Posted on Harvard Business Review: January 21, 2010 3:30 PM
Quick: Describe your company's business model.
Having trouble? That wouldn't surprise me. In reality, there isn't really any consensus about what the term "business model" even means. Suggestions range from the all-encompassing, everything-in-your-value-chain approach to the reductionist "A business model is nothing else than a representation of how an organization makes (or intends to make) money."
That latter definition is from Peter Drucker. And while I applaud his attempt to reach for the essence of the idea, I think he went too far. A business model has to specify more than just how a company intends to make money. It also needs to include some information about why a customer would ever want to give the company any money.
As something of a middle ground, I've proposed (in both an HBR article and in more depth in my book Seizing the White Space) a framework meant to be specific enough to overcome the reductionist problem but selective enough to overcome the unwieldiness of the kitchen-sink camp. I've broken it out into four boxes that answer the following questions:
Why would someone want to buy something from you?
How will you make money selling it?
What, exactly, are the important things you need to do to pull off the plan?
(I know that's three questions, but the answer to that last question comes in two parts, so the model requires four boxes.)
To answer the first question, you need to construct a customer value proposition (CVP)—not by trying to convince customers of the value of your products but the other way around, by identifying an important job a customer needs to get done and then proposing an offering that fulfills that job better than any alternative the customer can turn to. Generally speaking, the more important job is to the customer, the lower the level of satisfaction with current alternatives and the lower the price, the stronger the CVP.
To answer the second question, you need to specify your profit formula. On one level you could think of this merely as how much you expect to sell at a certain price minus your costs, but to be useful as a strategic tool, I've broken it out into four buckets:
Revenue model—simply, quantity times price
Cost structure—not only direct costs and indirect costs, but also overhead, which too many companies think of as immutable
Margin model— though technically part of the cost structure, I break it out separately because all too often companies mistake their margins for their entire profit formula and have tremendous difficulty understanding how a lower-margin opportunities could ever be profitable
Resource velocity—often overlooked as a profit generator, this measures how many widgets a company can invent, design, produce, warehouse, ship, service, sell, and pay for throughout the value chain for a given amount of investment, for a given amount of time. In some sense, it's a measure of not how much money flows through your company but how quickly it flows through it.
Finally, to answer the third question, you need to identify which company resources and which processes are essential to delivering the customer value proposition. These are not all the steps in the value chain—just those that are critical for the CVP.
As Peter Drucker did in the quote above, many people equate the profit formula with the entire business model. That's often all that's captured in many business model analogies, as well. Worse, many people focus just on the margin or overhead requirements of their current profit formula.
But every successful company is operating according to a business model that incorporates all four parts of this framework—a value proposition customers want, delivered through a coherent profit formula, which not only covers its overhead and margins but generates revenue at a certain volume and velocity, by employing certain key resources effectively through certain key processes.
Identify this model and you will go a long way toward understanding why your company is successful in what it's doing (or at least what it was doing before the recession). And unless you know that, you'll have little chance of working out what you need to change to be successful doing something else—like meeting whatever challenges the post-recession economy creates this year.