This is Professor Michael Rappa from North Carolina State University in Raleigh, North Carolina. And I’m here to speak with you about my course, Managing the Digital Enterprise.
If you were to take a second and go to a major search engine such as Google, and search on the phrase “business models,” you would see just how popular this term has become in recent years. The concept of the business model is indeed a very important one. But the term itself has grown and been used in many different ways. You see it discussed in literature, in the popular press. But at the heart of it, it really comes down to the very basic notion of understanding and defining how it is that an organization creates a sustainable revenue stream that generates a profit.
Depending on the industry we look at, business models can be either very simple, or rather complex. Business models become more interesting when we see new and different kinds of combinations of relationships between a business and its upstream suppliers and its downstream customers.
When the commercialization of the web began in earnest in the mid 1990s, the question of business model was something that, I think, came more to the forefront, because the web offered up new kinds of business opportunities. And so as those businesses emerged, they had to ask the question: how is it that we’re going to make money in our ventures on the web? And part of the unfortunate downside of the dot.com boom was that as people got caught up in the frenzy of doing something on the web, they spent less and less time thinking clearly through how it was that their endeavor was going to create a sustainable revenue stream.
Now when we think about the generic ways in which businesses can make money, I think that there’s a relatively limited set of combinations that have evolved over the years. Now with the emergence of the web, I don’t think the web, in and of itself, invented new or entirely new ways to make money. But it opened up opportunities for some models to evolve faster than others had in the offline world. It also just sort of added a new twist to well understood ways of organizing business.
And so it’s important to recognize that in all the years of business, a lot of ingenuity has gone into how does one make money in a particular endeavor. And I don’t mean here in terms of a unique product or unique service, but rather how one structures that business relative to customers or suppliers that is unique or different. There’s not much new under the sun there.
But having said that, the web does offer up interesting opportunities to add a new twist on an old business model, or to allow business models to evolve in interesting and different ways.
Now a few years back, I sat down and tried to think about what might be considered a taxonomy of generic business models based on my understanding of a wide variety of businesses across many different industries. And the purpose here was just to try to generalize and see what that set would look like.
And that was really the genesis of the web page on Managing the Digital Enterprise, called Business Models on the Web. What you see there is a taxonomy which was developed and has evolved over the last decade or so, that tries to describe generic business models and provide examples of different organizations on the web that are pursuing these kinds of approaches to generating revenue.
Now within each one of these generic models, I think there is a lot of creative variation, in terms of how a particular business might structure itself. And I think there probably is opportunities for an unlimited amount of variation within these genetic models. And so the web doesn’t lack any creativity when it comes to how businesses seek out to make a profit. However, I think that it is possible to generalize in relatively broad categories based both on what is going on on the web, but also a century or more of how businesses have sought to make money.
It’s also very important to recognize that when we look at various organizations on the web or off the web, especially large businesses, what we see is normally a combination of various business models. An organization – a Fortune 500 firm – is typically going to make money in a number of different ways across its various product or service mix. And so it’s not appropriate to think of a business as having a single business model. And usually we can see a variety of ways in which they structure their business. And one might consider business strategy really being exactly that decision: what business is it that I’m in, and how do I structure the business model across that range?
So what are these generic categories of business models? Well if you look at my web page on the subject, you’ll see that I break it down into nine categories: brokerage, advertising, infomediary, merchant, manufacturer, affiliate, community, subscription, and utility models. And I go into some brief detail on the basics of each of those. And clearly there could be a lot more to be further elaborated within each. But you’ll see within each of those generic categories, there are kind of subsets of variations on that theme.
Well let me just take a few of these business models and talk about them. And hopefully, through that conversation, we’ll get a clearer sense of what we mean when we talk about a business model. Let me start with the brokerage model. Brokers are essentially market makers. They bring buyers and sellers together to facilitate a transaction. If we look at any economy, we see brokering literally everywhere. And we even call certain people in certain industries, brokers, whether it’s stock brokers or insurance brokers.
There’s an enormous need within an economy, within the marketplace, to help buyers connect up with sellers. And what makes the brokerage model work is that brokers charge a fee or a commission for each transaction that they enable. And what’s interesting about the brokerage model is that relationship between the broker and the buyer and seller can vary across a wide range of formulas, in terms of how a fee is structured.
