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Our paper about building a business model and strategy how they work together.
Building a Business
Model and Strategy:
How They Work Together
Excerpted from
Entrepreneur’s Toolkit:
Tools and Techniques to Launch and Grow Your Business
Harvard Business School Press
Boston, Massachusetts
ISBN-10: 1-4221-0533-4
ISBN-13: 978-1-4221-0533-7
5337BC
Purchased by: Janet Le [email protected] on February 05, 2014
Copyright 2006 Harvard Business School Publishing Corporation
All rights reserved
Printed in the United States of America
This chapter was originally published as chapter 4 of Entrepreneur’s Toolkit,
copyright 2005 Harvard Business School Publishing Corporation.
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Purchased by: Janet Le [email protected] on February 05, 2014
Building a Business Model
and Strategy
Key Topics Covered in This Chapter
•
how the business model explains the way
key components of the enterprise work
together to make money
•
examples of two powerful business models
•
how strategy can confer competitive advantage
•
a ?ve-step process for formulating strategy
and aligning activities with it
•
why strategic thinking must be ongoing
How They Work Together
4
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A
fter you’ve identi?ed a money-making opportunity
and created a plan for addressing it, answer these three
important question:
1. How will our new business create value for customers?
2. How will it make a pro?t for us and our investors?
3. How will the business differentiate itself from competitors?
An entrepreneur should be able to provide concise answers to
anyone who asks these questions. If you don’t yet have the answers
for your business, this chapter’s primer on business models and strat-
egy will help you.
Business executives, consultants, and the business media use the
terms business model and strategy casually and generally without rigor.
Many, when pressed, cannot de?ne either term. Don’t be one of
them. As an entrepreneur, you cannot afford fuzzy thinking about
these important and very different concepts. As this chapter explains,
a business model identi?es your customers and describes how your
business will pro?tably address their needs. Strategy, on the other
hand, is about differentiating how your business satis?es customers.
Both are required for success.
Your Business Model
The term business model ?rst came into popular use in the late 1980s,
after many people had gained experience with personal computers
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and spreadsheet software. Thanks to these digital innovations, entre-
preneurs and analysts found that they could easily “model” the costs
and revenues associated with any proposed business. After the model
was set up, it took only a few keystrokes to observe the impact of in-
dividual changes—for example, in unit price, pro?t margin, and
supplier costs—on the bottom line. Pro forma ?nancial statements
were the primary documents of business modeling. By the time dot-
com fever had become rampant, the term business model had become
a popular buzzword. Still, most people were unable to articulate ex-
actly what it meant.
In the most basic sense, a business model describes how an en-
terprise proposes to make money. Two Harvard Business School
professors—Richard Hamermesh and Paul Marshall—have gone
beyond this basic de?nition. They have de?ned business model as “a
summation of the core business decisions and trade-offs employed
by a company to earn a pro?t.” The decisions and trade-offs they
refer to fall into four groups:
• Revenue sources. This money comes from sales, service fees,
advertising, and so forth.
• Cost drivers. Examples are labor, goods purchased for resale,
and energy.
• Investment size. Every business needs a measurable level of in-
vestment to get off the ground and, in the case of working cap-
ital, to keep it operating.
• Critical success factors. Depending on the business, a success
factor might be the ability to roll out new products on a sus-
tained basis, success in reaching some critical mass of business
within a certain time, and so on.
1
How would you describe your company or business concept in
terms of these model elements? Have you nailed down your revenue
sources and the factors that will drive costs for your business? Do you
know which costs will be ?xed and which will vary with sales vol-
ume? Have you calculated the capital you’ll need to launch and op-
erate the business? What factors are essential for success? Try to
Building a Business Model and Strategy 3
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answer each of these questions unambiguously, and do so before you
approach any investors.
Management consultant Joan Magretta has provided a useful in-
troduction to business models in “Why Business Models Matter,” a
2002 Harvard Business Review article in which she views a business
model as some variation of the value chain that supports every busi-
ness. “Broadly speaking,” she writes, “this chain has two parts. Part
one includes all the activities associated with making something: de-
signing it, purchasing raw materials, manufacturing, and so on. Part
two includes all the activities associated with selling something: ?nd-
ing and reaching customers, transacting a sale, distributing the prod-
uct or delivering the service.”
2
How would you describe your enterprise in terms of Magretta’s
de?nition? Does your model tell a logical, sensible story? If you were
to represent your model on a pro forma income statement with rea-
sonable projections of revenues and expenses, would it be pro?table?
Some of today’s most powerful and pro?table companies grew out
of business models that were elegant and compelling in their logic and
powerful in ?nancial potential. Let’s consider two that are probably fa-
miliar to you: Dell Computer and eBay. These examples will help you
understand the concept of a business model and its importance.
Example: Dell
Michael Dell went into the personal computer business when Apple,
IBM, and a handful of other producers were already established in the
market. These manufacturers sold through resellers and maintained
large inventories to accommodate the variety of PC features that cus-
tomers had come to expect. Both practices were costly for the man-
ufacturers, which had to give substantial discounts to resellers. At the
same time they took heavy losses in ?nished-goods inventory when-
ever the blistering pace of new product introductions made those in-
ventories seem old-fashioned. By one estimate, PCs lost 2 percent of
their value each day they sat in the ?nished-goods storeroom!
Dell’s business model avoided both of these pro?t-sapping prob-
lems. As everyone now knows, Dell identi?ed his target market
(fairly knowledgeable computer users who needed no hand-holding
4 Entrepreneur’s Toolkit
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by store salesclerks) and sold directly to it, skipping middleman costs.
At the same time he designed the business to avoid the cost of ?n-
ished-goods inventory. His solution was simple: Don’t have ?nished-
goods inventory. For the most part, Dell built only machines for
which the company had orders (and payments!), and it built those
machines to order—a major competitive plus. Dell’s ?nished goods
were not sitting in warehouses and losing value in anticipation of
customer orders; they were in delivery trucks headed toward waiting
customers. The business model facilitated this make-to-order
arrangement through a fast and ?exible supply chain of component
makers and just-in-time assemblers.
