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8 Essential questions you need to ask about your business model. Guest blog by Alex Osterwalder.

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Today’s guest blog post if from Alex Osterwalder, author of the Business Model Generation: A Handbook for Visionaries, Game Changers, and Challengers. Drop us a line if you want to run a guest blog. We would love to hear from awesome people with great things to share!

Alex will be speaking and running a workshop at the Business of Software Conference, Boston 24-26th October. If you are serious about building a sustainable, profitable software business, you should give some serious thought to getting there too.

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Alex asks you 8 essential questions that you should consider about your business model…

Ultimately, customers are the only relevant judges of your business model. However, you can increase your model’s long-term competitive advantage by assessing its design with a couple of questions that go well beyond the conventional focus on products and market segments.

I suggest you sketch out your existing or start-up business model with the Business Model Canvas below and then start assessing its design.

Business Model Canvas

The Business Model Canvas - a map of how your business makes money.

The Basics

Every business model has a product and/or service at its center that focuses on a customer’s job-to-be-done. I call this the Value Proposition. So before even assessing your business model as a whole, you need to ask yourself some basic questions related to your Value Proposition and the Customer Segments that you are targeting.

  • First, ask yourself how well your Value Proposition is getting your target customer’s job done. For example, if a user of a search engine is trying to find and purchase the latest Nike running shoe, the measure of success will be how well the search engine helps the user get this job done.
  • Secondly, ask yourself how many people or companies there are with a similar job-to-be-done. This will give you the market size.
  • Thirdly, ask yourself how important this job really is for the customer and if she actually has a budget to spend on it.

That’s it as to the basics. However, even the greatest products are having an increasingly hard time to achieve a long-term competitive advantage. That is the reason why you need to shift your focus away from a pure product/market segment oriented approach towards a more holistic business model approach. Below are eight questions to assess your business model design. Rank your business model’s performance on a scale of 0 (bad) to 10 (excellent) for each question.

1. How much do switching costs prevent your customers from churning?

The time, effort, or budget a customer has to spend to switch from one product or service provider to another is called “switching costs”. The higher the switching costs, the likelier a customer is to stick to one provider rather than to leave for the products or services of a competitor.

A great example of designing switching costs into a business model is Apple’s introduction of the iPod in 2001. Do you remember how Steve Jobs heralded his new product with the catchphrase “thousand songs in a pocket”? Well, that was more than a product innovation focusing on storage. It was a business model strategy to get customers to copy all their music into iTunes and their iPod, which would make it more difficult for them to switch to competing digital music players. In a time when little more than brand preferences were preventing people from switching from one player to another this was a smart move and laid the foundation for Apple’s subsequent stronghold on music and later innovations.

2. How scalable is your business model?

Scalability describes how easy it is to expand a business model without equally increasing its cost base. Of course software- and Web-based business models are naturally more scalable than those based on bricks and mortar, but even among digital business models there are large differences.

An impressive example of scalability is Facebook. With only a couple of thousand of engineers they create value for hundreds of millions of users. Only few other companies in the world have such a ratio of users per employee. A company that has pushed the limits even further is the social gaming company Zynga. By building games like Farmville or Cityville on the back Facebook, the world’s largest social network, they could benefit from Facebook’s reach (and scale) without having to build it themselves.

A company that quickly learned its lessons regarding scalability was peer-to-peer communication company Skype in its early days. Their customer relationship collapsed under the weight of large numbers, when they were signing up ten thousands of users per day. They quickly had to adapt their business model to become more scalable.

3. Does your business model produce recurring revenues?

Recurring revenues are best explained through a simple example. When a newspaper earns revenues from the sales at a newsstand they are transactional, while revenues from a subscription are recurring.  Recurring revenues have two major advantages. Firstly, the costs of sales incur only once for repetitive revenues. Secondly, with recurring revenues you have a better idea of how much you will earn in the future.

A nice example of recurring revenues is Redhat, which provides open source software and support to enterprises based on a continuous subscription basis. In this model clients don’t pay for new software versions because it is continuously updated. In the world of Software as a Service (Saas) these types of subscriptions are now the norm. This contrasts with Microsoft, which sells most of its software in the form of licenses for every major release.

However, there is another aspect to recurring revenues, which are additional revenues generated from an initial sales. For example, when you buy a printer, you continue to spend on cartridges, or when you buy a game console, you’ll continue to spend on games. Or have a look at Apple. While they still earn most of their revenues from hardware sales, the recurring revenues from content and apps is steadily growing.

4. Do you earn before you spend?

This one goes without saying. The more you can earn before spending, the better.

Dell pioneered this model in the computer hardware manufacturing industry. By assembling on order after selling directly they managed to escape the terrible inventory depreciation costs of the hardware industry. Results showed how powerful it is to earn before spending.

5. How much do you get others to do the work?

This is probably one of the least publicized weapons of mass destruction in business model design. What could be more powerful than getting others to do the work while you earn the money?

In the bricks and mortar world IKEA gets us to assemble the furniture we buy from them. We do the work. They save money. On the web Facebook gets us to post photos, create and participate in conversations, and “like” stuff. That’s the real value of Facebook, entirely created by users, while they simply provide the platform. We do the work. They earn the sky-high valuations of their shares.

Previously mentioned Redhat crafted another smart business model based on other people’s work. Their entire business model is built on top of software developed by the open source software development community. This allowed them to substantially reduce their development costs and compete head-on with larger companies like Microsoft.

A more malicious business model in which others do the work is the one practiced by so-called patent trolls. In this model patents are purchased with the sole intention of suing successful companies to extract payments from them.

6. Does your business model provide built-in protection from competition?

A great business model can provide you with a longer-term protection from competition than just a great product.

Apple’s main competitive advantage arises more from its powerful business model than purely from its innovative products. It’s easier for Samsung, for instance, to copy the iPhone than to build an ecosystem like Apple’s appstore, which caters to developers and users alike and hosts hundred thousands of applications.

7. Is your business model based on a game changing cost structure?

Cutting costs is a long practiced sport in business. Some business models, however, go beyond cost cutting by creating value based on a totally different cost structure.

Skype, for example, provides calls and communication almost like a conventional telecom company, but for free or for a very low cost. They can do this because their business model has a very different cost structure. In fact, Skype’s model is based on the economics of a software company, while a telecom provider’s model is based on the economics of a network company. The former’s costs are mainly people; while the latter’s cost include huge capital expenditures in infrastructure.

Similarly, Bharti Airtel, one of the world’s largest mobile network providers, has substantially modified its cost structure by getting rid of their entire network and IT. By buying in network capacity on a variable cost basis from a consortium around network equipment manufacturer Ericsson and IBM, they can now offer among the lowest prices for mobile telephony globally.

Redhat, which was mentioned previously, also built its business model on a game changing cost structure: by smartly building its own model on top of other people’s work.

8. How does your business model design perform?

Of course no business model design scores a perfect 10 as to every single one of the above questions. Some might even succeed in the market without scoring well at all. However, by asking yourself these questions and by scoring well on at least some of them you are very likely to substantially increase the long-term competitive advantage of your business.

Now all you need to do is test your business model with the real judge: the market…

This is a guest blog post from Alex Osterwalder, author of the Business Model Generation: A Handbook for Visionaries, Game Changers, and Challengers. Drop us a line if you want to run a guest blog. we would love to hear from awesome people with great things to share!

Alex will be speaking and running a workshop at the Business of Software Conference, Boston 24-26th October. If you are serious about building a sustainable, profitable software business, you should give some serious thought to getting there too.

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