We start businesses for various reasons. At the core of all the different reasons is a solution to a real problem that customers face. One popular checklist to use if you want to start a business is;
- Which problem are you trying to solve?
- Is there money in that problem?
- Can you scale the solution?
Once your idea meets these three conditions, then the chances are high that your business will succeed. All companies need to make money, not only to enrich the investors but, more importantly, for sustainability purposes. This is key in the early days when challenges are aplenty, and resources are required to bail you out of challenging situations.
Let us take a minute to focus on the second question above, as it defines what a revenue model is. Do not start a business and hope to make money, as it can determine if you succeed or not. We will dive deep into revenue modeling for businesses and highlight a few popular ones in this piece.
Read on;
What is a Revenue Model?
This is a framework businesses use to generate income. It helps companies identify where they are supposed to make money, which is vital for sustaining the business. The model gives business leaders a clear sight of their revenue generation strategies and fits into the larger business model. It is deeply tied to the niche the business operates in and the type of products and services it offers to customers. Companies can have multiple intertwined revenue models, especially if they provide various products and services. Regardless of the number of models, the individual ones tied to specific products and services should be easily identifiable.
How is a Revenue Model Different from a Business Model?
It is easy to confuse the two, especially when you find people using the two terms interchangeably. A business model is a holistic way to describe the way a company generates value for its customers.
A revenue model is a subset of the business model and focuses on how the company gets the money. Customer segments can have multiple revenue models.
The critical difference between the two lies in the terms “value” and “money.” Note that value is not always tied to money in some applications, especially if you consider some of the activities that a business engages in that do not directly affect revenue.
An example to differentiate the two is Uber. The business model here is arranging carpooling opportunities without owning any cars. People who own cars and those looking for a ride meet on this platform. Billing is done on the app based on multiple metrics such as the distance, cost of fuel, car, and location, and the passenger picks a payment method. It is automatically debited once they get to their destination. The driver has to register with Uber, subject to a couple of requirements to uphold the quality of drivers and cars.
The revenue model is viewed in the context of this larger business model, which is broken down. The company charges a basic fare plus an amount per kilometer and an additional amount per minute. The different price models come in with the cars’ variations, i.e. UberX, UberBlack, and UberVan. Note that these variations change from country to country, depending on the most common mode of transport used there. In addition, the company offers additional services such as UberEATs, UberCargo, and UberRideshare, among others. These outline the services that form the supplementary revenue models. 20 percent of the fare goes to Uber, and they are kept fluid and can increase when the demand is high.
The business model is holistic and contains aspects such as the key partners who are the drivers, technology enablers, and investors. Key resources are the skilled drivers and their platform. The value proposition to customers is minimum waiting time, lesser taxi fees, cashless rides, and transparency to see the price and route beforehand. The value proposition to drivers is an additional source of income, flexible working hours, easy payment procedure, and prompt payments. Customer relationship is done through social media, customer support, and review system. The customer segments are the drivers and users.
From this example, it is evident that the business model is a more extensive framework onto which the revenue model is a part. It is critical to understand how these two intermarry to each other, as it helps avoid confusion and make the right decisions. While a revenue model is important, it should not be king, as the business model is the bigger thing. All the different parts of a business model have a role to play and always approach them correctly if you want to succeed.
Why is a Revenue Model Important?
A revenue model is just a part of the whole business model, but why is it so hyped. Well, one can argue that if a business gets other things right, customers will buy.
This model gives a focused view of the activities that help generate income. Most of the other aspects of the business model take away money from the accounts in a business. The customers are the ones who only bring in money. If you separate the business model components such as marketing, resources, legal, IT, and corporate affairs in two columns depending on which ones bring in money and which ones take out, you will see the point. Sales might be the only side that brings in money.
Since the revenue model is probably the only one with a credit entry in the business model, it helps pay extra attention. The growth of many businesses relies on the revenue it brings, amongst other factors. The more money, the easier it is to get the best IT systems, hire the best personnel, and get a more extensive distribution network, to mention a few.
All the activities and processes of a revenue model should be singled out to help the business understand the crucial factors that feed into the model. In some cases, the model might not be working optimally due to internal and external factors, and some work should be done to improve them.
Lastly, a clear revenue model helps control any unnecessary costs that can limit business growth, especially for startups.
