When the economy gets tough, senior managers often put their companies under the microscope to identify where to cut or control costs that are dragging down the bottom line. Zeroing in on the minutiae of spending, however, may not be the best way to help a company’s flagging performance. A better option: look at the company through a wide-angle lens.

“Take a very hard look at how you do business,” advises Raphael Amit, a Wharton management professor. In a new paper, “Business Model Innovation: Creating Value in Times of Change,” Amit and Christoph Zott, a professor of entrepreneurship at IESE Business School, suggest that making a business model more innovative is a key to a company’s long-term success. “We are saying that this is an alternative to cost cutting,” according to Amit. “Rather than cutting costs to preserve your bottom line, you can increase your top and bottom lines by finding new and novel ways to do business.”

Scrutinizing a business model should be "a starting point to see how you could serve your customers in a different way without having to produce a new product or service, the development cost of which is much, much greater,” Amit says. “There are … costs associated with changing the business model in an existing organization, but usually they are substantially less than the costs associated with a long-term R&D project.”

However, changing a business model is difficult for several reasons, says Zott. “First it requires holistic thinking, which is not easy. It is much easier to optimize parts of a business — for example, marketing or accounting processes — than to improve all aspects of the business.” Second, he notes, “change is often resisted within an organization. It is difficult to modify or abolish deeply ingrained habits." Finally, it requires "courage, foresight and entrepreneurial initiative to do business in a different way from how it has been done before [and from how most competitors still do it]. These are rare skills within most organizations.”

Companies that have been pushing the boundaries of their business models are few and far between. As the professors note, that makes companies such as Inditex of Spain the exception rather than the rule. Inditex, which owns global brands such as fashion retailer Zara, has become well known for its highly integrated vertical business model. “It performs many activities in-house or controls activities that at first glance could be outsourced because they seem to add little value," says Zott. "But the highly integrated model gives Inditex an incredible speed advantage over competitors, which allows it to bring new [clothes] designs to shop floors within a few business days.”

That’s just one example why managers and entrepreneurs should care about business model innovation. As Inditex shows, such innovation can not only can unleash an overlooked or underutilized source of profits, but also be a source of competitive advantage — competitors might find it more difficult to imitate or replicate a new business model than a new product or process. In other words, changing a business model successfully could push a company ahead of the pack quickly and make it difficult for competitors to catch up. What’s more, given that a company could gain a competitive edge over its rivals by overhauling its model, companies need to be alert to the possibility that if they don’t innovate, a competitor is likely to do so.

Apple is one company that gained market share through business model innovation. For most of its history, it focused on producing hardware, primarily personal computers. When the company created the iPod and music downloads through iTunes, however, it became the first electronics company to include music distribution as part of its business model. According to the two professors, “Rather than growing by bringing a new hardware product to the market, Apple radically transformed its business model to include an ongoing relationship with its hardware customers [similar to the “razor and blade” model of companies such as Gillette]. In this way, Apple expanded the locus of its innovation from the product space to the business model.”

Boardroom Inspiration

A combination of factors inspired Amit and Zott to study business model innovation. They had noticed that advances in information technology have enabled companies to do business in different ways than in the past. Amit also recalls how sitting on the boards of several technology companies made him realize that changing the way a company does business could substantially enhance shareholder value. “I observed the distinction between the strategy of the firm — namely, how the firm positions itself in the market vis-à-vis competitors and what is the basis of its competitive advantage — and the business model, namely the way the firms does business," he explains. Each has its own set of issues that needs addressing.

Businesses often focus too much on strategy at the expense of business model analysis, notes Amit. A purpose of the paper “is to alert managers and entrepreneurs alike that they need to think deeply and thoroughly about their business model — namely the business template, how they do business — in addition to thinking about the strategy,” he says.

Radically innovative business models can do more than change a company’s fortunes. They can change entire industries, Amit says, citing the novel business model developed by Shai Agassi’s California-based electric car company, Better Place. To overcome the challenges of electric vehicles running out of power frequently and the electricity fueling the vehicles is often produced by burning fossil fuel, Agassi and his team changed the business model to fit the product, rather than vice versa as is often the case.

