Do Business models matter? Richard Lai. Peter Weill. and Thomas Malone April 26, 2006 Acknowledgment. This research was funded by the National Science Foundation under grant number IIS-0085725. We would especially like to thank Tom Apel for his insights and exemplary software support for this project. In a future paper, we hope to report on his even more impressive work on automatic classification of business models. We are grateful for the insightful comments of Erik Brynjolffson, George Herman, S.P. Kothari, Wanda Orlikowski, Stephanie Woerner, and JoAnne Yates on earlier versions of this paper. We would also like to thank Rani Bhuva, Preeti Chadha, Armando Herrera, J B Hohm, Jayne Huang, Sonia E. Koshy, Kelsey Presson, Kristen Quinn, Elisa Rah, Alice Takajan, Isaac Taylor, and Jason Yeung for their work on coding business models, and Aaron Johnson and Jon Scott for their work on selecting financial performance measures
i Do Business Models Matter? Richard Lai, Peter Weill, and Thomas Malone April 26, 2006 ________________________________ Acknowledgment. This research was funded by the National Science Foundation under grant number IIS-0085725. We would especially like to thank Tom Apel for his insights and exemplary software support for this project. In a future paper, we hope to report on his even more impressive work on automatic classification of business models. We are grateful for the insightful comments of Erik Brynjolffson, George Herman, S.P. Kothari, Wanda Orlikowski, Stephanie Woerner, and JoAnne Yates on earlier versions of this paper. We would also like to thank Rani Bhuva, Preeti Chadha, Armando Herrera, J B. Hohm, Jayne Huang, Sonia E. Koshy, Kelsey Presson, Kristen Quinn, Elisa Rah, Alice Takajan, Isaac Taylor, and Jason Yeung for their work on coding business models, and Aaron Johnson and Jon Scott for their work on selecting financial performance measures
Abstract A central question in strategic management is: what explains the difference in performance among firms? The traditional debate is whether firm or industry effects are the dominant explanation. Yet, among practitioners, a very different explanation, in the form of"business model, is commonly offered for why some firms do better than others. We provide a fundamental, reliable, and practical typological definition of business model, and use this to classify the segments of all U. S firms in COMPUSTAT/CRSP. We find that business model effects explain performance heterogeneity more than even industry effects do Running head Do Business models matter? Keywords business models, performance, strategic management, components of variance, analysis of variance
ii Abstract A central question in strategic management is: what explains the difference in performance among firms? The traditional debate is whether firm or industry effects are the dominant explanation. Yet, among practitioners, a very different explanation, in the form of “business model,” is commonly offered for why some firms do better than others. We provide a fundamental, reliable, and practical typological definition of business model, and use this to classify the segments of all U.S. firms in COMPUSTAT/CRSP. We find that business model effects explain performance heterogeneity more than even industry effects do. Running head Do Business Models Matter? Keywords business models, performance, strategic management, components of variance, analysis of variance
Do Business models matter? 1. INTRODUCTION A central question in strategic management is: what explains the difference in performance amon firms? Different theories have been proposed, many of which are aligned with one of two views. The first is the" industry view. It suggests that industry factors, such as market size and barriers to entry form the most important explanation for performance heterogeneity. Industrial organization in economics and industry analysis in the strategy field are examples of this view (e. g, (Porter, 1980)). The second is the firm view. It argues that firms' endowments and capabilities, and the difficulty of replicating these are why firms exhibit different performance. The resource-based perspective is one example of this view (e.g,(Wernerfelt, 1984)). A large empirical literature is based on testing which of these two views better explain differences in firm performance. We review this literature in section 2 Yet, among business practitioners and in the trade literature, a very different explanation, in the form of business model, is commonly offered for why some firms do better than others(e. g,( Kaplan et al. 2004),(Slywotzky et al, 1997),(Timmers, 1998),(Tapscott et al, 2000)). Many people corporate executives and especially venture capitalists- attribute the success of firms like Amway, eBay, Dell, and Wal*Mart, for example, not only to their industry or to their firm-specific capabilities, but also to their innovative business models. And among executives, innovation in products, services, and business models" is the single factor contributing the most to the accelerating pace of change in the global business environment, outranking other factors related to information and the Internet, talent, trade barriers, greater access to cheaper labor and capital(McKinsey, 2006)) In this paper, we provide one definition of"business model" that captures the similarities among the definitions provided by others, and relies on two fundamental intellectual traditions. The main question is how much business model, even in the simple way defined, matters to performance Our definition of business model is a typological one. In section 3, we describe this definition in the form of sixteen business models, such as Manufacturer and Wholesaler/Retailer. This typology is built
