Case Study: Can One Business Unit Have 2 Revenue Models?

As two of his business units were completing their merger, Peter Noll, chief of the Diagnostics division at the Frankfurt-based Scherr Pharmaceuticals, felt it was time to address a nagging issue: The combined entity had no overarching revenue model. This deficiency had been weighing on him for a year, ever since the merger had been approved by the CEO, the executive team, and the board. Although the two units had similar products, they relied on different strategies to earn their money. Their sales forces sometimes even called on the same customers, leaving potential buyers confused by the reps’ differing offers. “How does it make any sense?” he frequently asked. The only real issue seemed to be which legacy revenue model he should allow to prevail and which he should gracefully kill. But he couldn’t deny that the flexible, inventive models the two units had followed for years had served them well. Was he being too focused on strategy — too rigid — in this unique situation? Two Models Peter had been head of Diagnostics for a relatively short time. Many years had passed since Scherr’s acquisition of Siiquent, a DNA-sequencing start-up, and Teomik, a provider of research equipment, both of which held valuable patents on genetic diagnosis and research, so he had missed the golden years when their IP was protected. Siiquent sold everything that hospitals and big diagnostic labs needed for gene-based diagnosis; Teomik provided everything that research labs and universities needed for gene-based studies; and both offered comprehensive services such as customized training, workflow optimization, and hotline support from teams of PhDs in case of equipment failure. No other company was providing anything comparable. Over the years Scherr had made a couple of halfhearted attempts to merge the two units because they sold similar instruments and supplies. Each time, the idea was dropped, because both businesses had carved out lucrative niches for themselves and were doing quite well. There seemed little point. But all patents expire. Competitors had been waiting for that moment. First one and then two companies took aim at each unit’s market, aggressively selling products at lower prices. Siiquent and Teomik had begun to lose customers, and Scherr’s CEO had brought Peter in to tackle the nascent problem. Peter had been appalled by what he found in both units: weak strategic thinking. Siiquent’s head, the brilliant former researcher Isolde Kraft, had responded almost flippantly when Peter asked what revenue model her unit’s strategy was based on. “Our revenue model?” she retorted. “We make money. Lots of it.” By contrast, Teomik’s head, the former Olympic shot-putter Emanuel Geiger, wasn’t at all defensive about Peter’s question and proceeded to draw elaborate diagrams on his office whiteboard. But rather than illustrating a simple revenue model, the diagrams showed that over time he had adjusted his pricing policies to address customer demands, internal accounting guidelines, and competitive threats. “Basically, you just do what’s needed to make money, right?” Peter asked pointedly. Emanuel responded that he was proud of his unit’s flexibility — in fact, he said, he saw that as his unit’s single greatest competitive differentiator. In a series of daylong offsite meetings, the two unit heads came to a better understanding of each other’s businesses. Isolde, with her quick mind and flair for pithy expression, got the basics right away and explained them to Emanuel. “Like a lot of business-to-business companies,” she said, “we both sell two things: machines and stuff that the machines use. My unit makes its money on the stuff. It’s the classic razor-blade model: Sell the shavers at cost and make money on the blades. Your unit makes money on the machines, and it’s less relevant whether customers buy the stuff from you or from low-price competitors.” Peter was amused to see Emanuel struggle with the description of his sophisticated research instruments as “machines” and his vast array of chemical and biological consumables as analogous to disposable razor blades. But Isolde was essentially right, and Peter could see how the two units, despite their similarities, had evolved such different approaches to making money. The Value of Service When a team of Nobel Prize–winning scientists had launched Siiquent, they’d been ready and willing to sell the company’s gene-based diagnosis technology to all comers. But the procedures and equipment had turned out to be too costly for all but Germany’s biggest hospitals and diagnostic labs, and even those institutions were under such intense budgetary pressure that proposed purchases were frequently vetoed by high-ranking officials. Realizing that Siiquent had little hope of earning high margins on test instruments, its executives decided to seek sustainable profit from biological and chemical compounds, test kits, and other consumables. Siiquent had figured out how to provide these consumables for a bit less than the fixed reimbursements the hospitals and labs got from insurers and the national health service, so it was able to position itself as a revenue generator for the hospitals. Customers also loved the company’s high level of maintenance, which minimized downtime. Siiquent also won