Reinventing Business Models Through Risk Management

Karan Girotra , Serguei Netessine


November 1, 2014

rm1114_reinventionManaging risks can be far more profound than just improving financial performance-some risks can disrupt not only a single company, but entire industries, forcing those that want to remain successful to reinvent their business models. This requires managing two risks in particular:
informational risk and alignment risk. By addressing these threats and carefully considering risk-return tradeoffs, any organization can elevate risk management to the boardroom level and use it as a tool to innovate, rather than simply manage.

Consider Netafim, an Israeli company that manufactures drip irrigation equipment used in some of the least-developed regions of the world. The company had developed a new, high-tech irrigation solution that it believed would drastically improve crop yields. Initial attempts at selling this equipment, however, did not gain traction. Farmers were skeptical about potential benefits because of informational risks (the company claimed the equipment worked well, but the farmers had no independent third-party information about the performance of the technology) and alignment risks (the company had an incentive to sell the equipment regardless of its performance, but the value of the equipment to the farmers depended highly on performance). Add these to the many other risks that farmers already face, from the weather to the economy, and Netafim was facing an uphill battle.

Netafim's situation changed completely, however, when the company altered its business model and started selling the service of improving crop yields, rather than the technology itself. Farmers would no longer buy equipment, but instead would only pay based on increased yields at the end of the season. This new business model changed the risk allocation. Before, customers were bearing the lion's share of the risk once they purchased the product, leaving them to wonder if the equipment would work as advertised and whether benefits would materialize. The farmer could be stuck with an expensive piece of equipment that did not deliver.

Paying for performance rather than for equipment shifted the risk to Netafim. By virtue of its knowledge of the risk, and now with the right incentives to design, install and tune its equipment for peak performance, the company assumed the greatest burden, reducing the risk for farmers. Netafim could diversify the performance risk across many farms with different weather and could, in fact, further decrease risk through design and installation choices. Most importantly, by changing the risk-return equation, the company was able to increase adoption and drastically raise its market share. In essence, by selling the product as a service, Netafim provided a sort of insurance against the risks of using new equipment.

The company's struggle is typical of many high-tech companies. More often than not, the equipment they sell is costly and has unproven benefits. While most companies prioritize product and equipment innovation to overcome these issues, this effort is often misdirected since a relatively small change in the business model can lead to greater investments to improve the technology.

As another example, look at the kinds of lights your company is using. Chances are they are not the efficient type. The vast majority of workplaces still use dated incandescent light bulbs that are extremely inefficient, wasting 95% of the electricity used. Because the bulbs are initially much cheaper than more efficient alternatives like fluorescent or LED lamps, companies are hesitant to switch, even though simple calculations show that, in the long run, energy efficiency outweighs the initial investment cost.

Again, the reasons for not adopting a superior technology are two-fold. On one hand, there is information inefficiency-figuring out electricity costs is not entirely straightforward, so benefits of saving electricity in the long run appear highly uncertain (information risk). On the other hand, most building managers deal with annual budgets, so their incentives are often not well-aligned with investments that recoup themselves over the long term (alignment inefficiency).

The solution to this deadlock came again in the form of a business model innovation. Energy efficiency services companies offer the service of electricity bill reduction rather than selling energy-efficient bulbs. They offer an organization a contract that involves sharing the reduction in the electricity bill at the end of the year, while taking over the job of changing the lights, installing motion detectors to switch off lights and even insulating the windows. Given the uncertainties in electricity costs, consumption patterns and outside temperatures, these companies, like Netafim, essentially offer insurance against various risks that the organization faces when switching to the new technology.

In these two examples, company success was achieved not by reducing costs or improving revenues, but by better managing risks. This is often the missing link in executives' thinking as most initiatives to improve profitability focus on gaining efficiencies to decrease costs, or on revenue-enhancing opportunities. As new technologies often cost more and have unproven capabilities, it is hard to justify reducing their costs or charging more for them. Focusing on risks involved in the current business model does the trick, however, as identifying and correcting these through better risk management can lead to superior strategies.

