between offices. The element "govenance"refers to the structure of contractual arrangements that confer decision rights regarding policies or assets. For example, a given business model may contain as a"choice"the use of certain assets such as a fleet of trucks. The fleet can be owned by the company or leased from a third party. As literature on transaction cost economics shows(see, for example, Williamson, 1980), seemingly innocuous differences in governance of assets and policies may have dramatic effects on the effectiveness of a given business model. A consequence is flexible if it is sensitive to the choices that generate it. For example, large volume is a consequence of a policy of low prices. If the policy changes to high prices, volume is likely to fall rapidly. In contrast, a rigid consequence is one that does not change rapidly with the choices that generate it. For example, a"culture of frugality"is a consequence that changes only slowly with the choices that generate it. Perhaps a more tangible example is an installed base of PCs"which is (partly) a consequence of prices set by Intel and Microsoft for the microprocessor and the operating system, respectively. As prices change the installed base changes slowly: it is a rigid consequence. Clearly, no consequence is purely flexible or purely rigid. All consequences are somewhere in between; it is a matter of degree Business Model Representations A useful way to represent business models is by means of a causal-loop diagram(Baum and Singh, 1994): choices and consequences linked by arrows representing causality. However, except possibly for the simplest organizations, such a representation rapidly becomes highly complex and often intractable. In principle, one could make the effort of listing every choice made by management (although this would take a very long time). More difficult, perhaps, is to list the set of all consequences of those choices and to spell out exactly how choices (and different combinations of choices) deliver those consequences, and how exactly consequences (and different combinations of consequences) enable choices. In most businesses there are large numbers of choices and consequences. An analysis and evaluation of an organizations business model that takes into consideration every choice and every consequence is just impractical: nothing meaningful can be concluded by considering choices and consequences in full richness of detail To overcome this issue, we work with representations of business models (or models of business models). A business model representation consists of (i) choices (generally a subset of all choices), (i) consequences (generally a subset of all consequences), and (ii)theories Notice the third element: theories. Theories are suppositions on how choices and consequences are related. For example, a theory may be that as r&D expenses increase, products with innovative features are brought to market. In the causal loop diagram, we would have an arrow from"high R&D expenses"to "innovative products. In many cases theories are commonly accepted relationships open to little discussion. Other times, however,theories"are controversial. In the 1960s, Sam Walton believed that large volumes of merchandise would be Notice that intangible assets such as experience, brand equity, or even the value of patents are consequences generally rigid), not choices. Notice that disciplines such as economics, sociology, or psychology are, for the most part, devoted to generating theories. For example, there is a large body of economic literature devoted to understanding how incentives affect performance. These theories are distilled in our business model representation by use of a simple arrow (or a few arrows)connecting choices and consequences. Disciplines look at the arrows with great care, but have little concern bout how arrows interact with one another and contribute to making the whole of a business model
4 - IESE Business School-University of Navarra between offices.2 The element “governance” refers to the structure of contractual arrangements that confer decision rights regarding policies or assets. For example, a given business model may contain as a “choice” the use of certain assets such as a fleet of trucks. The fleet can be owned by the company or leased from a third party. As literature on transaction cost economics shows (see, for example, Williamson, 1980), seemingly innocuous differences in governance of assets and policies may have dramatic effects on the effectiveness of a given business model. A consequence is flexible if it is sensitive to the choices that generate it. For example, large volume is a consequence of a policy of low prices. If the policy changes to high prices, volume is likely to fall rapidly. In contrast, a rigid consequence is one that does not change rapidly with the choices that generate it. For example, a “culture of frugality” is a consequence that changes only slowly with the choices that generate it. Perhaps a more tangible example is an “installed base of PCs” which is (partly) a consequence of prices set by Intel and Microsoft for the microprocessor and the operating system, respectively. As prices change, the installed base changes slowly: it is a rigid consequence. Clearly, no consequence is purely flexible or purely rigid. All consequences are somewhere in between; it is a matter of degree. Business Model Representations A useful way