Module 4 – Article Notes

Paper #1
Profit Pools: A fresh look at Strategy (Gadiesh and Gilbert, 1998)

● Profit pool: the total profits earned in an industry at all points along its entire value chain
● A profit pool map answers the most basic questions about an industry: where and how is
money being made? The simple act of mapping can provide an entirely new perspective
on even the most familiar industry
● Mapping the profit pool not only shows the current state of an industry but also prompts
some fundamental questions about the industry’s evolution such as: why have profit
pools formed what they have? Are the forces that created those pools likely to change?
Will new, more profitable business models emerge? (For example, looking at the
chronically low margins in auto manufacturing, it is hard not to trace the root cause back
to global overcapacity, a condition that is not likely to go away anytime soon)
● The profit pool map prompts us to examine how some profit sources exert influence over
others and shape competition.
● Businesses that fail to understand profit pool dynamics may well find themselves
floundering in the shallows of the pool.
● Although the concept is simple, the structure of a profit pool is quite complex. The pool
will be deeper in some segments of the value chain than in others, and depths will vary
within an individual segment as well.
● Segment profitability will vary based on: Customer group, product category, geographic
market, distribution channel
● Pattern of profit concentration in an industry is often very different from the pattern of
revenue concentration. Using the U-Haul case, the shape of a profit pool reflects the
competitive dynamics of a business
● Profit concentrations result from the actions and interactions of companies and
customers. They form in areas where barriers to competition exist or in areas that simply
been overlooked by competitors. Profits do not tend to stay in one place, waiting to be
scooped by the next opportunists. Hence the profit pool is not stagnant.
● As power shifts among players in an industry, the competitors themselves, their
suppliers, customers, the structure of the profit pool will also change (often quickly and
dramatically)
● Although Executives understand these truths intuitively, they often purse strategies that
run counter to them: they usually focus on revenue growth, market share and assume
that profits will follow. For most managers today, growth is the holy grail (Dangerous
strategy for fast-paced businesses: today’s deep revenue pool may become tomorrow’s
dry hole)
● To create strategies that result in profitable growth, every company’s true aim should
begin on creating a systematic picture of the industry’s profit pool.
○ Profits don’t necessarily follow revenues

U-Haul Success is due to:

- Spotting a large, untapped source of profit in the truck rental industry (accessories
business, i.e., sale of moving boxes, insurance, rental of trailers and storage space,
 Module 4 – Article Notes

ancillary products and services consumers need to complete the job that has only begun
when they rent a truck.
- Cheapest storage space
- Low daily rental rates compared to competitors’ high prices
- Now control a large share of the truck rental industry’s profits pool with their business
accessories
- They crafted a strategy to maximize control of the profit pool, and dictate the terms of
competition within the industry (competitive advantage by creating more value for
the consumers)
- They taught rivals a valuable lesson the hard way: there are many different sources of
profit in any business and the company that sees what others do not – namely, the profit
pools it might create or exploit, will be best prepared to capture a disproportionate share
of industry profits.

Turbulent Industries (can be related to the Ryanair Case Study – Week 7)

● The profit pool can be illuminating for industries undergoing structural change (change
whether triggered by deregulation, new technology or new competitors always results in
a shit in the distribution of profits along the value chain)
● While rapid change can open new sources of profit, it can also close off traditional
sources (for industry leaders, the shift can be very dangerous, threatening their control
over the profit pool). Hence, Changes can open new pockets of profit or close existing
ones
● The pharmaceuticals business provides a good case in point (Merk triggered a wave of
restructuring in the industry by acquiring Medco, the largest pharmacy-benefit manager
(PBM) in 1993 -> other pharma companies soon followed Merck’s lead.
● Merck strategy constituted a hedge against the possible success of the PBMs: at least
Merck would control a large share (25% in fact of the profit pool).
● Some industry analysts have suggested that the pharma giants overpaid for the PBMs,
but from a profit pool perspective, it suggests that the drug companies actually received
much more than their money’s worth.
● By anticipating a potential reconfiguration of the profit pool, Merch and the other industry
leaders were able to take action to insulate themselves from the new entrants, protect
their existing sources of profits, gain greater access to patient information, and increase
the likelihood that the pool would evolve in a beneficial rather than destructive way.
(Porter’s 5 forces Analysis)
● Most of the profits in the pharma industry have been generated by two activities:
developing new drugs and convincing doctors to prescribe them
● Pharma industry unique structure resulted in an extraordinarily deep profit pool for the
drugmakers. Patent protection for new drugs effectively eliminated price competition,
and because drug costs were largely paid by insurers, consumers were not price-
sensitive.
● In 1990s, PBMs began to move aggressively into the business with generic drugs as
substitutes for equivalent but much higher priced branded drugs.
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● Hence, PBMs’ influence over the selection of drug products and brands together with
their direct access to information on patients’ drug purchases, posed a direct threat to
the established profit structure of the pharma industry.

