What is a business model?
A business model is a description of how your business intends to operate and make money. At the most basic level, it involves a producer making something and selling it directly to customers at a profit (but this simple model has propagated into numerous diverse models in recent years).
Alexander Osterwalder, co-author of the book Business Model Generation, defines a business model as:
‘… a description of the value a company offers to one or several segments of customers and of the architecture of the firm and its network of partners for creating, marketing, and delivering this value and relationship capital, to generate profitable and sustainable revenue streams.’
The development of a business model is essentially a strategic perspective rather than an operational assessment, and focuses on how you capture value i.e. it includes a description of the value proposition. Deciding upon a business model becomes particularly important as a concept when it is not a simple ‘make and sell direct‘ model and you are looking to create value through a non linear route.
The Business Model – An Introduction
In days of old, business was arguably a lot simpler; you produced something and sold it for a profit, building up a good reputation over time so as to ensure ongoing patronage. Before the industrial revolution most sales were essentially local, and you had a much greater steer on competition, demand levels and pricing. You probably sold your products directly to consumers as the butcher, baker or candlestick maker.
Fast forward 200 years and business has changed considerably. A lot more creativity is needed to get noticed in a time-pressed world (not to mention in making a sale). You are probably facing global competitors, and in many instances a widely dispersed audience who are increasingly difficult to reach in a cost effective manner. As a result, numerous alternative strategies have emerged to get your product to market, safely into the hands of the consumer and business model innovation has become increasingly popular.
“Companies that put more emphasis on business model innovation experienced significantly better operating margin growth (over a five-year period) than their peers.”
Source: IBM Global CEO Survey
Mark Johnson, author of ‘Seizing the White Space,’ agrees about the benefits, arguing that:
“Business model innovation is the key to unlocking transformational growth–but few executives know how to apply it to their businesses.”
In many respects the emergence of business model innovation started with Gillette and razor blades. They worked out that if they sold the razor at low cost, consumers would happily pay for the blades. Given the resultant switching costs and customer inertia, the result was often a lifetime of patronage (despite the fact the initial transaction was a loss-making one for the producer). In essence, by providing something at below the market price (the razor); you can create a market for a secondary product (the blade) upon which you make ongoing profits. A second characteristic of the model was that the mark-up on the secondary products were often disproportionate relative to their cost so were highly profitable for the manufacturer. Anyone who has had to buy replacement ink cartridges will bear witness to this!
A trend in recent years has however been the growth of companies (often Web 2.0 ones) with uncertain business models. Take Twitter, for example:
“Twitter has become an influencer in the way information is shared around the world. But while its immediacy, transparency and simplicity offer answers about all things both newsworthy and mundane, one big question about Twitter has gone virtually unanswered: how it plans to turn a profit.”
Source: CNN article (July 9, 2010)
Of course, the big challenge for the likes of Twitter, Facebook and other social media sites is that attempts to monetise come at a number of costs, often the privacy of the user and their ability to use the service without interruptions from third party advertisers. Monetising a free service invariably degrades the experience for the customer and hence companies need to walk a fine line as Facebook found to its cost in recent months.
Thinking about your business model
If you are an entrepreneur starting a new business, it is very important that you consider a number of different business models as it is possible to derive revenues from a range of different sources at various stages of the product’s lifecycle.
Businesses can also operate hybrid business models. For example, newspapers make their money from a mix of advertising revenue and the price they obtain for the newspaper. As we have seen in London, models can change over time as the value of certain portions of the business increase in value; for example, the Evening Standard newspaper is now given away free every evening (hence relying solely on advertising income to sustain itself). As U.S. Cambridge, U.K. -based entrepreneur Doug Richards proclaims:
‘One may start a business with the idea that one will sell a product to customers only to discover that no one will pay for it, but they will accept it when it is provided for free. When that’s the case, advertisers may pay for the production and distribution of the product.’
