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What is a 'Business Model'

A business model is the way in which a company generates revenue and makes a profit from company operations. Analysts use the metric gross profit as a way to compare the efficiency and effectiveness of a firm's business model. Gross profit is calculated by subtracting the cost of goods sold from revenues.

BREAKING DOWN 'Business Model'

During the dotcom boom analysts went in search of net income. The internet is a disruptive technology with the ability to revolutionize certain industries, but where was the cash flow? When analysts couldn't find the cash flow, they settled for the business model to legitimize the industry. Instead of looking at net income, calculated as gross profit minus operating expenses, analysts concentrated on gross profit. If the gross profit was high enough, analysts theorized, the cash flow would come.

Business Model Components

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. Gross profit is often considered the first line of profitability because it only considers costs, not expenses. It focuses strictly on the way in which a company does business, not the efficiency of management. Investors that focus on business models are leaving room for an ineffective management team. They believe the best business models can run themselves.

Comparing Business Models

As an example, assume there are two companies and both companies rent movies. Prior to the internet, both companies made $5 million in revenues and the total cost of inventory sold was $4 million. Gross profit is calculated as $5 million minus $4 million, or $1 million. Gross profit margin is calculated as gross profit divided by revenues, or 20%.

After the advent of the internet, company B decides to offer movies online instead of renting or selling a physical copy. This change disrupts the business model in a positive way. The licensing fees do not change, but the cost of holding inventory is down considerably. In fact, the change reduces storage and distribution costs by $2 million. The new gross profit for the company is $5 million minus $2 million, or $3 million. The new gross profit margin is 60%, which is much higher than 20%.

Company B isn't making more in sales, but it figured out a way to revolutionize its business model, which greatly reduces costs. Managers at company B have an additional 40% more in margin to play with than managers at company A. Managers at company A have little room for error.

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