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What Is a Business Model?
Understanding business models, evaluating successful business models, how to create a business model.
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Learn to understand a company's profit-making plan
Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.
Investopedia / Laura Porter
The term business model refers to a company's plan for making 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 businesses. They help new, developing companies attract investment, recruit talent, and motivate management and staff.
Established businesses should regularly update their business model or they'll fail to anticipate trends and challenges ahead. Business models also help investors evaluate companies that interest them and employees understand the future of a company they may aspire to join.
- A business model is a company's core strategy for profitably doing business.
- Models generally include information like products or services the business plans to sell, target markets, and any anticipated expenses.
- There are dozens of types of business models including retailers, manufacturers, fee-for-service, or freemium providers.
- The two levers of a business model are pricing and costs.
- When evaluating a business model as an investor, consider whether the product being offer matches a true need in the market.
A business model is a high-level plan for profitably operating a business in a specific marketplace. A primary 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 stated in a way that differentiates the product or service from its competitors.
A new enterprise's business model should also cover projected startup costs and financing sources, the target customer base for the business, marketing strategy , a review of the competition, and projections of revenues and expenses. The plan may also define opportunities in which the business can partner with other established companies. For example, the business model for an advertising business may identify benefits from an arrangement for referrals to and from a printing company.
Successful businesses have business models that allow them to fulfill client 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 possible investment, the investor should find out exactly how it makes its money. This means looking through 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 make better sense of the financial data.
A common mistake many companies make when they create their business models is to underestimate the costs of funding the business until it becomes profitable. Counting costs to the introduction of a product is not enough. A company has to keep the business running until its revenues exceed its expenses.
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 the 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. Gross profit alone can be misleading, however. Analysts also want to see cash flow or net income . That is gross profit minus operating expenses and is an indication of just how much real profit the business is generating.
The two primary levers of a company's business model are pricing and costs. A company can raise prices, and it 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 sound business plan. If expenses are out of control, the management team could be at fault, and the problems are correctable. As this suggests, many analysts believe that companies that run on the best business models can run themselves.
When evaluating a company as a possible investment, find out exactly how it makes its money (not just what it sells but how it sells it). That's the company's business model.
Types of Business Models
There are as many types of business models as there are types of business. For instance, direct sales, franchising , advertising-based, and brick-and-mortar stores are all examples of traditional business models. There are hybrid models as well, such as businesses that combine internet retail with brick-and-mortar stores or with sporting organizations like the NBA .
Below are some common types of business models; note that the examples given may fall into multiple categories.
One of the more common business models most people interact with regularly is the retailer model. A retailer is the last entity along a supply chain. They often buy finished goods from manufacturers or distributors and interface directly with customers.
Example: Costco Wholesale
A manufacturer is responsible for sourcing raw materials and producing finished products by leveraging internal labor, machinery, and equipment. A manufacturer may make custom goods or highly replicated, mass produced products. A manufacturer can also sell goods to distributors, retailers, or directly to customers.
Example: Ford Motor Company
Instead of selling products, fee-for-service business models are centered around labor and providing services. A fee-for-service business model may charge by an hourly rate or a fixed cost for a specific agreement. Fee-for-service companies are often specialized, offering insight that may not be common knowledge or may require specific training.
Example: DLA Piper LLP
Subscription-based business models strive to attract clients in the hopes of luring them into long-time, loyal patrons. This is done by offering a product that requires ongoing payment, usually in return for a fixed duration of benefit. Though largely offered by digital companies for access to software, subscription business models are also popular for physical goods such as monthly reoccurring agriculture/produce subscription box deliveries.
Freemium business models attract customers by introducing them to basic, limited-scope products. Then, with the client using their service, the company attempts to convert them to a more premium, advance product that requires payment. Although a customer may theoretically stay on freemium forever, a company tries to show the benefit of what becoming an upgraded member can hold.
Example: LinkedIn/LinkedIn Premium
Some companies can reside within multiple business model types at the same time for the same product. For example, Spotify (a subscription-based model) also offers free version and a premium version.
