The Four Fatal Mistakes Holding Back Circular Business Models

The urgency of the climate crisis is driving some of Europe’s leading manufacturers to pursue new strategic approaches intended to mitigate the environmental impacts of their products and processes. One such innovation is to adopt a circular business model, whereby a focal company collaborates with its ecosystem partners to create, capture, and deliver sustainable value.1 The goal: to improve resource efficiency — by extending the life spans of products and parts, for example — to achieve environmental benefits while still meeting profit targets.2

ABB, BillerudKorsnäs, Komatsu, LKAB, Metso, Sandvik, Scania, and Volvo are among the major companies that have moved from the traditional, linear model of take-make-dispose to a circular model of make-use-reuse-remake-recycle. For many manufacturers, that means bundling their products with advanced services in order to allow the products to be shared, repaired, upgraded, reused, refurbished, optimized, or recycled.

During the past five years, we studied how 15 large manufacturing companies designed, developed, and implemented circular business models with their ecosystem partners. While we learned from the companies’ successes, we also discovered that manufacturers’ ambitious profit targets and environmental goals — such as lower greenhouse gas emissions, improved resource efficiency, and reduced energy consumption — frequently failed to materialize.

Pursuing Value With a Circular Business Model

Making the transition from a linear to a circular business model is an ambitious undertaking that involves rethinking how the organization creates, captures, and delivers value.

Value creation. A manufacturer that adopts a circular business model must integrate itself more deeply in the operations of its customers, cocreate value with partners, emphasize value-in-use rather than value-in-transaction, and launch new, innovative services. For instance, heavy equipment provider Metso cocreates value with its customers by offering them a performance guarantee. Specifically, Metso optimizes the process and guarantees certain outputs — for example, cost-per-ton contracts in the mining, chemical, or pulp and paper industries. The results: increased uptime use of equipment, improved productivity, and enhanced worker safety during maintenance stops.

Value capture. Revenue models are likely to change with a circular business model. For instance, there might be a shift from up-front product sales to monthly leasing fees, combined with service contracts that frequently run for extended durations. (In financial terms, this represents an evolution from a capital expenditures revenue flow to an operational expenditures revenue flow.) The industrial motor division of ABB, for example, offers different levels of service contracts to extend the life spans of its products. Among those options is a take-back system developed in cooperation with Stena Recycling, an industrial recycling company in ABB’s ecosystem. After products or components are refurbished, they can either be used by ABB in manufacturing new motors or be resold to third parties for use in their products.

Value delivery. A circular business model requires companies to develop new capabilities to deliver value (such as building service delivery organizations) and to form strategic partnerships with external technology and service providers. For example, Volvo Construction Equipment (CE), its customer Skanska (a construction company), and additional ecosystem partners (a connectivity provider, an automation technology provider, and an equipment reseller and service provider) have created an electric site at Skanska’s Vikan Kross quarry outside Gothenburg, Sweden. The site has electrified each transportation stage — excavation, primary crushing, and transport to secondary crushing — with autonomous electric Volvo CE machines and site management systems. Tests at this site returned a 98% reduction in carbon emissions, a roughly 70% reduction in energy costs, and an estimated 25% reduction in total operating costs. Profit targets and environmental objectives have effectively become complementary.

Four Major Challenges in Execution

Our research identified four key areas where companies are challenged in making successful transitions to a circular business model, often because decisions are colored by two common biases. One bias, the fallacy of the wrong level, is the tendency to think of a circular business model as company-centric when in reality it operates across organizations and is ecosystem-centric. The other bias, the endowment effect, is a tendency for companies to overvalue their own internal resources, capabilities, needs, and wants — and underplay those of their ecosystem partners. These two biases are especially prevalent because circular business models frequently require system-level change through collaboration with external partners that operate outside of existing value chains.

These self-regarding biases can explain why so many incumbent businesses underemphasize relational processes and ecosystem issues and overemphasize internal structure, strategy, and resources.3 These habits are particularly perilous when companies encounter the following four challenges as they execute a shift to circular business models.

