Business Model

What Is a Business Model?
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 plans or they'll fail to
anticipate trends and challenges ahead. Business plans help investors evaluate
companies that interest them.
KEY TAKEAWAYS
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.
The two levers of a business model are pricing and costs.
When evaluating a business model as an investor, ask whether the idea makes sense
and whether the numbers add up.
Understanding Business Models
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.
1:24
Business Model
Special Considerations
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—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.
Each business plan is unique within these broad categories. Consider the shaving
industry. Gillette is happy to sell its Mach3 razor handle at cost or for a lower
price in order to get steady customers for its more profitable razor blades. The
business model rests on giving away the handle to get blade sales. This type of
business model is actually called the razor-razorblade model, but it can apply to
companies in any business that sells a product at a deep discount in order to
supply a dependent good at a considerably higher price.
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.1 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. But 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 2001.2 To fill seats, these airlines had to offer more discounts at even deeper
levels. The hub-and-spoke business model no longer made sense.
Examples of Business Models

Consider a comparison of two competing business plans where two companies rent and
sell movies. Both businesses made $5 million in revenues after spending $4 million
on their inventories of movies. This means that each company makes a gross profit
calculated as $5 million minus $4 million, or $1 million. They also have the same
gross profit margin, calculated as 20% of gross profit divided by revenues.
But things change with the arrival of the internet. Company B decides to stream
movies online instead of renting or selling physical copies. This change disrupts
the business model in a positive way. The licensing fees don't change, but the cost
of holding inventory goes down considerably. In fact, the change reduces storage
and distribution costs by $2 million. The new gross profit for the company is $5
million minus $2 million, or $3 million. The new gross profit margin is 60%.
Meanwhile, Company A fails to update its business plan and is stuck with a lower
gross profit margin. As a result, its sales begin to slide downwards. Company B
isn't even making more in sales, but it has revolutionized its business model, and
that has greatly reduced its costs.

Business Model

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Business Model

Uploaded by

Copyright:

Available Formats

What Is a Business Model?

Criticism of Business Models

Examples of Business Models

You might also like