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What is the Business Model?
In short, the business model is the mechanism (general process) by which your business will deliver and receive value from customers. It consists of information that can be found in a business plan, but the business model allows for a working visualization of all of the pieces and how they fit together. The business model focuses on the operational aspects of the business and incorporates short-term and long-term strategic positions. It is, in effect, far less cumbersome and detailed than the business plan. It prioritizes the operational aspects of the business to allow for strategic decision-making and assessment of the business’ development.
Business Models and Strategies
An effective strategy identifies and implements a business model that furthers that strategy or works in furtherance of strategic objectives.
For more on business models, see our posts:
- Business Model vs Business Plan
- Constructing a Business Model
- Business Model Canvass
- Insights into the Small Business Model
Let’s explain how business strategy and a business model are related. As discussed in other lectures, business strategy concerns the business orientation toward achieving goals and objectives. The business will establish operations that deliver a value proposition. These operations will employ numerous techniques that carry out or effectuate the business’s strategy for successful delivery of the value proposition. The method by which the business delivers value to the customer and, in turn, receives a return of the amount and type of desired value is known as the business model. That is, the business model tracks the inputs that go into delivering a value proposition and the output from delivering that value proposition. That output will allow for the receipt of the value desired by the business.
Let’s take a look at some examples of business models. A product manufacturer creates a product that a customer will eventually purchase. The business model may involve selling directly to customers through any channel, or selling to distributors or wholesalers who then resell the product to retailers. A service provider might deliver services to businesses or individual consumers. These services may be delivered in person or remotely (via the internet). Either of these recipients of service may pay an hourly rate, a fixed fee, a recurring subscription, or a contingency fee based upon success or performance. This is a common service provider business model. A more complicated business model would be a Facebook. Facebook delivers value to customers by providing a platform for connecting socially. In return, Facebook has access to customer demographic information and the ability to market to these customers. The value received from users is their attention and personal information. Now, Facebook can sell marketing space with special targeting ability to third-party sellers of products and services. This is a unique business model in that the individual user of Facebook does not directly compensate Facebook.
Business Model vs Business Plan
The business model is a fundamental concept/tool in entrepreneurship and is the subject of great attention in entrepreneurial circles. In fact, many entrepreneurs see the business model as more beneficial than the business plan. They believe that developing a full business plan is too detailed and cumbersome for a startup venture. As you see from these lectures, the business plan is a mass of information that bases calculations and projections in one section on assumptions from another section. Changes in any one aspect of the business can greatly alter the accuracy and overall usefulness of the plan. The answer to this is the boiling down of elements of the business plan into a useful tool (an operational assessment) that can guide decision-making and actions within the early-stage, startup venture.
While the business model advocates recognize the value of the business plan, they put greater emphasis on the business model as a useful tool for guiding the entrepreneur in the early stages of a start-up. Personally, I believe that the business model argument has a great deal of merit. This text focuses around the building of a business and uses the business plan as a teaching model. However, the tools derived during business planning (e.g., the feasibility analysis, the business model, the marketing plan) are extremely valuable standalone documents.
Value of the Business Plan
While the business model is slowly becoming the go-to instrument for business planning, the business plan still has a great deal of value. This is particularly true for business funding. A new business cannot get a business loan from a commercial lender without producing a business plan, complete with financial projections. Likewise, investors still want to see a detailed analysis of the business. While a business model provides a working model, it generally does not go into the depth required by equity investors. The point of this paragraph is to demonstrate that maintaining a well-constructed business plan is still critical to a new business.
Parts of the Business Model
Business models generally consist of multiple categories or sections that correspond to some critical operational and strategic aspect of the business. The actual components of the business model may differ depending upon the nature of the business; however, there are common segments that often appear in every business model. Below are some common elements of the business model.
- Value Proposition – The value proposition indicates how the business fulfills a customer need or want. Further, it describes the uniqueness of how it fulfills that need or want. The value proposition is linked very closely to the concept statement and a general description of the market opportunity.
- Target Markets – Target market breaks down the customer segment(s) that the product or service primarily serves. This section should explain each customer segment, the characteristics of each, and how the product or service will meet that customer segment’s wants or needs.
- Business Processes – This section explains all of the procedural or operational processes that have to take place in order to deliver value to the customer. The business processes will differ between businesses, but some common processes are as follows:
- Production – Producers of the product or service being sold.
- Sourcing – Process from obtaining raw material, parts, or finished products from suppliers.
- Value and Resource Configuration – How you utilize the activities, personnel, and resources necessary to produce your product are your value and resource configurations or value chain.
- Distribution and Movement Channel – How you get your product to its target market.
- Marketing to Consumers – Key aspects of the plan to reach customers with information about the business.
- Selling – How to exchange the value with the customer.
- Note: This section of the business model should account for the major procedural steps in the value chain. Each procedural aspect has a different level of importance or significance to the business’ development. As such, your model should contain some level of prioritization for aspect of operations and assign responsibility for tasks to given positions or individuals in the business.
- Strategic Positioning – This section contains details about how the business is positioned in the market relative to other competitors. It outlines the factors that set the business apart or provide some unique operational advantage in the market. Common elements of the strategic position segment include:
- Core Competencies – The basic knowledge, skill set, abilities, and expertise required to produce your product is your core competency. Initially, it rests in the owner-innovator and the team she surrounds herself with to bring the product to market.