1 Do Business Models Matter? 1. INTRODUCTION A central question in strategic management is: what explains the difference in performance among firms? Different theories have been proposed, many of which are aligned with one of two views. The first is the “industry view.” It suggests that industry factors, such as market size and barriers to entry, form the most important explanation for performance heterogeneity. Industrial organization in economics and industry analysis in the strategy field are examples of this view (e.g., (Porter, 1980)). The second is the “firm view.” It argues that firms’ endowments and capabilities, and the difficulty of replicating these, are why firms exhibit different performance. The resource-based perspective is one example of this view (e.g., (Wernerfelt, 1984)). A large empirical literature is based on testing which of these two views better explain differences in firm performance. We review this literature in section 2. Yet, among business practitioners and in the trade literature, a very different explanation, in the form of “business model,” is commonly offered for why some firms do better than others (e.g., (Kaplan et al., 2004), (Slywotzky et al., 1997), (Timmers, 1998), (Tapscott et al., 2000)). Many people – corporate executives and especially venture capitalists – attribute the success of firms like Amway, eBay, Dell, and Wal*Mart, for example, not only to their industry or to their firm-specific capabilities, but also to their innovative business models. And among executives, “innovation in products, services, and business models” is the single factor contributing the most to the accelerating pace of change in the global business environment, outranking other factors related to information and the Internet, talent, trade barriers, greater access to cheaper labor and capital ((McKinsey, 2006)). In this paper, we provide one definition of “business model” that captures the similarities among the definitions provided by others, and relies on two fundamental intellectual traditions. The main question is how much business model, even in the simple way defined, matters to performance. Our definition of business model is a typological one. In section 3, we describe this definition in the form of sixteen business models, such as Manufacturer and Wholesaler/Retailer. This typology is built
pon the intellectual traditions associated with asset rights and asset types In section 4, we describe how we use this typology to classify all the firms in COMPUSTAT between 1998 and 2002 based on the text of the SEC 10K filings. We report statistics to show that or classification has strong inter-rater reliability(some evidence of convergent validity) and is distinct from industry classification(discriminant validity). We also describe how we use ANOVA and variance decomposition methods-standard in the empirical literature--to analyze the extent to which business models matter in firm performance In section 5, we report our baseline results. The evidence is that business model effects are larger than year effects in explaining performance heterogeneity, as measured by return on assets(rOa)or return on sales(Ros). Importantly, business model effects also appear to be at least as strong, if not stronger, than industry effects in explaining performance In section 6, we report evidence that our interpretation is unlikely to be a result of reverse causality, or to systematic differences in the level of diversification in the firms in our sample. We also test the robustness of our finding to different interaction effects and treatment of outliers. And we address issues of potential sample selection bias and measurement errors. We find that our baseline conclusion This study does not claim that our definition of business model is unique, although we argue that it satisfies important criteria. Like the empirical literature on firm-versus-industry effects, we also have not answered questions like how business models impact performance, nor do we address the normative question of how individual firms can exploit or modify their business models to improve their performance. We hope that the work described here provides a foundation for future work on these questions 2. MOTIVATION AND ANTECEDENTS The"industry view"of performance heterogeneity among firms is usually associated with industrial organization(10).(Porter, 1980) develops the early IO structure-conduct-performance framework into a
2 upon the intellectual traditions associated with asset rights and asset types. In section 4, we describe how we use this typology to classify all the firms in COMPUSTAT between 1998 and 2002 based on the text of the SEC 10K filings. We report statistics to show that our classification has strong inter-rater reliability (some evidence of convergent validity) and is distinct from industry classification (discriminant validity). We also describe how we use ANOVA and variance decomposition methods—standard in the empirical literature—to analyze the extent to which business models matter in firm performance In section 5, we report our baseline results. The evidence is that business model effects are larger than year effects in explaining performance heterogeneity, as measured by return on assets (ROA) or return on sales (ROS). Importantly, business model effects also appear to be at least as strong, if not stronger, than industry effects in explaining performance. In section 6, we report evidence that our interpretation is unlikely to be a result of reverse causality, or to systematic differences in the level of diversification in the firms in our sample. We also test the robustness of our finding to different interaction effects and treatment of outliers. And we address issues of potential sample selection bias and measurement errors. We find that our baseline conclusion is robust. This study does not claim that our definition of business model is unique, although we argue that it satisfies important criteria. Like the empirical literature on firm-versus-industry effects, we also have not answered questions like how business models impact performance, nor do we address the normative question of how individual firms can exploit or modify their business models to improve their performance. We hope that the work described here provides a foundation for future work on these questions. 2. MOTIVATION AND ANTECEDENTS The “industry view” of performance heterogeneity among firms is usually associated with industrial organization (IO). (Porter, 1980) develops the early IO structure-conduct-performance framework into a
