What is a business model? Understanding 10 effective business model types

What is a business model?

A business model delineates a company's strategy for profitability, specifying its offered products or services, target market, and expected expenditures. Essential for startups and established enterprises alike, business models facilitate investment attraction, talent acquisition, and internal motivation for management and staff.

Established companies must consistently refresh their business models to foresee forthcoming trends and obstacles. Additionally, these models aid investors in assessing appealing companies and enable employees to comprehend the future trajectory of a potential employer.

MAIN POINTS TO REMEMBER:

• A business model is a fundamental strategy for a company to achieve profitability.
• Typical components of a model include the products/services to be offered, target markets, and expected expenses.
• Various business model types exist, such as retail, manufacturing, fee-for-service, or freemium models.
• Pricing and costs are pivotal aspects of any business model.
• As an investor assessing a business model, it's vital to determine if the offered product fulfills a genuine market demand.

Understanding business models

A business model is a strategic blueprint for running a profitable business within a particular market. At its core lies the value proposition, which outlines the products or services a company provides and highlights their appeal to customers, ideally setting them apart from competitors.

The business model of a fledgling venture should encompass estimated initial expenditures and potential funding channels, the intended clientele, marketing tactics, an analysis of competitors, and forecasts of income and outlay. Moreover, it might outline collaboration prospects with established firms. For instance, an advertising startup's model might highlight advantages from reciprocal referrals with a printing company.

Prosperous enterprises possess business models enabling them to meet customer needs competitively and sustainably. Over time, these businesses often adjust their models to align with evolving business landscapes and market requirements.

When considering a company for potential investment, it's crucial for the investor to understand its revenue generation method, which entails examining the business model. While the business model may not unveil all aspects of a company's future outlook, investors who grasp it can interpret financial information more effectively.

Assessing effective business models

One common error companies often make when formulating their business models is underestimating the funding required to sustain operations until profitability is achieved. Merely factoring in costs up to product launch is insufficient; ongoing operational expenses must be covered until revenues surpass expenditures.

Analysts and investors typically gauge the effectiveness of a business model by examining a company's gross profit, which is its total revenue minus the cost of goods sold (COGS). Comparing a company's gross profit with that of its main competitor or its industry provides insights into the efficiency of its operations. However, relying solely on gross profit can be misleading. Analysts also scrutinize cash flow or net income—gross profit minus operating expenses—which reflects the actual profit generated by the business.

The primary drivers of a company's business model are pricing and costs. By increasing prices or sourcing inventory at lower costs, a company can boost its gross profit. Many analysts prioritize gross profit when evaluating a business plan, as it signifies a robust strategy. If expenses are excessive, it may signal management issues that can be rectified. Consequently, it's often believed that companies with optimal business models can effectively manage themselves.

10 types of business models

There exists a diverse array of business models, mirroring the diversity of businesses themselves. Examples include direct sales, franchising, advertising-based models, and brick-and-mortar stores, all representative of traditional models. Additionally, hybrid models emerge, such as businesses merging internet retail with physical stores or partnering with sports organizations like the NBA. Presented below are some prevalent business model types, recognizing that the examples provided may overlap across categories.

1. Fee-for-service

Rather than focusing on product sales, fee-for-service business models revolve around offering labor and services. Such models typically bill clients based on hourly rates or predetermined fees for particular agreements. Fee-for-service enterprises are frequently specialized, providing expertise that may be specialized or necessitate specific training.

2. Subscription

Subscription-based business models aim to acquire customers with the intention of converting them into long-term, devoted patrons. This is achieved by providing a product that necessitates continuous payment, typically in exchange for a fixed period of benefit. While predominantly associated with digital firms offering access to software, subscription models are also prevalent for physical goods like monthly deliveries of agriculture or produce subscription boxes.

3. Manufacturer

A manufacturer is tasked with acquiring raw materials and fabricating finished products using internal manpower, machinery, and equipment. They may produce customized items or mass-produced goods. Manufacturers have the option to distribute their products through intermediaries like distributors or retailers, or they can sell directly to consumers.

4. Retailer

A prevalent business model encountered frequently is the retailer model. Positioned at the end of the supply chain, retailers typically purchase finished products from manufacturers or distributors and directly engage with customers.

5. Bundling

If a company is worried about the expense of acquiring individual customers, it might opt to bundle products, selling multiple items to a single client. Bundling leverages existing customer relationships by proposing various products for sale. This approach can be encouraged by providing price discounts for purchasing multiple products.

6. Affiliate

Affiliate business models rely on marketing and leveraging the extensive audience of a particular entity or individual's platform. Companies compensate these entities to endorse their products, often providing payment or a percentage of sales generated from their promotion, or both.

7. Reverse Razor Blade

Instead of depending on high-margin complementary products, a reverse razor blade business model focuses on selling a high-margin product initially. Subsequently, low-cost or complimentary products are offered to facilitate the use of the main product. This strategy aims to drive initial sales, as subsequent product usage may not yield significant profits.

