Is Your Business Model Part of Your Innovation Strategy?

Hbr.

On strategy.

Welcome to HBR on Strategy. Case studies and conversations with the world's top business and management experts hand selected to help you unlock new ways of doing business. The theory of disruptive innovation, first introduced in 1995 right here at HBR, has proven to be an enduring way to think about innovations that make a complicated and expensive product simpler and more affordable. Think about how Netflix disrupted video rental stores with streaming video. But the originator of disruptive innovation, Harvard Business School Professor Clay Christensen, says many managers overlook a crucial component, business model innovation. This episode will help you understand when and how to create a whole new business model for innovative activities with plenty of real world examples. And you'll learn why it's important to build a disruptive business model that avoids falling into the trap of marginal costs, which can be the difference between success or failure. This episode originally aired on HBR IdeaCast in November 2008. Here it is.

Hi, I'm Sarah Cliff, the Editorial Director of the Harvard Business Review. Our guest today is Clay Christensen, a professor at the Harvard Business School, co founder of the strategy consulting firm innosight, and author of many books and articles, including a recent article that he co authored in HBR on Reinventing youg Business Model. Welcome, Clay.

Thanks. Good to be with you, Sarah.

You are best known for your groundbreaking work on disruptive innovation, and I want to spend most of our time today on business model reinvention. But could you remind viewers first what disruptive innovation is in the history of.

Literally every industry as it moved from a cottage industry to a modern one? The original technologies that made it modern were very complicated and expensive. For example, the telegraph was very expensive. You had to go to an office and pay an operator who had the skill to run it. Mainframe computers cost millions of dollars, had to be run by PhD operators, and that characterizes pretty much the early phase of any industry's history. And then an innovation comes into the industry that transforms this very expensive, complicated product into something that is so simple and affordable that a whole new population of people who previously didn't have the money or the skill to own and use the products or receive the services, now they can do it. And we call those disruptive innovations. The word disruptive doesn't mean a breakthrough improvement, but it's an innovation that makes a formerly complicated, expensive product a lot simpler and more affordable. There is a technology in each one of these disruptions. So there's a technological improvement that transforms the complicated problem into a simple one. And then that simple solution has to be delivered to the market through a disruptive business model. And so disruptive innovation is a combination of an enabling and simplifying technology and a new business model that can deliver the solution cost effectively.

Perfect, thanks. Now, you say in the new article that established companies can't usually succeed with disruptive offerings or groundbreaking offerings unless they really understand how the new business model relates to their existing business model. And in the process of doing that, you offer up a pretty interesting definition of business model, which really intrigued me. So I wondered if you could walk us through how you build a business model, a new one. Where do you start?

Always. A business model starts, Sarah, with a value proposition. And that is an idea that will help customers do more affordably, effectively, and conveniently a job that they've been trying to get done. Now, if you help somebody do a job that they're not trying to do, then the business model flops. And so it's critical that you figure out how to help them do what they've already been trying to do, but more affordably and effectively. And we call that the value proposition. It's the start of a business model. And then you have to go next to a profit formula in order to deliver the value proposition at a price profitably. You then need to calculate what kind of direct and overhead costs do I need to be able to meet in order to deliver that value proposition. And given the kind of overhead structure that we're looking at, what do the gross margins have to look like, how fast do we have to turn the assets, and so on? So that's the second step, is what sort of a profit formula do we need to put into place in order to deliver the value proposition profitably? And then you put into place a set of resources. These are people, products, technologies, buildings, equipment that you have to have working inside of that profit formula to deliver the proposition. And as you do that, then processes coalesce, and processes are habitual ways of getting things done. And so the resources working in the processes consistent with the business model that deliver a value proposition are the four elements of a business model.

Do you want to run us through an example of how somebody developed a disruptive business model?