- Product Differentiation – This section acknowledges the position of other players (competitors) in the market and explains how your product or service is positioned relative to those players. It should highlight the product’s value proposition relative to that of other competitors. In short, is allows the entrepreneur to identify the key aspects of the product or service that serves as the primary selling point.
- Competitive Advantage – What aspects give your business (not just the product or service) an advantage above competing business? Examples of competitive advantage include: intellectual property rights, first mover advantages, size or capitalization, brand recognition, geographic location, supply-chain agreements (ex. Long-term contract for low-price material costs).
- Cost Structure – The costs structure outlines the fixed and variable costs necessary to establish and carry on business. The ratio of fixed costs to variable costs represents the cost structure. The model may include target cost structures at present and future points in the business’ development.
- Pricing – This section goes further than simply determining what your average potential customer is willing to pay for your product. While the customer’s expected price is a starting point, the model should provides for a strategic justification for a given or target price point. This requires that the entrepreneur adequately understand the present and future cost structure, competitors (prices and substitute products), and the intended product position in the market (lowest-cost, most versatile, best features, highest quality, easiest to use, etc.).
- Revenue Streams – This section includes any source of revenue, such as from sales, bartered goods, value-add returns form consumers, partners, and third parties (such as marketing). In this section you will compare the revenue to costs, particularly the cost of debt to fund the business.
- Key Partners – Represents the agreement between your business and the companies necessary to product and market your product. They include materials and parts suppliers, retail outlets, shippers, advertising agencies, and media outlets. Commercializing the value of your product depend on partnerships.
- Customer Focus
- Supporting Customers – A key, and often under emphasized, portion of the business plan is how you intend to support customer inquiries, demands, or claims. The value of customer support exceeds the operational aspects (product/service information, return goods, defects, ordering details, etc.); it also includes a testing component through customer feedback. This feedback is important for continued product or service development.
- Achieving Customer Satisfaction – What procedural process is in place to ascertain customer satisfaction? Making certain that customers are satisfied is important for repeat customers, word-of-mouth marketing, and brand development. Dissatisfied customers can be a huge potential liability for the business through legal suits and destructive media or press (think social media reviews such as yelp).
Summary of the Business Model Elements
As you can see, the categories of information above look very similar to the information that you examined when undertaking the feasibility analysis. Likewise, the common elements of the business model are similar (if not the same) as those that go into the business plan. The business model however is designed to be more of a fluid tool that molds and changes with the development of the business (more efficiently than a business plan).
The Business Model Canvass
Researchers have looked into the functionality of business planning and a reduction of the working elements into useable models. One of the most revolutionary tools for startup business modeling is the book, “Business Model Generation” by Alex Osterwalder (see the Harvard Business Review link for greater detail). The book gives detail of how to use a business model canvass to develop your business model. In summary, the business canvas is an operation outline that group 9 separate business segments into one-page model. The segments of the canvass are:
- Key Partners
- Key Activities
- Key Resources
- Value Proposition
- Cost Structure
- Customer Relationship
- Revenue Streams
- Customer segments
As you can see, the segments of the business model canvas are part of the list of business model sections above. Each segment has it’s own quadrant within the canvas. Within the quadrant there are a series of hypotheses about each segment as it pertains to your business model. Through testing these hypotheses, you develop the individual components of your business model. The benefit of the canvas is that it provides a one-page, operational overview of the business. The critical aspects of the business that are listed under each segment allows for continued strategic analysis of the operations.
A General Process for Constructing the Business Model
The process outlined in Mr. Osterwalder’s book is a great guide for building a business model. As an alternative, using the following steps you can use a set of general techniques to construct a business model that fits your business.
- Study the operation of competitors in the industry and list out the key functions of how they exchange value with customers.
- Comparing your business to the operational models of your competitors, identify the key operational characteristics that have to take place in order to successfully carry out your business.
- For example, your competitor may sell the use of its Internet services to customers. You may provide free services, but charge for certain upgrades to or premium features of the service.
- Categorize these elements under the appropriate section(s) of the business model listed above. (If it doesn’t fit under any of the listed business model segments, then create a new segment for it.)
- For each critical element, make a list of assumption or necessary occurrences that must take place in order to satisfy this critical element. Under each assumption or occurrence, explain why the assumption is true or how you will carry out each operational requirement.
- Note: As you can see, you now have a categorized list of operational segments:
- Key Segment
- Key operational characteristics
- Key occurrences or assumption
- Explanation of each assumption
- How you will execute or bring about occurrence.
- Note: As you can see, you now have a categorized list of operational segments:
- Organize the segments in quadrants and place the quadrants together so they can be seen as a holistic model.
- Note: Designate a single page of paper for each segment. Lay the segment pages out on a table. Organize the pieces of papers to that they are closest to (beside, below, above) operational segments that that are related in nature. Organizing the segments in this single view format allows you to prioritize and logically organize your operational segments.
- Change the location and order the segments as the business develops to demonstrate of their current operational priority.
You now have a working business model. You have an outline of the major activity needed to establish you business and a prioritized list of tasks to accomplish and resources to secure.
Using the Business Model
The business model is a stand-alone document that provides operational guidance for your business. All of the sections or segments of the business model should come together to provide a strategic vision for what you hope to accomplish and the necessary resources and actions to make it happen.