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HBR Spotlight: Practical Strategy essential to every successful organization, whether it,'s a and pay for it. The traveler's check turned the normal venture or an established player. But before managers cycle of debt and risk on its head. Because people paid can apply the concept, they need a simple working defini- the checks before(often long before)they used them tion that clears up the fuzziness associated with the term. American Express was getting something banks had long enjoyed - the equivalent of an interest-free loan from its Telling a Good Story customers. Moreover, some of the checks were never cashed, giving the company an extra windfall The word"model "conjures up images of white boards As this story shows, a successful business model repre- covered with arcane mathematical formulas. Business sents a better way than the existing alternatives. It may models, though, are anything but arcane. They are, at offer more value to a discrete group of customers. Or it heart,stories-stories that explain how enterprises work. may completely replace the old way of doing things and A good business model answers Peter Drucker's age-old become the standard for the next generation of entrepre- uestions: Who is the customer? And what does the cus- neurs to beat. Nobody today would head off on vacation tomer value? It also answers the fundamental questions armed with a suitcase full of letters of credit.Fargo's busi- every manager must ask: How do we make money in this ness model changed the rules of the game, in this case, the business? What is the underlying economic logic that ex- economics of travel. By eliminating the fear of being plains how we can deliver value to customers at an ap- robbed and the hours spent trying to get cash in a strange propriate cost? city, the checks removed a significant barrier to travel Consider the story behind one of the most successful helping many more people to take many more trips. Like business models of all time: that of the travelers check. all really powerful business models, this one didn't just During a European vacation in 1892, J.C. Fargo, the presi- shift existing revenues among companies; it created new, dent of American Express, had a hard time translating his incremental demand. Traveler's checks remained the letters of credit into cash. "The moment I got off the preferred method for taking money abroad for decades, beaten path, he said on his return, "they were no more until a new technology-the automated teller machi use than so much wet wrapping paper. If the president of granted travelers even greater convenience. American Express has that sort of trouble, just think what Creating a business model is, then, a lot like writing a ordinary travelers face. Something has got to be done new story. At some level, all new stories are variations on about it. "What American Express did was to create the old ones, reworkings of the universal themes underlying traveler's check-and from that innovation evolved a ro all human experience. Similarly, all new business model bust business model with all the elements of a good story: are variations on the generic value chain underlying precisely delineated characters, plausible motivations, all businesses. Broadly speaking, this chain has two and a plot that turns on an insight about value. parts. Part one includes all the activities associated with The story was straightforward for customers. In ex- making something: designing it, purchasing raw materi- change for a small fee, travelers could buy both peace of als, manufacturing, and so on. Part two includes all the ac- mind(the checks were insured against loss and theft)and tivities associated with selling something: finding and convenience(they were very widely accepted). Merchants reaching customers, transacting a sale, distributing the also played a key role in the tale. They accepted the checks product or delivering the service. A new business model's because they trusted the American Express name, which plot may turn on designing a new product for an unmet was like a universal letter of credit, and because, by accept- need, as it did with the traveler's check Or it may turn on ing them, they attracted more customers. The more other a process innovation, a better way of making or selling or merchants accepted the checks, the stronger any individ- distributing an already proven product or service. ual merchant's motivation became not to be left out Think about the simple business that direct-marketing As for American Express, it had discovered a riskless pioneer Michael Bronner created in 1980 when he was a business,because customers always paid cash for the junior at Boston University. Like his classmates, Bronner checks. Therein lies the twist to the plot, the underlying had occasionally bought books of discount coupons for economic logic that turned what would have been an un- local stores and restaurants. Students paid a small fee for remarkable operation into a money machine. The twist the coupon books. But Bronner had a better idea. Yes, the as float. In most businesses, costs precede revenues: Be-I books created value for students, but they had the poten- fore anyone can buy your product, you've got to build it tial to create much more value for merchants, who stood to gain by increasing their sales of pizza and haircuts Joan Magretta is a management consultant and writer and Bronner realized that the key to unlocking that potential a past winner of HBR's McKinsey Award. This article draws was wider distribution-putting a coupon book in every on material from her latest book, What Management Is: student,'s backpack. How It Works, and Why It's Everyone,'s Business(Free That posed two problems. First, as Bronner well knew, Press, 2002). students were often strapped for cash. Giving the book HARVARD BUSINESS REVIEW

