5. how to build risk into your business model

7262019 5 How to Build Risk Into Your Business Model

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How to BuildRisk into Your

Business ModelSmart companies design their innovationsaround managing risk by Karan Girotra andSerguei Netessine

This document is authorized for use only in PGDM-II-Term-III by Dr V K Gupta Mr V Shekhar Mr D S Singhal from October 2014 to April 2015




Business ModelSmart companies design their innovationsaround managing risk by Karan Girotraand Serguei Netessine

2 Harvard Business Review May 2011




I L L U S T R A T I O N D A V E W H E E L E R

Karan Girotra is an assis-tant professor of technologyand operations manage-ment at Insead

Serguei Netessine is theTimken Chaired Professorof Global Technology andInnovation at Insead

ployees it now sells furniture and other products in

four markets including the United States

MyFab did not identify new market segments

nor did it develop new products based on novel

technology In fact its products are similarmdashoften

nearly identicalmdashto those of its competitors Like

Dell Zara and Zipcar before it MyFab has prospered

by innovating its business modelmdashthe way it offers

existing products or services that address existing

customer needs using existing technologies Very

often this kind of innovation turns out to be more

valuable and transformative than product- or tech-

nology-driven innovation as readers of the work of

Clay Christensen or Inseadrsquos W Chan Kim and Reneacutee

Mauborgne well know

But therersquos a perennial problem with business

model innovation Managers often find it harder to

determine what changes to the model will work than

whether a new product or technology will catch on

So whatrsquos the secret How can companies system-

In early 2008 four entrepreneurs in Paris

started MyFab an internet-based furni-

ture retailer that is doing more to change

the industry than any other company

since IKEA Instead of building large

stocks of furniture as its competitors do

MyFab provides a catalog of potential

designs Customers vote on them and

the most popular ones are put into pro-

duction and shipped to buyers directly

from the manufacturing sitesmdashwith no retail outlets

inventories complicated distribution or logistics

networks

The engagement and social aspects of the voting

attracted customers in droves but they most loved

the prices By simplifying its supply chain and pro-

ducing only what customers wanted MyFab was

able to offer products at significantly lower cost than

established furniture retailers could In just two

years the company has grown to more than 100 em-

May 2011 Harvard Business Review 3

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Reducing Risks

Often companies that have lowered their businessmodel risk have done so by delaying production

commitments transferring risk to other parties or

improving the quality of their information

Delaying production commitments Speed-

ing up the production process is the most obvious

way to do this It usually means producing in higher-

cost locations which goes against supply chain

orthodoxy But surprisingly often the gains from

reducing demand uncertainty outweigh the added

costs This approach lies behind some very remark-

able innovations

Consider the famous Spanish clothing retailer

Zara Branded clothing companies have tradition-ally focused on managing costs by organizing their

sourcing production and distribution as efficiently

as possible As a result they may need as long as 12 to

18 months to design produce and deliver a new line

of clothing That means they have to make big bets

on future consumer preferences and demand Bear-

ing this risk has consequences for the bottom line

through inventory write-downs (if the clothes donrsquot

sell) or for the top line through stock-outs (if people

want more than yoursquove made)

Zara reduced the likelihood of these conse-

quences by designing a hyperfast supply chain

that turns a new line around in two to four weeksmdash

making it much easier to keep pace with consumer

preferences Of course there is a price The company

makes most of its products in an expensive loca-

tion (southern Europe) ships them to stores often

(weekly) and uses an expensive mode of transpor-

atically innovate their business models How can

executives identify and quantify the value of theirchanges We believe that the literature on business

model innovation has overlooked a critical driver of

value where in the value chain the risks associated

with creating supplying and consuming products

and services reside In designing their value chains

companies typically focus on three things revenue

(price market size and ancillary sales) cost struc-

ture (direct and indirect costs economies of scale

and scope) and resource velocity (the rate at which

value is created from the applied resources typically

captured through lead times throughput inventory

turns and asset utilization) These factors are well

understood and improving them is the main focusof management literature Less well understood is