If a company is concerned about the cost of attracting a single customer, it may attempt to bundle products to sell multiple goods to a single client. Bundling capitalizes on existing customers by attempting to sell them different products. This can be incentivized by offering pricing discounts for buying multiple products.
Marketplaces are somewhat straight-forward: in exchange for hosting a platform for business to be conducted, the marketplace receives compensation. Although transactions could occur without a marketplace, this business models attempts to make transacting easier, safer, and faster.
Affiliate business models are based on marketing and the broad reach of a specific entity or person's platform. Companies pay an entity to promote a good, and that entity often receives compensation in exchange for their promotion. That compensation may be a fixed payment, a percentage of sales derived from their promotion, or both.
Example: social media influencers such as Lele Pons, Zach King, or Chiara Ferragni.
Aptly named after the product that invented the model, this business model aims to sell a durable 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 blade companies may give away expensive blade handles with the premise that consumers need to continually buy razor blades in the long run.
Example: HP (printers and ink)
"Tying" is an illegal razor blade model strategy that requires the purchase of an unrelated good prior to being able to buy a different (and often required) good. For example, imagine Gillette released a line of lotion and required all customers to buy three bottles before they were allowed to purchase disposable razor blades.
Reverse Razor Blade
Instead of relying on high-margin companion products, a reverse razor blade business model tries to sell a high-margin product upfront. Then, to use the product, low or free companion products are provided. This model aims to promote that upfront sale, as further use of the product is not highly profitable.
Example: Apple (iPhones + applications)
The franchise business model leverages existing business plans to expand and reproduce a company at a different location. Often food, hardware, or fitness companies, franchisers work with incoming franchisees to finance the business, promote the new location, and oversee operations. In return, the franchisor receives a percentage of earnings from the franchisee.
Example: Domino's Pizza
Instead of charging a fixed fee, some companies may implement a pay-as-you-go business model where the amount charged depends on how much of the product or service was used. The company may charge a fixed fee for offering the service in addition to an amount that changes each month based on what was consumed.
Example: Utility companies
A brokerage business model connects buyers and sellers without directly selling a good themselves. 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.
There is no "one size fits all" when making a business model. Different professionals may suggest taking different steps when creating a business and planning your business model. Here are some broad steps one can take to create their plan:
- Identify your audience. Most business model plans will start with either defining the problem or identifying your audience and target market . A strong business model will understand who you are trying to target so you can craft your product, messaging, and approach to connecting with that audience.
- Define the problem. In addition to understanding your audience, you must know what problem you are trying to solve. A hardware company sells products for home repairs. A restaurant feeds the community. Without a problem or a need, your business may struggle to find its footing if there isn't a demand for your services or products.
- Understand your offerings. With your audience and problem in mind, consider what you are able to offer. What products are you interested in selling, and how does your expertise match that product? In this stage of the business model, the product is tweaked to adapt to what the market needs and what you're able to provide.
- Document your needs. With your product selected, consider the hurdles your company will face. This includes product-specific challenges as well as operational difficulties. Make sure to document each of these needs to assess whether you are ready to launch in the future.
- Find key partners. Most businesses will leverage other partners in driving company success. For example, a wedding planner may forge relationships with venues, caterers, florists, and tailors to enhance their offering. For manufacturers, consider who will provide your materials and how critical your relationship with that provider will be.
- Set monetization solutions. Until now, we haven't talked about how your company will make money. A business model isn't complete until it identifies how it will make money. This includes selecting the strategy or strategies above in determining your business model type. This might have been a type you had in mind but after reviewing your clients needs, a different type might now make more sense.
- Test your model. When your full plan is in place, perform test surveys or soft launches. Ask how people would feel paying your prices for your services. Offer discounts to new customers in exchange for reviews and feedback. You can always adjust your business model, but you should always consider leveraging direct feedback from the market when doing so.
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.
Criticism of Business Models
Joan Magretta, the former editor of the Harvard Business Review, suggests there are two critical factors in sizing up business models. When business models don't work, she states, it's because the story doesn't make sense and/or the numbers just don't add up to profits. The airline industry is a good place to look to find a business model that stopped making sense. It includes companies that have suffered heavy losses and even bankruptcy .
