Literature Review on the Importance of Business Models

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Joan Magretta’s article, “Why Business Models Matter” (HBR, 2002) clarifies and elaborates on a crucial element of a business. The article explains the importance of a business model, what causes it to succeed, and the role strategy plays in this.

Magretta argues that both business model and strategy have been the most commonly misused terms in businesses, thus rendering them meaningless. She refers to business model as a story that describes how a firm create and deliver values to its customers, and generates revenue, but it does not highlight one critical dimension of performance: competition. That, according to her, is where strategy comes in. She describes strategy as the differentiating factor that compliments the business model and helps it to succeed. To substantiate her point, she gives example of Walmart and how it used strategy to compete within the industry through a different approach to merchandising and pricing than its competitors, a unique competitive advantage

Further in her article, Magretta refers to business model as spreadsheets where companies could ask critical what-if questions underlying their assumptions and effortlessly model the behaviour of their business. But asserts that once an enterprise starts operating, these assumptions should be continuously tested to align them with the market demands. She elaborates that a business model can also be used to align different stakeholders on a common ground, and help them understand the firm’s core logic. And like a story, it is easy to grasp and easy to remember (Magretta, 2002).

Finally, the concept allow firms to rewrite their old way of doing things, as it did with Traveller’s check – providing customers a safe way to carry cash to other places using pre-paid checks instead of cash – or it may turn on a process innovation. All in All, she describes business model as a powerful tool to improve a firm’s execution, and simultaneously stresses on the importance of strategy.

Magretta’s article effectively lays down the importance of business model in an organizational setting, moreover, makes a valid point that business model alone is not enough, an argument which she supported by citing examples of companies like Walmart and Dell. A business model, no doubt, play an important role in the success of an organization, but considering it everything like Magretta states, is what leads an organization to failure. Strategy is equally important, it forms the basis for an effective model. Explicitly speaking, a Business Model when coupled with a strategic advantage, becomes a powerful tool to achieve superior performance and outshine competitors.

The implicit idea of a business model, according to Magretta’s definition, refers to how a firm provide value and earn money (Magretta, 2002). While Magretta’s definition may seem a bit vague, Amit and Zott’s is more precise: “A business model depicts the content, structure, and governance of transactions designed so as to create value through the exploitation of business opportunities.” (Amit and Zott, 2001, p.494). Albeit, her concept of a business model as a story has been useful to understand a firm’s organizational behaviour (Gabriel, 2000), the necessarily subjective nature pose challenges and is constraint to the firm’s logic and it’s environment. (Lewin, Long, & Carroll, 1999). Nonetheless, Magretta definition of Business models as “stories” (Magretta, 2002, p4), gained much attention in comparison to Porters definition being ‘fuzzy at best’ (Porter, 2001).

While the definition of a business model varied from one scholar to another, for instance designed structures (Amit & Zott, 2001), organizational narratives (Magretta, 2002), process of capturing value from innovation (Chesbrough & Rosenbloom, 2002), recipe for firm’s activities incorporating organizational design and strategy (Slywotzky & Wise, 2003), the common idea behind each notion can be summarised as a firm’s logic of how it operates and creates value for its stakeholders. That is, a firm’s business model should clearly explain the value proposition and how it ought to be implemented. Such value creation can take several forms; it can solve a problem, improve performance, or reduce risk and costs. As Magretta mentions that a Business model must answer the underlying economic logics of how a firm delivers value to customer at an appropriate cost (Magretta, 2002). G.J. Adam in his research used the analogy of a machine to describe a Business model, which operates on a particular logic, works in a particular way, and thus provides value for its user (A. J., & George, G., 2011). But for the machine to achieve the necessary, each component and the relative components will play an important role. Similarly, the success of a business model also depends on its components. G.G. Adam recognizes these as (a) the choices made by a company about how it must operate, that Magretta mention as all activities associated with making and selling something (Magretta, 2002), and (b) the resulting consequences. For instance in the case of Ryanair, these choices were: Secondary airports, lowest ticket prices, no meals, etc. with consequences resulting in low airport fees and large volume, faster turnaround, respectively.