that these value drivers are themselves affected by

sharp changes in for example demand and sup-

ply In thinking through changes to the business

model therefore it is essential to examine the major

sources of risk to the model and how the model will

handle them

Thinking in these terms quickly demonstrates the

potential for companies to create value by redesign-

ing their business models to reduce their risks It can

also reveal unsuspected opportunities for creating

value by adding riskmdashif the company is well-placed

to manage it In the following pages we draw on our

experience studying and consulting to dozens of

companiesmdashstart-ups and large corporations alikemdash

to describe the various types of risk-driven business

model innovations and discuss their advantages and

disadvantages

Zara designed a hyperfast

supply chain to make iteasier to keep pace withcustomer demand

HOW TO BUILD RISK INTO YOUR BUSINESS MODEL





Idea in Brief

Many managers find it harder

to tell if changes in their

business models will work

out than to guess whether a

new product or technologywill catch on

The secret to systematic

business model innovation

is to focus on identifying

where the risks are in your

value chain Then determinewhether you can reduce

them shift them to other

people or even assume

them yourself

If you take this approach

you wonrsquot need extensive

experimentation and

prototyping to identify

very powerful innovationsbecause many tools for

managing risk are available

tion is to relocate the contact center to a low-cost location

such as India

LiveOps turned this model on its head Instead of

employing and training a large workforce it maintains a

pool of loosely affiliated freelancers These are often stay-at-home parents who cannot take a job with fixed hours

but are available many times during the day The LiveOps

computerized system allows them to work remotely in

their free time Agents log on to the system when theyrsquore

available and customer calls are routed to them Most

important LiveOps pays the agents only for the time that

they are on support callsmdashmeaning that the employees

themselves bear the risk of their underutilization They

are willing to assume this risk in return for being able to

make their own hours and work from home

In the late 1990s Blockbuster handed off risk to suppli-

ers It revolutionized the highly competitive video rental

industry by shifting away from fixed-price contracts (un-

der which each VHS tape cost Blockbuster $60) and toward

revenue sharing with the major movie studios Under the

old arrangement the studios took little risk in terms of a

mismatch between demand and supply They received

$60 for a tape no matter how many times it was rented

Blockbuster assumed all the risk of acquiring a dud and

had to hedge its bets by buying fewer tapes

Under the new arrangement Blockbuster paid only

$5 to $10 up front but shared about 50 of its revenues

with the studios This changed the studiosrsquo information

sharing pricing and marketing incentives with the result

that Blockbuster could stock more tapes increasing the

availability of hit movies The companyrsquos market share

rose from 25 to 38 and profits for the industry grew

by up to 20

Gathering better data Sometimes it isnrsquot possible

to radically shorten the production process or alter your

relationship with other stakeholders in your value chain

In that case you can improve the quality of the informa-

tion on which you base your commitments

That is precisely what MyFabrsquos customer voting sys-

tem does The actual process of making and delivering

tation (air) But Zararsquos success demonstrates clearly

that a focus on managing demand risks can trump a

focus on costs

Note that Zara did not discover anything new

about the risks involved in retailing apparel Every-one knows that customers are fickle and hard to read