So sometimes we see, for example, the buyer pays the broker fee. In other instances, we see the seller paying the broker fee. Sometimes it’s a combination of both the buyer and seller paying the fee. In some instances, the fee is a percentage of what’s being transacted. In other cases it’s a flat fee. And sometimes it’s a flat fee and a percentage. And so you see here there’s just a myriad of ways in which brokers can set up their relationship between the buyer and the seller. And so brokerage models can vary between businesses within a particular industry, and across different industries, in terms of how that relationship was, in fact, structured.
Now what’s most interesting, I think, about the brokerage model when it comes to business on the web is that the web is inherently suited for brokerage. That is large numbers of buyers can be connected up with potentially large numbers of sellers, taking advantage of what is most powerful about the web, its network structure that enables people to connect up with each other relatively cheaply.
And so for this reason, it’s not surprising then that one of the most important businesses to emerge early on on the web was Ebay. Ebay is essentially a broker. And initially, it set up that relationship between buyers and sellers in an auction format. That is it allowed buyers to bid on what sellers were offering. But it’s evolved over time. And now it sells things fixed fee as well. So the important point here is that essentially what Ebay does is that it connects up buyers with sellers. That’s at the heart of it. Now the beautiful thing about Ebay is that it can connect up large numbers of buyers with large numbers of sellers relatively inexpensively. It’s really using the leverage and the power of the web to do what the web does best.
And what’s attractive about Ebay is that its relationship between buyers and seller is as a kind of distant third party in all of this, that is it doesn’t get into a lot of the complications that can normally occur when people are transacting goods and services. It’s really acting simply as a third party in this process. It doesn’t take possession of goods and services. And early on, it didn’t even guarantee anything, in terms of buyer or seller satisfaction. That’s evolved over the years, because they’ve gotten involved in payment processing via the acquisition of PayPal. It’s gotten more intimately involved in the buyer/seller relationship, and in guaranteeing satisfaction to some level.
But the real beauty about most broker models is simply that the broker is focused on one thing and only one thing. And that is bringing the buyer and seller together to consummate a successful transaction. And to the extent that that occurs, the broker walks away with a commission and very little overhead.
Now let me contrast Ebay with another well known organization, and one that we’ve talked about: Amazon.com. So when we think about Amazon, we’re really looking at here – at least from the early years – what we would call a merchant model. And a merchant is simply a wholesaler or retailer of a good or service. And typically we see in the economy, retailers all around us. And these are normal storefront businesses.
And what’s important to recognize about a retailer is that it’s typically someone who invests in an inventory, stocks an inventory of products, and then sells those products downstream. Maybe it’s to end consumers if it’s a retail storefront or what have you. But the key here is that a merchant is taking a certain amount of business risk. They’re buying an inventory. Maybe it’s apparel. Maybe it’s books. Maybe it’s CDs. What have you. They’re taking a risk, typically, with the investment in that inventory, and then turning around and attempting to sell that inventory at some markup.
In some retail businesses, the markup is relatively thin. And in other businesses, it might be more significant. It all depends on the price of the goods, and also the volume that the business is doing. High volume businesses tend to have lower markups. But the key here is that the merchant is taking a risk.
Another important aspect of the merchant model is that the merchant is intimately involved in distribution. They’re taking in the front end from suppliers. They’re handling product. They have to store product in warehouses. And then they have to mix and match that product to customer orders, and ship. And so the merchant model is really quite involved. I mean it’s not a simple business to be in.
And when we think of the example of Amazon.com, which is trying to manage the so-called world’s largest selection of goods, you can imagine the size of the warehouses that Amazon is dealing with, the complications involved in managing the supply chain, in terms of creating that inventory, having the right inventory, given what customer demand is. When customers place orders, putting that order together. All of this really adds cost to the merchant model.
And when we look at Amazon relative to Ebay, we can see how one business model is really highly leveraged when implemented on the web. In the case of Ebay, where you’re able to accomplish a lot at very low cost, and the Amazon merchant model as being fairly high cost and laden with complexity, that helps us explain why Ebay was really profitable from the very start. And Amazon, given its huge investments in its business, has in much of its early history generated losses, or at least a very difficult time generating a profit on its investments.