to represent business models is by means of a causal-loop diagram (Baum and Singh, 1994): choices and consequences linked by arrows representing causality. However, except possibly for the simplest organizations, such a representation rapidly becomes highly complex and often intractable. In principle, one could make the effort of listing every choice made by management (although this would take a very long time). More difficult, perhaps, is to list the set of all consequences of those choices and to spell out exactly how choices (and different combinations of choices) deliver those consequences, and how exactly consequences (and different combinations of consequences) enable choices. In most businesses there are large numbers of choices and consequences. An analysis and evaluation of an organization’s business model that takes into consideration every choice and every consequence is just impractical: nothing meaningful can be concluded by considering choices and consequences in full richness of detail. To overcome this issue, we work with representations of business models (or models of business models). A business model representation consists of (i) choices (generally a subset of all choices), (ii) consequences (generally a subset of all consequences), and (iii) theories. Notice the third element: theories. Theories are suppositions on how choices and consequences are related. For example, a theory may be that as R&D expenses increase, products with innovative features are brought to market. In the causal loop diagram, we would have an arrow from “high R&D expenses” to “innovative products.” In many cases theories are commonly accepted relationships open to little discussion.3 Other times, however, “theories” are controversial. In the 1960s, Sam Walton believed that large volumes of merchandise would be 2 Notice that intangible assets such as experience, brand equity, or even the value of patents are consequences (generally rigid), not choices. 3 Notice that disciplines such as economics, sociology, or psychology are, for the most part, devoted to generating theories. For example, there is a large body of economic literature devoted to understanding how incentives affect performance. These theories are distilled in our business model representation by use of a simple arrow (or a few arrows) connecting choices and consequences. Disciplines look at the arrows with great care, but have little concern about how arrows interact with one another and contribute to making the whole of a business model
bought in rural areas if discount stores were located there. At the time, most people did not share this view. (See Bradley, Ghemawat, and Foley, 1994.) Notice also that theories do not appear in the definition of a business model. a business model is made up of choices and consequences, but these are the actual choices and actual consequences as they are truly related. The term business model" refers to the real relationships. a business model representation, on the other hand, refers to a model of the business model. a business model representation integrates theories of causality that are believed to be true by the business model designer or analyst. If later they fail to hold up, there will be a break in the logic leading to business model failure ( partial or complete As mentioned above, we do not include every choice and consequence in the business model representation. There are two main ways to move from the full, true detail of a business model to a simplified, tractable representation: aggregation and decomposability. In most instances, business model representations make simultaneous use of both approaches Aggregation. Aggregation works by bunching together detailed choices and consequences into larger constructs. For example, specific incentive contracts (which may be unique to every individual in the organization) may be bunched together into a choice called"high-powered ncentives. "This captures the idea that contracts typically impose high-powered incentives on the workforce. In the business model representation, instead of detailing every contract offered to every individual, we simply write one choice: high-powered incentives. This allows a simplified representation that enhances our understanding of the organization. One can think of aggregation as 'zooming out and looking at the (real) business model from the distance. As the analyst zooms out, details blur and larger objects (aggregations of details)become clear. If one keeps one's nose too close to every choice and consequence, it is impossible to see the larger picture and understand how the business model works On the other hand, if one looks at the business model from very far away, all the interesting details are lost. It is more of an art than a science to find the right distance from which to assess a given business model. How much to ' zoom out generally depends on the question the analyst is trying to address In what follows we use the expression "level of aggregation"to refer to the extent to which we zoom out from the full business model. a high level of aggregation refers to looking at the business model from a long distance. A low level of aggregation refers to being close to the details. As we point out below, high levels of aggregation are needed when analyzing nteraction between business models of different players (or competition through business models). y. Sometimes business models are decomposable in the sense that different groups of choices and consequences do not interact with one another and thus can be analyzed in isolation. In this case, depending on the question to be addressed, representing just a few parts of an organizations business model may be appropriate. Clearly, this simplifies the analyst,'s task considerably. For example, in the case of Ryanair developed below, there are few interactions between Ryanair's choices on related businesses such as car rentals or accommodation, or on ancillary business by others, and therefore Ryanair's operative choices related directly to the management of the airline. Given this, one can understand the working of Ryanair's model without needing to be absolutely comprehensive. SE Business School-University of Navarra-5