One of the more remarkable aspects of the Dell business model was
its collection of payments in advance of ?lling customer orders. There
was no 30- to 60-day accounts receivable to be ?nanced with working
capital. There were no uncollectibles. Instead, the company turned the
traditional cash conversion cycle on its head, receiving customer pay-
ments immediately and paying its own suppliers after 30 days.
Example: eBay
eBay, the online auction company, grew out of an even simpler
model. Like a telephone company, eBay created an infrastructure
that allowed people to communicate—for a modest fee—with each
other. Its Web-based infrastructure of software, servers, and rules of
behavior allows a community of buyers and sellers to meet and con-
duct transactions for all manner of goods—from Elvis memorabilia
to used Porsches. The company takes no part in the transactions,
thereby avoiding many of the costs incurred by other businesses. As
described by author David Bunnell, eBay “has no responsibility for
goods offered at auction, for collecting buyer’s payments, or for ship-
ping. Its only responsibilities are to maintain the integrity of the auc-
tion process and the information linkages that make it feasible, and
to bill and collect the fees it charges sellers.”
3
As a mechanism for generating income, the eBay model is simple.
It receives revenues from seller fees. Those revenues are reduced by the
cost of building and maintaining the online infrastructure and by the
usual marketing, product development, general, and administrative
Building a Business Model and Strategy 5
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costs that keep the operation running and that attract buyers and sell-
ers to the site. The net of these revenues and costs is pro?ts for eBay
shareholders.
Aside from its simplicity, the great power of the eBay model is
the fact that a small number of salaried employees and outsource
partners can handle a huge and growing volume of business. Fur-
ther, a doubling of transaction volume (and revenue) can be accom-
modated with relatively modest investments. Software and servers do
6 Entrepreneur’s Toolkit
Testing Your Business Model
How well do you understand the business model of your pro-
posed enterprise? Make sure that the model is clear, complete,
and logical before you invest more time and money. In particu-
lar, note these tips:
• Be very clear about your revenue sources and the strength of
customer attraction to your product or service.
• Map out all tasks that must be accomplished in producing value
for customers—either by you or by an outsource partner.
• Translate your model into numbers by estimating revenue
?gures and associated costs.
After you’ve done all these things, use your model as a think-
ing tool. Look for weaknesses. Ask trusted and experienced
friends for assessments of the model’s feasibility. Test its compo-
nent parts. For example, use market research to verify your rev-
enue estimates; determine the interest of your target customers
in your product or service, and ?nd out what they are willing to
pay for it. If the model calls for outsourcing particular activities
in the value chain, con?rm that such outsourcing support is
available at a cost you can afford. Think creatively about how
key tasks in the value chain could be done better—by produc-
ing higher perceived quality, greater customer convenience,
faster delivery, or lower cost. In some cases, being distinctively
better at only one key task is the ticket to commercial success.
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Building a Business Model and Strategy 7
the heavy lifting. This adds power to the eBay business model. Its
heavy reliance on ?xed costs over variable costs gives the company
enormous operating leverage, allowing the larger part of incremen-
tal revenue increases to fall to the bottom line.
Strategy
A business model will help you—and anyone you approach for
funding—to understand what your business will do and how all its
key parts ?t together. But a well-conceived and promising business
model is only half the equation for success, because it doesn’t take
into account the market competition. Dealing with competition is
the job of strategy. Strategy, in fact, is a plan to differentiate the en-
terprise and give it a competitive advantage. A successful business has
both a solid business model and a good strategy.
Bruce Henderson, founder of Boston Consulting Group, once
wrote that competitive advantage is found in differences: “The dif-
ferences between you and your competitors are the basis of your
advantage.”
4
Henderson believed that no two competitors could co-
exist if they sought to do business in the same way. They must dif-
ferentiate themselves to survive. He wrote, “Each must be different
enough to have a unique advantage.” For example, two men’s cloth-
ing stores on the same block—one featuring formal attire and the
other focusing on leisure wear—can potentially survive and prosper.
However, if the same two stores sold the same things under the same
terms, one or the other would perish. More likely, the one that dif-
ferentiated itself through price, product mix, or ambiance would
have the greater likelihood of survival. Harvard Business School pro-
fessor Michael Porter concurs: “Competitive strategy is about being
different. It means deliberately choosing a different set of activities to
deliver a unique mix of value.”
5
Consider these examples:
• Southwest Airlines didn’t become the most pro?table air carrier
in North America by copying its rivals. It differentiated itself
with low fares, frequent departures, point-to-point ?ights, and
customer-pleasing service.
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• eBay created an entirely new way for people to sell and ac-
quire new and used goods: online auctions. The company’s
founders aimed to serve the same purpose as classi?ed ads, ?ea
markets, and formal auctions but made it simple, ef?cient, and
wide-ranging.
• Toyota’s strategy in developing the hybrid engine Prius passen-
ger car was to create a competitive advantage within an impor-
tant segment of auto buyers: people who want a vehicle that is
either environmentally benign, cheap to operate, or the latest
thing in auto engineering. The company also hoped that the
learning associated with the Prius would give it leadership in a
technology having huge future potential.
Strategies can be based on low-cost leadership, technical differ-
entiation, or focus. They can also be understood in terms of strate-
gic position. Michael Porter has postulated that strategic positions
emerge from three, sometimes overlapping, sources:
6
• Variety-based positioning. Here, a company chooses a narrow
subset of product or service offerings from within the wider set
offered in its industry. It can succeed with this strategy if it de-
livers faster, better, or at lower cost than competitors. For ex-
ample, Starbucks offers premium coffee products and places its
outlets in locations that are convenient for potential customers.
It doesn’t serve breakfast or sell sandwiches. Customers can get
those products elsewhere. Its focus is on coffee.
