What is a Business Model and How to Use It?

UTC by Osaemezu Ogwu · 13 min read
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Photo: Unsplash
Photo: Unsplash

Check this guide and find out what a business model is, why you need it, and what it takes to ensure that you put the right one in place.

A business model defines the steps a company will take to attain its aim of making a profit. The model describes how the company will provide its customers with great value but at an appropriate cost.

Accordingly, a business model consists of the company’s products or services, the potential market these products will be launched, and a forecast of the expenses that will be incurred. It also covers plans to get investors, hire qualified workers, and encourage the management and staff.

To that effect, business models are important for any new company looking to establish itself and grow. The same can be said for existing businesses that must consistently meet the challenges and competition. These companies have to improve their business model in areas that are in dire need of changes.

On the part of investors, they may evaluate the business plan of a company to help them make informed decisions. This plan is reviewed and analyzed to ascertain if the business has a well-defined process to help it achieve its goal. Based on this review, investors can then invest or find new companies to pitch their tent.

History of Business Model

The term business model became widely used after the launch of computers and spreadsheets. Both of these are tools that enable business owners to test, and model ways that would help to define their cost and source of revenue.

Let’s take the spreadsheet, for instance, it gives entrepreneurs a quick way to understand their business model. These individuals can also make changes to the model easily, and monitor how these changes affect their business. And most importantly, the impact of these changes in the near and long term.

Parts of a Business Model

A better understanding of the business model is gained by dividing it into parts. The first part of the model encompasses the materials, manpower, and equipment needed to set up the product or service.

The second part of the business model involves the promotion and delivery of the product of the service. It will require marketing, service delivery, and even sales processing. The final stage is determining how much the customer pays and the method of payment. It will involve setting up a payment method, pricing, and so much more.

It, therefore, follows that a good business model enables the company to use less money it receives from customers to design the product. The remaining portion serves as the company’s profit. Profit can be gotten either by reducing the design and manufacturing costs. Lesser funds can also be used with an effective marketing approach or using a cost-friendly payment method.

How Business Model Works

A business model comprises of different components, each of which aid in running the company in a profitable way. A value proposition is a major component of this model. It defines the company’s products and services and why they are what the customer actually wants. Also, the ways in which the company’s offering differs uniquely from that of its competitors are stated in this model.

Another component of the business model is its focus on startup costs. These are the expenses that will be made to create the product and even market it. Coupled with costs, is how the finance to create these products will be sourced. And even the marketing strategy that will be employed to spend less while reaching the right audience.

There’s also part of the business model that outlines potential partnerships with businesses in the same niche or industry. These partnerships may be with more established businesses that could improve the company’s chances of making a profit. A partnership of this nature could be between an advertising and printing company. The former could benefit from customers the printing company refers to them.

On the other hand, it is entirely possible to underestimate the funds that will be needed to manage the company until it makes a profit. In this case, the company may get it right in forecasting how much is needed to create the product and service and even market it. However, they may be unable to determine how much is needed to run the company until it runs into profit. The latter could result in issues given that the company has to be managed properly to a stage where the expenses are lesser than the revenues.

Different Kinds of Business Models

Various business models exist and they can be differentiated from each other. There are major types such as advertising, direct sales, franchising, and so much more. In the same vein, there are businesses that rely on a combination of these types. Nonetheless, the different business models include:

Advertising

This model has advanced from prints and is now based online. Instead of newspapers and the likes, an online platform is created to offer content such as videos, songs, news, etc. Besides, this is content that will be of interest to the platforms’ visitors. In return, money is made when visitors view this content due to the placement of adverts on the web pages.

Accordingly, this business model is targeted at both readers and advertisers. While the readers get such content for free, the business owner earns from advertisers. What’s more, content can be sourced from platform visitors without charges. Hence, it takes away the need to hire content creators. YouTube uses this business model.

Affiliate

This model can be compared with the advertising approach. But instead of displaying advertisements on the platform, links are embedded within texts. And as visitors click these links, they are redirected to the advertiser’s website where they can buy the product. The business owner is paid a commission for each sale or action.

An example of this model is a product review website. The latter may review the best selling products for home, security, or cooking sold on Amazon. This review consists of their affiliate link, which allows them to earn each time the site’s visitor purchases the product on Amazon using their link. A platform that has adopted this business model is TheWireCutter.

Crowdsourcing

There are business models that source content from a large group of people. This content is published on a website where visual advertisements are also present. The latter helps the site owners to generate revenue, part of which is paid to the content creators. Other means can be used to compensate the content creators either by pushing their own sites in front of a large audience.

There are different versions of this model and notable among this is a company like Threadless which sources for unique T-shirt designs. The creator of these designs is paid a certain percentage from the sales of the design.

Disintermediation

Often times, intermediaries along the supply chain are needed to get a product from the factory to consumers. And this adds up to the cost of the product and expenses on the part of the company. Nonetheless, disintermediation offers a possible way of sidestepping these intermediaries.

In this case, products can be sold to customers directly without moving these products through the supply chain. This helps to reduce the cost of the product and helps the company to form direct relationships with their customers.