Just like telecoms operators established a wireless network to enable mobile phone communication, Better Place established a network, but in its case to enable mobile transportation with electric vehicle charging spots and battery exchange stations powered by renewable energy. It is creating an ecosystem of companies, which will produce electric cars with batteries that can be exchanged or recharged at the stations, manufacture batteries, set up electric-car dealerships and more. Just like telecoms customers paying for minutes used on a wireless network, its customers pay for miles driven. The vehicles become the means of generating revenue for Better Place.

“The company thought about a novel way to [change] the automotive industry in a way that alleviates a reliance on fossil fuels. It’s good for the environment, good for national security, good for consumers,” Amit notes. Better Place "may even give customers a car for a nominal fee because it makes money from renting a battery, just like the cell operator gives you a free phone to use on their network." The Better Place business model, he says, has turned much of what the auto sector does on its head. "Right now, when a dealer sells you a car, he doesn’t make money when you drive it. The Better Place revenue model is based on car usage. This is a different business model.” (For more on Better Place, see Knowledge at Wharton’s recent interview with Agassi: https://knowledge.wharton.upenn.edu/article.cfm?articleid=2315.)

What, How and Who

Amit divides business models into three components: what the company does, how are the activities linked and who carries out the activities. Companies can develop innovative business models by changing one or more of these components.

IBM changed the first. Originally a provider of hardware, the company introduced a range of new services including consulting and IT maintenance in the 1990s. By 2006, those services accounted for more than half of IBM’s US$90 billion of annual revenue. Today it is no longer a hardware provider, having sold its PC business to Lenovo of China a few years ago.

Meanwhile, Priceline.com distinguished itself from other online travel agencies by finding a new way for travelers to buy airline tickets or secure hotel reservations. Instead of hotels and airlines determining the price of a ticket or room, Priceline created a reverse market so that customers suggest a price, which a seller does or doesn’t accept. The structure was so innovative that Priceline took out a business patent for it.

As for rethinking who carries out business activities, Amit points to Japan. In the early 1970s, Japan’s government restricted how large retailers could become and their opening hours. Toshifumi Suzuki, a retailing entrepreneur, realized that using a U.S.-style franchise system let him get around the restrictions and expand his business. By changing the traditional business model, Suzuki successfully franchised 7-Eleven stores across the country.

It’s especially in turbulent business environment like today that all this becomes much easier said than done. “Changing the whole activity system rather than optimizing individual activities, such as production, requires systematic and holistic thinking, which can be demanding,” the paper notes. “When responding to a crisis, operating in tough economic times or when taking advantage of a new opportunity, rethinking an entire business model may not always be the first thing on a manager’s mind.”

Yet scarcity of financial resources should not hinder a company’s business model from being put under scrutiny. “In a highly interconnected world, especially in the one where financial resources are scarce, entrepreneurs and managers must look beyond the product and process levels to focus on ways to ‘innovate’ their business model,” Amit writes. “This can help them create and exploit opportunities for new revenue and profit streams to counteract declining revenues and pressures on profit margins, and position themselves for the next economic upturn.”

So where can managers begin? The first step, say the authors, is to answer the following questions:

1. What is the new business model’s objective? In other words, what are the perceived needs to be satisfied by the new activity?

2. What novel activities are required to satisfy these needs?

3. How can these activities be linked to each other in novel ways?

4. Who should perform each activity — the firm or a partner? And what novel governance arrangements can enable this structure?

5. How will value be created for the firm and other parties involved in the model?

6. What will allow a firm to appropriate revenue from the new value created?

For sure, financial turmoil often leaves companies no choice but to reevaluate how they do business. American auto companies are now being forced to change their business models after many years of ignoring the importance of them, Amit contends. The financial services sector is also in upheaval, finding that the business model it used for decades no longer works. “Obviously the financial services industry made so much money [during the boom years], they said, ‘Well, if it ain’t broke, don’t fix it.’

“My point is that re-examining a business model and rethinking it is as important as reassessing — as most companies do — a business strategy,” Amit says. “That’s where leadership comes into play — visionary leadership. Thinking out of the box about the design of novel business models and providing the strong leadership to implement the organizational changes that bold, visionary business models require will pay off in the form of growth and profitability.”