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Deloitte Research

Deconstructing the formula for


BUSINESS MODEL INNOVATION
Uncovering value-creating opportunities in familiar places

A competitive strategy study


by Deloitte Consulting and Deloitte & Touche
CONTENTS
Deconstructing the Formula for
Business Model Innovation ................................................... 1
About the Study.................................................................... 4
Context:
Finding Opportunities in Familiar Places .............................................. 6
Innovating Around the Who:
Redefining Customer Segments,
Creating New Segments, or Changing the Buyer ................................... 9
Innovating Around the What:
Offering Customers What They Really Want ....................................... 14
Innovating Around the How:
Developing Unique Capabilities and Operational Structures............... 16
Creating a Sustainable Business Model ................................ 17
Putting Business Model Innovation to Work ......................... 20
About Deloitte Consulting and Deloitte & Touche................... 25
About Deloitte Research ...................................................... 25
Case Studies
Harley-Davidson: From Competing on Motorcycle
Performance to Selling the Rebel Lifestyle .................................... 8
WellPoint: From Near Death to Industry Leadership
Via Business Model Innovation ................................................. 11
Paychex: Bringing Big-Company Payroll
Services to Mom-and-Pop Operators .......................................... 18
Deloitte Research – Deconstructing the Formula for Business Model Innovation
Deconstructing the Formula for In deconstructing the formula for business model

Business Model Innovation innovation, our overarching question was this: What are the
patterns for creating enormous shareholder wealth through
The creation of new business models that would redefine
business model innovation? By that term, we refer to companies
industries was the boardroom game of the late 1990s’ dot-com
that introduce an entirely new approach to business, one that
boom. For many companies today, however, it appears to be an
diverges from industry norms in terms of “who” is targeted as
anachronism. Amid economic uncertainty and dot-com carnage,
customers, “what” is offered to those customers, and “how” that
executives are battening down the hatches – slashing payrolls,
offering is provided.1 We wanted to understand how companies
winnowing product and service lines, scaling back R&D programs,
were able to generate enormous returns for their shareholders by
and pressuring sales managers to redouble their efforts. Cost-
expanding their focus for differentiation beyond product
cutting and streamlining are back in vogue.
innovation. Finally, we wanted to understand how business model
Yet if creating significant shareholder value is still the goal,
innovation created sustainable advantages for the innovators.
the search for new business models that can rewrite the rules of
Our findings shattered many of the popular preconceptions
an industry shouldn’t end. Combined with our extensive
about business model innovation. In addition to finding that
experience helping clients with business model strategy, our new
business model innovation happens in both good times and bad,
study on some of the most successful business models of the past
our research and experience challenges today’s nostrum that
40 years shows that such opportunities exist regardless of the state
revolutionary companies succeed by being first to understand and
of the economy. In fact, companies such as Corning, WellPoint
act upon a new technology, regulatory shift, socio-demographic
Health Networks, and Charles Schwab demonstrate that economic
change or other significant discontinuity. In fact, we found
uncertainty is actually a fertile time for spawning entirely new
something else: While some companies capitalized on such trends,
business models.
most simply targeted customers whose needs had existed for
That was one of the key findings of our extensive research
some time but who, as a market segment, were considered
over the last year on business model innovation (BMI). We
undesirable or even unprofitable by the pack.
analyzed hundreds of publicly held companies across a wide range
The case of Paychex illustrates this vividly. In 1970, B. Thomas
of industries and selected 16 of the most impressive business
Golisano was a sales manager for a regional payroll processing
model innovators that redefined their business and generated
company in Rochester, N.Y., that served large companies. He
extraordinary shareholder value. We discovered that multibillion-
couldn’t convince his superiors that small companies – less than
dollar opportunities were there for the taking by large, lumbering
50 employees2 – were an untapped but lucrative market. While it
companies as well as by agile start-ups. In fact, established
took Golisano four years to turn a profit, his business model today
companies were responsible for more than half of the innovative
is irrefutable.3 Paychex, whose customers have an average of 14
business models that we examined (several of the 16 companies
employees, is a highly profitable company with revenues of nearly
launched more than one innovative business model). These
$900 million and a market value of $15 billion.4
organizations – General Electric, WellPoint, Enron and Corning
among them – overthrew cultural inertia and exploited enormous
advantages in generating billions for their shareholders.

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As Paychex and others like Southwest,WellPoint, and America Instead, they altered the existing structure of the industry in ways
Online show, the opportunity was there for all to see – and seize – that were unfathomable to the incumbents.
for some time. In other words, creating blockbuster new business Just as important, business model innovation requires going
models does not require an ability to predict the future – it far beyond identifying an unserved or underserved market
requires an ability to redefine the present. However, simple as segment – i.e., changing just the who component. Every one of
this may sound, doing so requires identifying and overturning the 16 companies we studied also carefully designed and built the
long-held industry norms – beliefs that have shaped existing what (the product/service offering and the customer’s experience
companies’ decisions regarding the who, what, and how of with it) and the how (the operations, supplier relationships, and
business and that blind most managers from seeing unexploited other activities that deliver that customer experience) in ways that
blockbuster opportunities. The Paychex scenario – in which the economically produced extraordinary customer value. The
industry incumbents dismissed a market segment as undesirable innovators also captured sustainable competitive advantages in
– was repeated in many of the companies we explored. one or more ways, including creating economies of scale, being far
Business model innovation does not require star-gazing; it ahead on the learning curve, having loyal customers, and
also usually doesn’t require leading-edge product or service possessing hard-to-duplicate resources. Further, the innovators
innovation. In fact, none of the 16 companies analyzed invented preyed upon the inherent constraints of the incumbents –
what could truly be considered a breakthrough product or service. disadvantages that included commitments to existing supply
In many cases, the business model innovators essentially left the chains and fears of disrupting existing channel relationships.
prevailing product/service offering of an industry unchanged.

FRAMEWORK FOR BUSINESS MODEL INNOVATION

CONTEXT WHO WHAT HOW SUSTAINABILITY


• External Factors • Segment • Channels • Resources • Innovator Advantages
• Internal Capabilities • Needs • Product/Services • Activities • Incumbent Disadvantages
• Perception • Total Experience • Partners

The Business Model Innovation framework is a structured approach to evaluating and introducing innovation to individual businesses.
SOURCE: DELOITTE CONSULTING
Deloitte Research – Deconstructing the Formula for Business Model Innovation
From our research, companies that wish to compete and This is our formula for successful business model innovation.
succeed on the basis of business model innovation must focus In this study, we explore the formula through the experiences of
on three core issues: the 21 innovative business models. Based on our research and

Context: The external factors and internal capabilities that consulting experience, we discuss the implications for established

can be exploited. companies looking for the next great opportunity or trying to

Innovation dimensions: How to redefine the basic protect their current model from attacks. Finally, we present a three-

dimensions of business – who to serve, what to offer, and step approach for identifying, evaluating, and bringing to market

how to operate – in new and profitable ways. promising new business models.

Sustainability: How to create a winning business model that


is hard to imitate.