IESE Business School-University of Navarra - 5 bought in rural areas if discount stores were located there. At the time, most people did not share this view. (See Bradley, Ghemawat, and Foley, 1994.) Notice also that theories do not appear in the definition of a business model. A business model is made up of choices and consequences, but these are the actual choices and actual consequences as they are truly related. The term “business model” refers to the real relationships. A business model representation, on the other hand, refers to a model of the business model. A business model representation integrates theories of causality that are believed to be true by the business model designer or analyst. If later they fail to hold up, there will be a break in the logic leading to business model failure (partial or complete). As mentioned above, we do not include every choice and consequence in the business model representation. There are two main ways to move from the full, true detail of a business model to a simplified, tractable representation: aggregation and decomposability. In most instances, business model representations make simultaneous use of both approaches. Aggregation. Aggregation works by bunching together detailed choices and consequences into larger constructs. For example, specific incentive contracts (which may be unique to every individual in the organization) may be bunched together into a choice called “high-powered incentives.” This captures the idea that contracts typically impose high-powered incentives on the workforce. In the business model representation, instead of detailing every contract offered to every individual, we simply write one choice: high-powered incentives. This allows a simplified representation that enhances our understanding of the organization. One can think of aggregation as ’zooming out’ and looking at the (real) business model from the distance. As the analyst zooms out, details blur and larger objects (aggregations of details) become clear. If one keeps one’s nose too close to every choice and consequence, it is impossible to see the larger picture and understand how the business model works. On the other hand, if one looks at the business model from very far away, all the interesting details are lost. It is more of an art than a science to find the right distance from which to assess a given business model. How much to ‘zoom out’ generally depends on the question the analyst is trying to address. In what follows we use the expression “level of aggregation” to refer to the extent to which we zoom out from the full business model. A high level of aggregation refers to looking at the business model from a long distance. A low level of aggregation refers to being close to the details. As we point out below, high levels of aggregation are needed when analyzing interaction between business models of different players (or competition through business models). Decomposability. Sometimes business models are decomposable in the sense that different groups of choices and consequences do not interact with one another and thus can be analyzed in isolation. In this case, depending on the question to be addressed, representing just a few parts of an organization’s business model may be appropriate. Clearly, this simplifies the analyst’s task considerably. For example, in the case of Ryanair developed below, there are few interactions between Ryanair’s choices on related businesses such as car rentals or accommodation, or on ancillary business by others, and therefore Ryanair’s operative choices related directly to the management of the airline. Given this, one can understand the working of Ryanair’s model without needing to be absolutely comprehensive
Decomposability also allows the study of individual business units in multi-business organizations. For example, below we represent Microsoft's business model for operating systems and productivity applications for the PC (at a high level of aggregation). Microsoft is present in many other sectors such as videogame systems or operating systems for personal digital assistants. Although there are interactions between all of these businesses, these may not be central to the particular question being addressed by the analyst and may therefore be ignored In what follows, we will abuse language and refer to business model representations as, simply, business models. In doing this, we are assuming that the representation does a good job of portraying the organizations true business model An Example: Ryanair To illustrate our notion of a business model, consider Ryanair in 1999 as described in