There are three innovation strategy options for dealing with the threat of imitation.
Option 1: Build Complementary Technological Capabilities That Are Hard to Imitate
Most products or services are systems composed of multiple complementary technologies. Some may be easier to imitate than others. For instance, in many product categories today, functionality is determined by both hardware and software. Hardware tends to be easier to imitate than software because it can be physically inspected and reverse engineered. Software is much harder to imitate and much harder to reverse engineer. A good strategy for protecting value is to build capabilities in those parts of the technology ecosystem that are inherently harder to imitate. This explains why traditional hardware-oriented companies have focused more heavily on software (and many have even gone as far as to outsource design and production of their physical products). While you often hear people say that “the software is where the value is added,” it’s not really true. It would be more accurate to say, “Software is where the value is captured.”
A variant of this strategy is to pursue complementary technologies that are not only harder to imitate but may also become bottlenecks in the overall ecosystem. Consider the electric vehicle market. It is impossible for anyone to patent the concept of electric vehicles (the first electric vehicles go back to the late nineteenth century, so the concept is hardly novel). And, today, just about every major auto company has a serious electric vehicle program, and many have electric vehicles on the market. So how will value be captured? Judging by its $5 billion investment in a “gigafactory” to produce batteries, it is clear that Tesla believes batteries will be the bottleneck in appropriating value.18 Batteries are a potentially more effective way to capture value because they require complex process technologies that can be safely shielded behind factory walls. In addition, the potential for steep learning curves creates strong first mover advantages, which can be a difficult advantage for rivals to circumvent.
An extreme version of this strategy is to simply focus on the part of the technology system that is hardest to imitate and easiest to protect with intellectual property. This is essentially what Intel and Microsoft did in the personal computer industry. Neither firm became a personal computer maker or marketer in the first decades of the industry. Instead, they focused on two core elements of the personal computer—the microprocessor and the operating system—that heavily shaped overall performance and user experience. Each of these elements was well protected by both intellectual property (e.g., design patents) and inherently complex to imitate (e.g., Microsoft could keep its source code hidden inside the operating system).
Option 2: Focus on Business Model Innovation
In some cases, it is impossible to find any one technology that is hard to imitate. When imitation comes easily, the technology becomes a commodity and cannot be a source of advantage. In these circumstances, business model innovation can be used as a means of protecting value. Business models tend to be hard to imitate because they consist of many interdependent elements.19 Dell was one of the few personal computer companies in the 1990s and early 2000s to earn profits. It was selling essentially the same “Wintel” machines as every other vendor. They performed the same, looked the same, and ran all the same software. How did Dell escape the commoditization that trapped other personal computer makers? It created a completely different business model based on online sales and customer configuration of machines. It focused on operational innovation and supply chain innovation to quickly and efficiently respond to changes in the market. Customers liked Dell because it offered the convenience of custom-configuring a machine online and then have it delivered within days. This protected Dell somewhat from the pricing pressures faced by other vendors. But it was also a much lower-cost model. Dell did very little design itself and outsourced all its manufacturing. Its supply chain capabilities and innovative operational configuration enabled very high inventory turns, which boosted Dell’s return on invested capital.
Option 3: Crank Up the Treadmill Through Rapid Routine Innovation
In cases where imitation is easy and business model innovation opportunities are limited, the only viable strategy to beat imitators is to outpace them through rapid and continuous routine innovation. You accept that imitation will happen and that prices will erode, but you try to keep just far enough ahead to earn premium prices. This is the strategy Apple now follows in the iPhone business. When the iPhone first came out, it was like nothing we had ever seen—it was a phone with no keypad that could seamlessly browse the web and run applications. But, within a year or so, we began to see the imitators arrive using alternative operating systems, like Google’s Android. And, over time, the new phones began to look an awful lot like iPhones. They had the same basic design and same basic functionality. So how did Apple continue to make huge profits from the iPhone? From iPhone 2, iPhone 3, iPhone 4, iPhone 5, iPhone 6, iPhone 7, iPhone X, and so on. Apple engaged in rapid routine innovation. It kept upgrading functionality, features (better camera, sharper screen), performance, and aesthetics. It stays just enough ahead and just different enough to earn a good price premium. Intel also followed a similar rapid routine innovation strategy to stay ahead (and earn giant profits) in microprocessors, long after it became feasible for its chief rival, AMD, to offer its own compatible designs. If you pursue this strategy, you have committed yourself to being on a treadmill that keeps getting faster, which requires a significant allocation of resources to routine innovation. Of course, this strategy has limits. Eventually, you will hit diminishing returns to customers’ willingness to pay for additional features and functionality. You can also hit fundamental limits of technology. Apple seems to be well aware of this, as we can see that it has already begun a heavier focus on integrating its devices with new service offerings, which represents a business model innovation.
