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This Simple Theory Is Behind Every Successful Business Model


A few years ago I was a hard believer that experience is the only thing you need and that theory is irrelevant. It might have been my arrogance or immaturity but as the time went on, especially during my MBA, I understood more about how theory helps you properly structure your thoughts and engage rules that are applicable to these structures.

As my consulting career evolved and I worked with more and more startup clients, the importance of using theory and its correct application to business models became critical. When you're thinking about launching a business and you're thinking about it in simple terms without applying certain definitions and frameworks, you're running a risk of not fully understanding or capturing all the details including some of the most vital ones. Let me illustrate what I mean by this.

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Image credit: http://www.amnh.org/exhibitions/einstein/ 

Let's say, you set up a business to sell Bluetooth headphones or similar type electronics online. Chances are you think about your business as something like this: my business model is selling products online. And then you go ahead and plan your actions accordingly. If you're lucky you'll raise some capital from your friends or relatives, build a website or create a store on a popular shopping platform and get going. You'll build a financial model that will most likely reflect rather traditional business planning figures and pretty soon you may find yourself running out of cash. Why? Because you failed to think correctly about your business. The right way to think about this specific venture is this: my business model is selling a commodity product online. After defining your business like that, a few things will become different in your approach.

When you're in a commodity business, a certain set of rules applies. Your margins are generally low, even if you're selling higher margin product categories (i.e. accessories in this case). But that's only the start. Because you're selling a commodity, your variable costs will be your biggest profit erosion component with the customer acquisition cost piece being the highest. Unless you're a huge brand like Target, Amazon, or similar company that sells commodities, you will have to consistently spend large amounts of dollars to convince customers to come to you and buy from you without generating much loyalty along the way. It will include constant targeting and retargeting, attracting shoppers with significant discounts and/or rebates, and the shipping costs will most likely have to be absorbed by you pretty much 100%.

Now that we cleared that piece out, let's talk about the major consequence of high variable costs – cash flow. When you build your financial model and forecast your transactions and cash, it's critical to understand that the high variable costs will be putting immense pressure on your cash flow. In my work with startups I consistently see entrepreneurs who forecast very aggressively by assuming that their revenues will be higher and the expenses will be lower. And it's ok when you don't have high variable costs but when you do – the more you sell the more cash you'll burn which leaves you with rather thin contribution margin to pay for your fixed costs.

There are a few other rules that would apply to this particular commodity business model case but I hope I was able to convey the point with the examples above. The best way to understand what you're getting into and plan in the best way possible is to actually understand what you're getting into but within a proper framework of concepts and rules. Although making basic assumptions and playing it by ear may still get you to success, it will take much longer and cost you a lot more money.

 

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