Rivkin's (2000) classic. Important choices in Ryanair's business model include: low fares, flying to secondary airports, all passengers treated equally, nothing is free, no meals, short-haul flights, standardized fleet of Boeing 737s, low commissions to travel agencies, non-unionized, high powered incentives, and Spartan headquarters. Consequences of those choices include: low variable and fixed costs, reputation for reasonable fares, combative management team, large olume, etc. Considering what we know about the industry, we can develop theories on how choices and consequences are related. For example, an arrow from low fares (choice) to high volume(consequence) reflects the theory that the demand function for flights is downward- sloping. We employ a causal loop diagram to represent Ryanair's business model (See Figure 2 Figure 2 Ryanair's Business Model No meals Low variable cost Nothing free Large Ancillary business Low fix cost Secondary airports west Reputation for High aircraft suppliers Standardized fleet of 737s o travel agencies Attracts combative team incentives
6 - IESE Business School-University of Navarra Decomposability also allows the study of individual business units in multi-business organizations. For example, below we represent Microsoft’s business model for operating systems and productivity applications for the PC (at a high level of aggregation). Microsoft is present in many other sectors such as videogame systems or operating systems for personal digital assistants. Although there are interactions between all of these businesses, these may not be central to the particular question being addressed by the analyst and may therefore be ignored. In what follows, we will abuse language and refer to business model representations as, simply, business models. In doing this, we are assuming that the representation does a good job of portraying the organization’s true business model. An Example: Ryanair To illustrate our notion of a business model, consider Ryanair in 1999 as described in Rivkin’s (2000) classic. Important choices in Ryanair’s business model include: low fares, flying to secondary airports, all passengers treated equally, nothing is free, no meals, short-haul flights, standardized fleet of Boeing 737s, low commissions to travel agencies, non-unionized, highpowered incentives, and Spartan headquarters. Consequences of those choices include: low variable and fixed costs, reputation for reasonable fares, combative management team, large volume, etc. Considering what we know about the industry, we can develop theories on how choices and consequences are related. For example, an arrow from low fares (choice) to high volume (consequence) reflects the theory that the demand function for flights is downwardsloping. We employ a causal loop diagram to represent Ryanair’s business model. (See Figure 2.) Figure 2 Ryanair’s Business Model Short haul flights No meals Nothing free All passengers treated equally Lowest fares Secondary airports Low commissions to travel agencies Non-unionized workforce High-powered incentives Spartan headquarters Standardized fleet of 737s Attracts young & pleasure travelers Reputation for “fair” fares Large volume Ancillary business. High aircraft utilization Bargaining power with suppliers Word of mouth advertising Attracts combative team Tough negotiators Low variable cost Low fix cost
Choices are in bold and underlined, rigid consequences are in boxes, and flexible consequences nor every consequence. We have made use of aggregation and decomposable ade by ryanair are plain text. Notice that the representation does not include every choice Figure 3 is a representation of Ryanair's business model with theories. To explicitly account for theories, we include a short text with the justification for each arrow. to keep the representations simple, however, in the rest of the paper we will place the arrows without explicit theories. Only when a theory is not obvious will it be written down because, as Figure 3 illustrates, when theories are explicitly accounted for, the diagram becomes harder to read. Figure 3 yanair's Business Model with Theories Absence c meals lowers cost Short haul Economies of scale Low vanable cost foung travelers are f Attracts abilty to 8noe, travel Large Sotmie_ Ancillary condary Secondary airports alka low D utilization air fares elate Bargaining po Standardized Excrement about lage noun depend fleet of 737s advertisi ing Low commissions Combative_ Attracts combative team-are lkely to act as Nonunionized uniore Incividuals selFeelect Spartan headquarters In summary, the causal loop diagram represents theories linking choices and consequences that allow us to conjecture that Ryanair is able to offer service at a very low cost without reducing too much the customers willingness to pay in the target segment We should point out that the absence of arrows also implicitly defines theories. For example, Ryanair's choices of a standardized fleet and the use of secondary airports are unrelated, even if they may reinforce one another by leading to low maintenance costs and rapid turnovers
