Transformation: The Challenge of Changing the Business Model

The transformation of a business is a very complex operation, but it is even more difficult when it involves a change of business model. Let’s look at why, with a simple example, that of Microsoft Office for its transition from a model of license sale to a model of selling subscriptions.

Microsoft built its economic and financial strength on two main products: Windows, its operating system, and Office, its office suite. Both are sold through a licensing system either to PC manufacturers, who install them in the factory, or to companies and the general public who install them themselves after purchasing a PC.

An Office license typically costs about $250. From a legal point of view, a license gives you permission to use the software included in the suite but it remains the property of Microsoft. The great advantage of this model for Microsoft is that it is a very high margin model: the creation of the suite is a fixed cost (A new version typically requires the work of around 5,000 programmers and testers for several months), but producing it, or manufacturing it costs almost nothing (for a long time it was a set of diskettes, then it was a CD of a few euros, and now everything is sold online, which again represents a fixed cost). For Microsoft, therefore, the sale of an additional unit of Office costs essentially nothing (the marginal cost is zero in economic language). As soon as the fixed costs are covered, the margin is 100%. Given the volumes, this is an extremely profitable business: Office 2010 sold about 100 million units, generating a minimum turnover of $25 billion. As soon as you buy a license, the total revenue ($250) goes immediately to the coffers of Microsoft.

Apres moi le déluge

Now, under the pressure of its competitors and especially Google, which introduced a fully Web-based office suite (cloud) low level competitor in 2006, Microsoft is now obliged to offer a cloud version of Office. Its name is Office 365, launched in 2011. The product is available for an annual subscription of about $70 per year.

The difficulty for Microsoft is that of course there is cannibalization between the two offers. If I subscribe to Office 365 on January 1st, 2017, Microsoft will earn $70 that year from me. If I buy Office, Microsoft will earn $250. The first effect of a switch from a license model to a subscription model is therefore an immediate and massive drop in revenue (-70%) for Microsoft. Under these conditions, we can see why Microsoft did not show a strong enthusiasm to carry out this switch aggressively. This probably explains why it had to wait 5 years after Google to launch its own version. But even after the launch, the product was not really pushed initially. It is only in recent years, and especially after the departure of former CEO Steve Ballmer, that the company’s priority has been put on the cloud at the expense of licensing sales.

Reluctance does not exist only at the strategic level. It exists at all levels of the organization: imagine that you are salesperson charged to sell Office, for example to companies. When you sell a pack of, say, 200 Office licenses, and assume a 50% discount for quantity, you realize an immediate turnover of $25,000, on which you get a nice commission. If you go to the subscription, your turnover will be only 200×35 = $7,000. Your commission will naturally decrease accordingly. Conclusion: You are not really motivated for the subscription, and you will continue to push the license purchase as long as possible, thus delaying Microsoft’s move from license to subscription.

Of course, in the long term, you can be a winner: next year, without you doing anything, the customer will pay you $7,000 again. And again the following year. In the end, from the fourth year onwards, you earn even more than with the licensing system: you have in fact created a potentially infinite income annuity for you and for the company. Yes, but it will be in four years, and four years is a long time in business. In four years, you may not even be a salesperson at Microsoft anymore. And then it is not certain that the company continues to pay you a commission for a sale that took place four years before. In the short term you are definitely a loser, and in the long run we are all dead to take up Keynes’ famous expression (we know that individuals strongly discount the future, and the more distant the future, the stronger the discount). We see here how the lack of alignment between the strategic intention of the company and the encouragement of employees on the ground can lead to a failure of the strategy, or in any case seriously slow down its implementation. Everyone can, in principle, agree to switch to the new model, but nobody wants to pay the price of the passage. Everybody will pay lip service, but nobody will move.

But the difficulty of changing a business model like this is not just about sales people, although it is often the most obvious one to observe. In fact, it affects just about all functions of the company. A subscription is also a significant change in the structure of the financial flow of income. For example, for clients, the much smaller amount will mean that the expense will no longer be considered as a depreciable investment, but as a current expense. The financial department of Microsoft will have to manage the cash differently, because instead of having immediate income at each contract signing, the income of a contract will be spread over time with lower sums. The very nature of a subscription will make it such that we will have a very different customer relationship. This will require different business profiles to manage this relationship. New profiles that HR will have to learn to identify, recruit, integrate and manage.

There is also an impact on distribution. The sale of a subscription will most often be direct, from the Web, bypassing our traditional distribution network (which the sale of a subscription at $70 does not interest anyway), which will legitimately feel let down by the switch to the new model (this is what happened with Microsoft). This dissatisfaction with the network is particularly problematic during the transition: you are starting to sell your subscriptions, this model is still only a small part of your income, but you immediately discontent your distributors, who are still responsible for the major part of your current income. You are confronted with the classic dilemma of the innovator: If you slow down the deployment of subscriptions to calm the dissatisfaction of distributors, you risk compromising your transformation strategy. But if you push this strategy, distributors can stop pushing your licenses, or worse, the best ones can jump ship and switch to the competition, with an immediate and highly visible effect on your sales.

One way to manage this conflict, especially at the organization level, will be to house the subscriptions activity in a special unit that will be able to create its own model. This will push the conflict to the highest level of the organization where it can normally be properly managed provided it is identified as such.

As can be seen, behind what may only appear as a “simple” change in the price model is actually a shake-up of the business model of the company, ie both its value and its resources, processes and values ​​(RPVs). We will no longer do the same thing, with the same profiles, with the same criteria of success, and with the same partners. It is potentially the whole value network of the company that must be rethought. This is already extremely complex in itself, and the fact that a company as well managed as Microsoft had a great difficulty in making the transition illustrates this well. And as if that were not enough, to this difficulty is added the famous dilemma, that is to say the conflict between the old model, which secures most of the income and profits today, and the future model, which is the key to the future performance. Any effort for one risks compromising the other, and the company finds itself in a permanent imbalance throughout the transition period.

See also a previous article: Disruption Is Not a Question of Technology, but of Business Model. See also: Immunity to change: these rational commitments that prevent innovation

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One response to “Transformation: The Challenge of Changing the Business Model

  1. Pingback: Why Transforming an Organization is Difficult: Resources, Processes, Values and the Migration of Skills | Philippe Silberzahn

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