• Need-based positioning. Companies that follow this approach,
according to Porter, aim to serve all or most of the needs of an
identi?able set of customers. These customers may be price
sensitive, may demand a high level of personal attention and
service, or may want products or services that are uniquely
tailored (customized) to their needs. For example, USAA is a
?nancial services company that caters exclusively to active-duty
and retired military of?cers and their families. After decades of
serving this population, USAA understands its unique banking,
8 Entrepreneur’s Toolkit
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Building a Business Model and Strategy 9
Fred’s Business Model
Recall Fred’s plan for The Hybrid Auto Care Center described
earlier in this book. Fred, the service manager for a dealer sell-
ing the new hybrid autos, sees a pro?table business in the repair
and maintenance of these gasoline-electric vehicles, especially
after their manufacturers’ warranties expire. His blueprint is es-
sentially the same one used by auto repair facilities everywhere:
1. Generate customers through local advertising and on-
premises information mini-seminars for owners of these
unique but increasingly popular vehicles.
2. Have the internal capabilities to diagnose and repair dam-
aged and malfunctioning hybrid engine vehicles of all
major manufacturers.
3. Establish a replacement parts pipeline with several regional
distributors.
4. Establish outsourcing relationships with a top-quality body
shop and an auto air conditioning service company so that
personnel can concentrate on mechanical problems.
This is Fred’s model for making money. His experience with
hybrid repair work and with running a dealer’s service depart-
ment have made him an expert in the details of pricing and cost
management. By modeling many different types of repairs on a
computer spreadsheet and factoring in known costs for labor,
parts, equipment loans, rent, and overhead, he is convinced
that he can break even with a crew of ?ve employees and eight
thousand “service hours” per year (roughly forty weeks per
year). Everything over that breakeven point should produce a
pro?t. He has worked these ?gures out in a pro forma income
statement.
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insurance, and retirement needs. And it knows how to deal
with the fact that military of?cers are often transferred from
post to post around the world and are often assigned to remote
locations for extended periods where they are unable to re-
spond to monthly billings.
• Access-based positioning. Some strategies can be based on ac-
cess to customers. A discount merchandise chain, for example,
might choose to locate its stores exclusively in low-income
neighborhoods. This reduces competition from suburban shop-
ping malls and provides easy access for its target market of low-
income shoppers, many of whom do not have automobiles.
Cracker Barrel Old Country Store, in contrast, locates its
restaurant/gift stores along the U.S. expressway system, where
it caters to travelers. Its Web site even includes a “trip planner”
that identi?es the locations of all Cracker Barrel outlets along
any “to-from” driving route.
What is your strategy for gaining competitive advantage? Will it
differentiate your company in ways that attract customers from ri-
vals? Will it draw new customers into the market? Will it give you a
tangible advantage?
Simply being different, of course, will not keep you in business;
something that is different must be perceived as valuable. And cus-
tomers de?ne value in different ways: lower cost, greater conven-
ience, greater reliability, faster delivery, or more aesthetic appeal.
The list of customer-pleasing “values” is extremely long. What
value does your strategy aim to provide? Can it deliver?
Steps for Formulating Strategy
Here are six steps you can follow in formulating a strategy. They in-
volve looking outside and inside your organization, thinking about
how you will deal with threats and opportunities as they present
themselves, building a good ?t with strategy-supporting activities,
aligning resources with goals, and organizing for execution.
10 Entrepreneur’s Toolkit
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STEP 1: LOOK OUTSI DE TO I DENTI FY THREATS AND OPPORTU-
NITI ES. At the highest level, strategy is concerned with analyzing
the outside environment and determining how the company’s ?nan-
cial resources, people, and capacity should be allocated to create an
exploitable advantage. There are always threats in the outside envi-
ronment: new entrants, demographic changes, suppliers who might
cut you off, substitute products that your customers could turn to,
and macroeconomic trends that may reduce the ability of your cus-
tomers to pay. The business you have in mind may be threatened by
a competitor that can produce the same quality goods at a much
lower price—or a much better product at the same price. A strategy
must be able to cope with these threats.
The external environment also harbors opportunities: a new-to-
the-world technology, an unserved market, and so forth. So ask
yourself these questions:
• What is the economic environment in which we must operate?
How is it changing?
• What opportunities for pro?table action lie before us?
• What are the risks associated with various opportunities and
potential courses of action?
STEP 2: LOOK INSIDE AT RESOURCES, CAPABILITIES, AND PRAC-
TICES. Resources and internal capabilities can be a constraint on
your choice of strategy, especially for a small start-up with few em-
ployees and ?xed assets. And rightly so. A strategy to exploit an un-
served market in the electronics industry, for example, might not be
feasible if your ?rm lacks the necessary ?nancial capital and the
human know-how to exploit it. A strategy can succeed only if it has
the backing of the right set of people and other resources. So ask
yourself these questions:
• What are our competencies as an organization? How do these
give us an advantage relative to competitors?
• What resources support or constrain our actions?
Building a Business Model and Strategy 11
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STEP 3: CONSI DER STRATEGI ES FOR ADDRESSI NG THREATS
AND OPPORTUNITI ES. Clay Christensen has recommended that
strategists ?rst prioritize the threats and opportunities they ?nd (he
calls them “driving forces” of competition) and then discuss each in
broad strokes. If you follow this advice and develop strategies to deal
with them, be sure to do the following:
• Create many alternatives. There is seldom only one way to do
things. In some cases, the best parts of two strategies can be
combined to make a stronger third strategy.
• Check all facts, and question all assumptions.
• Some information is bound to be missing. Determine what in-
formation you need to better assess a particular strategy. Then
get the information.
• Vet the leading strategy choices among the wisest heads you
know. Doing so will help you avoid groupthink within your
team.
STEP 4: BUI LD A GOOD FIT AMONG STRATEGY-SUPPORTI NG
ACTIVITI ES. Michael Porter has made the point that strategy is more
than just a blueprint for winning customers; it is also about combin-
ing activities into a chain whose links are mutually supporting and ef-
fective in locking out imitators.
7
He uses Southwest Airlines to
illustrate his notion of ?t.