Magretta further describes business model as a powerful tool or an organizational alignment tool (Magretta, 2002) that help managers understand, analyse, communicate and design a firm’s logic (Hayes and Finnegan 2005) and when need be analyse and modify it (Magretta, 2002; Osterwalder, 2005). A well-designed business model act as common language between stakeholders and serve as a blueprint that is automatically understood by all. It becomes easier to communicate what value a company wants to deliver and how it is to be delivered in a much more tangible way (Fensel, 2001). Clearly, analysing a problem through visual representation substantially improves how that problem is handled and understood, to a greater extend (Rode, 2000). Moreover, it serves as a dialogue among various stakeholders, as Magretta mentions that a business model can be used to align everyone around the kind of value the company aims to create. Camponovo (2004), highlights another aspect of the model as a mean for one firm to compare its own model with its competitors or even with one in a totally different industry. Where the former helps in identifying key indicators and monitoring strategy implementation, the latter may result in new opportunities and business model innovation. (Camponovo, 2004). He further described business model as a building plan that outlines a firms strategic positioning and strategic goals and allow it to shape its business structure and systems – a relation which he refers to as a business triangle, (see Fig.1). More importantly, mapping the business model creates the foundation for initiating change, it helps understand better which area in particular require immediate attention – in response to the inside and outside pressures like competitive forces (Porter, 2008), customer demand, social technological and legal change – and improve the speed and appropriateness of reaction.

Figure 1: The Business Model’s Place in the Firm (Osterwalder & Tucci, 2005, p.9).

Magretta (2002) mentions testing and revising the model, her argument however, is more concentrated on the implementation stage, when a firm tries out a new model; the effect of time is little discussed. On the other hand, Osterwalder (2005) goes to great lengths in defining the relationship of the model and time, he argues that the phrase ‘a company’s business model’ is about how it operates at a particular time (Osterwalder, 2005). However, as discussed, a firm’s business environment changes constantly (Hamel 2000; Linder and Cantrell 2000), this derives the need to shift from a current model to a new one (see Fig 2). Linder and Cantrell (2000) call these models ‘change models’ underlining the degree to which the core logic changes over time to maintain profitability in a dynamic environment, (see Fig. 3). He asserts that it becomes easier to move from one model to another when one clearly understand, how each element will change and more importantly how change in one element will affect the other (Linder and Cantrell 2000; Ushold et al., 1995; Morecroft, 1994). By the same token, Petrovic (2001) conceptualised business model as a key to modify the current business logic (Petrovic, Kittl et al. 2001), and Amit & Zott (2011) supported the argument by stating business model as a source of innovation for creating more value. (Amit & Zott, 2001; Zott et al., 2011).

Figure 2: Planning, Changing and Implementing Business Models (Osterwalder & Tucci, 2005, p.15).

Similarly, other scholars have also recognized business model as a systematic tool to identify the starting point for innovation in order to create an advantage over their competitors – business model innovation1, changing how to ‘play the game’ in an existing industry (Christensen et al. 2002; Gambardella and McGahan 2010; Markides 2008), creating new markets (Hamel 2001; Markides 2008) or even creating new industries (Teece 2010). Furthermore, they share a common point of view that, it is only those firms that develop dynamic capabilities (Teece et al., 1997) and innovate their business model to redefine their position and compete differently, that survives the rapidly changing competitive environment. (Zott & Amit, 2010; Teece, 2010, 2017; Bucherer, Eisert and Gassman, 2012; Baden-Fuller & Haefliger, 2013). Instead of engaging in price competition that porter regards as destructive (Porter, 1996), business model innovation allows firms to rewrite how they operate. While product and service innovation are comparitively easier to imitate, such a design may be complex and therefore difficult for the competition to copy (Zott, Amit & Massa, 2011; Mitchell & Coles, 2003).

Figure 3: Change Models (Linder and Cantrell, 2000).

Burgi (2004) described Business Model Innovation as endless possibilties limited only by the imagination and resources (Burgi, Victor, et al. 2004). For instance Apple Inc. When later in 1990s, its original business strategy (niche market) was losing ground, Apple responded by launching new products: iPod and iTunes, that later proved to be a business model innovation, transforming the concept of music distribution in the industry. Besides the new product launches the success was mainly attributed to iTunes, which served as a new model for downloading music as well as applications – something that allowed the music industry to sell individual songs. The ‘What?’ held idea of ‘product as an experience.’ The ‘How?’ was the introduction of iTunes and increased products, and the ‘How make money?’ was not just the new product line but also the use of iTunes to download music and applications. (See Appendix I)

Business model innovation can create new opportunities in existing markets (Baden-Fuller and Haefliger, 2013) or build a completely new one. For e.g. McDonald’s McCafé is an example of evolution in an existing market. Utilizing its core assets and capabilities i.e., stores and running a retail network to further grow its business, McCafé provides a new value proposition to customers, expanding not only its potential market but also the share of wallet of existing one. Alternatively Hilti, a Liechtenstein multinational company, is an example of a Business Model Innovation that created a completely new business. It revolutionised the market by shifting from a purchase to a rental based business model. Now their customer simply rent their tools, when they need it instead of purchasing.