When Growth isn’t good

● The leading companies had the resources to shift into distribution if it turned out that
changes in the industry’s profit pool would warrant such a move. Most companies,
however would not be able to achieve such a dramatic shift in their value-chain
positioning, no matter how attractive the profit concentrations in other segments (Entry
barriers are often too high)
● Nevertheless, the profit pool still provides a valuable lens for companies that cannot
hope to expand beyond the boundaries of their current business model
● Considering the personal computer industry: mapping profits across the value chain
shows that profit is much more highly concentrated in the microprocessor and software
segments than in hardware manufacturing. Yet, few if any computer manufacturers can
hope to shift successfully onto Intel’s or Microsoft’s turf. The differences in required
capabilities, competitive structure is enormous, and Microsoft and Intel have vast
resources with which to defend themselves (Apple did that successfully)
● The value chain for the personal computer industry includes 6 key activities:
microprocessors, personal computers, software, peripherals, services, other
components
● In addition to looking broadly across all industry segments, a company can also look to
deploy into the profit pools within its own segment: searching for pockets of profits that
can be either created or mined
● No market, no matter how homogeneous or narrowly defined has a perfectly even
distribution of profit (there are always products, customers, regions or channels that yield
above-average returns). Companies that recognize the variability of profit and can
exploit the deepest pools will earn superior returns even amid a sea of seemingly
identical customers and products
● For example, Dell competes in the least attractive segment of the industry (the
manufacturing hardware), but from its inception in 1984, it has had a unique perspective
on the industry. Dell built its business model on direct sales which was different than the
industry norm. it eliminated the middleman standing between companies and customers
which allowed it to keep a portion of the dealers’ profit pool for itself and to share the rest
with customers in the form of lower prices.
● Dell stopped making money and actually suffered losses in 1993. It looked for the most
profitable customers to serve in the own segment (pc manufacture) which overall was
not the most profitable in 1994. It lost its focus on the most profitable customer segments
and on a distribution model that is at heart more efficient than what the retailer can
provide.
● Companies declining not to participate in less profitable segments of the market, meant
not tailoring any of its products to the mass consumer market. They should instead
participate in that segment by using sophisticated understanding of profitability to
concentrate on the areas where the money is.
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● The profit pool approach has put Dell back on the path to profitable growth between
1994-1997: through the products it offers and the way it prices them, it attracts
consumers who are technologically more sophisticated, more profitable and
avoids entry-level buyers who tend to be unprofitable to serve
● Building an understanding of profit pools puts strategic thinking on a firm to go after the
bigger share of the profit pool, instead of more market share.