Zararsquos insight was simply that a faster cycle time

meant that decisions about product specifications

and quantities neednrsquot be made so far in advance

and fresher data would be available when the com-

pany did have to make commitments

Reducing cycle time allows some companies

to completely eliminate risks arising from demand

uncertainty Dell for example does not have to as-

semble a computer until the customer has ordered it

because it can turn the order around extremely fast

Again a price must be paid Like Zara Dell must set

up most of its production facilities close to its end

customers (in the United States) and therefore can-

not produce in low-cost locations for its main market

Similarly Timbuk2 a popular bag manufacturer can

ship custom-designed orders to its customers in just

two or three daysmdashbut its manufacturing has to be

done in San Francisco rather than in China

Rewriting your contracts Another way to

manage riskmdashespecially asset-related riskmdashis to

pass the exposure on to someone else This usually

involves altering your contracts with the other stake-

holders in your value chain employees suppliers

and customers

The customer-contact services provider LiveOps

demonstrates how changing the terms of employ-

ment can radically alter a companyrsquos risk profile

Traditional providers of contact services maintain a

workforce of customer service agents at a call cen-

ter The volume of service requests is highly variable

meaning that sometimes this workforce is underuti-

lized for a large portion of the workday but at other

times the call volume far exceeds its capacity and

customers must tolerate long waits The usual solu-






furniture quickly has been greatly refined so relo-

cating doesnrsquot make as much competitive difference

as it used to The data MyFab gets through customer

polling enable it to predict customer taste and de-

mand levels more accurately than its competitors

can reducing its exposure to stock-outs and excess

inventory

Even when companies can reduce risk using the

classic approaches they should consider upgrading

their information-gathering capabilities because

speeding up production or rewriting contracts often

creates a new risk This was a potential problem for

LiveOps Because its employees work from home

and are independent contractors it is much harder

to verify that they are appropriately trained to an-

swer calls LiveOps mitigates this information risk

by monitoring agentsrsquo performance and routing calls

first to the higher-ranked agents

Adding RiskMany people regard risk only as something to elim-

inatemdashan undesirable concomitant of managing the

resources and capabilities needed to deliver a prod-

uct or service But as the economist Robert Merton

has often pointed out one can also argue that com-

panies create value by being better at managing risk

than their competitors are The implication is that if

you are better than others at managing a particular

risk you should take on more of that risk

The history of innovation demonstrates that

quite a few companies have made money by taking

The Next Bi ThingWHAT ARE THE RISKS FOR SOMEONE WHODECIDES TO USE AN ELECTRIC CAR

The risk of running out ofelectricity in the middleof a trip Current batterieslast for only about 100 miles

and recharging them takesseveral hours

The asset risk associated withowning a battery The batteryis very expensive and tech-nology evolves quickly so the

owner has to maximize batteryuse despite being unable todrive long distances

The idea of an environmentally

friendly electric car has been

around for almost 100 years

Multiple product and technologyinnovations have steadily advanced

this industry but so far have failed

to create wide-scale adoption

on more riskmdashtypically by changing the terms of

their contracts with suppliers or customers Morethan 30 years ago Rolls-Royce a manufacturer of

aircraft engines identified a major pain point in the

industry Maintaining airplane engines is rife with

risk for the airlines Engine breakdown can ground a

plane for weeks while the airline pays for repair time

and materials Airlines especially small ones donrsquot

always have the resources to adequately provide for

such breakdowns

So in the 1970s Rolls-Royce started offering the

airlines a very different service contract ldquoPower by

the hourrdquo The airlines would pay Rolls-Royce for

an enginersquos flight hours rather than for repair time

and materials Of course much of the risk reduction

the airlines obtained was reflected in the price but

transferring the risk had a more profound effect

Rolls-Royce was motivated to improve its products

and maintenance processes because the fewer the

problems and the quicker the fixes the more the

manufacturer got paid The airlines could never

have created value in this way either on their own

or by prodding Rolls-Royce so the new contract

triggered a completely new value creation dynamic

This movement which is often referred to as ser-

vicization has spilled over to other industries For

example the German rail vehicle manufacturer

Bombardier charges its customers for maintenance

according to miles driven and Caterpillar charges

construction companies according to the amount of

earth moved

Sometimes trying to avoid a risk actually in-

creases it and you can better manage it by being will-

ing to own more of it Take the car rental business

The risk in this industry lies in underutilizing fixed

assetsmdashcars Traditional companies rent in daily in-

crements so the customer has to pay for a day even

The data MyFab gets through customerpolling reduce its exposure to stock-outsand excess inventory






if he needs the car for only a few hours He must as-

sume the risk of underutilized assetsIn 2000 Zipcar turned this model upside down

It realized that the ability to rent by the hour would

encourage people to switch from taxis or limos to

Zipcars It could price its offering to improve on alter-

native short-distance transportation modes and still

earn a much higher hourly rate than conventional

car renters (Zipcars cost about $8 an hour whereas

the prorated cost at a traditional company is $1 to $2)

