Key Features of 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 (“who?”).
2. Products or Services offered by the business (“why and often “why”).
3. Where is the company selling, and how do the products and services reach customers “where?”.
4. The pricing strategy of the firm (“how much?”).
5. Important assets, partners, and suppliers the firm requires (“how?”)

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. A business model should outline the core elements and their interactions without going into the depth of a full-fledged business plan.

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, and does it reach its customers?
4. How much is the pricing?
5. What is the value proposition of the firm?
6. What is the business organization and capabilities 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 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 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 company’s channel strategy explains where the firm is selling its products or services and how it reaches its customers. The channel strategy has two functions: sales and marketing and distribution (logistics).Analyzing a firm’s channel strategy involves differentiating between functions the firm can perform internally and what functions are effectively done by strategic partners and suppliers. As such, the anatomy of the channel strategy of a firm includes functions, assets, and other firms:
   • Function: selling/display, handling inquiries, order processing, physical distribution, after-sale service
   • Assets: Warehouses, retail stores, a sales force, and an e-commerce website.
   • Firms: retailers, wholesalers, agents, franchisees

   A firm’s channels impact its revenue and cost structures, profitability, and response to internal and external risk factors.

   There are three different types of channel strategies:

   1. 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.
   2. 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. In this arrangement, a firm 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.
   3. 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. Price discrimination occurs when firms charge different prices to different customers. Price discrimination aims to maximize revenues based on customers’ will to buy.
   Types of Pricing Models
   A pricing model describes how customers are billed based on the quantity of goods or services they purchase. Due to pricing discrimination, there are many pricing models. A unit of product or service can be specified in many ways, and prices can vary based on factors such as quality or grade, units sold, channel, customer size and type, and unit cost. Common pricing models include:
   1. 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.
   2. Dynamic pricing: Different prices are charged for different clients at different times depending on variables such as supply and demand.
   3. Tiered pricing: Different buyers are charged different prices based on volume or product features.
   4. Auction/ reverse auction models: Prices are established via an automated bidding process.

   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.
   • Add-on 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.
   • Razor, razor blade 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 to a razor and a high price on the blades.

   Pricing for Increasing Growth

   • 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.If penetration pricing is applied for an extended period of time, regulators may consider it anti-competitive. Moreover, the investors may question the profitability landmarks of the company.

   Pricing Models for Encouraging Trial and Adoption

   • 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.
   • 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:

   • 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 an entity (franchisee) a right 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 over 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 summary, the 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 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 must implement. 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, and profitability, and unit economics.
   Value Chain
   Value chain refers to the systems and processes within a firm that creates value for its customers. Note that the value chain only includes functions valued by customers and 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:
   1. Identifying the business value chain components conducted by the firm (as originally envisioned by Michael Porter in 1985):
      • Primary activities: Inbound Logistics, Operations, Outbound logistics, marketing and sales, and Service.
      • Support activities: Procurement, human resource management, technology development, and firm infrastructure.
   2. Approximating the value added and costs with each activity.
   3. Identifying competitive advantage opportunities.

   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.