Creating and managing a profit pool (can be related to the Ryanair Case Study – Week 7)
● In a rapidly growing industry, the profit-pool perspective helps companies to focus and
re-focus its resources on its best opportunities. By helping companies to see what their
rivals can’t see, the profit-pool lens helps inspire strategies to create and control new
profit pools, even in stagnating industries
● For example, the US beer industry: When Busch recognized that a great disparity
existed between the profitability of ‘premium’ beers and standard (or discount) beers –
both costs virtually the same to produce and distribute, but premium brands are sold for
a significantly higher price. As a result, Busch’s company saw the size of the industry’s
profit pool was driven primarily by the premium segment.
● He needs to carefully manage the price difference between its premium and discount
brands: the gap in prices would have to be wide enough to generate attractive profits but
small enough to compel discount beer drinkers to trade up and to dissuade premium
beer drinkers from switching down.
● By gaining dominance over an industry, companies can gain a disproportionate share of
industry profit
● However, it is not enough to simply expanding its share of the premium segment,
the more difficult challenge lays in protecting the segment’s profitability by doing
the following:
1) Do not make big investments to increase market share unless it could be
assured that the added profits would not be eaten away by the competition:
2) Hence make the profitable segment less profitable for competitors by
discouraging them from competing aggressively for the segment
3) Build a cost advantage over rivals: if it costs others more to produce and
distribute, they would have less money for advertising, and would find it
difficult to undercut Busch’s pricing
4) To ensure a supply of low-price and high-quality cans, the company integrated
vertically into can production.
5) The economies of scale resulting for this low-cost advantage, together with
more streamlined production processes, will provide companies with a
substantial operating-cost advantage over its competitors.
● Companies can grow the industry profit pool and raise competitive barriers around the
pool by expanding the profitability segment of the market while simultaneously cutting
manufacturing and distribution costs. Through superior knowledge of the profit pool,
companies can succeed in reshaping the industry to its own advantages
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A new set of imperatives

● Profit pools can take many shapes, depending on the economic and competitive forces
at work in an industry or industry segment
● Companies can use their understanding of the profit-pool in many different ways:
a) To identify news sources of profit in low margin industries as U-Haul has done
b) To chart acquisition and expansion strategy, as Merck has done
c) To decide which customers to pursue and which channel to use, as Dell has done.
d) To guide product, pricing, and operating decisions as Busch has done
● Understanding of profit-pool dynamics can help guide important decisions about every
facet of a company’s operation and strategy, leading in many cases to the development
of new, more profitable business models.
● Using the lens to formulate strategy may require the overturning of old assumptions, the
rethinking of old decisions, and the pursuit of counterintuitive initiatives
 Building an understanding of the profit pool does not obviate the need for good strategic
thinking. It puts strategic thinking on a firm footing.
 However, how a company puts its profit-pool insight to work will, of course, depend on
the company’s competitive situation, capabilities, economics, and aspirations.

For examples:
 Companies may hold off on pursuing obvious growth opportunities in favor of
concentrating first on seemingly less exciting business segments with richer profit pools.
 It may shed traditional customer groups, product lines, and even entire businesses in
order to focus on the best profit sources.
 It may deliberately reduce its profits in one area of its business to maximize them in
another
 It may decide to cooperate with rivals in order to block or take advantage of value-chain
shifts that threaten an existing profit pool.
 Module 4 – Article Notes

Paper #2
Business Models (BM): A Discovery Driven Approach (McGrath)

The Appeal of the Business Model Construct

● The business model concept offers strategist a fresh way to consider their options in
uncertain, fast-moving and unpredictable environments
● BM offers a new way of analyzing companies that is superior to traditional concepts such
as position within an industry. In contrast to conventional assumptions, recognizing that
newer BM are both feasible and actionable than ever before is creating unprecedented
opportunities for today’s organizations. Unlike, conventional strategies that emphasize
analysis, strategies that aim to discover and exploit new models must engage in
significant experimentation and learning
● Old-fashioned ideas like be profitable, or failing to reach profit goals or even revenues
continue to matter. However, the idea that a company can create a competitive
advantage by doing something differently such as adopting a new BM still remained
appealing
● The concept of the business model is appealing because it suggests a change in the
way strategies are conceived, created, and executed against. In highly uncertain,
complex and fast-moving environments, strategies are about insight, rapid
experimentation and evolutionary learning as much as the traditional skills of planning
and relentless execution
● Modeling, therefore, is a useful approach to figuring out a strategy, as it suggests
experimentation, prototyping and a job that is never quite finished
● The positioning school has long proposed that what firms need to do to succeed is to
find a truly differentiated and defensible position within an industry and execute
relentlessly against that position. The Resource-based view (RBV) argues that
competitive advantage stems from having difficult-to-copy resources that are often built-
up over long periods of time.
 The dilemma is that neither of these options give management much latitude for action.
Having selected a position in an industry, it is hard to pluck a firm out and move it to
some other position; similarly, after a firm has spent time and effort assembling a
compelling resource endowment, order of magnitude shifts is quite difficult. But making
business model decisions does fall into the realm of managerial choice, and is therefore
exceptionally useful to inform managerial decision-making.
 Therefore, companies should focus on making decisions intended to align the firm
around a new set of business models instead of making positional moves or resource-
based moves

