Business models are a company’s profit strategy. It lists the business’s products or services, target market, and expected costs. New and established businesses need business models. They help startups raise capital, hire talent, and inspire employees.
Established companies must update their business model to stay ahead of trends and challenges. Business models help investors and potential employees evaluate companies.
Key takeaways
A business model is a company’s profit strategy.
Models typically include business products, target markets, and expected expenses.
Retailers, manufacturers, fee-for-service, and freemium businesses exist.
Pricing and costs are business model levers.
Investors should consider whether a business model’s product meets a market need.
What exactly is Business Models?
A business model is a high-level strategy for making money in a specific market. Value propositions are crucial to business models. This describes a company’s products and services and why customers want them, ideally in a way that sets them apart from competitors.
A startup’s business model should include startup costs, financing sources, target customers, marketing strategy, competition analysis, and revenue and expense projections. The plan may also outline partnerships with established companies. An advertising business may benefit from a printing company referral arrangement.
Successful businesses meet customer needs at a competitive and sustainable price. Many companies update their business models to adapt to changing market conditions.
Investors should learn how a company makes money before investing. Examine the company’s business model. Business models don’t always reveal a company’s prospects. However, a business model-savvy investor can better interpret financial data.
Assessing Successful Business Models
Many companies underestimate the costs of funding the business until it becomes profitable when creating their business models. Product introduction costs are not enough. Businesses must continue until revenues exceed expenses.
Analysts and investors evaluate business models by looking at gross profit. Revenue minus COGS equals gross profit. Comparing a company’s gross profit to its main competitor or industry shows its business model’s efficiency and effectiveness. Gross profit alone can mislead. Analysts want cash flow or net income. Gross profit minus operating expenses shows the business’s actual profit.
Pricing and costs drive a business model. Companies can raise prices and find cheap inventory. Both boost gross profit. Analysts prioritize gross profit when assessing a business plan. Gross profit indicates a good business plan. The management team may be responsible for high expenses, which can be fixed. Analysts believe that the best business models can run themselves.
Before investing, find out how a company makes money, not just what it sells—business model.
What are the Kinds of Business Models?
As many business models as businesses, traditional business models include direct sales, franchising, advertising-based, and brick-and-mortar. Internet retailers that partner with NBA teams or brick-and-mortar stores are hybrid models.
The following business models may fit into multiple categories.
Retailer
Most people encounter the retailer model. Retailers end supply chains. They buy finished goods from manufacturers or distributors and deal with customers.
Manufacturer
Manufacturers use internal labor, machinery, and equipment to source and make products. Manufacturers make custom or mass-produced goods. Manufacturers sell to distributors, retailers, and customers.
Fee-for-Service
Fee-for-service businesses sell labor and services instead of products. Fee-for-service businesses charge by the hour or by the agreement. Fee-for-service companies often provide specialized knowledge that requires training.
Subscription
Subscription-based businesses aim to convert customers into loyal customers. Offering a product with recurring payments for a fixed benefit does this. Subscription business models are famous for physical goods like monthly agriculture/produce box deliveries. Digital companies mostly use them for software.
Freemium
Freemium models introduce customers to essential, limited-scope products. After using their service, the company tries to sell them a premium, paid product. Although a customer could use the free version forever, a company tries to show the benefits of upgrading.
Some companies use multiple business models for the same product. Spotify, a subscription service, has free and premium versions.
Bundling
A company may bundle products to sell multiple items to a single customer if it worries about customer acquisition costs. Bundling tries to upsell existing customers. Multi-product discounts can encourage this.
Marketplace
Marketplaces receive payment for hosting a business platform. This business model makes transactions more accessible, safer, and faster.
Affiliate
Marketing and platform reach drive affiliate business models. An entity promotes a product for a company and receives payment. That compensation may be a fixed amount, a percentage of sales from their promotion, or both.
Razor Blade
This business model, named after the invented product, sells a durable product below cost to generate high-margin sales of its disposable component. Razor blade companies may give away expensive blade handles under the “razor and blade model” to encourage consumers to buy razor blades.
“Tying” is an illegal razor blade model strategy that requires buying an unrelated good before buying a necessary good. For instance, Gillette might launch a lotion line and require customers to buy three bottles before buying disposable razor blades.
Reverse Razor
A reverse razor blade business model sells a high-margin product upfront instead of using companion products. For use, low-cost or free companion products are provided. Since product use is not profitable, this model promotes upfront sales.
Franchise
Franchises use business plans to expand and replicate a company. Franchisers help new franchisees finance, market, and run their food, hardware, or fitness businesses. The franchisee pays a percentage to the franchisor.
Pay-As-You-Go
Some companies use a pay-as-you-go model, charging based on usage. The service provider may charge a fixed fee and a monthly amount based on consumption.
Brokerage
Brokerages match buyers and sellers without selling goods. When a deal closes, brokers usually get a cut. Brokers are prevalent in real estate, construction, and freight.
How to Make a Business Model?
