What is a business model?

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What is a business model?

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This page provides ideas and discussion about business models (including a built-in method of assessing progress) and an example of how it can be done. Much is based on academic papers, so the writing is a bit more formal than most pages on this site.

Introduction
In the last few years the concept of the business model has become popular. New types of businesses, often created using the internet, have needed new models. When designing a new business, the model it uses is likely to be a crucial factor in its success. The other type of business that needs to worry about a business model is a business in a steadily declining market. Chesbrough and Rosenbloom (2002), searching the Web in May 2000, found 107,000 references to the term. In June 2004, the same search found 2,130,000 mentions on Google. A search now in September 2011 on the exact phrase returns 29,000,000 results. However the vast majority of these references are passing references that don't think about what a business model actually is. Audience Dialogue has evaluated websites for some a variety of organizations, and we've found that many of them have not developed a clear set of objectives for their website - and are thus unable to assess its effectiveness. We have also been approached by new business ventures that required advice on a suitable business model, in some cases to secure investment capital. So we searched the Web, as well as books and academic journal articles, looking for a method of putting together a business model. To our surprise, we didn't find anything usable - so we ended up developing our own concept for a business model. Despite the twenty nine million references to business models, surprisingly few articles have focused on this concept. The most-cited recent article is that by Timmers (1998), which offers a classification scheme for business models for e-commerce. Rappa (2000) extends that scheme, noting that "the business model spells out how a company makes money by specifying where it is positioned in the value chain." He identifies 29 different types of business model, in 9 categories. Chesbrough and Rosenbloom point out that "while the term 'business model' is often used these days, it is seldom defined explicitly." That paper (expanded in Chesbrough's 2003 book) specifies six functions of a business model: 1. to articulate the value proposition 2. to identify a market segment

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3. 4. 5. 6.

to to to to

define the structure of the firm's value chain specific the revenue generation mechanisms describe the position of the firm within the value network formulate the competitive strategy.

That's a concise summary of what a business model does - but how does it do it? They don't say. Let's move on to Afuah and Tucci (2000), who wrote the book that most specifically covers this topic. However, in 300 pages, it fails to give one full example of a business model. Also, as Dubosson-Torbay et.al (2002) point out, this book "neglects the customer aspect" - it's about what the model does for the business, not for the customers. Alt and Zimmerman (2001), again focusing on the Internet, noticed that the term "business model" was not consistently defined, and that a consensus on the elements of business models was lacking.

Several writers have produced typologies of business models, all focusing on the internet. For example, Bienstock et.al (2002) offer a "complete taxonomy" of web business models, based on four factors: number of buyers, number and type of sellers, nature and frequency of product offering, and price mechanisms. Vassilopoulou et.al (2002) propose a framework for the classification of e-business models, and Betz (2002) came up with yet another taxonomy, developing six generic types of business model. Dubosson-Torbay et.al (2002), in a more detailed article than the others, present a more flexible multidimensional classification scheme. The 2003 article by Hedman and Kalling is also detailed, but again gives a static view of a business model - despite all the evidence that initial business models are often unsuccessful, and need to keep being modified until a viable model is found. Roger Clarke (2004), in a discussion of the adoption of open-source software, created a framework for e-business models, with four questions: 1. Who pays? (consumer, producer, or third parties?) 2. What for? (e.g goods, services, expertise, assurances of quality or security.) 3. To whom? 4. Why? (e.g. perceived value, or being locked in.)

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Answers to those questions, according to Clarke, would form a business model but again, it's static. Several writers, including Chesbrough and Rosenbloom (2002) and Magretta (2002, in the Harvard Business Review)emphasize the need for flexibility in a business model for a new enterprise, pointing out that many successful businesses change their initial model. Therefore, a model whose assumptions are transparent is more easily reviewed than a model lacking explicit linkages between its elements. To summarize the writings on business models, most of the above papers and books focus on producing taxonomies or categorizations, or on stating what business models include or exclude. There was broad agreement between the various definitions in only two areas: that a business model (i) focuses on the mechanisms for generation of revenue in the value chain, in terms of (ii) broad principles (rather than the detail to be found in a full business plan). There was no consistent agreement on the other aspects of a business model. However, when it comes to the question of "what does a business model actually look like?" only Chesbrough and Rosenbloom (2002) and Afuah and Tucci (2000) offer detailed descriptions - but their concepts of a business model are so detailed that others would describe such a model as a business plan. Bearing in mind the use of the term "model" in systems theory, and that many of the above articles were from ICT-oriented journals, one might have expected to find a business model defined in systems terms - with inputs, processes, and outputs. However, of the 50-odd articles we looked at, only one by Betz (2002) used such an approach - and then only in a very general sense. A paper by Dr. Susan Lambert of the University of South Australia provides an overview of the state of play including how to use business model concepts, click here to access a short PDF document that includes further readings.