Getting the Balance Right
Though much maligned, routine innovation can be extremely profitable for quite a long time and can be a winning strategy when
• your current market segments have excellent growth potential,
• the customer’s most important needs are a long way from satiated,
• your current technological paradigm is still rich with opportunities to find innovations that will meet those important customer needs, or
• your current technological capabilities or your existing business model are powerful barriers to imitation.
The most-talked-about type of innovation—disruptive—is a widespread goal. But disruption is not a universal strategy. Like any strategy, it works under some circumstances but not others. It is an attractive strategy under the following circumstances.
• Growth in your current market segments is beginning to slow. This creates both opportunities (and threats) for new business models to address new segments of the market.
• The customer needs historically most important are becoming satiated (e.g., a closer shave), and customers are increasingly placing more value on new attributes (e.g., convenience).
• These new attributes are not easily addressed with technology solutions, but rather require different business models.
• There are strong first movers or scale advantages in the new business models needed to address these customer needs. These provide a barrier to imitation.
Like disruptive business model innovation, radical (technological) innovation has the capacity to transform industries and to destroy once-seemingly unassailable enterprises. Paradigm shifts in technology are relatively rare, but this does not mean you can ignore them. When they happen, they have a huge impact, and missing such a shift usually spells death for players in an industry. Radical innovation strategies involve exploring potential new technology paradigms. Such a strategy will be attractive when
• growth in your current market is robust enough to support investment in creating fundamentally new technological capabilities,
• customers’ most important needs are
a long way from satiated,
• the current technological paradigm is experiencing diminishing returns to making improvements that meet customers’ most important needs, or
• the new technological paradigm is characterized by strong appropriability (i.e., it is difficult to imitate and easy to protect with legal mechanisms) or your current business model is difficult to imitate.
Architectural innovation involves a combination of radical technological innovation and disruptive business model innovation. In many ways, this is the most difficult innovation strategy to pull off because it involves mastering two entirely new capabilities: a new technological capability and a new business model capability. The risks of failure are high, and perhaps this is why architectural innovation by established firms is so rare. But it can also be a very attractive strategy, given its potential to transform entire industries. Architectural innovation will be attractive when
• growth in your current market segments is beginning to slow,
• the historically most important customer needs are becoming satiated and customers are increasingly placing more value on new attributes,
• these new attributes cannot be addressed with either your existing technology capabilities or your current business model independently, or
• your new technology capabilities or your new business model (or both) can be used as a barrier to imitation.
In practice, the leaders of most organizations will find themselves in circumstances that require them to pursue multiple types of innovation. That is, they will have a mixed portfolio of projects. The factors discussed in this chapter should influence your relative weighting of efforts toward each, rather than suggest any “pure play” strategy. You can utilize the questions in this chapter to evaluate your current portfolio of projects and to identify areas where you may be missing opportunities or where you may be exposing yourself to risks. In the next two chapters, I build on some of the concepts presented in this chapter to explore more deeply the problem of business model innovation (Chapter 3) and the challenge of dealing with uncertainty in assessing both your opportunities and your threats (Chapter 4).
3
WHATEVER HAPPENED TO BLOCKBUSTER?
Competing Through Business Model Innovation
We can usually touch, see, and feel technological innovations such as new electronic devices and self-driving cars, so it is easy to forget that a lot of very important innovation has little to do with technology. That is especially so with business model innovation, even though humans for millennia have innovated the way we organize and conduct business. When ancient merchants in Babylonia and Assyria decided to make loans to farmers and traders who transported grains from one city to another, they innovated their business model to create a primitive form of banking. Then, when someone came up with the idea that a merchant could pay an extra sum to have their loan forgiven in case a shipment was lost or stolen, they created a business model innovation for what we now call insurance. When moneylenders in ancient Greek and Roman temples decided to accept deposits, they were introducing a very durable business model innovation to the banking world. Medieval guilds were a business model innovation. The Dutch East India Trading Company was a business model innovation that introduced the world to the concept of publicly traded enterprises. Supermarket and retail chains were business model innovations. Business model innovations have been transforming societies and economies for thousands of years, and it would be hard to argue their effect has been any less powerful than that of technological innovation.