foundation for competitive advantage. In this view, firm performance is primarily determined by industry-level factors like market share, entry barriers into the industry, and relative cost positions (Schmalensee, 1988 )and( rumelt et al., 1991) provide surveys of this view The"firm view'offers a different explanation of performance heterogeneity. It has many variants An important one is the resource-based view(e.g,(Amit et aL., 1993), Barney et al., 1986),(Cool et al. 1989),(Penrose, 1959),(Rumelt, 1984),(Teece, 1980),(Wernerfelt, 1984). Firms can produce sustained superior performance if they have valuable, scarce, inimitable, non-substitutable factor access or capabilities. Other variants include dynamic theories consistent with the firm view, such as those on organizational population and evolutionary economics by(hannan et al, 1992)and(Nelson et al, 1982) and the dynamic capabilities perspective by(Teece et al., 1997) The empirical literature focuses on disentangling the industry and firm explanations of performance heterogeneity.(Schmalensee, 1985), using 1975 data on lines of businesses, reports that industry explains 20% of return on assets(ROA) heterogeneity, while firm-using market share as a proxy - has negligible explanatory power. However, his study leaves 80% of performance variance unexplained. Partly driven by the large unexplained variance, (Rumelt, 1991)uses four years of FTC(Federal Trade Commission) data and a composite measure of firm effects. Unlike Schmalensee, he reports that firm(business unit) effects account for 34 to 46% of explained Roa heterogeneity while industry effects account for only 8 to 18%, of which about half of this is transient, as measured by the interaction of industry effects with year effects. Rumelt also includes a corporate-parent effect and finds that it is negligible. This is interpreted as consistent with the firm view: corporate strategy that structures industry and positions a firm within that industry, does not matter(e.g ,( Carroll, 1993)( Ghemawat et al., 1993),(Hoskisson, 1993) Rumelt's paper leads to a stream of others that focus on the robustness of his findings. -e. g (Bowman et al., 2001), (Brush et al., 1997),( Chang et al., 2000), (McGahan et al., 1997), and ( roquebert et al, 1996). Recent papers agree that firm effects dominate industry effects(e. g, (Agrawal et al., 1991), (Amit et al., 2001), Lubatkin et al., 2001),(Mauri et al., 1998), (McNamara et al., 2003),(Powell, 1996)
3 foundation for competitive advantage. In this view, firm performance is primarily determined by industry-level factors like market share, entry barriers into the industry, and relative cost positions. (Schmalensee, 1988) and (Rumelt et al., 1991) provide surveys of this view. The “firm view” offers a different explanation of performance heterogeneity. It has many variants. An important one is the resource-based view (e.g., (Amit et al., 1993), (Barney et al., 1986), (Cool et al., 1989), (Penrose, 1959), (Rumelt, 1984), (Teece, 1980), (Wernerfelt, 1984)). Firms can produce sustained superior performance if they have valuable, scarce, inimitable, non-substitutable factor access or capabilities. Other variants include dynamic theories consistent with the firm view, such as those on organizational population and evolutionary economics by (Hannan et al., 1992) and (Nelson et al., 1982), and the dynamic capabilities perspective by (Teece et al., 1997). The empirical literature focuses on disentangling the industry and firm explanations of performance heterogeneity. (Schmalensee, 1985), using 1975 data on lines of businesses, reports that industry explains 20% of return on assets (ROA) heterogeneity, while firm – using market share as a proxy – has negligible explanatory power. However, his study leaves 80% of performance variance unexplained. Partly driven by the large unexplained variance, (Rumelt, 1991) uses four years of FTC (Federal Trade Commission) data and a composite measure of firm effects. Unlike Schmalensee, he reports that firm (business unit) effects account for 34 to 46% of explained ROA heterogeneity while industry effects account for only 8 to 18%, of which about half of this is transient, as measured by the interaction of industry effects with year effects. Rumelt also includes a corporate-parent effect and finds that it is negligible. This is interpreted as consistent with the firm view: corporate strategy that structures industry and positions a firm within that industry, does not matter (e.g., (Carroll, 1993) (Ghemawat et al., 1993), (Hoskisson, 1993)). Rumelt’s paper leads to a stream of others that focus on the robustness of his findings. – e.g., (Bowman et al., 2001), (Brush et al., 1997), (Chang et al., 2000), (McGahan et al., 1997), and (Roquebert et al., 1996). Recent papers agree that firm effects dominate industry effects (e.g., (Agrawal et al., 1991), (Amit et al., 2001), (Lubatkin et al., 2001), (Mauri et al., 1998), (McNamara et al., 2003), (Powell, 1996)