The business model concept offers four ideas that are either new or that have not figured
substantively in considerations of strategy formulation historically:

1. Promotes an outside-in, rather than inside-out, focus

a. For some time, managers have been advised to get to know their ‘core
competences’ which are activities at which firms excel to find market
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opportunities and deploy them. The dilemma is that such analyses are often
carried out with an internal focus.
b. Focus on business models shift helps re-invigorate a view of firms as continually
engaged with, and adapting to changing customer values. Hence, instead of core
competency” focus it is about adapting to “changing customer values”.
c. Business models that don’t create value for customers, don’t create value for the
firms that seek to serve those customers either.

2. Business models can’t be fully anticipated in advance, they must be learned over
time which emphasizes the centrality of experimentation in the discovery and
development of new business models (discovery and experimentation)

3. Appreciation of dynamism of competitive advantage

a. Conventionally, the holy grail in strategy has been the creation of “sustainable”
competitive advantage
b. Now it’s about a “temporary” advantage which companies exploit until
competition has caught up or markets have changed at which point, the hunt is
on for a new advantage.
c. Business Model construct encourages conversations which might help us discern
possible early warning of model weakness and prompt to search for new ones.

4. As business models evolve and mature, adopting the notion suggests a

developing understanding that strategy itself is quite frequently discovery driven
rather than planning oriented.

Resource-Based View
 Largely in response to the preceding notion of ‘strategic business units’, proponents of
this concept for strategy argued that what really leads to competitive advantage are:
hard-to copy organizational capabilities that cannot be imitated or bought on the open
market.
 While the focus on firms’ capabilities led to a good many insights, it didn’t much help
managers who were trying to determine which resources to invest in, how much to put
toward them, and how particular resources would contribute to a future competitive
position.
 Indeed, even though a central proposition of what makes a given resource combination
interesting is that it is both rare and valuable, looking at value to a customer has too
often failed to take the customers’ perspective on its utility into account.
 The business model construct offers some intriguing opportunities to capture
better how a given set of resources translates into something a customer is
willing to pay for.

Two core components of what constitutes a business model:

1. The basic ‘unit of business’ ->

a. The building block of any strategy because it refers to what customers pay for
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2. Key metrics of process or operational advantages for delivering superior performance

b. It yields performance benefits when more adroit deployment of resources leads a
firm to enjoy superior efficiency or effectiveness on the key variables that
influence its profitability
c. These process advantages can be captured in a set of key metrics that allow a
firm to deliver superior performance

I. The unit of business

● Basic items on the invoice: products, services, guarantees or other things the firm offers
and for which customers pay. This is very important because the firm does not have a
business much less a business model without it.

