2. Fundamentals Demarcation of SMEs

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1 2. Fundamentals The present chapter offers insights into both SME characteristics and BM basics. The first subchapter focuses on SMEs. Quantitative and qualitative criteria help illustrate the nature of SMEs and distinguish them from large companies. The second subchapter explores the concepts BM and innovation by establishing links between the various approaches found in the literature Demarcation of SMEs Before discussing innovation in SMEs across the next chapters, a definition of the German Mittelstand is needed. According to the business register (IfM Bonn, 2012a), 99.7% of all German enterprises are small and medium-sized. In Germany, they are metaphorically regarded as a primary employment engine. Indeed, they employ about 60.7% 1 of the working population (Statistisches Bundesamt, 2011). In 2011 there were around 3.69m SMEs in Germany, forming the backbone of the German economy (IfM Bonn, 2012a). The term SME is derived solely from quantitative aspects, such as staff headcount, annual turnover and balance sheet total. These three conditions are used in empirical research due to practicability reasons. The original thought behind them is simplification. However, it is sometimes forgotten that behind quantitative lay qualitative criteria. Quantitative criteria alone are not enough to classify different enterprises as belonging to large or to middle-sized companies. They are only the first step (Becker, Ebner & Ulrich, 2010) Quantitative Criteria The Recommendation of the European Commission from the 6th of May 2003 (2003/361/EC), which replaced since the 1st of January 2005 the old Recommendation (96/280/EC), gave a new definition to SMEs. According to it, an SME is any company with: less than 250 employees and an annual turnover up to 50m or an annual balance sheet total up to 43m (IfM Bonn, 2012b). The IfM Bonn offers different staff and financial thresholds for SMEs (IfM Bonn, 2012b). SMEs are defined as having: up to 500 employees and an annual turnover of up to 50m. 1 This statistic relies on the SME definition provided by the EU see below. Therefore, 60.7% of the population works in SMEs with up to 250 employees. If one defines SMEs in accordance with the Deloitte Mittelstandsinstitut, the number of the population employed in SMEs rises. O. Buliga, Measures for Innovating Business Models, BestMasters, DOI / _2, Springer Fachmedien Wiesbaden

2 A more modern definition proposal comes from the Deloitte. It argues that SMEs have: up to about 3000 employees and an annual turnover of up to about 60m (Becker & Ulrich, 2009). The Institute for Economic Studies in Hamburg also provides wide boundaries for delimiting SMEs, defining them as companies with up to 999 employees (Haussmann, 2006). Table 1 offers an overview of the quantitative criteria proposed by the European Union, the IfM Bonn and the Deloitte Mittelstandsinstitut. Table 1: Company size class according to the EU, the IfM Bonn and the Deloitte Mittelstandsinstitut Annual turnover Annual balance sheet total Annual turnover Annual turnover EU IfM Bonn Deloitte Mittelstandsinstitut Headcount Headcount Headcount Small < 50 10m 10m < 10 < 1m 300 6m (7m in 1996) or (5m in 1996) Medi- < m 43m < 500 < 50m m um- sized 2 (40m in 1996) or (40m in 1996) Large 250 > 50m or > 43m m > 3000 > 60m Source: Own illustration, based on IfM Bonn (2012b) and Becker & Ulrich (2009) Qualitative Criteria According to the OECD (2003), quantitative criteria do not suffice for justifying whether a company is middle-sized or large. The IfM Bonn (2001) also places a special importance on qualitative criteria. Daschmann (1994) and Pfohl (1997) assume that SMEs are governed by other economic principles than large companies. Welsh & White (1981) note that A small business is not a little big business. Becker, Ebner & Ulrich (2010) see three key characteristics of SMEs: The company is commercially and legally independent. Companies which are part of a corporation, a trust or a group of affiliated companies are not SMEs. Ownership, risk and supervision form a unity. Most SMEs are managed by the owner and/or the owner family. Owners bear the full economic risks. However, the fact that an SME is led by a manager is not contrary to its status. Company philosophy and strategy derive from the owner s credo. His/her personality and way of doing business offer employees a sense of orientation. Long-term goals are well-defined, yet the strategies to achieve them are likely 2 Small companies are excluded. 6