There is no “one size fits all” business model. Different experts may advise you when starting a business and planning your model. Steps to create a plan include:
1. Know your audience.
Most business model plans start with problem definition or audience/target market identification. A good business model will help you tailor your product, messaging, and approach to your target audience.
2. Define it.
You must know your audience and your problem. Hardware stores sell home repair supplies. Restaurants feed people. If your services or products aren’t needed, your business may struggle.
3. Know your products.
Consider your audience and problem before offering anything. How does your expertise match the products you want to sell? This business model stage adjusts the product to meet market needs and your capabilities.
4. List your needs.
Your product is chosen; consider your company’s challenges. This includes product-specific and operational issues. To determine your launch readiness, document these needs.
5. Key partners.
Most companies use partners to succeed. Wedding planners may partner with venues, caterers, florists, and tailors to improve services. Manufacturers should consider their material suppliers and how meaningful their relationship is.
6. Plan monetization.
We have yet to discuss your company’s revenue. A business model is complete with a revenue model. This includes choosing a business model type strategy above. After reviewing your client’s needs, a different type may make more sense.
7. Test your model.
Test surveys or soft launches after completing your plan. Ask how people would feel paying your service prices—discount new customers for reviews and feedback. When changing your business model, use market feedback.
Instead of reinventing the wheel, study competitors and market positioning. You may spot gaps in others’ business models.
Criticisms of Business Models
Former Harvard Business Review editor Joan Magretta suggests two critical factors for assessing business models. She says business models fail because the story needs to make sense of the numbers that add up to profits.
Find a failed business model in the airline industry. It includes bankrupt and loss-making companies.
American Airlines, Delta, and Continental used a hub-and-spoke model for years, routing all flights through a few major airports. The business model made enormous profits by keeping most seats filled.
However, a competing business model burdened the significant carriers’ strength. Southwest and JetBlue flew cheaper between smaller airports. They reduced labor costs and avoided hub-and-spoke operational inefficiencies. That reduced prices, increasing demand for short city flights.
These newer competitors took customers away, leaving the old carriers to support their large, extended networks with fewer passengers. Traffic dropped sharply after the 2001 terrorist attacks, worsening the problem.
These airlines offered deeper discounts to fill seats. The hub-and-spoke model was obsolete.
Examples of Business Models
Microsoft’s vast portfolio. The company has added digital services, software, gaming, and more. Microsoft business models include:
Productivity and Business: Microsoft offers Office and LinkedIn subscriptions. SharePoint data uploads may determine these subscriptions.
Intelligent Cloud: Microsoft offers subscription-based server and cloud services. This offers consulting and services.
Microsoft sells Surface, Xbox, and PC hardware. Xbox content, services, subscriptions, royalties, and advertising sales are residual.
Retail giants include Best Buy, Target, and Walmart. These companies sell goods directly to consumers from manufacturers or distributors. Retailers sell goods but may need to make them.
Which Business Models Are Common?
Retailers and manufacturers are standard business models. Manufacturers may sell directly to consumers. Retailers buy goods to resell.
How do I create a business model?
Building a business model involves many steps, and business experts have different methods. A business model should identify your customers, understand the problem you are trying to solve, choose a business model type to determine how your customers will buy your product, and determine how your company will make money. After launching, periodically review your business model and adjust your target audience, product line, and pricing.
What should I consider when designing a business model?
Asking key questions helps you understand your business model. Questions like:
What’s my value proposition? My product/service solve what problem?
What’s my pricing?
My acquisition cost?
Where can I find my ideal customer?
Is my revenue predictable? How can I get that?
Your business model will be based on critical assumptions about your customers, how your product or service should look, their preferred channels, and others.
Startup operations will test those assumptions.
What tools are available for business model design?
The customer development manifesto is a popular business model design tool.
However, this manifesto was created when venture capital was scarce compared to the dot-com bubble of the late 1990s.
Business modeling tools were designed for that. Thus, those tools work best when capital is scarce and you must quickly test your business model assumptions. Three main tools are:
- Business model.
- Lean startup.
- Customer development.
These tools can help entrepreneurs generate business models:
Map business model hypotheses
Test these hypotheses with customer feedback.
Repeat this.
A minimally viable product will be developed incrementally.
Based on customer feedback, better products reach more people.
Lean works when capital is scarce, and burn rates are low.
Lean guided the founders’ frugal, fast operations. It wasn’t designed for consensus-seekers.
The lean startup: still relevant?
Steve Blank’s HBR article “Is the Lean Startup Dead?” I realized that customer discovery and product-market fit are inversely proportional to risk capital.
Thus, the more risk capital available, the less likely the lean startup model will work.
You must only test some assumptions if you have massive risk capital.
Instead, execute them quickly.
Lean startups aim to burn cash slowly while pivoting their business models.
Bottom Line
Companies sell more than goods. It’s an ecosystem that needs a plan for selling, charging, and creating value. A business model describes how a company creates long-term customer value. After building a business model, a company should have more precise goals and a financial outlook.
