Business Model

A business model is a company's plan for making a profit. It identifies the products or services the business will sell, the target market it has identified, and the expenses it anticipates.

A new business in development has to have a business model, if only in order to attract investment, help it recruit talent, and motivate management and staff. Established businesses have to revisit and update their business plans often or they'll fail to anticipate trends and challenges ahead. Investors need to review and evaluate the business plans of companies that interest them.

A business model is a high-level plan for profitably operating a particular 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 business model for a new enterprise should also cover projected startup costs and sources of financing, the target customer base for the business, marketing strategy, a review of the competition, and projections of revenues and expenses.

A common mistake in creating a business model is underestimating 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 revenues exceed expenses.

A business model may also define opportunities for partnering with other established businesses. An example would be an advertising business that could benefit from an arrangement for referrals to and from a printing company.

There are as many types of business models as there are types of business. Direct sales, franchising, advertising-based, and brick-and-mortar stores are all examples of traditional business models. There are hybrids as well, such as businesses that combine internet retail with brick-and-mortar stores.

Within these broad categories, each business plan is unique. Consider the shaving industry. Gillette is happy to sell its Mach3 razor handle at cost or lower in order to get steady customers for its more profitable razor blades. The business model rests on giving away the handle to get those blade sales. This type of business model is actually called the razor-razorblade model, but it can apply to companies in any business that sells a product at a deep discount in order to supply a dependent good at a considerably higher price.

[Important: When evaluating a company as a possible investment, find out exactly how it makes its money. That's the company's business model.]

Successful businesses have adopted 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.

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. 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 misleading, 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 costs. A company can raise prices, and it can find inventory at reduced costs. Both actions increase gross profit.

Nevertheless, 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 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.

Consider a comparison of two competing business plans. Both companies rent and sell movies. Before the internet existed, both companies made $5 million in revenues after spending $4 million on their inventories of movies.

That means each company makes a gross profit calculated as $5 million minus $4 million, or $1 million. They also have the same gross profit margin, calculated as gross profit divided by revenues, or 20%.

After the advent of the Internet, Company B decides to offer streaming movies online instead of renting or selling physical copies of movies. This change disrupts the business model in a positive way. The licensing fees do not change, but the cost of holding inventory is down considerably. In fact, the change reduces storage and distribution costs by $2 million. The new gross profit for the company is $5 million minus $2 million, or $3 million. The new gross profit margin is 60%.

Meanwhile, Company A is not only stuck with its lower gross profit margin but its sales will soon begin sliding downwards. It failed to update its business plan. Company B isn't even making more in sales, but it has revolutionized its business model, and that has greatly reduced its costs.

Joan Magretta, the former editor at the Harvard Business Review, suggests there are two critical factors in sizing up business models. When business models don't work, she states, it's because the story doesn't make sense and/or the numbers just don't add up to profits.

The airline industry is a good place to look to find a business model that stopped making sense. It includes companies that have suffered heavy losses and even bankruptcy.

For years, major carriers such as American Airlines, Delta, and Continental built their businesses around a "hub-and-spoke" structure, in which all flights were routed through a handful of major airports. By ensuring that most seats were filled most of the time, the business model produced big profits.

But a competing business model arose that made the strength of the major carriers a burden. Carriers like Southwest and JetBlue shuttled planes between smaller airports at a lower cost. They avoided some of the operational inefficiencies of the hub-and-spoke model while forcing labor costs down. That allowed them to cut prices, increasing demand for short flights between cities.

As these newer competitors drew away more customers, the old carriers were left to support their large, extended networks with fewer passengers. The problem was made worse when traffic fell sharply in 2001. To fill seats, the airlines had to offer more and deeper discounts. The hub-and-spoke business model no longer made sense.

The Investor's View

What does this mean to an investor? When evaluating a company as a possible investment, the investor should find out exactly how it makes its money. That's the company's business model. Admittedly, the business model doesn't tell you everything about a company's prospects. But the investor who understands the business model can make better sense of the financial data.

• A business model is a company's core strategy for profitably doing business.
• The two levers of a business model are pricing and costs.
• When evaluating a business model as an investor, ask whether the idea makes sense and whether the numbers add up.