Clearly, business model and business model innovation are important for a firm, but how does it design the right model? Amit & Zott (2012) suggests that managers should go through six key questions when considering model innovation. (See Appendix II). The needs it will fulfil, the activities required, the stakeholders, the value created for each of the participants, and lastly, the revenue model. To understand these questions, consider the case of book publishers e.g. McCraw Hill. The recent consumers tilt towards e-reading has resulted in an increase in demand of Kindle and iPad. Although one cannot expect the books to disappear, publishers will still be required to perform new activities to meet the customer’s shit in demand i.e. designing, uploading and maintaining content online. Additionally, they will need to look past the traditional bookstore retailers and develop a new marketing activity targeting digital distribution partners such as Amazon and Apple. Producing digital content further requires a change in activities. While carrying out these activities, the new business model also requires concrete understaning of trade-offs. Should it build its own branded device or partner with Amazon, Apple and the like, leveraging their built market. Or will it be available on the internet, facilitating global access. Lastly, the consideration of revenue models, for instance subscriptions, piecemeal pricing or value-based.

Then again, there are certain barriers to the business model innovation. Markides (2006) states a firm must accept innovations first, to be able to exploit it. In the similar context, Teece (2007) argue that for a firm to undergo reconfiguration, it must be able to sense the need for change, the resultant opportunity is then seized to gain operational efficiency.  Dasilva and Trkman (2012) argues that when a company operates on a BM over a long period of time, there develops an inertia of change that limits a firm to adopt new market trends (Leonard-Barton, 1992; Chesbrough, 2010). Another reason may be the lack of communication and awareness of the increased values associated with the new business model (Santos, Spector, & Van der Heyden, 2009). Amit and Zott (2010) further recognised the cost associated with the new technology as a barrier to Business Model Innovation. Whereas, Johnson et al. (2008) and Amit and Zott (2010) describe the inflexible resources supporting the prevailing BM being the main obstacle to BMI.

Having understood the significance of Business Model, the important question to ask is how does a firm implement it, and what are the underlying domains? Osterwalder (2005) complains that business model implementation has been a widely neglected issue i.e. the form it will take in reality. Magretta (2002) writes about successful business models but a business model cannot be successful by itself. How a firm implement it in reality plays a vital role. For instance, a model designed to perfection can be managed to fail, while a weak one can be strongly managed to success.

The implementation stage translates the business model into elements, such as the structure of a firm, its processes, infrastructure and systems (Brews and Tucci 2003), (see Fig. 6). One widely used business model tool is the Business Model Canvas by Alexander Osterwalder (2004) and Yves Pigneur. The canvas represents a set of decisions ‘building blocks’ that  describes a firm way to create, transfer, and capture value for customers, suppliers and stakeholders. (Osterwalder & Pigneur, 2010).  It comprises of four main areas of a company, namely, customer, product, infrastructure, finance, and is further divided into nine building blocks (see appendix), that together serves as a visual tool to understand a firm’s logic and develop strategic thinking about business model innovation (Spieth et al., 2014).

Though designing a business model for an innovative idea or to understand the business logic of a firm is indeed an intriguing activity and when implemented model may provide considerable value as well as revenue, however it falls short to assure competitive advantage.

That is, despite of all the opportunities a business model create for a firm and for business model innovation, it can by no means replace strategy. Chesbrough (2002) debates that a sound model plays a vital role to create a successful business, however, neither does it predict nor explain the successfulness of a business (Chesbrough & Rosenbloom, 2002). Strategy and business model are two distinct terms (Magretta, 2002), both important for a firms existence. A Business model shows how different elements of a business fit together, while strategy further focus on competition (Magretta, 2002). This is reinforced by Porter (2001), a business strategy is how the different elements of the company work together in order to create a long-term competitive advantage (Da Silvia & Trkman, 2012; Chandler, 1962; Teece, 2012), harder for another firm to copy (Teece, 2010). Where head to head competition drives the prices down to a point where returns are not favourable (Porter 1996) Magretta (2002) follows and argues that it is strategy that paves the way to success.

Figure 6: Implementing Business Models (Osterwalder & Tucci, 2005, p.15).

Putting it together, Zott & Amit (2008) points that both strategy and business model depend on each other (Zott & Amit, 2008). They assert that strategy represent how to cope with the external environment and a business model shows how to meet customer demands. Similarly, Casadesus-Masanell and Ricart (2010) states, “BMs are reflections of the realized strategy” (p.204). Consistent with this notion, the objective of strategy is to pick the right business model, and the business model employed governs the ways it will compete in the market, (see Fig. 7).