The business model and the business plan

At this point, it's worth mentioning the difference between a business model and a business plan. A business planis a detailed document, typically 50 to 100 pages, with a lot of financial projections. If you want to set up a new business and apply for a loan, the lending institution will demand a business plan. The lender wants all that detail to assess whether you'll be able to repay the loan. A business model is much less detailed. The consensus from the literature described above is that a business model describes the specific way the business expects to make money. While a business plan is on paper (lots of paper!) a business model should be small enough to stay in the heads of the owner and staff. If a business model is on paper, it should be one page, and it would be more clearly shown as a diagram than as words. Certainly there can be extras notes and explanations - but the business model itself is a single concept.

A systems approach to business modelling

After finding nothing useful in the literature we looked up, we decided to try

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constructing a business model using a systems approach. There are many varieties of systems approach, mostly derived from the systems dynamics model ( here's a nice clear overview by Daniel Aronson). But they all have in common a process that transforms inputs into outputs. This process can include feedback loops, which can be positive or negative. Peter Senge's book The Fifth Disciplineclearly explains this type of systems model. This is a very persuasive book - so bear in mind that this is only one of several types of model. The concept of a business model is most useful for a new business (which explains the predominance of ecommerce-related references in recent years), and it is essential for a new business to establish a positive feedback loop. For example, word of mouth has to be effective, and customers have to recommend other customers. Without that kind of acceleration, a business will never get off the ground. We decided to use a visual approach to modelling, because displaying a model as a diagram makes it easier to trace and check the processes. Another advantage is that it fits well with program logic modelling: in other words, a complex process can be divided into modular stages, and each stage can be assessed separately using whatever means is the most suitable. Also, the fact that components can be seen more clearly in a visual summary than in prose makes it easier to reorder or change a model when it's not working well. As many owners of websites found in the early years of the Worldwide Web (way back around 1999) their original business model didn't work, and the business soon failed: a classic example of that was boo.com. Other businesses found their customers adapted the products for a use that the businesses hadn't expected. This suggests that when a business model is developed, it should be a flexible one, which can be modified easily should financial growth not meet expectations. It's therefore useful for the business model to include methods for its own evaluation. The advantage of the using the program logic approach is that evaluation is built in. Specifically, if a model is displayed as a series of "boxes and arrows", the boxes represent activities, the arrows represent causal links between the boxes, and the strength of each link can be measured - or at least estimated. Putting all these clues together, we came with a system-based concept of a business model, with these five principles: 1. Based on the process of exchange - including the exchange of information. 2. Displayed in graphical form. 3. Modular format, with stages subdivisible or combinable as relevant. 4. Step-by-step evaluation, like a program logic model. 5. Enabling the assessment of positive feedback loops, using CRM concepts such as the Galaxy Model of Corkindale et.al (1996).

Example of a business model

Based on those principles, we tried setting up a simple business model to see how well our method worked. Since we know of three photographers (all women, incidentally) who are interested in setting up online businesses to

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display and sell their photos, that was a good starting point. The following diagram shows a tentative model, using the five principles outlined above. It is set out in three columns, with the left-hand column showing activities by the business, the central column applying to the website itself, and the right-hand column showing activities by customers.
FIGURE 1: MODEL FOR A PROPOSED ONLINE PHOTOGRAPHY BUSINESS

Having seen that, you might be thinking, "This is the typical sort of vague graph you see in management textbooks, with meaningless arrows shooting off in all directions to give an illusion of action." But this one is different, because the arrows have precise meanings. The direction of an arrow shows time sequence, and its existence shows that process A should lead to process B. "Should?" But does it really? That's where the arrows are useful. If you can devise some way of checking that A really does lead to B, you can know how well the business model is working. Those arrows are not just lines - they are also a means of evaluation. The following table shows how evaluation is built

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What is a business model?

