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What Is a Business Model?

Understanding business models, evaluating successful business models, how to create a business model.

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The Bottom Line

Learn to understand a company's profit-making plan

Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.

Investopedia / Laura Porter

The term business model refers to a company's plan for making a profit . It identifies the products or services the business plans to sell, its identified target market , and any anticipated expenses . Business models are important for both new and established businesses. They help new, developing companies attract investment, recruit talent, and motivate management and staff.

Established businesses should regularly update their business model or they'll fail to anticipate trends and challenges ahead. Business models also help investors evaluate companies that interest them and employees understand the future of a company they may aspire to join.

Key Takeaways

• A business model is a company's core strategy for profitably doing business.
• Models generally include information like products or services the business plans to sell, target markets, and any anticipated expenses.
• There are dozens of types of business models including retailers, manufacturers, fee-for-service, or freemium providers.
• The two levers of a business model are pricing and costs.
• When evaluating a business model as an investor, consider whether the product being offer matches a true need in the market.

A business model is a high-level plan for profitably operating a business in a specific marketplace. A primary component of the business model is the value proposition . This is a description of the goods or services that a company offers and why they are desirable to customers or clients, ideally stated in a way that differentiates the product or service from its competitors.

A new enterprise's business model should also cover projected startup costs and financing sources, the target customer base for the business, marketing strategy , a review of the competition, and projections of revenues and expenses. The plan may also define opportunities in which the business can partner with other established companies. For example, the business model for an advertising business may identify benefits from an arrangement for referrals to and from a printing company.

Successful businesses have business models that allow them to fulfill client needs at a competitive price and a sustainable cost. Over time, many businesses revise their business models from time to time to reflect changing business environments and market demands .

When evaluating a company as a possible investment, the investor should find out exactly how it makes its money. This means looking through the company's business model. Admittedly, the business model may not tell you everything about a company's prospects. But the investor who understands the business model can make better sense of the financial data.

A common mistake many companies make when they create their business models is to underestimate the costs of funding the business until it becomes profitable. Counting costs to the introduction of a product is not enough. A company has to keep the business running until its revenues exceed its expenses.

One way analysts and investors evaluate the success of a business model is by looking at the company's gross profit . Gross profit is a company's total revenue minus the cost of goods sold (COGS). Comparing a company's gross profit to that of its main competitor or its industry sheds light on the efficiency and effectiveness of its business model. Gross profit alone can be misleading, however. Analysts also want to see cash flow or net income . That is gross profit minus operating expenses and is an indication of just how much real profit the business is generating.

The two primary levers of a company's business model are pricing and costs. A company can raise prices, and it can find inventory at reduced costs. Both actions increase gross profit. Many analysts consider gross profit to be more important in evaluating a business plan. A good gross profit suggests a sound business plan. If expenses are out of control, the management team could be at fault, and the problems are correctable. As this suggests, many analysts believe that companies that run on the best business models can run themselves.

When evaluating a company as a possible investment, find out exactly how it makes its money (not just what it sells but how it sells it). That's the company's business model.

Types of Business Models

There are as many types of business models as there are types of business. For instance, direct sales, franchising , advertising-based, and brick-and-mortar stores are all examples of traditional business models. There are hybrid models as well, such as businesses that combine internet retail with brick-and-mortar stores or with sporting organizations like the NBA .

Below are some common types of business models; note that the examples given may fall into multiple categories.

One of the more common business models most people interact with regularly is the retailer model. A retailer is the last entity along a supply chain. They often buy finished goods from manufacturers or distributors and interface directly with customers.

Example: Costco Wholesale

Manufacturer

A manufacturer is responsible for sourcing raw materials and producing finished products by leveraging internal labor, machinery, and equipment. A manufacturer may make custom goods or highly replicated, mass produced products. A manufacturer can also sell goods to distributors, retailers, or directly to customers.

Example: Ford Motor Company

Fee-for-Service

Instead of selling products, fee-for-service business models are centered around labor and providing services. A fee-for-service business model may charge by an hourly rate or a fixed cost for a specific agreement. Fee-for-service companies are often specialized, offering insight that may not be common knowledge or may require specific training.

Example: DLA Piper LLP

Subscription

Subscription-based business models strive to attract clients in the hopes of luring them into long-time, loyal patrons. This is done by offering a product that requires ongoing payment, usually in return for a fixed duration of benefit. Though largely offered by digital companies for access to software, subscription business models are also popular for physical goods such as monthly reoccurring agriculture/produce subscription box deliveries.

