rtm2745 1..9 Why is business model innovation that extends beyond the sustaining innovation space so diffi cult for estab- lished fi rms? Sony developed the Walkman audio player, redefi ning the market for portable music devices, but failed to develop a successful MP3 player and allowed Apple to displace it in the portable audio space with the iPod. Similarly, Knight Ridder, one of the largest news- paper publishers in the United States and a pioneer in the digital news market, failed to develop new digital adver- tising channels to capitalize on the potential of new rev- enue streams such as those exploited by Monster.com , AutoTrader.com , and REALTOR.com , clinging instead to traditional ad-based models. And Kodak, which dominated the fi lm photography industry, ceded the digital photography market to companies such as Peter Koen is an associate professor in the Wesley J. Howe School of Technology Management at Stevens In- stitute of Technology, where he teaches undergraduate and graduate courses in corporate entrepreneurship and technology management. He is also the director of the Consortium for Corporate Entrepreneurship, an organization he founded in 1998 with the mission to increase the number, speed, and success rates of highly profi table products and services at the front end of innovation. Peter also has 18 years of industry experience, having worked at ATT Bell Laboratories and BD. He holds a PhD in biomedical engineering from Drexel University. www.frontendinnovation.com ; peter.koen@stevens.edu Heidi Bertels is a visiting assistant professor of business administration at the University of Pittsburgh, where she teaches courses in entrepreneurship, corporate entrepreneurship, and strategic management. She is fi nishing her dissertation research at Stevens Institute of Technology on how established organizations can be successful when they try to enter new value networks. She also has a BA and an MA in integrated product development from Hogeschool Antwerpen in Belgium. Her research interests are innovation man- agement, product development, and entrepreneurship. hbertels@katz.pitt.edu Ian Elsum is principal adviser in the Science Strategy and Investment Group of Australia’s Commonwealth Scientifi c and Industrial Research Organisation (CSIRO), with responsibilities in planning and investment. He is also a visiting fellow at the Australian National University, where he is undertaking research on the management of radical and breakthrough innovation. Ian has 24 years of experience in the strategic manage- ment of applied research. He has been a member of a number of company boards and management and advi- sory committees, and has also been a regular partici- pant in developing innovation policy. Ian has a PhD in chemistry from Monash University. ian.elsum@csiro.au OVERVIEW: Business model innovation represents a signifi cant opportunity for established fi rms, as demon- strated by the considerable success of Apple’s iPod/iTunes franchise. However, it also represents a challenge, as evi- denced by Kodak’s failed attempt to dominate the digital photography market and Microsoft’s diffi culty gaining share in the gaming market, despite both companies’ huge fi nancial investments. We developed a business model innovation typology to better explain the complex set of factors that distinguishes three types of business model innovations and their associated challenges. KEY CONCEPTS : Business model innovation , Value networks , Radical innovation , Breakthrough innovation , Sustaining innovation , Disruptive innovation THE THREE FACES OF BUSINESS MODEL INNOVATION: CHALLENGES FOR ESTABLISHED FIRMS Established fi rms frequently have diffi culty with business model innovation. The business model innovation typology defi nes the challenges. Peter A. Koen , Heidi M. J. Bertels , and Ian R. Elsum DOI: 10.5437/08453608X5403009 May—June 2011 1 0895-6308/11/$5.00 © 2011 Industrial Research Institute, Inc. The Unifi ed Business Model Innovation Typology Established fi rms consistently demonstrate their ability to succeed in sustaining innovation. Intel, for instance, leads in the development of next-generation micropro- cessor chips using radically new technology. However, these same companies frequently have diffi culty trying to develop new business models in new markets—even with existing technology. Intel, for example, has been unsuccessful in penetrating the market for cellphone chips, despite many valiant attempts. Current innovation typologies—including those that rely on distinctions such as incremental/radical ( Wheelwright and Clark 1992 ), sustaining/disruptive ( Christensen 1997 ), or ex- ploitation/exploration ( March 1991 )—are inadequate to explain this phenomenon. The BMIT allows for consid- eration of a more complex set of factors and thus more readily distinguishes why and where established fi rms have diffi culty with business model innovation. The BMIT classifi es innovation along three dimensions: technology, value network, and fi nancial hurdle rate ( Figure 1 ). It