In essence, business models are essentially dynamic as new opportunities can emerge at various points on the value chain. Sticking to the newspaper industry, the dominant online business model for many years was free online content supported by advertising. However, the commercial viability of such a model is not sustainable (most sites lose money) and this tactic also results in lost sales as some people substitute a free digital copy for a physical paid one. The Times in the U.K. has recently changed its model to a ‘paid for’ access one – whether they can make it a success is debatable, given the fact so many free substitutes are only one click away!
Uses for business models
1. Starting a new business
If you are starting a new business (particularly an Internet-based one) and are seeking investment, the business model will be an important element of your business plan. Any prospective investor will be very keen to understand your business model clearly i.e. how you intend to generate cash, and whether it appears that you can do so profitably.
2. Innovation and product design
Business model innovation enables you to take a holistic view of the business to assess unique opportunities that exist outside of innovation solely on the product side. Business models also jump industry so it is a good idea to keep a breast of innovative business models you come across (regardless of the context). One simple (yet common) form of innovation is deploying business models from another industry in your own. As Mark Johnson claimed in ‘Reinventing your Business Model’:
“Business model innovations have reshaped entire industries and redistributed billions of dollars of value.”
The low cost business model pioneered by the likes of Irish airline, Ryanair (replicating the Southwest Airlines model) is now becoming more popular in the hotel industry, for example, where costs are being reduced significantly and entire business models are being reassessed. The CitizenM hotel in Amsterdam airport, in the Netherlands is one such example; staffing levels are far below industry averages as customers are forced to self serve.
“We looked at every process to see where we could streamline,” says Michael Levie of the new hotel chain. “Building costs and personnel costs are the biggest outlay for hotels. So we have no reception or restaurant staff. And the construction is modular. Our hotel rooms are designed as fully fitted units that can be stacked one on top of the other. This way, we’ve managed to reduce the construction time to ten months, saving on costs.”
Over time as new technologies emerge inefficient business models get displaced. One good example is the music industry. While the primary driver of the value is the musician, the actual value created is dispersed in numerous directions as the following post illustrates:
|$0.17 Musicians’ unions||$0.80 Packaging/manufacturing|
|$0.82 Publishing royalties||$0.80 Retail profit|
|$0.90 Distribution||$1.60 Artists’ royalties|
|$1.70 Label profit||$2.40 Marketing/promotion|
|$2.91 Label overhead||$3.89 Retail overhead|
(Source: Almighty Institute of Music Retail)
The value dispersion is instructive and hence it is not surprising that digital delivery of music (disintermediating the distributor) would emerge as a more compelling business model. The launch of the iPad and the growing popularity of devices such as the Kindle are also likely to drive the take up of a new digital orientated business models for the book industry.
3. Creating Revenue Streams
As I mentioned in the opening sections some Internet companies struggle to monetize their customer base. Their business model is effectively parked as a trade off to attracting ‘users’. The logic here is simple; if you offer a free service you remove the biggest risk or barrier to new prospects. Once you have significant volumes of users you can then create a business model to monetise this large user base.
Similarly, in the gaming industry ‘free to play’ has been a popular model where users play the games for free but pay to acquire virtual goods be it tools to play the game better e.g. buying weapons or multiplayer access.
4. Competitive Analysis
A traditional means to assess the attractiveness of an industry was to undertake strategic analysis using the methodology prescribed by Michael Porter in his Five Force Analysis. His core argument was that these following five forces determine the competitiveness of an industry and hence its attractiveness:
- The threat of the entry of new competitors
- The intensity of competitive rivalry
- The threat of substitute products or services
- The bargaining power of customers (buyers)
- The bargaining power of suppliers
Understanding businesses from a business model perspective can also be extremely instructive as you can build up a narrative regarding how companies perform certain activities to gain a clear understanding as to their strategies. Using this in tandem with Porter’s Five Forces will give you a good sense of the competitive landscape which can then help you decide on the optimal strategy to pursue and also to preempt competitive threats.
About the Author:
Alan Gleeson is the managing director of Palo Alto Ltd, the UK division of Palo Alto Software.