Phase III of the Business Model: Value Capture
The litmus test of a sound business model is its ability to deliver customer value profitably. The third phase of the business model asks how you will capture the value generated by your offerings. A good idea unsupported by a financial formula for success remains nothing more than a good idea. The capture phase requires a firm understanding of the economic underpinnings of the offerings provided to customers to ensure sufficient cash flow and profit will fuel the business into the future.
There are four ingredients to consider when establishing how you will capture the value generated from your offering:
- 1. Price: The amount customers pay for the offering
- 2. Revenue: Price multiplied by volume sold
- 3. Cost: Expenditure of resources to provide offering
- 4. Profit: Revenue minus cost
These four elements can be calculated for older offerings in mature markets as well as new offerings in emerging markets. The price can be identified in both quantitative and relative terms. A number alone, say $100, is insufficient for understanding how that price will position our offering versus the competition. Does the $100 price point represent a premium position in the market, a moderate position, or a discount relative to competitors? Therefore, it’s helpful to identify price in both quantitative (e.g., $100) and relative (e.g., premium) terms.
When it comes to revenue, price is multiplied by the expected volume (e.g., number of customers, units per customer per transaction, transactions per customer) to determine the amount of money to be made from the offering. While an asset sale, such as a bicycle purchase, may be the most common form of revenue, there are now many additional ways to generate revenue.32 The following are examples of how major corporations generate revenue:
- • Bill Gates built Microsoft’s software fortune through licensing.
- • Enterprise Rent-A-Car became an industry giant by renting cars primarily in community settings.
- • The Wall Street Journal has continued to produce revenue through both print and online subscriptions.
- • FedEx has garnered a large share of shipping revenues through usage fees for the delivery of packages from point A to point B.
- • Google has used advertising as a primary revenue stream at the foundation of their business.
- • Financial investment firms like Charles Schwab have built vast sums of wealth by connecting investors with financial products through intermediary services charging brokerage fees.
With a variety of options at a leader’s disposal, a company’s success can be greatly enhanced or stymied by their choice of revenue stream.
It seems that the first place leaders turn to when a business model isn’t working is to the cost component. Costs are described in many different ways, including fixed, variable, direct, indirect, and sunk, depending on the structure in place. While cutting costs is a common reflexive response when a business is not generating sufficient profit, it may only provide short-term relief at the expense of longterm growth. The key is a solid understanding of the costs involved in providing the offering and how they contribute to the value being produced.
In the previous discussion of the value chain, once the activities have been identified and arranged in order of use, costs can be assigned to each. This exercise helps to establish a clear view of both the benefit and the cost of each activity in the value chain so a leader can ensure any cost reductions are not jeopardizing the important value-generating activities. For a professional services firm providing accounting software solutions, cutting costs in research and development activities may lead to short-term profit but a long-term loss of valuable intellectual property. However, an industrial supplier of construction materials able to reduce costs in their manufacturing processes can boost margins, and potentially pass along some of the cost savings to customers in the form of lower prices.
The final element of the capture phase is profit. Research by UCLA business professor Richard Rumelt showed that the number-one factor in a business unit’s profitability was its choice of strategy.33 While we’ve covered price, revenue, and costs—the components of profit—it’s still important to isolate and study profit. As professor Paul Rubin writes:
Profit maximization is good because it leads directly to maximum benefits for consumers. Profits provide the incentive for firms to do what consumers want. . . . What if a business does not maximize profits? Then it is either not making the products that consumers want the most, or it is not producing its products at the lowest cost. In either case, consumers are harmed.34
A long list of companies have been lured into the rocks of bankruptcy by the siren song of growth for growth’s sake. In fact, growth at the expense of profit can lead to a colossal collapse. A five-year study of 600 companies showed that less than half the companies with annual revenue growth rates of 5 percent or more also attained increasing operating margins. In fact, more than 20 percent experienced an absolute decline in profits. As the researchers concluded, “While revenue growth must be part of any strategy to enhance profitability and shareholder value, it’s not sufficient in itself.”35
When it comes to generating profit, you have two primary levers: revenue and costs. You can increase revenue through greater volume, higher prices, or lower costs. Which lever you pull will be determined by a number of factors including the context of the business, competitive landscape, core competencies, and capabilities to name just a few. But recent research by Michael Raynor and Mumtaz Ahmed on business performance shows the revenue lever may be more effective than the cost lever. They concluded:
. . . by an overwhelming margin, exceptional companies generate superior profits through higher revenue than their rivals, with higher prices more popular than higher volume .. . the highest-performing companies tended to rely more on higher gross margins than on lower cost as a source of performance advantage, suggesting a better before cheaper bias.36
To summarize, the three phases of a business model can be described as follows:
Phase I: Value Creation
Core competency: Primary area of expertise (what you know) Capabilities: Activities performed with key resources (what you do)
Value proposition: Rationale for the offering (customer, need/job, approach, benefit)
Phase II: Value Delivery
Value chain: Configuration of capabilities to provide value (how you do it)
Channels: Customer access points for offerings (where you offer it)
Phase Ш: Value Capture
Price: Amount customers pay for the offering
Revenue: Price multiplied by volume sold
Cost: Expenditure of resources to provide offering
Profit: Revenues minus costs