further divides the innovation space into two zones: sustaining innovation, where established fi rms generally succeed, and business-model innova- tion, where otherwise successful fi rms frequently fail. Within the technology dimension, the model distin- guishes among incremental, architectural, and radical technological innovation. Incremental technological innovation involves the refi nement, improvement, and exploitation of existing technology. Architectural inno- vation involves creating new ways to integrate com- ponents in a system based on current or incremental changes to existing technology ( Henderson and Clark 1990 ). The iPod, for instance, incorporated no new technology, but provided an entirely new design. Fi- nally, radical innovation introduces an entirely new core technology. Hewlett-Packard, Canon, and Nikon. In each of these cases, the fi rms had adequate resources, an in-depth market understanding—not to mention a solid head start in the market—and the technical competencies needed to succeed, yet each of these companies allowed new entrants to disrupt them. We wanted to fi nd out why es- tablished companies that dominate their markets later allow other companies to succeed with business model innovations that either disrupt them or limit their ability to grow further. These cases do not fi t the usual pattern of disruptive in- novation. In elaborating their concept of disruptive in- novation, Christensen and colleagues ( Christensen and Raynor 2003 ; Christensen and Rosenbloom 1995 ) argue that “there are two types of disruptive innovations: low- end and new market” ( Christensen, Anthony, and Roth 2004 , xvii). At the low end, disruptors gain market share through a low-price business model focused on over- served customers. New market disruption targets new nonconsumers. Intel’s development of the low-priced Celeron microprocessor, which targeted the cost-con- scious computer market, is an example of an established fi rm pursuing a low-price business model. Sony’s Walk- man audio player is an example of a business model focused on reaching new nonconsumers. The new non- consumers for Sony’s portable transistor radio were teenagers who couldn’t afford more expensive, high- performance vacuum-tube radios. These consumers, who had previously had no other alternative, were delighted to have control of their own music, even with a sound quality much lower than that offered by vacuum-tube radios. However, Sony’s domination of the portable au- dio player market was disrupted by Apple’s iPod, which neither offered a lower price nor focused on new non- consumers. In fact, none of the disruptions we’ve de- scribed—Apple’s iPod, new digital advertising channels, and digital photography—relied on either a low-price or a new nonconsumer business model. As part of an Industrial Research Institute (IRI) Re- search-on-Research (ROR) working group project, we set out to better understand how and why disruption oc- curs in these cases, which do not seem to fall into Chris- tensen’s model for disruptive innovation. Furthermore, while Christensen’s work focuses on new disruptive business models, we wanted to understand the problem of disruption, and the challenges presented by disrup- tion, from the established fi rm’s perspective. We sought to develop a more comprehensive model to explain dis- ruptive business model innovations, especially those that do not involve low-cost or new nonconsumer busi- ness models. The result is a unifi ed business model in- novation typology (BMIT). 1 The BMIT classifi es innovation along three dimensions: technology, value network, and fi nancial hurdle rate 1 A brief, preliminary overview of our work was presented in an ear- lier report ( Koen et al. 2010 ). The work is also part of the PhD dis- sertation of Heidi Bertels. Research • Technology Management2 The value network dimension encompasses how a fi rm identifi es, works with, and reacts to customers, suppli- ers, and competitors. The value network is a tightly connected, complex system of suppliers, customers, distributors, and partners ( Christensen and Rosenbloom 1995 ). The value network dimension is encompassing, embracing the unique relationships that a company builds with both its upstream (supplier) and downstream (distributor and customer) channels. Relationships in these channels are a critical source of competitive ad- vantage. Business model innovation often requires the development of a new value network. The new relation- ships embedded in a new value network can be problem- atic, as they are diffi cult to establish and can disrupt existing relationships. For example, Nestlé distributed Nescafé coffee through existing mass market depart- ment store and grocery sales channels, a value network that was very familiar to them. In contrast, the company needed to develop an entirely new value network for Nespresso, a high-end coffee shop targeted to reach young professionals. In the BMIT, the value network dimension is divided into two areas: innovations within the company’s