Using strategy to change your business model

Business models rose to prominence in the dot-com boom. Their usefulness may not have ended with the dot-com bust. George S Yip believes that business models may shed important light on how we understand and practise strategy.
Using strategy to change your business model Summer 2004 G Volume 15 Issue 2 Business Strategy Review
17

Business academics and consultants have been writing about strategy for over 40 years. Yet there is still great confusion as to what strategy is. The Internet boom and bust introduced a new term, business model, that may go a long way to clearing up the confusion. In essence, companies use radical (or transformational) strategies to change their business models and routine strategies to change their market positions (Exhibit 1). So both types of strategy are dynamic and change oriented and it is not a matter of static versus dynamic strategy. All strategies are dynamic. Companies use routine strategies, such as a marketing strategy to increase market share, all the time. But they use radical strategies rarely usually only when changes in their environment render their current business models obsolete or when they voluntarily choose to embrace a new business model. The root cause and rarity of radical strategies explains their low rate of success. First, having to replace an obsolete business model is inherently risky. Second, the rarity of use means that most companies and executives have little experience of devising and implementing radical strategies. After all, many business models work successfully for decades.

For example, IBMs mainframe computer business model worked from the mid-1960s to the PC revolution of the mid-1980s. Sears Roebucks catalogue retailing business model worked for nearly 100 years from the 1890s to the 1980s. In a few rare cases, companies seek to change their business model while still operating from strength (although typically facing incipient environmental changes and threats), as Motorola did in shifting from its consumer electronics business model in the 1970s and 1980s to its high-technology industrial and mobile telecommunications business model in the 1980s. Similarly, in the 1990s Microsoft extended its business model from personal computer operating systems and software to include the Internet and the web. Even so, all radical (or transformational) strategies are inherently risky as they involve moving from one equilibrium position through disequilibria before arriving at a new equilibrium.

Strategic positioning is really a business model

The term business model has been widely used to explain how an Internet company operates.

1.To change (market etc.) position within current business model:

e.g. 10% Share

Current Position

Routine Strategy

e.g. 15% Share

New Position

2. To change the business model:

Old Business Model

Radical Strategy

New Business Model

Old Environment

New Environment

Exhibit 1

Two primary uses of strategy

18

Business Strategy Review Summer 2004 G Volume 15 Issue 2

Using strategy to change your business model

VALUE

PROPOSITION

SCOPE

Nature of Inputs

How to Transform Inputs

Nature of Outputs

Channels

Nature of Customers

DIFFERENTIATION

ORGANISATION

Exhibit 2

Elements of a business model

Used in this way its meaning embraces the target customer, the nature of the business and how revenues (and hopefully profits) are generated. Sound familiar? Indeed, this sounds very much like conventional notions of what constitutes a strategy. In his Harvard Business Review article What is strategy?, criticising Internet strategies and business models, Michael Porter defined strategic positioning as having six elements:
G G G G G G

Strategy as a dynamic activity

The term strategy is more usefully reserved for dynamic activities that are used to change either a market or other position or a business model. Lets look first at routine strategies. Nearly every business seeks to improve its position on an incremental basis. A company with a given market share usually wants to increase that share; or to improve its cost position, its quality position or its profitability. In most cases companies seek to do so with routine strategies that do not change the underlying business model. For example, market share increases can be achieved through strategies such as increasing advertising, introducing more new products, increasing customer satisfaction and the like. Such routine strategies can usually achieve reasonable improvement, such as from 10 per cent to perhaps 15 per cent share. More drastic ambitions, such as doubling or tripling market share, may require a fundamental change in the business model to target new customer groups, to change the nature of the value position and so on. A radical (or transformational) strategy is needed to change the business model in one or more
Summer 2004 G Volume 15 Issue 2 Business Strategy Review
19

The right goal A value proposition A distinctive value chain Trade-offs Fit among strategy elements Continuity of direction.

In fact, these elements make up a static positioning of where the company wants to be and could just as well be described as a business model. Most of the examples used by Porter and other strategy writers tend to describe static business models: whether Southwest Airlines, Neutrogena or IKEA. There is nothing wrong with having a static business model. Indeed, being static should be the ideal because it means that the company is enjoying a dominant and profitable market position.
Using strategy to change your business model

easyGroup

Easygoing: the groups expansion is based on simple key principles

fundamental ways. A business model can be broadly defined as comprising these elements: (see Exhibit 2)
G G G G G G G G G

Value proposition Nature of inputs How to transform inputs (including technology) Nature of outputs Vertical scope Horizontal scope Geographic scope Nature of customers How to organise.

