Business Models

A business model outlines how a business is organized to deliver value to its customers. A business model encompasses the following aspects:

1. Target customers of the business.
2. Supporting logic of the business.
3. How the business serves its customers.
4. Important assets and suppliers of the business.

A business model describes what a business is about, how it runs its operations and generates revenue and profits, and how it differs from its competitors. Even though a business model is detailed, it isn’t exactly like a business plan, which gives financial forecasts.

Value Proposition

Value proposition to customers describes the target customers and how a business retains its customers. It also outlines the products (or services or experiences) a firm offers and pricing relative to its competitors.

Value Chain

The value chain outlines the execution strategy of a firm and its competitive capabilities.

Additionally, a business model should outline a firm’s profitability with regard to its effect on revenue and cost models, and asset and financial structures.

Business models – usually provided in the annual reports or other disclosure documents of a firm – allow analysts to get deeper insights into a business in terms of its operations, strategies, target customers, important partnerships, risks, financial profiles, and prospects.

Features of a Business Model

A business model should answer the following questions:

1. Who are the target customers (or market)?
2. What does the firm offer?
3. Where does the firm sell its products or services?
4. How much is the pricing?
5. What is the value proposition of the firm?
6. What is the profitability and unit economics of the firm?

We discuss each of the above questions.

1. Target Customers

A business model should outline the target customers of a firm. Key issues that should be seen here include the geographies, market segments, and customer segments that a firm will serve. Concerning customer segments, a business model can be business-to-business (B2B) or business-to-consumer (B2C) markets.

2. Product or Services Offered by a Firm

A business model should define a firm’s offering: products or services offered. Further, it should outline how the products and services differ from those of the firm’s competitors based on the target customers’ needs. A well-defined firm offering helps analysts to determine the total amount of capital available for a business and identify important competitors and risks.

3. Channels of Selling its Offerings (Channel Strategies)

A business model should define the jurisdiction or geographical location within which a firm offers its products and how it reaches its customers. It may be direct, through intermediaries, or digitally. Channels strategy is responsible for selling and delivering a firm’s products and services to customers.

The channel strategy of a firm involves different functions executed from assets that might be utilized. Further, it entails a firm’s involvement in the execution of those functions or owning those facilities.

The assets may include warehouses, retail stores, a sales force, and an e-commerce website. The assets may be used to sell or display, handle inquiries, order processing, physical distribution, or after-sale service. The firms that perform these functions (or the owners of the facilities) include retailers, wholesalers, agents, and franchises.

The channels a firm uses impact its revenue and cost structures, profitability, and response to internal and external risk factors.

There are three different types of channel strategies:

a. Traditional Channel Strategy

In the traditional channel strategy, finished goods flow from the manufacturer to the wholesaler, then to the retailer, and lastly to the end customer. Intuitively, it is a common strategy in the product business.

b. Direct Sales Strategy

In a direct sales strategy, a manufacturer sells directly to the end customer, disintermediating the distributor or retailer. In other words, the manufacturing firm utilizes its own sales force, which may be a whole department. It is a common strategy in B2B businesses, pharmaceutical firms, and life insurance.

Direct sales may involve an intermediary. In this case, the intermediary works on an agency basis. A firm, in this arrangement, pays commissions to an intermediary, but the intermediary does not claim ownership of the goods. A good example is drop-shipping in eCommerce, where an online marketer can initiate a delivery from a manufacturer to the end-user without taking an inventory of the products.

c. Omnichannel Strategy

The omnichannel strategy involves the employment of a combination of both physical and digital methods to finalize a sale. For instance, a customer might order a product online and later pick it up at the store or get it delivered to a place of choice.

4. Pricing Details of a Firm

A business model should sufficiently explain the pricing details so that the business logic of a firm is understandable. For instance, a business model should have pricing details relative to its competitor(s): is it a premium, parity, or discount compared to competitors? Moreover, a business model should justify the pricing structure.

Pricing is relatively nonessential in a business model of a price-taker firm such as commodity producers. Being “price takers” implies that they must take the prices the market sets. As such, they face high price elasticity and higher pricing risk from competitors. To circumvent this “pricing disadvantage,” the price-takers emphasize on other sources of value, such as cost advantage.

