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What is a Business Model?

2012 March 4
businessman wearing  paper bag

“How do you expect to make money?” There is probably no more important question in business.  If you can’t answer that, you’re not likely to get very far or, in fact, anywhere at all.

Of course, conditions can change and very quickly, so the question is a fluid one.  A highly competitive approach ten years ago might not be viable today and companies that are barley five years old are commanding valuations in the billions.

That’s why there’s so much talk about business models.  Somebody claims to have new one, while another says that an old one is defunct.  But what is a business model really?  As innovation researcher Tim Kastelle points out, there a multitude of definitions representing different points of view.  That can be confusing.  It’s time to clear things up.

An Insight

In essence, a business model is an idea about why people will pay more than it costs you to produce a product or service.  Most business models are run of the mill, like a deli owner who simply believes that people will pay extra for someone to make their lunch for them, but others as truly innovative.

For instance, Henry Ford realized that by using an assembly line to manufacture cars, he could take a very niche product, a curiosity really, and make it into a product for the masses.   Lou Gerstner transformed IBM’s diverse product line into a powerful consulting model.   More recently, the Google guys realized that the same logic that conveys authority is an academic setting could create a better search engine.

Sometimes, the innovation isn’t about the product itself, but merely the way it’s sold.  Tim Kastelle gives a great example in the story of Xerox, where they failed when they tried to sell copiers but then when on to great success when they began leasing them.

A Fully Blown Concept

Of course, Google didn’t make money with their insight about search engines, they just made a better search engine.  They had no idea how to monetize it.  First they tried licensing the product to sites that already had a big audience, like AOL, but that didn’t get them very far.  Finally they hit on Overture’s idea about selling ads related to the results and struck it big.

In other words, a business model is a lot more than just a key insight (Jon Kleinberg of Cornell had an idea for a search engine that was very similar and, some believe, superior to Google’s concept, but it never really gained traction).  You need to also figure out the mundane stuff, like how much your product will cost to make, who you’ll sell it to and so on.

There are a lot of ideas how to do this.  Kastelle gives examples of eight types of business models on his site.  One of the best is the Business Model Canvas by Alex Osterwalder.
 

 
However, even after you have all that figured out, you still need to get some idea if your business will be steady for years, grow very quickly or whether it’s likely to decline over time. For that, you’ll need more than just clever ideas, you’ll need to plug in some numbers.

A Set of Assumptions

A business model is essentially forward looking, if it’s not, then it’s a financial statement. Most financial models are done with a five year outlook, so there’s a fair amount of guesswork involved.  While an Excel workbook full of numbers may look concrete, it’s really just a set of assumptions.

That’s fairly obvious with a start-up, but it’s also true of an established business.  As I’ve pointed out before, prediction is a tricky business, even if you have a wealth of data at your disposal.  The past can’t be automatically extrapolated into the future.

And that’s where industries run into trouble.  Clayton Christensen points out that disruptive innovations change business models because they render old assumptions about value impotent.  They’re disruptive because they change the basis of competition.

An Excuse

Business models, of course, don’t play out in Excel spreadsheets or PowerPoint decks but in the real world, where things are messy.  As I explained in an earlier post, Blockbuster got themselves into a world of trouble not because they didn’t realize that things were changing, but because they failed to change key facets of their model.

Here’s where a well articulated and deeply ingrained business model can become a vulnerability.  Long time employees become loyal to it, take comfort in it and become blind to possible flaws.  They respond to new innovations by saying “that’s not our business model.”

In other words, a business model can become an excuse.  Once it’s successful, it’s hard to argue with and hence hard to change even when, as in the case of Blockbuster and Kodak, the need for change is overwhelmingly obvious.

A Benchmark

Most of all, a business model is a mental model.  It offers a theoretical construct of how management thinks a business can work.  Much like the Constitution of a country, it is a philosophy as much as anything else and philosophies, to paraphrase Camus, are there to serve man and not the other way around.

In other words, they are means to an end, not an end in themselves and that’s where the confusion often arises.  There’s no reason for people to favor one model over another unless it performs demonstrably better.  A business model should never be mistaken for a business purpose.