business by providing a valuable free service: Its customers were bound by an exacting regulatory framework that required them to follow specific procedures and use specific compounds, and Siiquent helped them dot every “i” and cross every “t.” In fact, Siiquent prided itself on constantly seeking input from customers and adjusting to their wishes. When they complained about the inefficiency of opening a whole bottle of reagent to run a single test with a very small quantity and then having to throw the rest away, the company offered to let them pay by the number of tests performed and committed to providing whatever reagents and equipment they needed to conduct the tests. Teomik’s path was different. It had been selling biological research equipment and materials for a half-century, so when it acquired patents on gene-based scientific technologies, in the early 2000s, it continued to focus on the research market. Since there were numerous providers of compounds to these customers and few regulatory restrictions, it had to compete on price, and margins were slim. But the Max Planck Institutes and other big funders of genetic research didn’t balk at high instrument prices, so Teomik was able to earn fat margins on patent-protected devices that helped scientists do their genomics studies and aim for glory in prestigious scientific journals. Although Teomik didn’t need to offer its customers regulatory assistance, it provided expert support when things went wrong along with free advice on a wide range of topics. Thus, as Isolde said, Siiquent earned its profits on stuff, and Teomik earned its profits on machines, while neither made money from the extensive customer service it provided. Both companies had been attractive acquisition targets for Scherr. But after their patents expired and the competition became heated, the idea of merging them made sense: Consolidating their sales forces and operations would reduce costs. There was another factor, too: The line separating the two units’ markets had grown fuzzy. Some of the diagnostic labs in Siiquent’s niche had begun functioning like the research institutions in Teomik’s, investing heavily in their own research to create specialized tests. The labs’ new research push allowed them to get around some health-care-related regulatory restrictions and buy compounds from Teomik — at prices lower than what Siiquent had been offering. They got a helping hand from Teomik’s salespeople, who took a certain pride in undercutting Siiquent, seeing it as an internal competitor. So the Scherr board was quick to approve the merger, and the units now faced a wedded future. Isolde and Emanuel had been made co-leaders, but everyone knew that one of them would eventually become the sole chief and the other would depart — a gloomy prospect for Peter, who liked and respected both. Everyone also knew, because Peter had announced it, that only one revenue model would be needed going forward. Peter expected that the new entity, dubbed Siiquent-Teomik, would make its money either on stuff or on machines. Scherr’s leaders had let it be known that they were neutral on this question, so the choice was up to him. A United Front A planner and strategist through and through, Peter relished the challenge. He was looking forward to hearing Isolde and Emanuel debate about which model should prevail. He called a meeting to kick off the discussion. When the two walked into his office, their body language surprised him. Below a big abstract painting of black and white lines, Isolde and Emanuel settled in on the couch like friends meeting for tea. They chatted for a moment before turning their attention to Peter, and he detected something defiant in their faces. “Stuff or machines,” Isolde stated, “is a false dichotomy.” Emanuel nodded in agreement. Peter was stunned. “What matters to us is customers, competitors, and employees,” Isolde continued. “We give customers what they want; we respond to competitors’ initiatives; and we listen to employees. That’s how we conduct business. That’s how we move forward. You may say it lacks structure. You may call it unstrategic. You may say we need to adhere to a single revenue model. Well, I like logic and consistency as much as the next person, but our ingenuity has served us superbly in a rapidly changing market. Siiquent’s and Teomik’s legacy revenue models have morphed into a way of doing business that is marvelously flexible.” She added, “I would like to see Siiquent-Teomik maintain its current revenue model, which is really an ever-changing mix of models, and to have the authority to shift to new strategies and tactics as circumstances dictate.” Emanuel chimed in, his voice more forceful than usual: “Business-to-business relationships are a complicated thing, Peter, and imposing an either-or choice on us would be counterproductive.” “Counterproductive?” Peter asked. “Think about our customer service,” Emanuel replied. “Our team of PhDs is critical to maintaining our differentiated brand image. Service is a crucial part of relationship building — customers rave about it. Yet it’s not officially part of our revenue model. So why does it matter if one part of our business makes money from machines and not compounds, while the other makes money from compounds and not machines?” Peter scrambled to collect his