exist- ing network and innovations requiring value networks with components that are new to the company; new value networks may reach existing consumers in the market or new nonconsumers. For example, Zipcar, which makes cars conveniently available for very short- term rental at urban locations, mostly targets existing consumers for rental cars, but the company created a dif- ferent business model in the way that those consumers access the cars and pay rental fees. By contrast, the an- gioplasty catheter, developed to widen arteries blocked by cardiovascular disease, replaced the need for open- heart surgery to treat moderate cardiac disease. In mar- keting the device to cardiologists, who previously did not do surgeries for blocked arteries, rather than cardio- thoracic surgeons, medical device companies such as Bard and Medtronic reached out to a set of new noncon- sumers—cardiologists who could now treat their own patients rather than referring them to a surgeon. Hurdle rate is another factor in the BMIT. The hurdle- rate dimension describes the relationship of a given project’s fi nancial projections to the minimal expected return. The hurdle rate is a key factor in traditional dis- ruptive innovation that relies on a low-cost business model. Such low-cost business models are diffi cult for established companies to pursue because they do not meet the hurdle rates defi ned by the fi rm’s cost structure and expected rate of return. However, it is possible for established fi rms to pursue low-cost business models successfully. Dow Corning’s subsidiary Xiameter ( Gary 2004 ) offers one success story for low-cost business models implemented by established fi rms. Dow Corning Figure 1 .— Business model innovation typology (BMIT) model. Established fi rms tend to be successful in sustaining innovation (innovation that falls into the area defi ned by the bottom three boxes), but may have diffi culty succeeding with innovations outside this area. May—June 2011 3 developed Xiameter as a web-based discount channel through which customers could bulk order at a lower price the company’s more traditional products without the customer service usually provided by Corning. Xiam- eter became an important part of Dow Corning’s service offering and prevented the erosion of their market share by companies focused on commodity customers. Challenges in Sustaining Innovation The sustaining innovation space, where established fi rms tend to succeed, is marked by a reliance on exist- ing value networks and a comfortable fi nancial hurdle rate. However, this space is not without challenges even for innovative companies. Exploring it helps provide perspective on the challenges established companies en- counter when they leave the relative comfort zone of sustaining innovation. Sustaining innovation—technology improvements or even radical new technologies implemented within the companies’ existing value network and established fi - nancial hurdle rates—protects the status quo and repre- sents the majority of product development activities. Incremental sustaining innovations, which deploy mi- nor, progressive improvements in technology within an established value network, are the easiest and least risky, and hence the most common activities. Sustaining in- novations that utilize the existing value network to pro- duce and market architectural or radical technology improvements while maintaining existing fi nancial hur- dle rates are more diffi cult, since they involve higher degrees of technological novelty and higher levels of risk. As an example, Toyota’s Prius is a sustaining archi- tectural innovation; it involved no new technology, but combines existing gasoline and electric motor technol- ogy to create a hybrid design with signifi cantly improved fuel effi ciency, and it was created and sold within exist- ing value networks and hurdle rates. Intel’s dual-core processor is also a sustaining innovation, as it incorpo- rated a radical technology innovation (new designs that doubled the chip’s performance while reducing cooling demands) but relied on an existing value network for distribution. Sustaining innovations that rely on incremental technol- ogy improvements require different behaviors and pro- cesses than those implementing architectural or radical technology. Incremental projects can be managed using a well-honed serial innovation process with gated deci- sion points ( Cooper 2001 ), a system that has proven its merit in projects where the market and technology are known. In contrast, architectural and radical technology projects require a more complex learning strategy to manage the challenges associated with radical technol- ogy. A learning strategy is a cyclical process in which assumptions and uncertainties are tested and resolved through experimentation and iteration ( O’Connor et al. 2008 ). The project direction and strategy often shifts as uncertainties decrease. Challenges in Business Model Innovation The business model innovation space, where established fi rms frequently fail, requires