Southwest’s strategy is based on rapid gate turnaround. Rapid
turnaround allows SWA to make frequent departures and better uti-
lize its expensive aircraft assets. This, in turn, supports the low-cost,
high-convenience proposition it offers customers. Thus, each of
these activities supports the others and the higher goal. That goal,
Porter points out, is further supported by other critical activities,
which include highly motivated and effective gate personnel and
ground crews, a no-meals policy, and a practice of not making in-
terline baggage transfers. Those activities make rapid turnarounds
possible. “Southwest’s strategy,” writes Porter, “involves a whole sys-
12 Entrepreneur’s Toolkit
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tem of activities, not a collection of parts. Its competitive advantage
comes from the way its activities ?t and reinforce one another.”
8
STEP 5: CREATE ALIGNMENT. After you’ve developed a satisfac-
tory strategy, your job is only half ?nished. The other half is to cre-
ate alignment between the people and activities of the company and
its strategy. Alignment is a condition in which every employee at
every level (1) understands the strategy and (2) understands his or her
role in making the strategy work. Alignment is a powerful thing.
Make sure that you have it working in your favor.
Alignment also involves other resources. Marketing must be fo-
cused on the right customers—the ones de?ned in the strategy.
Compensation and bonuses must be aligned with behaviors and
performance that advance the strategy. And physical assets must be
deployed—aligned—with the highest goals of the organization.
STEP 6: BE PREPARED TO I MPLEMENT. A powerful strategy is
impotent if your organization isn’t prepared to implement it effec-
tively. Unfortunately, some people get so carried away with the de-
tails of their strategy that they forget about the downstream activities
required to make it work. One of the bene?ts of an entrepreneurial
start-up is that you’re beginning with a clean slate. After you have a
strategy, you have a free hand in organizing around it: hiring people
with the necessary competencies, acquiring the right equipment,
structuring these resources, and so forth. As UCLA’s Alfred E. Os-
borne Jr. has put it, “I think of the 4 S’s: structure follows strategy,
and staf?ng follows structure, and you hold the strategy together
with systems.”
9
Be Prepared for Change
The initial strategies of start-up companies often fail to hit the mark.
Customers don’t value the differentiation—or they don’t respond to
it as anticipated. Or the company is mistaken in its choice of target
customers. These failures happen because every start-up business is
Building a Business Model and Strategy 13
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an experiment to some degree. The outcome of this experiment can
surprise and disappoint even the best planners. For example, Web-
van’s founders and investors thought that a Web-based grocery deliv-
ery business was a perfect idea for af?uent, Web-savvy, time-starved
households. But those customers balked at the higher price of buy-
ing their weekly groceries. To them, the extra convenience wasn’t
worth it.
The entrepreneur’s antidote to a disappointing strategy is a will-
ingness to (1) recognize the bad news and (2) respond quickly with
a revised strategy. Recognition requires the ability to admit a mis-
take. Responding requires an energetic search for what went wrong
and the ?exibility to make adjustments and get back into the game.
14 Entrepreneur’s Toolkit
Fred’s Strategy for The Hybrid Auto Care Center
Strategy is about being different and choosing a different set of
activities to deliver a unique mix of value to customers. Let’s
consider our hypothetical friend Fred and the strategy of his
auto repair and maintenance facility.
Fred has clearly differentiated his business. Every town and
every city has many automotive service businesses, but one that
specializes in hybrid engine vehicles will be very different. Fred
can use that distinctiveness to gain customer attention and
recognition. You can almost hear the advertising: “If your hy-
brid car needs maintenance or repair, bring it to the specialists at
The Hybrid Auto Care Center. They will do the job right and
usually at lower cost than your dealer.”
Fred must also deliver on that offer of greater know-how
and high-quality work. To do that, Fred must acquire the right
resources and align them in support of his distinctive offer. For
example, he must hire or train mechanics who really know
how to deal with the unique problems of hybrid cars. He must
also acquire the tools and diagnostic equipment required by
those vehicles.
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Successful entrepreneurs are adept at both of these things. They are
also masters of incrementalism—that is, if they ?nd that something
is working, they do more of it. If they achieve success in a small,
niche market, they use what they have and what they have learned
to enter another niche—altering the product or service as necessary.
A powerful business model and a sound strategy are essential if
your venture aims to be competitive and pro?table. Although the
market provides the ultimate test for these two important concepts,
you should test and verify every one of your assumptions before the
business is launched. And remember that many minds are better than
one. Explain your business model and strategy to as many trusted
and experienced people as possible. They may spot defects or op-
portunities for improvement that you have missed.
Summing Up
• A business model describes an enterprise’s revenue sources, cost
drivers, investment size, and success factors.
• Strategy differentiates the enterprise and gives it a competitive
advantage.
• Per Michael Porter, strategic positions can be found in variety-
based, need-based, or access-based positioning.
• The ?ve steps of strategy formulation are (1) looking outside
the enterprise for threats and opportunities, (2) looking inside
at resources, capabilities, and practices, (3) considering strate-
gies for addressing threats and opportunities, (4) building a
good ?t among strategy-supporting activities, and (5) creating
alignment between the organization’s people and activities and
its strategy.
• A start-up business should be viewed as an experiment. If the
experiment fails to produce the desired result, be prepared to
change—and quickly.
Building a Business Model and Strategy 15
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Notes
Chapter 4
1. Richard G. Hamermesh and Paul W. Marshall, “Note on Business
Model Analysis for the Entrepreneur,” Class Note 9-802-048, Harvard
Business School Publishing, Boston, 22 January 2002, 1.
16
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2. Joan Magretta, “Why Business Models Matter,” Harvard Business
Review, May 2002, 86–92.
3. David Bunnell, (with Richard Luecke) The eBay Phenomenon (New
York: John Wiley & Sons, 2000), 77.
4. Bruce Henderson, “The Origin of Strategy,” Harvard Business Re-
view, November-December 1989.
5. Michael E. Porter, “What Is Strategy?” Harvard Business Review,
November-December 1996: 61–78.
6. Ibid.
7. Ibid., 12–13.
8. Ibid., 12.
9. Professor Alfred E. Osborne, memo to writer, 21 March 2004.
17 Notes
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Our paper about building a business model and strategy how they work together.
