When embarking on a new business venture, one of the first things to establish is how the company will make a profit. This is determined by your company's business model. The business strategy your organization uses can provide a competitive advantage and help you gain market share. Identifying which of the innovative business models will work best for your business plan will also intrigue investors to get them on board with funding your company.
What Is a Business Model?
A business model is a company’s plan for how it will make money. The business model is the foundation for almost every aspect of the company, from the products and services to the marketing campaign and the operations and logistics. Understanding the revenue model and cost structure helps companies anticipate their revenue streams.
There are many reasons to establish a business model, including attracting investors to provide funding and recruiting the best employees for the business. The company should review its business model frequently to take into account the fluctuations in the market and the changes within the company, ensuring the model will still help it achieve its revenue goals. If not, it’s important to alter or add elements to the current business model to increase revenue.
Business Model Canvas
A business model is typically represented on a tool called a business model canvas. This was first established by Alexander Osterwalder, a Swiss business theorist. Each business model, according to the canvas, needs to include:
- Unique value proposition: The core value your business provides to your target market. This is one of the most important sections of the business model. It’s vital to identify what you do and why it’s different from your competitors. In addition, it’s important to articulate the problems you’re solving with your offerings and the needs that your products and services meet for the target audience.
- Key partners: The people involved in the business, including suppliers and manufacturers without whom the business cannot function. This section should outline the resources that are being acquired from the partners as well as what function each partner performs. Knowing this information helps to reduce risk and plan for acquiring resources.
- Key activities: The tasks that need to be completed in order to deliver the key value proposition to the target market. This section may include information about the distribution channels as well as how the company interacts with customers. It should also outline the company's various revenue streams.
- Key resources: What you need to deliver your unique value proposition. This section may include elements like copyrights or patents in addition to funding, human resources and physical warehouse space or an office.
- Cost structure: The costs that are inherent in your business model. This includes fixed costs like rent in addition to variable costs like shipping. It’s critical to figure out which resources and activities are the most expensive. This section can help businesses to identify whether they are cost-driven or value-driven.
- Customer relationships: The way your business interacts with customers throughout their journey. In this section, it’s important to outline how your target audience expects you to interact with them as well as the current interactions the company has established. Looking at the cost of customer interactions is also important in this area.
- Channels: The way the company sells and delivers its products and services. In this section, you should outline how each audience segment needs to be reached, which channels are the most cost efficient and how channels can be integrated with customer journeys.
- Customer segments: The people for whom you create value with your business. This section identifies the target market and any secondary markets for the business. In this section, it’s important to identify how customers are segmented and articulate their needs, wants, challenges and behaviors.
- Revenue streams: The way the business earns money from the unique value proposition. This section looks at what the target market is willing to pay for your offering, the way they prefer to pay and how each stream contributes to the overall company revenue.
Types of Business Models
There are many different types of business models and hybrid models that companies can use to make a profit. The type of business model you use will affect the profitability of your organization, your competitiveness within the market and whether or not you will attract investors. It’s important to weigh the pros and cons of several different business models to understand which will most appeal to your target market while helping the company reach its profit margin and revenue goals.
The different types of business models include:
- Retailer: The business sells directly to the public from a physical or online store after purchasing products from a manufacturer, distributor or wholesaler. Retailers can be exclusively brick-and-mortar, like many small businesses, or exclusively online, like Amazon. They can also include a hybrid “bricks-and-clicks” model where they have a physical store and an online store, like many apparel and shoe companies.
- Distributor: This business purchases products from manufacturers and resells them to retailers. Automotive dealerships are an example of distributors.
- Manufacturer: In this business model, the company makes the end product using raw materials. It may sell directly to the public or may sell to a distributor or retailer. Examples of manufacturers include 3M, General Electric and Ford Motors.
- Franchising: There are many different forms of franchises. A franchisee uses the business model of the parent company and pays it royalties in order to use its brand and processes. McDonald's and Arby’s are examples of franchises.
- Hidden revenue: In this online model, a free app or service is offered. The company then uses the data of the users to earn revenue. Google and Facebook, for example, sell ads based on their user data, but the service to the users is free.
- Freemium: This is one of the most common online business models. The basic service is provided free to customers with additional packages they can purchase for add-on services. The basic service has specific restrictions and limitations, so many customers need to purchase extra services in order to meet their needs. In the freemium model, the free services act as a marketing tool for the paid services the company offers. Examples include LinkedIn, YouTube and Dropbox.
- Aggregator: A recent development, this business model brings together different service providers to sell their offerings to consumers under one brand. The service providers earn their income through commission from the aggregator. Uber, Lyft and AirBnb are aggregators. This is sometimes referred to as the peer-to-peer business model.
