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Better Business Models Lead to Better Businesses | The Discipline of Innovation

Better Business Models Lead to Better Businesses

I read in a blog post over the weekend about someone who had switched from an iPhone to a Samsung Galaxy smartphone. Their comment on the move was something like “and I’m glad that I did, because the Galaxy is a much better phone.”

What does that remind you of?

It reminds me of what all of the Apple users were saying in the early 90s about Apple’s OS versus Windows – that the Apple was objectively a much better product.

In both cases, the statements are probably true. From what I’ve seen, I suspect that the Galaxy is a better phone. And even though I had to use it for work, I was never a fan of Windows.

And yet, Microsoft dominated the desktop in throughout the 90s with Windows, and Apple is doing pretty well in smartphones now. How can this be so if their products are objectively inferior?

It’s because their business models were better. Ash Maurya puts it well in a very insightful post called Your Product is NOT “The Product”:

Entrepreneurs are typically more passionate about their solution than any other part of the business model which left unchecked can become a problem. While building a product is what you do best and where you derive the biggest sense of accomplishment,
building a product is NOT “the product” of your startup.
Your business model is “the product”.

I’ve talked about the importance of the value network part of your business model before. Here is how Apple has constructed the value network for the iPhone (the diagram is adapted from the book Invisible Engines by Evans, Hagiu & Schmalensee – legally downloadable here):

The circle that I’ve drawn in shows how much of the network Apple tries to directly control. Now compare that to the value network that Google has put together for Android:

Apple tries (and succeeds) to control a lot more of the value network than Google does. Consequently, even though “the Product” is the same in both cases – a smartphone, the different business models are actually radically different products.

Now, here is why these differences in business models are so important.

Horace Dediu has a post on his outstanding blog looking at Apple’s operating margin on the iPhone. The operating margin on the iPhone is about 51% – and this is WAY more than other smartphone makers are getting. Here is part of a larger chart showing this – the solid part of each bar is the profit:

Where is all of that extra profit coming from?

The network operators. In business model terms, Apple is the only smartphone maker to try to control the Network Operators through the provision of exclusive access to their phones. Desiu explains why the Network Operators are willing to pay for exclusivity:

The question should be: How is this possible? What does this product have that gives it such a pricing advantage? Note the the ratio was preserved through the three years shown and has persisted for nearly five years.

The answer to this paradox is in data that is not visible in any of the diagrams above: The largest revenue attached to the iPhone comes into the mobile network operators. We don’t have global averages but the revenue the iPhone generates over its lifetime is probably two to three times the revenues that Apple directly receives. The ARPU iPhones are attached to allows for a substantial subsidy, but more importantly, loyalty (or churn)

In short, Apple makes (a lot!) more money on the iPhone than other makers do on theirs because the Apple business model is different.

My friend Ben Skrainka points to a research paper that explains the economics behind this (.pdf here). Basically, it comes down to elasticity of demand.

This means that the people that want an iPhone really want an iPhone, while those that want a different smartphone are not as fussed about whether they have an HTC or a Samsung phone.

This difference in demand is also due to business model differences. Apple builds the demand through providing a different value proposition – being an Apple user is qualitatively different from being a Samsung user. They have different distribution channels, different customer relationships, and so on.

Even though the products seem close to identical, the business models are very different.

So your product is not “The Product”, your product is your business model.

And better business models lead to better businesses.

About Tim Kastelle

Student and teacher of innovation - University of Queensland Business School - links to academic papers, twitter, and so on can be found here.

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8 Responses to Better Business Models Lead to Better Businesses

  1. Greg Satell 1 March 2012 at 10:05 pm #

    Tim,

    I’m not sure I agree with you on this one. What you are basically describing is modular vs. integrated organization and I don’t think it’s clear that integrated is better.

    Surely, it’s much better for integrating seamlessly and capturing more value, but it doesn’t scale well. So more mature markets tend to favor modular organizations who collaborate effectively.

    Just my 2 cents…

    Greg

  2. Tim 2 March 2012 at 5:00 am #

    Thanks Greg. That’s not what I was trying to argue at all, so I must have screwed this up. The cases are definitely examples of modular and integrated, and in this instance, the integrated business model is working better. My point isn’t that this is the model that people should be using, but rather that the model you pick can make a difference. Whichever one is right will definitely vary by situation and market.

  3. Greg Satell 4 March 2012 at 6:49 am #

    I think it is a bit confusing. A business model changes over time, while architecture tends to be much more sticky. You can’t adapt it to market conditions. You are pretty much what you are.

    I think a business model must be more maleable than organizational architecture. Value shifts and so does the basis of competition.

    My personal feeling is that market conditions are changing to Microsoft’s advantage (I have a post coming out about it this week). Apple won’t be able to change their architecture, but they can change their business model (possible towards educational institutions).

    Greg

  4. Tim 4 March 2012 at 6:06 pm #

    The tricky part is that the architecture is part of the business model – so changing is not as easy for a well-established firm.

    Which gives me an idea for a post…

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