EasyGroups low cost business model

To better understand the elements of a business model, consider easyJet, the UKs Internet-based version of Southwest Airlines. Founded in 1995 by a young Greek entrepreneur, Stelios Haji-Iaonnou, success in airlines has allowed the geographic and horizontal expansion of its parent company, easyGroup, all over Europe and in the US and into car rental (easyCar) and Internet cafs (easyInternetcaf). The groups initial public offering for easyJet in 2000 on the London Stock Exchange was about 10 times oversubscribed. EasyGroups business model has these key features:
20

A clear value proposition. The easy concept is to bring cheap and efficient services to the mass market. Very simple inputs. EasyJet, like Southwest Airlines, operates only one type of aircraft (Boeing 737). EasyCar rents only one type of car (the sub-compact-sized Mercedes A class). A common, pervasive technology, the Internet. Most customers book over the Internet. EasyGroup companies pursue constant and common goals of cutting out unnecessary costs, bolting on the efficiencies of new technologies, maintaining very high customer satisfaction and creating strong brand awareness. Simple outputs. All easyGroup companies offer no-frills stripped-down services.A horizontal scope based on common elements in providing a low-cost, efficient service to mass-market customers, where the common Internet technology and easy brand provide more relatedness than the actual services themselves. EasyGroup has also diversified into financial services with easyMoney, undercutting margins on credit card and unsecured loans. A geographic scope that increases in opportunistic fashion: whenever and anywhere
Using strategy to change your business model

Business Strategy Review Summer 2004 G Volume 15 Issue 2

established players with overpriced operations dominate markets, there is a niche for easyGroup. EasyInternetcaf, originally set up in London, now operates throughout Europe and in the US. A common type of customer. Most easyGroup customers are young, urban and hip (or think of themselves that way). A focused and lean organisation that also depends on the charismatic, hands-on leadership of Haji-Iaonnou, who is a tireless marketer of his companys brands. The company achieves the paradox of low costs with high quality by putting people at the top. With a low-cost model there is very little left except people. The company also has a learning and culture building process that emphasises learning, innovation and speaking up.

Interestingly, easyGroups first possible stumble, with easyCinema, launched in 2003, departs from its core business model, which involves self-sufficient defiance of established competitors. EasyCinema, however, depends on co-operation from film distributors. But these are mostly owned by film producers, who balk at undercutting the high prices of their own business model. Companies use real strategy only when they seek to change their business model. Lets look at three examples: Enron, Schwab and Merrill Lynch.

Enrons changing business models

Enron was born in 1985 from the merger of two Texas-based natural gas pipeline operators. Through the late 1980s Enrons managers gradually transformed its business model from being a primarily domestic pipeline operator to a global, natural gas company. Some of the radical change strategies used were:
G G

The easyGroup story illustrates the truth that most companies do not have strategies other than routine ones. Rather, they hit upon or deliberately develop one successful business model that they try to maintain for as long as possible. EasyGroups expansion from airlines into car rental, Internet cafs and financial services represent incremental rather than radical changes to its core business model.

Expansion of horizontal scope by adding wholesale energy distribution and trading Expansion of geographic scope of operations to become a global company building, running and operating power and water utility business units in 30 countries

Index of Share Price Relative to S&P 500

500

400

300

200

PHASE 1

PHASE 2

PHASE 3

PHASE 4

0
90 n91 n92 n93 n94 n95 n96 n97 n98 Ja n99 Ja n00 Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja n01
Jan-02

n-

Stability

Market rewards new business model

Stability

Market rewards Collapse embrace of Internet

Exhibit 3

Enrons relative share price

Using strategy to change your business model

Summer 2004 G Volume 15 Issue 2 Business Strategy Review

PHASE 5

100

21

Index of Share Price Relative to S&P 500

3500 3000 2500 2000 1500 1000 500 0

90 91 92 93 97 96 98 99 00 nnnn94 95 nnnnnnnnJa 01

PHASE 1

PHASE 2

PHASE 3

Jan-02

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Market rewards Schwabs discount brokerage model

Ja

Ja

Market recognises success of Internet business model

Ja

Dot-com bust and Merrill catches up

Exhibit 4

Charles Schwabs relative share price

Changing how it transformed inputs into outputs by focusing on financing its own business, using financing tools ranging from traditional corporate finance techniques (stocks) to derivatives-linked instruments (weather risk derivatives). Pushing for regulatory changes.

This new model, combined with the boom in Internet stocks, led to a further doubling of Enrons share price relative to the market index (Phase 4 in Exhibit 3). Of course, Enrons new business model was fundamentally flawed. A model that provided liquidity and assumed risk was inherently highly risky and exposed the company to severe potential losses. Long Term Capital Management, the derivatives-based investment company, collapsed in 1998 from a similarly flawed highrisk business model. On October 16, 2001, Enron revealed a $1.2bn equity write-off to cover trading losses. Its stock price had already been battered by the general dot-com bust and could not survive this new problem (Phase 5 in Exhibit 3). In response, Enron offered itself to be acquired by a much smaller rival, Dynegy, which planned to cut back Enrons activities to an earlier, safer business model. When this possible rescue fell through, Enron had to declare bankruptcy in December 2001. A key point is that it was Enrons flawed business model that led to the fraudulent accounting practices. The collapse was not caused by the accounting practices per se.
Using strategy to change your business model