3 to change. The main difference to large enterprises is exactly this flexibility. While large companies usually take decisions based on facts and figures, SMEs frequently decide based on qualitative, long-term aspects. The interplay between culture and strategy leads many SMEs to follow a niche strategy. Haussmann et al. (2006) argue that the focus on market niches is one of the most important characteristics of SME global leaders. In the US and several European countries, there is a clear distinction between SMEs and family firms. In Germany however, the terms are almost synonymous. Middlesized companies can be perceived through two lenses: the social-psychological and the economic. The first one regards the amount of risk an entrepreneur is willing to take, the company s role within the society and the business practices. The second lens brings quantitative criteria forward (Becker, Ebner & Ulrich, 2010). The companies analyzed in the present thesis fulfill both the quantitative criteria provided by the EU as well as the qualitative aspects regarded so far Scholarly Definitions and Auxiliary Theoretical Findings The export-focus of German companies sets them apart in the economic environment. Researchers thus refer to German firms as having an export-oriented BM (Prognos, 2009; Bieger, zu Knyphausen-Aufseß & Krys, 2011). Other renowned BM types are, for example, the B2B or the low-cost BMs. The broad differences in meaning between these three illustrate the wideness of the BM concept. The BM notion continues to gain new definitions. No definition has gained full acceptance up to now. The following subchapters therefore aim to clarify the concepts BM and BMI. BMs are a tool to help managers and entrepreneurs navigate in the more and more complex business landscape. The purpose of BMI is to replace outdated models. Innovation thus begins by questioning and challenging the existing models (Osterwalder & Pigneur, 2010) Business Model Basics Morris, Schindehutte & Allen (2003) mention that scholars discuss BMs as being architectures, patterns, designs, assumptions, methods or plans. The variety of definitions may complicate understanding. Therefore, the purpose of the present subchapter is to build bridges between various definitions and to clarify the aspects for which researchers have used different perspectives. Regarding BMs, three aspects contribute to the fact that no coherent perception has established itself so far: First, the concept is developed in parallel by several groups of researchers. Second, the BM draws on notions and theories from various social sciences: economics, management, psychology and communication. Third, the concept was 7

4 intensively studied from the perspective of the New Economy and narrowed down to e-bms, when, in fact, its applications are much broader (Baden-Fuller & Morgan, 2010; Ghaziani & Ventresca, 2005; Teece, 2010). Chesbrough (2007) states that each BM has two purposes: to create value and to capture it. This view is shared by most researchers: among others, Osterwalder & Pigneur, 2010; Casadesus-Masanell & Ricart, 2011; Wirtz, 2011; Johnson, Christensen & Kagermann, 2008; Johnson, 2010a & 2010b. Value creation encompasses the whole chain of activities which lead a company to meet the needs of its customers. Value capture refers only to the activities through which a company receives a return from its customers. The return is generally a monetary payment, but it can also be advertising or as will be shown in subchapter for the multi-sided platforms simply the maintained fidelity of a certain customer group. Osterwalder et al. (2005) very concisely define a BM as the blueprint for operating a business. The Business Model Canvas developed by Osterwalder & Pigneur (2010) can also be structured into value creation (the left side) and value capture (the right side) see figure 1. Figure 1: Business Model Canvas divided into value creation and value capture Key Activities Customer Relations Key Partners Value Proposition Customers Key Resources Channels Costs Revenues Value Creation Value Capture Source: Own illustration, based on Osterwalder & Pigneur, 2010, pp A strong linkage between BMs and strategy is observed by Casadesus-Masanell & Ricart (2011), Wirtz (2011), Richardson (2008), Shafer, Smith & Linder (2005) and Cavalcante, Kesting & Ulhøi (2011). Casadesus-Masanell & Ricart (2011) encourage companies to think in terms of choices and consequences when discussing BMs. Thus, a company s policy, asset and governance choices are shaping its value creation and value capture (see figure 2). The policy refers to all processes performed by the company. A large influencer in this process is company culture. Asset choices are choices about resources: e.g., employees, capital and know-how. Finally, governance choices refer to who performs a certain activity: whether the company conducts the activity itself or it buys it on the market. 8

