What is meant by the term business model?

The term business model is now in common use in commerce and industry throughout the world. Surprisingly, however, many people - even some who own and manage businesses themselves – struggle to articluate just what the term means. This may be so, in part, because it is a term which has come into common usage quite quickly, and relatively recently, and is therefore perceived differently depending on the nature of the business involved.

It is easy to overcomplicate the process of trying to understand or explain the term business model. In essence, it is simply the way in which a company operates and attempts to make a profit.

For a corner store stocking basic consumer staples, the model is relatively simple. The proprietor buys product from wholesalers, displays it in his store and sells to walk-in customers at a mark-up. The difference between his gross margin and his overheads is profit before tax. The model could be enhanced by the proprietor, for example, taking orders online, offering discounts for bulk purchases, offering home deliveries for a premium price, stocking more hard-to-get items which appeal to a new demographic, etc.

Most telecommunications companies, in contrast, have more sophisticated business models. They offer a range of plans under which customers are offered more expensive “free” handsets for higher value monthly plans. The cost of the handsets is, of course, built into the minimum spend on the monthly bills. A huge range of promotions, many undertaken in conjunction with media companies, sports events, etc, are offered as enticements for customers to increase air time usage – via voice calls, text and multimedia messaging, Internet downloads, etc -  as this is how the telecoms primarily make their money.

The views from academia and big business

Langdon Morris, a Senior Practice Scholar at the Ackoff Center for the Advancement of Systems Approaches at the University of Pennsylvania, described it this way in his 2003 paper Business Model Warfare (link here):

... a comprehensive description of business as an integrated system functioning in an intimate relationship with the broader market. ..., the individual components of an organization do not matter as much as the way they work together to enable the organization to create value and deliver it to customers.

A business model is therefore a description of a whole system, a combination of products and services delivered to the market in a particular way, or ways, supported by an organization, positioned according to a particular branding that, most importantly, yields a particular set of strong relationships with present and future customers. Further, a business model describes how the experiences of creating and delivering value may evolve along with the changing needs and preferences of customers. ...

... a “business model” is a description of the entire marketplace and the relationship of the company to that commercial environment. It is a precise definition of who customers are, and how the company intends to satisfy their needs both today and tomorrow. A business model also includes a specific assessment of today’s competitors, and tomorrow’s, and the technologies that will be embedded in various competing versions of products and services. ...

Large companies tend to define the term business model in accordance with their own particular business focus and experience. In a recent edition of Fast Thinking magazine (link here), for example, the leader of Strategy and Change Consulting with IBM Global Business Services,  Matt English, had this to say:

… The concept of the business model is broad in scope, and manifests itself in many different ways. Fundamentally, the term refers to the way an organisation shapes itself to be competitive in the market place.

In IBM’s experience, we have found that “business model” can refer to an organisation’s structure, its use of major strategic partnerships, the application of shared services, alternative financing, divestitures, and the use of third parties. …

A new field of study

The business model is increasingly coming under academic study. The Massachusetts Institute of Technology (MIT) Sloan School of Management, for example, released a report in May 2006 - Do Some Business Models Perform Better Than Others? (link here) - based on a study of the business models of nearly 11,000 US companies which were publicly traded between 1998 and 2002. Identifying 16 categories of business model, the report concluded that, while no model outperforms others in all dimensions, some models do perform better financially. The report concludes:

… we hope that our framework can provide investors with a useful lens for analyzing potential investments. Unlike well known concepts such as industry classification, this perspective focuses on the deep structure of what firms actually do. And, since this perspective is not yet well-known, it may lead to novel insights about which investment opportunities are most attractive. …

Based on a review of a range of academic and other studies, Alex Osterwalder, a young Swiss business consultant whose PhD was focused on business model design, offers a four-group/nine-component business model structure (link here). The broad structure is as follows:

Recent emergence of the term into common business usage

While it seems that the term business model has been used in business and commerce for several decades, it is clear that it only came to prominence in its current context in the late 1990s, in the lead-up to the dotcom crash of 2000/2001. It was during this time that the term became synonymous with what often appeared, and were later confirmed, to be implausible explanations of how billions of dollars being raised on equity markets around the world would be used to finance the new online business behemoths being promised by the promoters. We know how that all ended.

In May 2002, a paper appeared in the Harvard Business Review which both pointed out the blatant flaws in the business models behind some of the dotcom disasters, and also affirmed the importance of the concept of the business model in the wider commercial world. In Why Business Models Matter (link here), Joan Magretta presents what remains one of the most insightful discourses on the centrality of the business model to modern commerce. It is well worth recording some of her observations:

A shorthand overview

… A good business model begins with an insight into human motivations and ends in a rich stream of profits. …

On the essence of the business model

... When business models don't work, it's because they fail either the narrative test (the story doesn't make sense) or the numbers test (the P&L doesn't add up). ...

On one of the key advantages of focusing on the business model

… it actually forces managers to think rigorously about their businesses. A business model’s great strength as a planning tool is that it focuses attention on how all the elements of the system fit into a working whole. …

On the importance of the emergence of PC-based spreadsheets in the 1980s to the development of the business model concept

… By enabling companies to tie their marketplace insights much more tightly to the resulting economics – to link their assumptions about how people would behave to the numbers of a pro-forma P&L – spreadsheets made it possible to model businesses before they were launched. …

On the difference between business models and strategy

… Every viable organisation is built on a sound business model, whether or not its founders or managers conceive of what they do in those terms. But a business model isn’t the same thing as a strategy, even though many people use the terms interchangeably today. Business models describe, as a system, how the pieces of a business fit together. But they don’t factor in one critical dimension of performance: competition. Sooner or later – and it is usually sooner – every enterprise runs into competitors. Dealing with that reality is strategy’s job. …

On the power of a compelling new business model (commenting on the success of the Dell Computers business model)

... When a new business model changes the economics of an industry and is difficult to replicate, it can by itself create a strong competitive advantage. ...