How to Measure the Effectiveness of Your Business Model

by Sean Ross

4 min read

It is critical that small business owners, financial advisors, and investors are able to measure the effectiveness and strength of a business model. Fortunately, the actual calculation is not very difficult; the most difficult part may be deciding which business model is best for a company.

Business Models: A Quick Definition

The term “business model” is sometimes treated with a nebulous definition. Some lengthier and more demanding descriptions involve many different elements, such as value propositions, profit-making formulas, resources, processes, and so on. Best-selling industry author Michael Lewis uses a very blunt definition when describing business models. Referring to the attitude in corporate America during the late 1990s and early 2000s, Lewis explained that, “All it really meant was how you planned to make money.”You may find it useful to begin with such a simple definition because it can help you drill down to the core purpose of any business activity. As Ramon Casadesus-Masanell and Joan Ricart wrote for the Harvard Business Review, “In its simplest conceptualization, therefore, a business model consists of a set of managerial choices and the consequences of those choices.” The ultimate consequence, at least with for-profit business models, is whether the company earns enough revenue.

Examples of Business Models

Fortunately for product sellers and business owners, there are plenty of potential revenue strategies. Some common examples of business models include:Leasing: Leasing companies own valuable goods, often capital goods and equipment, cars, or accommodation, and lease the right to use those goods to customers or tenants. Brick and Mortar: The classic business model is the brick and mortar, which depends on a “build it and they will come” mentality. Most brick and mortar companies build a standing physical location to which customers travel and purchase goods. Traditionally, customers buy on location. Since the dawn of the Internet Age, some companies allow customers to shop online and have products shipped directly to their local stores or home. Subscription: The original subscription-based models were magazines and record clubs. Thanks to the proliferation of the internet and internet-based product offerings, subscription-based models can apply to a very wide range of products. These companies generate revenue before delivering products or services, which is great for cash flow, and customers gain the convenience of not having to pay each time they use something. Lowest-Cost: This model is a variation that can incorporate elements of other business model delivery systems. The lowest-cost method survives by obtaining common consumer goods and selling them for less than the competition. It lends itself to capitalizing on economies of scale and was perfected first by Wal-Mart and then Amazon.com. Brokerage: Brokers are the quintessential middle-men. This model relies on markets where buyers and sellers have difficulty finding one another efficiently. The broker earns a fee for brokering deals between providers and consumers, and in some cases, offering expert advice along the way. Traditional brokers work in financial services, such as lenders, stockbrokers, realtors, and the like, but other brokerage companies include eBay, Orbitz, and Priceline.

Business Model vs. Operating Model

There is a great deal of connectedness between a business model and an operating model. The major difference between the two may be the level of abstractness or simplicity. Business models are more general and easier to describe. What does a business do and what kind of value does it generate? Operating models are more particular. They deal with the core processes of a business. For example, consider a company that manufactures toys. The finished toys sell for a higher price than the value of the raw materials that it took to create them, which means the business model provides value in the eyes of its customers; otherwise, they wouldn’t pay higher prices for the finished toy. To understand the operating model, you need to know how the toy manufacturer sources its parts, from where, and how its supply chain functions, among many other things.

Measure Your Business Model With Gross Margin Analysis

You can calculate gross margin in no time. Take your gross sales revenue over any period of time, and then add up your total cost of goods sold. Subtract costs of good sold from revenue, and then divide the result by the gross revenue. Here’s a simple example:RIck’s Auto Lot earns $400,000 in sales revenue. Its COGS is $350,000. In this instance, the company’s revenue exceeds COGS by $50,000. To calculate the gross margin, divide $50,000 by the total revenue, or $400,000, and you get a gross margin of 12.5%. Simply knowing a company’s gross margin can be useful, and you can learn a lot about your progress, or lack thereof, by measuring changes in gross margin over time. However, if you really want to know where you, or a client, stands relative to the competition, you could compare the average gross margin to similar companies.

How to Make a Business Model Better

Ultimately, you can choose to measure business model performance any number of ways. In terms of accounting, gross margin analysis is a pretty useful and fast mechanism, but the ultimate judge is the consumer. If consumers find value in a product or service offering, they’ll make purchases. If a company wants to see improvement in its business metrics, it needs to worry first and foremost about satisfying consumers.

References & Resources

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