Building a Business
Model and Strategy:
How They Work Together
Excerpted from
Entrepreneur’s Toolkit:
Tools and Techniques to Launch and Grow Your Business
Harvard Business School Press
Boston, Massachusetts
ISBN-10: 1-4221-0533-4
ISBN-13: 978-1-4221-0533-7
5337BC
Purchased by: Janet Le [email protected] on February 05, 2014
Copyright 2006 Harvard Business School Publishing Corporation
All rights reserved
Printed in the United States of America
This chapter was originally published as chapter 4 of Entrepreneur’s Toolkit,
copyright 2005 Harvard Business School Publishing Corporation.
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Building a Business Model
and Strategy
Key Topics Covered in This Chapter
•
how the business model explains the way
key components of the enterprise work
together to make money
•
examples of two powerful business models
•
how strategy can confer competitive advantage
•
a ?ve-step process for formulating strategy
and aligning activities with it
•
why strategic thinking must be ongoing
How They Work Together
4
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A
fter you’ve identi?ed a money-making opportunity
and created a plan for addressing it, answer these three
important question:
1. How will our new business create value for customers?
2. How will it make a pro?t for us and our investors?
3. How will the business differentiate itself from competitors?
An entrepreneur should be able to provide concise answers to
anyone who asks these questions. If you don’t yet have the answers
for your business, this chapter’s primer on business models and strat-
egy will help you.
Business executives, consultants, and the business media use the
terms business model and strategy casually and generally without rigor.
Many, when pressed, cannot de?ne either term. Don’t be one of
them. As an entrepreneur, you cannot afford fuzzy thinking about
these important and very different concepts. As this chapter explains,
a business model identi?es your customers and describes how your
business will pro?tably address their needs. Strategy, on the other
hand, is about differentiating how your business satis?es customers.
Both are required for success.
Your Business Model
The term business model ?rst came into popular use in the late 1980s,
after many people had gained experience with personal computers
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and spreadsheet software. Thanks to these digital innovations, entre-
preneurs and analysts found that they could easily “model” the costs
and revenues associated with any proposed business. After the model
was set up, it took only a few keystrokes to observe the impact of in-
dividual changes—for example, in unit price, pro?t margin, and
supplier costs—on the bottom line. Pro forma ?nancial statements
were the primary documents of business modeling. By the time dot-
com fever had become rampant, the term business model had become
a popular buzzword. Still, most people were unable to articulate ex-
actly what it meant.
In the most basic sense, a business model describes how an en-
terprise proposes to make money. Two Harvard Business School
professors—Richard Hamermesh and Paul Marshall—have gone
beyond this basic de?nition. They have de?ned business model as “a
summation of the core business decisions and trade-offs employed
by a company to earn a pro?t.” The decisions and trade-offs they
refer to fall into four groups:
• Revenue sources. This money comes from sales, service fees,
advertising, and so forth.
• Cost drivers. Examples are labor, goods purchased for resale,
and energy.
• Investment size. Every business needs a measurable level of in-
vestment to get off the ground and, in the case of working cap-
ital, to keep it operating.
• Critical success factors. Depending on the business, a success
factor might be the ability to roll out new products on a sus-
tained basis, success in reaching some critical mass of business
within a certain time, and so on.
1
How would you describe your company or business concept in
terms of these model elements? Have you nailed down your revenue
sources and the factors that will drive costs for your business? Do you
know which costs will be ?xed and which will vary with sales vol-
ume? Have you calculated the capital you’ll need to launch and op-
erate the business? What factors are essential for success? Try to
Building a Business Model and Strategy 3
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answer each of these questions unambiguously, and do so before you
approach any investors.
Management consultant Joan Magretta has provided a useful in-
troduction to business models in “Why Business Models Matter,” a
2002 Harvard Business Review article in which she views a business
model as some variation of the value chain that supports every busi-
ness. “Broadly speaking,” she writes, “this chain has two parts. Part
one includes all the activities associated with making something: de-
signing it, purchasing raw materials, manufacturing, and so on. Part
two includes all the activities associated with selling something: ?nd-
ing and reaching customers, transacting a sale, distributing the prod-
uct or delivering the service.”
2
How would you describe your enterprise in terms of Magretta’s
de?nition? Does your model tell a logical, sensible story? If you were
to represent your model on a pro forma income statement with rea-
sonable projections of revenues and expenses, would it be pro?table?
Some of today’s most powerful and pro?table companies grew out
of business models that were elegant and compelling in their logic and
powerful in ?nancial potential. Let’s consider two that are probably fa-
miliar to you: Dell Computer and eBay. These examples will help you
understand the concept of a business model and its importance.
Example: Dell
Michael Dell went into the personal computer business when Apple,
IBM, and a handful of other producers were already established in the
market. These manufacturers sold through resellers and maintained
large inventories to accommodate the variety of PC features that cus-
tomers had come to expect. Both practices were costly for the man-
ufacturers, which had to give substantial discounts to resellers. At the
same time they took heavy losses in ?nished-goods inventory when-
ever the blistering pace of new product introductions made those in-
ventories seem old-fashioned. By one estimate, PCs lost 2 percent of
their value each day they sat in the ?nished-goods storeroom!
Dell’s business model avoided both of these pro?t-sapping prob-
lems. As everyone now knows, Dell identi?ed his target market
(fairly knowledgeable computer users who needed no hand-holding
4 Entrepreneur’s Toolkit
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by store salesclerks) and sold directly to it, skipping middleman costs.
At the same time he designed the business to avoid the cost of ?n-
ished-goods inventory. His solution was simple: Don’t have ?nished-
goods inventory. For the most part, Dell built only machines for
which the company had orders (and payments!), and it built those
machines to order—a major competitive plus. Dell’s ?nished goods
were not sitting in warehouses and losing value in anticipation of
customer orders; they were in delivery trucks headed toward waiting
customers. The business model facilitated this make-to-order
arrangement through a fast and ?exible supply chain of component
makers and just-in-time assemblers.
One of the more remarkable aspects of the Dell business model was
its collection of payments in advance of ?lling customer orders. There
was no 30- to 60-day accounts receivable to be ?nanced with working
capital. There were no uncollectibles. Instead, the company turned the
traditional cash conversion cycle on its head, receiving customer pay-
ments immediately and paying its own suppliers after 30 days.
