The Business Model: How a Company Makes Money

March 28, 2017

Business Model

Tip Content Provided By: Babson

All businesses have to be concerned about making money. Even not-for-profit organizations have to make money or else they would not have the means to pursue their mission or pay their employees! The need to make money is so universal that it is often taken for granted. However, making money surely isn’t automatic.

Every entrepreneur needs to understand the mechanics through which his or her particular business is going to make money.

Every business leader needs an understanding and appreciation of all of the critical money-making factors that need to be taken into account.

Every business manager needs to know how his or her activities contribute to the goal of making money.

This set of inter-related factors and mechanics is called the business model.

In the simplest terms, a company’s business model is comprised of the answers to four essential questions: 1. What will the business sell or offer to its customers? 2. Who are the primary customers (the target market)? 3. Why would those customers want to buy what the business is selling (the customer value proposition)? 4. How will the business make money when it produces and sells those things with those value attributes to those buyers?

The first three of those questions define the business unit strategy. There should be a single answer to those questions, one that incorporates all three dimensions. That unified answer should sound like a strategy. “Selling shoes to people who don’t want bare feet” is not a business strategy! The product/service offering is a bundle of attributes, not a “thing.” The target market is a potential collection of people or economic entities with specific needs and desires. The value proposition describes the way in which the offering satisfies those needs and desires. Note that, by this definition, a change in any one of the three dimensions of the answer suggests at least a somewhat different business strategy.

The answer to the fourth question turns the business unit strategy into a business model. However, unlike the first three questions, which seek a single unified answer, the fourth question has multiple answers (or at least multiple parts)! In financial terms, how a business expects to make money isn’t a terribly complicated issue. Operationally, however, it can be very complicated. The purpose of this note is to explore both of the financial and operational views of how a business makes money and to show how they inter-relate. Before we examine how a business makes money, however, we need to define what we mean by the phrase “making money.”

Making money means getting more money out of a venture than you put in. If you don’t get more out, then you haven’t made any money. Note that the income statement, by itself, doesn’t fully address this idea. Net income shows by how much revenues exceeded expenses in a year. However, although expenses measure how much resources the business consumed in a year, they don’t reflect how much unexpensed resources were also required to run the business that year. Most investors, entrepreneurs, and managers utilize the concept of return on investment – ROI – to measure whether a business made money. ROI is a concept, not really a specific ratio. It is the relationship of some measure of income divided by some measure of the investment used to generate that income. Ultimately, it is the goal of every business organization to improve and grow its ROI.

This simple ratio – income divided by investment – suggests that there are two mechanical ways to improve ROI – increase the income while maintaining the same level of investment or decrease the investment tied up in the business while maintaining the same level of income. Mathematically, either of these approaches will ramp up the return ratio. However, each of these approaches is clearly easier said than done. In fact, it would be quite difficult to affect one part of the ratio without affecting the other in some way, too. Finally, most companies aren’t interested in “maintaining” as much as “growing.” In order to provide a little more insight into the notion of ROI, many managers and analysts use a system that breaks ROI down into several component parts. This approach is called DuPont analysis, named after the company that first employed it nearly 100 years ago. 

The DuPont model is based on a particular measure of ROI. The ultimate investment base under this definition is the owners’ investment in the business. In the DuPont model, the general concept of ROI is measured by ROE, return on equity: ROE = Profit margin X Asset turnover X Financial leverage

Each of the three factors in this formula is also a ratio, itself. The DuPont formulation emphasizes each of these three ratios as an important factor in the determination of overall ROI. In turn, each of the three ratios can be broken down into its own contributing factors and analyzed at a deeper level. Financial analysts have fairly tight measurement definitions for the three component ratios in the DuPont model, but for our purposes here, the concepts are more important than the specifics of how they are measured. The objective is to get an idea of where changes in profitability can come from, not to be precise in the measurement. Thus, we will examine these ratios using simple definitions. Profit margin (PM) equals net income divided by net revenue (NI/Revenue). Asset turnover (ATO) is net revenue divided by total assets (Revenue/Total Assets). 2 Financial leverage is total assets divided by total owners’ equity (TA/TOE). Thus, higher financial leverage ratios reflect greater use of debt to fund the business.