SELECT BUSINESS MODEL INNOVATIONS

WHO WHAT HOW


LEVERAGEABLE SUPERIOR
PRECISE UNIQUE SUSTAINABLE
Business SPECIFIC SHAREHOLDER
Customer Focus Customer Business Factors
Context Offering Capabilities VALUE

Incumbent channel
PC industry focused Experienced Self-service Build to order, constraints & build- TSR:52%
on build-to-stock PC buyers PC solutions direct channel MV: $70B
Virtually-integrated to-order expertise
customer direct

Deregulation and TSR:17.5%


volatile energy Commercial end Turnkey energy Risk forecasting, Long-term
prices users of energy outsourcing solution packaging customer contracts MV: $34B
Energy outsourcing provider

Incumbents TSR:26.2%
Online access for Lifelong, average Multi-channel, Integrated unwilling to sell
Self-service information net-worth investor multi-product access channels competing products
MV: $21B
multi-channel brokerage

Deregulation and Incumbents commit-


airlines’ focus on Cost-sensitive No-frills travel Point-to-point ment to higher cost
TSR:35.9%
business travelers traveler resources business model MV: $15B
Low-cost air travel

Small businesses Incumbents unable TSR:32%


underserved by Small Small-biz focused Brand, low-cost to profitably serve
Small business outsourcing industry businesses payroll outsourcing operations small business MV: $15B
payroll outsourcing

Japanese lead in Business model TSR:35%


motorcycle Rebel image Branded motorcycle Brand, Harley built around
technology executives rebel lifestyle owner groups MV: $16B
rebel brand
Lifestyle provider

Payer industry Incumbents unable TSR:25.5%


focused on Individuals and Tailored healthcare Customer-centric
small business organization to become MV: $7B
large groups solutions
Customized health insurer
customer-centric

NOTE: MV = Market Value (as of 7/31/01)


TSR = Total Shareholder Return (Five-year annualized rate, including dividends, as of 7/31/01)
SOURCE: DELOITTE CONSULTING

3
About the Study Percent future: The percentage of total market value that

Deloitte Consulting launched its formal study of business model the stock market assigns to the company’s expected

innovation in November 2000. Despite volumes of research and future investment. This was determined by subtracting

writings on the topic in the last 20 years, we found little in-depth the portion attributed to the present value of existing

analysis regarding what factors and design patterns enable and assets and investments from the market value of debt and

sustain profitable business model innovation. equity, then dividing by the total market value of debt

We weren’t interested in studying business model and equity.

innovation per se – only the kind that generates superior


Out of all U.S. public companies, 169 emerged as
financial results. As a result, we began by identifying companies
significantly outperforming their peers, representing a wide
from a range of industries that outperformed their peers in
range of industries including beverage, drugstore, food
generating shareholder value and compared their business
processing, retail, utilities, natural gas, financial services,
models to the pack.5
computers, manufacturing, and telecom. Business model
Identifying Top Performers innovation was not the lever for superior performance for the
To identify the most successful business model innovators, we majority of these companies For example, in the drugstore
first had to uncover the top-performing companies (whether industry, the top-performer (Walgreen) simply executed better
or not their performance was based on business model than others without changing the segment’s long-existing
innovation), and then evaluate the basis of their performance model. Quaker Oats and McGraw-Hill outperformed their rivals
(whether or not they were business model innovators). Our through product leadership. And Amgen’s product innovation
screen for the top-performing companies was based on four was the reason it topped the list of pharmaceutical companies.
indicators used by Holt Value Associates, a financial consulting
Identifying Successful Business Model Innovators
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firm, to evaluate corporate performance:
After extensive discussions with industry experts within and
Total shareholder returns (TSR): Share price
outside Deloitte Consulting, 16 companies emerged from the
appreciation plus dividends over the last three (or five)
list of 169 top performers as those that successfully launched
fiscal years.
21 business model innovations (several launched more than
Cash flow return on investment (CFROI): The ratio of
one new business model). The list of business model innovators
gross cash flow to gross investments translated into an
features 10 start-ups (Amazon, America Online, Cisco, Dell, IMS,
internal rate of return. This recognizes the finite economic
Paychex, Schwab, Southwest Airlines, Starbucks, and Wal-Mart)
life of depreciating assets and residual value of non-
and 11 established companies who have significantly
depreciating assets.
transformed their business models (AOL/Time Warner,
Premium: The sum of current market values of debt and
Columbia, Corning, Enron’s three evolutions, General Electric,
equity, including the value of minority interest, divided by
Harley-Davidson, Schwab, Wal-Mart, and WellPoint). (See table
current inflation-adjusted net assets plus three years of
on following page.)
capitalized R&D.
Research–– Deconstructing the Formula for Business Model Innovation
Understanding the Patterns of Successful Business We conducted extensive analysis to identify the factors
Model Innovation behind the context, elements, and sustainability of superior
With these 21 cases in hand, we then embarked on an extensive
business model innovation. For example, to examine the context,
examination of public information about them (books,
we identified 14 external factors (e.g., regulatory changes,
newspaper and magazine articles, regulatory filings, corporate
socioeconomic shifts) and eight internal factors (e.g.,
annual reports, Web site documents, etc.). We also interviewed
entrepreneurial culture, strong brand equity, new executive
numerous executives and Deloitte consultants with expertise
leadership, risk of insolvency). We then identified the innovation
on these companies. In pouring through this material, we
levers used in the who (users, needs, customer views), what
sought to understand three aspects of business model

DeloitteResearch
(channels, offerings, support), and how (assets, processes,
innovation:

Deloitte
relationships).
Context of their innovation: The conditions that enabled
Finally, we explored the elements of sustainability – the
or drove their success (regulatory, technology, socio-
factors the business model innovators had at their disposal (e.g.,
economic, industry, etc.).
first-mover, brand equity) and the handicaps of incumbents in
Elements of business model innovation: The innovation
pursuing the new business models (e.g., cultural inertia, fear of
levers they used to change the prevailing who, what, and
disrupting existing distribution channels).
how, and create substantial new customer value.
By identifying such factors, we were able to understand which
Sustainability factors: How they were able to avoid being
innovations occurred in what context and why they have been
copied by competitors or start-ups.
sustainable, ultimately forming the basis of our findings.

Top Performing Company Business Model Innovation Year introduced

Amazon Online retailer 1995


AOL1 Online content provider 1993
Cisco Innovation acquirer 1993
Dell Virtually-integrated customer direct model 1984
IMS Health care information aggregator 1954
Start ups

Paychex Small business payroll outsourcing 1970


Schwab 1 Discount brokerage 1971
Southwest Low-cost air travel 1971
Starbucks Multi-channel experience retailer 1971
Wal-Mart 1 Mass discounter 1962

AOL 2 Vertically-integrated conglomerate 2000


Columbia Specialty clothing mass merchandiser 1985
Corning Alliance-based market maker 1990
Enron 1 Energy trader 1988
Transformations

Enron 2 Energy outsourcing provider 1992


Enron 3 Bandwidth trader 2000
GE Bundled product/service solution provider 1990
Harley Davidson Lifestyle provider 1987
Schwab 2 Self-service multi-channel brokerage 1992
Wal-Mart 2 One-stop mass merchandiser 1987
WellPoint Customized health insurer 1986
SOURCE: DELOITTE CONSULTING

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Context: Finding Opportunities We found that even the most technologically sophisticated

