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Why Business Models Matter - HBR.org

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Why Business Models Matter
by Joan Magretta

A good business model begins with an insight into human motivations andends in a rich stream of profits.

“Business model” was one of the great buzzwords of the Internet boom, routinely invoked, as the writer Michael Lewis put it, “to glorify all manner of half-baked plans.” A company didn’t need a strategy, or a special competence, or even any customers—all it needed was a Web-based business model that promised wild profits in some distant, ill-defined future.Many people—investors, entrepreneurs, and executives alike—bought the fantasy and got burned. And as the inevitable counterreaction played out, the concept of the business model fell out of fashion nearly as quickly as the .com appendage itself. That’s a shame. For while it’s true that a lot of capital was raised to fund flawed business models, the fault lies not with the concept of the businessmodel but with its distortion and misuse. A good business model remains 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 arcanemathematical formulas. Business models, though, are anything but arcane. They are, 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 economiclogic 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 beaten path,” he said on his return, “theywere 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, plausiblemotivations, 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 waslike 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 logicthat 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 cycle of debt and risk on its head. Because people paid the checks before (often long before) they used them, American Express was getting...