On the other hand, some companies that are price-setters face less pricing risk from their competitors. Therefore, such companies can differentiate their offering to gain pricing power.

Types of Pricing Models

There are two types of pricing models:

• Value-based pricing models: Pricing is based on the value acquired by the customer. For instance, a car manufacturing company may price cars at a premium because their cars have low operating costs.
• Cost-based pricing models: The pricing is set based on the costs incurred by the firm. For instance, a firm that offers its service on a per-hour basis.

Price Discrimination

Price discrimination occurs when firms charge different prices to different customers. Price discrimination aims to maximize revenues based on customers’ will to buy.

Price discrimination strategies include:

1. Dynamic pricing: Prices are determined based on different times. For instance, off-peak pricing in airline tickets.
2. Tiered pricing: Different prices quoted to different buyers vary depending on the volume of goods purchased.
3. Auction and reverse auction models: Auction establishes prices either through bidding or sellers during reverse actions.

Pricing Models for Multiple Products

Models for pricing multiple products include:

• Bundling: Customers are incentivized to combine multiple products (usually complementary goods with high incremental margins and marketing costs). Examples are furnished rental apartments and TV cable subscriptions with internet services.
• Optional product pricing: Applicable when a customer purchases extra services or products on the purchase date (for example, an order in a restaurant) or afterward (for example, a change in subscription package). A company usually seeks higher margins on optional features or services. However, excess application of this model can hurt a company’s reputation and  distort customer goodwill.
• Razors-and-blades pricing: Occurs when a low price is charged on equipment and a high price on a dependent accessory. For instance, a relatively low price may be applied on a razor and a high price on the blades.

Pricing for Increasing Growth

• Freemium pricing: This model is common in digital content and services. It allows customers to access a certain level of usage or functionality for free. An example is video games.
• Penetration pricing: It is a form of discount pricing where a firm sacrifices margins with the intention of building scale and market share. An example is video subscription services such as Netflix.
• Hidden revenue business models: Occur when a firm provides services for free and generates revenue in a different way. For example, content creators provide “free” content and get paid for advertising in the media sector.

Creating Value through Alternatives to Purchasing

Business models can create value by allowing an alternative form of owning an asset or product. These alternatives include:

• Fractionalization: This model creates value by selling products in smaller units or using products at different times. An example is web-hosting services.
• Leasing: In this case, a firm transfers ownership to customers who will bear lower costs for capital and maintenance. Examples are real estate and automobiles.
• Recurring revenue or subscription pricing: Allows customers to “rent” items for a period of time of their choice. An example is the subscription services in the media industry.
• Licensing: A firm receives royalty payments from customers who use intangible assets such as brand names or songs.
• Franchising: An advanced form of licensing where a firm (franchisor) gives a right to an entity (franchisee) to distribute its products or services in a given jurisdiction. The franchisor gives support such as marketing to the franchisee.

5. Value Proposition of a Firm

A business model should outline the value proposition of a firm. A firm’s value proposition gives the characteristics of the firm that attract the target customers. Besides, it informs customers’ preference of a firm to its competitors. 

The value proposition of a firm is built through:

• Service and support, such as effective customer service, from a firm.
• The sale process, such as ease of purchase.
• Features of the product, such as performance and style.
• Pricing as compared to competitors.

In a summary, value proposition considers the following questions: “Who?” “What?” “Where?” and “How much?”

6. Business Organization and Capability of a Firm

A business model should outline a firm’s business organization and capabilities. This is what defines how a firm is structured to deliver the value proposition.

A business model should give assets and capabilities (such as skilled labor and modern technology) that a firm requires to implement it. It should also state whether these assets and capabilities are owned (insourced) or rented (outsourced) since it is important in determining business strategies and potential risks.

Within the business organization of the firm and its capabilities, we need to discuss the value chain.

Value Chain

Value chain refers to the systems and processes within a firm that create value for its customers. Note that the value chain only includes functions that are valued by customers and are executed by a single firm. They, however, do not involve physical adjustment or handling of a product.

