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Month: August, 2012

The two base business models and what they mean for your business

6 August, 2012 (17:16) | business design | By: Shannon Clark

There are only two basic business models.

Two.

Yes, only two.

Every business falls into one of these two models (and many non-businesses such as organizations, non-profits and others also fit here). I would even claim that most people’s jobs fit into one of these two business models (though primarily most people who work for a company fall into the first model almost entirely). Both of these models can be fantastic businesses and they each offer advantages as well as disadvantages. Many businesses use a mix of the two models, though often without fully realizing it.

So, what are these two business models.

Model One – Sell something non-discretionary

Put simply this model is to sell a good or service to someone who uses that good or service to accomplish their business objectives. This sounds simple but it has a few key and important facts to remember.

  1. Price is constrained by the value your goods or service offer to your buyers. If they cannot buy your goods or services and use them to generate more income than they spend with you they will not be repeat customers. This means that if you want to sell at a higher price level you have to find a way to generate a great return for your buyers either by improving the value of your product (again either goods or services) or you have to find new buyers who can obtain a greater value from your products than your current buyers.
  2. Scale is dependent on the scale of your buyers. On the positive side this means that as your buyers are able to grow their businesses your business can grow at nearly the same rate. On the negative side this means that if your customers’ businesses are not growing your sales will also slow until you find new buyers (think sellers of horse carriage parts as the automobile industry grew, some were able to adjust and sell products to the automobile companies but many were not able to adjust).
  3. Competition is limited to products that can deliver the same value needed by your buyers. This is usually a good thing for businesses as while you can face a lot of competition it is limited to competitors that can fit into the business of your buyers in the same way your products fit. However this means that when the business of your buyers changes or when you try to grow by selling to a new category of buyers that you can face a very large pool of competitors who were working with those buyers already.

Or your business can be

Model Two – sell a discretionary product

This is a very broad category of businesses most of whom today don’t fully realize that they are competing with each other. What do I mean by a “discretionary product”? Simply put this is any product whether a good or a service which is not purchased as a component of another business. i.e. goods and services which are purchased out of personal preference or desire over being a necessary part of another business’ process.

This is a very broad category it includes a large swatch of local businesses – from restaurants, cafes, bars, hair salons and bookstores. All these businesses primarily sell a service or physical good that isn’t bought as part of a business process but out of a personal need. However they all may have aspects of their business which serve other businesses (remembering that you can think of yourself as a business of one). A restaurant can be used for a business meeting or event to take just one example. But while that event may be a necessary part of a business process the decision about where to hold it, what to serve at it and how much to spend on it is a discretionary decision for most buyers.

Advantages and disadvantages of discretionary businesses:

  1. Price is potentially unlimited. Discretionary businesses have the advantage, though it can be a challenging one, that pricing is potentially unlimited. Since the products these businesses offer are discretionary purchases they can potentially be sold at any price since the buyers are choosing to buy for reasons other than as part of a business process. The disadvantage of this unlimited pricing option is that frequently leads to pricing of discretionary businesses being an artform not a science. You have to figure out a pricing model that will accomodate your costs of business while also selling to the right mix of buyers. For some businesses this may be selling a large amount to a very small number of buyers. This is partially why many discretionary businesses have a history of selling at flexible and negotiated prices. Local monopolies may also shift what people are willing to spend (think the concession stand at a local movie theater – purchases there are fully discretionary and since there are constraints on the competition via “don’t bring in outside food” policies the prices are typically marked up from what the identical good may be for sale just outside of the theater.
  2. Competition is essentially unlimited. This is a big challenge and one that many businesses in a discretionary business don’t fully grasp. The competition of a new restaurant is not just the other restaurants in that neighborhood but all of the other discretionary purchases available to potential customers – the movies available to be seen, the newest video game, the latest bestselling book, the new sneakers and more. The competition that any new social game company faces is not just other social game companies but all games, in all genres as well as all other discretionary ways people could spend their limited time and funds.

Businesses that operate in both models face some unique challenges, especially around thinking carefully about their pricing as well as definition of the goods and services that they offer. The needs of their non-discretionary buyers may conflict with the interest and potential business from discretionary buyers. The airline industry perhaps is a key example of this conflict. “Business travelers” are traveling because they have made a calculated decision that the costs of that travel are less than the opportunity they gain from traveling. What the value is travel arrangements that increase the value they can generate – from getting on and off the plane faster to having the flexibility to reschedule their travel. Discretionary travelers however value a different set of elements when choosing to travel. In many cases they want to spend as little as possible on their travel costs – to allow them to spend more on other discretionary elements of their vacations – but there are also travelers who may choose to spend more than even a business traveler because they value certain elements of the travel experience highly. 1st class cabins are one attempt to capture this part of the business.

The variable pricing of airline tickets is in no small part a result of these competing forces on airlines as well as their own highly variable non-discretionary purchases to operate their business (fuel, plane financing, gate fees, flight crews etc).

Which of these business models does your business (or business idea) fall into?