8. Franchise

The franchise business model utilizes established business strategies to extend and replicate a company in various locations. Typically employed by businesses in industries such as food, hardware, or fitness, franchisors collaborate with incoming franchisees to fund the venture, market the new establishment, and supervise its operations. In exchange, the franchisor receives a portion of the profits generated by the franchisee.

9. Pay-As-You-Go

Rather than employing a predetermined fee, certain companies might adopt a pay-as-you-go business model, where the charges are based on the extent of product or service usage. Alongside a fixed fee for providing the service, the company may adjust the monthly charges based on the actual consumption.

10. Brokerage

A brokerage business model facilitates connections between buyers and sellers without directly engaging in the sale of goods themselves. Brokerage firms typically earn a percentage of the transaction amount upon the completion of a deal. While commonly observed in real estate, brokerage services are also prevalent in industries such as construction/development and freight.

How to create a business model?

Creating a business model isn't a one-size-fits-all endeavor. Various experts may propose different approaches to crafting your business plan and model. Here are some general steps you can take to develop your plan:

• Understand your offerings: With your audience and problem identified, consider what products or services you can offer. Adapt your product to meet market needs and align with your capabilities.
• Define the problem: Understand the problem or need you aim to address. Whether it's offering products for home repairs or providing community dining experiences, clarifying the problem ensures there's demand for your services or products.
• Identify your target audience: Start by defining your audience and target market. A robust business model understands the audience you're trying to reach, enabling you to tailor your product, messaging, and engagement strategies accordingly.
• Document your needs: Identify and document the challenges your company will encounter, both product-specific and operational. This helps assess your readiness for future launches.
• Test your model: Once your plan is complete, conduct test surveys or soft launches. Gather feedback from potential customers regarding pricing and services. Leverage market feedback to refine and adjust your business model as needed.
• Establish monetization solutions: Determine how your company will generate revenue. Select appropriate strategies based on your business model type, considering your clients' needs and feedback.
• Find key partners: Forge partnerships to drive company success. For example, a wedding planner may collaborate with venues, caterers, florists, and tailors. Manufacturers should consider material providers and the significance of those relationships.

Criticism of business models

Joan Magretta, the former editor of the Harvard Business Review, proposes two crucial factors for evaluating business models. According to her, when business models fail, it's typically due to a lack of coherence in the narrative or an inability to generate profits from the numbers.

The airline industry serves as a prime example of a business model that ceased to be viable. Established carriers such as American Airlines, Delta, and Continental had long operated on a hub-and-spoke framework, funneling flights through major airports to maximize seat occupancy and profitability. However, emerging competitors like Southwest and JetBlue adopted a different approach, flying between smaller airports at lower costs and circumventing the operational inefficiencies inherent in the hub-and-spoke model. By reducing labor expenses and slashing prices, these newcomers stimulated demand for short-haul flights between cities.

As these new players attracted more passengers, legacy carriers found themselves struggling to maintain their extensive networks with diminishing clientele, a situation exacerbated by the sharp decline in air travel following the September 11 terrorist attacks in 2001. To fill seats, these incumbent airlines resorted to offering deeper discounts, rendering the hub-and-spoke model obsolete.

Example of business models

Reflect on the extensive array of offerings within Microsoft's diverse portfolio. Over the course of several decades, the company has broadened its product range to encompass digital services, software, gaming, and beyond. Among the various business models employed within Microsoft's ecosystem are:

• Intelligent Cloud: Microsoft offers server products and cloud services through subscription models, alongside supplementary services and consulting.
• Productivity and Business Processes: Microsoft provides subscription-based access to Office products and LinkedIn. These subscriptions may be tailored to reflect product usage metrics, such as the volume of data uploaded to SharePoint.
• More Personal Computing: Microsoft markets physically manufactured products like Surface devices, PC components, and Xbox hardware. Additionally, residual revenue from Xbox sales encompasses content, services, subscriptions, royalties, and advertising revenue.

What are the main types of business models?

Retailers and manufacturers represent key business models in the commercial landscape. Manufacturers create their own products, which they may or may not directly sell to consumers. On the other hand, retailers procure goods for resale to the public.

How to build a business model?

Constructing a business model involves multiple steps, and there's no universally accepted approach among business professionals. Generally, a business model entails identifying your customer base, comprehending the problem you aim to address, selecting a suitable business model type to define how your clients will purchase your product, and outlining revenue generation strategies. It's also crucial to periodically reassess your business model; after launching, you can review your plan and make adjustments to your target audience, product offerings, or pricing as necessary.

In essence, a company transcends mere product sales; it embodies an intricate ecosystem necessitating a strategic blueprint delineating its target audience, offerings, pricing strategies, and the value it delivers. A business model outlines the systematic approach an organization employs to consistently generate enduring value for its clientele. Upon crafting a business model, a company should gain clearer direction on its operational strategies and discern a more lucid financial trajectory.