in Familiar Places companies generated superior shareholder value by focusing on


unmet and overlooked customer needs – not by focusing on
In our research, we first wanted to understand what context enables
technology. Dell, for example is known for technology-enabled
business model innovation. What environmental forces were in
supply chain sophistication that dramatically minimizes inventory,
play in each of the cases? To what degree was innovation success
costs, and cycle time. But when the company was launched out
driven by an ability to exploit emerging socio-economic trends?
of Michael Dell’s University of Texas dorm room in 1984, Dell’s
Was the innovation opportunity largely driven by regulatory
technological infrastructure was nothing like the Web-enabled
changes that redefined markets or opened up new ones? Were
one for which it is famous. Indeed, Dell’s initial epiphany was
innovations largely the response to emerging technologies that
about recognizing the overlooked needs of a rapidly-growing
enabled new and better ways to serve the existing market?
customer segment: technically sophisticated business and
Given all the discussion about looking for discontinuities in
personal PC users who found no value in dealing with PC stores’
the marketplace, it’s no surprise that several of the business model
inflated prices and often less than sophisticated sales personnel.
innovators did in fact capitalize on shifts in the macro- and micro-
“The indirect channel was based on a marriage of the unknowing
economic environment. Amazon, Schwab, and Paychex exploited
buyer and the unknowledgeable seller,” explained the company’s
new or emerging technologies to serve entirely new segments.
founder and CEO in his autobiography.6 “I knew that marriage
To our surprise, however, the major contextual driver behind
could not last… that customers would become even more
the innovation success cases we examined was not a new
knowledgeable and demanding every year.”
technology, regulation, or socioeconomic change – it was the
existence of an unmet or overlooked customer need. A good
example of this is Southwest Airlines. The company started
Key Takeaway
operations in Texas in 1971 to serve an enormous but underserved
The greatest opportunities for business model
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market: short-distance travelers who couldn’t justify the high fares innovation are in established industries thought
charged by traditional national carriers when comparing those to be "mature." In these industries, prevailing
fares to alternatives like bus, car, or train travel. While regulatory norms obscure a hotbed of customer needs just
factors were an issue in Southwest’s case, they were a hindrance – waiting to be addressed.
not an enabler – of innovation, initially preventing the company
from expanding its business outside of its home state.
Consider Starbucks. The Seattle-based company tapped into
American consumers’ long-existing but relatively unmet lifestyle
need for affordable luxuries, and a meeting place where people
could relax, chat and participate in a café community experience
like Europeans had done for decades.
Deloitte Research – Deconstructing the Formula for Business Model Innovation
Most of the 21 business model innovations came from what carriers have bounced up and down, Southwest has been
many viewed as mature industries, not emerging technology profitable since 1973.
sectors where new entrants often create whole new industries Another thread that ran through many of the established
virtually overnight. While two of the 16 companies were companies that launched successful new business models was the
technology suppliers (Dell and Cisco), the majority were in presence of a strong perceived need to innovate, driven by
industries considered to be decidedly low-tech, mature, and desperation or inspiration. Either survival was at stake (the case
saturated with competition. Wal-Mart, for example, launched a at Schwab, WellPoint, Columbia, and Harley-Davidson) or the
discount retailing business in 1962 in an industry that had been company had a developed a culture that embraced innovation as
dominated by companies such as F.W.Woolworth. Paychex started key to long-term success (a defining factor at AOL, Enron, and GE).
its business in an industry controlled by Automatic Data Processing In addition, many business model innovators that were
Inc. (ADP). Few airline experts thought that upstart Southwest established companies (firms such as Harley-Davidson, Columbia,
Airlines would ever be more than a small regional carrier, especially and Enron) created new wealth in part by leveraging their existing
after watching the demise of bargain carriers such as People brand equity or a strong, loyal customer base, or both. The ability
Express. The predominant belief was that the largest, most to leverage existing resources proved critical. Enron, for example,
profitable carriers had to be national or international. Regional capitalized on its financial capability in creating trading markets
airlines were considered to be small potatoes. But today, for energy and bandwidth. Harley-Davidson’s strong brand among
Southwest’s market capitalization ($15 billion) is larger than the motorcycle riders enabled it to shift its business model to
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combined market caps of American, United, and Continental. And promoting the Harley lifestyle. Had Harley-Davidson launched its
while Amazon and America Online sound like high-tech new business model as an unknown start-up, it most likely would
companies, they have merely used technology to carve out a piece have gained little traction. In combining groceries with general
of an established industry (retailing for Amazon and content for merchandise in its second business model innovation, Wal-Mart
AOL). took advantage of its vaunted inventory management and
Industries that appear to be static provided some of the best distribution capabilities, its vast and loyal customer base, and its
opportunities for business model innovation. In 18 of the 21 cases strong brand. Without that, it would have taken years for the
studied, there was strong homogeneity among competitors’ company to gain ground in the grocery business.
business models prior to the innovation. In fact, most of the What does all of this say for the context of business model
business model innovations disrupted industries thought to be innovation? It validates that regulatory, socioeconomic,
mature, highly competitive, and therefore devoid of any great new technological, and other environmental changes can indeed create
unexploited opportunities, at least until the innovator proved major opportunities. More importantly, though, our analysis of
otherwise. context reveals that mature industries with well-established norms
Certainly, that was the case for Southwest Airlines. Looking at about the who, what and how of business often hold the greatest
the cutthroat competition and huge losses by airlines like Pan Am opportunities for business model innovation. Underneath the
and Texas Air, most potential entrants would have looked for complacent homogeneity in many industries is often a hotbed of
opportunities outside the industry. While earnings at the major significant but unmet customer needs just waiting to be addressed.

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Harley-Davidson: From Competing on Harley-Davidson also wisely differentiated the value

Motorcycle Performance to Selling the experience (the what) on attributes other than the performance
of its bikes. These attributes included the sound of its bikes,
Rebel Lifestyle
their look and feel, and, just as importantly, accessories, clothing,
Nearly 20 years ago, Harley-Davidson Inc. was in danger of losing
and community events that had nothing to do with motorcycle
its U.S. market to a rash of Japanese motorcycle manufacturers.
performance. Thus, the company repositioned itself from a
A financial crisis at Harley-Davidson and management buyout
motorcycle to a lifestyle brand.
of the company from its parent, AMF Inc., drove an entirely new
In changing the how, Harley-Davidson reinvigorated its
business model, which has spawned enormous marketplace and
dealer relationships through cosponsoring community events,
Wall Street success. Today, with sales of about $3 billion, Harley-
which was the focus of an entire new Harley-Davidson division.
Davidson is the largest seller of motorcycles in the United States
It also founded the world’s largest motorcycle club, the Harley-
and is valued on Wall Street at more than $15 billion.8
Davidson Owners Group (appropriately called HOG, for short).
But Harley-Davidson’s potential for success wasn’t nearly as
And it extended its brand to a range of Harley lifecycle
obvious back in the early 1980s. The context for Harley-Davidson’s
accessories for biking life, such as clothes. The company also
innovative business model was one of extreme distress.
improved its quality and manufacturing operations’ efficiency.
Companies like Honda, Suzuki, Yamaha, and Kawasaki had
How did Harley-Davidson sustain its initial business model
infiltrated the U.S. market with better-quality, higher-performing,
innovation? The company strengthened its chosen customer
and lower-priced motorcycles. These companies used high-tech,
segment (the who) by emphasizing the brand and lifestyle
high-volume production operations, advertised heavily and
aspects of buying a Harley-Davidson. It also maintained
priced lower to gain market share. Internally, Harley-Davidson
ongoing contact with customers through the Harley-Davidson
struggled with poor labor relations and highly inefficient
communities and community events. Harley competed
8 manufacturing operations. Yet the company had several strong
effectively on the what of business model innovation through
capabilities to leverage: a brand that was an American icon, a
its image-based branding campaigns. Technology and
strong independent dealer network (which has grown to 1,300
performance-focused competitors couldn’t compete against
worldwide), and an intensely loyal customer group.
the Harley-Davidson lifestyle. In the how, Harley-Davidson
In creating a new business model that would enable it to
outran competitors in the United States through the strength
differentiate itself from its fierce Japanese competitors, Harley-
and loyalty of its dealer network and through economies of
Davidson management redefined all three aspects of the model.
scope; that is, the company leveraged its brand identity to sell
It broadened the customer base (the who) beyond the hard-core
non-motorcycle products at steep margins.
biker crowd to include leisure riders and weekend rebels. It
Harley-Davidson’s highly profitable rebel lifestyle business
addressed this larger segment’s need for community, while
model is closely studied by others in both manufacturing and
changing the basis of comparing motorcycle brands from one
consumer business circles. As a success, Harley-Davidson’s story
of product versus product to one of lifestyle versus lifestyle. As a
validates the power of customer-centric business model
lifestyle offering, competitors couldn’t compete against Harley-
innovation.
Davidson on its home turf.
Deloitte Research – Deconstructing the Formula for Business Model Innovation
Innovating Around the Who: Several innovators created enormous wealth by developing

Redefining Customer Segments, Creating entirely new markets. Schwab virtually created a whole new