The product of the first two factors in the DuPont analysis breakdown (PM X ATO) has its own name, return on assets (ROA). ROA is the prime factor related to how a business makes money. This is not to say that financial leverage is unimportant, but financial leverage only improves the stockholders’ returns if ROA is higher than the interest rate paid to debt holders. If a company’s ROA was 5%, but the interest rate paid to debt holders was 10%, then each borrowed dollar invested in the company would yield 5 cents a year in return. However, the interest payment on that borrowed dollar would be 10 cents. The additional 5 cents for the interest expense payment would have to come out of the stockholders’ share of earnings! This interest would also decrease income and, therefore, PM. On the other hand, borrowing money at a 5% interest rate to invest in a business that has an ROA of 10% means additional earnings go to the stockholders.

Financial leverage can be powerful, but it’s more financial management than business management. Furthermore, debt providers typically give the best terms to businesses with strong ROA. Thus, the operating manager’s primary objective is to improve ROA. The logic of how a business makes money can be seen in the decomposition of ROA into its two components. Let’s look at the formula again: ROA = PM X ATO. Profit margin obviously tells you something about the company’s ability to earn income. A positive PM is a required part of making money. If the year’s activities result in a loss, no ATO value will result in a positive ROA. Asset turnover says something about the efficiency of asset utilization of the business. Given a positive PM, the higher the ATO rate, the higher the ROA.

Thus, two basic ways of making money are ones that emphasize just one factor or the other. Some companies make money by using a heavy level of assets to produce large profit margins. Other companies focus on being efficient with their utilization of assets, trying to multiply up modest PMs with high ATO. Each of those two extreme approaches represents the mechanical framework of the respective companies’ business model. But business models are not comprised of mechanical frameworks. They are comprised of the array of factors and the relationships among them that result in strategic financial performance. We now need to take a look at those factors and relationships.

Crafting a potentially effective strategy is a challenge on its own, but managing all of the puzzle pieces for executing that strategy into place is an order of magnitude more complicated. Many managers and entrepreneurs spend significant time and effort searching for an explicit set of guidelines – a checklist – to help them deal with that complexity. The notion that such a detailed and explicit checklist could exist is a myth, but general guidelines and, in some cases, processes for turning those guidelines into their own checklist, do exist. One general guideline/process model that has become popular is the “business model canvas” developed by Osterwalder and Pigneur. While a full review of their methodology is beyond the scope of this note, their basic business model categories and related questions can provide some insight into the operational view of a business model. Here is their list of categories, ordered for our purposes:

• Value propositions
• Customer segments – target markets and most important customers
• Key activities to be performed to support the value propositions
• Key resources needed to support execution of the value propositions
• Key partners (suppliers): activities performed, resources provided  
• Customer relationships to be established and maintained • Channels for reaching the target markets
• Revenue streams – pricing and payment for the target markets
• Cost structure

The first two categories in their model are related to business strategy. The remaining categories are all related to the question of how the business delivers the value proposition to the target market in a way that makes money. In this model, the bundle of attributes comprising the product/service is implicit in several of these categories. Note that there is no logical set of serial, one-way relationships among these categories. The categories represent a network, in a sense. That is, for example, key activities affect the choice of key partners, but the identification of key partners influences the list of key activities. Osterwaller and Pigneur propose an iterative process for specifying the contents of this network of relationships, re-examining how the developing list in each category fits after each round. In the end, the objective is to determine what to do and how to do it in order to execute the strategy. The financial side of the business model – the revenue stream and cost structure in Osterwaller and Pigneur’s approach – is based on a central idea. If you do something, it should be in support of delivering the value proposition to the target market and, therefore, directly or indirectly result in revenue. Also, if you do something, there will be a cost. We will now return to an examination of how the operational activities of the business model are reflected in the financial side of the business model. Using the DuPont framework, we can investigate what is sometimes called the “financial footprint” of the business.

