Business Model Basics

Business models are representations of an organization’s work in the present.  We can contrast a business model with the firm’s strategy which illustrates its long-term goals and objectives.  Strategy creates the overarching purpose for a company, explaining why it is in business in the first place.  Part of the strategy encompasses the vision for the organization, indicating where it hopes to be in the future as an industry competitor and participant in the economic environment.  In contrast, business models show how the firm is competing today and how it should position products and services to be competitive in the current environment.

Traditionally, business models have four elements that interact and integrate to create a competitive position for the organization.  These components are:

1. The customer value proposition,
2. Pricing and profit formulas,
3. A growth model, and
4. Key resources and processes.

Customer Value Proposition

Anyone working in new product development (NPD) knows that most successful development efforts are customer-centric.  Understanding customer needs is a foundational step in any NPD effort.  Furthermore, new product development practitioners must clarify the difference between customer needs and product features – what is the problem that needs to be solved and how can the product address a technical solution to that problem?

The customer value proposition expands customer needs beyond feature design.  Customers will purchase a product only if it solves their problems and only when they see value in the proposed solution.  Benefits must exceed the costs of the product to the customer in order for him or her to make a purchase.  It should be noted that costs are not merely monetary, but also include time, convenience, and social image.  For example, some studies have noted that customers will purchase a more expensive Starbuck’s coffee over a fast food coffee in order to be seen with a cup with the memorable logo.  Thus, part of the customer value proposition of a Starbuck’s coffee results in a social benefit which cannot be measured by any standard financial metrics.

Pricing and Profit Formulas

Of course, the customer value proposition is closely linked to the price for which a company can sell a product.  A customer’s perceived benefits must exceed the actual price paid though many of these benefits are not measurable in monetary terms.  A company, on the other hand, must charge a high enough price to recoup R&D, production, and marketing costs.  Business models will clearly address the pricing and profit formula.

One element to consider in setting prices is a consumer’s reservation price.  The reservation price is the highest price a customer is willing to pay in order to receive the benefits that the product offers.  A company will naturally wish to set the selling price as close to the reservation price as possible in order to maximize profits.  However, if the difference between the benefits that a customer perceives and his/her reservation price is very small, the likelihood of a purchase will decline.

Growth Models

Like the pricing and profit formulas, a business model should describe the growth model for the product or service.  As a business model provides a clear roadmap to discharge the firm’s strategy, the business model must elucidate growth of the product or service over the short- to medium-term.  Most products will evolve through a distinct life cycle from introduction to growth and maturity and eventual decline.  The business model describes how a product will achieve increased sales volume, revenues, and market share in the growth phase.

Growth models may include targeting of new customer segments, increased purchases by existing customers, or international roll-out of a product for different geographical markets.  Through the growth model, an organization will link its long-term strategic objectives with the shorter term sales and marketing plans for the product as an element of the business model.  If a firm has a strategic goal to increase its presence in Asian markets, for example, the growth model for a particular product may be to roll-out the product first in Japan, then in Korea, and finally in China.

Key Resources and Processes

Every business is unique.  Firms with different strategies can compete successfully in the same industry.  The business model defines how each company competes, notably through the application of key resources and processes.

For example, many petrochemical companies are vertically integrated in an oil company with upstream drilling capabilities.  Because of special access to key raw materials, the petrochemical company may institute unique business models that capitalize on the available oil.  Another company may set up its business model for the same product based on acquiring feedstocks in the open market.  Both companies can be successful in delivering product solutions to customers and in meeting their long-term strategic goals, yet each will focus on a different set of key resources, leading to different combinations of the four elements of a business model.

Similarly, key business processes also lead firms to unique and competitive business models.  Today, companies may utilize technology, big data, or customer relation information to gain insights to customer needs and benefits.  Such business processes can generate competitive advantages when executed consistently across the product line.

Why Do You Need a Business Model?

Business models provide a way to implement a longer term strategy through products today.  Companies should constantly study, revise, and update business models in order to address marketplace changes.  Technologies and markets are changing at a rapid pace and competition introduces new product solutions that can make an existing product obsolete overnight.  A business model helps to clarify customer-centric decisions to deliver value to consumers consistent with the firm’s strategic objectives.

To learn more about business models, please join us for a workshop on NPD best practices.  Contact me at info@simple-pdh.com with the subject “Business Model Basics” to download two free papers on business model innovation.  At Simple-PDH, we want to make it simple to study, learn, and earn your professional certifications.

 

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