Example: Spotify

Freemium business models attract customers by introducing them to basic, limited-scope products. Then, with the client using their service, the company attempts to convert them to a more premium, advance product that requires payment. Although a customer may theoretically stay on freemium forever, a company tries to show the benefit of what becoming an upgraded member can hold.

Example: LinkedIn/LinkedIn Premium

Some companies can reside within multiple business model types at the same time for the same product. For example, Spotify (a subscription-based model) also offers free version and a premium version.

If a company is concerned about the cost of attracting a single customer, it may attempt to bundle products to sell multiple goods to a single client. Bundling capitalizes on existing customers by attempting to sell them different products. This can be incentivized by offering pricing discounts for buying multiple products.

Example: AT&T

Marketplace

Marketplaces are somewhat straight-forward: in exchange for hosting a platform for business to be conducted, the marketplace receives compensation. Although transactions could occur without a marketplace, this business models attempts to make transacting easier, safer, and faster.

Example: eBay

Affiliate business models are based on marketing and the broad reach of a specific entity or person's platform. Companies pay an entity to promote a good, and that entity often receives compensation in exchange for their promotion. That compensation may be a fixed payment, a percentage of sales derived from their promotion, or both.

Example: social media influencers such as Lele Pons, Zach King, or Chiara Ferragni.

Razor Blade

Aptly named after the product that invented the model, this business model aims to sell a durable product below cost to then generate high-margin sales of a disposable component of that product. Also referred to as the "razor and blade model", razor blade companies may give away expensive blade handles with the premise that consumers need to continually buy razor blades in the long run.

Example: HP (printers and ink)

"Tying" is an illegal razor blade model strategy that requires the purchase of an unrelated good prior to being able to buy a different (and often required) good. For example, imagine Gillette released a line of lotion and required all customers to buy three bottles before they were allowed to purchase disposable razor blades.

Reverse Razor Blade

Instead of relying on high-margin companion products, a reverse razor blade business model tries to sell a high-margin product upfront. Then, to use the product, low or free companion products are provided. This model aims to promote that upfront sale, as further use of the product is not highly profitable.

Example: Apple (iPhones + applications)

The franchise business model leverages existing business plans to expand and reproduce a company at a different location. Often food, hardware, or fitness companies, franchisers work with incoming franchisees to finance the business, promote the new location, and oversee operations. In return, the franchisor receives a percentage of earnings from the franchisee.

Example: Domino's Pizza

Pay-As-You-Go

Instead of charging a fixed fee, some companies may implement a pay-as-you-go business model where the amount charged depends on how much of the product or service was used. The company may charge a fixed fee for offering the service in addition to an amount that changes each month based on what was consumed.

Example: Utility companies

A brokerage business model connects buyers and sellers without directly selling a good themselves. Brokerage companies often receive a percentage of the amount paid when a deal is finalized. Most common in real estate, brokers are also prominent in construction/development or freight.

Example: ReMax

There is no "one size fits all" when making a business model. Different professionals may suggest taking different steps when creating a business and planning your business model. Here are some broad steps one can take to create their plan:

• Identify your audience. Most business model plans will start with either defining the problem or identifying your audience and target market . A strong business model will understand who you are trying to target so you can craft your product, messaging, and approach to connecting with that audience.
• Define the problem. In addition to understanding your audience, you must know what problem you are trying to solve. A hardware company sells products for home repairs. A restaurant feeds the community. Without a problem or a need, your business may struggle to find its footing if there isn't a demand for your services or products.
• Understand your offerings. With your audience and problem in mind, consider what you are able to offer. What products are you interested in selling, and how does your expertise match that product? In this stage of the business model, the product is tweaked to adapt to what the market needs and what you're able to provide.
• Document your needs. With your product selected, consider the hurdles your company will face. This includes product-specific challenges as well as operational difficulties. Make sure to document each of these needs to assess whether you are ready to launch in the future.
• Find key partners. Most businesses will leverage other partners in driving company success. For example, a wedding planner may forge relationships with venues, caterers, florists, and tailors to enhance their offering. For manufacturers, consider who will provide your materials and how critical your relationship with that provider will be.
• Set monetization solutions. Until now, we haven't talked about how your company will make money. A business model isn't complete until it identifies how it will make money. This includes selecting the strategy or strategies above in determining your business model type. This might have been a type you had in mind but after reviewing your clients needs, a different type might now make more sense.
• Test your model. When your full plan is in place, perform test surveys or soft launches. Ask how people would feel paying your prices for your services. Offer discounts to new customers in exchange for reviews and feedback. You can always adjust your business model, but you should always consider leveraging direct feedback from the market when doing so.

