A good business model begins with an insight into human motivations and ends in a rich stream of profits.
Why Business Models Matter
by Joan Magretta
"BUSINESS MODEL" was one of the great buzzwords ;时髦口号； of
the Internet boom, routinely invoked, as the writer Michael Lewis put it, "to glorify all manner of halfbaked plans" A company didn't need a strategy, or a special competence, or even any customers.all it needed was a Webbased business model that promised wild profits in some distant, illdefined future.Many peopleinvestors, entrepreneurs, and executives alike bought the fantasy and got burned.And as the inevitable counterreaction played out, the concept of the business model fell out of fashion nearly as quickly as the .com appendage itself.
That's a shame.For while it's true that a lot of capital was raised to fund flawed business models, the fault lies not with the concept of the business model but with its distortion and misuse.A good business model remains essential to every successful organization, whether it's a new venture or an established player.But before managers can apply the concept, they need a simple working definition that clears up the fuzziness associated with the term.
Telling a Good Story
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? Consider the story behind one of the most successful business models of all time: that of the traveler's check. During a European vacation in 1892, J.C. Fargo, the president of American Express, had a hard time translating his letters of credit into cash."The moment I got off the beaten path" he said on his return, "they were no more use than so much wet wrapping paper.If the president of American Express has that sort of trouble, just think what ordinary travelers face.Something has got to be done about it"1 What American Express did was to create the traveler's check and from that innovation evolved a robust business model with all the elements of a good story: precisely delineated characters, plausible motivations, and a plot that turns on an insight about value. The story was straightforward for customers.In exchange for a small fee, travelers could buy both peace of mind (the checks were insured against loss and theft) and convenience (they were very widely
accepted).Merchants also played a key role in the tale.They accepted the checks because they trusted the American Express name, which was like
a universal letter of credit, and because, by accepting them, they attracted more customers.The more other merchants accepted the checks, the stronger any individual merchant's motivation became not to be left out. As for American Express, it had discovered a riskless business, because customers always paid cash for the checks.Therein lies the twist to the plot, the underlying economic logic that turned what would have been an unremarkable operation into a money machine.The twist was float. In most businesses, costs precede revenues: Before anyone can buy your product, you've got to build it and pay for it.The traveler's check turned the normal cycle of debt and risk on its head.Because people paid for the checks before (often long before) they used them, American Express was getting something banks had long enjoyed the equivalent of an interest free loan from its customers.Moreover, some of the checks were never cashed, giving the company an extra windfall.
As this story shows, a successful business model represents a better way than the 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.Nobody today would head off on vacation armed with a suitcase full of letters of credit.Fargo's business model changed the rules of the game, in this case, the economics of travel.By eliminating the fear of being robbed and the hours spent trying to get cash in a strange city, the checks
removed a significant barrier to travel, helping many more people to take many more trips.Like all really powerful business models, this one didn't just shift existing revenues among companies; it created new, incremental demand.Traveler's checks remained the preferred method for taking money abroad for decades, until a new technologythe automated teller machine granted travelers even greater convenience.
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, as it did with the traveler's check.Or it may turn on a process innovation, a better way of making or selling or distributing an already proven product or service.
Think about the simple business that directmarketing pioneer Michael Bronner created in 1980 when he was a junior at Boston University.Like his classmates, Bronner had occasionally bought books of discount
coupons for local stores and restaurants.Students paid a small fee for the coupon books.But Bronner had a better idea.Yes, the books created value for students, but they had the potential to create much more value for merchants, who stood to gain by increasing their sales of pizza and haircuts. Bronner realized that the key to unlocking that potential was wider distribution putting a coupon book in every student's backpack. That posed two problems.First, as Bronner well knew, students were often strapped for cash.Giving the books away for free would solve that problem.Second, Bronner needed to get the books to students at a cost that wouldn't eat up his profits.So he made a clever proposal to the dean of Boston University's housing department: Bronner would assemble the coupon books and deliver them in bulk to the housing department, and the department could distribute them free to every dorm on campus.This would make the department look good in the eyes of the students, a notoriously tough crowd to please.The dean agreed.
Now Bronner could make an even more interesting proposal to neighborhood business owners.If they agreed to pay a small fee to appear in the new book, their coupons would be seen by all 14,000 residents of BU's dorms. Bronner's idea took off.Before long, he had extended the concept to other campuses, then to downtown office buildings.Eastern Exclusives, his first company, was born.His innovation wasn't the coupon book but his business model; it worked because he had insight into the
motivations of three sets of characters: students, merchants, and school administrators.
