A desirable product is not enough to bring the customers flocking. But nor do customers guarantee a healthy profit, say  W. Chan Kim and Renée Mauborgne .
 

If there is one lesson to emerge from the plunging prices of technology shares over the past few months, it is that companies must make money. By that measure many dotcoms look inadequate: the worst did not even have a serious notion of how to make profits at any point in the near future. Advertising revenues were supposed to be many companies' main source of revenue - but they are falling as other start-ups, alarmed at the way they are consuming capital, are cutting their "burn rates" to stay afloat.

It is not easy to build an innovative business. As discussed yesterday, buyer utility - the existence of a compelling reason for consumers to buy the product or service - is an essential ingredient. But utility alone does not guarantee an innovation's success. Companies must also set a strategic price to induce the mass of buyers to purchase their product and they must build a business model that can deliver the product at a healthy profit. 

Our research over the past 10 years* has revealed that successful innovative businesses set a strategic price and build their business model in different ways from traditional businesses. This is true whether they are dotcoms, such as America Online, or bricks-and-mortar companies, such as Starbucks, Home Depot and Dyson. 

First consider strategic pricing. The aim is to set a price that creates demand and wins customers not just from within an industry as it is currently defined but from across industries as well. To do this, successful companies disregard the norms established by their competitors in an industry and instead look to the price of alternatives and substitutes. 

From the sellers' point of view, software for managing personal finances and the pencil used to tot up a balance in a cheque book may not compete. But from the customer's point of view they are alternatives. Understanding how alternatives are priced and used is vital for winning customers. 

The relevant questions are: what products and services are alternatives to the product or service a company intends to launch? What is their price and how many customers do they win? 

Consider, for example, air travel for corporate executives. There are two main alternatives: one is business- and first-class tickets, priced at several thousand pounds, which account for the mass of corporate executive travel; the other is corporate jets, which cost tens of millions of pounds and capture minuscule market share. 

Executive Jet, a subsidiary of Berkshire Hathaway, came up with a breakthrough pricingmodel: instead of selling jets, it sold shares of time in using a jet. This allowed it to price jets per year at roughly the amount a company would spend on business- and first-class tickets. It won orders both from business-class customers and from executives who preferred a relatively cheap time-share in Executive Jet to full ownership of a Gulfstream or Learjet that would spend much of its time sitting idle on the Tarmac. Executive Jet created a scenario in which companies got the convenience of private air travel at the price of the annual business-class budget. 

Our research has revealed five ways of pricing so as to hit the strategic price and make a profit. There are the familiar approaches of direct sales and leasing or renting. A third approach is time-share, as practised by Executive Jet. Then there is "slice-share", as in mutual funds, where investors are sold part of a big portfolio rather than their own individual portfolio to cut costs and deliver higher returns. Finally there is "equity for price", as practised by Hewlett-Packard, the US computer group, which exchanges high-powered servers for a share of the customer's revenue. The customer gets immediate access to an important piece of equipment and HP stands to earn a lot more than the price of a machine. 

Once companies have decided upon their pricing, they need to think about the business model and, in particular, target costing. To arrive at the cost target for the business to generate a decent profit, they should start at their strategic price and subtract the desired profit margin. Companies have three ways to hit the cost target without compromising on price or utility. 

First, they can replace familiar raw materials with unconventional, less expensive ones. Swatch, for instance, was able to produce one of the world's lowest-cost fine watches in one of the world's highest-cost labour markets by rethinking the materials it used. Instead of metal, it used plastic. And instead of expensive packaging made of velvet and leather-like cardboard, Swatch supplied a clear envelope. 

Another way to hit the cost target is to eliminate, reduce and outsource high-cost, low value-added activities in their supply chain. Again, Swatch is an example. It eliminated the screws for closing its watches and used ultrasonic welding to seal them. It reduced the number of parts from about 150 to 50. 

Finally, companies reduce costs by digitising assets or activities. For example, customers and suppliers of Cisco, the networking technology company, use the internet to place orders, to find out when shipments will arrive and check payment records - there is no need to speak to a company representative. Roughly 90 per cent of Cisco's orders are processed without ever being touched by human hands. This not only lowers Cisco's costs but also allows its employees to move from low-value-added activities to high-value-added customer satisfaction. 

In bringing a new product or service to market, many companies mistakenly set out to do it all alone. This slows them down and prevents them from taking advantage of other companies' lead in cost, quality, and speed - precisely what the innovator cannot afford to see happen. 

Successful innovators close the gaps in their capabilities by capability partnering - that is, they avail themselves of others' strengths. They form and disband networks around the competences they need to deliver their utility proposition quickly, cheaply and reliably. SAP, for instance, had the idea of real-time business-application software. But the software group did not have the capabilities to realise its idea. Instead of trying to build them, it sought help. Oracle, another software company, provided its central database and consultancies such as Cap Gemini sold and implemented SAP products. 

Here are some questions to help you assess whether you are building a profitable business model:

• What price model should you use to hit the strategic price and still earn a profit? 

• Should you sell, rent, lease, time-share, slice-share or provide equity for payment? 

• What must the cost target be? 

• What components should be reduced, eliminated, outsourced or digitised to achieve the target cost? 

• Whom should you choose as your partner to close capability gaps fast and leverage the quality, speed, and cost advantages of other companies? 

These are the parameters that distinguish innovative businesses with profitable business models from innovative businesses that lose money. 
 
 

Tomorrow:  Hurdles to adoption and the Winning Business Idea Index

 

* Knowing A Winning Business Idea When You See One, Harvard Business Review, September-October, 2000