People will always stress that having a well researched business plan is key before you start your business. Although creating a business plan is often an important step in the evolution of a business, particularly if you need financing or you are not experienced at running a business, it is not necessarily the essential first step. There are two key elements that should be completed prior to the business plan:
- The business model
- The strategy
What is a Business Model?
While the word model often stirs up images of mathematical formulas, a business model is in fact a story of how a business works. In general terms, a business model is the method of doing business by which a company can generate revenue. Both start-up ventures and established companies take new products and services to the market through a venture shaped by a specific business model. In their paper, The Role of the Business Model in Capturing Value from Innovation, Henry Chesbrough and Richard S. Rosenbloom outlined the six basic elements of a business model:
- Articulate the value proposition – the value created to users by using the product
- Identify the market segment – to whom and for what purpose is the product useful; specify how revenue is generated by the firm.
- Define the value chain – the sequence of activities and information required to allow a company to design, produce, market, deliver and support its product or service.
- Estimate the cost structure and profit potential – using the value chain and value proposition identified.
- Describe the position of the firm with the value network – link suppliers, customers, complementors and competitors.
- Formulate the competitive strategy – how will you gain and hold your competitive advantage over competitors or potential new entrants.
Joan Magretta in her article Why Business Models Matter took the concept of the business model a little further. Magretta suggests every business model needs to pass two critical tests, the narrative test and the numbers test. The narrative test must tell a good story and explain how the business works, who is the customer, what do they value and how a company can deliver value to the customer. The numbers test means your profit and loss assumptions must add up. At the most basic level, if your model doesn’t work, then your model has failed one of the two tests.
To begin the modeling process you need to articulate a value proposition on the product or service being provided. The model must then describe the target market. The customer will then value the product on its ability to reduce costs, solve a problem or create new solutions. A market focus is needed to identify what product attributes need to be targeted and how to resolve product trade-offs such as quality versus cost. You also need to identify how much to charge and how the customer will pay.
Think of business modeling as the managerial equivalent of the scientific method – you start with a hypothesis, which you then test in action and revise when necessary. The business model also plays a part of a planning tool by focusing managements on how all the elements and activities of the business work together as a whole. At the end of the day, the business model should be condensed onto one page consisting of: a diagram outlining how the business generates revenue, how cash flows through the business and how the product flows through the business and; a narrative describing the product/ service components, financial projections or other important elements not captured in the diagram.
Business Models and Strategy
It is important to note that completing a business model does not constitute strategic planning. Strategic planning factors in the one thing a business model doesn’t; competition.
What is strategy?
According to the Collins English Dictionary, strategy is “a particular long-term plan for success”. For our purposes, we will consider the essence of strategy as a formula for coping with the competition. Competitive strategy is about being different and the goal for a corporate strategy is to find a position in the industry where the company is unique and can defend itself against market forces. To do this the company must choose a set of activities that can deliver a unique mix of value.
Market Forces and Strategy
The determination of a strategy is rooted in determining how a company stacks up against basic market forces, how it can defend itself against these forces and how it can influence these forces. Fortunately, Michael E. Porter in his article How Competitive Forces Shape Strategy defined these market forces for us. Known as Porter’s 5 forces they consist of:
- The industry – this is the jockeying for position among current competitors, this can consists of price competition, new product introduction or advertising slugfests.
- The threat of new entrants – the seriousness of the threat of entry depends on the barriers to entry and reaction from existing companies. There are 6 major barriers to entry: 1) economies of scale 2) product differentiation 3) capital requirements 4) cost disadvantages independent of size 5) access to distribution channels 6) government policy. A new company will generally have second thoughts about entering an industry if the incumbent has substantial resources to fight back, the incumbent seems likely to cut prices or industry growth is slow.
- The threat of substitute products/services – substitutes can place a ceiling on prices that are charged and limit the potential of an industry.
- The bargaining power of suppliers – suppliers can squeeze profitability by increasing prices or lowering the quality of the goods.
- The bargaining power of buyers (customers) – customers can force down prices, demand better quality, more service or play competitors off on each other.
Once you assess how the market forces are affecting competition in your industry and their underlying causes, you can identify the underlying strength and weaknesses of your company, determine where it stands against each force and then determine a plan of action. Plans of action may include:
- Positioning the company – match your strengths and weaknesses to the company’s industry, build defenses against competitive forces or find a position in the industry where forces are the weakest. You need to know your company’s capabilities and the causes of the competitive forces
- Influencing the balance – take the offensive, for example innovative marketing can raise brand identification or differentiate the product.
- Exploiting industry change – an evolution of an industry can bring changes in competition. For example, in an industry life-cycle growth rates change and/or product differentiation declines; anticipate shifts in the factors underlying these forces and respond to them.
The framework for analyzing the industry and developing a strategy provides the road map for answering the question “what is the potential of this business?”
Reconciling the Business Model and Strategy
I will use a short example to illustrate the difference between a business model and strategy. Although you may think that Wal-Mart pioneered a new business model on its road to success, the reality is that the model was really no different than the one Kmart was using at the time. But it was what Sam Walton chose to do differently than Kmart, such as focusing on small towns as opposed to large cities and everyday low prices, that was the real reason for his success. Although Sam Walton’s model was the same as Kmart’s, his unique strategy made him a success.