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home > knowledge > what is a business model?

What is a
business model?
A new approach

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The term “business model” has grown rapidly in importance in recent years, particularly in the venture and innovation communities. Today, executives, entrepreneurs and investors all recognize the importance of having a good business model. They understand that without a good business model, new technologies and products remain good ideas that never translate into value – for their inventors, investors or society at large.

It is ironic, therefore, that there is no generally accepted definition of a business model. And perhaps more than ironic – if developing a good business model is a primary goal for the stakeholders in a business, then they need a clear definition in order to know whether or not they have achieved this goal. Moreover, a clear definition of a business model would help everyone involved in creating and commercializing product and service innovations understand the key elements that need to be addressed to be successful.

A good definition of a business model must be simple, clear and comprehensive. Simplicity will ensure it is easy to learn and remember. Clarity will ensure it is understood, and meets the intuitive “gut feel” test of experienced venture players. Comprehensiveness will ensure that it includes all the key elements that innovation and venture leaders need to consider in creating successful business models.

With a view to developing such a definition, this paper will review several recent approaches to business models. It will then propose a new approach that integrates all the key elements of these approaches, and also meets the “simple, clear and comprehensive” test.

The following authors have presented perhaps the most useful insights into the definition and components of a business model. We urge interested readers to consult the referenced works, as this paper can do no more than present a very short summary of each author’s approach. 

Henry Chesbrough: Open Innovation

In his seminal work, Open Innovation, Henry Chesbrough describes the business model as creating and capturing value from technology. He suggests that a business model has six functions:

  1. To articulate the value proposition – the value created for users by the offering based on the technology.
  2. To identify a market segment – the users to whom the technology is useful and the purpose for which it will be used.
  3. To define the structure of the firm’s value chain, which is required to create and distribute the offering, and to determine the complementary assets needed to support the firm’s position in the chain.
  4. To specify the revenue generation mechanism(s) for the firm, and estimate the cost structure and target margins of producing the offering, given the value proposition and value chain structure chosen.
  5. To describe the firm’s position within the value network linking suppliers and customers, including identification of potential complementary firms and competitors.
  6. To formulate the competitive strategy by which the innovating firm will gain and hold advantage over rivals.          

Gary Hamel: Leading the Revolution

Hamel defines a business model as “a business concept that has been put into practice”. He proposes a business model framework comprising four primary elements:

  1. Core strategy – this includes the business mission, its product market scope and its basis for differentiation
  2. Strategic resources – the organization’s core skills, assets and processes that deliver the core strategy
  3. Customer interface – how customers interface with and experience the organization, including fulfillment / support, information / insight, relationship and pricing
  4. Value network – the organization’s external suppliers, partners and coalitions.

These elements are linked in three ways: strategic resources are configured to deliver the core strategy; the core strategy provides benefits realized through the customer interface; and the boundaries of the organization determine what is done internally leveraging strategic resources and what is done externally in the value network.

Peter Skarzynski and Rowan Gibson: Innovation to the Core

Building on Hamel’s and Chesbrough’s work, Skarzynski and Gibson define a business model as “a conceptual framework for identifying how a company creates, delivers and extracts value”. They propose five components of a business model:

  1. Who do we serve? Includes market segments, customers, and buyers.
  2. What do we provide? Includes products, services, solutions, benefits.
  3. How do we provide it? Includes value chain, processes, skills, assets, partners, suppliers
  4. How do we make money? Includes pricing, revenue, costs, profits. 
  5. How do we differentiate and sustain an advantage? Includes differences versus competitors, value to customers, sustainability based on skills and assets.

Mark Johnson, Clayton Christensen and Henning Kagermann: Reinventing Your Business Model

In their recently published Harvard Business Review article, Johnson et al. define a business model as “consisting of four interlocking elements that, taken together, create and deliver value.” These four components are:

  1. Customer value proposition: Target customer, needs (job to be done), offering
  2. Profit formula: revenue model, cost structure, margin model and resource velocity (asset turnover)
  3. Key resources, including people, technology, equipment, information, channels, partnerships and brand
  4. Key processes, including processes, metrics and norms.

Alexander Osterwalder and Yves Pigneur: Business Model Generation

In their recent book, Osterwalder and Pigneur define a business model as something that “describes
the rationale of how an organization creates, delivers, and captures value.” They propose a framework comprising nine components:

  1. Customer segments
  2. Channels
  3. Customer relationships
  4. Value propositions
  5. Revenue streams
  6. Key activities
  7. Key resources
  8. Partners
  9. Cost structure

John Mullins and Randy Komisar: Getting to Plan B

In their new and well-received book, Mullins and Komisar define a business model in economic terms: “By business model, we mean the pattern of economic activity – cash flowing into and out of your business for various purposes and the timing thereof – that dictates whether or not you run out of cash and whether or not you deliver attractive returns to your investors. In short, your business model is the economic underpinning of your business, in all of its facets.” Their framework comprises five elements:

  1. Revenue model – includes defining target customers, needs addressed, product offered, timing / frequency of purchase, pricing and cost of customer acquisition 
  2. Gross margin model – margin per product and across the product mix  
  3. Operating model – all other costs, noting difference between fixed and variable
  4. Working capital model – optimizing current assets and liabilities to maximize cashflow
  5. Investment model – optimizing capital required pre-launch through to break even.

A new approach: a simple, practical and powerful business model definition

Over the past few years, we have explored each of the above approaches in practice, by designing business models for dozens of new technologies, products and services. We have conducted countless experiments to see what works most effectively in driving results, working with hundreds of entrepreneurs, investors, product managers, engineers, salespeople and corporate executives.

While all the above approaches have their strengths, in our view they all lack one key element: a sufficient emphasis on the people – the core stakeholders – as a primary element of the business model. We believe this is a major omission, as the core players in the business, what they each contribute, what they each are looking to get in return, and what they collectively want to do, are primary drivers of the organization’s ability to create value.

Ask any entrepreneur, CEO or investor, and he or she will tell you how much time is devoted to attracting and coordinating key management team members, investors and strategic partners, because of the profound influence these stakeholders have on the business model. In our view, all business models have a major stakeholder component – they only make sense with a particular mix of stakeholders – and as such, this element must be explicitly designed and managed like any other.   

With that caveat, the two approaches we like best are those of Chesbrough, and Skarzynski and Gibson. In our view, both of these capture most of the essential elements of a business model, do the best job of presenting the most important primary elements in an appropriate and balanced way, and have the right level of simplicity and clarity. The other models all contribute thinking of value, but we think they are either missing key primary elements, are too complex to be immediately useful, or present a suboptimal mix of primary and subsidiary elements.

With these thoughts in mind, we have evolved the following approach to a business model. We believe it builds on the best of the above frameworks, addresses their weaknesses, and also meets the “simple, clear and comprehensive” test. Perhaps most importantly, it is grounded in extensive practical experience designing and implementing successful business models for a wide range of information, communication, medical and clean technologies.

 

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