Why Business Models Matter Redux

As a strategist and market analyst, I have become prone over the years to collecting white papers, reports and any interesting treatment of key topics on my professional and personal agenda.  Then, every once in a long while, I go through the collection (mostly physical documents, to this point) and purge the ones that no longer resonate or seem to hold some continuing value.  Most of these end up in file 13 because their proposition or point-of-view was very much of the moment and that moment has passed them by, and the content is no longer relevant to my worldview.  A much smaller group consists of documents for which I can’t make a case for ever having wasted the time and paper to print them out.  The smallest and rarest of this library is composed of a few timeless treatments of topics that remain very close to my heart, falling generally in the strategy and marketing buckets.

Recently, I performed this cleansing process (and creating in the process, a great paper recycling event) and discovered several of those incredible reports and white papers that are actually more relevant now than they were when first published.  Perhaps, like a good Cabernet, laying them down for a decade or more has refined the cogent, cohesive and coherent arguments originally put forth by the authors.

One that emerged from the latter category is an article from the May 2002 edition of the Harvard Business Review addressing the key foci of my strategy work over the past two decades, that of business models.  Joan Magretta, currently a Senior Institute Associate at the Institute for Strategy and Competitiveness at Harvard Business School, authored the article, “Why Business Models Matter”, and after re-reading it several times over the past several weeks, I view it as perhaps the best rationale in support of the concept that I have encountered.

With that said, I thought it would be worthwhile and valuable to share some of Magretta’s key points in making the case for the importance of business models.

Business Models Tell the Corporate Story

• A good business model remains essential to every successful organization, whether it’s a new venture or an established player.
• The word “model” conjures up images of white boards covered with arcane mathematical formulas. Business models, though, are anything but arcane.  They are, at heart, stories – stories that explain how enterprises work.  A good business model answers Peter Drucker’s age-old questions:  Who is the customer? And what does the customer value?  It also answers the fundamental questions every manager must ask: How do we make money in this business? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost?
• A successful business model represents a better way than existing alternatives.  It may offer more value to a discrete group of customers.  Or it may completely replace the old way of doing things and become the standard for the next generation of entrepreneurs to beat.
• Creating a business model is, then, a lot like writing a new story.  At some level, all new stories are variations on old ones, reworkings of the universal themes underlying all human experience.  Similarly, all new business models are variations on the generic value chain underlying all businesses.  Broadly speaking, this chain has two parts.  Part one includes all the activities associated with making something: designing it, purchasing raw materials, manufacturing, and so on.  Part two includes all the activities associated with selling something:  finding and reaching customers, transacting a sale, distributing the product or delivering the service.  A new business model’s plot may turn on designing a new product for an unmet need.  Or it may turn on a process innovation, a better way of making or selling or distributing an already proven product or service.

Business Model Origins

• The term “business model” first came into widespread use with the advent of the personal computer and spreadsheet.
• Before the personal computer changed the nature of business planning, most successful business models were created more by accident than by design and forethought.  The business model became clear only after the fact.  By enabling companies to tie their marketplace insights much more tightly to the resulting economics, spreadsheets made it possible to model businesses before they were launched.

The Value of Business Models

• When managers operate consciously from a model of how the entire business systems will work, every decision, initiative, and measurement provides valuable feedback. Profits are important not only for their own sake but also because they tell you whether your model is working.  Business modeling is, in this sense, the managerial equivalent of the scientific method – you start with a hypothesis, which you then test in action and revise when necessary.
• When business models don’t work, it’s because they fail either the narrative test (the story doesn’t make sense) or the numbers test (the P & L doesn’t add up).
• The irony about the slipshod use of the concept of business models is that when used correctly, it actually forces managers to think rigorously about their businesses.  A business model’s great strength as a planning tool is that it focuses attention on how all the elements of the system fit into a working whole.

Business Models ≠ Strategy

• Every viable organization is built on a sound business model, whether or not its founders or its managers conceive of what they do in those terms.  But a business model isn’t the same thing as a strategy, even though many people use the terms interchangeably today.
• Business models describe, as a system, how the pieces of a business fit together.  But they don’t factor in one critical dimension of performance: competition.  Sooner or later – and it is usually sooner – every enterprise runs into competitors.  Dealing with that reality is strategy’s job.
• A competitive strategy explains how you will do better than your rivals.  And doing better, by definition, means being different.  Organizations achieve superior performance when they are unique, when they do something no other business does in ways that no other business can duplicate.  When you cut away the jargon, that’s what strategy is all about – how you are going to do better by being different.
• When a new model changes the economics of an industry and is difficult to replicate, it can by itself create a strong competitive advantage.
• Because a business model tells a good story, it can be used to get everyone in the organization aligned around the kind of value the company wants to create.

I encourage you to read Magretta’s complete article for a view of business models that remains incredibly contemporary and relevant.