Creative Construction
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Even worse, a critical ingredient of Blockbuster’s pricing strategy was late fees. These not only generated revenue, but they were critical for ensuring timely return. Why was timely return so important? For instance, why not just charge an extra day of rent? Why “punish” the renter with a late fee? Again, we have to go back to resources. Unlike Netflix’s film library, Blockbuster’s was composed largely of the perishable good of “new” films. After four weeks, a new film is no longer “new.” If your business model centers on providing customers access to the latest new releases, you need to make sure these are available. Renters who hold onto films (even if they pay for them) create a cost for others. Thus, Blockbuster used late fees to induce timely return. There is only one problem with late fees. Everyone hated them. I have taught the Netflix versus Blockbuster case to more than a thousand students and executives over the past few years. Whenever I ask what people liked least about Blockbuster, almost universally the number one answer is “late fees”; and what they like most about Netflix—you guessed it, lack of late fees. For customers, late fees were value destroying. They made the experience worse (even the threat of late fees seemed to bother some people, even if they never paid them!). Blockbuster eventually responded by eliminating late fees, but this was costly to them in two respects. First, there was the direct revenue hit (recall that late fees accounted for 10 percent of Blockbuster’s revenue). Second, as renters freed from the prospect of late fees held on to videos longer, they caused inventory turn to drop (and revenue per square foot to fall). This is a huge problem for an organization like Blockbuster with a high fixed cost base of stores. Now, add the heavy debt burden created by the value distribution component (remember the special dividend to shareholders), and you have a death spiral. Revenue falls, fixed costs largely stay the same, cash flow dwindles, and high interest payments on debt remain. Chapter 11 is all but inevitable.
Netflix’s business model innovation was a success because it attacked Blockbuster’s biggest vulnerability—the high fixed costs of stores and its video library (see Figure 3.2). Netflix not only substituted cheaper resources but was able to offer comparable (and eventually better) value in terms of convenience. It was also a coherent model. Its choice of resources was aligned with its chosen mode of value creation that, in turn, was supported by its approach to value capture.
FIGURE 3.2
Comparing the Business Models of Blockbuster and Netflix Using the RV3 Framework
Blockbuster
Resources: 8,000+ retail outlets (at peak)
Most recently available to rent, well-known movies (theatrical “blockbusters”)
Value Creation: Availability of high-profile movies for rent immediately
Convenient locations
Tailoring inventory to local tastes
Value Capture: Per film rental fees
Late fees
Sales of videos
Sales of “movie night” ancillaries (popcorn, candy, etc.)
Value Distribution: Paid one-time special dividend to shareholders
Netflix
Resources: Warehouses and logistics system
“Tail of distribution” film library
Recommendation engine
Value Creation: Convenience of ordering from home
Availability of previously unknown films
Discovery of new movies
Value Capture: Flat monthly subscription fee
Value Distribution: Capital appreciation
Netflix: Innovating the Business Model for Video on Demand
The Netflix-Blockbuster saga increasingly feels like ancient history. Most of us are not sticking physical disks into DVD players but streaming content through the web using video on demand (VoD), a set of technologies that enables content in digital form to be stored and then delivered at a time and screen of a user’s choosing. VoD, offered by Netflix since 2007, is a great example of new technology that also requires a new business model (it is, in the terminology of Chapter 1, an architectural innovation). What’s different about VoD, and what are the implications for business model design?
First, obviously, no physical disk, meaning that two of Netflix’s key resources—the film library and its distribution system—are no longer valuable. Because there is no more inventory, you do not have to worry about inventory management. Those independent art house films were never going to be attractive for the old Blockbuster because they were not an efficient way to use scarce shelf space. But, once content is completely digital, this no longer matters, creating competition for content. The other problem is that VoD technology is relatively ubiquitous. Many companies offer it: Amazon, Apple, Google, phone companies, and other Internet service providers. This means it is harder to create value for the user through the viewing experience. In the old world of DVDs, Netflix could create a different user experience in terms of ordering movies and having a super-convenient way of receiving and returning disks. That is no longer the case. Everyone can get VoD on their televisions (or phones or tablets).
How do you create value in a business like this? What makes you unique? Content clearly becomes critical. If Netflix has content that Amazon does not, then maybe I will pay more for a Netflix subscription. The problem is that this just triggers competition for content that leads to higher content prices. Expensive content is great for content producers (like studios) but not so great for content distributors like Netflix. VoD has shifted the source of value creation upstream from content distribution to content creation. This helps to explain, then, why Netflix shifted its business model to focus heavily on content creation. It has produced its own hit series like House of Cards and Orange Is the New Black. Such content now becomes the scarce resource that determines which business models will be profitable. Scale also helps. Netflix’s large subscriber base (a critical resource) better enables it to capture value on both acquired and organically created content. Not surprisingly, Netflix spends more on content creation and acquisition (about $6 billion in 2017) than any other media company except ESPN (which must purchase expensive rights to sporting events).7 Netflix now uses its proprietary content as a way to create and capture value.