Profit margin answers the question “What percentage of revenue was left as profit after deducting expenses?” Profit margin is a highly summarized figure. It captures the effect of a whole year of business operations. There are two primary factors that ultimately result in the percentage of the average sales dollar that becomes profit. The first of these two factors is the size of the price premium above the cost of the products and services sold. You have seen this expressed as gross profit or gross margin on an income statement. This figure, especially when it is expressed as a percentage of sales revenue, tells how much value is created by the business operations. The second factor relates to how efficient the company is in terms of attracting customers and executing its administrative functions. On an income statement, this factor is quantified as operating expenses. Let’s take a look at an income statement to see how it reveals these factors and how they reflect the business model. We will use a company with which you are likely to be familiar, at least by reputation and brand - Tiffany & Co.

Exhibit 1

The income statement in Exhibit 1 shows the results for Tiffany from its fiscal year 2011 (ending January 31, 2012). Consistent with the percentage idea reflected in the concept of profit margin, the last column of the report shows each row value as a percent of total net revenues. Thus, Tiffany’s profit margin in 2011 was about 10.2%, as shown on the last line of the income statement. This version of an income statement, expressed with percentages, is called a common size statement. Comparing the percentages down the statement is called vertical analysis. Vertical analysis allows you to investigate the two factors mentioned earlier, value creation and execution. The first factor contributing to profit margin is the price premium. This factor is measured by the gross profit expressed as a percentage of revenue. For Tiffany in 2011, the gross profit margin was 59%. Is this a big price premium or not? Given what we know about Tiffany – that it is a high-end “premium” retailer of jewelry (a luxury good), we would suspect that it should be. Nevertheless, in isolation it’s difficult to say anything about this number with much confidence. We need to compare it to other firms in the same industry in order to determine if we would consider it high or low.

Exhibit 2 provides some selected income statement details from two other jewelry retailers, Signet Jewelers and Blue Nile. These are quite different jewelry retailers from Tiffany. Signet is the parent of a handful of familiar retail brands, including Jarrod’s and Kay Jewelers. In terms of annual sales revenue, it is about the same size as Tiffany & Co. Blue Nile is an exclusively online jeweler. Its annual sales revenues are considerably smaller – roughly one-tenth of the other two.

Exhibit 1

Signet’s gross profit margin in the period under examination was 37% and Blue Nile’s GP margin was 21%. Given those comparisons, it appears that Tiffany had a sizeable price premium. By comparison, it appears that Blue Nile had a very small price premium for a jewelry retailer. So? Is Tiffany’s high GP% good and is Blue Niles’ bad? How do we decide?

As it turns out, all three GP%s are probably about right! They reflect the respective business models of the three retailers. Tiffany is a premium brand that sells exclusive, sometimes one-of-a-kind goods. Signet is a mass market jeweler, with moderately price goods (for jewelry) sold primarily through mall outlets. Blue Nile is an internet retailer. The value proposition for each of these retailers is quite different. While we would expect all three to have higher GP%s than a commodity, wouldn’t we also expect them to be different from each other in exactly the way they are? Shouldn’t an exclusive luxury goods retailer have a higher price premium than an internet retailer? Shoppers expect to get the best prices on the internet – lower prices than at the retailers at the mall, and certainly much lower prices than at an exclusive shop.