New Segments, or Changing the Buyer segment of investors: do-it-yourselfers whose desire for low-cost,
no-frills securities trading went underserved. In 1975, Schwab
How could so many dominant, well-financed companies overlook
quickly followed the deregulation of securities brokering and
the new opportunities exploited by Wal-Mart, Schwab, WellPoint,
commissions pricing by targeting the unmet needs of stock buyers
Southwest, and the other business model innovators? How did
who didn’t value the premium advisory services of companies like
they allow poorly-financed and often unsophisticated upstarts to
Merrill Lynch and Dean Witter. After brokerage deregulation,
steal target portions of their market or dominate new markets?
leading brokerage houses actually considered raising commissions
In recognizing what others had missed, the business model
to further solidify their premium brand positions. Schwab, a
innovators either:
struggling second-tier brokerage house, had little to lose in
Redefined customer segments and targeted those with
pursuing the opposite strategy – serving the newly viable no-frills
underserved needs;
segment by unbundling stock-trading advice from securities
Created a new customer segment; or
transactions and offering the bare-bones transaction processing
Changed the decision maker within the existing customer
service at a discounted commission price. As a result, Schwab
base.
shifted customers’ perceptions about their trading alternatives
WellPoint Health Networks demonstrates the power of redefining
from one of brand versus brand to premium versus discount. In
an existing customer segment. The Thousand Oaks, Calif.-based
Schwab’s first five years as a publicly traded company (1987-1992),
health insurer nearly went bankrupt in the mid-1980s as Blue Cross
its total shareholder returns were the highest in the industry and
of California. It began its dramatic recovery in the late 1980s
double those of Merrill Lynch, the largest U.S. brokerage.
through business model innovation that refocused around two
customer groups that had largely been ignored. At the time of Key Takeaway
WellPoint’s innovation, small businesses and individual customers Successful innovators look beyond industry
had been largely underserved by other health plans, which norms and tap into huge unmet needs by
optimized their products, processes, and channels to serve redefining a customer segment, creating a new
corporations and other large group customers. To better pursue
segment, or changing the decision-maker.
these individuals and small businesses, WellPoint decided to create
units that were separate from operations catering to large groups.
As a direct result of these changes, WellPoint had grown solidly to
$7.5 billion in revenue by 1999, with CFROI and TSR well above
industry averages. (See sidebar on WellPoint.)

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Paychex, a provider of payroll outsourcing services, also In the early 1990s, America Online tapped a relatively new and
created a new market and a new business model to serve it. Since underserved segment of online computer users – technologically
its 1970 launch as a new business dedicated to the small business unsophisticated newbies who needed simple interfaces and
segment, Paychex has expanded dramatically, growing to nearly a navigation. Ten years ago, AOL had far fewer online subscribers
billion dollars in annual revenue while keeping its focus on small than CompuServe, which had been around since 1969 and over
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businesses. (The average Paychex customer has 14 employees. ) the years had developed a steadily growing and highly profitable
Paychex continues to capture value with its business model, business catering to mature and sophisticated online computer
earning a five-year average annual growth in total shareholder users. CompuServe’s motto – “the information service you won’t
returns of more than 50 percent – nearly double that of ADP’s. In outgrow” – spoke volumes about its scant interest in attracting
addition, Paychex’s after-tax return on sales is a whopping novice computer users. America Online, however, catered to the
29 percent.10 newbies by focusing on what CEO Steve Case called the 3 Cs:
Columbia Sportswear created a new segment of outdoors- communication (e-mail and chat room sessions), community
wear buyers. Founded in 1938, Columbia transformed itself from (letting subscribers interact with other subscribers), and clarity
a regional hat distributor to one of the largest distributors of (making the service easy to use). CompuServe, with its deep
clothes and shoes for outdoor activities such as fishing, hiking, offerings in online content, saw CompuServe as “nutritional” and
hunting, and golf. At the beginning of the 1990s, the outdoor gear AOL as “junk food.” But CompuServe’s management ignored a key
industry was dominated by branded manufacturers that fact: “America loves junk food,” as the author of a book on AOL
competed on quality to serve a niche market: hardcore outdoors put it.11
enthusiasts. At the same time, manufacturers that competed on Companies like GE demonstrate the rewards of rethinking the
cost dominated the mass-market outdoor clothing industry with target buyer. The industrial and services giant understood that
very limited branding. Recognizing a consumer shift in interest most manufacturing customers were not one-time buyers
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toward more active lifestyles, Columbia identified a new segment ordering on spec but rather ongoing purchasers looking for
that bridged the two existing segments: a mass-market segment broader solutions. As a result, GE redefined the target buyer from
for branded outdoor wear at affordable prices. By mid-2001, with the engineering or procurement head to senior executives buying
sales of $615 million and a market premium that’s more than an end-to-end solution. The company then applied this concept
double the industry average, Columbia has become a pacesetter of service provider to the majority of its manufacturing businesses.
at mass-producing technically legitimate outdoor wear in the GE’s business model continues to capture significant shareholder
apparel industry. value, earning a five-year annual total shareholder return
(1996 – 2001) of more than 30 percent – second highest among
its peer group within the manufacturing industry.
WellPoint: From Near Death to Industry

Research–– Deconstructing the Formula for Business Model Innovation


‘hand from the grave’ that came out and pulled us back in.”
Leadership Via Business Model Innovation With the organization staring death in the face, Schaeffer

Few companies better demonstrate the power of rethinking questioned many of the norms that had gotten it in trouble.

the who, what, and how of business model innovation – The first was if large-group customers – big companies,

rejecting the industry norms – than WellPoint Health Networks universities, government institutions, and the like – were indeed

Inc.. Near bankruptcy 15 years ago as Blue Cross of California, the only profitable segment. “Individual insurance is considered

the company has since made a stunning reversal, becoming by ‘true’ insurance people to be a non-insurable event,”

the best-performing U.S. health insurer, a highly profitable Schaeffer explained, meaning that pooling risk is far more

business with 2001 revenues in excess of $12 billion, and a star difficult than it is in a large company with thousands of

DeloitteResearch
on Wall Street. But to make the shift, the company had to employees. Small businesses, with much higher failure rates

Deloitte
eschew a number of long-held industry beliefs, particularly than large companies and therefore much higher receivables

about the viability of certain market segments and the need risks, were considered undesirable as well. “Small groups were

for economies of scale in back-office operations. [insured] in case the small group eventually became a big

The context for WellPoint’s business model innovation was group,” he said.

a dire one. In the 1980s, for-profit health maintenance At first, Schaeffer wasn’t certain that the company could

organizations (HMOs) were proliferating, siphoning off many profitably serve individuals and small groups. But he knew it

profitable customers – i.e., healthy consumers requiring little wasn’t possible under any circumstances through the

medical care. Health plans looked indistinguishable except in company’s existing organizational structure, one in which

price, where Blue Cross of California was at a disadvantage. In technology and paper intensive claims processing, customer

the midst of this, the company was suffering from spiraling service, and other back-office operations were combined for

medical costs, a “well-deserved reputation for poor service,” and all customers for economies of scale.

a “bloated bureaucracy,” as the Los Angeles Times put it.12 On the way to transforming the organization, which by

By 1986, when the company brought in Leonard D. 1999 was able to go public as WellPoint Health Networks,

Schaeffer as CEO, the organization was hemorrhaging $160 Schaeffer redefined the who of the industry by carefully carving

million in annual losses. “The company was insolvent – they out operations to serve three separate customer segments –

just hadn’t shut it down,”said Schaeffer, who had been president individuals, small groups, and large groups. “We had to break

at a Minnesota health insurer, Group Health Inc., but had spent this huge mess into manageable chunks,” he explained. A

most of his career in government, as the first head of the federal general manager over each customer segment was given strict

government’s Health Care Financing Administration and profit-and-loss responsibility, as well as all the operations

budget director for the State of Illinois. necessary to conduct business – marketing, sales, product

Almost immediately, he slashed the Blue Cross development, claims processing, customer service, and finance.

organization’s payroll of 6,600 nearly in half and sold the As a result, WellPoint broke its massive claims processing

headquarters building for $90 million. But that wasn’t enough. factory into three pieces, each serving its own customer

“Things were in terrible shape and every couple of weeks they segment. The industry considered that heresy.

would get worse,” he remembered in an interview at WellPoint’s The first chunk to be created was the individual segment,

Thousand Oaks headquarters just north of Los Angeles. “No one in which the company was losing $45 million a year in

matter where we tried to make progress, there always was a insuring 65,000 people. This segment turned out to be much

