You could think of there being three business models. At one end is the supply of expensive, boutique, products to customers who are willing and able to pay more for the extra quality. This is the High-end Model. Then there is the supply of the normal products in the market, neither expensive nor cheap, the Standard Model. And finally the provision of the lowest cost, lowest price, lowest quality products to those customers who are either unwilling or unable to pay more. This is the Low-cost Model.
Strictly speaking, these are actually three price-points, not business models. Behind the price of sale is a cost to the company of buying, transforming, and then selling the good. In the High-end Model, that is a higher cost, which in turn means higher quality, explaining why the customer is willing to pay more.
The Standard Model has mid-range costs and quality, and the Low-cost Model has the lowest costs and quality, as might be expected.
Thus, to build our business models we actually have three data points for each model. There is the maximum a customer is willing to pay, then somewhere beneath that there is the price at which the company sells, and somewhere beneath that there is the cost of providing the good, from the company’s point of view.
Value Sticks, or customer Willingness To Pay (WTP) Sticks, are often drawn to visualise the three data points.
WTP, Price, Cost
The WTP is the maximum theoretical value the customer sees themselves as getting from a product (note that this is not always the same as the value they are actually getting…). If the Price were equal to the WTP, then a customer would be indifference to having the product or the amount of money in their pocket, as the two are equal.
A Price higher than the WTP would stop a customer from buying the product. As the Price moves lower away from the WTP, the customer is left with more value after the transaction; if Price = WTP the customer has no value, just indifference.
The more value a customer keeps after paying the Price, the more they value the product, the more customers there will be. So, the lower the Price, the more the value to customers, the more customers, the more sales.
The other relationship that drives the model is that between Price (of sale) and Cost. If a company’s Cost in providing the product is on par with the Price it sells it for, then however many sales are made, no profit is generated. Profit for a company is Price minus Cost. As Price moves upwards away from Cost, profit is generated.
This creates a continuous tension for a company. It wants to lower its Price in order to create more value for customers and therefore create more customers, but at the same time it wants to raise its Price to increase the profit per sale. Some simple maths will show a company where exactly the optimal point is for maximising profit- this is about the Price Elasticity of Demand.
The question to ask is whether a company’s resources and customers match the business model it has chosen. It is a question of alignment. A Low-cost Model is premised upon large numbers of sales, which means that large logistical support is required to physically get the product out there, as well as there being a large number of customers in existence, hearing about the product, needing or wanting to buy it within the timeframe required, and so on.
A High-end Model means making a better quality product than the market incumbents, and customers believing that to be true. The alignment issue here is whether your new company has resources allowing it to make something better- not only technically, but in a customer’s eyes also- than the incumbents. “Better” might mean a range of things, like more tailored, faster, more choice- but note that all of these usually cost more.
Assumptions
There are a number of assumptions behind these models. Most obvious is that value to a company is the cash profit in the near future. You might want to operate at a loss, or without profit, for some time to establish market share. Another is that high quality necessarily means high costs; progress is premised on driving the frontier of the cost-quality trade-off outwards. And a third is that customers use financial value as the only measure of a good; brand, corporate image, and environmental concerns might turn that on its head.
As ever, you are free to pick your path through these ideas, but you’ll need some credible data to support whichever route you choose to take if an investor is going to go with you.