?

Could these segments become attractive by altering the value

experience? Could these needs be served better by creating a

new customer segment, redefining an existing segment, or

changing the buyer?

In looking at all the steps that customers take in purchasing

and using the offering – from search to replacement – what

attributes (e.g., variety, speed, ease of use) are most important to

each segment? For segments that appear to offer the greatest

customer and shareholder value, how can the value experience

be delivered most efficiently? What kinds of competitive

advantage could be created (scale, learning curve, etc.)? What

disadvantages are existing competitors likely to have in pursuing

the opportunity?

Managers then must assess how well the opportunities fit with

existing resources and how well the organization can sustain the

new business models in the face of competition. At the end of

this step, managers will have a range of business model

opportunities ranked by such criteria as size of potential

opportunity, degree of fit with corporate capabilities, and level of

sustainability.

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22

The third step is to refine the design of the new business

models, plan their rollout, and then pilot them. A road map must

be developed for each opportunity, with major tasks, milestones,

and key success factors. It is at this stage that risk must be

evaluated. The key risks of business model innovation include

technology immaturity, customer reluctance to adopt a new

offering, organizational resistance, and the possible disruption of

existing business operations. Managers must develop strategies

to mitigate their primary risks. Critical go and no-go hurdles should

be created in advance. Managers must develop explicit

implementation plans, financial forecasts, and risk and

sustainability assessments.

There is not one ideal business model. Developing value

business models requires a measured approach and a significant

amount of “analytical heavy lifting” focused on rethinking industry

norms, identifying underserved customer segments, and deciding

where and how to apply the lessons learned from successful

innovators.

The dot-com collapse and economic uncertainties have

caused established companies to pause before they invest in the

next breakthrough business concept. Billions of dollars in

corporate R&D and venture funds have been lost because of

insufficient due diligence on promising-sounding new business

models. But the rising sea of red ink should not blind executives

to the substantial value created through business model

innovation over the last 40 years. If anything, the success of

outsiders like Wal-Mart, Schwab, AOL, and Starbucks demonstrates

how costly it can be to let others rethink the prevailing who, what,

and how of an industry.

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1 London Business School Professor Constantinos Markides in his1999 book “All the Right Moves” created the framework of the Who,What, and How to examine business models.

2 W. C. Symonds, “The Power of the Paycheck,” Business Week, May 24,1999, p. 71.

3 Golisano talked about the early days at Paychex Inc. in a Q&A withInc. magazine, “How to Build an Inc. 500 Company,” December 1, 1988.

4 Market value as of July 31, 2001.

5 Financial performance of the industry leaders was tracked througha HOLT value analysis conducted at the end of December 2000. Holtuses six metrics in its analysis: “premium current,” “percent future,”“cash flow return on investment,” “total shareholder returns,” “five-year real annual asset growth,” and “current market value.” For moreinformation about these measures, see sidebar “About the Study.”

6 M. Dell with C. Fredman, “Direct from Dell: Strategies ThatRevolutionized an Industry,” p. 12 (HarperBusiness, 1999).

7 H. Kelleher with K. Brooker, “The Chairman of the Board Looks Back,”Fortune, May 28, 2001, p. 63. Market value as of July 31, 2001.

8 Market value as of July 31, 2001.

9 Paychex press release of July 11, 2001, “ABA selects Paychex asprovider of new member benefit for payroll processing,”www.paychex.com/paychex/press/071101.html

10 W.C. Symonds, “The Power of the Paycheck.” Business Week, May 24,1999, p. 71.

11 K. Swisher, “aol.com”, (Times Business, 1999), pp. 86-87.

12 J. Peltz, “Behind Aetna Bid …,” Los Angeles Times, March 3, 2000,p. C-1.

13 R. Rundle, “Calling the Shots: California Health Plan Thrives, ButDoctors Claim Care Suffers,” The Wall Street Journal, May 31, 2000,Page A1.

14 So predicts John Szabo, an analyst at CIBC World Markets, accordingto a May 14, 2001 Business Week article by A. Weintraub, “Leonardthe Giant Killer?” p. 78.

15 Market value as of July 31, 2001.

16 A. Weintraub, “Leonard the Giant Killer?”, Business Week, May 14, 2001,p. 78.

17 According to a survey by International Communications Research,as cited in an Entrepreneur magazine article by M. Hogan,“Automation for the People,” January 1, 2000.

18 H. Kelleher as told to K. Brooker, “The Chairman of the Board LooksBack,” Fortune, May 28, 2001, pp. 63-76.

19 W.C. Symonds, “The Power of the Paycheck,” Business Week, May 24,1999, p. 71.

20 S. Perman, “Automate or Die,” eCompany Now, July 2001, pp. 60-67.

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24

For Further Information, Please Contact

AMERICASANDREW GARBER

Tel: 404.631.3570

Email: [email protected]

ASIA PACIFICTODD GENTON

Tel: +852.2852.6650

Email: [email protected]

EUROPEHANS-RUDOLF DICKE

Tel: +49.40.4609930

Email: [email protected]

GLOBALLARRY SCOTT

Tel: 416.601.5666

Email: [email protected]

DELOITTE CONSULTING

BMI THOUGHT LEADERSHIP TEAM

©2001 Deloitte Consulting and Deloitte & Touche LLP. All rights reserved.ISBN 1-892383-90-X

DAVID ROSENBLUM

Tel: 213.688.5169

Email: [email protected]

SANFORD DAVIS

Tel: 213.688.4712

Email: [email protected]

DOUG TOMLINSON

Tel: 415.783.4161

Email: [email protected]

MUMTAZ AHMED

Tel: 415.783.5597

Email: [email protected]

Special thanks to those who contributed to this research: Professor B. Mahadevan (Indian Institute of Management), Rik Geiersbach,

Mathias Herzog, Donald Hicks, Mark Holmstrom, Alison Keiller, Mark Mullikin, Michele Parmelee, Stephanie Siegel, Steve Watkins, and

Sarah Wiley.

Recent Deloitte Research Thought Leadership:■ Collaborative Knowledge Networks: Driving Workforce Performance Through Web-Enabled Communities

■ Digital Loyalty Networks: eDifferentiated Customer and Supply Chain Management

■ Mobilizing the Enterprise: Unlocking the Real Value of Wireless

■ Strategic Flexibility in the Communications Industry: Making Billion-Dollar Bets in a World of Uncertainty

■ Strategic Flexibility in the Energy Industry: Competing in a Decade of Uncertainty: 2000-2010

Please visit www.dc.com for the latest Deloitte Research thought leadership or contact us at Tel: +1.212.492.3791

or e-mail: [email protected].

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About Deloitte Consulting and Deloitte & ToucheDeloitte Consulting is one of the world's leading consulting firms, providing services in all aspects of enterprise transformation, from

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About Deloitte ResearchDeloitte Research, a permanent thought leadership organization established by Deloitte & Touche and Deloitte Consulting, is dedicated

to providing ongoing research and insight into the critical global and industry-specific issues facing business today. Comprised of both

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For more information about Deloitte Research, please contact

ANN BAXTERGlobal DirectorTel: +1.415.783.4952 Email: [email protected]

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