These are some of the questions entrepreneurs or business managers should consider if they want to improve their business performance. Why? They encourage greater focus on the business model.
- How does your business make money?
- Where does your revenue come from?
- What are your major costs?
- Have you invested enough to ensure you can continue operating in the future?
- What are the critical success factors of your business?
What is a business model?
A business model is a short sharp description of how a business makes money; it is an explanation of the profit engine within the business. In order to capture how a business makes money a business model needs to:
- Capture how the business generates revenue
- Identify the major costs incurred in generating revenue
- Describe the investments required to implement and sustain the business into the future
- List the factors that are critical for the success of the business
A business model description can be captured in a few sentences or depicted as a diagram that shows the flow of income and costs.
Why is it useful to think about your business model?
Thinking about your business model can be an excellent source of clarity, focus, innovation and differentiation.
Clarity And Focus
Lack of clarity and focus can erode potentially good business ideas. Too few entrepreneurs and business managers take the time to clarify critical issues such as their target market, what they are going to do to make money, what their major cost drivers are and what they can do to minimise those costs? Because people don’t take the time and effort to address these issues, they operate their business in a haze, making vague decisions and hoping for the best. Managers add on new lines of business without ever really understanding whether it makes sense to diversify.
They see an opportunity and just start exploiting it without really analysing whether it will make a profit. The discipline of defining and articulating your business model will help you streamline your business so that you only engage in activities that positively contribute to the bottom line and assist you in identifying activities that should be discontinued because they are using up resources in an inefficient and unproductive way.
Building and Refining your Business Model
The process of building or refining your business model is a matter of carefully working through and answering these four important questions:
1. How Does The Business Generate Income?
This question forces you to focus on how your business will generate revenue. In thinking about this question it is important to:
- Identify the target customer. Who will buy your products or services? Be specific in identifying your target customers by their demographic profile, where they live, their preferences, and what will trigger their buying decision.
- Be specific about the value you will be providing to the customer. What benefit will they get from the goods or services you are selling to them? The more clear you are about exact value that customers can expect, the easier it will be for you to sell the goods or services. The value that you provide should be communicated in all marketing material that goes out from the company.
- Be clear on the number of revenue streams you will have in your business. Many businesses have more than one revenue stream and there is a different set of customers attached to each revenue stream. For example, a magazine will generate revenue from unit sales and advertising. The customers linked to the unit sales are the readers and the customers linked to the advertising revenue are the companies placing adverts.
- Be specific about price. What do you expect to charge for your product or service? Knowing your expected price point is important so that you can evaluate whether customers perceive that they are getting tangible value at that price point and to evaluate whether you can make a profit selling at your intended price.
- Recognise the timing of expected income from sales. Will you collect revenue before or after the sale? Will the revenue be collected as a once off payment or over a period of time?
How to Fine Tune The Business Model to Increase Revenue:
In order to think about how you can make your business model more innovative from an income generation perspective, consider these questions:
1. Are there people or businesses that could use my goods or services but don’t currently have access to them? Would it be beneficial for me to reach out to such
Example: One of the major business model innovations in the South African cell phone industry was “pay-as-you-go”. By changing the nature of the offering, South African cell phone companies were able to tap into much larger markets. MTN and Vodacom were global pioneers in the pay-as-you-go cell phone business model and it is one of the reasons that both companies have been so successful.
2. Are there people who are not buying what I offer because of the price point? If I shifted the price point up or down and adjusted my offering could I tap into a whole new market?
Example: Kulula.com radically expanded the market for airline travel in South Africa by dropping the price point for domestic airline tickets. Virgin Active innovatively expanded their offering by creating classic clubs with a premium offering and a higher price point to establish exclusivity for those willing to pay for it.
3. Is everything you are doing for customers providing them with value? Could you simplify or lessen your offering without impacting your customers’ perception of value?
Example: Outsurance discovered that not everyone valued the services of a broker when buying insurance. People were willing to do the work of a broker themselves if they were given the right information. Outsurance created the highly successful direct model for selling insurance.
4. Are there additional untapped revenue streams that you could exploit?
Example: Vida e Caffe don’t only sell great coffee, they also sell advertising space, creating lucrative additional revenue streams. They produce and sell advertising space in a quarterly magazine called Obrigado that is available in their stores. They also sell advertising space on their take away cup holders and little tags attached to their in-store mugs.
5. Are there ways that you could alter the timing of revenue collection to benefit the business? Most smaller businesses benefit by getting cash in earlier to speed
up cash flow.
Example: Many coffee shops in the USA have store cards. If you buy a store card you are in effect paying for ten cups of coffee in advance. This means that the coffee shop collects cash on their sales a long time before the sale is made and they reward customers for this by reducing the price of a cup of coffee for those who buy on a prepaid card. This practice benefits all parties: the shop has a healthy cash flow, customers don’t need to carry cash and can get their daily fix at a cheaper price. Many larger companies benefit by slowing down the payment process. For example, BMW make more money by financing cars than they do selling them. By slowing down the payment process they make money on the interest that is charged to customers.
