[1/2] What is a Business Model with types and examples

What is a Business Model?

The term business model refers to a company’s plan for making a profit. It identifies the products or services the business plans to sell, its identified target market, and any anticipated expenses. Business models are important for both new and established businesses. They help new, developing companies attract investment, recruit talent and motivate management and staff.

Established businesses should regularly update their business model or they’ll fail to anticipate trends and challenges ahead. Business models also help investors evaluate companies that interest tem and employees understand the future of a company they may aspire to join.

Understanding Business Models

A business model is a high-level plan for profitably operating a business in a specific marketplace. A primary component of the business model is the value proposition. This is a description of the goods or services that a company offers and why they are desirable to customers or clients, ideally stated in a way that differentiates the product or service from its competitors.

A new enterprise’s business model should also cover projected startup costs and financing sources, the target customer base for the business, marketing strategy, a review of the competition, and projections of revenues and expenses. The plan may also define opportunities in which the business can partner with other established companies. For example, the business model for an advertising business may identify benefits from an arrangement for referrals to and from a printing company.

Successful businesses have business models that allow them to fulfill client needs at a competitive price and a sustainable cost. Over time, many businesses revise their business models from time to time to reflect changing business environments and market demands.

When evaluating a company as a possible investment, the investor should find out exactly how it makes its money. This means looking through the company’s business model. Admittedly, the business model may not tell you everything about a company’s prospects. But the investor who understands the business model can make better sense of the financial data.

Evaluating Successful Business Models

A common mistake many companies make when they create their business models is to underestimate the costs of funding the business until it becomes profitable. Counting costs to the introduction of a product is not enough. A company has to keep the business running until its revenues exceed its expenses.

One way analysts and investors evaluate the success of a business model is by looking at the company’s gross profit. Gross profit is a company’s total revenue minus the cost of goods sold (COGS). Comparing a company’s gross profit to that of its main competitor or its industry sheds light on the efficiency and effectiveness of its business model. Gross profit alone can be is leading, however. Analysts also want to see cash flow or net income. That is gross profit minus operating expenses and is an indication of just how much real profit the business is generating.

The two primary levers of a company’s business model are pricing and cost. A company can raise prices, and it can find inventory at reduced costs. Both actions increase gross profit. Many analysts consider gross profit to be more important in evaluating a business plan. A good gross profit suggests a sound business plan. If expenses are out of control, the management team could be at fault, and the problems are correctable. As this suggests, many analysts believe that companies that run on the best business models can run themselves.

Fast fact: When evaluating a company as a possible investment, find out exactly how it makes its money (not just what it sells but how it sells it). That’s the company’s business model.

Types of Business Models

There are as many types of business models as there are types of business. For instance, direct sales, franchising, advertising-based, and brick-and-mortar stores are all examples of traditional business models. There are hybrid models as well, such as businesses that combine internet retail with brick-and-mortar stores or with sporting organisations like NBA.

Below are some common types of business models; note that the examples given may fall into multiple categories.

Retailer

One of the most common business models most people interact with regularly is the retailer model. A retailer is the last entity along a supply chain. They often buy finished goods from manufacturers or distributors and interface directly with customers.

Ex: Costo Wholesale

Manufacturer

A manufacturer is responsible for sourcing raw materials and producing finished products by leveraging internal labor, machinery, and equipment. A manufacturer may make custom goods or highly replicated, mass-produced products. A manufacturer can also sell goods to distributors, retailers or directly to customers.

Ex: Ford motor company

Fee-for-service

Instead of selling products, fee-for-service business models are centered around labor and providing services. A fee-for-service business model may charge by an hourly rate or a fixed cost for a specific agreement. Fee-for-service companies are often specialised, offering insight that may not be common knowledge or may require specific training.

Ex: DLA Pipe LLP

Subscription

Subscription-based business models strive to attract clients in the hopes of luring them into long-term, loyal patrons. This is done by offering a product that requires ongoing payment, usually in return for a fixed duration of benefit. Though largely offered by digital companies for access to software, subscription business models are also popular for physical goods such as monthly recurring agriculture/produce subscription box deliveries.

Ex: Spotify

Freemium

Freemium business models attract customers by introducing them to basic, limited-scope products. Then, with the client using their service, the company attempts to convert them to a more premium, advanced product that requires payment. Although a customer may theoretically stay on freemium forever, a company tries to show the benefit of what becoming an upgraded member can hold.

Ex: LinkedIn/LinkedIn Premium

Important: Some companies can reside within multiple business model types at the same time for the same product. For example, Spotify – a subscription-based model also refers free version and premium version

Bundling

If a company is concerned about the cost of attracting a single customer, it may attempt to bundle products to sell multiple goods to a single client. Bundling capitalises on existing customers by attempting to sell them different products. This can be incentivized by offering pricing discounts for buying multiple products.

Ex: AT&T

Marketplace

Marketplaces are somewhat straight-forward: in exchange for hosting a platform for business to be conducted, the marketplace receives compenstation. Although transactions could occur without marketplace, this business models attempts to make transacting easier, safer, and faster.

Ex: Ebay

Affiliate

Affiliate business models are based on marketing and the broad reach of a specific entity or person’s platform. Companies pay an entity to promote a good, and that entity often receives compensation in exchange for their promotion. that compensation in exchange for their promotion. That compensation may be a fixed payment, a percentage of sales derived from their promotion, or both.

Ex: social media influencers such as Lele Pons, Zach King, or Chiara Ferragni

Razor Blade

Aptly named after the product that invented the model, this business model aims to sell a durable product below cost to then generate high-margin sales of a disposable component of that product. Also referred to as the “razor and blade model”, razor blade companies may give way expensive blade handles with the premise that consumers need to continually buy razor blades in the long run.

Ex: HP – printers and ink

Fast fact: Tying is an illegal razor blade model strategy that requires the pruchase of an unrelated good prior to being able to buy a different (and often required) good. For example, imagine Fillette released a line of lotion and required all customers to buy three bottles before they were allowed to purchase disposal razor blades.

Reverse Razor Blade

Instead of relying on high-margin companion products, a reverse razor blade business model tries to sell a high-margin product upfront. Then, to use the product, low or free companion products are provided. This model aims to promote that upfront sales, as further use of the product is not highly profitable.

Ex: Apple (IPhones + applications)

Franchise

The franchise business model leverages existing business plans to expland and reproduce a company at a different location. Often food, hardware, or fitness companies, franchisers work with incoming franchisees to finance the business, promote the new location, and oversee operations. In return, the franchisor receives a percentage of earnings from the franchisee.

Ex: Domino’s Pizza

Pay-as-you-go

Instead of charging a fixed fee, some companies may implement a pay-as-you-go business model where the amount charged depends on how much of the product or service was used. The company may charge a fixed feed for offering the service in addition to an amount that changes each month based on what was consumed.

Ex: Utility company

Brokerage

A brokerage business model connects buyers and sellers without directly selling a good themselves. Brokerage companies often receive a percentage of the amount paid when a deal is finalised. Most common in real eastate, brokers are also prominent in construction/development or freight.

Ex: Remax

Source: Investopedia