For years, major carriers such as American Airlines, Delta, and Continental built their businesses around a hub-and-spoke structure , in which all flights were routed through a handful of major airports. By ensuring that most seats were filled most of the time, the business model produced big profits.
However, a competing business model arose that made the strength of the major carriers a burden. Carriers like Southwest and JetBlue shuttled planes between smaller airports at a lower cost. They avoided some of the operational inefficiencies of the hub-and-spoke model while forcing labor costs down. That allowed them to cut prices, increasing demand for short flights between cities.
As these newer competitors drew more customers away, the old carriers were left to support their large, extended networks with fewer passengers. The problem became even worse when traffic fell sharply following the September 11 terrorist attacks in 2001 . To fill seats, these airlines had to offer more discounts at even deeper levels. The hub-and-spoke business model no longer made sense.
Example of Business Models
Consider the vast portfolio of Microsoft. Over the past several decades, the company has expanded its product line across digital services, software, gaming, and more. Various business models, all within Microsoft, include but are not limited to:
- Productivity and Business Processes: Microsoft offers subscriptions to Office products and LinkedIn. These subscriptions may be based off product usage (i.e. the amount of data being uploaded to SharePoint).
- Intelligent Cloud: Microsoft offers server products and cloud services for a subscription. This also provide services and consulting.
- More Personal Computing: Microsoft sells physically manufactured products such as Surface, PC components, and Xbox hardware. Residual Xbox sales include content, services, subscriptions, royalties, and advertising revenue.
A business model is a strategic plan of how a company will make money. The model describes the way a business will take its product, offer it to the market, and drive sales. A business model determines what products make sense for a company to sell, how it wants to promote its products, what type of people it should try to cater to, and what revenue streams it may expect.
What Is an Example of a Business Model?
Best Buy, Target, and Walmart are some of the largest examples of retail companies. These companies acquire goods from manufacturers or distributors to sell directly to the public. Retailers interface with their clients and sell goods, though retails may or may not make the actual goods they sell.
What Are the Main Types of Business Models?
Retailers and manufacturers are among the primary types of business models. Manufacturers product their own goods and may or may not sell them directly to the public. Meanwhile, retails buy goods to later resell to the public.
How Do I Build a Business Model?
There are many steps to building a business model, and there is no single consistent process among business experts. In general, a business model should identify your customers, understand the problem you are trying to solve, select a business model type to determine how your clients will buy your product, and determine the ways your company will make money. It is also important to periodically review your business model; once you've launched, feel free to evaluate your plan and adjust your target audience, product line, or pricing as needed.
A company isn't just an entity that sells goods. It's an ecosystem that must have a plan in plan on who to sell to, what to sell, what to charge, and what value it is creating. A business model describes what an organization does to systematically create long-term value for its customers. After building a business model, a company should have stronger direction on how it wants to operate and what its financial future appears to be.
Harvard Business Review. " Why Business Models Matter ."
Bureau of Transportation Statistics. " Airline Travel Since 9/11 ."
Microsoft. " Annual Report 2021 ."
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What is a business model and how to choose the best one for your venture
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You’re here because you want to start a new business. You might have an idea of the type of business you want to run, but you’re not entirely sure. Or you might even be asking, “What is a business model?”
That’s perfectly understandable, starting a new business is filled with uncertainty and excitement.
However, to improve your chances of success, there are a few things you’re going to need to nail down:
- A deep understanding of the problem that you’re solving for your customers.
- A market where your customers can actually pay for what you’re offering.
- A business model that actually makes your business money.
For the entirety of this post, we’re going to dive deep into that third point — finding a business model that aligns with your market and brings in revenue.
Guide to business models
Here is what we’ll be covering:
- Advertising business model.
- Affiliate marketing business model.
- Franchising business model.
- Freemium business model.
- Razor blade business model.
- Reverse razor blade business model.
- Subscription business model.
- Agency business model.
- Ecommerce business model.
Below you’ll learn what a business model is and isn’t, the most common business models out there today, and finally, how you can choose the right business model for your new venture.