The companyrsquos annual revenues are approaching

$200 million demonstrating that returns on its new

model outweigh the costs of maintaining a large fleet

and multiple pick-up and drop-off locations

Advantages and ChallengesThe risk-driven innovation we describe has one

important advantage over other forms of innova-

tion Itrsquos much cheaper Innovating products and

technologies often involves generating a lot of ideas

and then trimming the list down through discussion

voting and prototyping Multiple iterations of proto-

types customer feedback and experimentation are

necessary Significant RampD expenditures are often

involved

Risk-driven innovation however can be ap-

proached in a systematic way and with few expendi-

tures and relatively clear and credible estimates can

be made of the potential benefits and costs A great

deal of research has been done on the pricing of risk

and sound methods exist for putting a dollar value

on contracts and real options that involve reducing

transferring or adding risk In fact a recent article

by Suzanne de Treville and Lenos Trigeorgis (ldquoIt May

Be Cheaper to Manufacture at Homerdquo HBR October

2010) described how real options analysis lets you

put a dollar value on the benefits of moving produc-

tion from distant but cheap locations to close-by but

expensive onesIn addition you donrsquot need extensive experimen-

tation and prototyping to identify very powerful in-

novations because some of them have already been

done and others can be quantified Zipcar essentially

reprised Rolls-Roycersquos approach and Zararsquos innova-

tion resembled Dellrsquos The sidebar ldquoThe Next Big

Thingrdquo points out that a start-up in Israel is borrow-

ing ideas from Zipcar and Rolls-Royce to introduce

an electric car on a large scale (see ldquoHow to Jump-

Start the Clean-Tech Economyrdquo by Mark W Johnson

and Josh Suskewicz HBR November 2009)

You might think that such innovations arenrsquot a

sustainable form of competitive advantage But ex-

perience shows that they actually can be because

copying someone elsersquos business model innovation

often involves changing processes that are embed-

ded in the culture of an organizationmdashand sub-

stantially changing the cultural DNA is harder than

adopting a new technology or design or entering a

new market Itrsquos particularly challenging when the

company being copied is a competitor Other car

companies took decades to become as good as Ford

is at mass production And although the famous

Toyota Production System is well described in nu-

merous books and anyone can visit a Toyota factory

US automakers still struggle to implement it as ef-

fectively as Toyota does Meanwhile companies in

other industries prospered mightily from being the

first to adopt mass production or TPS

The lesson If you really want to steal a march on

your rivals shift some of the focus that you now put

on improving your products and services to thinking

about how you your suppliers and your customers

can manage the risks of the business you conduct

together HBR Reprint R983089983089983088983093G

Think about Zipcar Take onrisk by offering customers theability to exchange depletedbatteries for fully charged

ones This requires buildingbattery-switching stations

Look at Rolls-Royce Doublethe risk by transferring batteryownership from the customerto the company and selling the

customer ldquodriving distancerdquo onemile at a time A company thatowns thousands of batteries notonly can ensure that the bat-teries are properly utilized butalso will be better positioned toforecast technology evolutionand amortize expensive assets

These solutions may sound fa-miliar The Israeli start-up BetterPlace has applied them both andis on track to enable electric-

car adoption across Israel Itsbusiness model innovation mayachieve what technological andproduct innovation have longfailed to deliver

HOW COULD THESE RISKS BE REDUCEDFOR POTENTIAL ADOPTERS

FURTHER READING

More information on the conceptsand case studies inthis article can befound at renaissanceinnovatorcom







Business ModelSmart companies design their innovationsaround managing risk by Karan Girotraand Serguei Netessine






















Mauborgne well know


















networks













Reducing Risks











able innovations







































handle them











disadvantages








Idea in Brief













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earth moved


































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Reducing Risks











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FURTHER READING







Reducing Risks











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handle them











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Idea in Brief













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experimentation and





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earth moved


































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Idea in Brief













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FURTHER READING




























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FURTHER READING





5. how to build risk into your business model

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