IESE Business School-University of Navarra - 7 Choices are in bold and underlined, rigid consequences are in boxes, and flexible consequences are plain text. Notice that the representation does not include every choice made by Ryanair nor every consequence. We have made use of aggregation and decomposability. Figure 3 is a representation of Ryanair’s business model with theories. To explicitly account for theories, we include a short text with the justification for each arrow. To keep the representations simple, however, in the rest of the paper we will place the arrows without explicit theories. Only when a theory is not obvious will it be written down because, as Figure 3 illustrates, when theories are explicitly accounted for, the diagram becomes harder to read. Figure 3 Ryanair’s Business Model with Theories In summary, the causal loop diagram represents theories linking choices and consequences that allow us to conjecture that Ryanair is able to offer service at a very low cost without reducing too much the customers’ willingness to pay in the target segment. We should point out that the absence of arrows also implicitly defines theories. For example, Ryanair’s choices of a standardized fleet and the use of secondary airports are unrelated, even if they may reinforce one another by leading to low maintenance costs and rapid turnovers
However, the assumption is that these choices are independent. For simplicity, in the diagram above, we do not spell out these "absent arrow"theories Virtuous Cycles- The Dynamics of Business Models By now, it should be apparent that our concept of a business model is intrinsically dynamic The relationship between choices and consequences occurs over time. Moreover, some"rigid consequences are stocks(such as an installed base or cumulative experience) that are built over time. An understanding of the functioning and evaluation of business models requires explic consideration of the dynamics between choices and consequences One of the most striking features of business models is that their dynamics often generate feedback loops. This happens when, in addition to choices yielding consequences, consequences enable choices. Feedback loops can be of two types: virtuous cycles and vicious cycles. Since these are symmetric, and the same principles therefore apply to both, we need to study one type of feedback loop and have chosen to focus on virtuous cycles. Virtuous cycles are feedback loops that, with every iteration, strengthen some components of the model at every iteration. For example, Honda historically set low prices for its motorcycles (a choice); the consequences were high volume and high cumulative output which allowed the company to move down the learning curve, and thus result in low cost. Low cost (a consequence), in turn, enabled Honda to profitably set low prices (a choice). As the cycle spun again and again, Honda kept lowering prices because (marginal)cost decreased. Using the representation diagram igure 4 Example of a Virtuous Cycle High Volume Low price cumulative Low cost virtuous cycles are feedback loops that, with every iteration, strengthen the value of the components of the model Once they get going, virtuous cycles take on a life of their own; just as a fast-moving body is hard to stop because it possesses kinetic energy, well-functioning virtuous cycles cannot easily be brought to a halt 4 See Christiansen and Pascale(1983) Kinetic energy is the energy that a body possesses by virtue of its movement
8 - IESE Business School-University of Navarra However, the assumption is that these choices are independent. For simplicity, in the diagram above, we do not spell out these “absent arrow” theories. Virtuous Cycles – The Dynamics of Business Models By now, it should be apparent that our concept of a business model is intrinsically dynamic. The relationship between choices and consequences occurs over time. Moreover, some “rigid” consequences are stocks (such as an installed base or cumulative experience) that are built over time. An understanding of the functioning and evaluation of business models requires explicit consideration of the dynamics between choices and consequences. One of the most striking features of business models is that their dynamics often generate feedback loops. This happens when, in addition to choices yielding consequences, consequences enable choices. Feedback loops can be of two types: virtuous cycles and vicious cycles. Since these are symmetric, and the same principles therefore apply to both, we need to study one type of feedback loop and have chosen to focus on virtuous cycles. Virtuous cycles are feedback loops that, with every iteration, strengthen some components of the model at every iteration. For example, Honda historically set low prices for its motorcycles (a choice); the consequences were high volume and high cumulative output which allowed the company to move down the learning curve, and thus result in low cost. Low cost (a consequence), in turn, enabled Honda to profitably set low prices (a choice). As the cycle spun again and again, Honda kept lowering prices because (marginal) cost decreased.4 Using the representation diagram: Figure 4 Example of a Virtuous Cycle Low price High Volume Large cumulative output Low cost Learning economies Virtuous cycles are feedback loops that, with every iteration, strengthen the value of the components of the model. Once they get going, virtuous cycles take on a life of their own; just as a fast-moving body is hard to stop because it possesses kinetic energy,5 well-functioning virtuous cycles cannot easily be brought to a halt. 4 See Christiansen and Pascale (1983). 5 Kinetic energy is the energy that a body possesses by virtue of its movement