What is a business model?
Put simply, a business model is an approach that you’re taking to make money. It’s how you deliver value to your customers, via products or services, in exchange for a set cost.
A business model is an essential element of any new startup, as it’ll help you understand your value over the long term.
Remember, your business model isn’t set in stone. Instead, think of it as a way to experiment and test different ways to monetize your business.
It’s more the revenue model you’re following.
For example, think of a company like Facebook. They started by making the platform completely free, and once the audience was large enough, they began monetizing via advertising. And that’s just one model they could have taken.
Others would have included charging a monthly subscription fee, or selling products and services.
Often, the business model you adopt will depend upon your market and what they’re willing to pay for. There’s a good chance that you might not end with the same business model you started with.
Take Amazon, for example. Today, Amazon AWS is one of Amazon’s biggest revenue generators by providing scalable cloud infrastructure solutions. But, when it was initially created, it was for an entirely different purpose.
It’s important to note that a business model is not a business plan.
Your business model is the revenue-generating approach you’re taking, while a business plan is an in-depth document that outlines your future and how you’ll go about achieving that future.
You can help to streamline the process of choosing and evaluating a business model via business model templates and canvases.
Related: 8 best business plan templates (and what to include in your own)
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9 common business models
There are dozens of different business models out there. Typically, businesses will rely on an overarching model and refine it to their own business needs.
The route you choose will depend upon your industry, but even more so, by what your customers are willing to pay for. So what are some of those business models?
Here’s a look at nine of the most common business models available to you today.
1. Advertising business model
The advertising business model has been around for a long time. Although print used to be the leading advertising medium, this has drastically switched to online and mixed-media formats.
The approach is simple: You create content that people want to consume and use display ads to monetize your business. You’re not charging your readers or visitors, but instead, are monetizing their attention by selling advertising space.
If you’re running a website, there are all kinds of advertising networks you can partner with to run ads. In this scenario, you usually get paid by clicks or views.
2. Affiliate marketing business model
The affiliate model is another incredibly common and lucrative business model, especially online. With affiliate marketing, you’re recommending products or services in exchange for a commission.
One super popular affiliate program is the Amazon Associates program . Once you join this affiliate network, you can promote any Amazon product in the world in exchange for a commission.
Beyond Amazon, there are thousands of additional products and services you can recommend depending on your niche and audience.
There’s an incredible number of successful case studies, including Pat Flynn of Smart Passive income who generates millions of dollars from affiliate sales . Or, Adam Enfroy, whose 9-month-old site brings in over $18k a month in affiliate revenue .
Related: How to get marketers for your affiliate marketing program
3. Franchising business model
Most of the examples here apply to the online space, although they can still be translated to the offline world as well.
However, the franchising business model is primarily an offline model.
Nearly every single 7-Eleven, McDonald's, and other fast-food restaurant chain is a franchise. In the case of McDonald's, over 90% of its locations are franchised .
This model works incredibly well if you're focused on expansion.
The franchisor will license most aspects of it's business to a franchisee, which then sells those products or services for a royalty.
Sometimes, the franchisor will also get a piece of the revenues, as is the case with the real estate giant RE/MAX .
4. Freemium business model
The freemium business model is another one you're probably very familiar with. This is where you give away an aspect of your product or service for free, then you charge for the premium version or for add-on features.
The critical distinction with freemium is that it's free forever. You could essentially have a large group of users who never upgrade to the premium version.
There are a ton of different examples of this, especially in the software space.
For example, Sumo is a suite of free apps to help your website generate more revenue. The free tools are packed with some serious power and will be more than enough for a majority of website owners.
But, there's also a sliding scale of premium options that provide website owners with more advanced features.
Another great example is Evernote . The organization and planning app has a freemium version that will suit most users’ needs, while the Premium and Business plans are equipped with higher-level features.
5. Razor blade business model
The razor blade business model is named after the product that basically invented the model. I bet you can guess what it is?
The business model is selling a particular aspect of your product at below cost — basically giving it away — to sell high volumes of another component of that product.
The most famous example of this is, of course, disposable razors. They give away the razor handle for free and make their money back on the high volume of blades you buy over the lifetime of the product.