essential to every successful organization, whether it’s a new venture or an established player.But before managers can apply the concept, they need a simple working definition that clears up the fuzziness associated with the term. Telling a Good Story The word “model” conjures up images of white boards covered with arcane mathematical formulas.Business models, though, are anything but arcane.They are, at heart, stories – stories that explain how enterprises work. A good business model answers Peter Drucker’s age-old questions: Who is the customer? And what does the customer value? It also answers the fundamental questions every manager must ask: How do we make money in this business? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost? Consider the story behind one of the most successful business models of all time: that of the traveler’s check. During a European vacation in 1892, J.C. Fargo, the president of American Express, had a hard time translating his letters of credit into cash.“The moment I got off the beaten path,” he said on his return, “they were no more use than so much wet wrapping paper.If the president of American Express has that sort of trouble, just think what ordinary travelers face.Something has got to be done about it.”1 What American Express did was to create the traveler’s check – and from that innovation evolved a robust business model with all the elements of a good story: precisely delineated characters, plausible motivations, and a plot that turns on an insight about value. The story was straightforward for customers.In exchange for a small fee, travelers could buy both peace of mind (the checks were insured against loss and theft) and convenience (they were very widely accepted).Merchants also played a key role in the tale.They accepted the checks because they trusted the American Express name, which was like a universal letter of credit, and because, by accepting them, they attracted more customers.The more other merchants accepted the checks, the stronger any individual merchant’s motivation became not to be left out. As for American Express, it had discovered a riskless business, because customers always paid cash for the checks.Therein lies the twist to the plot, the underlying economic logic that turned what would have been an unremarkable operation into a money machine.The twist was float. In most businesses, costs precede revenues: Before anyone can buy your product, you’ve got to build it and pay for it.The traveler’s check turned the normal cycle of debt and risk on its head.Because people paid for the checks before (often long before) they used them, American Express was getting something banks had long enjoyed – the equivalent of an interest-free loan from its customers.Moreover, some of the checks were never cashed, giving the company an extra windfall. As this story shows, a successful business model represents a better way than the existing alternatives.It may offer more value to a discrete group of customers.Or it may completely replace the old way of doing things and become the standard for the next generation of entrepreneurs to beat.Nobody today would head off on vacation armed with a suitcase full of letters of credit.Fargo’s business model changed the rules of the game, in this case, the economics of travel.By eliminating the fear of being robbed and the hours spent trying to get cash in a strange city, the checks removed a significant barrier to travel, helping many more people to take many more trips.Like all really powerful business models, this one didn’t just shift existing revenues among companies; it created new, incremental demand.Traveler’s checks remained the preferred method for taking money abroad for decades, until a new technology – the automated teller machine – granted travelers even greater convenience. Creating a business model is, then, a lot like writing a new story.At some level, all new stories are variations on old ones, reworkings of the universal themes underlying all human experience.Similarly, all new business models are variations on the generic value chain underlying all businesses.Broadly speaking, this chain has two parts.Part one includes all the activities associated with making something: designing it, purchasing raw materials, manufacturing, and so on.Part two includes all the activities associated with selling something: finding and reaching customers, transacting a sale, distributing the product or delivering the service.A new business model’s plot may turn on designing a new product for an unmet need, as it did with the traveler’s check.Or it may turn on a process innovation, a better way of making or selling or distributing an already proven product or service. Think about the simple business that direct-marketing pioneer Michael Bronner created in 1980 when he was a junior at Boston University.Like his classmates, Bronner had occasionally bought books of discount coupons for local stores and restaurants.Students paid a small fee for the coupon books.But Bronner had a better idea.Yes, the books created value for students, but they had the potential to create much more value for merchants, who stood to gain by increasing their sales of pizza and haircuts. Bronner realized that the key to unlocking that potential was wider distribution – putting a coupon book in every student’s backpack. That posed two problems.First, as Bronner well knew, students were often strapped for cash.Giving the books 4 harvard business review HBR Spotlight: Practical Strategy Joan Magretta is a management consultant and writer and a past winner of HBR’s McKinsey Award. This article draws on material from her latest book, What Management Is: How It Works, and Why It’s Everyone’s Business (Free Press, 2002)