Now that’s not to say that Amazon can’t be a profitable business. It has shown that it can generate a profit. It’s just a much more complicated business, logistically, to manage. And the cost overhead can be quite high. And therefore, the profit margins are going to be less than what we see in an Ebay type situation.
Another important generic business model is advertising. And advertising is a very common feature of various kinds of media through much of the last century. So whether we talk about print, newspapers and magazines, or the migration of advertising into radio and subsequently television, it’s really no surprise that when the emerged, one of the things that businesses viewed as a possibility – especially content-driven businesses – was advertising. You know here the basic idea is that I can support various kinds of content-driven businesses – let’s say it’s a newspaper – by seeking out businesses that will pay to place advertisements somewhere within the content. And so we see this, of course. Everyone understands how this works in various media like radio and TV. Someone produces content that it thinks people will find interesting to listen to or watch, and then they make money off of that content by placing advertisements somewhere within it. And this has been a very successful model. And a lot of entertainment is driven basically by advertising.
Now there’s been an evolution over the years. And it’s interesting to look at how advertising has evolved on the web in particular. The key to understanding what’s interesting about advertising and its migration to the web is that for the first time, people recognized that you had an opportunity to understand a whole lot more about what effect the advertising was having on the viewer, on the potential consumer. And what I mean by this is that for the first time, a banner advertisement on a particular web page is something that not only a potential consumer could see, but that the mere action of clicking through on an advertisement was now recognition that the advertisement had captured somebody’s attention, their interest, that they were potentially now someone who was in the market to buy whatever the good or service that was being advertised was.
And so there was an enormous amount of interest right from the start that said – wow, advertising now is moving into a new world where the relationship between what it is that we’re trying to sell, and how we’re trying to sell it, is much more closely connected to the reaction that a potential customer could have as part of this process in which advertising occurs.
Now early on, advertising on the web was met with an enormous amount of skepticism. And it didn’t take long for people to recognize that the banner advertisement, that image that goes on the top or the bottom of a web page that we saw all through the mid 1990s, was not a very effective tool, that the click-through rates declined rapidly, to the point where maybe they became invisible to most viewers. They didn’t pay attention to them.
And in the desire for them to generate more attention, advertisers went in the wrong direction and made advertising even more annoying, and created blinking banners, and all kinds of things to try to distract the viewer. I think we’ve come a long way since then. And advertising has really moved in two important directions: one, the basic image type advertising has evolved to become much more sophisticated with a so-called “rich media” that is more likely to attract people’s attention without actually being annoying to them, through various kinds of new technologies. Also, I think that the adoption of many different formats within this kind of advertising helps a lot. So we have some larger images. We have lots of smaller images. And that’s been an important part of the evolution to make it more palatable, I think, to the web audience.
But the other main direction has really been the most important part of the evolution in advertising. And this is really what’s been done by companies like Google, and Yahoo, and others. And that is the so-called paid placement approach of advertising within search, and also the placement of search links, or advertising links, within various kinds of websites. So in the Google case, this is the ad words program on the one hand, which one can bid on various search terms on the Google site, and then the ad sense program on the other hand, which places links on partner websites based on the content of those websites.
And of course link advertisement is very unobtrusive. It’s almost invisible, to the extent that a web user can pay attention to those links, or not pay attention to those links. The key thing though is that the links are being generated based on the content of the page, much more tightly coupled to the content. And so the notion here is that a company like Google, with its partners, is basically able to offer up advertising links – links that are paid for in those placements – that are more closely coupled to what the viewer is actually interested in, or maybe looking for. And so there’s a much greater degree of potential effectiveness there.
And then you have all of the other benefits wrapped up together, in terms of being able to examine very closely the effect that the advertising is having in terms of actual click-throughs, and all the things that we talked about in the earlier module on metrics. So although the advertising business model has sort of gone through some fits and starts on the web, today it is becoming an extremely important part of how businesses generate revenue. And again, it’s important to recognize here that the advertising model is relatively synergistic with other things. And so we see businesses marrying together a collection of business models, in which advertising tends to fit fairly well with some of the others we’ve seen.
