Business Model Definition – The term business model refers to a company’s plan to make a profit. It identifies the products or services the business plans to sell, its identified target market and any anticipated expenses. Business models are important for both new and established companies. They help new and growing businesses attract investment, recruit talent and motivate management and staff.
Established companies should regularly update their business model or they will not be able to anticipate future trends and challenges. Business models also help investors evaluate companies they are interested in and employees understand the future of a company they may aspire to join.
Business Model Definition
A business model is a high-level plan for profitably operating a business in a specific market. A major component of the business model is the value proposition. This is a description of the goods or services offered by a company and why they are desirable to customers or clients, ideally stated in a way that differentiates the product or service from its competitors.
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A new company’s business model should also cover expected start-up costs and sources of funding, the target customer base for the business, marketing strategy, a review of the competition and revenue projections and expenses. The plan may also define opportunities where the company can partner with other established companies. For example, the business model of an advertising business may identify the benefits of a referral agreement to and from a print shop.
Successful companies have business models that allow them to meet customer needs at a competitive price and a sustainable cost. Over time, many companies revise their business models from time to time to reflect changing business environments and market demands.
When evaluating a company for potential investment, the investor must find out exactly how it makes its money. This means looking through the company’s business model. It’s true that the business model may not tell you everything about a company’s prospects. But the investor who understands the business model can better understand the financial data.
A common mistake many companies make when creating their business models is to underestimate the costs of financing the business until it is profitable. It is not enough to count the costs of introducing a product. A company must keep the business going until its revenues exceed its expenses.
What Is The Difference Between Business Model And Business Plan?
One way analysts and investors evaluate the success of a business model is by looking at the company’s gross profit. Gross profit is a company’s total revenue minus cost of goods sold (COGS). Comparing a company’s gross profit to that of its main competitor or its industry sheds light on the efficiency and effectiveness of its business model. However, gross profit alone can be misleading. Analysts also want to see cash flow or net income. This is gross profit minus operating expenses and is an indication of how much real profit the company generates.
The two main levers of a company’s business model are prices and costs. A company can raise prices and can find inventory at reduced costs. Both actions increase gross profit. Many analysts consider gross profit to be more important in evaluating a business plan. A good gross profit suggests a solid business plan. If expenses are out of control, the management team could be blamed and the problems can be corrected. As this suggests, many analysts believe that companies that operate on the best business models can operate on their own.
When evaluating a company as a potential investment, find out exactly how it makes its money (not just what it sells but how it sells it). This is the company’s business model.
There are as many types of business models as there are types of businesses. For example, direct sales, franchises, advertising-based stores, and brick-and-mortar stores are examples of traditional business models. There are also hybrid models, such as companies that combine Internet retail with brick-and-mortar stores or sports organizations like the NBA.
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Below are some common types of business models; note that the examples given may fall into several categories.
One of the most common business models that most people interact with on a regular basis is the reseller model. A retailer is the last entity along a supply chain. They often buy finished products from manufacturers or distributors and interact directly with customers.
A manufacturer is responsible for sourcing raw materials and producing finished goods using in-house labor, machinery and equipment. A manufacturer can make customized products or mass-produced products that are highly replicated. A manufacturer may also sell goods to distributors, retailers, or directly to customers.
Instead of selling products, fee-for-service business models focus on labor and service delivery. A fee-for-service business model may charge for an hourly rate or a fixed cost for a specific arrangement. Fee-for-service companies tend to be specialized and offer knowledge that may not be common knowledge or may require specific training.
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Subscription-based business models strive to attract customers in hopes of attracting long-time, loyal customers. This is done by offering a product that requires an ongoing payment, usually in exchange for a fixed benefit duration. While digital businesses largely offer access to software, subscription business models are also popular for physical goods, such as monthly recurring agricultural/product subscription box deliveries.
Freemium business models attract customers by introducing them to basic, limited-scope products. Then, with the customer using their service, the company tries to convert them to a more premium, advanced product that requires payment. While a customer can theoretically stay on freemium forever, a company tries to show the benefit of becoming an upgraded member.
Some companies may reside in several types of business models at the same time for the same product. For example, Spotify (a subscription-based model) also offers a free version and a premium version.
If a company is concerned about the cost of attracting a single customer, it can try to bundle products to sell multiple products to a single customer. Bundling takes advantage of existing customers by trying to sell them different products. This can be incentivized by offering price discounts for purchasing multiple products.
What Is A Business Model? Definition, Explanation & 30+ Examples
Marketplaces are somewhat simple: in exchange for hosting a platform for conducting business, the marketplace receives compensation. Although transactions could occur without a marketplace, this business model attempts to make transactions easier, safer, and faster.
Affiliate business models are based on the marketing and broad reach of a specific person’s entity or platform. Businesses pay an entity to promote a good, and that entity often receives compensation in exchange for its promotion. This compensation can be a flat payment, a percentage of sales from your promotion, or both.
Aptly named after the product that invented the model, this business model aims to sell a durable product below cost to generate high-margin sales of a single-use component of that product. Also known as the “razor blades and razor blades model,” razor companies can give away expensive blade handles on the premise that consumers must continually buy razor blades in the long run.
“Tying” is an illegal razor blade model strategy that requires the purchase of an unrelated good before a different (and often required) good can be purchased. For example, imagine Gillette launched a line of lotions and required all customers to buy three bottles before they were allowed to buy disposable razor blades.
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Instead of relying on high-margin complementary products, a reverse razor blade business model tries to sell a high-margin product upfront. Then, to use the product, low-cost or free companion products are provided. This model aims to promote this early sale, since the subsequent use of the product is not highly profitable.
The franchise business model leverages existing business plans to expand and reproduce a business in a different location. Often food, hardware, or fitness businesses, franchisors work with incoming franchisees to finance the business, promote the new location, and oversee operations. In return, the franchisor receives a percentage of the franchisee’s earnings.
Instead of charging a flat fee, some companies may implement a pay-as-you-go business model, where the amount charged depends on the amount of the product or service used. The company may charge a fixed fee for providing the service in addition to an amount that changes each month based on what is consumed.
A brokerage business model connects buyers and sellers without directly selling a good. Brokerage firms often receive a percentage of the amount paid when a deal closes. Most common in real estate, brokers are also prominent in construction/development or freight.
Business Plan Generator
There is no “one size fits all” when building a business model. Different professionals may suggest different steps to take when starting a business and planning your business model. Here are some general steps you can take to create your plan:
Instead of reinventing the wheel, consider what competing companies are doing and how you can position yourself in the market. You may be able to easily spot gaps in others’ business models.
Joan Magretta, the former editor of the Harvard Business Review, suggests that there are two critical factors when sizing business models. When business models don’t work, he claims, it’s because the story doesn’t make sense and/or the numbers just don’t add up
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