CHALLENGE 1: Align incentives and motives among ecosystem partners. Few, if any, incumbent businesses have the financial resources and organizational capabilities to successfully design, develop, and implement a circular business model themselves. That’s why they seek alliances with ecosystem partners, such as specialized service companies, digital actors, and sub-suppliers. To make such alliances materialize, an incumbent should adopt the role of keystone player in the ecosystem and develop an alignment structure for the specific set of partners in the circular business model at hand. A well-designed alignment structure secures ecosystem partners’ mutual agreement about positions (where each partner is situated) and activity flows (what each partner is responsible for doing).4

THE PITFALL: For the companies we studied, achieving mutual agreement was a big challenge. Not only did different partners have dissimilar motives and aims, but many incumbent businesses also underinvested in securing collective agreement and overemphasized their own internal strategies at the expense of their partners’ strategies. This mistake often led to misconceptions about partners’ motives and incentives, conflicting interpretations of situations and goals, and increased transaction costs.5 The problem was particularly acute when incumbents sought new types of collaboration — for example, in recycling, upgrading, and refurbishing products, which are common activities in circular business models but not prevalent in traditional, linear models.

One case involved developing smart ventilation systems for underground mines to improve air quality and reduce energy consumption. A global provider of ventilation hardware and technology was collaborating with another global company specializing in telecommunications, as well as with connectivity providers, a company specializing in artificial intelligence solutions for mines, a smart-tag technology provider, and a sub-supplier of fans and sensors. The customer wanted to sign one contract for the overall solution rather than individual contracts with each company. But the ecosystem partners failed to reach an agreement, and after long delays, the customer procured parts of the project as traditional product sales because the incentives and motives of key partners were misaligned. The keystone player had simply failed to nurture development, resolve conflicts, and empower its partners.

THE SOLUTION: The keystone player must create a well-designed alignment structure reflecting agreement among ecosystem partners. But rather than designing that structure in a silo, it should allow the partners to participate in the process, articulate their own incentives and motives, negotiate the terms of ongoing collaboration, and reach consensus. The smart ventilation system provider mentioned above even gave financial support to its sub-suppliers in order to provide incentives for product reengineering. Unfortunately, this company failed overall in shifting to a circular business model. Although it succeeded in certain respects, such as using monetary and growth incentives to try to enhance partners’ collaborative behavior, those successes simply weren’t enough.

CHALLENGE 2: Look beyond existing ecosystem relationships. Most of the companies we studied underestimated the need not just for ecosystem collaboration in general but for new types of partnerships in particular. A keystone player should begin with a draft value proposition for the circular business model — and then search broadly to identify the set of appropriate partners needed for that value proposition to materialize.

THE PITFALL: In one forestry industry case we studied, an equipment provider sought an unorthodox collaboration with key competitors and with innovative small and medium-size enterprises (SMEs) to optimize tree harvesting. It specifically needed to facilitate equipment pooling and data sharing to achieve optimal value for one of its customers, a large pulp and paper company. But the key actors were stuck in their existing views on business relationships, were naive about data usage and data sharing, and unwilling to see their competitors as potential collaborators. The keystone player should have created a value proposition of the circular business model, attempting as unbiased a search as possible in order to identify optimal partners. Search costs in such a case may be substantial in the short term, but the long-term advantage of finding better partners justifies those costs.

THE SOLUTION: Create an explicit value proposition for the circular business model early in the process, even if multiple revisions are necessary. Don’t hesitate to go beyond existing relationships and search for partners that bring new resources and capabilities to the table. For example, technology platform companies such as Amazon, IBM, and Microsoft now offer complementary digitalization capabilities to traditional companies that seek to experiment with circular business models. Our research also revealed that newly established SMEs, which are often motivated to use alliances with larger companies as stepping-stones to further business expansion, can contribute innovative products and services that support incumbent companies’ circular business models. Technology-oriented SMEs that want to scale their digital solutions to multiple industries may be especially interested in such partnerships.

CHALLENGE 3: Involve customers deeply. A circular business model represents a shift from a transactional setup with customers to a more relational approach whereby customers are actively involved in developing the offer.6 Resources, processes, and people need to be combined across organizational boundaries to ensure that the value proposition will comprehensively address customers’ unique needs — for example, how they dispose of waste or use resources more efficiently.

THE PITFALL: Many of the customer organizations we studied were not ready or willing to open up their internal operations to incumbent manufacturing companies, consequently limiting the potential to cocreate value. Most customers were accustomed to procuring products rather than contracting advanced services. Some customers also feared that they might lose or depreciate their core knowledge base, and they raised concerns about becoming too integrated with, or too dependent on, the manufacturing company (a lock-in effect).

