Most clients I see can articulate their Business Model. But when I ask them about their Economic Model they struggle and often think they are the same. They are not.
Simply put a Business Model is primarily customer-focused while an Economic Model is owner-focused.
Within the Economic Model, there are four key dimensions:
- Revenue Drivers
- Volume
- Margin
- Operating Leverage
Revenue Drivers
Revenue drivers are how many ways you have to separate your customer from his money.
A few years ago, I went to the Dixie-Stampede while I was in the Great Smoky Mountains. The ticket price was a reasonable $45 per person, which is a sensible price for a dinner and a show. But the listed start time was for a pre-show in the bar where you were encouraged to buy a drink while you waited to be let into the actual arena for the main show.
When you were finally invited in to see the show you had to file in through a photo area where a dozen or so photographers took your individual or group pictures.
Then, as you left the show when it ended you were channeled through a gift shop. There, your pictures were displayed on a board and you were encouraged to buy them, not to mention all the other items in the gift shop.
All in all the cost was closer to $65 per person since they effectively used multiple revenue drivers to separate me from my money.
Too many small business owners have a rather limited perspective when it comes to looking at ways the separate a customer from his money.
The following is a video provides a look at several different revenue drivers that
When it comes to revenue drivers, you have to consider the following questions:
- For what value are your customers really willing to pay?
- What do they currently pay?
- How are they currently paying?
- How would they prefer to pay?
- How much does each revenue stream contribute to your overall business revenues?
Margins
Margins can be defined simply as the difference between your Direct Cost to deliver a service or a product (often called COGS or Cost of Goods Sold) and the price you charge the customer for that product or service.
The basic coffee you buy at Starbucks costs about 10 cents to make, including the cup, yet might sell for $2.00. Therefore, $1.90 is the margin.
However, don’t confuse margin with profit. Margin has only accounted for direct costs, and there are plenty of indirect costs that have to be accounted for.
In our Starbucks example, we have to cover such indirect costs as rent, utilities, the salary for the barista, and so on before we make a profit.
To understand more about margins check out: To Maximize Profit You Need To Understanding Margin Pricing
Sales Volume
Sales volume works in concert with margins. Sales volume is simply the number of units you sell in a specific period of time, say in a month.
You can be just as successful if you have a high-margin low-volume business as you could with a low-margin high-volume business.
A Lamborghini dealership can afford to sell only a few cars each month since their margins are high, but a Nissan dealer will have to sell lots of new cars to earn the same profits since their margins are much smaller.
Software companies with a successful product experience a very high sales volume and high sales margins and reap huge rewards.
Operating Leverage
Operating leverage is the relationship between fixed costs and variable costs.
A construction business that rents a backhoe when they have a job that needs a backhoe will have higher variable costs and would be said to have low operating leverage. The same company that owns a backhoe is said to have high operating leverage.
The first company only has the expense when they have a job that requires a backhoe but pays more money when they need one, while the second company owns the asset and likely has a fixed monthly payment which is spread across all jobs that require a backhoe.
Business with low leverage fare much better if they fail to meet their break-even point. Said another way, they lose less money if sales don’t meet expectation because their expenses only occur if they sell a product or have a service contract. However, companies with low operating leverage that routinely exceed their break-even also make less money. Low operating leverage means less risk and less reward.
High operating leverage, by contrast, means the company has the fixed payment each month and if they have no work they still need to make the payment. Therefore, a business with high operating leverage stands to lose more money if they don’t meet their break-even sales goals but makes more money if they routinely exceed their break-even. High operating leverage means more risk and more reward.
Generally, start-ups don’t meet their break-even and are better off with lower operating leverage (low risk/low reward). This is one reason banks don’t like to lend to start-ups.
When a business matures and exceeds their break-even consistently operating leverage can be used to extend profits.
I own a restaurant. When I bought it it had cash on cash annual return of 7.5%. I put down 40% of my own cash and borrowed the other 60% from a lender at 6%. On my 40%, I make a 7.5% return, plus I pocket an additional 1.5% (7.5% minus 6%) return on the 60% of the borrowed money, making the overall return of 9.75%.
Therefore, for taking on the addition of what I would say is a very minimal increased level of risk, I use leverage (the bank’s money) to maximize my returns. As business owners, we want to use operating leverage when we
Can you define your economic model?
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