A Framework for Business Model Innovation
Article · January 2004
1 author:
B. Mahadevan
1
A framework for Business Model Innovation
B. Mahadevan
Indian Institute of Management Bangalore
Bannerghatta Road, Bangalore, 560 076 INDIA.
E-mail: mahadev@iimb.ernet.in
Ph: (91 - 80) - 699 3275
Abstract
Innovation as a key enabler of value creation has been
the subject matter for study by several strategy
researchers in the past few decades. However, the notion
of business model innovation has not been distinctly
established in the previous studies. This paper seeks to
fulfill this objective. We develop a framework for
business model innovation using a two-fold process. On
the one hand, we explore theoretical foundations of
creating and sustaining competitive advantage of firms
and deduce factors that play an important role in the
process. On the other hand, we study 18 successful
business models from a variety of sectors of industry in
the US and identify key success factors.
The study identifies several useful implications for
practice. Our framework suggests that incumbent firms
and start-ups differ vastly in their approach towards
business model innovation. Moreover, the success of a
business model innovation hinges closely on the degree
of differentiation and the degree of sustainability that the
business model innovation provides to the innovating
firm.
Keywords: Innovation, Business Model, Framework,
Empirical Study
I. INTRODUCTION
To be successful businesses need to constantly engage in
value creation for both the shareholders and the
customers. Innovation has been recognised as one
potential lever for value creation. Despite this simple
truth, business leaders have often grappled with the issue
of value creation over several years. Recently, innovation
has been the subject matter of discussion by several
researchers both in popular press and scholarly journals
[1,2,3]. Alternative forms of innovation have been
identified in the literature. These include market, product,
process innovations [4] and technological innovation [5].
Earlier research on sources of innovation has generally
classified innovations into Administrative Vs Technical
or Product Vs Process. However, in our understanding,
recently several firms have seldom deployed radical
innovations in technology, product or the business
processes to create value. This has renewed the interest in
the subject and raises the fundamental question “what
are successful companies leveraging on?”
We show that these firms deploy business model
innovation (BMI), a framework that creates a strategic
positioning for a firm. BMI enables a firm to uniquely
deploy available alternatives with respect to product,
technology, process and markets with a view to create
new value propositions and appropriate value arising out
of the competitive advantage. We show in this paper that
business model innovation is the current source for value
creation and develop a framework for the same. Before
we proceed further, we define the term value creation. By
value creation, we mean the sum of all values that can be
appropriated by participants in business transactions [6].
This research adds a few dimensions to the existing body
of knowledge in the area. First, the notion of BMI has
neither been explicitly recognised nor defined in the past.
We provide a formal definition for BMI and develop a
framework for the BMI process. Furthermore, we link the
theoretical foundations pertaining to value creation to
various components of a business model and show how
in practice these ideas have found expression in the
business models. Finally, we identify some implications
for practice and identify areas that require further
research.
II. COMPONENTS OF A BUSINESS MODEL
The term business model has been used widely among
the practising community and consultants in a loose
fashion. It is often linked to the revenue model or the
operating model of the firm and is used to indicate how
robust is the revenue potential of the business idea.
Hamel [7] suggested that the high capitalisation of silicon
valley firms could be due to the business model than the
talent of the entrepreneurs. Kim and Mauborgne [8] took
a narrower view of a business model. They defined
business model with the objective of arriving at a pricing
structure for the product. Amit and Zott [9] noted that the
perspective of business model is absent in the academic
literature. They define business model as a careful design
of content, structure and governance of transactions so
that it creates value. Venkatraman and Henderson [10]
defined business model as a strategy pertaining to
customer interaction, asset configuration and knowledge
leverage.
Mahadevan [11] defined a business model for an Internet
based E Commerce using three components: value
stream, revenue stream and logistic stream. Value stream
is nothing but a list of tangible value propositions that a
customer is likely to derive from the business. On the
other hand, logistic stream will focus on various elements
pertaining to asset control and configuring the supply
chain. All the above definitions point to three important
2
ingredients of a business model: a need to understand the
customer requirements, linking it to various operational
choices to be made and activities (transactions) of the
business and the need to include supply chain elements in
the definition.
based on the premise that innovation creates disequilibrium in the market paving the way for new value
creation opportunities. McGrath et al. [19] argued that
heterogeneity of a firm is likely to delay appropriation of
rents in competitive markets by the competitors.