For example, one mining industry equipment manufacturer that we studied offered to sell its customers full unit operations for individual segments of the ore extraction process (such as primary crushing), along with advanced-service and proactive-maintenance contracts. Given the manufacturer’s intimate knowledge of the equipment, it knew that it could optimize the machinery’s operation and efficiency and therefore prolong its life cycle and reduce energy consumption. The manufacturer’s customer, a mining company, feared that such contracts threatened both its core competency and its traditional procurement model. In short, the mining company was culturally resistant to forging a new, deeper relationship with one of its partner producers. The result: The originally desired efficiencies and environmental benefits were never realized.

In another case we followed, a world-leading provider of heavy trucks was developing autonomous solutions combined with a fleet management system. In theory, the innovation could have prolonged the product life cycle and reduced fuel consumption, thereby lowering operating costs for customers and generating environmental benefits. Inertia on the customer side eventually stalled the project. The customers (logistics companies) had been accustomed to buying trucks, not fleet management systems, and some customers that bought the new system simply did not know how to use it and were unwilling to collaborate in a new way with their supplier. The result was that the training programs failed. This case had multiple pitfalls, many of which could have been anticipated had customers been involved at the outset.

THE SOLUTION: To identify customers’ greatest pain points, create a joint sphere in which value is cocreated among the keystone player, its customer, and ecosystem partners. Pooling resources, processes, and people from multiple organizations can nevertheless be challenging because of entrenched cultural resistance. In most cases we studied, launching smaller, highly customized services or solutions that were developed iteratively, with close customer involvement, worked well. This approach gradually fostered greater trust between providers and customers. Partners were able to move forward to engage in more complex activities for cocreating value while gradually addressing their fear of relinquishing core knowledge.

CHALLENGE 4: Plan for extended implementation. Regardless of the industry, incumbent manufacturing businesses focus on developing and selling products, which historically has implied that value resides primarily in the transaction. Shifting to a circular business model means embracing advanced-use-oriented or results-oriented services, where the value resides in the customer’s use of the service. Such service contracts can span many years, which means an ongoing relationship with extended implementation.7 As our research clearly showed, ecosystem partners (including customers) must develop routines for this extended implementation. For example, to ensure adequate quality in maintenance and follow-up support, customers must be trained to use the equipment properly.

THE PITFALL: Few of the companies we studied had thought through extended implementation, and many experienced great difficulties in overcoming a culture rooted in transactions and product sales. In the cases we studied, customers often cut back on services too soon, whereas providers (which wanted to protect service revenues) pushed for additional sales. A heavy process equipment provider we studied offered performance guarantees, including ambitious uptime targets and productivity goals, for an underground mining customer in northern Europe. From the outset, the provider had underinvested in creating a dedicated service organization with explicit delivery routines, whereas the customer was unwilling to permit full access to the site. The relationship eventually came under great strain, and the service contract was finally dissolved. Both parties, in our view, were wrong in aiming for short-term “sales” rather than seeking the benefits of long-term partnerships. In a purely transaction-based relationship, ongoing upgrades and improvements simply don’t happen.

THE SOLUTION: Follow-up support is critical, as are training customers in how to best use equipment and solutions and creating delivery and implementation routines that involve staff members from all participating organizations. In the successful cases we studied, biweekly service maintenance meetings, bimonthly technology team meetings, and quarterly executive meetings were common — and all of them required a strong commitment to long-term relationships. Key performance indicators also must be jointly defined so that they support long-term collaboration, not just short-term transactions. Ecosystem partnerships where roles were flexible and adaptive generally had a more resilient and well-functioning extended implementation phase, which usually resulted in renewal of the advanced-service contract.

Circular business models hold promise for renewing the vitality of manufacturing companies — by enabling them to work in new ways with business-ecosystem partners to minimize environmental harms while maintaining profitability. In short, circular business models can allow companies to simultaneously target all pillar objectives of the so-called triple bottom line: financial, social, and environmental.

“Going circular” is a gradual process for revamping a company’s approach to achieving all three of those elements. But a company’s leaders and managers need to remain vigilant about their biases and their resistance to cultural change as they confront the challenges of moving from a company-centric mindset to an ecosystem-centric mindset. A broader, more long-term orientation to designing and developing products, collaborating with new and existing ecosystem partners in novel ways, and moving away from a transaction-based interaction will make manufacturers more likely to achieve long-term sustainability, both as companies and as stewards of a changing planet.