Concierge

Concierge defines a business model where customization is made to an existing product or service. The goal is the make the product unique, hence, customers may get the same product or service, that still differs from that of another customer.

Franchise

Franchising is where ideas are sold to upcoming businesses. These ideas enable the company to set up and run successfully. In the same vein, the company is sold access to support service and to a national brand. This can be said to the sales of the knowledge of running a successful business to a company looking to start.

Freemium

Here, a company does not charge for a product’s standard features but demands a subscription for advanced functionality. Freemium may be confused with a free trial, but it differs since the latter offers the product’s full features for a specified time.

Accordingly, users of freemium products can take advantage of the standard features for an unlimited time. Whereas customers who want to make the most of the software using its premium features need to make payments periodically. Shareware software and McAfee security are some freemium products.

Brokerage

This model links buyers with sellers and enables both participants to transact in a safe and seamless manner. The broker charges the transacting parties a fee for serving as an intermediary between. There are companies in the real estate industry that help buyers and sellers to purchase or sell a property. These companies get a certain percentage after the transaction has been completed.

Pay-as-you-go

Customers have a choice of paying for services as they use them instead of subscribing before its use. This model is called pay-as-you-go and has been adopted by companies that offer home utilities. For instance, customers are charged for electricity as they use it in real-time. The minutes they spend on the phone also determine how much is charged.

Subscription

Here, customers pay a monthly or yearly subscription for a service. For instance, this subscription can be for a movie streaming service or use a product within a specified period. Netflix is an example of a movie streaming service that uses this model.

Advantages of a Business Model

Some advantages of a business model are:

Meet the Customer’s Needs

A good business model enables companies to launch products and services that meet the need of the customer and at a competitive price. However, there is often a need to revise the business model occasionally to ensure it meets the current business environment and even the demands of the market.

Revenue Generation

Another advantage of a business model is that it helps a company to generate revenue especially if it is aimed at a market with a large customer base. An example, in this case, would be the sale of subscriptions to businesses and these sales could be for each employee the company has.

Competitive Advantage

Companies with a business model have a competitive advantage in industries they are tailored at. Besides, the use of a unique business model gives the company a reputation and makes it stand out in the ecosystem. A unique product that meets the customers’ needs is able to encourage purchases.

Financial Sustainability

A business model offers companies financial sustainability where the business expenses can be well-handled even before the company makes a profit. In the same vein, this model helps the company to stand the test of time despite the changing market conditions. The latter is especially useful given that several businesses close down as a result of mismanagement of funds.

On the other hand, gross profit is a factor that is used to determine the success of a business model. In this case, the businesses’ total revenue subtracted from the cost of creating or selling its products gives this gross profit. This profit is compared side-by-side with the profit made by a competitor in the same industry. And it gives an insight into the efficiency of the business model the company had adopted.

Coupled with the businesses’ gross profit, net income is another factor used to determine the success of this business model. The net income is a subtraction of the gross profit from the operating expenses. And the resulting value reveals the profit generated by the business.

Disadvantages of a Business Model

Some disadvantages of a business model are:

Potential for Losses

There are business models that neither work nor make sense. It could be that the content of the plan cannot lead to a profit. When a company relies on a business model of this nature, it could run into losses or go bankrupt.

A good example of an industry with a business model that ceased working is the airline industry. There’s Delta for instance, whose business model allowed flights to follow several major airports. This model also ensured that seats were filled most times, which enabled the company to make profits. Nonetheless, a more competitive business model was designed which turned the strength of these major carriers into a burden.

Difficulty in Maintaining a Steady Income

Another disadvantage of a business model is that it may be difficult to get a steady flow of income with the use of a price per user model. The latter may not be the case if the product or service targets a large and growing audience. There are also no challenges if the company opts to make new versions of the product to sell to return customers.

Example of Business Model

Two companies, A and B, used the same business model to offer movies for rent or sale. They’d invested around $5 million each in the business. Both companies were able to raise $6 million in revenue and as such $1 million in gross profit (revenue – the amount invested). Their gross profit margin is 16%.

Upon the arrival of the internet, Company A to switch to digital videos. It changed its model to allow individuals to subscribe and stream videos online. While the business model has changed, Company A still pays a licensing fee for the movies if offers. Nonetheless, it has been able to reach a wider audience, and at the same time, eliminate the cost of keeping stock of physical cassettes or CDs.

Therefore, the cost of running the business has been reduced. This reduction is evident in the storage and distribution of movies given that the cost is down by $3 million. Company A’s gross profit now sits at $3 million and its gross margin is 50%.

In contrast, Company B is still maintaining the business model of offering real copies of movies. While it still generates profit, the world is gradually diverting to digital versions movies. As such, Company B is already facing strong competition. There’s still the cost of maintaining stock which it still has to handle. As such, it still maintains a lower gross profit margin.

Conclusion

Remember, a good business model can help your company cut costs, manage its expenses until it makes a profit, and even deliver a product or service that meets the customers’ needs.

There’s also the benefit of choosing from a wide range of business models, hence, there’s the right model tailored to the industry your business is. You can also take it one step further to make slight changes to the model you’ve chosen to make the most profit.

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