11
different than the other two because the person receiving key is to get to know those customers well enough to identify
and paying for health services was one and the same, unlike product attributes that others don’t identify, and then build those
the small- and large-group segment in which employers pick attributes into products,” Schaeffer explained. “They are very small
up most of the tab. Marketing to and serving individuals were changes, but they’re very powerful.” For example, WellPoint lets
far different than they were for corporate accounts. Ford Motor Co., a major account, pay according to the car-maker’s
Individuals often buy insurance through independent cash-flow schedules. WellPoint knows when that’s going to be,
brokers, not through the benefits consultants used by large and prices it to account for the time-value of money.
companies. They don’t have an HR department to iron out On the other hand, the payment rules for small groups are
problems. And they are bewildered by the complexities of much stricter. Since a high percentage of small businesses fold
health insurance. annually, those that don’t pay WellPoint within 30 days are
Because of such differences, WellPoint realized that the automatically cancelled. “Treating the receivables of small
what (the insurance products and the channels employed) businesses like large businesses has gotten other health insurers
and the how (delivery approaches for those products) had in huge trouble in recent years,” Schaeffer said.
to be different for each customer segment as well. At the WellPoint has been able to deliver attractive health plans
time, the prevailing norm around the what of the industry profitably in its three segments through carefully thinking about
was that HMOs were the ideal insurance product for the how. First, each customer segment has its own dedicated
controlling escalating medical costs. HMOs restrict a patient’s operations, including claims processing and customer service.
choice by stipulating which doctors and healthcare facilities WellPoint’s business model innovation, in effect, was to create three
will be covered. But Schaeffer thought otherwise, feeling that separate business models, each serving a different customer
people would pay higher deductibles and co-payments for segment. This shifted spending in the company from 80 percent
more choice. “I believed very strongly that the HMO was not at the corporate level and 20 percent in the line businesses to

12 the answer, and to organize around something that I felt was 10 percent corporate/90 percent line.
transient, to say the least, just didn’t make any sense to me.” In the small-group sector, WellPoint can offer a range of health
By offering multiple health plans to small groups (HMO plans because it has standardized the nine plans. “We know from
and others) – even different health plans to different our customers that these plans work for them and if we need to
employees of the same company – WellPoint hit a responsive make changes, our customers will drive that, not industry opinion,”
chord during the economic boom of the 1990s. “We’re the Schaeffer said. Second, the company uses actuaries to price its
company that believes in choice, and that notion of choice is policies, which most HMOs didn’t use 15 years ago. “I was stunned
very powerful because satisfaction correlates with whether to find out that the people who manufactured product in these
you chose or were forced to go into a health plan,” Schaeffer kinds of companies didn’t know anything about costs,” Schaeffer
said. Today, for example, the company offers small-business said. “We have more actuarial discipline than most insurance
employees nine different health plans. Less than a third of companies.” Third, WellPoint’s contracts let it change prices more
the company’s members are in HMOs. frequently than most other plans. And fourth, the company has
By separating the operations for each customer segment, one of the best databases in its industry on the cost of specific
WellPoint has dramatically improved its ability to understand medical procedures.13 Updated continually, the database lets
the important needs of each segment, and to create new WellPoint increase or decrease premiums faster than most other
health insurance plans or features to meet those needs. “The plans.
Innovation
Model Innovation
The who, what, and how of the three business units are revenue 34 percent to more than $12 billion.14 And the company,
further improved at the corporate level through several which was worth literally nothing 15 years ago, today has a

Business Model
mechanisms: a strict planning and budgeting process; market cap of more than $6 billion.15 In addition, WellPoint has

for Business
continual measurement of key performance indicators; strong earned Fortune magazine’s distinction as the best-managed

Formula for
rewards (or penalties) for meeting or missing performance healthcare company the last three years. Furthermore, Schaeffer

the Formula
targets; and the clout to negotiate big pricing concessions from was named one of Business Week magazine’s top 25 managers

Deconstructing the
Research–– Deconstructing
healthcare providers. Schaeffer referred to the planning and across all industries last year.
budgeting process as “loose-tight” – loose in that the three The 56-year-old Schaeffer has accomplished all this while
business units are not instructed by corporate on such issues continuing to thumb his nose at industry convention. This year,

DeloitteResearch
as marketing, but tight in that numbers promised must be met. he petitioned the U.S. Food & Drug Administration to make three

Deloitte
An information system built for Schaeffer and other WellPoint safe, non-sedating allergy medications available over the counter.
corporate executives provides key performance metrics by the The move would benefit consumers, who would have OTC access
day. “If the [business units] are missing their numbers, I know to safer, more effective drugs than currently available, at out-of-
about it the minute that they know about it,” he said. “And if pocket costs equal to or less than current prescription co-
they’re not working on a way to fix it, they know they’re in payment. In addition, WellPoint would save about $90 million a
trouble.” Schaeffer is known for ruling with an iron fist. Poor year, mitigating pressure on insurance premiums. It was the first
performers are fired fast. “You do not do 15 percent [annual time an insurance company has asked the FDA to shift a drug to
earnings growth] for seven years because you’re lucky,” he said, OTC status.16
alluding to the pressure he puts on managers to perform. And remember the industry norm about the individual and
How has WellPoint sustained its success? For one, many small-group businesses being undesirable? For several years,
competitors have huge costs tied up in serving all their WellPoint’s individual and small-group businesses have been its
customers through a single organization; separating these most profitable – a compelling feat in an industry that still
operations as WellPoint has would cost millions and risk gravitates toward large organizations. “Even in the 1990s, one
organizational havoc. The inability to make changes all the way major insurer would tell you that only schlocky companies would
through the who, what, and how of their businesses has left insure organizations of less than 350 employees,” he said. On
many would-be WellPoint imitators far behind. Secondly, the contrary, catering to all three segments in good and bad
Schaeffer’s outsized skepticism about popular wisdom in the economic times has become critical to WellPoint’s success.
industry has resulted in few bad acquisitions, errant product During economic downturns, the individual market grows as
introductions, or failed technology investments. For instance, people lose their jobs. In upswings, the small-business segment
he declined to enter the Medicare HMO market in the mid- (which in the past has produced the greatest number of new
1990s, even while competitors made big money at first. But jobs) and large-group segment boom.
then the HMOs hit the wall when the government cut rates in “We like being diversified,” said Schaeffer, smiling broadly
1997. like a doctor who has brought a patient back from the brink,
The impact of WellPoint’s moves has been spectacular. One against all medical odds and medical conventions.
leading Wall Street analyst predicts the company’s operating
earnings will grow 21 percent this year to $714 million and

13
Innovating Around the What: In tailoring the offering, business model innovators utilized multiple

Offering Customers What They Really Want levers, including:


Customizing the offering or allowing customers to configure
The leaders at business model innovation were extremely careful
it themselves;
about what they offered their customer segments, the second
Letting customers access the offering through new channels;
element of the business model formula. They carefully tailored
and
the offering to their chosen segments. In some cases, they stripped
Dramatically expanding the product/service selection.
out features and functions from the industry-standard offering that
their chosen segments did not value and provided what they did In targeting the small-company market, Paychex slashed the costs

value at a lower cost. In other cases, they expanded the industry- of providing payroll services by creating highly standardized payroll

standard offering with attributes that customers embraced and services. In doing so, Paychex brought a valuable offering to small

competitors overlooked. Other innovators drastically reduced the businesses – the outsourcing of complex payroll processes – that

price component of the what by making structural cost reductions previously had only been affordable for large corporations. Given

in the how. the company’s rapid growth, there’s no question that small

The “what” includes not only the product and service offering businesses need to outsource payroll as much as large businesses

but also the channels through which customers become aware of do. In fact, small businesses on average spend 50 hours a year on

the company and its offering. Moreover, it includes customers’ total payroll issues, in part to comply with dozens of changing payroll

experience in using the offering after the purchase. We refer to tax regulations.17

this collectively as the “value experience.” Innovators also created integrated solutions that enhanced

