What Is a Business Model?
A business model refers to a company’s strategic plan for generating profits. It outlines the products or services the company intends to offer, its target market, and projected expenses. Business models are crucial for both new ventures and established businesses, aiding in attracting investment, securing talent, and inspiring management and staff.
Established businesses must regularly update their business model to stay ahead of upcoming trends and challenges. These models also assist investors in evaluating potential companies and help employees understand a company’s future direction.
Key Takeaways:
- A business model is a company’s core strategy for profitable operations.
- It includes details like products/services, target markets, and expected expenses.
- There are various business model types like retailers, manufacturers, fee-for-service providers, and freemium offerings.
- The key components of a business model are pricing and costs.
- Investors should assess if the product aligns with market needs when evaluating a business model.
Investopedia / Laura Porter
Understanding Business Models
A business model is a comprehensive plan for operating a business profitably within a specific market. Central to this model is the value proposition, describing the company’s offerings and why they are appealing to customers, ideally setting them apart from competitors.
New enterprises should detail startup costs, financing sources, target customer base, marketing strategies, competitive analysis, and financial projections within their business model. They may also explore partnership opportunities with established companies to enhance their operations.
Successful businesses have models that efficiently meet client needs at competitive costs. Businesses often adjust their models to align with evolving market dynamics and demands.
When considering a company for investment, understanding its business model is crucial. It sheds light on how a company generates revenue and helps investors interpret financial data effectively.
Evaluating Successful Business Models
One common mistake in creating business models is underestimating the funds needed to sustain the business until it becomes profitable. It’s essential to consider ongoing operational costs beyond product launch.
Analysts and investors evaluate business model success by analyzing a company’s gross profit. This figure reflects total revenue minus cost of goods sold, offering insights into a model’s efficiency. However, gross profit alone may not provide a complete picture, necessitating examination of cash flow and net income for a comprehensive assessment.
Pricing and costs are pivotal levers in a business model, impacting gross profit. Emphasis on maintaining a healthy gross profit is crucial for a sustainable business strategy. Companies with strong business models can often operate effectively even without constant managerial intervention.
Understanding how a company generates revenue, not just what it offers, is key to evaluating its business model as an investor.
Types of Business Models
Business models vary based on the nature of the business. From retailing to manufacturing and service-based models, the options are diverse. Some businesses even combine traditional and digital models for enhanced operations.
Here are some prevalent business model types, with examples that could overlap between categories:
Retailer
Retailing is a common model where businesses buy goods and directly sell them to customers, serving as the final link in the supply chain.
Example: Costco Wholesale
Manufacturer
Manufacturers source raw materials to produce finished goods, which they can sell directly or through intermediaries.
Example: Ford Motor Company
Fee-for-Service
Fee-for-Service models focus on labor and service provision, charging per hour or via fixed agreements. These specialized services cater to unique needs.
Example: DLA Piper LLP
Subscription
Subscription models aim to retain loyal customers with ongoing payments for continuous benefits, often offered by digital and physical goods providers.
Example: Spotify
Freemium
Freemium models entice customers with basic offerings before encouraging them to upgrade to premium options for additional perks, demonstrating the value of advanced features.
Example: LinkedIn/LinkedIn Premium
Some companies can operate under multiple business model types simultaneously. For instance, Spotify offers both free and premium versions within its subscription-based model.
Bundling
Bundling involves selling multiple products to a single customer to maximize sales and incentivize customers with pricing discounts.
Example: AT&T
Marketplace
Marketplaces facilitate business transactions, receiving compensation for providing a platform that streamlines buying/selling processes for enhanced convenience and efficiency.
Example: eBay
Affiliate
Affiliate models leverage marketing collaborations to promote products, where companies pay entities for publicity, leading to a mutually beneficial relationship.
Example: Influencers like Lele Pons, Zach King, or Chiara Ferragni
Razor Blade
The Razor Blade model involves selling a durable product at a loss but profiting from sales of disposable components for continuous revenue.
Example: HP (printers and ink)
“Tying” is a controversial strategy in the Razor Blade model, mandating purchases of unrelated items to access essential goods.
Reverse Razor Blade
The Reverse Razor Blade model prioritizes selling high-margin products upfront with low-cost or free accessories to enhance user experience.
Example: Apple (iPhones + applications)
Franchise
Franchise models expand businesses by replicating them in different locations using existing plans, partnering with franchisees who share revenues in exchange for operational support.
Example: Domino’s Pizza
Pay-As-You-Go
Pay-As-You-Go models charge based on usage, providing flexibility in payment methods depending on services consumed.
Example: Utility companies
Brokerage
Brokerage models facilitate transactions between buyers and sellers, earning a percentage of deal values without directly selling goods.
Example: ReMax
How to Create a Business Model
Crafting a business model is a custom process with various methodologies suggested by business experts. Key steps include identifying the target audience, defining the problem to solve, selecting an appropriate business model type, outlining revenue sources, and validating the model through feedback and adjustments.
- Identify your audience to tailor your products and messages effectively.
- Define the problem you aim to solve to address market demands.
- Understand your offerings and align them with customer needs.
- Document your operational and product-specific requirements.
- Establish key partnerships crucial for business success.
- Set revenue strategies essential for financial sustainability.
- Test your model with surveys and pilot launches to gauge market reception.
Assessing competitors can reveal gaps in business models, aiding in strategic positioning within the market.
Criticism of Business Models
Joan Magretta highlights the importance of coherence between the narrative and profitability for successful business models. A classic example is the airline industry’s shift from hub-and-spoke to point-to-point models, as exemplified by Southwest and JetBlue’s disruptive strategies against legacy carriers.
Legacy carriers like American Airlines faced challenges as new competitors offered cost-effective alternatives, leading to significant business model changes. Market dynamics prompted industry-wide shifts, reflecting the critical role of evolving business models in adapting to changing environments.
Example of Business Models
Microsoft’s diverse portfolio showcases various business models, spanning digital services, software, and gaming. Notable models within Microsoft include:
- Productivity and Business Processes: Offering Office and LinkedIn subscriptions tailored to user activity, like SharePoint data uploads.
- Intelligent Cloud: Providing server products, cloud services, and consulting for subscriptions.
- More Personal Computing: Selling physical products like Surface and Xbox, with revenue streams from content, services, subscriptions, royalties, and ads.
What Is a Business Model?
A business model is a strategic plan of how a company will make money. It determines the products, market targets, promotional strategies, and revenue sources of a business.
What Is an Example of a Business Model?
Retail giants like Best Buy, Target, and Walmart exemplify traditional retail business models, sourcing goods for direct sale to consumers, highlighting the interaction between retailers and their customer base.
What Are the Main Types of Business Models?
Primary business model types include retailers that sell goods directly to consumers and manufacturers that create and may sell products to end-users.
How Do I Build a Business Model?
Building a business model involves defining your market, identifying problems, selecting a model type, planning revenue streams, and ongoing evaluation for enhancements.
The Bottom Line
A successful business model systematically creates long-term value for customers through its operational strategies. By developing a robust model, businesses gain clarity on their approach and financial prospects for sustainable growth.