Each of these retailers attracts customers for different reasons. Perhaps the same shopper might buy from two or even all three retailers, but for different reasons. For example, one of the benefits from buying a Tiffany product is the brand image. Giving a present in Tiffany’s famous little blue box signals to the recipient that the gift is an extravagant one. Giving a gift purchased at Kay Jewelers conveys a different story. It may be a bit of an overstatement, but for the buyer at Kay, a purchase of any item of jewelry may already qualify as an extravagance. When that Jarrod’s ad shows a young man proposing to his girlfriend on an airplane, it’s clear that they aren’t sitting in first class! Blue Nile, meanwhile, seems to be aimed at people buying for themselves – they want something nice, they know exactly what they like, they are not trying to impress with a brand name, and they are looking for a good deal. Not only is the value proposition different across these three retailers, then, but so is the target market.The Business Model: How a Company Makes Money 8

Price premium (the GP%) only reflects a small part of the business model. As discussed above, the business model is concerned with a list of operational questions. What does the company have to do in order to create the price premium? How does it have to organize its activities? These activities are focused on the strategy and revenue, but they have resource cost implications, too. How much does the company have to spend to perform those activities? At Tiffany, creating the impression of elegance and exclusivity means having shops in the high rent district. It means expensive displays, store décor, and store furnishings. It means hiring educated and highly knowledgeable salespeople (and probably paying them big commissions). It means tasteful advertising in media focused on high wealth buyers (e.g., The Wall Street Journal and Forbes). It means promotion through sponsorships of big-ticket charity events. Perhaps it means having exclusive, creative, “name” designers under contract. In short, it means lots of support costs. Much of that cost shows up in operating expenses.

By comparison, Signet, as a mass market retailer, has to have nice stores, but not opulently appointed ones. Each store needs capable salespeople. Sales volume (in transactions, not simply revenues) is the key, so it has to have mass market advertising. Meanwhile, Blue Nile has no stores and, consequently many fewer sales staff. In fact, a substantial number of its sales can take place without the involvement of any salesperson! Thus, it’s not surprising that the Selling, General and Administration expense for Tiffany is the highest of the three at 40% of sales revenue, that Signet is next highest at 28% and that Blue Nile is lowest at under 16%.

Based on the different business models, we observe a much tighter range of final profit margin % numbers, roughly 12%, 8%, and 3% for Tiffany, Signet, and Blue Nile, respectively. What started out looking vastly different at the GP% level, with wildly different price premiums, resulted in much closer PM%s. But we are not finished with analyzing the financial footprint of their business models yet. We still have to consider asset turnover.

Exhibit 3 shows Tiffany & Co.’s balance sheet for FY 2011. We already have revenues from the income statement, so the only number we really need in order to compute ATO at this point is total assets. Tiffany’s ATO is about 0.88 ($3,642,937/$4,158,992). This means that Tiffany’s ROA is about 10.5% (.12 x .88).

Exhibit 3

The Business Model: How a Company Makes Money 10 A standard way to put that number into perspective is to look at how long it would take to sell off the inventory at the current rate of sales. Inventory cost becomes COGS when sold, so the appropriate comparison is COGS/Inventory (called Inventory turnover). In this case, that ratio is 0.72 (1,491,783/2,073,212), which means that about 72% of the inventory value equals one year of sales. We can flip that around to calculate the number of “days of sales in inventory” (called DSI) by dividing 365 days by 0.72. So inventory represents over 500 days of sales! That certainly does not represent anything like “just in time” inventory management. But, as we have already noted, this level of assets in inventory may be a necessary component of Tiffany’s business model.

Let’s do a similar kind of analysis with accounts receivable. To what extent does Tiffany’s business model imply giving customers time to pay their bills? Based on the evidence, it appears such an attribute is not a major part of the “bundle” that Tiffany sells. The receivables turnover (revenues/accounts receivable) is almost 20 times, equivalent to collection of outstanding accounts receivable in 18 days (called DSO). That’s much shorter than the typical 30 days that monthly billing would imply. Tiffany’s seems to be a cash (or credit card) business.