Example: eBay
eBay, the online auction company, grew out of an even simpler
model. Like a telephone company, eBay created an infrastructure
that allowed people to communicate—for a modest fee—with each
other. Its Web-based infrastructure of software, servers, and rules of
behavior allows a community of buyers and sellers to meet and con-
duct transactions for all manner of goods—from Elvis memorabilia
to used Porsches. The company takes no part in the transactions,
thereby avoiding many of the costs incurred by other businesses. As
described by author David Bunnell, eBay “has no responsibility for
goods offered at auction, for collecting buyer’s payments, or for ship-
ping. Its only responsibilities are to maintain the integrity of the auc-
tion process and the information linkages that make it feasible, and
to bill and collect the fees it charges sellers.”
3
As a mechanism for generating income, the eBay model is simple.
It receives revenues from seller fees. Those revenues are reduced by the
cost of building and maintaining the online infrastructure and by the
usual marketing, product development, general, and administrative
Building a Business Model and Strategy 5
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costs that keep the operation running and that attract buyers and sell-
ers to the site. The net of these revenues and costs is pro?ts for eBay
shareholders.
Aside from its simplicity, the great power of the eBay model is
the fact that a small number of salaried employees and outsource
partners can handle a huge and growing volume of business. Fur-
ther, a doubling of transaction volume (and revenue) can be accom-
modated with relatively modest investments. Software and servers do
6 Entrepreneur’s Toolkit
Testing Your Business Model
How well do you understand the business model of your pro-
posed enterprise? Make sure that the model is clear, complete,
and logical before you invest more time and money. In particu-
lar, note these tips:
• Be very clear about your revenue sources and the strength of
customer attraction to your product or service.
• Map out all tasks that must be accomplished in producing value
for customers—either by you or by an outsource partner.
• Translate your model into numbers by estimating revenue
?gures and associated costs.
After you’ve done all these things, use your model as a think-
ing tool. Look for weaknesses. Ask trusted and experienced
friends for assessments of the model’s feasibility. Test its compo-
nent parts. For example, use market research to verify your rev-
enue estimates; determine the interest of your target customers
in your product or service, and ?nd out what they are willing to
pay for it. If the model calls for outsourcing particular activities
in the value chain, con?rm that such outsourcing support is
available at a cost you can afford. Think creatively about how
key tasks in the value chain could be done better—by produc-
ing higher perceived quality, greater customer convenience,
faster delivery, or lower cost. In some cases, being distinctively
better at only one key task is the ticket to commercial success.
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Building a Business Model and Strategy 7
the heavy lifting. This adds power to the eBay business model. Its
heavy reliance on ?xed costs over variable costs gives the company
enormous operating leverage, allowing the larger part of incremen-
tal revenue increases to fall to the bottom line.
Strategy
A business model will help you—and anyone you approach for
funding—to understand what your business will do and how all its
key parts ?t together. But a well-conceived and promising business
model is only half the equation for success, because it doesn’t take
into account the market competition. Dealing with competition is
the job of strategy. Strategy, in fact, is a plan to differentiate the en-
terprise and give it a competitive advantage. A successful business has
both a solid business model and a good strategy.
Bruce Henderson, founder of Boston Consulting Group, once
wrote that competitive advantage is found in differences: “The dif-
ferences between you and your competitors are the basis of your
advantage.”
4
Henderson believed that no two competitors could co-
exist if they sought to do business in the same way. They must dif-
ferentiate themselves to survive. He wrote, “Each must be different
enough to have a unique advantage.” For example, two men’s cloth-
ing stores on the same block—one featuring formal attire and the
other focusing on leisure wear—can potentially survive and prosper.
However, if the same two stores sold the same things under the same
terms, one or the other would perish. More likely, the one that dif-
ferentiated itself through price, product mix, or ambiance would
have the greater likelihood of survival. Harvard Business School pro-
fessor Michael Porter concurs: “Competitive strategy is about being
different. It means deliberately choosing a different set of activities to
deliver a unique mix of value.”
5
Consider these examples:
• Southwest Airlines didn’t become the most pro?table air carrier
in North America by copying its rivals. It differentiated itself
with low fares, frequent departures, point-to-point ?ights, and
customer-pleasing service.
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• eBay created an entirely new way for people to sell and ac-
quire new and used goods: online auctions. The company’s
founders aimed to serve the same purpose as classi?ed ads, ?ea
markets, and formal auctions but made it simple, ef?cient, and
wide-ranging.
• Toyota’s strategy in developing the hybrid engine Prius passen-
ger car was to create a competitive advantage within an impor-
tant segment of auto buyers: people who want a vehicle that is
either environmentally benign, cheap to operate, or the latest
thing in auto engineering. The company also hoped that the
learning associated with the Prius would give it leadership in a
technology having huge future potential.
Strategies can be based on low-cost leadership, technical differ-
entiation, or focus. They can also be understood in terms of strate-
gic position. Michael Porter has postulated that strategic positions
emerge from three, sometimes overlapping, sources:
6
• Variety-based positioning. Here, a company chooses a narrow
subset of product or service offerings from within the wider set
offered in its industry. It can succeed with this strategy if it de-
livers faster, better, or at lower cost than competitors. For ex-
ample, Starbucks offers premium coffee products and places its
outlets in locations that are convenient for potential customers.
It doesn’t serve breakfast or sell sandwiches. Customers can get
those products elsewhere. Its focus is on coffee.
• Need-based positioning. Companies that follow this approach,
according to Porter, aim to serve all or most of the needs of an
identi?able set of customers. These customers may be price
sensitive, may demand a high level of personal attention and
service, or may want products or services that are uniquely
tailored (customized) to their needs. For example, USAA is a
?nancial services company that caters exclusively to active-duty
and retired military of?cers and their families. After decades of
serving this population, USAA understands its unique banking,
8 Entrepreneur’s Toolkit
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Building a Business Model and Strategy 9
Fred’s Business Model
Recall Fred’s plan for The Hybrid Auto Care Center described
earlier in this book. Fred, the service manager for a dealer sell-
ing the new hybrid autos, sees a pro?table business in the repair
and maintenance of these gasoline-electric vehicles, especially
after their manufacturers’ warranties expire. His blueprint is es-
sentially the same one used by auto repair facilities everywhere:
1. Generate customers through local advertising and on-
premises information mini-seminars for owners of these
unique but increasingly popular vehicles.