The business model innovators we studied took painstaking customer loyalty. Schwab, for example, added mutual funds and

care to match the design of the value experience to precisely fit financial products from other institutions, while opening other

the needs of the customer group they were targeting. These channels for customers to transact their business, including stores
14
companies developed channels and levels of integration between and the Web. In each case, customer-targeting decisions guided

these channels that best corresponded to what their targeted business choices on what services and experiences to offer. The

segment valued. innovators didn’t fall into the trap of trying to become all things to

They also let their target customers’ needs dictate the all people, knowing that would put them on an unprofitable path.

functionality and quality of the products and services offered –


Key Takeaway
often stripping down a more robust offering to only the features
Successful innovators precisely tailor their
and functions that the segment really needed and would pay for.
offering to their segment's unique needs.
Consider the case of Southwest. To deliver low-cost fares to its
budget-conscious market, the airline skimped on meals, in-flight
Sometimes this means stripping out features from
entertainment, and other services it considered unnecessary for the industry-standard offering; other times it
cost-conscious travelers. In catering to the health insurance needs means adding features that competitors missed.
of individuals and small businesses, WellPoint created health plans,
customer support, and marketing programs that were distinct from
those designed for large companies.
Deloitte Research – Deconstructing the Formula for Business Model Innovation
Other advantages were achieved through offering one-stop the world can match Amazon’s reader reviews with as many
shopping. This was the case in Wal-Mart’s second business model insights into as many books. And although the World Wide Web
innovation: its push in the late 1980s to combine grocery items hadn’t taken off when Dell started to gain critical mass in the early
and general merchandise through its mainline stores, Sam’s Clubs 1980s, the company later used the Internet to take its self-service
and super-centers. At the time, most grocery and general model to the next level. Dell offers its largest customers
merchandise stores were separate entities. Wal-Mart leveraged customized Web pages in part so they can get the technical details
the brand equity it had built over the years for everyday low prices of their purchases up to the minute (a major source of value for
in general merchandising to steal share of the grocery market. their IT departments, which must enforce corporate policies and
Through the new business model and relentless store openings, standards). Dell’s Web pages give customers a much greater sense
the company’s market value exploded by 2001 to more than of their options in tailoring a PC to their liking – far beyond what
$200 billion. an order taker could explain over the phone or in a store. At $32
Cisco Systems’ business model success in the billion in revenue, Dell has become the world’s largest and most
telecommunications equipment industry came from a different efficient maker of PCs.
type of one-stop value experience. The company’s business model
“The key is to get to know those customers well
brilliance came from truly understanding and catering to the
enough to identify product attributes that
increasingly complex needs of corporate telecommunications
managers in the 1990s. In the late 1980s, more and more corporate
others don’t identify, and then build those
data was shifting from high-cost, proprietary computer networks attributes into products.”
to lower-cost, Internet-based networks. A host of new and existing – Leonard Schaeffer, CEO of WellPoint

telecommunications equipment and software suppliers were No-frills value experiences helped power Schwab’s first
chasing this huge market. For a corporate telecommunications business model incarnation, as well as Southwest’s. To undercut
manager, betting on any one of these vendors was a highly risky stock trading fees of the incumbents, Schwab unbundled the
proposition. From a customer’s perspective, there is great risk that standard offering – trading plus investment advice. Southwest’s
either the technology of such a company will become obsolete, a offering was constructed to profitably undercut the prices of all
nonstandard, or that the vendor will go belly-up and not be able other carriers on its routes. This required stripping away on-board
to support its installed base. Cisco shaped its business model to services and the use of travel agents.
mitigate that risk by creating a one-stop shop for Internet As these examples show, the changes the business model
networking hardware, software, and services. It created a multi- innovators made in the what were not incremental improvements
product, multi-technology portfolio through an aggressive to the norm. They were, in fact, structural changes. WellPoint
merger-and-acquisition strategy and as it grew, customers’ risks tailored products to meet the distinct needs of individuals and
in choosing Cisco continued to decrease. small businesses, while cultivating the agents who could connect
Two other popular themes in the what of business model with these customers. Southwest dramatically pared back the
innovation were information-enabled self-service and its close services that flyers had been used to – food, movies, and so on –
cousin, the no-frills offering. Amazon and Dell pioneered self- to deliver low-cost air travel. Wal-Mart’s stores in essence were
service-based business models in the book and personal computer giant warehouses with shopping carts – retail environments
industries. In both cases, self-service was in many ways better than designed to drastically reduce the cost of merchandising and
the full-service options of the incumbents. No bookstore clerk in increase the flow-through of shoppers.

15
Innovating Around the How: they couldn’t hope to match Dell’s structural cost advantages in
Developing Unique Capabilities tailoring PCs to customers’ specifications and selling direct to
and Operational Structures customers, thereby reducing channel cost and minimizing
inventory obsolescence (the biggest risk of making and
After having a specific customer focus and offering that meets the
distributing products and components with half-lives that can be
precise needs of that target segment, the third factor in business
measured in months). To make sure it was competitive with
model success involves developing unique capabilities and
computer stores’ quick delivery (at least, for off-the-shelf products),
operational structures to make the offering possible. Such
Dell located supplier operations near its assembly plants and
capabilities come in three forms: resources (such as intellectual,
integrated with those suppliers virtually through its own computer
physical, structures, and brand assets), activities (such as product
network. The efficiency of Dell’s how is still unmatched in the
development, distribution, and manufacturing processes), and
computer industry.
partners (such as valued suppliers).
In unbundling its one-size-fits-all health insurance offering,
Dominant themes we witnessed across successful innovators
WellPoint, the California-based health insurer, organized its
include:
resources around distinct customer segments: large employer
Developing unique capabilities and control over the value
groups, small businesses, and individuals. It created self-sufficient
chain;
business units with separate information systems for each
Optimizing provider operations to targeted segments;
segment, which enabled each unit to maintain its own
Driving down costs either through
membership and claims records, and more directly respond to
– making explicit trade-offs in what is provided to the
each segment’s needs. Each unit was given true profit-and-loss
customer, or
responsibility.
– creating significant structural cost advantages.
The capabilities that Southwest built to deliver to budget-
16 The capabilities that the innovators used to deliver their value
conscious travelers a value experience featuring low-cost, on-time
experience were in all cases unique. That is, they couldn’t be easily
flights are truly unique in the airline industry. First, its resources
copied by established or start-up competitors. Take the example
are far different. Southwest’s flight network is point-to-point (city-
of Dell Computer. In Dell’s case, the who was knowledgeable
to-city), whereas the national airlines use hub-and-spoke systems.
buyers of PCs (especially large organizations) who didn’t need the
help of a dealer or other channel intermediary to get what they
Key Takeaway
wanted. Dell’s target segments are big institutions (they have the
Successful innovators develop unique capabilities
greatest sales volume potential and the largest, most sophisticated
and operational structures, often creating cost
IT departments) and PC-savvy individuals who need little support.
Michael Dell decided that providing customizable PCs through
advantages that competitors can’t match.
self-service was the way to go (the what), and that the way to
deliver that experience was by going direct and building to order.
As long as the direct model appeared to be a fraction of the market
(which it was until the 1990s), the established PC manufacturers
were reluctant to go around their dealers and face expulsion from
the channel. But as long as they sold through the intermediary,
Deloitte Research – Deconstructing the Formula for Business Model Innovation
Southwest also focuses on short-haul routes and uses one type Creating a Sustainable Business Model
of jet, the Boeing 737. In contrast to the major carriers that use an
While a new business model may be innovative and create
assortment of jets, Southwest standardized on one model to
significant customer value, it is not automatic that it will also
reduce maintenance costs, standardize processes, improve fleet
generate superior shareholder value. The hundreds of dot-coms
flexibility, and better ensure on-time arrivals and departures.
that have crumbled over the last year attest to that. Internet
There’s no way that the national carriers operating different aircraft
shopping malls like buy.com and Value America came to realize
and hub-and-spoke routes can compete with Southwest on price
that their business models were barely profitable largely because
and enjoy Southwest’s margins.
they were easy to imitate. Endless new entrants sparked cutthroat
Second, its activities ran counter to the pack by shunning
competition, which quickly eroded any profit margins originally
premium services such as elaborate meals. Third, its partner
captured.
relationships with employees, airports, and others were atypical:
The business model innovators we studied were successful
employee stock ownership; close relationships with under-utilized,
because they could defend their business models from the
secondary airports; and a strong social contract with employees
inevitable attackers. The ability to sustain one’s business model
built upon a history of no layoffs. That’s a far cry from the industry
innovation depends on two factors: the extent to which the
norm, where downturns result in thousands of layoffs. “Nothing
innovator creates real advantages, and the existence of real or
kills your company’s culture like layoffs,” Southwest CEO Herb
psychological disadvantages among the innovator’s competition.
Kelleher told Fortune magazine recently. “Nobody has ever been
furloughed here, and that is unprecedented in the airline industry. Innovator Advantages
It’s been a huge strength of ours. It’s certainly helped us negotiate In nearly every case, the innovators created significant advantages
18
our union contracts.” For example, the company’s 10-year and created enormous brand equity. AOL has become a
contract with its pilots (three to four years is typical in the industry) household word, while few teenagers would likely recognize the
has helped it control costs. name of CompuServe, an online service that has been around far
Innovating around the how, as these cases illustrate, longer than AOL. Has any airline executive generated more
frequently involves configuring activities, resources, and headlines than Herb Kelleher of Southwest? And do any
partnerships in one or more ways that reduce costs. In some consumers or airline industry experts – even after the failure of
instances, innovators reduced costs by eliminating elements of People Express – now doubt the viability of a discount carrier?
the standard offering (e.g., Schwab removing investment advice The logos and associated values of these modern corporate icons
from stock trading), by reducing or aggregating steps in the value are imprinted in the brains of their customers.
chain (e.g., Dell), leveraging economies of scale (e.g., Wal-Mart), Another innovator advantage is an economic one – a superior
by engineering operations to be low-cost (e.g., Southwest), ability to deliver a product or service based on scale economies,
and/or by gaining control over critical assets or resources. learning curve advantages, and locking in critical assets and
Importantly, in every case the choices regarding the how were resources. The successful innovators created complex, hard-to-
tightly linked to choices regarding the what, which in turned copy business models. They tailored their operations to finely-
depended upon who was being targeted. That is, the business targeted customer segments, leveraged technology in often
model innovators thought through all three aspects of their ingenious ways, and created distinctive corporate cultures that
business models in achieving significant advantages. The changes kept the machine the founders built constantly in tune.
were inextricably linked.