thoughts. “OK, then let’s put services on the table as yet a third possible source of revenue,” he said. “Why not make money on services?” “This is what we mean when we say we listen to employees,” Emanuel responded, glancing at Isolde. “We’ve found that our salespeople don’t like to sell services. When they try, the only part that customers hear is the hotline support — they don’t seem to grasp the value of our advice and training before they’ve experienced them. Our reps don’t want to be explaining that sometimes even the best equipment breaks and even the best compounds fail. So services won’t work as a profit driver.” “OK, forget services for now,” Peter said. “But you can’t really be arguing that a no-strategy approach is best for your unit. I’ve never heard of such a thing. Without an established revenue model, you can’t know how to select customers or deal with the competitive landscape.” “Our strategy is to respond to the market, and a single revenue model would be stifling,” Isolde said. “Think about the pay-per-test innovation: We invented it in response to customer complaints, and it won us fantastic loyalty and retention.” “And also created a moral hazard,” Peter said. “As you well know, the unintended consequence is that customers no longer have any incentive to be careful or efficient in their use of equipment or materials. There’s a lot of waste and damage — we still don’t know the extent to which that will eat into profits.” He added, “Don’t you see that both of you are constantly wriggling away from your revenue models to meet this or that customer need or to respond to competitors? This random reactivity is crazy.” “The only thing crazy,” Isolde replied, “is imposing a single, rigid structure that’s going to hamstring us when we need to be nimble, flexible, and ingenious to keep up with a dynamic marketplace.” Peter looked from Isolde to Emanuel. The two were perfectly united, and they were speaking from long experience. That tiny voice of doubt in his mind was growing louder. The Experts Respond: Should Peter impose the structure of a single revenue model or let Siiquent-Teomik continue on its flexible way? Bodo Eickhoff is a senior vice president at Roche Diagnostics in Germany. It would be a mistake for Peter Noll to impose a single revenue model on Siiquent-Teomik. There’s nothing wrong with allowing different revenue models to coexist under one roof. And in this case, a dual model would enable the unit to maintain a competitive advantage by meeting the needs of its disparate customers in different ways. After a merger of two units of Roche Diagnostics in Germany—the situation on which this fictionalized case study is loosely based—we overhauled the combined organization’s operations, achieving savings through greater efficiency in logistics and standardizing processes such as making offers to customers and placing orders. At first we thought we might get a competitive advantage by standardizing the revenue models, too. We thought we could merge them somehow. But we looked at the facts—particularly customer needs. Nothing’s wrong with allowing different revenue models to coexist under one roof. Long before the merger, I had been a sales rep in one of the units and later a manager in the other, so I had a deep understanding of exactly what the separate customer segments needed. In one, customers were used to a simple system of cash sales for diagnostic instruments. In the other, they were used to a pay-per-test model similar to the one described by Isolde. After the merger, we realized that eliminating or even downplaying either model would be counterproductive and would prevent us from catering to certain customers’ preferred ways of doing things. Some customers even choose to buy through both models, for reasons having to do with their business structures and regulatory requirements. In the worst-case scenario, we could have lost an entire segment. We saw that it was critically important to retain both revenue models and allow them to work in parallel. I also see the value in allowing Siiquent-Teomik some flexibility to adapt to customers’ needs as they change. The evolution of the pay-per-test model is a good example of that. Customers’ satisfaction with it demonstrates its long-term strength, but the unit should find a way to manage the cost of waste that comes with pay-per-test. At Roche we were flexible enough to begin monetizing the value of our customer services, such as installation, training, and advising. We charge for them, and we’ve become more transparent about them: We highlight their value and give a lower price if customers don’t want them. That doesn’t mean I favor giving Siiquent-Teomik unlimited freedom to improvise its strategy. I don’t think Isolde Kraft or Emanuel Geiger would want that either. But keep in mind that they are trying to make money in an industry that has no economies of scale. It isn’t like the telecom industry, in which each new customer is pure gravy. In diagnostics every new customer generates significant new fixed costs—of transporting machinery, hiring service staff, training the customer, maintaining the equipment, and so on. In a sense, Isolde and Emanuel are in a handcraft industry, in which every solution has a custom element. So they must constantly look for new ways to increase profitability with existing