Although not everyone likes to talk about making money or generating revenue for the company, the fact is that every organization needs funds to survive, grow and develop. For this, we need customers who actually pay us and that’s where the business model comes in.
Before digitalization became such an important development, many companies used a transactional business model where the customer paid for the widget that the company sold, at which point ownership was transferred from the company to the customer. With digitalization, however, the relationship between the customer and the company often becomes continuous, as a consequence of which it’s less obvious how to monetize the offering.
In my experience, there are at least three challenges or complications many are unaware of when assuming a simple (or simplistic) business model: the monetization model, the elements included in the model and the flow of funds through the business ecosystem.
First, for the monetization model, especially with continuous models, there tend to be three main alternatives: subscription, usage and performance. The challenge is that even if you sign a contract with a large company, the number of seats in the subscription or the amount of usage may be quite limited, making it difficult to generate sufficient revenue to cover the expenses of creating and evolving the solution in the first place.
Second, especially for companies that used to sell predominantly mechanical products, it’s surprising to see how digitalization adds components to the offering. In addition to the continuous updating of the software in the product itself, there’s often a complementing cloud solution and mobile application that are part of the entire customer experience as well. Depending on the setup, the business model is a bundled one where everything is included in one fee, a freemium one where some features in the cloud and on the mobile app (and sometimes even in the product itself) need to be paid for separately or an unbundled offering where each part needs to be paid for separately.
Especially when it’s feasible to collect data from products in the field, many companies also offer their customers data-driven services that are separate from the product itself. The use cases can vary from predictive maintenance to fleet management to comparative services where customers can compare their performance KPIs to those of others. As these services aren’t narrowly connected to the product itself, they’re often easier to monetize. In fact, some companies are using the revenue from data-driven services to subsidize the price of the physical product and seek to achieve a virtuous cycle where more products get sold due to the more attractive price, generating more data to be monetized, allowing for lowering the cost on the physical products, and so on.
Third, even when the company is generating significant revenue from its offerings, the margins might be quite low or even negative. One reason might be that customers have demanded service-level agreements where significant clawbacks can occur due to underperformance of the offering. Also, partners and suppliers in the business ecosystem (or value network) may demand a significant part of the generated revenue.
A typical pattern is a setup where we need significant scale to become profitable as the fixed costs are considerable and need to be amortized over a large volume. Especially in companies that are used to scaling their traditional business in terms of manufacturing and procurement capacity, there’s often a tendency to scale well before product-market fit has been established for the new digital offerings. And, of course, the nature of digital technologies is that these tend to scale at very low cost, but the initial R&D investment can be quite significant.
I have an engineering background and haven’t bothered much with sales for most of my professional life, but I have an increasing respect for those who work with the issues around the business model and sales. Although not an expert, I feel three areas are important to discuss.
First, deciding on the business model is a hard and involved process that can typically not be done in an ivory tower inside the company. Especially when adding new digital elements to the offering to customers, experimentation with different models is often required to figure out what generates sufficient revenue at relevant margins. Frequently, this is concerned with the perception of customers of what you’re trying to get them to pay for. As an example, in most cases, charging a fee for services that are very close to the product itself isn’t accepted as customers feel this should be for free since they already paid for the product.
Second, there often is a need to balance short-term revenue versus long-term benefits. The term “lifetime value” of a customer is often used in this context. Finding the right balance between charging in the short term and not losing the customer the moment a cheaper alternative presents itself is incredibly difficult and often requires experimentation. Many companies I work with have learned the hard way that it’s much more expensive to close a new customer than to keep an existing one.
Third, especially in continuous models with significant digital components, there are network effects that can be exploited. This is often referred to as “growth hacking” where the team seeks to balance incentives for different stakeholders in the business ecosystem to reach the “ignition point” where the scaling of the business fuels itself, rather than requiring continuous investment and effort from the company. In my experience, everyone loves to have a network business, but getting there is incredibly difficult and the path is littered with companies that didn’t succeed with this.
Even if business models were easy at some point in the past when we were selling widgets and had transactional sales, they’re most certainly no longer simple in a digitalizing world. It’s easy to miss that the monetization model can include different mechanisms that have major implications on the revenue generated. There are also elements that are included in the business model that didn’t exist before, like cloud, mobile and data-driven services. And the flow of funds through the business ecosystem may result in low margins despite significant revenues. Instead, focus on experimentation when creating new business models, optimize the lifetime value of customers with careful balancing and seek out and exploit network effects when these present themselves. As Alexander Osterwalder said, “Once you understand business models, you can then start prototyping business models just like you prototype products.”