5 Figure 2: The link between strategy and the BM Strategy Choices Policy Assets Governance Consequences Value creation Value capture Business model Source: Own illustration, based on Casadesus-Masanell & Ricart, 2011, p. 103 & p Cavalcante, Kesting & Ulhøi (2011) define a company s BM as the sum of its key recurrent standard processes. BMI is therefore only triggered by innovations in these specific areas. The key recurrent standard processes can be linked to Osterwalder & Pigneur s (2010) BM building blocks. Osterwalder & Pigneur also consider that BMI can only be achieved through the innovation of the building blocks. Cavalcante, Kesting & Ulhøi (2011) mention that a company which performs radical BMI (or BM revision), replaces an old key process with a new one, in order to develop an alternative way of conducting business. According to Mitchell & Coles (2003), a BM is the sum of several questions: who, what, where, when, why, how and how much a company uses in order to offer products and services. Figure 3 gives an overview of these components. All seven components correspond to the BM building blocks which make up the value creation. BMI is defined as the effective change in at least four of these elements, which increases the company s performance and leads to a new offering. The researchers see BMI as the managerial practice which rewards the company with the highest growth (Mitchell & Coles, 2004a). 9

6 Figure 3: BM components How much Who What How Business model Johnson (2010b) defines the BM as the sum of those elements which allow a company to deliver value to its customers while also delivering value for itself. Again, a link to value creation and value capture is made. The author (2010a) thus proposes the Four Box model a framework for BM analysis. The four boxes comprise the custom- Where Why When Source: Own illustration, based on Mitchell & Coles, 2003, p. 18. Johnson, Christensen & Kagermann (2008) suggest that BMI implies innovation in any of the following: value proposition, customer groups, offer distribution, resources, processes, revenues and costs. This definition bears much resemblance to the definition of Osterwalder & Pigneur (2010). Johnson, Christensen & Kagermann (2008) additionally mention that the rules and norms governing the company may also be subject to change in the BMI process. Zott & Amit (2012) consider the BM to be the task which a company sets for itself and wishes to fulfill. According to the researchers, a BM is a set of interdependent activities which define the way a company does business with its suppliers, customers and other partners. The BM is based on an activity system, a bundle of particular activities. These are performed in order to fulfill the needs of the customers. Furthermore, a BM is a holistic approach and does not have a certain business process in focus. In their studies, Amit & Zott (2010, 2012) use a company s activity as the unit of analysis and the activity system as the level of analysis. The activity system finds an equivalent in the Business Model Canvas developed by Osterwalder & Pigneur (2010). BMI is the redesign of a company s activity system. It encompasses both small-scale yet meaningful improvements as well as game-changing breakthrough moves (see figure 4). Opposed to Mitchell & Coles (2003), Amit & Zott (2010) see the focus of a BM not in the what, when and where, but only on how business is done. Amit & Zott consider that BMI is a tool which helps managers understand that the trade-off between costs and benefits of doing business is only apparent (Amit & Zott, 2012). 10