17
Paychex: Bringing Big-Company Payroll The Rochester, N.Y., company was founded by Tom

Services to Mom-and-Pop Operators Golisano in late 1970 to serve a small-business segment


largely ignored by payroll giants such as ADP. Golisano, in
Opportunities for business model innovation are right in front
fact, had failed to convince his boss at a regional payroll
of every organization. But to pursue them, executives have to
processor of the viability of the small-business niche before
rethink their core beliefs about the who, what, and how of their
launching Paychex.19
business.
Paychex defined the who by looking closely at the payroll
When managers do this, they can discover customer needs
needs of small businesses. Realizing that small-business
that they’ve overlooked or misunderstood for some time. The
needs for efficient, affordable payroll processing were unmet,
small-businesses payroll outsourcing model on which Paychex
it understood their needs better and redefined them. In the
is thriving today is a case in point. With superior performance
process, Paychex successfully altered customer perspectives
over its industry peers on total shareholder returns, market
on what their choices were. Paychex defined the what by
value, real asset growth, and other measures, the company is
broadening customers’ choices and simplifying the offerings.
on strong footing today.
For instance, it provided a choice of customized solutions that
How did Paychex create its business model in 1970? Two
are typically available only for large companies.
key factors allowed Paychex to come into being. First was the
Consistent with its definitions of who and what, Paychex
development of technology for cost-effectively complying with
configured its how by engineering operations to serve its
state and federal tax requirements. The second was the
targeted customer group and using information technology
opportunity to satisfy a large number of small businesses whose
to tightly integrate with customers’ systems.The sustainability
needs were not being addressed by the leading incumbent,
of Paychex’s business model innovation is undoubtedly
Automated Data Processing Inc. (ADP). Had Paychex believed
rooted in the advantageous customer access and customer
18 that ADP controlled a mature market for payroll services, where
loyalty it has achieved as part of its first-mover advantages.
all the market opportunities were already uncovered and
adequately addressed, it never would have gotten off the
ground.
Deloitte Research – Deconstructing the Formula for Business Model Innovation
Incumbent Disadvantages In addition to these real constraints, psychological hurdles
Such advantages weren’t the only way for a business model handicapped incumbents as well. By far the biggest was the
innovator to carve a chunk out of an existing market or to create inability of incumbents to think beyond the current business
a new market. The incumbents in these industries frequently had norms of the industry. This myopia prevented incumbents in most
many disadvantages that gave the business model innovators of the industries studied from seeing the unserved customer needs
considerable time and leeway to pioneer a new approach. We in the market that could provide major opportunities for growth.
came across three real disadvantages most often: the potential The competitors of over 80 percent of the business model
of a business model innovation to disrupt existing channels of innovators studied shared this blindness. This myopia allowed
distribution, the fear of eroding the existing brand, and the business model innovators to capture significant first-mover leads
difficulty in managing multiple operational models. before incumbents could figure out what hit them. These
Fear of channel disruption stops many incumbents from disadvantages are formidable.
creating new business models. Compaq, IBM, Hewlett-Packard, These examples suggest that before launching a new business
Packard Bell, and the other PC makers who sold through channel model, executives must rigorously identify the advantages their
in the 1980s and 1990s were reluctant for many years to risk their organization can create – and the disadvantages of the existing
channel relationships by going direct. By the time they did, Dell competition. In their excitement over a new business opportunity
was already in motion, with the company building and perfecting and all the hard work in executing it, managers often forget the
supply chain and assembly operations that are still unmatched importance of due diligence to understand the sustainability of
in the industry. Merrill Lynch and other full-service brokerages the innovation. The fall to earth of many once-meteoric companies
let Schwab control the discount market for years, not wanting to attests to this.
damage the relationships and goodwill they had built up with
their brokers. Key Takeaway
An important part of Schwab’s success can be attributed to Successful innovators exploit key assets such as
its ability to capitalize on competitors’ fears, namely that copying brands, innovative cultures, scale economies, and
Schwab would erode their brand equity as premium brokerage deep knowledge. They also prey on incumbents'
houses. They did not try to match Schwab’s discount model. real and perceived constraints.
Similarly, in Southwest’s early years, few of the national airlines
wanted to pollute their premium brands by offering a discount
model to compete with Southwest’s regional play. Competitors
used to joke that Southwest and the long-defunct, no-frills airline
People Express stuffed passengers in like cattle.

