As a small business owner, you need to know how to measure the effectiveness of your business model. This analysis involves taking the measure of the effectiveness of your target audience, your business processes and resources, and your marketing strategies, and it should always ensure you have room to innovate. Choosing the right company business model is the first key choice in working with a model that’s effective for your unique business.
What Is a Business Model?
While some descriptions of business models evoke different elements including value propositions, profit-making formulas, resources, and processes, the simplest definition may be that from best-selling industry author Michael Lewis: Your business model is how you plan to make money.
As Ramon Casadesus-Masanell and Joan Ricart wrote for the Harvard Business Review, “In its simplest conceptualization, therefore, a business model consists of a set of managerial choices and the consequences of those choices.” The ultimate measure of effectiveness in business is whether the company earns enough revenue to thrive.
Operating Model vs. Business Model
Your business model and an operating model share a close connection. Business models focus on what a business does and what kind of value it generates. Operating models deal with the core processes of a business. For example, consider a company that manufactures toys. The finished toys sell for a higher price than the value of the raw materials that it took to create them. That means its business model is simple, focusing on providing added value in the eyes of the company’s customers. To understand the operating model, though, you need to know how the toy manufacturer sources its parts, where it gets them from, and how its supply chain functions, among many other things.
Examples of Business Models
How many business models are there? Some common examples include the following.
Leasing companies own valuable goods, often capital goods and equipment, cars, or accommodation. They lease the right to use those goods to customers or tenants.
Brick and Mortar
The classic business model is the brick-and-mortar retail store. Most brick-and-mortar businesses use a corporate operating model that relies on a standing physical location, with customers travelling to and purchasing goods in person at that location. Some companies also make it possible for customers to shop online and have products shipped directly to their local stores or home in the so-called “brick-and-click” business model.
The original subscription-based models were magazine and record clubs. Thanks to the internet, modern subscription-based models can deliver a wide range of products. These companies generate revenue before delivering products or services, which is great for cash flow, and customers gain the convenience of not having to pay each time they use something.
This business model incorporates elements of other business model delivery systems. The lowest-cost method survives by obtaining common consumer goods and selling them for less than the competition. It lends itself to capitalizing on economies of scale. In the U.S., this was perfected first by Wal-Mart and then by Amazon.
This model operates in markets where buyers and sellers have difficulty finding one another efficiently. The broker earns a fee for brokering deals between providers and consumers, and in some cases, for offering expert advice along the way. Traditional brokers work in financial services, the stock market, and real estate, but the model has expanded into other industries in recent years. For example, both eBay and Airbnb have brokerage business models.
How Does Your Business Model Perform?
Calculating gross margin is a key way to measure your business model. To calculate gross margin, start with your gross sales revenue over a period of time, then add up your total cost of goods sold (COGS). Subtract COGS from revenue, then divide the result by the gross revenue.
Here’s a simple example: Say Rick’s Auto Lot earns $400,000 in sales revenue. Its COGS is $350,000. In this instance, the company’s revenue exceeds COGS by $50,000. To calculate the gross margin, divide $50,000 by the total revenue, or $400,000, and you get a gross margin of 12.5%. When you know your company’s gross margin, you’re able to assess your progress, or lack thereof, by measuring changes in gross margin over time. Comparing your average gross margin to that of similar companies lets you see how you measure up to your competition.
Is Your Business Model Effective?
Scoring your business model holistically makes it possible to look at more than your numbers. Swiss business theorist Alexander Osterwalder proposes a checklist of questions that allows you to evaluate your entire business. By scoring your business on a scale of 1 to 10 on each question, you’re able to compare your business to itself over time and to assess any growth or stagnation. The factors to assess in a holistic approach include:
- The effort it takes for customers to switch to another service or product provider (a measure of customer loyalty)
- The scalability of your business
- The potential for your business to generate recurring revenue
- The extent to which you’re able to make sales with incurring additional investments
- The extent to which your company encourages customers to create value for your business (e.g., by assembling final products at home)
- Your level of protection against competition
- The effectiveness of your cost model
Gross margin analysis and more holistic approaches are all useful measures of business model effectiveness, but the ultimate judge is your consumer. If customers find value in your products or services, they make purchases. Using available tools to see where you stand helps you make smart decisions about your company’s future. Using an accounting system, such as QuickBooks Online, you can generate a Profit and Loss statement automatically. Learn how today.