7 er value proposition, key resources, key processes as well as the profit formula and are illustrated in figure 5. Figure 4: Reach of BMIs Breakthrough moves Design of a completely new model Business model innovation Small steps Source: Own illustration, based on Amit & Zott, 2010, p. 2. Modification of an existing model Figure 5: BM as a four box model Key resources Key processes Value proposition Revenue model Quantity * Price Cost structure Direct Costs Indirect Costs Overhead Profit formula Margin model Profit margin in % Resource velocity = = = = Widgets invented, designed, produced, shipped, serviced, and sold Source: Own illustration, based on Johnson, 2010a, p. 24. The value proposition box describes the way in which a company fulfills its customers needs: through products, services or a combination of both. The profit formula is based on the value proposition and analyzes the payment mechanisms through which value is captured for the company (Johnson, 2010b). The profit formula is further divided into four components. Besides revenue model and cost structure, which also appear in Osterwalder & Pigneur s Business Model Canvas, there are the margin model and resource velocity. The margin model is a useful tool in clarifying why and how a low-margin BM can still be profitable. Resource velocity is analyzed for a given amount of time and investment, for which the company delivers the value proposition (Johnson, 2010b). It thus shows how innovative the company is. In the top box, the key resources and key processes are illustrated. These do not include all elements of the value chain, but only the ones which are vital for delivering the value proposition (Johnson, 2010b). 11

8 Comparing the Four Box model with the Business Model Canvas, four main similarities arise: key resources, processes (activities), value proposition, revenue and cost structure have the comparable weight and meaning in both models. However, while Johnson pays more attention to the profit formula and explains it in-depth, Osterwalder & Pigneur emphasize the interaction between the company, its customers and its partners. A summary of the BM concept is given by Eriksson & Penker (2000). According to the authors, a BM fulfills two functions: it first serves for understanding the key mechanics of the business as seen above, value creation and value capture. Second, it is a platform for experimentation and for organizational improvement, as will be illustrated in subchapter 3.3, which discusses BMI implementation Business Model Innovation Characteristics Innovation research streams can be found in social, political and natural sciences, as well as in economics and in the business administration field. Innovation, like the BM concept, is subject of different views and there is yet no full consensus on its purpose or economic effects. The term is used in a variety of contexts, some of which are less well-suited. Usage inflation in the media also diminishes the public s ability to properly understand the concept (Wirtz, 2011). After illustrating BM design in the previous subchapter, it may be useful to present several innovation characteristics, as discussed by Hauschildt & Salomo (2007): Innovation leads to a substantial differentiation from the initial situation. Innovation implies not only an invention, but also its valorization on the market (Roberts, 1987). An innovation can be either the result of a demand pull or a technology push. Innovation has a procedural structure. Many authors consider BMI to be the third innovation pillar, next to product and process innovation (PPI) (Zollenkop, 2006). BMI is, however, a relatively abstract field in comparison to PPI (Wirtz, 2011). One of the main differences between PPI and BMI is the higher abstraction degree implied by the latter. While PPI involves concrete transformation on value-adding process level, BMI entails transformations of the value proposition or of the value constellation. The value constellation is explained in the next paragraph. Interdependencies between PPI and BMI can also be observed: product innovations may require changes in the production process or in the BMs supporting them. Besides that, BMI often calls for transformation on process level. However, process innovation takes place on the operational level, while BMI is performed on a strategic level (Wirtz, 2011). A BMI key characteristic, discussed at length in the literature, is the change in the value proposition resulting from the innovation. Beside the value proposition, many authors consider the value constellation to be one of the best fit subjects for BMI. The 12

