Business Model Graphic – 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, the identified target market and any anticipated expenses. Business models are important for both new and established businesses. They help emerging companies attract investment, recruit talent and motivate management and staff.
Established businesses must regularly update their business model or they will fail to anticipate trends and challenges ahead. Business models also help investors evaluate companies they are interested in and employees understand the future of a company they might aspire to join.
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A business model is a high-level plan for the profitable operation of a business in a specific market. A key component of the business model is the value proposition. This is a description of the goods or services that a company offers and why they are desirable to customers or clients, ideally expressed in a way that distinguishes the product or service from its competitors.
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A new enterprise’s business model should also cover anticipated start-up costs and funding sources, the target customer base for the business, marketing strategy, a competitive review, and revenue and expense projections. The plan may also outline opportunities in which the business may partner with other established companies. For example, the business model for an advertising business might identify the benefits of a referral agreement to and from a printing company.
Successful businesses have business models that allow them to meet customer needs at a competitive price and a sustainable cost. Over time, many businesses revise their business models from time to time to reflect changing business environments and market demands.
When evaluating a company as a potential investment, the investor must find out exactly how it makes its money. This means looking at the company’s business model. Admittedly, 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 becomes profitable. Counting the costs of introducing a product is not enough. A company must keep the business operating until its revenues exceed its expenses.
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One way analysts and investors gauge 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 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 business is generating.
The two main levers of a company’s business model are price and costs. A company can raise prices and find inventory at reduced costs. Both actions increase gross profit. Many analysts consider gross profit to be the most important in evaluating a business plan. A good gross profit suggests a sound business plan. If expenses are out of control, the management team can be blamed and the problems are correctable. As this suggests, many analysts believe that companies operating on the best business models can run themselves.
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, franchising, advertising-based and brick-and-mortar stores are all examples of traditional business models. There are also hybrid models, such as businesses 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 can be divided into multiple categories.
One of the most common business models that most people interact with on a regular basis is the retailer model. A retailer is the last entity along a supply chain. They often buy finished goods from manufacturers or distributors and deal directly with customers.
A manufacturer is responsible for procuring raw materials and producing finished products using internal labor, machinery, and equipment. A manufacturer may make custom goods or highly repetitive, mass-produced products. A manufacturer may also sell goods to distributors, retailers, or directly to customers.
Instead of selling products, fee-for-service business models center around labor and service delivery. A fee-for-service business model can charge an hourly rate or a fixed cost for a specific deal. Fee-for-service companies are often specialized, offering knowledge that may not be common knowledge or may require specific training.
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Subscription-based business models try to attract customers with the hope of luring them into long-term loyal customers. This is done by offering a product that requires ongoing payment, usually in exchange for a certain duration of benefit. Although widely offered by digital companies for access to software, subscription business models are also popular for physical goods, such as monthly recurring farming / subscription box shipments.
Freemium business models attract customers by introducing them to basic products with limited scope. Then, when the customer uses their service, the company tries to convert them to a more premium, upfront product that requires payment. Although a customer can theoretically stay on freemium forever, a company tries to show the benefit of what becoming an upgraded member can bring.
Some companies may inhabit multiple 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 may try to bundle products to sell multiple goods to a single customer. Packaging takes advantage of existing customers by trying to sell them different products. This can be stimulated by offering price discounts for purchasing multiple products.
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Markets are somewhat straightforward: in exchange for hosting a platform for business to take place, the market receives compensation. Although transactions can happen without a marketplace, this business model tries to make the transaction easier, safer and faster.
Affiliate business models are based on the marketing and broad reach of a particular entity or person’s platform. Companies pay an entity to promote a good, and that entity often receives compensation in exchange for promoting them. This compensation can be a flat fee, a percentage of sales derived from their promotion, or both.
Aptly named after the product that invented the model, this business model aims to sell a stable product below cost to then generate high-margin sales of a disposable component of that product. Also referred to as the “razor and blade model,” razor companies can provide expensive blade handles with the premise that consumers should keep buying razors in the long run.
“Tying” is an illegal razor pattern strategy that requires the purchase of an unrelated commodity before being able to purchase a different (and often sought-after) commodity. For example, imagine Gillette released a line of lotion and required all customers to purchase three bottles before being allowed to purchase disposable razors.
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Instead of relying on high-margin companion products, a reverse razor business model tries to sell a high-margin product. Then, to use the product, low or free companion products are offered. This model aims to promote that pre-sale, since further use of the product is not very profitable.
The franchise business model uses existing business plans to expand and reproduce a company in another country. Often food, hardware, or fitness companies, 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 profits.
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 varies each month based on what is consumed.
A brokerage business model connects buyers and sellers without directly selling a commodity itself. Brokerage companies often receive a percentage of the amount paid when a deal is finalized. Most common in real estate, brokers are also prominent in construction/development or freight.
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There is no “one size fits all” when creating a business model. Different professionals may suggest taking different steps when setting up a business and planning your business model. Here are some broad steps one can take to create their 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 the business model of others.
Joan Magretta, former editor of the Harvard Business Review, suggests that there are two critical factors in sizing business models. When business models don’t work, she says, it’s because the story doesn’t make sense and/or the numbers just don’t add up.
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