Not all technological innovations have the breakthrough impact of the microprocessor or the telephone; likewise, not all business model innovations are as transformative as the first bank or first insurer. Just as there are many incremental technological innovations (e.g., a better screen on your smart phone), there are also many incremental business model innovations (e.g., free shipping for Internet retail). But if you are not thinking about business model innovation as part of your portfolio of innovation activities, you could be missing big opportunities. Or, worse, you could be exposing yourself to great threats. Clay Christensen has written extensively about disruptive business model innovation, and he documents clearly its potential to transform industries, to propel some companies to stardom, and to doom others to the dustbin of Chapter 11.1
The power of business model innovation is clear to most senior executives I meet. Less clear is how you can design and implement effective and potentially transformative business models. A big part of the haziness lies with ambiguity about the concept itself. Most of the talk about “business model innovation” takes place without a precise understanding of what exactly it is. “Business model” is often used as a synonym for strategy or for describing the structure of a business or its revenue and profit streams. The literature on the subject is equally frustrating. A quick perusal of definitions reveals a plethora of abstract descriptors such as “a framework,” “a structure,” “mission,” “a rationale,” and so forth. It is hard to imagine becoming excellent at business model innovation if we cannot even agree on what a business model is! Thus, let’s start by trying to get our arms around this concept, and make it as concrete as possible.
The fundamental task of a business enterprise—whether a global multinational like IBM or a kid selling lemonade on the corner—is to create, capture, and distribute value from some set of resources. Every business gathers resources, transforms those resources in some way to create value, utilizes mechanisms to capture some share of that value, and ultimately must distribute value back to those who provided resources. Resources include the tangible assets and inputs required by the business such as financial capital, human capital, intellectual property, raw materials, capital equipment, and information, as well as intangibles like reputation, customer relationships, and know-how. A business creates value by transforming those resources into products, services, intellectual property, or other tradable commodities (cars, financial advice, patented or copyrighted property, lemonade, etc.). It captures value by finding ways to monetize the output of this process (e.g., it sells lemonade, charges for subscriptions, bills for the time of professionals, licenses intellectual property, etc.). Finally, the business has to distribute value to the people and organizations that provided resources (equity investors, employees, suppliers, etc.) in order to ensure continued or future access to those resources.
FIGURE 3.1
Business Model Framework
Business model design involves making choices about resources, value creation, value capture, and value distribution (Figure 3.1). For shorthand, we will call this the RV3 business model framework.
Typical resource choices include capital structure issues (private equity vs. public equity, levels of debt relative to equity, etc.), human resource strategies (e.g., skill levels), investments in technologies and intangible assets (e.g., brand), and outsourcing strategies. Value creation has to do with both the form in which value is created and the specific value proposition of the firm. In the biotech industry, we find companies that are trying to create value by focusing on drug discovery, some are trying to take drugs all the way to market, others are offering contract development services, and still others are offering access to intellectual property or information on a subscription basis. Value capture choices involve decisions about what to charge for and the sources of profit. GE’s aircraft engines business unit creates value by designing, making, selling and servicing aircraft engines; but, increasingly, it captures value in this business by charging fixed lease fees per hour of operation on the engines that bundle both the value of the engine and the value of the maintenance. Finally, companies can choose a wide range of approaches for value distribution. Some companies distribute value to investors through steady dividends or stock buybacks. Others offer the potential for significant capital appreciation. Some start-up companies are “built to be sold” (thus creating the potential for significant capital appreciation). Some companies pay emplo
yees relatively fixed salaries with small bonuses; others rely more heavily on stock options.
As you can see, decisions about each of these elements—resources, value creation, value capture, and value distribution—are not wholly independent. Attracting financial capital from dividend-hungry institutions will commit you to a specific value distribution model. Deciding to franchise your restaurant chain will have big implications for how you capture and distribute value. Business models are systems in the sense that each component is connected to the other. Good business model design is good system design. It takes into account and exploits the interdependencies among components.
Before examining the principles of business model design and innovation, let’s illustrate the RV3 by analyzing the salient differences between the business models of traditional taxi companies and Uber, one of the most widely discussed business model innovations of the past few years.
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