9 value constellation is the structure of the value creation. In this context, the value chain is subject to change: i.e. putting aside or outsourcing value-adding activities or, on the contrary, integrating new partners in the value-adding process, for example customers (Wirtz, 2011). In the literature there is wide accord regarding the practical relevance of BMI and its importance for company development. Here, as in the theory of BMs, several research streams can be identified: Several of them suggest that a company has a range of influencing factors which lead to BMI: Chesborugh (2006, 2010), Johnson, Christensen & Kagermann (2008) as well as Zott & Amit (2007, 2008, 2010) share this view. Other studies find, contrary to this, that the innovation itself models a company s characteristics: Casadesus-Masanell & Ricart (2010) as well as Sosna, Trevinyo-Rodriguez & Velamuri (2010). Another aspect considered in the literature is BMI structuring: While some researchers view the process as being well-structured and organized, others perceive it as rather chaotic. Chesbrough (2006, 2010), Casadesus-Masanell & Ricart (2010) as well as Sosna, Trevinyo-Rodriguez & Velamuri (2010) regard BMI as a relatively unstructured process and quite often a trial-and-error method. Contrary to this, Johnson, Christensen & Kagermann (2008) and Zott & Amit (2007, 2008, 2010) view it as a structured and planned task of the management. Open for discussion remains also the degree of innovation starting from which a BM change can be considered a BMI. A BM change becomes BMI if it has a radical character at least for the company itself, if not for the whole industry (Johnson, Christensen & Kagermann, 2008; Demil & Lecocq, 2010). Johnson, Christensen & Kagermann (2008) recommend BMIs which are novel or ground-breaking for the whole industry, and not just for the company itself. Unlike BMs, BMIs are not perceived at a specific moment in time, but in their evolution (Demil & Lecocq, 2010). The present thesis aims, in this context, to illustrate steps, rather than end results of BMI in middle-sized companies Reasons to Innovate the Business Model Chesbrough (2007) makes a compelling case for BMI, stating that R&D and technological innovations are not sufficient in our age. While the costs for developing unique products have sharply risen, their life cycles have shortened. Imitations ultimately lead to the commoditization of once novel products. Innovative BMs can therefore make the difference by shedding new light on the needs of the customer. Goffin, Herstatt & Mitchell (2009) find that chiefly three factors lead to innovations in the BM field: technological leaps and increasing competition paired with changing customer demands (dynamic market environment). 13

10 Johnson (2010b) structures the situations which call for BMI into threats and opportunities. There are two main types of threats: commoditization and disruptive innovations. Commoditization occurs when industries mature. In young industries, companies compete on performance. Since customers pay more for the product which performs better, there is also a high demand for product innovation. Sooner or later, firms develop ways to make a certain product offer the customer everything that is asked from it. Thus the basis of competition shifts from innovation to reliability. When a product is offered by more and more competitors, customers will be willing to pay premium prices for the product which lasts the longest or hardly ever malfunctions. In the long run, the basis of competition shifts again, to convenience and customization. Customers expect products which are easily available as well as custom-built. Finally, a market becomes purely commoditized when customers are not willing to pay premium prices for additional benefits and a low price becomes the only competitive advantage (Johnson, 2010b). Starting from the third market maturity stage, companies generally require new BMs. Customization and convenience often require operating processes and delivery systems which are at odds with traditional BMs. If a traditional company wishes to offer its customers the possibility to design or assemble products themselves, it has to change parts of its BM, such as the value proposition, distribution system or customer relations (Johnson, 2010b). The second threat against which BMI is proved to be effective is disruption. When a company faces disruptive innovations by competitors, it is generally the low-end customers who are first lost (as was the case of steel mills vs. mini-mills, minicomputers vs. personal computers). If the incumbent decides to settle for only the high-end (and generally high-margin) customers and accept the loss of the low-end ones, it runs the risk to slowly lose its whole customer base. Commoditization interacts in this process as well. Therefore, the incumbent should experiment with BMs designed especially for the most endangered customer segment (Johnson, 2010b; Bower & Christensen, 1995). Beside the above-mentioned threats, there are several market opportunities which call for BMI: market democratization and opening new markets (exploration), product and service innovation (expansion) as well as securing the current BM (adaptation). Market democratization represents an opportunity for BMI, when products are too expensive, complicated or time-consuming. The lack of financial resources, time, skill or access is a frequent barrier for customers to accomplish a certain task. The computer market is one example in this sense. Computers evolved from mainframe to minicomputers, to PCs, laptops, netbooks, handheld computers, tablets and ultrabooks. Almost at each stage of this process another company dominated the industry each company having a different BM than the previous one (Johnson, 2010b). Casadesus-Masanell & Ricart (2011) emphasize the need for opening new markets in developing countries as one of the most important triggers for BMI. Especially the 14

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