Perhaps the closest definition for a business model stems
from Markides [12]. According to Markides, every firm
needs to position itself appropriately in a three
dimensional strategic map comprised of who, what and
why. The “who” element addresses the target group for
the business. By appropriate identification of customers
and their needs, it sets the stage for building the other
components of the business model. Once the right target
is identified, firms need to decide the exact nature of the
value proposition that it needs to provide to the targeted
segment. It may call for deciding the breadth and the
depth of the offering, the level of interface required with
the customer and the mode of offering. The “what”
aspect of a business model addresses these issues. Once
these components of the business model are established,
the value delivery system could be configured. The
“how” dimension of the business model addresses these
issues. Configuring the operational aspects of the
business would mean deciding on the type of product and
process technology to be adopted, decisions on asset
configuration, the extent and nature of interactions with
other supply chain elements and overall operating system
design.
Therefore, degree of differentiation is an important
element of innovation. Further, degree of differentiation
is a good measure of assessing the value creation
capability of an innovation. By degree of differentiation,
we mean distinctiveness in the offering.
Clearly, the “who”, “what” and “how” form the core
elements of a business model. We see this definition of
the business model to be broad. Further, it encompasses
multiple perspectives suggested by other definitions.
Therefore, in this study, we adopt this definition.
Consequently, we define business model innovation as a
strategic initiative to configure or reconfigure various
elements pertaining to the three dimensions of the
business model to enhance value creation potential of the
firm and sustain it over a longer time.
III. VALUE CREATION AND VALUE
APPROPRIATION FROM AN INNOVATION
The nature of innovation in firms has been broadly
classified into three [13]: Administrative Vs Technical
[14], Product Vs Process [15] and Radical Vs
Incremental [16]. Technical innovation pertains to
products, services and production process technology. On
the other hand, administrative innovation involves
organization structure and administrative processes.
However, the notion of business model innovation has
not been explicitly discussed in any of the previous
studies.
A set of highly homogenous firms in a sector of an
industry has very little opportunity for value creation.
The notion of creating value through innovation has well
been articulated in the seminal works of Schumpeter
[17,18]. Schumpeterian innovation-based competition is
Firms operating in all sectors of industry go through a
cycle of initial value creation (through innovation), value
shrinkage (when competitors imitate the innovation) and
value migration (identifying the next lever for value
creation). Slywitsky [20] identified value migration paths
in several sectors of industry and concluded that in order
to be profitable, firms need to migrate their value
propositions from time to time. Kim and Mauborgne [3]
observed a similar phenomenon and proposed drawing
value curves to identify when to start the next cycle of
innovation.
Rumelt [21] has shown that intra-industry differences in
profits are greater than inter-industry differences,
strongly suggesting the importance of firm-specific
factors and the relative unimportance of industry effects.
Clearly, one of the important firm-specific factors is the
propensity to innovate. The variability in the propensity
to innovate explains why firms experience persistent
profitability to varying degrees. These studies lead to the
proposition that in every firm innovation is a persistent
activity required to remain competitive.
However, persistent innovation is a necessary but not a
sufficient condition for sustaining the profitability. Teece
{5] argued that innovation and value appropriation might
not go together. While innovation undoubtedly throws up
opportunities for value creation, there are other factors
that determine who benefits from the innovation.
Similarly, McGrath et al. [19] argued that firms must
establish distinctive competitive advantage before they
could appropriate value out of an innovation. If they did
not, rival firms appropriate the value.
According to resource-based view (RBV), there are
several resources in a firm that share properties such as
scarce, unique, inimitable, durable, idiosyncratic, nontradeable, intangible and non-substitutable making them
difficult to imitate [22,23,24]. These difficult-to-imitate
resources may include a firm’s strategic assets such as its
brand name, buyer-seller trust and other unique methods
of marshalling the resources at its disposal. Ghemmawat
[4] identified size and access as important factors in
sustaining the competitive advantage. Lieberman and
Montgomery [25] identified three mechanisms for
enhancing first mover advantage.
3
Clearly, while innovation could trigger the process of
value creation, the value that accrues to the innovating
firm is dependant on its ability to sustain the innovation.
Inimitability of resources, preferential access to
resources, lock-in and switching costs determine the
degree of sustainability of an innovating firm. The
greater the degree of sustainability, the greater are the
chances of appropriating value from the innovation.