Both of these examples showed how new business models were needed to achieve acceptance of a new technology in the market. This is not always the case. Business models can often change the risk-return equation for existing products and technologies as well. Consider risks faced by most service organizations like hotels and airlines. Given their highly rigid and perishable capacity (a seat on a flight today has no value tomorrow), filling it up with paying customers is the top priority. To better manage these risks, airlines invented dynamic pricing as early as the 1980s as a way to deal with information risk. Instead of posting fixed prices before knowing how popular any particular day will be for travel, prices are continuously adjusted depending on how demand shapes up. So the person next to you on an airplane could be paying three times more, or less, depending on when you purchased the tickets.

The same risks of unsold capacity plague many other industries where demand fluctuates wildly from day to day. Uber, a recent newcomer in the transportation business, matches the demand for taxi services with potential sources of supply. It has rapidly disrupted the traditional hired taxi and limousine industry in city after city. Unlike traditional taxi companies, it changes prices depending on demand and supply. High prices on Christmas Eve, for example, bring more drivers to the road and encourage travelers to use other means of transportation. This allows for better matching of supply with demand. Recent developments in data analytics allow companies to even fine-tune pricing to a personal level so that a consumer calling a casino might hear anything between "we have no rooms" and "we are happy to offer you a complimentary presidential suite" on the same day, depending on past spending habits. By pricing services responsively, these firms mitigate the expensive risk of having unsold capacity and maximize financial returns.

Business model innovation through risk management has many advantages over other approaches. First, unlike traditional innovation through new products or technology, business model innovation does not require huge investments into research and development.
It can be done systematically, with the main expense being the time of top management. Second, business model innovation often succeeds in industries where other types of innovation may fail. For instance, traditional commoditized industries (such as travel-related industries or oil and gas) find it hard to innovate by constantly introducing new products and technologies. Third, in innovating business models, some well-known risk management tools can be applied to identify and evaluate the right risk-return tradeoffs. Finally, business model innovation is often transferable across industries so that the best risk management practices in one industry can be transferred to another.

Dell once disrupted the computer hardware industry by pioneering the production-to-order process, whereby the computer is built only after the customer buys it. This eliminates the risk of building what customers don't want. Following Dell's lead, other companies started producing products on-demand, such as travel bags (Timbuk2), shoes (Nike) and shirts (Threadless). Recently, companies such as even started hiring customer service agents on demand by routing calls to home-based freelancers, and paying them only when they spend time on a call.

The systematic approach of innovating business models starts with an audit, identifying risks and inefficiencies in the current business model the same way auditing of financial statements aims to identify financial health issues. Such audits should take place often-at least as often as analysis of financial statements-because the competitive situation and associated risks change constantly as new players come in, technology evolves and customer preferences evolve. Unfortunately, most companies do not engage in this essential exercise and they typically get disrupted by others. For instance, the "sharing economy" disrupted such traditional industries as hotels (by AirBNB) and taxis (by Uber), just like the now-bankrupt video rental leader Blockbuster was disrupted by Netflix and Redbox. The difficulty lies in the fact that most established companies are entrenched in their existing business models and find it hard to break with tradition.

The business model audit should be followed by a systematic process of identifying information and alignment risks that can be reduced by altering the business model. This process takes root in changing how decisions are made in the existing business model. By altering what decisions must be made, when they are made, who makes them, the incentives driving the decisions and why they are made, firms can invent business models that change the risk-return tradeoff.

Finally, any new business models must be piloted and gradually introduced to fine-tune their design and identify best launch strategies.

The reinvention of business models to change the way they bear risks is a promising and underused technique for innovation. At the heart of this technique lies an ability to better understand and manage business strategy. This requires elevating risk management to the boardroom level and reconfiguring the organization to use risk management as a tool to innovate and disrupt rather than to just limit downsides.
Karan Girotra, a former entrepreneur, is a professor of technology and operations management at INSEAD and co-author of The Risk-Driven Business Model.
Serguei Netessine is a professor of global technology and innovation at INSEAD, research director of the INSEAD-Wharton Alliance and co-author of The Risk-Driven Business Model.