Instead of reinventing the wheel, consider what competing companies are doing and how you can position yourself in the market. You may be able to easily spot gaps in the business model of others.

Criticism of Business Models

Joan Magretta, the former editor of the Harvard Business Review, suggests there are two critical factors in sizing up business models. When business models don't work, she states, it's because the story doesn't make sense and/or the numbers just don't add up to profits. The airline industry is a good place to look to find a business model that stopped making sense. It includes companies that have suffered heavy losses and even bankruptcy .

For years, major carriers such as American Airlines, Delta, and Continental built their businesses around a hub-and-spoke structure , in which all flights were routed through a handful of major airports. By ensuring that most seats were filled most of the time, the business model produced big profits.

However, a competing business model arose that made the strength of the major carriers a burden. Carriers like Southwest and JetBlue shuttled planes between smaller airports at a lower cost. They avoided some of the operational inefficiencies of the hub-and-spoke model while forcing labor costs down. That allowed them to cut prices, increasing demand for short flights between cities.

As these newer competitors drew more customers away, the old carriers were left to support their large, extended networks with fewer passengers. The problem became even worse when traffic fell sharply following the September 11 terrorist attacks in 2001 . To fill seats, these airlines had to offer more discounts at even deeper levels. The hub-and-spoke business model no longer made sense.

Example of Business Models

Consider the vast portfolio of Microsoft. Over the past several decades, the company has expanded its product line across digital services, software, gaming, and more. Various business models, all within Microsoft, include but are not limited to:

• Productivity and Business Processes: Microsoft offers subscriptions to Office products and LinkedIn. These subscriptions may be based off product usage (i.e. the amount of data being uploaded to SharePoint).
• Intelligent Cloud: Microsoft offers server products and cloud services for a subscription. This also provide services and consulting.
• More Personal Computing: Microsoft sells physically manufactured products such as Surface, PC components, and Xbox hardware. Residual Xbox sales include content, services, subscriptions, royalties, and advertising revenue.

A business model is a strategic plan of how a company will make money. The model describes the way a business will take its product, offer it to the market, and drive sales. A business model determines what products make sense for a company to sell, how it wants to promote its products, what type of people it should try to cater to, and what revenue streams it may expect.

What Is an Example of a Business Model?

Best Buy, Target, and Walmart are some of the largest examples of retail companies. These companies acquire goods from manufacturers or distributors to sell directly to the public. Retailers interface with their clients and sell goods, though retails may or may not make the actual goods they sell.

What Are the Main Types of Business Models?

Retailers and manufacturers are among the primary types of business models. Manufacturers product their own goods and may or may not sell them directly to the public. Meanwhile, retails buy goods to later resell to the public.

How Do I Build a Business Model?

There are many steps to building a business model, and there is no single consistent process among business experts. In general, a business model should identify your customers, understand the problem you are trying to solve, select a business model type to determine how your clients will buy your product, and determine the ways your company will make money. It is also important to periodically review your business model; once you've launched, feel free to evaluate your plan and adjust your target audience, product line, or pricing as needed.

A company isn't just an entity that sells goods. It's an ecosystem that must have a plan in plan on who to sell to, what to sell, what to charge, and what value it is creating. A business model describes what an organization does to systematically create long-term value for its customers. After building a business model, a company should have stronger direction on how it wants to operate and what its financial future appears to be.

Harvard Business Review. " Why Business Models Matter ."

Bureau of Transportation Statistics. " Airline Travel Since 9/11 ."

Microsoft. " Annual Report 2021 ."

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What Is a Business Model?

• Andrea Ovans

A history, from Drucker to Christensen.

