The Business Model: How a Company Turns Activity Into Profit

Two things sit underneath everything below. The first is that a firm has a boundary: some work happens inside it and some happens outside, and the participants on the far side of that boundary have already been drawn. The second is the set of statements a company files. A business model shows its consequences in those statements. How to read a statement is covered separately. Finding revenue and finding a margin is enough.

What Is a Business Model, and What Is It Not?

Four questions give the model. What does this firm sell? Who pays for it? On what terms does the money change hands? And what must be spent to keep the selling going? Answered in plain sentences, the four together predict, before a single ratio is opened, roughly what the accounts will look like. A business model is not a strategy and not a mission: it is a description of how cash moves, and it can be written for a firm that has no strategy at all.

The difference between a model and a strategy is worth sitting with. The two words get used as though they were the same thing. A strategy is a choice about where to compete and what to do differently. A mission is a statement about why the place exists. Neither is required for cash to move. A tea stall outside a bus depot has no strategy anybody has written down, and its model is completely legible: it sells hot tea, to commuters, for coins handed over at the moment of service, and it must spend on milk, sugar, leaves, gas and a boy who arrives at five in the morning. Four sentences, and what its accounts do is settled.

Anjani Stationers Private Limited, an invented manufacturer, answers the four questions like this. The firm sells notebooks and stationery it manufactures. It sells them to schools and to a few dozen other business buyers. Business buyers pay on credit termsThe agreed number of days a buyer may wait after receiving goods before paying for them. Thirty, sixty and ninety days are common in trade between businesses. rather than at the counter, so it bills them and waits. And it must spend on paper and board, on the people who run the works, and on machinery that wears out. Setu Bazaar, an invented marketplace, answers the same four questions and gets four different answers. The platform sells access to a marketplace where sellers meet buyers. Both sides pay it, but it charges by keeping a slice of every transaction rather than by sending a bill. The money reaches it at the instant a transaction settles. And it must spend on the technology, the support desk and the marketing that keep both sides showing up, almost all of which costs the same whether one transaction happens that day or a hundred thousand do.

How a Business Creates Value: Who Gets the Difference?

Value is created whenever something is worth more to the buyer than it cost to provide. The definition stops there, and everything else is about who ends up holding the difference. If a notebook costs Rs 33/- of paper and board to make, and a school would rather part with Rs 70/- than have no notebooks at all, then Rs 37/- of value has been created by the act of making it and handing it over. The price decides how that Rs 37/- gets divided. Charge Rs 60/- and the maker keeps Rs 27/- while the school keeps Rs 10/-. Charge Rs 40/- and the maker keeps Rs 7/- while the school keeps Rs 30/-. The value created did not change. Only the split did.

Creating value and capturing it are two separate events, and a firm can create an enormous amount of value and keep almost none of it. This is not a rare pathology; it is the ordinary condition of a great many useful businesses. A road that halves everybody's travel time creates value for every person on it, and if the toll is a rupee it keeps almost none. Usefulness does not decide the kept share. Where the kept share actually sits, and how it is measured across a whole field, is worked through in The Profit Pool: Where the Money in an Industry Actually Sits.

Anjani Stationers Private Limited supplies one published delivery to look at: 4,000 notebooks invoiced at Rs 2,40,000, or Rs 60/- a notebook. Its cost of materials consumed for the year was Rs 1,48,50,000 against revenue of Rs 2,70,00,000, or 55.00 per cent. Applying the year's average materials ratio to that one delivery puts about Rs 33/- of paper and board inside each notebook. The firm therefore captures Rs 27/- a notebook before anything else is paid for. The top of the picture is the part no statement anywhere records: how much the school would have paid rather than go without. The number exists, every buyer carries one, and no accounting system has ever collected it.

How Business Models Shape Revenue, Costs and Cash Flow: Where Does Each One Land?

Now take the four answers and push them through the statements. Revenue first. Anjani Stationers Private Limited reported revenue of Rs 2,70,00,000 for year two, and that revenue arrives in lumps: a school orders for a session, a delivery goes out, an invoice is raised. Setu Bazaar reported revenue of Rs 20,00,00,000, and it arrives as fifty thousand buyers each generating about Rs 4,000 across a year of small takes. Setu Bazaar keeps that Rs 20,00,00,000 out of a far larger quantity of goods moving across it, Rs 5,00,00,00,000 of gross merchandise valueThe total worth of everything sold across a marketplace in a period. The total passes through the platform rather than belonging to it, so it is not the platform's revenue., and the difference between those two numbers is worked through on Take Rate: What a Platform Keeps of What Passes Through. Same word on the statement, completely different texture underneath it.

Costs next. Anjani Stationers' largest line by a distance is cost of materials consumed at Rs 1,48,50,000, and it is a variable costA cost that rises and falls roughly in step with how much is produced or sold. Buy fewer notebooks' worth of paper, spend less on paper.: fewer notebooks made means less paper bought. Everything else it spends is a fixed costA cost that stays put over the period whether output rises or falls. Rent, salaries and the wearing out of machinery are the usual examples. for the year, and it comes to Rs 80,00,000, being employee cost of Rs 42,00,000, other operating expenses of Rs 26,00,000 and depreciation and amortisationThe portion of an asset bought in an earlier year that this year is treated as having used up. No money leaves the bank for it in the current period. of Rs 12,00,000. Setu Bazaar is built the other way round. Rs 10,00,00,000 of what it spends moves with transaction volume, and Rs 12,50,00,000 does not move at all. The model has to be described before any figure taken from it is compared with anything. The same profit can sit on completely different cash timing, and the same revenue can sit on completely different cost shapes.