So business models serve us best when used as benchmarks.  They document our business concept so that we can test them in the marketplace.  Inevitably, they will be off somewhat and will need to be jiggered, tweaked and sometimes transformed.  They are not a set of commandments, but living documents that must evolve and adapt.

Greg
 
Note: Tim Kastelle has another great post about business models on his site today. Check it out here.

14 Responses leave one →
  1. March 4, 2012

    A nice set of comments around the Business model- thanks.

    The three stand outs for me that always need top of mind you mention are “the excuse” on why you stay with what you know and ” a mental model- of how it can work and where this does need to go- beyond its existing frame- you really touched upon at the end, as did Tim, as others also- until we see this BM evolve and adapt- the very essence of Tim’s dynamic argument it will not have the place it deserves in (innovation) business management.

    [Reply]

    Greg Reply:

    Tim’s truly one of the great ones!

    Thx.

    Greg

    [Reply]

  2. Dick Taylor permalink
    March 18, 2012

    Greg,

    Your posts are truly amazing. I find myself always learning something new and thinking about things I thought I knew.

    With the state of newspapers, radio, TV — mass mediated communication — and the disruptive innovation called the Internet, what can be done about the business model, in your opinion, to allow these ventures to continue?

    It’s a subject I think about constantly.

    Would appreciate a little “whack up the side of the head” on this one.

    Dick

    [Reply]

    Greg Reply:

    Dick,

    It’s an interesting question. Each medium has different issues. TV is surprisingly unaffected, viewership is still very high historically and DVR’s have had minimal impact. I think that will change over the next few years (http://www.digitaltonto.com/2012/the-new-digital-battlefield/), but the programmers themselves are in a good position.

    Radio has been doing okay, but I don’t see much of a future with services like Pandora and Spotify available on smart car systems like Ford’s Sync and Toyota’s entune.

    Print is interesting because there are two very different businesses. Newspapers have historically been reliant on classifieds and have been utterly obliterated by the Internet. They still need to make big adjustments and have, for the most part, failed to do so. Magazines, on the other hand, have held up much better, but are facing a complete paradigm shift as tablet penetration grows (See: http://www.digitaltonto.com/2012/the-future-of-publishing/).

    The main difference is that the distinction between “brand building” media and direct response will fade. Every medium will have to do both and build advocacy as well.

    I hope that answers your question (it’s quite a wide ranging one).

    Greg

    [Reply]

    Sergei P. Reply:

    Mass media have a different audiences – watching, listening, reading and seeking information. Internet offers the additional alternative for customers to spend their time. When seeking information (for example, local ads) customer can save his time using Internet. But for relaxation mode Internet is not the main choice.

    [Reply]

    Greg Reply:

    Except, of course, on tablets…

    Greg

    [Reply]

    Sergei P. Reply:

    Yes, and this is a sad news for traditional media. Tablet becomes the sociolyzer which not only allows to be connected with virtual communities but opens the window to digital world of augment and virtual reality. Magazines’ pictured image of reality should compete with this new temptation…

    Greg Reply:

    It might seem that way, but “traditional media” has become less traditional than you’d think. In ten years, the major players of today will still be major players. There’s a lot of smart people out there.

    Greg

    Sergei P. Reply:

    Right assumption but not because the smart people will secure business stability. 85% people are indifferent to innovations, 15% of enthusiasts are very, very tired from digital innovations. May be major players also will get tired of their success and will retire :-)

    Greg Reply:

    Interesting perspective.

    Thanks

    Greg

  3. March 27, 2012

    I enjoyed this survey of business model theory, thanks.
    Giri Fox´s last blog post ..On introversion

    [Reply]

    Greg Reply:

    Glad you liked it Giri!

    Greg

    [Reply]

  4. Bernard Spencer permalink
    June 19, 2012

    Hi, Greg
    I enjoy what you’ve written about business models as I do for your other posts. Nevertheless I think your readers will learn much more about business models and strategic innovation through the views of Allan Afuah. Allan Afuah is an Associate Professor at the Stephen Ross School of the University of Michigan.
    Thank you for all

    PS. As a reader, I am a newcomer in your blog.

    [Reply]

    Greg Reply:

    Thanks for the tip! I’m always on the lookout for new people to read.

    – Greg

    [Reply]

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