- Online marketplace: This is a version of the aggregator model; however, the key difference is that the providers sell their goods and services under their own brand. In an online marketplace, different vendors provide similar products at competitive prices. The marketplace earns commission on every item that is sold via its platform. Examples include Alibaba and Amazon.
- Subscription: This business model is designed for industries where the cost of customer acquisition is high. A subscription model enables the business to get recurring revenue through consistent repeat purchases. Netflix is an example of the subscription business model.
- Affiliate marketing: By promoting a partner’s product, the affiliate earns a commission every time a sale is successfully referred. Lifewire is an example of the affiliate model.
- Multilevel marketing: This is a pyramid structure business network where a company earns a commission every time a sale is made or if the recruits under it make a sale. Direct selling is a large component of this business model. Examples include Avon, Tupperware and The Pampered Chef.
- Crowdsourcing: This model relies on large masses of users to provide value for each other. This business model is usually combined with other ones in order to provide several revenue streams for users and for the company. YouTube and Wikipedia are examples of crowdsourcing.
- Nickle and dime: The key offering is provided to customers at a very low price. Anything extra that is offered in relation to the key product is sold at a higher cost. For example, budget airlines price their seats low but charge extra for baggage or seat selection.
- Negative operating cycle: The business is able to offer competitively low prices by asking for payment before the product or service is delivered to the customer. Amazon is an example of this model.
- Low touch: Businesses can offer low prices by removing specific services that others in the industry may offer. IKEA is a low-touch model, as customers have to get their own products from the warehouse and assemble them after purchase.
- Razor-razorblade: A high-margin product is sold slightly below cost with the goal of increasing sales of a low-margin companion product, like ink and printers or razors and razor blades.
- Reverse razor-razorblades: This is the opposite of the razor blade, where the low-margin product is sold below cost to encourage volume sales of the high-margin item, like Kindle and other e-readers.
- Product to service: Instead of selling the product, businesses sell the service that the product is needed for performing. For example, ZipCar and similar companies don’t sell cars — just the ability to drive when required.
Keep in mind that your business doesn’t have to limit itself to one business model. Many companies use a combination of business models and business model innovation in order to make money. It all depends on your customers and the value you offer them.
Evaluating the Success of a Business Model
In order to figure out whether the new business model is working, it’s important to look at the company’s gross profit, which is the revenue minus the cost of goods. When compared to industry standards, this will show the efficiency of the business model. In addition, it’s wise to look at cash flow or net income, which is the gross profit minus the operating expenses. This is a clear indication of the profit the business is making.
A high gross profit shows that the company is using the correct business model for selling its unique value proposition to its target market through the best channels. If the gross profit is lower than industry standards, it’s important to look at how it can be improved. Ways to increase the gross-profit metric include raising the prices of products and services or reducing the costs of expenses.
Business Model Canvas Template and Example
The business model canvas that was first developed by Alexander Osterwalder is the go-to tool for creating a successful business model for your business. On one page, it outlines all of the key information you need to identify how your business will be profitable.
If an entrepreneur is looking to start selling children’s clothes in a store and online, for example, the business model canvas may include:
- Unique value proposition: Carefully curated designer clothing for fashionable kids
- Key partners: Clothing suppliers and manufacturers, angel investors and e-commerce site partner
- Key activities: Supply-chain management, brand exploration and building, community-building activities and web platform development
- Key resources: Funding, sales employees and brick-and-mortar space with a large storage room and shipping-label equipment
- Cost drivers: Inventory, human resources, fixed expenditures (rent, utilities) and online platform charges
- Customer relationships: Building the brand community online through social media and providing high-touch sales support in the store and online
- Channels: Social media, online store, print advertising, boutique location
- Customer segments: Parents of children who have a high income and affinity for fashion
- Revenue streams: In-store purchases, online purchases and affiliate links
- Investopedia: Business Model
- Harvard Business Review: What Is a Business Model?
- FourWeekMBA: What is a Business Model?
- Corporate Finance Institute: Business Model Canvas Template
- Alexander Cowan: The 20-Minute Business Plan: Business Model Canvas Made Easy
- Development Impact and You: Business Model Canvas
Anam Ahmed is a Toronto-based writer and editor with over a decade of experience helping small businesses and entrepreneurs reach new heights. She has experience ghostwriting and editing business books, especially those in the "For Dummies" series, in addition to writing and editing web content for the brand. Anam works as a marketing strategist and copywriter, collaborating with everyone from Fortune 500 companies to start-ups, lifestyle bloggers to professional athletes. As a small business owner herself, she is well-versed in what it takes to run and market a small business. Anam earned an M.A. from the University of Toronto and a B.A.H. from Queen's University. Learn more at www.anamahmed.ca.