Business Model – Definition, Components, Role and Importance

Business model describes entire procedure of creation, delivery, and capturing of organizational values in both economic and social aspects. It represents core aspects of the business which include strategies, organizational structure, purpose, operational processes, policies, infrastructure, and business practices. Entire functioning of the business is based over this business model as it provides guideline to the organization to carry out all its activities. Thus there is a need to define business model of any organization at first in an explicit manner to avoid all the discrepancies at first end. Business model directly focuses over customer needs as it is this particular aspect along with product differentiation strategy, i.e. to introduce new product to make sure that company is able to capture optimum market share. This model also specifies customer groups through market segmentation to directly focus over those market sectors that will provide maximum return to the associated product. Business model can also be held responsible for defining distinctive competencies of the company that will ensure that the company is positioned at highly appropriate and differentiated place in the market. Broad differentiator is the USP (Unique Selling Proposition) that allows company to differentiate its product from its competitor’s product.

The essence of a business model is that it defines the ways by which the business enterprise delivers value to customers, entices customers to pay for value, and converts those payments to profit: it thus reflects management’s intention of what customers want, how they want it, and how an enterprise can organize to best meet those needs, get paid for doing so, and make a profit. After all the future of any company lies in the value that they deliver. Business models are used to describe and classify businesses (especially in an entrepreneurial scenario), but they are also used by managers inside companies to explore possibilities for future development, and finally well known business models operate as recipes for creative managers.

Business models are “stories that explain how enterprises work”.  A good business model answers Peter Drucker’s age old questions: Who is the customer? And what does the customer value? It also answers the fundamental questions every manager must ask: How do we make money in this business? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost?. A business model is a concise representation of how an interrelated set of decision variables in the areas of venture strategy, architecture, and economics are addressed to create sustainable competitive advantage in defined markets.

Role and Importance of  Business Model

Nowadays, the business models used depends on the technology levels in the organization. Top level managers have created entirely new models that depend fully on existing or emergent technology. Using technology, businesses can reach a large number of customers with minimal costs. Such is its importance in today’s world that a properly framed business model provides clarity to any business.

To identify and create value from an innovation, a start-up needs a well structured business model. Business models transform latest technology into outputs at the economic level.

For emerging firms in industry, established business models cannot be followed, therefore there is a need to frame a new business model. Not only is the business model important, in some situations, innovation lies not in the product or service offered but in the business model itself.

Taking into account the complexities of products, markets, and the environment in which the firm operates, very few individuals fully understand the organization’s tasks and objectives in their entirety. The technical experts and the business experts know each of their domains clearly.

Characteristics of Business Model

Research of several companies business models says that there is no such model which the best in producing financial results; however, the comparatively successful models possess the three following characteristics.

  1. Unique value offering  – this comes mostly in the form of a new idea. Mostly the offering is in the form of a combination of a product and a service; low price same benefit or same price greater benefit.
  2. Excellence is hard to imitate – by building up a key differentiating factor like good execution; these models build barriers to entry in market that will protect their profit streams and from other competitors.
  3. Successful models are backed up hard by reality – since they are framed on the basis of accurate customer feedback. The cost structure would be compatible with the revenue earned. However, many firms lack a clear understanding of where they create revenue, why customers prefer their product or service over the competitors and which customers actually bring revenue.

The main factors for which businesses compete against each other are competitors and resources, so in a business model the following aspects should be properly be covered- competitive edge, investor attraction, profit earning capacity; etc. The components of an effective business model are linked with each other and are backed with good detail: if the firm changes any one factor it gets a different model.

Components  of a Business Model

Following are the six major elements in business models:

  1. Value proposition – a clear description of the root cause for customer need, the product that will satisfy the need, and the delivered value of the product from customer’s view.
  2. Market segment – the genre of customers to target, recognizing the fact that different market segments have different needs. Sometimes the capacity of an innovation is revealed only when a different market segment is targeted. In short, the ‘segmentation, targeting and positioning of value’ (STP).
  3. Value chain structure – the point in the value chain where the firm is and how it shall capture that part of value.
  4. Revenue generation and margins – how the firm generates revenue in sales, leasing, subscription, support, etc, the pricing, and projected profit margins.
  5. Position in value network – locating the firm’s competitors and complementors, and any networking that can be done to deliver more value to the customer.
  6. Competitive strategy – what strategy the company will implement, pricing, differentiation or niche strategy, to gain a competitive edge in the market.