2. Have the internal capabilities to diagnose and repair dam-
aged and malfunctioning hybrid engine vehicles of all
major manufacturers.
3. Establish a replacement parts pipeline with several regional
distributors.
4. Establish outsourcing relationships with a top-quality body
shop and an auto air conditioning service company so that
personnel can concentrate on mechanical problems.
This is Fred’s model for making money. His experience with
hybrid repair work and with running a dealer’s service depart-
ment have made him an expert in the details of pricing and cost
management. By modeling many different types of repairs on a
computer spreadsheet and factoring in known costs for labor,
parts, equipment loans, rent, and overhead, he is convinced
that he can break even with a crew of ?ve employees and eight
thousand “service hours” per year (roughly forty weeks per
year). Everything over that breakeven point should produce a
pro?t. He has worked these ?gures out in a pro forma income
statement.
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insurance, and retirement needs. And it knows how to deal
with the fact that military of?cers are often transferred from
post to post around the world and are often assigned to remote
locations for extended periods where they are unable to re-
spond to monthly billings.
• Access-based positioning. Some strategies can be based on ac-
cess to customers. A discount merchandise chain, for example,
might choose to locate its stores exclusively in low-income
neighborhoods. This reduces competition from suburban shop-
ping malls and provides easy access for its target market of low-
income shoppers, many of whom do not have automobiles.
Cracker Barrel Old Country Store, in contrast, locates its
restaurant/gift stores along the U.S. expressway system, where
it caters to travelers. Its Web site even includes a “trip planner”
that identi?es the locations of all Cracker Barrel outlets along
any “to-from” driving route.
What is your strategy for gaining competitive advantage? Will it
differentiate your company in ways that attract customers from ri-
vals? Will it draw new customers into the market? Will it give you a
tangible advantage?
Simply being different, of course, will not keep you in business;
something that is different must be perceived as valuable. And cus-
tomers de?ne value in different ways: lower cost, greater conven-
ience, greater reliability, faster delivery, or more aesthetic appeal.
The list of customer-pleasing “values” is extremely long. What
value does your strategy aim to provide? Can it deliver?
Steps for Formulating Strategy
Here are six steps you can follow in formulating a strategy. They in-
volve looking outside and inside your organization, thinking about
how you will deal with threats and opportunities as they present
themselves, building a good ?t with strategy-supporting activities,
aligning resources with goals, and organizing for execution.
10 Entrepreneur’s Toolkit
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STEP 1: LOOK OUTSI DE TO I DENTI FY THREATS AND OPPORTU-
NITI ES. At the highest level, strategy is concerned with analyzing
the outside environment and determining how the company’s ?nan-
cial resources, people, and capacity should be allocated to create an
exploitable advantage. There are always threats in the outside envi-
ronment: new entrants, demographic changes, suppliers who might
cut you off, substitute products that your customers could turn to,
and macroeconomic trends that may reduce the ability of your cus-
tomers to pay. The business you have in mind may be threatened by
a competitor that can produce the same quality goods at a much
lower price—or a much better product at the same price. A strategy
must be able to cope with these threats.
The external environment also harbors opportunities: a new-to-
the-world technology, an unserved market, and so forth. So ask
yourself these questions:
• What is the economic environment in which we must operate?
How is it changing?
• What opportunities for pro?table action lie before us?
• What are the risks associated with various opportunities and
potential courses of action?
STEP 2: LOOK INSIDE AT RESOURCES, CAPABILITIES, AND PRAC-
TICES. Resources and internal capabilities can be a constraint on
your choice of strategy, especially for a small start-up with few em-
ployees and ?xed assets. And rightly so. A strategy to exploit an un-
served market in the electronics industry, for example, might not be
feasible if your ?rm lacks the necessary ?nancial capital and the
human know-how to exploit it. A strategy can succeed only if it has
the backing of the right set of people and other resources. So ask
yourself these questions:
• What are our competencies as an organization? How do these
give us an advantage relative to competitors?
• What resources support or constrain our actions?
Building a Business Model and Strategy 11
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STEP 3: CONSI DER STRATEGI ES FOR ADDRESSI NG THREATS
AND OPPORTUNITI ES. Clay Christensen has recommended that
strategists ?rst prioritize the threats and opportunities they ?nd (he
calls them “driving forces” of competition) and then discuss each in
broad strokes. If you follow this advice and develop strategies to deal
with them, be sure to do the following:
• Create many alternatives. There is seldom only one way to do
things. In some cases, the best parts of two strategies can be
combined to make a stronger third strategy.
• Check all facts, and question all assumptions.
• Some information is bound to be missing. Determine what in-
formation you need to better assess a particular strategy. Then
get the information.
• Vet the leading strategy choices among the wisest heads you
know. Doing so will help you avoid groupthink within your
team.
STEP 4: BUI LD A GOOD FIT AMONG STRATEGY-SUPPORTI NG
ACTIVITI ES. Michael Porter has made the point that strategy is more
than just a blueprint for winning customers; it is also about combin-
ing activities into a chain whose links are mutually supporting and ef-
fective in locking out imitators.
7
He uses Southwest Airlines to
illustrate his notion of ?t.
Southwest’s strategy is based on rapid gate turnaround. Rapid
turnaround allows SWA to make frequent departures and better uti-
lize its expensive aircraft assets. This, in turn, supports the low-cost,
high-convenience proposition it offers customers. Thus, each of
these activities supports the others and the higher goal. That goal,
Porter points out, is further supported by other critical activities,
which include highly motivated and effective gate personnel and
ground crews, a no-meals policy, and a practice of not making in-
terline baggage transfers. Those activities make rapid turnarounds
possible. “Southwest’s strategy,” writes Porter, “involves a whole sys-
12 Entrepreneur’s Toolkit
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tem of activities, not a collection of parts. Its competitive advantage
comes from the way its activities ?t and reinforce one another.”