2. What Are The Major Costs Incurred in Generating Revenue?
Every business needs to incur costs to operate. Incurring costs is part of doing business but the trick is to get the maximum return on your costs. Different kinds of business will have different kinds of costs at their core. A retail business has rental and inventory at its core, for a consulting business the major cost is likely to be labour, while a courier business will incur the bulk of its costs in vehicles and technology. When projecting your costs, it is important to:
- Identify major categories of costs affecting your business. Labour, technology, marketing, rental and capital equipment are all possible cost categories that may be at the core of your business.
- Understand the true nature & extent of the costs you incur to reach your projected revenue & growth levels. Costs can either be fixed, variable or semi variable. Fixed costs, such as rental, imply that a fixed amount will be incurred no matter what is produced or sold. Variable costs, such as sales commission, vary depending on the amount of output that is produced and sold. Semi variable costs, such as workers’ overtime payments, increase in steps as the level of output increases.
- Play out payment terms for major costs you incur to generate revenue. Payment will have a major impact on the cash flow of your business and it is important to know whether you will be paying for things upfront, over time or after receiving the goods or services.
How to Reduce Costs on Your Business Model
In order to think about how you can reduce costs through business model innovation consider these questions:
1. Are there clever ways of reducing costs by looking for others who can do things cheaper than you?
Example: One of the major trends in our globalised world is to find people in other countries who will do tasks at a much cheaper rate than what it would cost to get them done in your home country. Over a million US tax returns are now done in India. US accounting firms have set up processes and systems to electronically ship documents and information across to professional consultants in India, trained in US tax law, who complete the tax return at a tenth of the cost of what a consultant in the US would charge.
2. Are there ways you can change the nature of costs from fixed to variable or variable to fixed to benefit the company?
Example: African Encounters, the entrepreneurial African travel package company realised that they could reduce the cost of getting their clients to desired destinations by leasing a plane for a few days a week. This changed the flight costs from a variable to a fixed cost. Instead of paying a cost per seat on SAA or Air Tanzania, they now pay a lump sum amount to lease the whole plane. As long as they have enough people buying trips to Zanzibar, they are able to substantially reduce the cost of air travel from SA to Tanzania and some of this benefit is passed on to the customer. Smaller firms often benefit by limiting their fixed costs. It is for this reason that start-ups use freelancers and contract workers who only get paid for the work they do instead of weighing the new company down with a heavy salary bill.
3. Are there means for you to negotiate more beneficial payment terms with suppliers? Negotiating to pay suppliers for the goods or services they provide after you have used or sold those goods or services can create significant cash flow benefits and give the business a competitive advantage.
Example: Part of Dell’s business model innovation was that they negotiated to pay suppliers after they had received the cash from customers, and built and shipped the computer. Pick n Pay negotiates similar arrangements with its suppliers: It gets the goods on its shelves, sells them two to five days later, collects the cash and pays suppliers 90 days later. As a result, Pick n Pay has access to large amounts of interest generating cash that can be used to finance growth.
3. What Investments Are Required to Build and Sustain The Business?
Once you understand the cash flow implications of costs and revenue, it is important to use this information to calculate what size investment will be required to sustain the business through its initial negative cash flow. Almost all new projects, initiatives or ventures go through a period during the early growth phase when they use more money than they make. Depending on the nature of the business, the amount of time and level of investment required to sustain the business through this time will vary. Entrepreneurs and business managers must calculate accurately the size of the investment required for any new project, initiative or venture in order to ensure that they have enough money to build a sustainable business.
Fine Tune Business Model Innovation on The Investment Element
Innovating on the investment dimension of a business model is less common. There are, however, a number of things that you can do to enable innovation.
- Provide sufficient investment to give a new business model time to work. Customers and suppliers don’t buy into new ways of doing things immediately and it often takes time for a new business model to take hold. If you don’t have enough investment to see you through the period when the new business model is gaining traction, then the model is likely to fail.
- Provide sufficient investment to allow for some experimentation. The perfect business recipe is very seldom the first recipe you try out. You will need to experiment a little and experimenting takes money. Most new business models go through three to six iterations before the manager discovers a model that works well.
4. What are the critical success factors for the business?
Critical success factors are the actions and outcomes that will have a significant influence on a project or venture. The entrepreneur or business manager must rely on research, intuition and brainstorming to identify such critical issues. It is important to be precise and explicit in identifying such issues that could include sourcing the right location, fostering an important partnership, securing a big contract, creating a powerful brand or scaling up to a certain size.
Fine Tune Business Model On The Critical Success Factors
In order to ensure that you are being innovative in deciding on your critical success factors it is worth having two groups of critical success factors. Group one are the critical success factors that allow you entry in the game – the things that you must do just to compete with the businesses that are currently operating in your industry. This may include things such as high foot traffic location, a quick and functional website or nationwide distribution. Group two are the critical success factors that will differentiate you from the competition – the things that will cause your business to stand out from the crowd. These may include things such as widest selection of designs, unique and innovative website feature or same day delivery (when no one else is able to do it).
Both groups of critical success factors are important; the first group provides access and the second enables success. The four concepts of revenue, costs, investment and critical success factors pulled together into a single story, spreadsheet or diagram clarifies the business model for a venture or project. A business model is an interdependent system in which all the components interrelate with one another. To ensure that it is workable and flexible, you should make every effort to understand how the components interrelate and what the impact of a change in one component of the model will mean for the other components. Don’t be afraid to experiment a little with your business model, test different ideas, get feedback from customers and work with employees to ensure you are creating a system that maximises your business success.