Components  of a Business Model

Business Model and Strategy

A business model is often mistaken for a business strategy. A firm must avoid using them interchangeably. Following are three main differentiators between the two:

  1. Creating value vs. capturing value – a business model aims at creating value. While it also includes how that value will be captured by the firm, a business strategy focuses on building a sustainable competitive advantage.
  2. Business value vs. shareholder value – the business model is responsible for transformation of ideas into valuable outputs. However, the business model does not focus on delivering this value to the end customers, but a business strategy does. For example, business model does not elaborate on financing methods, but they affect the stakeholders’ intentions.
  3. Predetermined knowledge levels – the business model requires only a basic level of knowledge, whereas strategy involves application of conduct more than knowledge of the environment.

Strategic or institutional management is defined as the conduct of drafting, implementing and evaluating cross-functional decision making that will enable an organization to achieve its long-term objectives. It is the process of charting out the organization’s mission, vision and objectives, developing policies and plans, often in terms of projects and programs, which are designed to achieve these objectives and then allocating resources to implement the policies, and plans, projects and programs. Framing a business model helps carry out the above practices.

A business model includes every aspect from how a company makes profit to how it structures its business. Mostly, these constitute the components of a business model.  A well structured business model is any organization’s crux of creating value. More specifically, it is the set of value propositions an organization offers to its stakeholders, along with the operating processes to deliver on these, arranged as a coherent system that both relies on and builds assets, capabilities and relationships.

Changing Business Models

However well designed a model is, it does not last forever in the market. The business model should constantly update itself from changing customer needs, market needs and the competitors.

The following are six common approaches for a business model to changes in market conditions:

  1. Showing proportional change by extending business model:  Geographical expansion, widening customer target, rearranging prices, extending product and service lines can be some ways of extending business model. By making these small changes the firm can achieve a boost to the existing business model. For example, a company called W.W. Grainger’s customers enjoy convenient placing of orders-through geographical branches, phone, fax or teletype machines. Adding Web channels to sales strengthened Grainger’s business model.
  2. Changing the distinctive factor of the existing business model:  When there is competition based on price, the firm changes its value proposition by redefining its existing business model. Teradyne, for example, market leader which manufactures semi conductor testing equipment’s, ropes in customers with innovative products but brings in revenue through a steady stream of product enlistments and efficient service. The company’s value proposition is its leading edge products and trustworthy service. To rejuvenate its business model, Teradyne periodically introduces breakthrough products that sets it go.
  3. Replicate a model in new domains:  By using same business formula, companies introduce new products into new markets. This is known as replicating the business model in new domain. Example, Aurora Foods and the Gap. Aurora Foods buy unpopular brands like Aunt Jemima Waffles and Lender’s Bagels and makes use of its marketing strategies and cost cutting measures to give those brands a lift up in market. Likewise, the Gap applies its brand marketing and merchandising experience to create entirely new retail signatures like BabyGap, Banana republic, and Old Navy Clothing.
  4. Including other models of acquisitions to firm portfolio:  Through acquisitions and mergers companies regain their operating positions. For example, Seagram’s which is basically a wine and spirits company, ventured in as an entertainment firm. It acquired Vivendi another French company hoping to use its cellular telephones, pay television, and Internet portals to distribute Seagram’s’ entertainment content.
  5. Identifying existing capabilities and implementing to create new models:  By identifying their skills and capabilities, companies grow their business models. For example, the Canadian company Bombardier which manufactures snowmobiles got a foothold in financial services by selling on credit then moved into capital leasing. Experience in manufacturing snowmobiles threw light on many opportunities in large scale manufacturing, including aircraft for the firm. Based on leasing experience and aviation background, Bombardier Company offered fractional jet ownership to corporations and high-net-worth individuals. Thus, Bombardier has leveraged the capabilities, knowledge and relationships that it developed as part of one model to create the next.
  6. Making fundamental changes in the model:  A whole new transformation of organisation structure, culture, and the values. The transformation being quicker, more drastic and sudden the change will be. During the process of an idea changing into a product and it being introduced to the market, the firm usually faces the dynamic change environment.

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