● Examples of business models that include some elements of “free” unit of business
(collecting revenues from parties other than those who use/benefit from what is sold)
○ Advertising: companies are paid for attracting users even though the users don’t
pay for what they receive, but they will be exposed to advertising messages
○ Cross-subsidization (bundling / Ryanair): in this model, certain units of
business are given away for free or at lower than market-rate price in the interest
of making fat margins on another part of the business (example: ink-jet printer
manufacturers)
○ Promotion: a low-cost good is given away to promote something that might be
entirely different (ex: a brand, membership in a community or attendance at a
concert for software of digital music company)
○ Freemium: a basic version of an offering is given away for free with the hope of
eventually persuading sufficient numbers of customers to pay for a more
advanced version (ex: LinkedIn)
○ Barter: when a good is given away without cost to customers who provide in
return something of value to the sponsoring organization. (Ex: google with free
directory assistance + drug companies)
○ Gratis: something of value is provided for free simply because those involved
enjoy interacting or making a contribution (Ex: the rise of open-source software
and various forms of wiki encyclopedias

II. Key process and metrics

After choosing a particular unit of business, next choice is to look at process steps, which sets
of activities are needed to sell those unites
● Look at key metrics that help drive performance -> operational activities that
influence the critical dimensions of performance for a firm. For example, for airlines they
look at how full the planes are when they take off; the industry looked at measures of
passenger yield to determine how effective a competitor is.
● Key metrics are almost always derived from the most critical constraints or rate-limiting
step in a particular value chain, and are therefore extremely helpful in comparing the
 Module 4 – Article Notes

performance of firms struggling with similar constraints. Inventing a new way around a
constraint can created differentiated business models and yield a competitive advantage
● Business model analysis can help us understand why some companies’ competitiveness
declines, as well as why it was successful.
● When an existing business model has been copied, made irrelevant by environmental
events or is otherwise no longer relevant to customers, new business models have the
opportunity to flourish. It is difficult, however, to plan analytically for which new models
will supplant old ones, since so many of the variables relevant to their success are
unknown at the outset, so experimentation is central.

The centrality of experimentation:

Experimentation, failure and learning.

● New BM emerge when a constraint is lifted, and old ones often come under pressure
when one emerges. A more dynamically oriented business model lens suggests that
many of the constraints that will turn out to be competitively important aren’t known at
the time that critical resource allocation decisions need to be made. It takes marketplace
experimentation and time to discover the most effective models.
● Changing social norms, changes in technology, financial constraints can empower or
disable modes. Given uncertainty about how such forces might affect the future working
of a potential business model, it is more sensible to engage in experimentation and
discovery than to try to assume the relevant information is all known.
 While it is usually quite possible to detect such trends and changes, it is difficult to know
in advance how best to take advantage of them via business model innovation. Such
uncertainty places a huge premium on experimentation.
● A major change in underlying technology tends to spark an era of ferment that only ends
when key design decisions are made and a dominant design emerges
● New business design concepts produce massive amounts of experimentation without
any clear understanding at the outset of who the winners will be. (Google success stems
from and built upon the many previous experimental efforts made by preceding
companies)
● Business model experimentation takes place across as well as within firms
● Business model evolution is path dependent as early experiments often shape the
trajectory of models to come. It’s nearly impossible to tell in advance which design will
win
● Business model innovation demands experimentation which requires investment. Then
firms will need to become comfortable with financial tools that make sense in an
experimental world. This implies that decisions will be based a lot less on such
deterministic concepts as projected economic value added, net present value and a lot
more on investment ideas such as real options reasoning.
 Module 4 – Article Notes

Conventional vs real options-oriented investment approach (See PowerPoint Module 4

notes)
● Conventional: Blackhole investment strategy (article, p.10) -> plan depicts a pattern
of cumulative cash flow that is extremely negative over the short term on the hopeful
assumption that eventually the business will pick up and things will turn positive in a
massive way (experienced managers often deride this pattern as the hockey stick
approach)
● Options oriented investment strategy: Many smaller investments are made with a
deliberately limited downside, but which can still accumulate to significant positive
returns over time
● “Little hockey sticks” are really options, in which a small investment is made today
with the understanding that the company is earning its way into a new and promising
area

Overlooking Business Model Erosion

 Just as experimentation is central to business model creation, a new set of skills
involving the detection of any erosion of their business model will be at a premium for
company leaders
 BM embed the logic of the particular set of constraints is likely also to alter the validity of
their own models, or those of competitors. Successful incumbents may even entirely
miss the erosion of their model’s ability to generate value until it is too late

Why new models don’t look attractive or threatening?