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into the model. TABLE 1: EVALUATING THE BUSINESS MODEL, STAGE BY STAGE Arrow 1 2 3 4 5 6 7 8 9 10 Stage create site promote site learn of site visits to site know of site but do not visit find photos don't find photos impressed with photos not impressed place order Unit cost (incl. time) cost (incl. time) Data sources accounts, timesheets accounts, timesheets site log

no. of potential visitors survey user sessions no. of potential visitors survey no. of visitors no. of visitors no. of visitors no. of visitors no. of orders site log, online survey online survey online survey online survey invoices

[The table covers only half the diagram, but should be enough to give you the general idea.] The progress between one activity and the next can be assessed by selecting a suitable indicator, and tracking its progress against the business plan. In other words, Table 1 can be extended to the right, adding two columns for each time period: the figure you expected, and the figure you ended up getting. Even if it's too expensive to collect data on every indicator, every period, it's usually possible to make informed estimates. For example, even if you don't know the total number of visits to the website, the log files will give some indication. Even if you know the number is too low, the error is likely to be steady from one week to the next. And when you've collected 10 to 20 weeks' data, you can begin to see how the indicators affect each other, and how long it takes for that to happen. Since positive feedback is vital for a successful business, loops that amplify the customer-side processes need to be cultivated like delicate seedlings. In Figure 1 this applies to arrows 13, 18, 20, and 22. Without substantial flows on those paths, the business would be less likely to succeed - so it's really important to monitor those flows. So that's our concept of a business model. It has three main components: A list of activities, on the part of both the business owner and potential customers A likely sequence for those activities (which may later be altered in the light of customer behaviour). This is shown in the form of a flow chart. A set of indicators or metrics for measuring the linkage between the activities.

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The above diagram is a very simple one - it deals with only one type of offer. A realistic model will include multiple sequences, including multiple paths, with branching. (This can be most clearly depicted as several linked diagrams). By monitoring the progress of the various business hypotheses, the business owner will be able to adapt the model to the business's customer environment.

Conclusions
That's a start, but more work is needed: (1) The model needs to include a way of finding necessary changes, when the original model does not work as envisaged. This might be done by including more options in the original model, plus decision points on when to start using these options. (2) The model focuses too much on the point of view of the business owner. It might be more useful to develop a model from the point of view of potential customers, which could include market research data. Julia de Roeper and I (DL) are working on such a dual model for arts marketing, and when we're happy with it this page may be radically changed. (3) The above model shows what's meant to happen, but not why. It's missing the owners' and customers' reasons for action - which suggests this model should be part of a larger one. Though the above model was developed for a web-based business, this type of model could be applied to any type of business - but it makes most sense for a new business.

Further reading
From 2,130,000 web pages and 7,000 books and magazine articles, these look to be the most useful for businesses that need a model... A Afuah and C Tucci: Internet Business Models and Strategies. Irwin McGraw-Hill, USA, 2000. An informative book, but it doesn't show one single example of a business model, so you're left wondering what they mean by the term! Henry Chesbrough and Richard S Rosenbloom: "The role of the business model in capturing value from innovation: evidence from Xerox Corporation's technology spin-off companies." Industrial and Corporate Change, 2002, vol.11, no.3, pp.529-555. Six components for a business model. Henry Chesbrough: Open Innovation: the New Imperative for Creating and Profiting from Technology.Harvard Business School Press, 2003. Repeats the above article (with a lot of padding) but may be easier to find in a library. Roger Clarke: Open source software and open content as models for eBusiness. Presented at 17th International eCommerce Conference, Slovenia, June 2004. David Corkindale, Peter Balan and Caroline Rowe: Marketing: Making the Future Happen. Thomas Nelson, Australia, 1996. Pages 50-57 explain the authors'

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Galaxy Model of marketing implementation. Meanwhile, if you would like to explore organisational tools for business, this project resource management solution may be useful to you. Magali Dubusson-Torbay, Alexander Osterwalder, and Yves Pigneur: "E-business model design, classification, and measurements." Thunderbird International Business Review, 2002, vol.44, issue 1, pages 5-23. A useful article, with some ideas that were helpful in developing the kind of business model discussed on this page. Jonas Hedman and Thomas Kalling: "The business model concept: theoretical underpinnings and empirical illustrations." European Journal of Information Systems,2003, issue 12, pages 49-59. An outline for a business model that includes customers, competitors, the offering, activities, and organization, resources and market interactions. Very detailed, but more of a taxonomy or checklist than a model. Michael Rappa: Business models on the Web: managing the digital enterprise. North Carolina State University, USA, 2000. A famous typology of busines models. Online at digitalenterprise.org/models/models.html Peter Timmers: "Business models for electronic commerce." Electronic Markets, 1998, vol.8, no.2, pages 3-8. This is the article that started the recent discussion of business models. And for a handy short overview by Dr. Susan Lambert of the University of South Australia including how to use business model concepts, click here to access a PDF document that includes further readings. An expanded version of this page has been included as a chapter in the book Business Models: An Introduction, edited by Amit Singh Sisodiya, and published in 2005 by the ICFAI University Press, India.

Related pages on this site: how to get a website and an introduction to program logic models.
Updated 30 September 2011 Home | Tools | Techniques | Cases | About us | Sitemap | Search

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