The Netflix example shows that companies with successful business models can, contrary to popular wisdom, innovate new business models to thrive as technology and markets change. When Netflix innovated its business model to address VoD in 2007, it was not a small company. It was the dominant player in the traditional DVD rental market, with revenues of $1.2 billion. It is also a great example of business model innovation that leverages the advantages of scale. VoD meant a shift in the source of value creation from distribution to content. There are high fixed costs of acquiring or developing original content. This gives an advantage to larger players, and thus it should come as no surprise that the VoD market is dominated by larger, established companies: Netflix, Amazon, Google, Apple, Hulu (a joint venture of Disney, 21st Century Fox, and Comcast), and Internet service providers. Not only is business model innovation possible at scale, sometimes scale is actually required.
Principles of Business Model Design and Innovation
The Netflix business model innovation succeeded. That, however, is clearly not always the case,8 as even very successful companies can fail at business model innovation. Consider Lego. In 2005, it introduced a business model in the form of a new service called Lego Design byME. Today, you can buy a growing variety of Lego-designed kits. The idea behind Design byME was to allow consumers to design (using a simple CAD program) their own Lego kit, and then custom-order the required bricks. Sounds like a cool idea, right? The problem was that custom-configuring kits is extremely costly for an operation like Lego’s, which is oriented around mass production (to give you some idea of just how “mass” Lego’s production is, it manufactures more [mini] tires than any other company in the world). To profit from this concept, Lego had to charge much higher prices for custom kits than for stock kits. Not only did it charge for the bricks ordered, but it
charged a separate service fee (for custom-picking bricks) along with the costs of shipping. Customer may have liked the idea of custom kits, but they were not willing to pay the higher price. In other words, Design byME did not create enough value relative to the cost of the resources required and was discontinued in 2011.
It should not be surprising that many business model innovations fail—after all, many technology innovations fail. Innovation—whether a business model or a physical technology—means pushing the limits on what’s known. New combinations of resources, value creation, value capture, and value distribution can be just as uncertain as new combinations of technology. So how can you decide what business model innovations might be reasonable bets?
One popular approach, using reasoning by analogy, is imitating seemingly successful business models from other sectors:9 “We want to be the Uber of business X” or “We want to be the Amazon of business Y.” Nothing wrong here since analogies help simplify complex things and stimulate creativity.10 Reed Hastings said he got his idea for Netflix’s subscription pricing model on his way to the gym, where he paid a flat monthly membership fee.11
We will have more to say about analogies as a means of stimulating innovation in future chapters, but suffice to say flawed analogic reasoning can lead you astray. This can happen even to the most successful entrepreneurs. Consider the example of Stelios Haji-Ioannu, the founder of easyJet, one of Europe’s leading discount airlines, carrying about 70 million passengers per year (second only to Ryanair).12 Its business model revolves around maximizing utilization of its airplane fleet (an expensive resource) by maximizing the load per flight (the percentage of seats sold). Typically, easyJet’s load factor is around 90 percent (compared to about 70 percent average for the European airline industry).13 It gets such high loads by charging low fares, thus attracting more passengers. The company creates value for passengers by giving them a lower cost alternative to other airlines. It only captures this value through lower costs by flying out of secondary airports, providing no meals or frills, using Internet-only ticketing through its own site (fewer personnel and no travel agent commissions). And, of course, with higher loads, easyJet’s capital cost per passenger flown is lower. This is a great example of a business model where each component reinforces the others. Expensive planes require high loads, which requires low prices, which, in turn, require a low cost structure. That is, easyJet’s choices in its business model are complementary.
The idea of porting this successful business model over to other industries was not lost on Stelios. The parent company of easyJet is called easyGroup, and its subsidiaries include easyCar, easyBus, easyPizza, easyHotel, easyOffice, easyProperty, easyGym, and other “easy” brand concepts. But as the case of easyCar shows, business model concepts do not always translate across industries.
In April 2000, Stelios launched a car rental company based on the same principles as easyJet.14 Stelios noted, “The car-hire industry is where the airline industry was five years ago, a cartel feeding off the corporate client.”15 Like easyJet (but unlike major rental operators like Hertz or Avis), easyCar targeted price-sensitive customers and aimed to be the lowest-cost provider in the market. It did not operate at airports or other expensive city center locations; booking was strictly through the Internet. And just as easyJet used only new Boeing 737s, easyCar offered only one type of car—the new Mercedes A-Class. And as was the case for easyJet, the economics of easyCar hinged heavily on the utilization of its fleet (depreciation of vehicles accounts for about 30 percent of the costs of a car rental company). The “easy” business model was very different from that of the traditional rental operator: it employed a different resource mix (e.g., one type of vehicle) and different value creation and capture models (low prices and low cost, high volume).