Another common example of this is a printer. You buy the printer once, and you have to buy replacement ink cartridges time and time again (probably more often than you'd like).
6. Reverse razor blade business model
This business model flips the above approach on its head.
Instead of selling a low-margin product at the outset, you sell a high-margin product upfront and offer sales of low-margin products down the line.
With both of these products, you're joining a product ecosystem.
For example, let's look at the Apple ecosystem of products. If you buy a new MacBook, there's a good chance you'll end up buying apps from the App Store, songs from Apple Music, and maybe even an iPhone.
This model ensures a single (or multiple) high-end purchases, followed by a series of smaller purchases over the long-term.
7. Subscription business model
The subscription model goes back to the day of magazines, newspapers and even milk bottle home delivery.
No doubt, you already have a handful of subscription products you pay for every month.
The process is simple. Your customers pay a monthly fee to continue using your product or service. This is incredibly common for SaaS and content-driven businesses.
For example, The New York Times has a paywall where you can read four free articles per month, after which you'll have to pay a monthly membership fee to keep reading.
Netflix is a classic example of the subscription model. You pay your monthly subscription and get access to the entire streaming library.
Related: Subscription-based sales — A primer for small businesses
8. Agency business model
The agency model involves generating quality leads and selling them on services and marketing campaigns. This model has been alive and well for more than 200 years. The first advertising agency was founded back in 1786 by William Taylor .
The modern agency is obviously quite different from the first agencies, and the “Mad Men” days, but the process and work are similar. You manage marketing-related projects for several different clients.
For example, digital marketing superstar Neil Patel runs his own digital marketing agency and generates leads via his blog .
This model isn’t as scalable as selling subscription software or your own products, but it can still generate some serious revenue.
9. Ecommerce business model
Ecommerce is the fastest-growing retail sector . When most people think ecommerce, Amazon typically comes to mind. But, with beginner-friendly tools like GoDaddy’s Websites + Marketing Ecommerce and WooCommerce, starting your own ecommerce store is only a couple of clicks away.
There are countless success stories in the ecommerce space.
For example, Dollar Shave Club was able to bring the age-old business of selling razors to the modern world. They sell individual products, along with recurring product subscriptions delivered right to your door.
Or how about, Minaal , which was able to take their massive Kickstarter success into developing a highly successful ecommerce brand.
They sell backpacks and other travel gear that’s designed with digital nomads and full-time travelers in mind.
How to choose the best business model for you
As you can see, when you're launching your new startup, you're going to have a lot of different choices regarding your business model.
Do you use the subscription model, ecommerce, freemium or something else entirely?
Here's a process you can follow to help you determine the best business model for your new venture:
1. Consider your customer needs
The model you choose should align with your customer's needs and expectations.
For example, if you're taking the subscription model approach, then you'll be doing your customers a disservice if you also include advertising.
You can most definitely combine multiple models, but they need to place customer experience, and not profit, above all.
2. Consider how your customers buy
Some markets will be challenging to monetize. If you have a content-driven website that gets a high volume of traffic but doesn't convert well to product sales, then the advertising model is probably your best bet.
Do your customers often make high-end purchases? Or, will they be more receptive to a recurring subscription or a low-end product?
3. Consider the market potential and competition
Spend some time analyzing your market to see how other companies are generating revenue. If they've been in business for a while, then they've probably found a model that can be replicated.
However, there's always space to innovate and disrupt in a given market.
So don't feel like you're stuck doing only what's been done before.
4. Consider your value proposition
What makes you stand out in the marketplace ? If you're running an ecommerce business, do you only use U.S.-based manufacturers?
Or, do you offer a freemium version of an app in a marketplace dominated by paid app subscriptions?
Related: What is a value proposition?
5. Consider multiple revenue streams
Most successful businesses will rely on multiple revenue streams. In the early days of your new business, it's all about experimentation.
Now that you know what a business model is, feel free to play around with different models until you find one that deeply aligns with your business.
Most of the business model examples above can be combined to enhance one another to bring in more revenue for your business.