We argue that unless firms are able to exploit value
creating and value appropriation opportunities fully, the
innovation is neither successful nor logically complete.
Therefore, the elements of a successful business model
innovation would have factors that enable firms to both
value creation and value appropriation. The development
of a framework for BMI will be on this basis. However,
before we develop the framework, we provide additional
insights on the basis of an empirical analysis of several
business models that we have observed in practice.
IV. BUSINESS MODEL INNOVATION: AN
EMPIRICAL ANALYSIS
We present our overall analysis of 18 business models of
15 companies operating in the US. While 10 business
models were those pertaining to start-ups (including
Amazon, Cisco, Dell, Wal-Mart, Southwest Airlines,
Charles Schwab and AOL), the remaining were those of
incumbent firms (including GE, Corning, and Harley
Davidson). The term start-up has a slightly different
connotation in the paper. In this paper, we have made an
attempt to analyse multiple business models of the same
company. For instance, we analyse two versions of WalMart and two versions of Charles Schwab. In such cases,
while analyzing the first version, we treat the company as
a start-up and while we anlayse the subsequent versions,
the same company is treated as an incumbent. We have
clarified this in the revised version.
The results used in this paper consist of the findings from
a partial list of business models taken up for the study.
For more details on the study, readers are referred to
Deloitte research [26]. The business models were
selected on the basis of an initial short-listing of
companies using financial analysis data. From a shortlist
of top performers in each segment, 16 companies were
selected for detailed analysis. Using a structured
approach for data collection each of these cases were
classified on the basis of over 60 factors for preliminary
analysis. Further analysis involved use of BMI
conceptual framework to fit these cases, pattern synthesis
and empirical generalisation.
The study was aimed at understanding three main
questions: (a) What are the internal and external drivers
that cause or enable companies to innovate their business
model? (b) How do companies configure various
elements in the business model? Are there any
discernable patterns in the strategies adopted? (c) How
could companies ensure that their business models are
sustainable over a period of time? We present some of
our key findings pertaining to these below.
A. Context for innovation
Our analysis shows a pattern in the process that drives a
business model innovation (Figure 1). First, firms
experience value shrinkage due to existing market
conditions. Homogeneity of business models in the sector
of the industry and changing customer needs contributed
much to the value shrinkage phenomenon. Except AOL
all other firms were experiencing high degree of
homogeneity of business models with that of the
competition. Similarly, existing business models were not
addressing the changing customer needs. For example,
prior to Charles Schwab’s introduction of a “self-service
multi-channel brokerage” model during early 1990s,
there was none to address the needs of the investor
community that was becoming increasingly diverse.
Starbucks, on the other hand, responded to the growing
demand for “café community”, a relatively unmet
lifestyle need for high-quality yet affordable luxuries
(such as gourmet ice cream, tennis shoes etc.).
Figure 1
An analysis of the context for Business Model Innovation
Competition
issues
Technology
issues
Value
Shrinkage
New Value
Creation
Strategies
Changing
customer needs
Regulatory/
Economy issues
Firm level
issues
Firms in our sample have gainfully exploited
opportunities that enabled them to create dis-equilibrium
in the market. Southwest Airlines and Charles Schwab
responded to the changes in the regulatory framework
and came with new business models in the respective
sectors. Firms such as Amazon, Dell and Cisco could
exploit new technology options for value creation.
Similarly, Owens Corning made significant advances in
optical fibre technology to grow into a diversified hightech manufacturer from a mere specialty glass
manufacturer. In several of the incumbent firms, firm
level competencies enabled new value creation strategies.
One prominent example in our sample was GE.
B. Business Model components
The business models were analysed using the three
dimensional framework (who-what-how). The firms in
our sample exhibit several features that may enable firms
not only to create value but also sustain them for a longer
4
time. They have achieved this by gainfully exploiting
several factors identified in the literature for sustaining
competitive advantage. While the “who” segment of the
business model has provided sufficient scope to create
dis-equilibrium in the market through innovative
practices, the “what” and the “how” components have
enabled the firms to deploy strategies to sustain the
competitive advantage.
Earlier research emphasized that inimitability of the
business model plays a fundamental role in sustaining the
competitive advantage for a longer time. The empirical
study confirms these as we see several features that
provide inimitability. Prominent among them is the
variety of customer engaging alternatives deployed in the
“what” component of the business model. The
sustainability of Paychex’s BMI was anchored on the
advantageous customer access that it achieved through
greater opportunities of engaging the customer with their
business.