A look through HBR’s archives shows that business thinkers use the concept of a “business model” in many different ways, potentially skewing the definition. Many people believe Peter Drucker defined the term in a 1994 article as “assumptions about what a company gets paid for,” but that article never mentions the term business model. Instead, Drucker’s theory of the business was a set of assumptions about what a business will and won’t do, closer to Michael Porter’s definition of strategy. Businesses make assumptions about who their customers and competitors are, as well as about technology and their own strengths and weaknesses. Joan Magretta carries the idea of assumptions into her focus on business modeling, which encompasses the activities associated with both making and selling something. Alex Osterwalder also builds on Drucker’s concept of assumptions in his “business model canvas,” a way of organizing assumptions so that you can compare business models. Introducing a better business model into an existing market is the definition of a disruptive innovation, as written about by Clay Christensen. Rita McGrath offers that your business model is failing when innovations yield smaller and smaller improvements. You can innovate a new model by altering the mix of products and services, postponing decisions, changing the people who make the decisions, or changing incentives in the value chain. Finally, Mark Johnson provides a list of 19 types of business models and the organizations that use them.

In The New, New Thing , Michael Lewis refers to the phrase business model as “a term of art.” And like art itself, it’s one of those things many people feel they can recognize when they see it (especially a particularly clever or terrible one) but can’t quite define.

That’s less surprising than it seems, because how people define the term really depends on how they’re using it.

Lewis, for example, offers up the simplest of definitions — “All it really meant was how you planned to make money” — to make a simple point about the dot.com bubble, obvious now, but fairly prescient when he was writing at its height, in the fall of 1999. The term, he says dismissively, was “central to the Internet boom; it glorified all manner of half-baked plans…The ‘business model’ for Microsoft, for instance, was to sell software for 120 bucks a pop that cost fifty cents to manufacture …The business model of most Internet companies was to attract huge crowds of people to a Web site, and then sell others the chance to advertise products to the crowds. It was still not clear that the model made sense.” Well, maybe not then.

A look through HBR’s archives shows the many ways business thinkers use the concept and how that can skew the definitions. Lewis himself echoes many people’s impression of how Peter Drucker defined the term — “assumptions about what a company gets paid for” — which is part of Drucker’s “theory of the business.”

That’s a concept Drucker introduced in a 1994 HBR article that in fact never mentions the term business model. Drucker’s theory of the business was a set of assumptions about what a business will and won’t do, closer to Michael Porter’s definition of strategy . In addition to what a company is paid for, “these assumptions are about markets. They are about identifying customers and competitors, their values and behavior. They are about technology and its dynamics, about a company’s strengths and weaknesses.”

Drucker is more interested in the assumptions than the money here because he’s introduced the theory of the business concept to explain how smart companies fail to keep up with changing market conditions by failing to make those assumptions explicit.

Citing as a sterling example one of the most strategically nimble companies of all time — IBM — he explains that sooner or later, some assumption you have about what’s critical to your company will turn out to be no longer true. In IBM’s case, having made the shift from tabulating machine company to hardware leaser to a vendor of mainframe, minicomputer, and even PC hardware, Big Blue finally runs adrift on its assumption that it’s essentially in the hardware business, Drucker says (though subsequent history shows that IBM manages eventually to free itself even of that assumption and make money through services for quite some time).

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How to Design a Winning Business Model

Joan Magretta, too, cites Drucker when she defines what a business model is in “ Why Business Models Matter ,” partly as a corrective to Lewis. Writing in 2002, the depths of the dot.com bust, she says that business models are “at heart, stories — stories that explain how enterprises work. A good business model answers Peter Drucker’s age-old questions, ‘Who is the customer? And what does the customer value?’ It also answers the fundamental questions every manager must ask: How do we make money in this business? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost?”

Magretta, like Drucker, is focused more on the assumptions than on the money, pointing out that the term business model first came into widespread use with the advent of the personal computer and the spreadsheet, which let various components be tested and, well, modeled. Before that, successful business models “were created more by accident than by design or foresight, and became clear only after the fact. By enabling companies to tie their marketplace insights much more tightly to the resulting economics — to link their assumptions about how people would behave to the numbers of a pro forma P&L — spreadsheets made it possible to model businesses before they were launched.”

Since her focus is on business modeling, she finds it useful to further define a business model in terms of the value chain. A business model, she says, has two parts: “Part one includes all the activities associated with making something: designing it, purchasing raw materials, manufacturing, and so on. Part two includes all the activities associated with selling something: finding and reaching customers, transacting a sale, distributing the product, or delivering the service. A new business model may turn on designing a new product for an unmet need or on a process innovation. That is it may be new in either end.”