 Brand new business models are more like experiments than proven business ideas. It is
not surprising that incumbent firms often fail to respond effectively to the threats signaled
by the advent of innovative new models
 New models are often designed for customers that an incumbent doesn’t serve, at price
points they would consider unattractive, and builds on resources that they don’t have.
From the perspective of an established firm, new models can look positively unattractive
 Leadership challenge lies in getting firms’ decision-makers to recognize the threats to
the viability of their business models before it is too late, and then to mobilize their
resources to address the concerns (Ex: Kodak)

Oblique competition  firms who are competing not directly with a local firm for customers,
but rather for something that allows the firm to function

Difference between a Discovery driven and a conventional approach

 Conventional approaches to planning businesses suffer from a mismatch between the
knowledge a firm actually possesses and the knowledge its planning systems assume it
possesses
● In conventional strategic planning, the measure of a plan’s success is how close
your projections came to what happened later on. This is nonsensical in a high-
uncertainty environment, if you could predict what was going to happen
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accurately, so could everyone else, and there would be very little advantage to be
gained
● As a firm ventures into new business models, increasing numbers of the underlying
assumptions it makes will differ from those inherent in its existing models, and this will
place a premium on ‘discovery driven’ rather than conventional practices in planning
(and in funding) forays into new business models
● Since new business models tend to be highly experimental at the outset, a
planning approach that recognizes their fundamental uncertainty, and that keep
costs contained make sense. Goal of a discovery-driven plan is to learn as much
as possible at the lowest possible cost, bringing us back to the theme of
experimentation.
● Discovery driven planning processes demand that BM assumptions are both articulated
and tested (having come up with an idea that an executive think represents an
opportunity, the next step is to validate whether it can really deliver a compelling result
for the company)
● Business model is benchmarked against competitive models and against potential
market demand. Then, the key process metrics that would support the plan are
described, together with the most critical assumptions being made by the
executives developing the plan.
● The whole concept moves forward on the basis of key checkpoints and moments in time
when assumptions can be tested, and, if necessary, the plan re-evaluated: the decision
to stop, redirect or to try something different can be made at each checkpoint.
● Using a discovery driven planning (DDP) approach, one can experiment with business
models conceptually before any investment is requirement: thinking about new BM
frequently involves trying to model different units of business and their key drivers
● This process resembles the ‘rapid prototyping’ version of planning which allows
teams to gain familiarity with a new model and how it would need to be executed
before investments are made. DDP is also unusual in that it does not take a given
unit of business or set of key metrics for granted. The goal is to discover the right
approaches as new information is revealed.

Barriers to the Discovery driven approach

 It is ironic that one would think the firms that would capitalize on new business models
are the incumbents with a great many advantages, great brands, sharp people and
significant resources. Instead, it is new entrants and upstarts that seem most often to
benefit from rapidly growing markets. One reason incumbents so often miss the
opportunities and threats inherent in new models could be that their internal systems
have no incentive to embrace a discovery driven approach
 Giving staff the license to plan, but to plan to experiment and to learn is a difficult
assignment for many established companies, comfortable with the idea that good plans
are ones that work out as expected. A firm needs a determined champion, or a real and
recognized problem, or a series of unsuccessful attempts to drive growth before the
necessity of using a different planning logic becomes evident. When it does, the results
can be profound.
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Conclusion
 Business Model concept is a powerful idea for strategic thinking and strategic research,
and allows to shift focus from a pre-occupation with the resources a firm has, to the use
to which those resources are put. This sort of analysis may well help us understand why
some firms are more successful than others, despite their similar-looking resource
endowments
 With new business models, experimentation is key, and it can take place both within
firms and across industries. This itself may offer another source of competitive
differentiation, as some firms develop superior capabilities at experimentation and
consequently can build better models more quickly than their slower counterparts
 Encouraging leaders to question the viability of a business model and to have the right
conversations with those who might challenge it, will become increasingly important. So
too will the use of planning and analysis frameworks appropriate to the level of
uncertainty a company is facing