Figure 7: The generic two-stage competitive process framework (Osterwalder & Tucci, 2005, p.15).

Recapitulating, business model provides a complete view of how a firm operates. It helps to logically structure the various activities involved in providing value and generating revenue. By adopting the business model, managers clearly understand their target customer segments, potential alliances, key activities and required assets to fulfil the customer’s demands. The purposeful design of the model serves as an important source of innovation, allowing the firm to view and capture the market before its competitors.

Other key conclusion of the literature is that to maintain an effective ground in the market place the firms business model must be more than its way of doing business. It should be coupled with strategic choices to develop a differentiated and hard-to-imitate model. The rapidly changing nature of a firm’s external environment demands that the business model be constantly evaluated to see, if it fits with the changing needs of the customers and that each of the other building blocks is up-to-date. Moreover the firm itself must develop dynamic capabilities to meet the changing needs of its target customers and more importantly to survive the competition. All in All, a company with a clear direction and focused strategic goals and, i.e., sound strategy and a business model, possess higher odds.

References

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  • Amit, R., & Zott, C. (2010). Business Model Innovation: Creating Value in Times of Change.
  • Baden-Fuller, C & Morgan S, M. (2010). Business Models as Models. Long Range Planning, 43(23), 156-171.
  • Bucherer, E., Eisert, U., & Gassmann, O. (2012). Towards Systematic Business Model Innovation: Lessons from Product Innovation Management. Creativity And Innovation Management, 21(2), 183-198.
  • Burgi, P., B. Victor, et al. (2004). “Case Study: Modeling How Their Business Really Works Prepares Managers for Sudden Change.” Strategy & Leadership 32(2): 28.
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Appendix I

Figure 4: Apple’s performance before and after business model chnages (Amit & Zott, 2012, p.43).

Appendix II

Figure 5: Six questions about Business Model Innovation (Amit & Zott, 2012, p.45).

BUSINESS MODEL DESIGN

In  this  section,  we  provide  an  overall  description  of  the  Business  Model  Canvas framework, as that “visual and design-informed tool to enhance strategic thinking about business model  innovation”  (Spieth  et  al.,  2014).  Our aim  is  to  study the  diffusion  of innovations under the lens of the business model design literature in order to provide an evidence  that  particular  business  model  design  choices  with  which  an  innovation  is commercialized affect the speed and patterns of diffusion. A Business Model represents a set of strategic decisions  that  defines  how  organisations  create,  transfer,  and  capture value  according  to their  internal  activities  and  relationships  with  stakeholders, among which suppliers and customers (Afuah & Tucci, 2001; Osterwalder et al., 2005; Zott et al.,  2011;  Osterwalder  and  Pigneur,  2013).  For  several  years,  literature  on  strategic management has studied the role of the Business Model as a means to shape the strategy of  organisations.  Indeed,  the  Business  Model  represents  for  organisations  a  driver  of competitiveness, defining how to position in the market against competitors. Accordingly, managers  consider  the  design  of  the Business  Model  as  a  strategic  priority  for  their organisations (Chesbrough, 2007, 2010; Ireland et al., 2001). However, one of the main representations of the Business Model, from a strategic design perspective (Spieth et al., 2014) is the Business Model Canvas of Alexander Osterwalder (2004). His Canvas is a reference framework with nine building blocks through which organisations can represent their  business.  The  customer  segment  block  describes  the  group  of  customers  with different characteristics  and needs that organisations aim to reach and serve. The value proposition block  represents  the  bundle of products  and  services  that satisfy  customer segments’  needs.  The  distribution  channels  and  customer  relationship  blocks  aim  at connecting the customer segments and value proposition blocks. In particular, the former describe  the  channels  through which  organisations  communicate  with  customers  and through which offer their value proposition, the latter highlight the types of relationships that organisations establish with each customer segment. These four blocks constitute the dimension of  the Customer Value Proposition & Interface of the organisation. The key resources block describes the set of assets on which the business model of organisations is  built.  The  key  activity  block  includes  the  most  important  activities  performed  by organisations to implement their business model. The key partners (or partner network) block shows the network of suppliers and partners the organisations work with. These three blocks constitute the dimension of the Value Network of the organisation. Finally, the  revenue  streams  and  the  cost  structure  blocks  constitute  the  dimension  of  the Economic Model of the organisation. The  former  describes  the  streams  through which the organisation earns revenues from its customers for value creating and customer-facing activities, the latter describes the costs the organisation incurs to run its business.

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