Firmly in the “a business model is really a set of assumptions or hypotheses” camp is Alex Osterwalder, who has developed what is arguably the most comprehensive template on which to construct those hypotheses. His nine-part “ business model canvas ” is essentially an organized way to lay out your assumptions about not only the key resources and key activities of your value chain, but also your value proposition, customer relationships, channels, customer segments, cost structures, and revenue streams — to see if you’ve missed anything important and to compare your model to others.

Once you begin to compare one model with another, you’re entering the realms of strategy, with which business models are often confused. In “ Why Business Models Matter ,” Magretta goes back to first principles to make a simple and useful distinction, pointing out that a business model is a description of how your business runs, but a competitive strategy explains how you will do better than your rivals. That could be by offering a better business model — but it can also be by offering the same business model to a different market.

Introducing a better business model into an existing market is the definition of a disruptive innovation . To help strategists understand how that works, Clay Christensen presented a particular take on the matter in “ In Reinventing Your Business Model ” designed to make it easier to work out how a new entrant’s business model might disrupt yours. This approach begins by focusing on the customer value proposition — what Christensen calls the customer’s “job-to-be-done.” It then identifies those aspects of the profit formula, the processes, and the resources that make the rival offering not only better, but harder to copy or respond to — a different distribution system, perhaps (the iTunes store); or faster inventory turns (Kmart); or maybe a different manufacturing approach (steel minimills).

Many writers have suggested signs that could indicate that your current business model is running out of gas. The first symptom, Rita McGrath says in “ When Your Business Model is In Trouble ,” is when innovations to your current offerings create smaller and smaller improvements (and Christensen would agree). You should also be worried, she says, when your own people have trouble thinking up new improvements at all or your customers are increasingly finding new alternatives.

Knowing you need one and creating one are, of course, two vastly different things. Any number of articles focus more specifically on ways managers can get beyond their current business model to conceive of a new one. In “ Four Paths to Business Model Innovation ,” Karan Giotra and Serguei Netessine look at ways to think about creating a new model by altering your current business model in four broad categories: by changing the mix of products or services, postponing decisions, changing the people who make the decisions, and changing incentives in the value chain.

In “ How to Design a Winning Business Model ,” Ramon Cassadesus-Masanell and Joan Ricart focus on the choices managers must make when determining the processes needed to deliver the offering, dividing them broadly into policy choices (such as using union or nonunion workers; locating plants in rural areas, encouraging employees to fly coach class), asset choices (manufacturing plants, satellite communication systems); and governance choices (who has the rights to make the other two categories of decisions).

If all of this has left your head swimming, then Mark Johnson, who went on in his book Seizing the White Space to fill in the details of the idea presented in “Reinventing Your Business Model,” offers up perhaps the most useful starting point — this list of analogies, adapted from that book:

Can’t Think of a New Business Model?

Try adapting one of these basic forms.

Source: Seizing the White Space, by Mark Johnson

• AO Andrea Ovans is a former senior editor at Harvard Business Review.

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Entrepreneurship: The Practice and the Mindset

Student resources, learning objectives.

8-1: Define the business model.

The business model is the framework for creating and delivering consumer value, while extracting value for the entrepreneur as well.

8-2: Identify the four core areas of a business model.

Broken into four parts, each business model includes an offering, customers, infrastructure, and financial viability.

8-3: Explore the importance of the Customer Value Proposition in further detail.

The CVP outlines exactly how the firm will generate value, how it will generate it in excess of its competition, and how it will continue to do so in the future. As the true measure of any business is creating value, the true measure of a business model is its customer value proposition.

8-4: Describe the different types of Customer Value Propositions and learn how to identify your target customers.

Businesses tend to have different CVPs for each customer segment. This is to ensure they are meeting the needs of the customers within each segment. Examples of different customer segments targeted by different types of businesses include mass market, niche market, segmented market, diversified market, and multisided markets. Types of CVPs include all-benefits, points of difference, and resonating focus.

8-5: Identify the nine components of the business model canvas.

The four core elements of a business model can be expanded to nine business model components. Separating core elements into their respective components makes them easier to define and integrate with one another. The offering constitutes the (1) value proposition. Customers relate to (2) customer segments, (3) channels, and (4) customer relationships. Infrastructure includes (5) key activities, (6) key resources, and (7) key partners. Financial viability includes (8) cost structure and (9) revenue streams.