8
STEP 5: CREATE ALIGNMENT. After you’ve developed a satisfac-
tory strategy, your job is only half ?nished. The other half is to cre-
ate alignment between the people and activities of the company and
its strategy. Alignment is a condition in which every employee at
every level (1) understands the strategy and (2) understands his or her
role in making the strategy work. Alignment is a powerful thing.
Make sure that you have it working in your favor.
Alignment also involves other resources. Marketing must be fo-
cused on the right customers—the ones de?ned in the strategy.
Compensation and bonuses must be aligned with behaviors and
performance that advance the strategy. And physical assets must be
deployed—aligned—with the highest goals of the organization.
STEP 6: BE PREPARED TO I MPLEMENT. A powerful strategy is
impotent if your organization isn’t prepared to implement it effec-
tively. Unfortunately, some people get so carried away with the de-
tails of their strategy that they forget about the downstream activities
required to make it work. One of the bene?ts of an entrepreneurial
start-up is that you’re beginning with a clean slate. After you have a
strategy, you have a free hand in organizing around it: hiring people
with the necessary competencies, acquiring the right equipment,
structuring these resources, and so forth. As UCLA’s Alfred E. Os-
borne Jr. has put it, “I think of the 4 S’s: structure follows strategy,
and staf?ng follows structure, and you hold the strategy together
with systems.”
9
Be Prepared for Change
The initial strategies of start-up companies often fail to hit the mark.
Customers don’t value the differentiation—or they don’t respond to
it as anticipated. Or the company is mistaken in its choice of target
customers. These failures happen because every start-up business is
Building a Business Model and Strategy 13
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an experiment to some degree. The outcome of this experiment can
surprise and disappoint even the best planners. For example, Web-
van’s founders and investors thought that a Web-based grocery deliv-
ery business was a perfect idea for af?uent, Web-savvy, time-starved
households. But those customers balked at the higher price of buy-
ing their weekly groceries. To them, the extra convenience wasn’t
worth it.
The entrepreneur’s antidote to a disappointing strategy is a will-
ingness to (1) recognize the bad news and (2) respond quickly with
a revised strategy. Recognition requires the ability to admit a mis-
take. Responding requires an energetic search for what went wrong
and the ?exibility to make adjustments and get back into the game.
14 Entrepreneur’s Toolkit
Fred’s Strategy for The Hybrid Auto Care Center
Strategy is about being different and choosing a different set of
activities to deliver a unique mix of value to customers. Let’s
consider our hypothetical friend Fred and the strategy of his
auto repair and maintenance facility.
Fred has clearly differentiated his business. Every town and
every city has many automotive service businesses, but one that
specializes in hybrid engine vehicles will be very different. Fred
can use that distinctiveness to gain customer attention and
recognition. You can almost hear the advertising: “If your hy-
brid car needs maintenance or repair, bring it to the specialists at
The Hybrid Auto Care Center. They will do the job right and
usually at lower cost than your dealer.”
Fred must also deliver on that offer of greater know-how
and high-quality work. To do that, Fred must acquire the right
resources and align them in support of his distinctive offer. For
example, he must hire or train mechanics who really know
how to deal with the unique problems of hybrid cars. He must
also acquire the tools and diagnostic equipment required by
those vehicles.
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Successful entrepreneurs are adept at both of these things. They are
also masters of incrementalism—that is, if they ?nd that something
is working, they do more of it. If they achieve success in a small,
niche market, they use what they have and what they have learned
to enter another niche—altering the product or service as necessary.
A powerful business model and a sound strategy are essential if
your venture aims to be competitive and pro?table. Although the
market provides the ultimate test for these two important concepts,
you should test and verify every one of your assumptions before the
business is launched. And remember that many minds are better than
one. Explain your business model and strategy to as many trusted
and experienced people as possible. They may spot defects or op-
portunities for improvement that you have missed.
Summing Up
• A business model describes an enterprise’s revenue sources, cost
drivers, investment size, and success factors.
• Strategy differentiates the enterprise and gives it a competitive
advantage.
• Per Michael Porter, strategic positions can be found in variety-
based, need-based, or access-based positioning.
• The ?ve steps of strategy formulation are (1) looking outside
the enterprise for threats and opportunities, (2) looking inside
at resources, capabilities, and practices, (3) considering strate-
gies for addressing threats and opportunities, (4) building a
good ?t among strategy-supporting activities, and (5) creating
alignment between the organization’s people and activities and
its strategy.
• A start-up business should be viewed as an experiment. If the
experiment fails to produce the desired result, be prepared to
change—and quickly.
Building a Business Model and Strategy 15
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Notes
Chapter 4
1. Richard G. Hamermesh and Paul W. Marshall, “Note on Business
Model Analysis for the Entrepreneur,” Class Note 9-802-048, Harvard
Business School Publishing, Boston, 22 January 2002, 1.
16
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2. Joan Magretta, “Why Business Models Matter,” Harvard Business
Review, May 2002, 86–92.
3. David Bunnell, (with Richard Luecke) The eBay Phenomenon (New
York: John Wiley & Sons, 2000), 77.
4. Bruce Henderson, “The Origin of Strategy,” Harvard Business Re-
view, November-December 1989.
5. Michael E. Porter, “What Is Strategy?” Harvard Business Review,
November-December 1996: 61–78.
6. Ibid.
7. Ibid., 12–13.
8. Ibid., 12.
9. Professor Alfred E. Osborne, memo to writer, 21 March 2004.
17 Notes
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Harvard Business Essentials
The New Manager’s Guide and Mentor
The Harvard Business Essentials series is designed to provide com-
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Finance for Managers
Hiring and Keeping the Best People
Manager’s Toolkit
Managing Change and Transition
Managing Creativity and Innovation
Managing Employee Performance
Managing Projects Large and Small
Marketer’s Toolkit
Negotiation
Power, In?uence, and Persuasion
Strategy
Time Management
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