Why Business Models Matter away for free would solve that problem. Second, Bronner tions that go into it. Once an enterprise starts operatin needed to get the books to students at a cost that wouldn't the underlying assumptions of its model-about both eat up his profits. So he made a clever proposal to the motivations and economics-are subjected to continuous dean of Boston University,'s housing department: Bronner testing in the marketplace. And success often hinges on would assemble the coupon books and management's ability to tweak, or even partment, and the department could dis- Business modeling roDisney opened its paris theme park in tribute them free to every dorm on cam- is the managerial 1992, it borrowed the business model that pus. This would make the department had worked so well in Disneys U.S. parks. look good in the eyes of the students, a equivalent of the Europeans, the company thought, would notoriously tough crowd to please The scientific method- spend roughly the same amount of time Now Bronner could make an even you start with a food. rides, and souvenirs. hood business owners. If they agreed to hypothesis, which the revenue side of the business turned pay a small fee to appear in the new you then test in out to be wrong. Europeans did not, for book, their coupons would be seen by example, graze all day long at the park's all 14,000 residents of BU's dorms. action and revise various restaurants the way Americans Bronner's idea took off. Before long, he when necessary did. Instead, they all expected to b seated at precisely the same lunch or dir puses, then to downtown office build ner hour, which overloaded the facilities ngs. Eastern Exclusives, his first company, was born. His and created long lines of frustrated patrons. Because of innovation wasn't the coupon book but his business those miscalculations, Euro Disney was something of a dis- model; it worked because he had insight into the motiva- aster in its early years. It became a success only after a tions of three sets of characters students, merchants, and dozen or so of the key elements in its business model school administrators were changed, one by one. Tying Narrative to Numbers s When managers operate consciously from a model of how the entire business system will work, every decision, initiative, and measurement provides valuable feedback The term"business model" first came into widespread use Profits are important not only for their own sake but als with the advent of the personal computer and the spread- because they tell you whether your model is working. If sheet.Before the spreadsheet, business planning usually you fail to achieve the results you expected, you reexam- meant producing a single, base-case forecast. At best, you ine your model, as EuroDisney did Business modeling is did a little sensitivity analysis around the projection. The in this sense, the managerial equivalent of the scientific spreadsheet ushered in a much more analytic approach to method-you start with a hypothesis, which you then test planning because every major line item could be pulled in action and revise when necessary. apart, its components and subcomponents analyzed an tested. You could ask what-if questions about the critical assumptions on which your business depended-for ex.I Two Critical Tests ample, what if customers are more price-sensitive than we When business models don,t work,it's because they failei- thought?-and with a few keystrokes, you could see how ther the narrative test(the story doesn't make sense)or any change would play out on every aspect of the whole. the numbers test(the P&l doesn' t add up). the business In other words, you could model the behavior of a busi- model of on-line grocers, for instance, failed the numbers test. The grocery industry has very thin margins to begin This was something new. Before the personal computer with, and on-line merchants like Webvan incurred new changed the nature of business planning, most successful costs for marketing, service, delivery, and technology. dent than by design and forethought. The business model for groceries bought on-line than in stores, there i more business models, like Fargo,s, were created more by acci- Since customers weren,,t willing to pay significantly became clear only after the fact. By enabling companies way the math could work. Internet grocers had plenty of to tie their marketplace insights much more tightly to company. Many ventures in the first wave of electronic the resulting economics-to link their assumptions about commerce failed simply because the basic business math how people would behave to the numbers of a pro formawas flawed P&L--spreadsheets made it possible to model businesses Other business models failed the narrative test Con- before they were launched der the rapid rise and fall of Priceline Webhouse Club Of course, a spreadsheet is only as good as the assump- This was an offshoot of Priceline. com, the company that