However, easyCar has not achieved anything like the success of easyJet. By 2013, the company reported profits of only £800,000 on revenues of just £15 million. The problem was that easyCar did not achieve the cost advantage needed to drive the model (unlike easyJet). In addition, it learned that part of the value creation equation for customers involves the convenience of rental locations: by avoiding airport rental locations, it made itself less convenient for customers. In 2014, the company switched models to focus on becoming a broker of private vehicles owners are willing to rent out. It calls this peer-to-peer model the easyCar Club. In essence, easyCar Club wants to be the Airbnb of the car rental business.
The case of easyCar is a cautionary tale about imitating business models. Analogies can be a helpful start, but additional analyses are required to help you identify what parts might need to be modified. Just as in technological innovation, it is impossible to eliminate completely the uncertainty of business model innovation. There are no sure-fire business models and none that universally work under all conditions. A business model needs to be tailored to the specific market, technological, and competitive conditions of the industry. Although there are no universal models, there are some design principles that can help you.
Business Model Design Principle 1: Search for Complementarities. By definition, the word “model” means a representation of a system using rules and concepts.16 Like any system, a business model requires coherence among its components to be effective. Your choice about resources, value creation, value capture, and value distribution should complement one another. Netflix is a good example (Figure 3.3). Carrying the lesser-known art house films (a resource) was complemented by software algorithms to help users discover new films. And discovering new films became part of the appeal (value creation) of Netflix. The software algorithm also interacted with the company’s inventory system to promote films it had in stock (the perfect Netflix film for you was a film that fit your tastes and that Netflix had in stock and was ready to ship to you). The connection to the inventory management system provided you better service (value creation) in terms of reducing your wait time for films. And the pricing model (fixed monthly fee to check out a specific number of films at any one time) made users more comfortable taking risks on a film they never heard of. In the mind of users, the fixed fee with no late charges was also a source of value creation since they hated late fees charged by video stores. A subscription model for value capture also generates somewhat predictable cash flows. When combined with a no-dividend value distribution policy, you get an enterprise with the financial resources to continue to invest in building out its distribution network—which enabled it to improve delivery times, which, in turn, created more value for users (which, in turn, increased the subscriber base). Later on, Netflix’s strong cash position and big subscriber base enabled the company to invest in creating and developing proprietary content—a key resource in the world of video on demand.
FIGURE 3.3
Key Complementarities in Netflix DVD Rental Business Model
Complementarities can clearly make your business model more effective, but the added benefit is that they make it harder to imitate.17 Strong complementarities among the parts mean that would-be imitators have to replicate the whole system, rather than picking off one or two critical practices or policies.
Business Model Design Principle 2: Create Value for the Ecosystem. All too often, business model design is egocentric. Management teams design and propose models focused solely on the value captured by their organization without considering the value created for other critical members of the ecosystem—like suppliers, partners, investors, customers, and employees. The only way to secure the necessary cooperation of these players is to make sure your model also creates value for them. This requires a very different way to think about business model innovation. Instead of thinking strictly about the value you can capture, you have to think about the value you create for your partners in the ecosystem. Good business model innovators make the whole pie larger, not just their own slice.
Think about Uber’s business model. It only works if there are independent drivers (with cars) willing to join their network. The more Uber driv
ers in the network, the better it is for customers looking for a ride. The more customers who routinely use Uber, the more business there is for drivers. Uber attracts drivers to join their network by making it economically advantageous and by making the arrangement flexible. If you drive for Uber, you have a high degree of latitude when and where you operate. You are not assigned shifts. Many Uber drivers have other jobs or other commitments and use Uber as a way to supplement their income. Uber also provides its drivers access to their technology platform. Uber drivers do not have to wait in lines at taxi stands. They can potentially be more productive driving for Uber than for a traditional taxi company or a limo service. Amazon creates value for third parties to sell on their platform by providing access to a massive customer base. Companies like Apple, Intel, and Microsoft provide independent software vendors the development tools they need to create applications that run on their systems. Toyota has long followed a strategy of supporting the long-term financial viability of their critical prime suppliers as a means of inducing them to make long-term investments in technology and operational capabilities. Investing in training, providing good working conditions, and paying well are means by which companies attract talent.
Business Model Principle 3: Exploit “Free” Resources. When it comes to resources, nothing beats free. A resource that costs you nothing but creates value is pure gravy. It sounds too good to be true, right? After all, economic theory has drummed into our heads that there is no such thing as a free lunch. But, it turns out, this is only true for commodities and resources for which there are well-functioning markets. Not all resources are tradable in markets. And this creates opportunities to find resources essentially for free if you can figure out the right way to access them.