Analysing a Business Model

Rajendra Desai, XIME, 2009

4 groups of business decisions

• Revenue Sources• Key Expenses• Investment Size• Critical Success Factors

Rajendra Desai, XIME, 2009

Revenue Sources

• How many different revenue streams will the business model generate ?

• What is the source of each revenue stream (sales, service fees, advertising, subscription)

• What is the relative size and importance of each revenue stream ?

• How fast is each revenue stream likely to grow ?

Rajendra Desai, XIME, 2009

Cost Drivers

• What cost drivers have the greatest impact on the cost structure ?

• Are the costs fixed, semi-variable, variable or non-recurring ?

• What is their relative size and importance ?• Will the cost drivers change with time ?

Rajendra Desai, XIME, 2009

Investment size

• How much cash is required to launch the business model ?

• How much working capital is required to sustain the business ?

• What are the timings of these cash needs ?• Will the cash expended produce a viable

business entity ?

Rajendra Desai, XIME, 2009

Critical Success Factors

• Which elements of the business model are most important to achieving it’s profit goals ?

• Which of these elements are the most difficult to execute ?

• Will they change over time ?

Rajendra Desai, XIME, 2009

Starting point of Analysis

• Balance Sheet / Income Statement and Cash flow statements – actual or pro-formas.

• Other sources of information – mission statement, business overview, strategic goals, operating principles obtained from annual reports / press clippings / media kits.

Rajendra Desai, XIME, 2009

Steps in the Analysis

• Uncover the revenue drivers – that is key factors influencing the total revenues

• Determine the cost drivers• Determine the total investment required to achieve a

positive cash flow position• Plot the cash flow vs time graph to generate a cash

curve. This curve will illustrate the maximum financing needs and the timing to positive cash flows and cash breakeven.

• Perform a sensitivity analysis to understand the critical factors that have the greatest impact on the cash flows

Rajendra Desai, XIME, 2009

Revenue Streams• Single Stream – from one product or service• Multiple streams – from different products with

each revenue stream being sizeable enough to have an impact on profits.

• Interdependent – sells one product to stimulate revenues from another – razor – razor blades / printer – ink cartridge

• Loss leader – one stream from multiple streams loses money but drives traffic to spur other purchases (some grocery stores will sell a popular frequently bought item below cost )

Rajendra Desai, XIME, 2009

Revenue Models

• Subscription/ Membership – fixed amount at regular intervals

• Volume / Unit based – price per unit• Advertising based – end user pays nothing or a

fraction of the cost of the products / service• Licensing – one time fee• Transaction fee – fixed or % of total value of

transaction

Rajendra Desai, XIME, 2009

Focus of Revenue Model Analysis

• Revenue Streams – kind of revenue stream ; if loss leader revenue stream how likely are the losses to be covered by other revenue streams.

• Revenue Model - is it a single or hybrid revenue model ?- In case of hybrid which are the underlying revenue models ?- How fast will the revenues increase ? Any barriers ?- How long does it take to collect cash after a sale ?

Rajendra Desai, XIME, 2009

Rajendra Desai, XIME, 2009

Revenue Model of The Grateful Dead

Revenue Streams Revenue Drivers

Concert Revenue # of Concerts

Revenue / Concert <<<<<<<< # of Tickets

Price / Ticket

Total Revenue Merchandise Revenue # of Concerts

Revenue / Concert <<<<<<<< # of Attendees

Revenue / Attendee

Recording Revenue Albums Recorded

Revenue / Album <<<<<<<< # Albums Sold

Revenue / Album

Cost Drivers

• Any factor that affects the total costs – usually vary with time or output.

• 4 types of cost drivers :• Fixed – no variation with volumes – rent/taxes / salaries• Semi-variable – payroll of a supermarket where they need to

maintain a min number of employees but need to scale up as sales volumes increase.

• Variable – change proportionate to volumes – ex. Commisions.

• Non Recurring – infrequent or irregular costs like property or equipment purchase.

Rajendra Desai, XIME, 2009

Cost Structures• The dominant cost driver of a business model usually characterises the

overall cost structure.

• Common cost structures :• Payroll Centered (direct) – Semi variable employees costs directly involved

in the output of the firm – consulting firms / investment bank.• Payroll Centered (indirect) – Fixed employees costs indirectly involved in

the output of the firm – insurance agencies.• Inventory – Automobile firms / jewellery retailers – primary costs in

inventory of raw material or finished goods.• Space / rent – high costs of space rentals – restaurant in prime locations• Marketing / Advertising – to retain – draw customers ; internet content /

websites.

Rajendra Desai, XIME, 2009

Focus of Cost Driver Analysis

• Cost Driver :• Is the business model’s cost based on primarily fixed, semi-

variable, variable or non-recurring costs ?• How much volume can be supported with the fixed cost

base ? How likely is a reduction in the fixed cost base of the firm ?

• Are the primary cost drivers expected to change over time ?• Cost Center :• What are the largest cost centers for the business model ?• What is the relative size and importance of each cost center ?• Do any of the cost centers deliver a strategic cost advantage ?

Rajendra Desai, XIME, 2009

Rajendra Desai, XIME, 2009

Cost Structure of 7-11 Japan Cost Centers Cost Drivers

Cost of Goods Sold Price/SKU # of Suppliers Inventory Turns

Information Technology Development Costs Implementation Costs Maintenance

Total Cost Payroll Head Office Payroll Employee/Store Daily Wage / Employee Facilities Square Footage / Store Price / Square Foot Marketing / Advertising Advertising Cost / Store Company-wide Spend

Investment Size

• Maximum investment size is the amount of cash required before the company achieves a positive cash flow – depends on revenue model, cost drivers and critical success factors.

• Cash flow diagram gives :• Maximum financing needs – depth of the cash trough ; over

what period is the investment required.• Positive Cash flow – at what point does the cash flow turn

positive ? How long does it take to reach this point ?• Cash breakeven – when does the firm achieve cash breakeven

? How does the slope of the cash curve change after breakeven ?

Rajendra Desai, XIME, 2009

Examples of Investment size

• Software – large upfront investment – small investment in sales, customer service are required to capture a large revenue stream if the product is successful.

• Retail – large lease- rent, inventory and payroll costs require consistent financing needs over time.

Rajendra Desai, XIME, 2009

Critical Success Factors

• Operational function or competency that the firm must posess to be profitable and sustainable.

• Use sensitivity analysis on revenue and cost drivers to determine which are the most important factors affecting the amount and timing of cash flows – these are the critical success factors

Rajendra Desai, XIME, 2009

Examples

• Subscription /membership – ability to retain customers over a long period of time / acquire new customers at a low costs / consistently increase the share of wallet of old customers.

• Transaction based – command a price premium without much increase in costs, exploit economies of scale to lower costs as sales increase.

• Advertising based – maintain revenues during low economic periods

Rajendra Desai, XIME, 2009