resources. That takes deep reserves of ingenuity and flexibility. Eric Achtmann is a tech investor, a corporate adviser, and the architect and program director of Costa Coffee’s Project Marlow. Siiquent-Teomik needs a single coherent strategy that is consistent with its current organization so that it can successfully exploit appropriate avenues for growth. Otherwise it will continue to demonstrate opportunism under the wrong circumstances. In classifying commercial organizations in the context of innovation, it can be helpful to invoke a martial metaphor: the traditional “standing army” versus the “special forces” unit. Each has its own mission, characteristics, and advantages. The role of a standing army, like that of a large corporation, is predominantly to secure territory or maintain the status quo. The standing army functions through strict command and control, with standardized processes that are aimed at executing a predefined strategy. Decision making is centralized. Creativity is welcome insofar as it does not disrupt the master plan. Owing to its inertia, the standing army typically has limited dynamism and can successfully take advantage of opportunities only with sufficient lead time for planning and mobilization. Large production companies are like standing armies. The role of special forces, by contrast, is to achieve aggressive goals with limited resources under tight time constraints. That often means using speed, surprise, and unorthodox tactics. Although unit objectives are usually well articulated, tactical decision making is highly distributed and based on real-time information. Independent thinking, flexibility, decisiveness, and comfort with risk and ambiguity are part of the special-forces DNA. In comparison with the standing army, the special-forces unit has little inertia and can respond quickly to change and opportunity. Entrepreneurs are like special-forces units. Isolde Kraft and Emanuel Geiger are asking for autonomy when their real goal is stability. The newly merged Siiquent-Teomik is effectively a standing army. It conquered a couple of customer segments long ago and is now mainly concerned with holding its ground against competitors. It shows none of the qualities of a special-forces-type organization. Developing new ways to cater to customers’ preferred means of payment hardly constitutes radical entrepreneurialism. And yet Isolde Kraft and Emanuel Geiger want the unit to be treated as if it were some sort of hybrid. They are asking for the autonomy to seize opportunities, when their real goal is stability. Although it would be prudent for Peter Noll to pursue a single revenue model, he could still create space for radical innovation by establishing teams with the requisite DNA and independence adjacent to Siiquent-Teomik’s main operations. These teams could tackle specific challenges even as the broader unit got on with its work. In 2012 I proposed and led an autonomous team of designers, engineers, and businesspeople to redefine the global vending industry for Whitbread’s Costa, the world’s second-largest coffeehouse chain. The mission of that endeavor, Project Marlow, was to deliver, in six months, a “full five senses” vending system capable of delivering barista-grade coffee. The Project Marlow team was independent of and tangential to the standing army of Costa Coffee. Our work was based on principles I learned in the military, at McDonnell-Douglas, and on my own rapid-reaction product development teams at McKinsey. Communication and decision-making cycles were short—typically less than 10 minutes and 24 hours, respectively. The team significantly surpassed all the original project goals. It is important that a special-forces unit operate alongside a standing army but independent of it. Trying to merge the two functions into a single organization is a fool’s errand. Comments from the HBR.org community The Strategy Is Agility The unit does have a strategy, and it is successful: being agile in meeting customer needs. The complexity of the unit’s business makes it necessary to have a diversified portfolio of products and services to keep customers satisfied. —Pierre Palmberg, vice president, Fire Protection Engineering, COWI A False Problem As Isolde says, the existence of multiple revenue models may be a false problem. What matters is whether the unit can generate, deliver, and capture value. Rather than trying to unify the revenue model, Peter should concentrate on ensuring a steady flow of innovation for machines, stuff, and service. —Luca Orlassino, strategic marketing and organization, GI Group, Italy Customers Won’t Understand A unit with two revenue models may survive, but can it achieve competitive advantage? No. Unless Peter Noll makes strategic trade-offs, resources won’t be aligned, sales force incentives won’t be clear, and customers won’t understand the value proposition. —Victor Santos Martins Gomes, R&D manager, Enel (formerly Endesa) Brasil HBR’s fictionalized case studies present problems faced by leaders in real companies and offer solutions from experts. This one is based on the London Business School case study “Revenue Model Innovation at Roche Diagnostics,” by Marco Bertini and Nader Tavassoli.

Case Study: Can One Business Unit Have 2 Revenue Models?

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