Sub-Optimal Business Models – Part 1: The Encyclopedia Wars

Are you confused if your company that is an incumbent market leader is facing the threat of disruption? Or are you a company which wants to use disruption as a growth strategy? Or are you an entrepreneur who wants to disrupt a big incumbent? Then it is important to know if a business model has become sub-optimal so that you can either fix them (if you are an incumbent) or attack them (if you are a new entrant/startup).

When Business Models become Sub-Optimal…

I define sub-optimal business models as those which can only fulfill a visibly sub-optimal value proposition for a given customer segment. Note that the same business model can be ‘optimal’ for some customer segments while becoming sub-optimal for others.

Business models become sub-optimal usually because of the following process:

 Suboptimal Process

  1. Incumbent business operates under some assumptions of ‘how business is done’. These assumptions of ‘how business is done’ is because of the initial constraints governing the solution.
  2. A new ‘Technology Enabler’ or what is commonly called General Purpose Technologies (an invention/innovation that can be applied to drive radical change in the capabilities of a user) arrives. For example, these technology enablers can be the Internet, Mobile, Cloud Computing, 3D Printing etc.
  3. The new ‘Technology Enabler’ over time enables businesses to challenge the initial assumptions.
  4. When these assumptions are challenged, a new business model emerges and becomes optimal at least for a new customer segment or a customer segment that was initially served by the incumbent solution. The incumbent business model in other words becomes sub-optimal.
  5. The new business model then gradually replaces the old business model and then becomes the new incumbent.
  6. The Process continues with the new incumbent operating under a new set of ‘assumptions’.

Britannica, Encarta and Wikipedia

Britannica Encyclopedia – an incumbent solution founded in 1770 with a huge brand name, a very superior product. The company lists more than 110 Nobel Prize winners and 5 US Presidents as its contributors. They faced their big competition in 1993 with the launch of Microsoft’s Encarta.

Some of the assumptions under which Britannica would have operated:
1. Customers would only buy high quality encyclopedias
2. Customers would only want a complete encyclopedia
3. Door-to-door salesmen were the best distribution channel
4. Locking in that distribution channel would give a competitive advantage

While Britannica sold bounded encyclopedia books, Microsoft sold its Encarta encyclopedia on a (relatively) new technology – the CD-ROM. The irony was that Microsoft wanted to license rights from Britannica and was refused. Microsoft found a licensor in Funk and Wagnalls.

The economics should have been frightening for Britannica. Britannica sold its product for $1500 to $2200 per set while Encarta retailed for $99. The marginal cost for production for Britannica was $250 per copy (you have to use paper and bind those books) while the marginal manufacturing cost for a CD was $1.50. And worse still the salesperson’s commission was rumoured to be around $500 to $600. Note that Microsoft could just bundle their product with Windows.

Why did Britannica not introduce a competing product? Funk and Wagnalls was a nearly defunct and third rate product compared to the iconic Britannica. Britannica at 40 million words was not only a more complete Encyclopedia than Encarta, it could not fit the entire Encyclopedia in a CD-ROM. Encarta meanwhile had 7 million words. But customers cared only so much about quality, many wanted the product and many would have been first time buyers. The Encarta product was ‘good enough’ for many of them or rather ‘infinitely better than nothing’.

Britannica to be fair tried to introduced a text only CD-ROM in 1995. The sales force revolted. They could never get a better commission than they did in bounded books. Britannica responded with a bigger mistake – the CD would be a free bonus for those who buy the bounded books, the CD alone would cost $1000! But customers did not want that. Sales continued to plummet. There were other fierce CD-ROM based competitors like Compton’s.

All the above assumptions of Britannica were trivialized.

What next happened to the new incumbents – Microsoft Encarta and the like was even more spectacular. It is said that Bill Gates conceptualized a CD-ROM based encyclopedia way back in 1985 (the year CD-ROM standard was commercialized by Philips and Sony) and thought it would be a “high-price, high-demand” product with the potential of becoming as profitable as Microsoft Office applications.

Wikipedia was launched on January 15, 2001 by Jimmy Wales and Larry Sanger (I looked it up on Wikipedia). It used a new technology enabler – the internet.

Remember Britannica’s assumptions? What would have been Microsoft’s assumptions of the way an Encyclopedia is made and sold? For illustration, let us challenge ourselves to look at the most basic and reasonable assumptions any company would have:

  • You have to license the product which has to be built by hiring expensive contributors
  • Only few people are qualified to write about some topic
  • No one will write articles for free
  • No one will fact check articles for free
  • It is impossible to distribute a quality encyclopedia for free

In 2001, these would not have even been assumptions. Any reasonable person would have judged as ‘laws’. Still Wikipedia built one of the classic disruptive products of all time. These laws went back to being just assumptions when a new tech enabler came into play.

Stunningly Encarta responded with a similar response as Britannica to its own product – to get online access to the complete Encyclopedia, one had to buy the Encarta CD-ROM or DVD.

As it is clear by now, Wikipedia punted each of the above assumptions. Initially Wikipedia appealed to the non-consumers – people who could not afford Britannica or even Encarta but demanded a solution. Bill Gates was right about the ‘high demand’ part not just about the ‘high price’ part. In fact, the number of non-consumers was very large – Wikipedia has 500 million unique visitors each month. It has more than 69000 active editors who edit for free. What is more, the magazine Nature claimed that Wikipedia became as accurate as the high quality Britannica in 2005 just four years after it was founded.
Some ‘tweetable’ takeaways from the above story:
1. Assumptions make sense initially for constraints around the incumbent technology.
2. Assumptions, however trivial might be challenged with a new tech enabler
3. Fear of Cannibalization delayed much necessary action and killed Britannica and Encarta.

It is therefore, important for incumbent companies and market leaders to understand that their current solution operates under assumptions and is in threat of becoming sub-optimal when a new technology enabler arrives. And even the most trivial of assumptions must be treated as just that – assumptions.

On trivial assumptions, let us take the Hospitality Industry. What are some of the entrenched assumptions under which the incumbent solutions (Hilton and others) operate?

  • People would like a separate place to stay when they visit a new place
  • The rooms have to be well decorated and may require miscellaneous comforts
  • Staff must be hired and trained for better service
  • You have to charge on a per day basis
  • People will not stay in a stranger’s home
  • Spending money on marketing your property will make more people to stay

AirBnB challenges many of the above ‘trivial’ assumptions with its disruptive solution. The result is a company that is valued significantly more than some of the biggest hotels.

In this post, we saw the process by which incumbent business models become sub-optimal. I hope to write soon on some quick-check indicators to find out whether a business model is in danger of becoming or already has become sub-optimal.

Sources for data:

http://capitalismmagazine.com/2000/12/how-encyclopedia-britannica-was-blown-to-bits/

http://www.nytimes.com/2009/05/03/business/03digi.html?_r=0

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