Similarly, asset control strategies and branding strategies
are likely to play a significant role in inducing switching
costs and provide benefits of lock-in. Harley Davidson
could leverage on its brand equity among its loyal
customers to promote Harley Lifestyle. On the other
hand, BMI in Corning involved leveraging the existing
strengths in product development and technology
research as well as developing new supply chain linkages
to outsource execution. Asset control strategies such as
achieving a dominant position on critical assets required
for the innovation and acquiring/licensing IP with the
partners were important elements of Corning’s strategy.
C. Sustainability of the innovation
Past research seem to converge on a set of factors for
sustaining competitive advantage. The business model
component of each firm in our sample exhibits a
combination of several of these. Wal-Mart, for example,
took advantage of its valuable inventory management and
distribution capabilities while innovating its second
business model. Based on the detailed analysis of the
factors that provided sustainability, we have identified
four generic categories under which these fall:
(a) Size based: The strategies deployed in the business
model components are mainly arising out of size
advantages.
(b) Complimentary physical assets based: The
competitive advantages stem in this case from
physical assets that are essential for benefiting from
the innovation.
(c) Relationship based: In this case, the firms move
from a mere transactional interaction to one of a
relational mode. Over time, deep and lasting
relationships are formed with the customers.
(d) Tacit knowledge assets based: In addition to physical
resources and deep relationships, firms have
accumulated valuable experiences pertaining to
operating in a unique mode arising out of business
model innovation. This forms the core of the tacit
knowledge assets of the firm.
As we can see, the extent of imitability of these strategies
decreases as we go down the list. While replicating large
scale assets are possible (although not worthwhile in
several cases), tacit knowledge assets can neither be
sourced in the market nor developed overnight.
We make several observations based on the analysis.
First, very few have made use of tacit knowledge assets
based strategies for sustaining innovation. On the other
hand, the strategies are size oriented and in some cases
relationship oriented. Second, incumbent firms have been
able to exploit several advantages arising out of size,
learning experience, asset control, supply chain
reconfiguration and other resource-based strengths. In
contrast, start-up firms have been able to create business
models that are highly distinctive. These firms have
developed new modes of developing deep linkages with
the customer and operate in areas that are hitherto
unknown or untested by the competition. Starbucks,
Amazon, and Southwest airlines are some of the
examples in our sample that demonstrate this method of
innovation and value appropriation.
D. A framework for business model innovation
A successful business model innovation requires three
important ingredients; recognizing the need to migrate
the business model to the next cycle as value shrinkage
occurs, exploiting new value creation opportunities for
crafting the next business model and sustaining the
innovation sufficiently long to appropriate value ahead of
the competition through careful choices of the business
model components. The basic structure of business model
innovation that we propose is ground on this premise
(Figure 2). The process is repetitive as diffusion of
innovation happens over time.
The context drives one cycle of business model
innovation. During this stage, firms experience value
shrinkage as business models are highly homogeneous.
They look for alternative paths that enable them identify
new opportunities for configuring various elements of the
business model. Through such an innovation the firm
creates dis-equilibrium and customers perceive
distinctiveness in the offerings. The operational details of
the nature of innovation are evident in various choices
made in the core elements of the business model. Various
alternative choices are employed in the “who”, “what”
and “how” components of the business model. As we
noted in the empirical study, these choices impact the
sustainability of the model over time. These choices
enable the firm to develop idiosyncratic insights,
resources and routines out of innovation. Diffusion of
innovation is unavoidable. At best, it can be postponed to
a later time. Therefore the context will once again drive
the next cycle of innovation.
5
Competition
Context for BMI
Technology
Core Elements of BMI
Target
Customers
Who
Value
Propositions
What
Regulatory & Economy
Value
Delivery
System
Changing customer needs
Figure 2
A framework for Business Model Innovation
How
Firm Level issues
These include, for instance, cultural and mind-set inertia,
fear of disrupting existing channels, fear of
cannibalisation, inability to manage different operational
modes and loyalty to large sunk costs (pertaining to
earlier operations). The incumbent firms experience path
dependence while they engage in the next business model
innovation. Therefore, incumbent firms have a
compelling reason to consolidate their existing linkages
(of customers and supply chain partners) and seek to
provide them new value perceptions or strengthen the
existing value perceptions.