Tying Narrative to Numbers
The term "business model" first came into widespread use with the advent of the personal computer and the spreadsheet.Before the spreadsheet, business planning usually meant producing a single, basecase forecast.At best, you did a little sensitivity analysis around the projection.The spreadsheet ushered in a much more analytic approach to planning because every major line item could be pulled apart, its components and subcomponents analyzed and tested.You could ask what if questions about the critical assumptions on which your business depended.for example,what if customers are more price-sensitive than we thought? and with a few keystrokes, you could see how any change would play out on every aspect of the whole. In other words, you could model the behavior of a business.
This was something new.Before the personal computer changed the nature of business planning, most successful business models, like Fargo's, 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 economicsto link their assumptions about how people would
behave to the numbers of a pro forma P&Lspreadsheets made it possible to model businesses before they were launched.
Of course, a spreadsheet is only as good as the assumptions that go into it.Once an enterprise starts operating, the underlying assumptions of its model about both motivations and economics are subjected to continuous testing in the marketplace.And success often hinges on management's ability to tweak, or even overhaul, the model on the fly.When EuroDisney opened its Paris theme park in 1992, it borrowed the business model that had worked so well in Disney's U.S. parks. Europeans, the company thought, would spend roughly the same amount of time and money per visit as Americans did on food, rides, and souvenirs.
Each of Disney's assumptions about the revenue side of the business turned out to be wrong.Europeans did not, for example, graze all day long at the park's various restaurants the way Americans did.Instead, they all expected to be seated at precisely the same lunch or dinner hour, which overloaded the facilities and created long lines of frustrated patrons.Because of those miscalculations, EuroDisney was something of a disaster in its early years.It became a success only after a dozen or so of the key elements in its business model were changed, one by one. When managers operate consciously from a model of how the entire business system 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.If you fail to achieve the results you expected, you reexamine your model, as EuroDisney did.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.
Two Critical Tests
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 business model of online grocers, for instance, failed the numbers test.The grocery industry has very thin margins to begin with, and online merchants like Webvan incurred new costs for marketing, service, delivery, and technology. Since customers weren't willing to pay significantly more for groceries bought online than in stores, there was no way the math could work.Internet grocers had plenty of company.Many ventures in the first wave of electronic commerce failed simply because the basic business math was flawed.
Other business models failed the narrative test.Consider the rapid rise and fall of Priceline Webhouse Club. This was an offshoot of Priceline.com, the company that introduced name your own pricing to the purchase of airline tickets.Wall Street's early enthusiasm encouraged CEO Jay Walker
to extend his concept to groceries and gasoline.
Here's the story Walker tried to tell.Via the Web, millions of consumers would tell him how much they wanted to pay for, say, a jar of peanut butter. Consumers could specify the price but not the brand, so they might end up with Jif or they might end up with Skippy.Webhouse would then aggregate the bids and go to companies like P&G and Bestfoods and try to make a deal: Take 50 cents off the price of your peanut butter, and we'll order a million jars this week.Webhouse wanted to be a power broker for individual consumers: Representing millions of shoppers, it would negotiate discounts and then pass on the savings to its customers, taking a fee in the process.
What was wrong with the story? It assumed that companies like P&G, KimberlyClark, and Exxon wanted to play this game.Think about that for a minute.Big consumer companies have spent decades and billions of dollars building brand loyalty.The Webhouse model teaches consumers to buy on price alone.So why would the manufacturers want to help Webhouse undermine both their prices and the brand identities they'd worked so hard to build? They wouldn't.The story just didn't make sense.To be a power broker,Webhouse needed a huge base of loyal customers.To get those customers, it first needed to deliver discounts.Since the consumer product companies refused to play, Webhouse had to pay for those discounts out of its own pocket.A few
hundred million dollars later, in October 2000, it ran out of cash and out of investors who still believed the story.
In case anyone thinks that Internet entrepreneurs have a monopoly on flawed business models, think again.We tend to forget about ideas that don't pan out, but business history is littered with them.In the 1980s, the onestop financial supermarket was a business model that fired the imagination of many executives but Sears, to cite one example, discovered that its customers just didn't get the connection between power tools and annuities.In the 1990s, Silicon Graphics invested hundreds of millions of dollars in interactive television, but it was unable to find real customers who were as enchanted by the technology as the engineers who invented it.Ultimately, models like these fail because they are built on faulty assumptions about customer behavior.They are solutions in search of a problem.
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.It's no surprise that, even during the Internet boom, executives who grasped the basics of business model thinking were in a better position to lead the winners.Meg Whitman, for example, joined eBay in its early days because she was struck by what she described as