What it means
Two companies can sell the same product and have completely different business models. One sells printers cheaply and earns its profit on ink; another sells them at full margin and earns nothing after the sale.
One airline sells a seat with everything included; another sells the seat cheaply and charges separately for bags, food and choice of seat. One software company sells licences for a large upfront fee; another rents access monthly.
The product is similar; the model, and therefore the economics, the risks and the valuation, are not. The most widely used framework for describing a model, the business model canvas, sets out nine elements: customer segments, value propositions, channels, customer relationships, revenue streams, key resources, key activities, key partnerships and cost structure.
The framework's value is that it forces the elements to be consistent with each other. A premium value proposition sold through discount channels, or a subscription revenue stream with a cost structure built for one-off sales, is a model with an internal contradiction that the financials will eventually expose.
For finance the two elements that matter most are revenue streams and cost structure, and above all the relationship between them. Revenue streams differ in quality: recurring subscription revenue is worth more per dollar than one-off project revenue because it is predictable and cheaper to retain than to win; transaction revenue scales with volume; licensing and royalty revenue has almost no marginal cost.
Cost structures differ in shape: a model with high fixed costs and low variable costs (software, airlines, pharmaceuticals) has high operating leverage, meaning profit rises steeply once volume passes break-even and falls steeply below it; a model with low fixed costs and high variable costs (agencies, distributors, contractors) has flatter profit but lower risk. Business models also determine working capital and cash flow patterns.
A subscription model paid annually in advance generates cash before cost; a project model paid on completion consumes cash first. A marketplace that holds no inventory needs little capital; a retailer that stocks goods needs a great deal.
Understanding the model is therefore essential to reading a balance sheet and forecasting cash. Models change.
Companies move from selling products to selling services, from licences to subscriptions, from owning assets to platforms that connect owners with users. Each shift changes the financial profile, usually with a transition period in which revenue falls before it recovers, and investors and lenders need to understand the change to judge it.
Describing the business model clearly, in words and in numbers, is one of the finance function's contributions to that understanding.
In practice
Real-world examples.
Example
A razor manufacturer sells handles at cost and earns its margin on blades: a razor-and-blades model.
Example
A marketplace takes a 15% commission on transactions between buyers and sellers, owning no inventory: a platform model.
Example
A newspaper offers free articles supported by advertising, with a paid tier for full access: a freemium model.
Think of it
“A business model is your blueprint for making money-how all the pieces fit together to generate profit.
Formula
Calculation
The business model is a description, not a formula, but its economics can be tested with:
Unit Economics = Revenue per unit minus Variable cost per unit = Contribution per unit
Break-even Units = Fixed costs / Contribution per unit
Customer Lifetime Value to Acquisition Cost = (Contribution per customer per year x Expected years) / Cost to acquire a customer
Worked example. A company that makes accounting software compares two models for the same product.
Model A, perpetual licence: price $2,400 once, plus optional annual support at $480 taken by 60% of customers. Sales and marketing cost per new customer $900. Variable cost per customer (hosting, support) $150 a year. Fixed costs (development, overhead) $3,000,000 a year. Expected customer life 5 years.
- Revenue per customer over 5 years = $2,400 + (0.6 x $480 x 5) = $3,840
- Contribution over 5 years = $3,840 minus ($150 x 5) minus $900 = $2,190
- Year-one cash per customer = $2,400 + $288 minus $150 minus $900 = $1,638
Model B, subscription: price $80 a month ($960 a year). Same acquisition cost, variable cost and customer life. Churn of 12% a year is built into the 5-year average life.
- Revenue per customer over 5 years = $960 x 5 = $4,800
- Contribution over 5 years = $4,800 minus $750 minus $900 = $3,150
- Year-one cash per customer = $960 minus $150 minus $900 = minus $90
Break-even, 1,500 new customers a year in each model: Model A year-one contribution = 1,500 x $1,638 = $2,457,000, short of fixed costs by $543,000. Model B year-one = 1,500 x (minus $90) = minus $135,000, short by $3,135,000. By year four, Model B has a base of about 5,000 subscribers paying $960 a year ($4,800,000 revenue, contribution after variable cost $4,050,000, after acquisition cost for new customers $2,700,000), while Model A's revenue depends on continuing to sell 1,500 licences a year and its support income from the installed base.
The subscription model produces 44% more contribution per customer and a more predictable revenue base, but it requires funding for a loss-making transition of about three years. The board's decision on which model to adopt is therefore a financing decision as much as a commercial one, and the switch is made only after a $6,000,000 facility is arranged.Case study
Seen in the real world.
A regional equipment hire company had a simple model: buy machines, hire them out by the day, sell them after five years. Its finance director noticed that utilisation was 55%, that the largest customers were asking for guaranteed availability, and that a competitor had begun offering long-term contracts with maintenance included. She modelled an alternative: a managed-fleet model in which the company would supply a customer's entire equipment need under a three-year contract at a fixed monthly fee, with the company managing maintenance, replacement and logistics.
The unit economics changed in every element. Revenue became recurring and predictable, which the bank valued enough to lend against the contracts at a lower rate. Utilisation of the contracted fleet rose to 85% because the company controlled deployment.
Customer acquisition cost rose, because each contract required months of negotiation, but the average customer's lifetime revenue rose eightfold. The cost structure gained a fixed element (a planning team and telematics) and lost some variable transport cost.
The company piloted the model with two customers, refined the pricing after the first year showed maintenance costs 20% above estimate, and then shifted the majority of its fleet to contracts over four years. Its profit margin rose from 9% to 16%, its valuation multiple rose because of the recurring revenue, and the finance director's board paper on the change was later used in the sale of the business as the clearest statement of what the buyer was acquiring.
Watch out
Common mistakes.
- Describing the product and calling it the business model. The model is how the product makes money, which can differ completely for the same product.
- Changing the revenue model without changing the cost structure and funding to match, which produces a transition the company cannot survive.
- Ignoring the working capital implications of a model, such as inventory in a retail model or upfront costs in a subscription model.
Questions
People also ask.
What is the difference between a business model and a strategy?
Strategy is the choice of where to compete and how to win. The business model is the mechanism by which that choice is turned into value and cash. Strategy chooses; the model executes.
What makes a business model good?
Consistency between its elements, unit economics that are positive at scale, revenue that is repeatable, and defensibility against imitation.
Can a company have more than one business model?
Yes, and many do. Each should be understood and measured separately, because their economics differ.
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