You bet. If you go back in history, one of the most successful business model innovators, and there really not a lot of them, was IBM. They originally built a mainframe computer business, and these machines sold for over a million dollars apiece. They sold a few hundred of them every year. And given the overhead intensiveness and the complexity of that business, they had to generate 60% gross margins on every computer they sold to cover the overhead cost that was inherent in their profit model. Then in the 1970s, a new set of companies came in that made mini computers, and we called them mini because they were much smaller than mainframes, which filled the whole room. But to play in that game, these computers sold for about $200,000. You sold them by the thousands, not the hundreds. And it wasn't as overhead intensive. You had to make money at about 45% gross margins. So every one of the mainframe computer companies got disrupted by these minicomputers except IBM. And the reason IBM survived is they went to rochester, Minnesota, and set up a completely different business model with a different profit formula, different set of resources and processes, and they became very successful in competition with Digital equipment and other players like that. Then the next disruptive innovation in that industry was the personal computer. And these machines sold for $2,000 by the millions, not the thousands or the hundreds. And so IBM went again to Florida and set up a different business model where they needed to hit a $2,000 price point profitably. That meant they had to squeeze their overheads down so they could make money at 25% gross margins, a different channel to the marketplace. IBM was the only minicomputer company that made the transition to personal computers, again, because they created a business model. So it wasn't. The disruption wasn't hard to catch because the technology in these subsequent disruptive generations was difficult. But you had to create a different business model because the old ones simply could not profitably pursue the new opportunity. And every other computer company of the 60s and 70s just died because IBM was the only one that engaged in business model innovation.

And it sounds like going to Rochester and down to Florida was important. They needed to set up a separate operation.

They did. And you have different resources, so different levels of technical talent, equipment, product designs, different processes. It took four years to design a mainframe, two years to design a minicomputer. But the development rhythm in personal computers was annual. And so you just couldn't do the new thing and the old thing because you couldn't play the game in the way it needed to be played.

So it sounds as if comparing your new business model with your old business model wouldn't be that difficult a problem. And yet you say in the article that very few companies are able to do this successfully. What gets in the way?

I think what gets in the way, Sarah, is business school professors, because we teach a paradigm in financial analysis that you should not look at the sunken fixed cost, but Rather, just look at the marginal cost when you're evaluating an investment compared to the marginal revenue that it would generate. We actually published an article about this earlier this year in the HBR called Innovation Killers. But an established company that has an existing business model, the question will always come up in their innovative activities. Should we invest to create a new business model or should we leverage what we already have in place? And this marginal cost thinking causes you to believe that if we leverage what's already in place, the marginal cost associated with launching these new products is a lot lower than would be the full cost of creating a whole new business model. And because the marginal cost always trumps the full cost, most companies keep trying to leverage what they already have put into place. Now, if your existing business model is what you need for the future, then of course you want to leverage it and, and just look at the marginal cost. But if you're actually trying to create a new business model because the world is changing on you, then you don't want to leverage what's already in place. And the reason why entrant companies so readily beat the incumbents is the incumbents are comparing the marginal cost of leveraging what we have with the full cost of creating something new. But an entrant doesn't have anything that exists that they're tempted to leverage, and so they just create what needs to be created. And so that doctrine that we teach that you should just look at the marginal cost and the marginal revenue, which is really in the DNA of managers, it causes them to think that business model innovation is not necessary or attractive. In reality, business model innovation is always what creates the big new waves of growth. And you see these things happening all over. Sarah, just a few examples. The business model of the newspaper is just dying as Craigslist and ebay and online mechanisms for advertising through Google and others are just disrupting the revenue model of newspapers in a very significant way. Some newspapers have created different business models. Boston.com here with the Boston Globe is a very successful new business model. But a lot of newspapers went online but didn't create a new profit formula, a new set of resources and processes. And so it's a new product within the old business model. And almost all of them have fared miserably. Voice over IP is a disruptive innovation against conventional wireline telephony and now mobile telephony. Voiceover mobile phones is going to disrupt the conventional telephone operators unless they also engage in the kind of business model innovation that Skype has become.

You've covered so much so quickly. Thank you so much.

Thanks to you, Sarah.

That was innovation and growth expert Clay Christensen in conversation with Sarah Cliff on the HBR IdeaCast. Christensen was the Kim B. Clark professor of Business Administration at Harvard Business School. If you like this episode, check out HBR IdeaCast wherever you get your podcasts. We'll be back next Wednesday with another handpicked coin conversation about business strategy from the Harvard Business Review. If you found this episode helpful, share it with your friends and colleagues and follow our show on Apple Podcasts, Spotify, or wherever you get your podcasts. While you're there, be sure to leave us a review. We're a production of the Harvard Business Review. If you want more articles, case studies, books and videos like this, be sure to subscribe to hbr@hbr.org this episode was created and produced by Ann Sani, Ian Fox and me, Hannah Bates. Special thanks to Maureen Hoch, Audie Ignatius, Karen Flair, Ramsey Kabaz, Nicole Smith, Ann Bartholomew and you, our listener. See you next.

Sam.