At this point, we have most of what we need to figure out Tiffany’s “cash cycle.” Tiffany has to acquire inventory, hold it, sell it, and then finally collect cash for the sale. We know how long it takes to collect, on average – 18 days. We know how long the inventory sits, on average – 507 days. All that is missing is how long Tiffany takes to pay for the inventory it purchases. This comes from payables turnover. Comparing Tiffany’s payables to COGS, this is a turnover of 4.5 times or 80 days. This length of time is pretty long for “trade credit.” Tiffany is probably using some heavy leverage over its suppliers to make them wait that long. Still, Tiffany’s cash conversion cycle is 445 days (18 + 507 – 80), almost 15 months. All of these components factor into Tiffany’s business model and are reflected in its financial footprint.

Exhibit 4 provides some selected balance sheet data from Signet and Blue Nile, along with related ratios. The patterns in Exhibit 4 are quite different from the numbers for Tiffany, reflecting significant differences in their business models. Signet needs inventory in its stores, just like Tiffany does. But, as a mass retailer, it probably has a less broad array of products for sale and a system for store inventory replenishment based on daily sales. Thus, it could rely more on central inventory (or even direct shipping) than in-store stock. Thus, Signet has significantly less of its assets in inventory than Tiffany – 35% rather than 50%. But both of these numbers stand in stark contrast to Blue Nile’s 8% of assets in inventory. Blue Nile needs no store inventory. Furthermore, part of Blue Nile’s value proposition is design-it-yourself jewelry. What that means is that ring buyers, for example, can specify what kind of stone they want in which available style of setting. Blue Nile’s in-house jewelers can then do the final assembly of those parts immediately before shipping. The result is that Blue Nile’s “virtual” inventory is much larger than its physical inventory.

Exhibit 4

We can see the impact of other business model choices in some of the ratios. As a mass market jewelry retailer with a target market that may be financially stretched a bit to buy jewelry, Signet clearly needs to offer its customers time to pay. The financial footprint evidence for this is the relatively long collection period of 106 days, a bit more than 3 months. By comparison, as an internet retailer Blue Nile operates in a pay-up-front world. The 5 day collection period may simply be an artifact of the lag between sale and payment from the credit card company or PayPal. Finally, Signet seems to pay for its purchases on a fairly standard monthly cycle. Blue Nile, on the other hand, pushes its payments out quite far, about 4 months. The results reflect critical implications of the 2 different business models. Signet’s cash conversion cycle takes 283 days. Blue Nile receives cash from sales 83 days before it pays for its purchases!

The 3 business models all work, but in very different ways. Tiffany’s ROA of 10.5% relies heavily on PM which is, in part, enabled and enhanced by a large asset base. Signet’s ROA is 9% based on a balanced contribution of PM and ATO. Blue Nile relies very heavily on asset efficiency. Its ATO of 2.43 times pumps up the effect of its very modest 3% PM to an overall ROA of 7.9%.

Since we began our discussion with the full DuPont model, we should probably close the loop on our 3 example firms by looking at the last effect – financial leverage. The FLs for Tiffany, Signet, and Blue Nile are, respectively, 1.77 times, 1.58 times, and 4.08 times. In the end, then, the ROE for Tiffany was a solid 19% and the ROE for Signet was 14%. But Blue Nile, with its tiny 3% PM turns out to have provided the most impressive return for its investors – an ROE of 32%!

The fact that all 3 companies have ROA values in the same neighborhood is not a coincidence. Each of the companies obtained its results through very deliberate design and execution of its business model. Those business models represent a balance of strategic implications and effective execution choices. While the financial footprint of the business model does not drive the operational requirements of the business model, it does provide a logic discipline for choosing the way those operations requirements are met. Business managers of successful established firms like Tiffany and entrepreneurs like the founders of Blue Nile need to be equally attentive to the operational aspects and to the financial implications of their business models. Superior financial performance only comes from the careful execution of both sides of an appropriate business model.