away for free would solve that problem.Second, Bronner needed to get the books to students at a cost that wouldn’t eat up his profits.So he made a clever proposal to the dean of Boston University’s housing department: Bronner would assemble the coupon books and deliver them in bulk to the housing department, and the department could distribute them free to every dorm on campus.This would make the department look good in the eyes of the students, a notoriously tough crowd to please.The dean agreed. Now Bronner could make an even more interesting proposal to neighborhood business owners.If they agreed to pay a small fee to appear in the new book, their coupons would be seen by all 14,000 residents of BU’s dorms. Bronner’s idea took off.Before long, he had extended the concept to other campuses, then to downtown office buildings.Eastern Exclusives, his first company, was born.His innovation wasn’t the coupon book but his business model; it worked because he had insight into the motivations of three sets of characters: students, merchants, and school administrators. Tying Narrative to Numbers The term “business model”first came into widespread use with the advent of the personal computer and the spreadsheet.Before the spreadsheet, business planning usually meant producing a single, base-case forecast.At best, you did a little sensitivity analysis around the projection.The spreadsheet ushered in a much more analytic approach to planning because every major line item could be pulled apart, its components and subcomponents analyzed and tested.You could ask what-if questions about the critical assumptions on which your business depended – for example, what if customers are more price-sensitive than we thought? – and with a few keystrokes, you could see how any change would play out on every aspect of the whole. In other words, you could model the behavior of a business. This was something new.Before the personal computer changed the nature of business planning, most successful business models, like Fargo’s, were created more by accident than by design and forethought.The business model became clear only after the fact.By enabling companies to tie their marketplace insights much more tightly to the resulting economics – to link their assumptions about how people would behave to the numbers of a pro forma P&L – spreadsheets made it possible to model businesses before they were launched. Of course, a spreadsheet is only as good as the assumptions that go into it.Once an enterprise starts operating, the underlying assumptions of its model – about both motivations and economics – are subjected to continuous testing in the marketplace.And success often hinges on management’s ability to tweak, or even overhaul, the model on the fly.When EuroDisney opened its Paris theme park in 1992,it borrowed the business model that had worked so well in Disney’s U.S. parks. Europeans, the company thought, would spend roughly the same amount of time and money per visit as Americans did on food, rides, and souvenirs. Each of Disney’s assumptions about the revenue side of the business turned out to be wrong.Europeans did not, for example, graze all day long at the park’s various restaurants the way Americans did.Instead, they all expected to be seated at precisely the same lunch or dinner hour, which overloaded the facilities and created long lines of frustrated patrons.Because of those miscalculations, EuroDisney was something of a disaster in its early years.It became a success only after a dozen or so of the key elements in its business model were changed, one by one. When managers operate consciously from a model of how the entire business system will work, every decision, initiative, and measurement provides valuable feedback. Profits are important not only for their own sake but also because they tell you whether your model is working.If you fail to achieve the results you expected, you reexamine your model, as EuroDisney did.Business modeling is, in this sense, the managerial equivalent of the scientific method – you start with a hypothesis, which you then test in action and revise when necessary. Two Critical Tests When business models don’t work, it’s because they fail either the narrative test (the story doesn’t make sense) or the numbers test (the P&L doesn’t add up).The business model of on-line grocers, for instance, failed the numbers test.The grocery industry has very thin margins to begin with, and on-line merchants like Webvan incurred new costs for marketing, service, delivery, and technology. Since customers weren’t willing to pay significantly more for groceries bought on-line than in stores, there was no way the math could work.Internet grocers had plenty of company.Many ventures in the first wave of electronic commerce failed simply because the basic business math was flawed. Other business models failed the narrative test.Consider the rapid rise and fall of Priceline Webhouse Club. This was an offshoot of Priceline.com, the company that may 2002 5 Why Business Models Matter Business modeling is the managerial equivalent of the scientific method – you start with a hypothesis, which you then test in action and revise when necessary