The two share-of-revenue rows carry the whole story. Look at them together. Setu Bazaar keeps a larger fraction of each rupee of revenue after the moving cost, its contribution marginThe share of a rupee of revenue that survives the costs which move with volume, and is therefore left over to pay for everything that does not move., 50.00 per cent against 45.00 per cent. The platform still loses money: the load that does not move eats 62.50 per cent of its revenue against 29.63 per cent for the manufacturer. Subtracting the second row from the first gives each firm's operating margin exactly: 45.00 less 29.63 is 15.37, and 50.00 less 62.50 is minus 12.50. The subtraction is the one the statement already performs, rearranged, so it cannot disagree and is not a check on anything. The rearrangement shows which of the two terms moves when volume moves, and the answer is only ever the second one.

Then cash. Anjani Stationers billed Rs 2,70,00,000 and was still owed Rs 95,00,000 on the last day of the year. The balance is 35.19 per cent of the year's revenue and 128.4 days of sales. Every rupee of its profit is a rupee it has earned and, on average, will collect roughly four months later. Setu Bazaar's take is deducted from money already passing through the marketplace, so the revenue and the cash are the same event: nothing is owed and nothing is waiting. Two firms, one of them profitable and one of them not, and the cash question splits them along a completely different line from the profit question.

Why Does the Same Fall in Volume Change the Two Models Differently?

Here is the test that separates the two models more sharply than anything else. Hold prices where they are, hold the fixed load where it is, and take 20.00 per cent of the volume away from both firms. Anjani Stationers Private Limited then bills Rs 2,16,00,000 and buys Rs 1,18,80,000 of paper, so Rs 97,20,000 is left against a fixed load that has not moved at all at Rs 80,00,000. Operating profit lands at Rs 17,20,000 and the margin at 7.96 per cent, down from 15.37 per cent. Setu Bazaar takes Rs 16,00,00,000 and spends Rs 8,00,00,000 that moves, leaving Rs 8,00,00,000 against Rs 12,50,00,000 that does not. Its loss widens from Rs 2,50,00,000 to Rs 4,50,00,000 and its margin goes from minus 12.50 per cent to minus 28.13 per cent.

The cost shape decides what a change in volume does to the margin. No other feature of a model matters as much, and the two firms above lost 7.41 and 15.63 margin points from the identical shock. The reason is arithmetic rather than character. A cost that moves with volume shrinks when volume shrinks, so it defends the margin by getting out of the way. A cost that stays put has to be carried by fewer rupees of revenue, so it rises as a share of revenue exactly as fast as revenue falls. Anjani Stationers' fixed load went from 29.63 per cent of revenue to 37.04 per cent. Setu Bazaar's went from 62.50 per cent to 78.13 per cent. Neither firm did anything wrong; they simply have different amounts of weight that will not move. Put the same thing in terms of the volume each firm needs in order to break evenThe level of activity at which what a business earns exactly covers what it spends, so the operating result is neither a profit nor a loss.: Anjani Stationers Private Limited can lose 34.16 per cent of its volume before its operating profit reaches zero. Setu Bazaar has to gain 25.00 per cent to get there.

Two households on the same street meet the same event, a salary cut by a fifth. The first spends most of its money on food and travel and can genuinely spend less on both. The second has the same income but Rs 30,000 of it goes on rent and a school fee that will not change this year. Same shock, and one household absorbs it while the other cannot. Neither household is better managed. The difference is entirely in the shape of what they spend. The unit-level version of this, worked out one customer at a time, is covered under Unit Economics: Profitability at the Level of One Customer.

How to Research a Company's Business Model: In What Order Are the Questions Asked?

Five steps, in this order, and none of them requires a spreadsheet. The last step usually changes a reader's mind, and it is placed last rather than made optional for exactly that reason.

The five steps run on Anjani Stationers Private Limited take about ten minutes for the first four. The firm sells notebooks; it sells them to schools and business buyers; it bills them; and its largest cost line, at Rs 1,48,50,000 of Rs 2,28,50,000 spent, moves with volume. All comfortable. Step five is where the picture changes: Rs 95,00,000 owed against Rs 2,70,00,000 billed is 128.4 days. The firm is financing about four months of its own sales, and that is not a fault in the model, nor is it a scandal. The delay is a fact about the model that the first four steps could not have given, and it changes what the next question has to be about working capitalThe money tied up in running the business day to day: stock sitting in the store, bills customers have not yet paid, less the bills the business has not yet paid itself..

What Does a Business Model Not Say?

Three things, and each of them gets asked of a model constantly. A model does not say whether the business is a good one. The description does not say whether the field it operates in permits anybody to make money. And it puts no price on the firm. A description is not a judgement.

Each in turn. Whether a business is good is a question that needs a standard to be good against, and no such standard appears anywhere above. Setu Bazaar loses Rs 2,50,00,000 a year and Anjani Stationers Private Limited makes Rs 41,50,000. The two firms are at different points in their lives and are built to do different things, so the comparison establishes almost nothing. Whether the field permits profit at all is a question about industry structure, covered under Industry Structure and Sector Behaviour, and it is a genuinely different question: a beautifully described model in a field where nobody makes money is still a model where nobody makes money. And valuing the firm is a different question again, needing a price, a horizon and a discount rate, all three of them covered separately.