companies to succeed with business models that require a lower than normal fi - nancial hurdle rate or the development of new value networks. Established companies typically encounter signifi cant challenges in this more diffi cult zone of the BMIT. Financial Hurdle Business Model Innovations Business model innovation challenges in the fi nancial hurdle space were fi rst explained by Christensen and colleagues, who describe how disrupters gain market share through low-price business models designed to appeal to existing consumers with a more affordable option ( Christensen and Raynor 2003 ; Christensen and Rosenbloom 1995 ). Low-cost business models like the disruptive innovations defi ned by Christensen are busi- ness model innovations that are guided by the fi nancial hurdle rate ( Figure 2 ). Innovations in this area typically involve projects with a lower hurdle rate than the estab- lished cost structure would allow. Christensen’s prime example was steel minimills, which disrupted integrated steel mills with electric arc-furnace technology, a radical new technology that allowed for cheaper production, although initially these furnaces could not match the quality of the larger mills’ product. The established mills initially ceded market share to the minimills, allowing the small producers to gain a foothold in the market by making cheap reinforcing bars (rebar). Over time, mini- mill producers learned how to make more profi table sheet steel at an acceptable quality level and eventually replaced integrated steel mills. The sustaining innovation space is not without challenges even for innovative companies. Research • Technology Management4 Some established companies have fl ourished by accept- ing a low-cost business model, meeting potential dis- rupters head-on. Intel developed the low-cost Celeron chip and Dow Corning established Xiameter in order to prevent erosion of their main offerings by low-cost competitors. Similarly, the Mercedes A-Class targeted a middle-class market, but leveraged existing sales chan- nels and distribution networks to sell the car. Marriott’s Courtyard chain of hotels targets a lower-cost segment of the market by eliminating the fancy restaurants and conference and meeting facilities that characterize its higher-end hotels. We found fewer examples of companies utilizing archi- tectural innovation within their existing value networks to power a low-cost business model. One example is the BIC pen corporation, which moved from manufacturing expensive fountain pens to selling low-cost ballpoint pens using a highly integrated, automated manufactur- ing process. Moving to a low-cost business model presents unique challenges for established fi rms. As both Christensen and Raynor (2003) and Govindarajan and Trimble (2005) argue, it is extraordinarily diffi cult for a company to maintain two different business models within the same business division. Such a situation, they assert, would produce trade-offs that would result in a strategy favoring the sustaining business. As a result, both Christensen and Raynor and Govindarajan and Trimble recommend that a company interested in pursuing a low-cost model while maintaining its existing business create two distinct organizations—which is exactly what Intel did in the development of the Celeron chip and Dow Corning did in establishing Xiameter. Both Intel and Dow Corning separated these units from the sustain- ing business. Where the larger Intel business pursued a string of breakthrough innovations in chip technology, the Celeron division focused on cost effi ciency, both in achieving just good enough performance features to offer value and in aggressively pursuing manufacturing effi ciencies. New Value Network Business Model Innovations Targeting Existing Consumers Established fi rms often see opportunities for growth in seeking out existing consumers within a new value net- work that allows the fi rm to maintain existing fi nancial hurdle rates ( Figure 3 ). For example, in an effort to reach young urban professionals, Nestlé developed Nespresso, a coffee outlet that has been described as an upscale Starbucks. Nespresso represented a new value network for Nestlé’s coffee business, which had previously sold instant coffee to the mass market via department and grocery stores. Similarly, Tesco, the United Kingdom’s largest supermarket chain, developed Tesco Direct as an online outlet to sell not only grocery items but also books, CDs, and other nonfood items. Toyota and Honda both developed luxury car brands, Lexus and Acura, which they sold in separate dealerships from their cur- rent lines, focused on a different market via a new value network for them targeted at existing affl uent customers. Fewer fi rms pair architectural innovation with a new value network. Microsoft launched a new business—videogame Figure 2 .