Business Models For Dummies
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To create the best business model possible, find the best place on the industry value chain. Every firm involved in getting a product from initial creation to purchase and consumption by the end consumer adds value in the form of activities, incurs costs, and has a resulting margin. Some positions in this value chain offer a greater opportunity than others.

Different industries value the places on this value chain differently. For instance, clothing retailers enjoy a more profitable position on their value chain than the clothing manufacturers. In automobiles, retailers tend to make less than the manufacturers. In some industries, no desirable places on the value chain are available, making the overall market less attractive for your business.

Consider a cup of coffee. Several operators add value to your daily cup of joe. However, the market rewards some activities much more richly than others. If your business model is to be the most successful, you want to assume a position on the value chain that offers the best potential profits. This table shows the value chain for coffee.

Value Chain for Coffee
Firm Value Added Key Activities
Coffee bean grower Operations Farming
Shipper Logistics Transportation and logistics
Coffee roaster Operations Converting beans into drinkable coffee
Marketers (Folgers, Starbucks) Sales Branding, sales, customer service
Retailer Sales Merchandising

Whole green Columbian coffee beans sell for $1.97 a pound. Assume the farmer has cost equal to about half that. The farmer’s margin is 98.5 cents per pound of coffee. The roaster buys the coffee from the farmer for $1.97 a pound and transports it, roasts it, and grinds it. The cost of logistics and transportation is around 2 cents per pound.

The roaster then sells it to a coffee service, consumer products company, or retail outlet. Unbranded wholesale coffee sells for around $5 per pound. If the coffee roaster’s cost of operations is about half the $3.03 per pound value added, then the coffee roaster makes a margin of around $1.51. If the coffee is branded (Starbucks, Folgers, Seattle’s Best), add a dollar or two to the value added.

Note that almost all the value added by branding drops to profit/margin. Finally, a company like Starbucks, Folgers, Kroger, or a coffee service delivers the coffee to the consumer. Folgers coffee sells for $9.99 a pound (Starbucks $13.95 per pound). Therefore, the retail seller of Folgers has added about $4 of value (mostly margin). This comprises the entire value chain for a one-pound bag of coffee.

This table shows the value added by each function and the approximate margin. Note that the marketing and sales-related functions are much more handsomely rewarded than the functions that make the product.

Value Added for Coffee
Firm Cost Added per Pound Margin Earned per Pound Total Value Added
Coffee bean grower $0.985 $0.985 $1.97
Shipper $0.015 $0.005 $.02
Coffee roaster $1.52 $1.51 $3.03
Marketers (Folgers, Starbucks) $0 $2 $2
Retailer $2 $2 $4

Some places on the coffee value chain are much more profitable than others. To maximize the effectiveness of your business model, find the most profitable portion of the value chain. Usually, the closer you are to the end user or consumer, the greater the opportunity for margin.

Don’t misconstrue this statement. This doesn’t mean that the best business models are retail models. What it means is that as manufacturing has shifted to low-wage countries, the value add for manufacturing and related activities has gone down dramatically. As the ability to add value for manufacturing has decreased, the ability to add value through sales, distribution, and branding has increased. This shift has provided opportunities for savvy entrepreneurs.

Savvy entrepreneurs have also created new positions on the value chain to carve value away from existing players. For example, in the field of law, several new players have emerged to carve out a portion of the value chain traditionally owned by lawyers.

Law firms in India specialize in large-scale complex research only. Some firms audit bills from law firms in an attempt to save their clients money. Both of these industries used to be part of the law firm value chain.

Ironically, there seems to be very little correlation between the amount of work or the difficulty of work and the amount of value added in the value chain. As you can see from the coffee example, the hardest work is done by the farmer.

The farmer takes the risk of bad weather, has the highest number of employees, and puts in the most hours proportionately. However, the farmer makes the least amount of money on the value chain.

Certain portions of the value chain tend to add more value than others. Note that value added is the difference between sales price and cost. An item may have a large percentage of the total sales price to the end consumer, but add little value on the chain.

Many businesspeople pick an industry because they’re familiar with it. If you’re an HVAC technician, you tend to create a business model in the HVAC industry. It makes sense. However, your HVAC skills can be applied to many industries, some of which may be more attractive than HVAC.

About This Article

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About the book author:

Jim Muehlhausen is the founder and President of the Business Model Institute as well as consultant and speaker to businesses large and small. He is the author of The 51 Fatal Business Errors and How to Avoid Them and a frequent contributor to Entrepreneur, Businessweek, and dozens of other publications.

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