19
Putting Business Model companies we studied – AOL, Schwab, Wal-Mart, and Enron – have

Innovation to Work launched fundamental business model innovations more than


once in their lifetimes. Enron has actually introduced three business
Given today’s economic uncertainty, executives understandably
model transformations, expanding its business model from energy
may view business model innovation as a risky proposition.
trading to include energy outsourcing and bandwidth trading.
However, our research shows how playing it safe can actually cause
While the other innovators in the study did not repeatedly
companies to incur larger risks – the risk of watching someone
launch discrete new business models, they were by no means
else redefine the who, what, and how of the industry. While it’s
standing still after launching their initial innovation. These
hard to imagine today, most of the established players in the
companies instituted ongoing incremental improvements to stay
industries that Wal-Mart, AOL, Schwab, Columbia, Dell, and
ahead of the pack. For example, Dell was one of the first PC
other innovators first entered grossly underestimated the
companies to jump on the Internet. As of summer 2001, Dell sells
importance of the new business models. Business model
half of its products online and has become the largest PC maker in
innovation can come from any place, any time. Schwab launched
the world, direct or indirect.20
discount brokerage services for the mass market amid a protracted
In learning from these companies, it is clear to us that business
bear market. Similarly, Corning began its alliance-based path of
model innovation should be approached methodically and on a
developing new product markets during a market recession.
consistent basis. A three-step approach can bring order to what
The innovators don’t rest peacefully at night. They realize that
can easily become a chaotic process.
even the most lucrative breakthrough business models can run
their course or at least need continual tune-ups. Four of the

PUTTING BUSINESS MODEL INNOVATION TO WORK

20
Scan and Rethink and Plan and
Scope Redesign Implement

Set BMI objectives Rethink the who,


what and how Define pathway

Understand Assess ft-gap of Build workplan


industry norms each option and milestones
Assess sustainability
Assess external factors of each option Prototype and evolve

Assess internal Refine and Rapidly implement


capabilities and constraints compare options

BMI Ranked Value-Creating


Focus Areas BMI Opportunities BMI

SOURCE: DELOITTE CONSULTING


Deloitte Research – Deconstructing the Formula for Business Model Innovation
The first step in this process involves scanning for In looking at all the steps that customers take in purchasing
opportunities and determining when new business models should and using the offering – from search to replacement – what
be explored. What is the current context of the industry? What attributes (e.g., variety, speed, ease of use) are most important to
key technology, regulatory, and socioeconomic trends could spell each segment? For segments that appear to offer the greatest
major opportunities? Industry norms must be articulated around customer and shareholder value, how can the value experience
target customers (who), offerings (what), and operating models be delivered most efficiently? What kinds of competitive
(how). What customer segments are considered undesirable? For advantage could be created (scale, learning curve, etc.)? What
desirable customers, what is the prevailing belief about their core disadvantages are existing competitors likely to have in pursuing
needs? the opportunity?
Additionally, managers must understand the capabilities of Managers then must assess how well the opportunities fit with
their organization that can be leveraged in a new business model. existing resources and how well the organization can sustain the
Brands (which Harley-Davidson exploited in creating a lifestyle new business models in the face of competition. At the end of
business model), business processes (Wal-Mart took advantage of this step, managers will have a range of business model
its inventory management and distribution systems in its second opportunities ranked by such criteria as size of potential
business model innovation), existing customer bases, and other opportunity, degree of fit with corporate capabilities, and level of
assets can provide important capabilities for new business models. sustainability.
Which should managers reexamine first – the who, what, or
how of their industry? We believe that a company’s core
capabilities (i.e., the how) needs to be determined by choices
around the who and the what – and not vice versa. Starting by
assessing one’s core capabilities – for example, first-class R&D or
distribution management – may lead managers to discover new
customers and products that can be easily served by existing
capabilities. However, we believe the best place to start is to
identify the target who – the significant, underserved customer
needs. Around that who, a unique offering and profitable
operating model must be built that other would-be competitors
cannot easily match or outdo.
The second step involves getting senior executives to
proactively challenge the norms around the who, what, and how
of their industry to identify new business opportunities. Why were
the segments identified in the first phase considered undesirable?
Could these segments become attractive by altering the value
experience? Could these needs be served better by creating a
new customer segment, redefining an existing segment, or
changing the buyer?

21
The third step is to refine the design of the new business
models, plan their rollout, and then pilot them. A road map must
be developed for each opportunity, with major tasks, milestones,
and key success factors. It is at this stage that risk must be
evaluated. The key risks of business model innovation include
technology immaturity, customer reluctance to adopt a new
offering, organizational resistance, and the possible disruption of
existing business operations. Managers must develop strategies
to mitigate their primary risks. Critical go and no-go hurdles should
be created in advance. Managers must develop explicit
implementation plans, financial forecasts, and risk and
sustainability assessments.
There is not one ideal business model. Developing value
business models requires a measured approach and a significant
amount of “analytical heavy lifting” focused on rethinking industry
norms, identifying underserved customer segments, and deciding
where and how to apply the lessons learned from successful
innovators.
The dot-com collapse and economic uncertainties have
caused established companies to pause before they invest in the
next breakthrough business concept. Billions of dollars in
22
corporate R&D and venture funds have been lost because of
insufficient due diligence on promising-sounding new business
models. But the rising sea of red ink should not blind executives
to the substantial value created through business model
innovation over the last 40 years. If anything, the success of
outsiders like Wal-Mart, Schwab, AOL, and Starbucks demonstrates
how costly it can be to let others rethink the prevailing who, what,
and how of an industry.
Deloitte Research – Deconstructing the Formula for Business Model Innovation
1
London Business School Professor Constantinos Markides in his
1999 book “All the Right Moves” created the framework of the Who,
What, and How to examine business models.
2
W. C. Symonds,“The Power of the Paycheck,” Business Week, May 24,
1999, p. 71.
3
Golisano talked about the early days at Paychex Inc. in a Q&A with
Inc. magazine,“How to Build an Inc. 500 Company,”December 1, 1988.
4
Market value as of July 31, 2001.
5
Financial performance of the industry leaders was tracked through
a HOLT value analysis conducted at the end of December 2000. Holt
uses six metrics in its analysis: “premium current,”“percent future,”
“cash flow return on investment,” “total shareholder returns,” “five-
year real annual asset growth,” and “current market value.” For more
information about these measures, see sidebar “About the Study.”
6
M. Dell with C. Fredman, “Direct from Dell: Strategies That
Revolutionized an Industry,” p. 12 (HarperBusiness, 1999).
7
H. Kelleher with K. Brooker,“The Chairman of the Board Looks Back,”
Fortune, May 28, 2001, p. 63. Market value as of July 31, 2001.
8
Market value as of July 31, 2001.
9
Paychex press release of July 11, 2001, “ABA selects Paychex as
provider of new member benefit for payroll processing,”
www.paychex.com/paychex/press/071101.html
10
W.C. Symonds,“The Power of the Paycheck.” Business Week, May 24,
1999, p. 71.
11
K. Swisher, “aol.com”, (Times Business, 1999), pp. 86-87.
12
J. Peltz, “Behind Aetna Bid …,” Los Angeles Times, March 3, 2000,
p. C-1.
13
R. Rundle, “Calling the Shots: California Health Plan Thrives, But
Doctors Claim Care Suffers,” The Wall Street Journal, May 31, 2000,
Page A1.
14
So predicts John Szabo, an analyst at CIBC World Markets, according
to a May 14, 2001 Business Week article by A. Weintraub, “Leonard
the Giant Killer?” p. 78.
15
Market value as of July 31, 2001.
16
A.Weintraub,“Leonard the Giant Killer?”, Business Week, May 14, 2001,
p. 78.
17
According to a survey by International Communications Research,
as cited in an Entrepreneur magazine article by M. Hogan,
“Automation for the People,” January 1, 2000.
18
H. Kelleher as told to K. Brooker, “The Chairman of the Board Looks
Back,” Fortune, May 28, 2001, pp. 63-76.
19
W.C. Symonds, “The Power of the Paycheck,” Business Week, May 24,
1999, p. 71.
20
S. Perman, “Automate or Die,” eCompany Now, July 2001, pp. 60-67.

23
For Further Information, Please Contact
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Email: lscott@dc.com Email: agarber@dc.com Email: tgenton@dc.com Email: hdicke@dc.com

BMI THOUGHT LEADERSHIP TEAM


MUMTAZ AHMED SANFORD DAVIS DAVID ROSENBLUM DOUG TOMLINSON
Tel: 415.783.5597 Tel: 213.688.4712 Tel: 213.688.5169 Tel: 415.783.4161
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Special thanks to those who contributed to this research: Professor B. Mahadevan (Indian Institute of Management), Rik Geiersbach,
Mathias Herzog, Donald Hicks, Mark Holmstrom, Alison Keiller, Mark Mullikin, Michele Parmelee, Stephanie Siegel, Steve Watkins, and
Sarah Wiley.

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©2001 Deloitte Consulting and Deloitte & Touche LLP. All rights reserved.
ISBN 1-892383-90-X
Deloitte Research – Deconstructing the Formula for Business Model Innovation
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