— Examples of innovation projects at the intersection of the fi nancial hurdle and technology dimensions. May—June 2011 5 consoles—with a new value network with its develop- ment of the Xbox and its accompanying online services, and Knight Ridder, which already owned a network of print newspapers, developed an online newspaper to reach a wider market. In each case, the fi rms launched new businesses to reach existing consumers via new value networks. In each of these cases the companies lost a considerable amount of their investment. It is even rarer for a established fi rm to pair a radical technical in- novation with a new value network to reach existing consumers. Christensen and Raynor (2003) and Govindarajan and Trimble (2005) recommend separating sustaining busi- nesses from new value network projects. However, Markides and Charitou (2004) challenge this recom- mendation, arguing that separation should be dependent on the degree of synergy and confl ict between the two business models. Nestlé separated the Nespresso busi- ness unit from Nescafé, as the Nescafé division per- ceived that Nespresso would cannibalize its sales and the two units had markedly different cultures: the Nes- café unit saw its product as a low–price, fast-moving consumer product, while the Nespresso unit was work- ing to position itself as an up-market luxury experience. Unsurprisingly, values and attitudes were signifi cantly different, creating the potential for confl ict. In contrast, Markides and Charitou describe the creation of Tesco Direct as a part of Tesco, launched from one of Tesco’s west London stores. Since the supermarket’s customers were confi ned to the area surrounding the store, in con- trast to the Internet arm whose reach extended to all of the United Kingdom, there was little confl ict between the two ventures. Tesco Direct built on the synergy of the supermarket and leveraged the store’s stock to keep the initial start-up investment low. The most successful players in value network innovation pair the new value network with an incremental technology innovation. Figure 3 .— Examples of innovation projects at the intersection of the value network and technology dimension. Research • Technology Management6 O’Reilly and Tushman (2004) advocate yet another ap- proach for business model innovations in this area: the ambidextrous organization. This approach offers a mid- dle ground between completely separated and com- pletely integrated organizations. O’Reilly and Tushman suggest separating the new business model from the sustaining organization—but they argue that both or- ganizations should share senior management. Such an arrangement, they argue, ensures that the startup unit will have access to the resources and expertise of the established unit. Developing an ambidextrous organiza- tion requires considerable senior management leader- ship training. IBM has followed this approach with considerable success, growing their new-business-model revenue from $400 million in 2000 to $22 billion in 2006 ( O’Reilly, Harreld, and Tushman 2009 ). The most successful players in value network innova- tion pair the new value network with an incremental technology innovation. Fewer fi rms have successfully matched a new value network with an architectural or radical technology innovation. Knight Ridder reportedly accumulated losses of over $100 million in the launch of its fi rst online newspaper. Information Week reported in 2009 that Microsoft had total losses in the gaming indus- try of about $7 billion ( Schestowitz 2009 ). And Kodak invested over $5 billion in digital technology and never managed to become more than a small player in the market. Knight Ridder and Kodak perceived a threat to their businesses and invested signifi cant amounts of money in an effort to head off the threat. Microsoft, on the other hand, anticipated a technological revolution that would turn the family room into a wireless, networked nerve center for seamlessly accessing and managing all kinds of media, and positioned the XBox to be at the center of that revolution ( Grossman 2005 ). In that context, Micro- soft developed the XBox not as a game machine or toy, but as a way to own the entire digital environment in the home, a center for accessing music, movies, photo- graphs, and television. While the Xbox has achieved moderate success in the gaming market, Microsoft was unable to establish it as the nerve center for the family room, resulting in a signifi cant fi nancial loss for the company. Knight Ridder and Kodak acted out of fear, while Mi- crosoft saw a very large opportunity, but all of these companies were defeated by similar forces. All of these efforts failed in spite of the enormous resources made available to them because of routine rigidity—the ten- dency to frame responses to new challenges to fi t famil- iar frameworks ( Gilbert 2003 ). Routine rigidity led executives at all three companies to frame their efforts to fi t the familiar frameworks of their sustaining busi- nesses. Kodak could envision being successful only by leveraging its existing relationships with retailers and offering digital photography CD disks and digital pho- tography kiosks. Focused on its existing business mod- els, the