What is a business model?
A business model is a business plan for making a profit. It identifies the products or services that the company will sell, the target market it has identified and the expenses it forecasts.
A new business in development must have a business model, if only to attract investment, help it recruit talent and motivate management and staff. Established businesses often have to review and update their business plans, or they will fail to anticipate future trends and challenges. Investors should review and evaluate the business plans of the companies that interest them.
How a business model works
A business model is a high-level plan for profitable operation of a particular business in a specific market. A main element of the business model is the value proposition. It 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 business model for a new business should also cover start-up costs and expected sources of funding, target business customers, marketing strategy, competitive review, and revenue and expense projections.
A common mistake in creating a business model is to underestimate the costs of financing the business until it becomes profitable. It is not enough to count the costs for the introduction of a product. A business must continue to operate until revenues exceed expenses.
A business model can also define partnership opportunities with other established businesses. An example would be an advertising company that could benefit from an arrangement for referrals to and from a print shop.
Types of business models
There are as many types of business models as there are types of businesses. Direct selling, franchising, advertising, and brick and mortar stores are all examples of traditional business models. There are also hybrids, such as companies that combine Internet retailing with brick and mortar stores, or sports organizations like the NBA.
Within these broad categories, each business plan is unique. Consider the shaving industry. Gillette is pleased to sell its Mach3 razor handle at cost or less to obtain stable customers for its more profitable razor blades. The business model is based on giving the handle to get these blade sales. This type of business model is actually called the razor-razor blade model, but it can be applied to any business that sells a product at a significant discount in order to provide a dependent good at a considerably higher price.
When you value a business as a possible investment, find out exactly how it makes money – it’s the business model of the business.
The benefits of a business model
Successful companies have adopted business models that allow them to meet customer needs at a competitive price and at a sustainable cost. Over time, many companies revise their business models from time to time to reflect changing business environments and market demands.
Analysts and investors assess the success of a business model by examining the company’s gross profit. Gross profit is the total income of a business less the cost of goods sold. Comparing a company’s gross profit to that of its main competitor or its industry highlights the efficiency and effectiveness of its economic model.
Gross profit alone can, however, be misleading. Analysts also want to see cash flow or net profit. This is gross profit minus operating expenses and indicates how much real profit the business generates.
The two main drivers of a business model are prices and costs. A business can raise prices and find inventory cheaply. Both actions increase gross profit.
Nevertheless, many analysts consider that gross profit is more important in the evaluation of a business plan. A good gross profit suggests a solid business plan. If the expenses are out of control, management could be at fault and the problems are correctable. As this suggests, many analysts believe that companies that operate on the best business models can manage themselves.
Examples of business plans
Consider a comparison of two competing business plans. Both companies rent and sell films. Before the advent of the Internet, the two companies made $ 5 million in revenue after spending $ 4 million on their film inventories.
This means that each business makes a gross profit calculated at $ 5 million minus $ 4 million, or $ 1 million. They also have the same gross profit margin, calculated as gross profit divided by revenues, or 20%.
After the advent of the Internet, Company B decided to offer online streaming movies instead of renting or selling physical copies of movies. This change is disrupting the economic model in a positive way. License fees remain the same, but the cost of holding inventory has dropped significantly. In fact, the change reduces storage and distribution costs by $ 2 million. The company’s new gross profit is $ 5 million minus $ 2 million, or $ 3 million. The new gross profit margin is 60%.
Meanwhile, Company A is stuck with its lower gross profit margin and sales will soon start to decline. He failed to update his business plan. Company B is not even making more sales, but it has revolutionized its business model, which has significantly reduced its costs.
The disadvantages of business models
Joan Magretta, former editor-in-chief of Harvard business review, suggests that there are two critical factors in the sizing of 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 match the profits.
The airline industry is a good place to look for a business model that no longer makes sense. It includes companies that have suffered heavy losses and even bankruptcy.
For years, major carriers such as American Airlines, Delta and Continental have built their business around a “hub and spoke” structure, in which all flights are routed through a handful of major airports. By making sure that most of the seats were occupied most of the time, the business model generated big profits.
But a competing business model emerged that made the strength of the major carriers a burden. Carriers like Southwest and JetBlue commuted between smaller airports at lower cost. They avoided some of the operational inefficiencies of the hub and spoke model while lowering labor costs. This allowed them to lower prices, increasing the demand for short flights between cities.
As these new competitors attracted more customers, the old carriers were left to support their large, extensive networks with fewer passengers. The problem worsened when traffic fell sharply in 2001. To fill the seats, airlines had to offer larger and larger discounts. The star business model no longer makes sense.
Investor’s point of view
What does this mean for an investor? When evaluating a business as a possible investment, the investor should know exactly how he is making his money. It is the business model of the company. Certainly, the economic model does not tell you everything about the prospects of a business. But the investor who understands the business model can better understand the financial data.
- A business model is a company’s basic strategy for doing business profitably.
- The two levers of an economic model are pricing and costs.
- When evaluating a business model as an investor, ask if the idea makes sense and if the numbers add up.