As such, the value chain is different from the supply chain. The supply chain is the sequence of firm internal and external processes involved in creating products. An example of a supply chain is the production and delivery of products to the end customer.

The value chain can be seen as a bridge between the value proposition of a firm and its profitability. Essentially, the value chain involves three key factors:

• Identifying competitive advantage opportunities.
• Identifying the key activities conducted by a firm, which, according to Michael Porter (1985), include inbound and outbound logistics, marketing, sales, and service and operations. Other support activities include procurement, human resource, technology development, and firm infrastructure.
• Approximating the value added and costs with each activity.

7. Profitability and Unit Economics

A business model should highlight how a firm intends to generate profit. Profit expectations can be analyzed by examining margins, break-even points, and unit economics. Unit economics involves expressing revenues and costs on a per-unit basis.

Types of Business Models

Business models vary from one industry to another. In the goods-producing industry, firms can be classified according to how they fit into the supply chain:

• Manufacturers.
• Wholesalers.
• Retailers.
• Suppliers of raw materials, components, equipment, and services.

For the service industry, business models vary; some are business to consumers (B2C), while others are business to business (B2B). In some instances, business models are specific to a certain sector. For example, the financial service sector includes business models such as insurance, payment processing, brokerage, merchant trading, asset management, lending, and deposit taking, or a combination of more than one business model.

Innovation of Business Models

New business models can be introduced jointly with a new business or introduced to an existing business. For instance, technological innovation has led to the emergence of new business models such as content development, digital advertising, data and related services, and software development.

The significant impact of technological innovation on the rise of new business models can be explained by the following reasons:

• Location does not matter.
• Outsourcing is easily achievable.
• Marketing is easy and cost-effective.
• Development of powerful network effects that can be easily accessible by many firms.

Network effects refer to the increase in the value of a network to its users as more users connect. Network effects lead to the development of different network-based business models.

Network effects can also apply to businesses that do not use the internet. Such businesses include real estate agencies and telephone services. Moreover, the network effect applies to two or more groups, such as buyers and sellers transacting online.

Network effects can be one-sided or multi-sided. One-sided network effects arise when a single homogeneous group uses a network. The opposite is true for multi-sided network effects.

E-Commerce Business Models

E-commerce primarily includes internet-based sales. Examples of business models include:

• Marketplace business: Develops a network of buyers and sellers without owning the products. A good example is Alibaba.
• Affiliate marketing: Earns commission revenues for sales made on a different website of a marketer or agency.
• Aggregators: Same as a marketplace. However, an aggregator must remarket the product and services using its brand. A good example is Spotify.

Platform Business Models

A platform business model is a business based on a network, where value is created from a network outside the firm. It is different from a linear (traditional) business model that creates value for a product sold to customers in a linear supply chain.

Crowdsourcing Business Models

In crowdsourcing business models, users can contribute directly to the value of a product. Crowdsourcing involves user communities that allow voluntary collaboration among users of a product or users with either low or no regulation.

Examples include online gaming, open-source software, and knowledge aggregation sites such as Wikipedia.

Hybrid Business Models

The hybrid business model combines both linear and platform business. An example is Amazon which does goods distribution and online marketing and advertising.

Other Business Model Variations

• Licensing arrangement: A product-producing company uses someone else’s brand and, in return, pays royalty. For instance, they may pay for the right to use the name of a celebrity.
• Franchise models: Distributors or retailers closely associated with the parent association manage sales and services while using the business models and model of the parent company.
• Private label (contract manufacturers): A firm manufactures goods marketed by others. For example, manufacturing might be based in one country and marketing in another.

Question

Which of the following is least likely found in a firm’s business model?

1. Target customers.
2. Financial forecasts.
3. Pricing methodology.

The correct answer is B.

Financial forecasts is detailed information usually found in a business plan.

B and C are incorrect. Features of a business model should highlight the following aspects:

• Target customers (or market) of the firm.
• Offering of a firm.
• Pricing of the firm.
• Value proposition of the firm.
• Profitability and unit economics of the firm.