company did not pursue sales of digital cameras, photo printers, and printer disposables, which ended up being the real moneymakers in the digital market, until much later. Similarly, Knight Ridder could only envi- sion the digital newspaper as an extension of the print newspaper, and so failed to exploit new revenue chan- nels or to develop the digital channel fully. Microsoft’s vision of the XBox as a gateway into the living room drove important technology decisions that ultimately produced an expensive console that appealed primarily to hardcore gamers—no one else was ready for the home entertainment hub Microsoft wanted to build. However, the hub platform strategy never came to fruition; al- though the Xbox became a moderately successful gam- ing product, the project was a failure that generated huge losses. And it never delivered on the intended business model. One notable example of a successful architectural inno- vation by an established company accessing a new value network is the iPod and iTunes. iTunes, which delivers single song tracks to consumers in a user-friendly for- mat, required Apple to build unique partnerships with the music industry, resulting in new value networks. Apple did not envision the music industry as a threat to the company or essential to its future. Rather, the com- pany envisioned music as a new opportunity to be ap- proached prudently, with limited initial investments. As a result, Apple did not try to frame the market as an ex- tension of its current sustaining computer business. First and second-year sales were paltry by most standards, less than $4 million the fi rst year and $10 million the second. But since the company did not view the iPod as central to its future business, the lower initial returns were acceptable and Apple was able to give the new business time and space to develop. The challenges of business model innovation are shaped by the scope and target of the innovation. May—June 2011 7 New Value Network Business Model Innovations Targeting Nonconsumers Established fi rms may also seek to establish entirely new value networks to reach nonconsumers—potential customers who have not entered the market. Developing new businesses in this context presents a different set of challenges for established companies, one that was also explored by Christensen and colleagues ( Christensen and Raynor 2003 ; Christensen and Rosenbloom 1995 ). Innovations to reach nonconsumers are the “hardest in- novations to identify” ( Christensen, Anthony, and Roth 2004 , 8), but they have the greatest potential for growth. We did not fi nd any examples of successful innovation in this space paired with incremental technological innovation. Sony’s Walkman is an example of archi- tectural innovation to access a market of previous nonconsumers, and Ciba Vision’s Visudyne represents a radical innovation paired with a new value network. With Visudyne, Ciba Vision entered a global agreement with QLT PhotoTherapeutics to develop compounds that can be used with photodynamic therapy to treat age- related macular degeneration, a debilitating disease that leads to blindness. Ciba Vision’s sustaining business is focused on improving their hard contact, extended wear, and daily disposable lenses, which are typically sold directly to end users. Visudyne, by contrast, uses funda- mentally different technology to slow macular degen- eration; it is a pharmaceutical product that is sold to ophthalmologists. Both the Walkman and Visudyne have proven to be very successful for their companies, estab- lishing entirely new value networks and entirely new markets. Christensen and Raynor (2003) provide numerous exam- ples of start-ups that have succeeded in implementing in- cremental and architectural innovations with new value networks to access an entirely new market. It is, they demonstrate, quite diffi cult for established companies to gain management support for the development of an en- tirely new business in a market that is yet to be defi ned. As a result, we suspect that new business model develop- ment in this area will be driven by new companies. Conclusion The BMIT illustrates how and why businesses behave differently in the two innovation zones—sustaining in- novation, where established fi rms typically succeed, and business model innovation, where they frequently fail. The challenges of business model innovation are shaped by the scope and target of the innovation. Established fi rms will fi nd both rewards and considerable risks in developing new value networks to reach existing con- sumers who are not yet customers. The challenges faced in building a value network to reach nonconsumers are quite different from those encountered in other types of innovation projects. Business model innovation represents a new frontier in innovation beyond just product or service innovation. However, it challenges most established fi rms to the core of their organization and culture and has proven very diffi cult for many companies. 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