Well the fourth model I want to call your attention to is called the subscription model. And subscriptions, of course, are things that we have all seen before, well before anything having to do with the web itself. The basic notion here is that the customer is charged a periodic fee, whether it’s daily, or monthly, or annual to subscribe to a particular service. And subscription is a very important facet of the internet, because we’re seeing more and more things which were formerly products, things that were sold to the customer as a product – and in particular in the area of software, like various applications sold as products installed on your computer – are now starting to transition quite rapidly to services.
And those services are built upon a business model of subscription. So instead of buying a piece of software and installing it on your computer, you subscribe to a piece of software, and pay some kind of periodic fee to have the benefit of using that application. And so there’s a lot of interesting economics involved in that, that make one approach more profitable than the other. But we’re going to see more and more of this.
Now what’s interesting about subscription is that a subscription in fees can occur irrespective of actual usage rates. And so a person who subscribes to a service can use that service a lot, or use it a little. And depending on how that subscription is set up, the subscription fee itself doesn’t change. And having customers on a subscription, from a business point of view, can be a very attractive thing, because you can see and predict very clearly your revenue stream in the future. You know how many subscribers you have. You know what your subscription fees are, and you can project out a revenue stream.
Of course, it works in the other direction as well. If your subscription base is beginning to decline, you can see your declining revenues out into the future, much more clearly than, for example, if you’re a merchant model or a broker model. What’s most interesting about subscription models on the web is that we’re seeing businesses, industries which had been structured with different business models in the offline world. Now all of a sudden subscription is becoming possible as a business model.
And so the great example here is with DVD rentals. So the DVD rental industry was pretty much owned by Blockbuster in the offline world. And you had a kind of rental fee per DVD, or per video in earlier years. And as the web came along, you have companies such as Netflix come into play, who took the opportunity to say – you know, we can create a business around DVD rental, which is built around subscribers, as opposed to per video, or per DVD rental charges.
And so Netflix has come along, and it’s created a very interesting approach to being able to watch DVDs or watch movies, by saying there’s a monthly subscription fee, and for that monthly subscription fee, you can have in your possession up to x number of DVDs in your home. And once you’re done watching one, you can send it back, and will send you a new one from your cue.
And if you take a close look at Netflix, you’ll see that if offers some very attractive facets to its relationship with that customer that the traditional model of a Blockbuster was unable to do. And we’ve seen Netflix grow very rapidly into a fairly popular business on the web. And it’s certainly worth taking a close look at that as a case study. At the same time, Blockbuster’s business has eroded quite rapidly as people have decided that per video rentals is really a fairly painful way to engage in that kind of a service.
So if we look at brokerage with Ebay, or the merchant model with Amazon, or advertising model with an organization like Google, and subscriptions in the case of Netflix, we can really begin to understand how business models have migrated onto the web, how some unpopular business models have now become extremely popular, how certain business models have really benefited and leveraged from what the web does well into creating profitable businesses. We can see that there’s a lot of excitement in this field, that there’s a lot of ingenuity going on, in thinking through what business models really resonate well.
I think it’s safe to say that we’re going to continue to see an enormous amount of creativity with respect to business models as we continue to expand business activities on the web. And so it’s a very exciting area to pay close attention to, and certainly the case studies I’ve talked about here are all worthy of closer examination. They’re all works in progress, to some extent, in trying to discover what the best formula is, what the best mix of business models are that will make a successful overall strategy for business on the web.
Certainly there’s a lot more that we could talk about in this regard. And I think I’ll leave that to another conversation at some future time. But I encourage you to look very closely at what’s going on in these businesses, and ask yourself – how is it that they make money? What kinds of generic approaches are they taking? What kinds of business models are they marrying together in their overall business strategy that’s yielding them better success or less success, depending on what the case may be? And to look at how business models are evolving, as businesses learn more and more about their customers, and the way in which they want to structure these relationship via the web.
This is Professor Michael Rappa. Thank you for listening, and best of luck with your studies.
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Unedited transcript of audio podcast produced on September 27, 2005.
Audio source file: https://digitalenterprise.org/podcasts/business_models.mp3
Michael Rappa is the Alan T. Dickson Distinguished University Professor of Technology Management at North Carolina State University.
For more information, please visit: digitalenterprise.org
Copyright 2006 Michael Rappa. All rights reserved. Please do not reproduced, distribute or quote without written permission of the author.