A Business Model Definition

The authors define a business model as consisting of four parts: A customer value proposition, a
profit formula, key resources, and key processes.

1. Start by developing a customer value proposition, i.e., how to satisfy a real customer
who needs to get a real job done.

2. Construct a profit formula that defines how the company creates value for itself while
creating value for the customer. This includes a revenue model, cost structure, margin
model, and resource velocity. Start with the price needed to deliver the desired profit and
work backwards to determine what the variable cost and margins must be.1

3. Key resources required to deliver the value proposition to the target customer, e.g.,
people, technology, channels, etc.

4. Key processes that allow the company to deliver value that can be successfully repeated
and increased in scale, e.g., training, manufacturing, planning, budgeting, sales, service,
rules, etc.

How Great Models are Built

The most important part of a customer value proposition is how precise it is in satisfying the
customer's need. A lack of focus dilutes the effectiveness of the model. A value proposition that
attempts to do many things, tends to do nothing really well. To be precise, a company needs to
start by thinking about the most common barriers that keep people from getting a job done: Lack
of wealth, lack of access, lack of skills, and lack of time. For example, Intuit broke the skills
barrier by developing QuickBooks, a program that provided small-business owners with access
to simplified accounting software. Apple solved the access barrier when it introduced the iPod
with the iTunes store to make downloading digital music easy and convenient. Tata Motors,
broke the wealth barrier when it developed a safer, all-weather alternative (the Tata Nano) for the
scooter families in Mumbai. Hilti, a Liechtenstein-based manufacturer of high-end power tools
broke the time barrier when it shifted to a lease/subscription model that made a full complement
of tools available to contractors on a timely basis.

Designing a Profit Formula and Identifying Key Resources and Processes

Tata Motors profit formula required a significant decrease in gross margins and a radical
decrease in cost structure. It did this by dramatically minimizing the number of parts in the
vehicle, and outsourcing 85% of the Nano's components to nearly 60% fewer vendors than
normal to reduce cost and build economies of scale. It also developed a new business model for
assembling and distributing its cars, i.e., ship the modular components to a network of company-
owned and independent assembly plants that build their cars to order.

Hilti's tool fleet management service's value proposition is based on leasing a comprehensive
fleet of tools to increase contractors' on site productivity. Their profit formula is based on higher
margins, monthly payments for tool maintenance and replacement, supported by a direct sales
approach, contract management, robust IT systems for inventory management and repair, and
warehousing. They also developed a website that allowed construction managers to view all the
tools in their fleet and their usage rates.

When Will the Old Model Work?

The old business model will work when it can fulfill the new customer value proposition with the
current profit formula, key resources and processes, and core metrics, rules, and norms. For
example, Procter & Gamble introduced the Swiffer using its existing business model because the
profit formula and key resources were not radically different from their other household
products.

When is a New Business Model Needed?

There are five circumstances that frequently require a business model change:

1. When large groups of potential customers are shut out of the market because of one or
more of the barriers mentioned above, i.e., lack of wealth, access, skills, or time, e.g., the
target customers for Tata's Nano.
 2. When there is an opportunity to capitalize on a new technology by combining it with a
new business model (e.g. Apple and MP3 players), or by leveraging a tested technology by
bringing it to a new market.

3. When there is an opportunity to focus on doing a job that is not being done, e.g.,
FedEx's faster, more reliable package delivery service.

4. The need to fend off low-end competitors.

5. The need to respond to a change in the basis of competition.

Creating a new business model does not mean the current model should be changed. A new
model may reinforce the existing model. Questions that help a company decide whether a new
business model will produce acceptable results include:

1. Can a focused, compelling customer value proposition be developed?

2. Can a model be developed where all the elements (value proposition, profit formula, key
resources and processes) work together to get the job done in the most efficient way
possible?

3. Can a new business development process be developed without being influenced

negatively by the company's core business?

4. Will the new business model disrupt competitors?

How Dow Corning Got Out of its Own Way

Dow Corning's development of a new model for Xiameter is provided as an example. The
company's established value proposition was based on customized solutions, and negotiated
contracts. It's profit formula included high-margin, high-overhead retail prices, and pay for
value-added services. It's key resources were R&D, sales, and a service orientation. However,
customers in the company's low-end product segment needed basic products at low prices and
little if any service. The company needed a new value proposition for these price-driven
customers and a new business unit to fulfill the need and avoid "the corporate antibodies that
would kill the initiative" before it had a chance to succeed. There were just too many rules,
norms and metrics standing in the way, e.g. requirements related to gross margins, product
quality, pricing, channels, net present value calculations, etc. To satisfy this need, the new unit's
value proposition was based on no frills, bulk prices, and products sold through the internet. The
profit formula involved spot-market pricing, low overhead, lower margins, and high throughput.
It's key resources were its IT system, lowest-cost processes, and maximum automation.