Conclusions and next steps
As you can see, some business models have stood the test of time and are hundreds of years old. Others are much newer, but scaling rapidly and taking over the marketplace.
Overall, there is no best business model, but instead, the best business model for your business. Let your market and customers dictate how you'll generate revenue.
Finally, remember that your choice of business model isn't set in stone, most businesses rely on multiple models and refine their approach with time.
This article includes content originally published on the GoDaddy blog by Robin Walters .
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What Is a Business Model?
- Andrea Ovans
A history, from Drucker to Christensen.
A look through HBR’s archives shows that business thinkers use the concept of a “business model” in many different ways, potentially skewing the definition. Many people believe Peter Drucker defined the term in a 1994 article as “assumptions about what a company gets paid for,” but that article never mentions the term business model. Instead, Drucker’s theory of the business was a set of assumptions about what a business will and won’t do, closer to Michael Porter’s definition of strategy. Businesses make assumptions about who their customers and competitors are, as well as about technology and their own strengths and weaknesses. Joan Magretta carries the idea of assumptions into her focus on business modeling, which encompasses the activities associated with both making and selling something. Alex Osterwalder also builds on Drucker’s concept of assumptions in his “business model canvas,” a way of organizing assumptions so that you can compare business models. Introducing a better business model into an existing market is the definition of a disruptive innovation, as written about by Clay Christensen. Rita McGrath offers that your business model is failing when innovations yield smaller and smaller improvements. You can innovate a new model by altering the mix of products and services, postponing decisions, changing the people who make the decisions, or changing incentives in the value chain. Finally, Mark Johnson provides a list of 19 types of business models and the organizations that use them.
In The New, New Thing , Michael Lewis refers to the phrase business model as “a term of art.” And like art itself, it’s one of those things many people feel they can recognize when they see it (especially a particularly clever or terrible one) but can’t quite define.
That’s less surprising than it seems, because how people define the term really depends on how they’re using it.
Lewis, for example, offers up the simplest of definitions — “All it really meant was how you planned to make money” — to make a simple point about the dot.com bubble, obvious now, but fairly prescient when he was writing at its height, in the fall of 1999. The term, he says dismissively, was “central to the Internet boom; it glorified all manner of half-baked plans…The ‘business model’ for Microsoft, for instance, was to sell software for 120 bucks a pop that cost fifty cents to manufacture …The business model of most Internet companies was to attract huge crowds of people to a Web site, and then sell others the chance to advertise products to the crowds. It was still not clear that the model made sense.” Well, maybe not then.
A look through HBR’s archives shows the many ways business thinkers use the concept and how that can skew the definitions. Lewis himself echoes many people’s impression of how Peter Drucker defined the term — “assumptions about what a company gets paid for” — which is part of Drucker’s “theory of the business.”
That’s a concept Drucker introduced in a 1994 HBR article that in fact never mentions the term business model. Drucker’s theory of the business was a set of assumptions about what a business will and won’t do, closer to Michael Porter’s definition of strategy . In addition to what a company is paid for, “these assumptions are about markets. They are about identifying customers and competitors, their values and behavior. They are about technology and its dynamics, about a company’s strengths and weaknesses.”
Drucker is more interested in the assumptions than the money here because he’s introduced the theory of the business concept to explain how smart companies fail to keep up with changing market conditions by failing to make those assumptions explicit.
Citing as a sterling example one of the most strategically nimble companies of all time — IBM — he explains that sooner or later, some assumption you have about what’s critical to your company will turn out to be no longer true. In IBM’s case, having made the shift from tabulating machine company to hardware leaser to a vendor of mainframe, minicomputer, and even PC hardware, Big Blue finally runs adrift on its assumption that it’s essentially in the hardware business, Drucker says (though subsequent history shows that IBM manages eventually to free itself even of that assumption and make money through services for quite some time).
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How to Design a Winning Business Model
Joan Magretta, too, cites Drucker when she defines what a business model is in “ Why Business Models Matter ,” partly as a corrective to Lewis. Writing in 2002, the depths of the dot.com bust, she says that business models are “at heart, stories — stories that explain how enterprises work. A good business model answers Peter Drucker’s age-old questions, ‘Who is the customer? And what does the customer value?’ It also answers the fundamental questions every manager must ask: How do we make money in this business? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost?”