As this new business model and resulting increased profits became recognised, the stock market rewarded Enron. In the early 1990s its share price doubled relative to the market as a whole (Phase 2 in Exhibit 3 shows Enrons share price relative to the Standard and Poor 500 Index). Enron then stayed with this model through most of the 1990s, again recognised by the stock market when its share price stayed level relative to the S&P500 Index (Phase 3 in Exhibit 3). With the Internet boom of the late 1990s Enron made another major change to its business model by embracing the Internet. Its radical strategy was to create EnronOnline, which traded not just energy but many other commodities and whose trading volume ranked it among the largest e-commerce sites. An essential part of Enrons new business model was that it would provide liquidity in illiquid commodities markets.
22

Business Strategy Review Summer 2004 G Volume 15 Issue 2

Index of Share Price Relative to S&P 500

120

100 80

60 40

20
PHASE 1 PHASE 2

0
00 nJa Ja 90 91 92 97 93 94 95 96 98 99 nnnnnnnnnnn01

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Jan-02

Steady decline relative to Schwab and other discounters

Market rewards embrace of Internet trading

Exhibit 5

Merrill Lynchs relative share price

Charles Schwabs and Merrill Lynchs competing business models

Charles Schwabs first business model exploited the 1975 deregulation of stock and bond brokerage commission in the US. Its essential business model had four key elements: much lower trading commissions than traditional stock brokers; customer service representatives who were paid on salary, not commission; heavy investment in technology to reduce costs; and a resultant emphasis on customer contact over the telephone in increasingly automated ways rather than in person. The success of this business model resulted in high growth rates in revenues and profits. Through the 1980s and 1990s the stock market rewarded Schwab by steadily increasing its share price relative to the market as a whole, with a tenfold increase from early 1990 to early 1998 (Phase 1 in Exhibit 4). In late 1995, Schwab modified its business model by introducing e.Schwab, which initially provided account and research information but by early 1996 became the first major brokerage firm to offer trading over the Internet. With the dot-com boom, Schwabs share price enjoyed further gains relative to the overall market (Phase 2 in Exhibit 3). But by
Using strategy to change your business model

Merrills conversion to an Internet business model required a far more radical strategy than did Schwabs
Summer 2004 G Volume 15 Issue 2 Business Strategy Review
23

early 2000, Schwabs e-business model was no longer unique, as its larger rival Merrill Lynch also embraced the Internet. The dot-com bust further depressed Schwabs share price (Phase 3 in Exhibit 4). Merrill Lynch had used the same business model since its founding in 1914: full-service brokerage with an army of brokers paid on commissions. Technology and Internet advances in the wealth-management industry had begun to blur the differentiation between customer segments; there was increased competition coming from the discount brokerage houses, such as Schwab, for the affluent individual investor. In the face of the discounters, Merrill Lynch believed that its customers would still need sophisticated analysis and expert financial advice and was still charging small trades at $100 while they were advertised for less than $30 on the Internet. Merrill Lynchs business model was so entrenched through the firms all-powerful brokers, who controlled the customers, that Merrill was able to do little to respond to the discounters. The stock market saw this weakness and during the greatest equity boom period in history, drove Merrills share price down by 60 per cent relative to the S&P500 Index (Phase 1 in Exhibit 5). Only when Merrill finally embraced Internet trading did its relative share price turn around (Phase 2 in Exhibit 5). Merrills conversion to an Internet business model required a far more radical strategy than did Schwabs. This was mainly based around redefining Merrill Lynchs pricing structure and its distribution scope. Merrill Lynch changed how it transformed inputs into outputs by thoroughly re-evaluating all aspects of the product/price equation. It started to reconsider the value added brought about by each component of its value chain and charged accordingly. Trade execution, now a commodity with the Internet, was charged at a flat fee of $29.95 and more emphasis was given on finding the right charging structure for financial advice. This contributed to transforming the business model from brokerage (commissionbased transaction) to asset gathering (asset management fees). Merrill Lynch expanded its vertical scope by creating new services and routes to market. The company became the first full-service firm to offer online trading. Customers were offered a continuum of products through all channels (Internet, telephone, representatives, financial consultants with personalised relationships) at different prices based on customers individual needs and preferences.

What we can conclude from these diverse examples is that the distinction between business model and strategy is more than one of semantics. There are two different concepts that need to be distinguished by managers. Using one term strategy for both has served to create confusion for the last 40 years. Its time to act upon the two terms and to think about them differently. I

George Yip is professor of strategic and international management at London Business School and also Lead Fellow of the UKs Advanced Institute of Management Research. He is author of Total Global Strategy II (Prentice Hall 2003)

The distinction between business model and strategy is more than one of semantics. They are two different concepts
Using strategy to change your business model

24

Business Strategy Review Summer 2004 G Volume 15 Issue 2