Therefore, it is likely that incumbent firms will find the
deterrence mode more useful whereas new firms (with
low market share and aggressive growth projections) will
often employ war mode innovation strategies. Such a
separation of strategies is hardly surprising. On the other
hand, it is indeed natural.
Sustainability
In our study, we find that incumbent firms have been able
to exploit several advantages arising out of size, learning
experience, asset control, supply chain reconfiguration
and other resource based strengths. On the other hand,
the business models were less distinctive. However, even
when the business model was less distinctive, they have
been able to appropriate sufficient value on account of
high degree of sustainability. We characterise this as
deterrence mode of innovation. The primary value driver
in deterrence mode innovation is the ability to induce
switching costs to existing customers. This stems largely
from economies of scale, monopoly control over critical
resources and a control on the eco-system.
In contrast, start-up firms have been able to create
business models that are highly distinctive. Start-up firms
do not have rich endowment of resources as incumbent
firms to provide them high degree of sustainability.
Despite this they were able to appropriate value due to
high degree of differentiation of their business model.
We refer to this as war mode innovation. Essentially, war
mode innovations work from the other side. They reduce
the switching costs to competitors’ customers and trigger
them to embrace the new offering. Furthermore, through
significant transactional efficiency increases, increased
economies of scope (often due to use of IT based
strategies for providing the value proposition) and
developing intimate relationships with the newly found
customers they bring in an element of uniqueness and
strengthen their value proposition. War mode innovation
helps a firm not only to appropriate value, but also
prevent the competition from imitating for a period of
time (primarily arising out of substantial investments in
new relationships and exploiting resources outside the
firm).
Furthermore, start-up firms have the benefit of not having
many of the disadvantages that an incumbent firm faces.
Figure 3
Alternative value migration path in a BMI process
High
Degree of Differentiation
V. MANAGERIAL IMPLICATIONS
Based on these findings we propose five categories of
innovating firms on the basis of alternative value
migration paths that these firms pursue when they engage
in a business model innovation exercise (Figure 3). We
use degree of differentiation and degree of sustainability
as the two dimensions on which we identify these
categories. The first two are deterrence mode innovators
and war mode innovators. We have already characterised
these two categories.
Low
Suc
Inn cessfu
(W ovato l
ar
mo rs
de)
d
en
Tr ters
t
Se
Followers
Im
ita
t
ors
ul
ssf ors de)
e
o
c c at
Su nov ce m
In ren
r
ete
(D
Degree of Sustainability
High
Trend setters deploy new strategies that are promisingly
good innovation ideas. They portray high degree of
differentiation. However, without the required
endowment of physical and knowledge assets they fail in
appropriating value over time. Several Internet start-ups
in the last five years belong to this category. However,
some of the trend setters evolve into war mode once they
experience first mover advantage arising out certain
strategic pursuits after the innovation is out in the market.
Some strategies do not appropriate value as they are not
outcomes of genuine innovation but of limited tinkering
6
of competitors’ ideas. They are neither good in
differentiating nor in sustaining “so-called” innovation.
We characterise them as imitators. Finally, there is a
category of followers. Several other firms take time to
copy the innovation by suitably adjusting the innovation
to their operating system. These are defined as followers.
Followers play an important role in diffusing the
innovation over time and triggering the next cycle of
innovation.
VI. CONCLUSIONS
Innovative practices enable organisations to discover new
value creation opportunities. In the past, several types of
innovation have been found to be useful. BMI is a metalevel activity that provides a basis for deploying available
options in technology, product, markets, supply chain
alternatives and assets to provide unique advantages to
the firm. We provide a formal definition and description
of the BMI process from an analysis of business models
found in practice. Alternative migration paths proposed
in this study require considerable research and empirical
verification. We suspect that firms are likely to switch
from one migration path to another over time. It is
important to know what factors drives this phenomenon.
ACKNOWLEDGEMENT
The conceptual foundations of this paper were evolved
during a collaborative research work the author did with
concultants of Deloitte Consulting, L.L.P, USA as a part
of an assignment during 2001 – 2002. The author wishes
to place on record the support provided by Mr. Mumtaz
Ahmed and Mr. Douglass Tomlinson of Deloitte
Consulting by way of joint discussions and sharing of
data for the purpose of developing a framework for
Business Model Innovation.
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