Magretta, like Drucker, is focused more on the assumptions than on the money, pointing out that the term business model first came into widespread use with the advent of the personal computer and the spreadsheet, which let various components be tested and, well, modeled. Before that, successful business models “were created more by accident than by design or foresight, and became clear only after the fact. By enabling companies to tie their marketplace insights much more tightly to the resulting economics — to link their assumptions about how people would behave to the numbers of a pro forma P&L — spreadsheets made it possible to model businesses before they were launched.”
Since her focus is on business modeling, she finds it useful to further define a business model in terms of the value chain. A business model, she says, has two parts: “Part one includes all the activities associated with making something: designing it, purchasing raw materials, manufacturing, and so on. Part two includes all the activities associated with selling something: finding and reaching customers, transacting a sale, distributing the product, or delivering the service. A new business model may turn on designing a new product for an unmet need or on a process innovation. That is it may be new in either end.”
Firmly in the “a business model is really a set of assumptions or hypotheses” camp is Alex Osterwalder, who has developed what is arguably the most comprehensive template on which to construct those hypotheses. His nine-part “ business model canvas ” is essentially an organized way to lay out your assumptions about not only the key resources and key activities of your value chain, but also your value proposition, customer relationships, channels, customer segments, cost structures, and revenue streams — to see if you’ve missed anything important and to compare your model to others.
Once you begin to compare one model with another, you’re entering the realms of strategy, with which business models are often confused. In “ Why Business Models Matter ,” Magretta goes back to first principles to make a simple and useful distinction, pointing out that a business model is a description of how your business runs, but a competitive strategy explains how you will do better than your rivals. That could be by offering a better business model — but it can also be by offering the same business model to a different market.
Introducing a better business model into an existing market is the definition of a disruptive innovation . To help strategists understand how that works, Clay Christensen presented a particular take on the matter in “ In Reinventing Your Business Model ” designed to make it easier to work out how a new entrant’s business model might disrupt yours. This approach begins by focusing on the customer value proposition — what Christensen calls the customer’s “job-to-be-done.” It then identifies those aspects of the profit formula, the processes, and the resources that make the rival offering not only better, but harder to copy or respond to — a different distribution system, perhaps (the iTunes store); or faster inventory turns (Kmart); or maybe a different manufacturing approach (steel minimills).
Many writers have suggested signs that could indicate that your current business model is running out of gas. The first symptom, Rita McGrath says in “ When Your Business Model is In Trouble ,” is when innovations to your current offerings create smaller and smaller improvements (and Christensen would agree). You should also be worried, she says, when your own people have trouble thinking up new improvements at all or your customers are increasingly finding new alternatives.
Knowing you need one and creating one are, of course, two vastly different things. Any number of articles focus more specifically on ways managers can get beyond their current business model to conceive of a new one. In “ Four Paths to Business Model Innovation ,” Karan Giotra and Serguei Netessine look at ways to think about creating a new model by altering your current business model in four broad categories: by changing the mix of products or services, postponing decisions, changing the people who make the decisions, and changing incentives in the value chain.
In “ How to Design a Winning Business Model ,” Ramon Cassadesus-Masanell and Joan Ricart focus on the choices managers must make when determining the processes needed to deliver the offering, dividing them broadly into policy choices (such as using union or nonunion workers; locating plants in rural areas, encouraging employees to fly coach class), asset choices (manufacturing plants, satellite communication systems); and governance choices (who has the rights to make the other two categories of decisions).
If all of this has left your head swimming, then Mark Johnson, who went on in his book Seizing the White Space to fill in the details of the idea presented in “Reinventing Your Business Model,” offers up perhaps the most useful starting point — this list of analogies, adapted from that book:
Can’t Think of a New Business Model?
Try adapting one of these basic forms.
Source: Seizing the White Space, by Mark Johnson
- AO Andrea Ovans is a former senior editor at Harvard Business Review.