See also:
Top Business Revenue Models
Subscription
Here, a business charges a recurring fee for its products and services. The charges can be on a monthly or annual basis. It is popular among SaaS companies, thanks to its versatility and “guarantee” of recurring revenue plus high value. Note “guarantee” is singled out since it is not always the case. Done well, this model can be an excellent way to build sustainable growth, as one can easily forecast revenues in a financial year based on the number of active subscriptions.
In legacy business models, revenue flows from marketing to sales and then finance. However, the flow is different in subscription models. All the other units still hold their roles, but implications on interactions with customers are felt. Customers do not need to be “won’ once, but through all the different billing cycles. With the right plan, businesses can lock in customers to lengthy billing cycles which “guarantees” incomes.
The advantages of the subscription revenue model include easier forecasting and better revenue expansion opportunities. A good example is Netflix, where the business can easily predict income based on past customer behavior and the probability of churning the service. Once a customer is locked into a basic plan, you get the chance to showcase the value and up-sell the package for more revenue. That way, you can get additional income from a customer without spending on acquisition. Lastly, subscription models foster better customer relationships since there is a loyalty aspect to them. A customer will have a positive brand affinity to one they’ve subscribed to and continue to get value from.
One downside of the subscription model is the increased competition and uncertainty in the opening phases. The increased competition can increase customer churn rate since they are spoilt for choice and can easily switch to the competition. As a result, businesses now have to demonstrate value to keep customers constantly.
Markup
This is a straightforward business model where a company buys products at price X and sells them at a higher price Y. The difference between X and Y should be enough to cater to costs and return a sustainable profit. It can be applied to both products and services, and you will find multiple variations of it today.
The most common difference between markup models is the wholesale and retail versions. For wholesale, the business sells to retailers, business users, or other wholesalers. It can be supplied to other companies in bulk, often at a lower markup due to the volumes involved. The retail version involves identifying demand and satisfying it through a set distribution channel.
Succeeding in the markup model goes down to a delicate balance needed to get the correct markup. If it is too high, the chances are high the competition will opt for other players offering goods at a lower price. If it’s too low, your costs will eat up into most of the markup, making your business hard to sustain. This way, always do your homework to determine what markup is perfect depending on your costs, niche, and competition.
Advertising
This model allows businesses that can reach customers to leverage that and make money from it. Online advertising has burst this scene opens, and today, even small companies that operate in other niches can leverage some of their channels to make money from advertising. A good example is the Google Development Network, which places advertisements on multiple websites and sites like YouTube, and the returns are split between the owner of the video or website and YouTube.
Some traditional advertising agencies owned spaces in strategic places such as billboards, digital signage, and display screens. Other companies can rent the space to showcase what they have to offer.
Advertising is a considerable facet of marketing, and the demand for spaces where businesses can reach customers is high. As long as you can show how much reach and the type of engagement your channels have, you are almost guaranteed of getting people to rent these channels. Some businesses run advertising as their primary revenue models, such as online and offline media houses, content sites, and influencer-led pages. Others use advertising as a way of complementing their primary revenue model, where they have other products and services but still use their channels for advertising other products.
The advantage of this model is that online marketing has made it accessible to just about any business, and with the right plan, a business can reap huge rewards from it. The downside is that the competition is increasing, and businesses that are not traditional advertising houses face tough times deciding if the people offering to rent their channels can negatively impact their brand. If a customer had a bad experience with a brand and saw their advertisement on your channel, they can extend the experience to yours, even if you had nothing to do with it.
Production
This is a traditional revenue model that can have different twists to it. Here, the business creates a product or service and then sells it to the customers. An example is a company that produces soft drinks by sourcing the raw materials, running them in a factory, packaging, and selling the drinks to customers. Note that customers can be other businesses or regular customers at a retail level.
The two different types of the production revenue model are the manufacturing and construction types. Manufacturing has been mentioned above, where a company produces finished goods using labor, materials, and equipment. Revenue is generated by selling the finished products to other manufacturers, wholesalers, or retailers. Manufacturers can sell goods directly to end-users but generally do not, as managing the supply chain is a whole different thing, and they prefer to specialize.
The construction model is the other twist to the production model, and here, it involves making real estate. It differs from the manufacturing model since it involves making a structure in a specified location for a known client or speculatively for the real estate market.
One advantage of this model applies if you invest deeper down the value chain. Production is no easy fit, as you rely on external forces that control the raw materials. If you can get down the value chain, where you own the raw materials, it gives you a considerable advantage over the competition.
The downside is that running this model is a bit capital intensive.
Licensing
This revenue model allows a business to generate income by allowing it’s copyrighted or patented material to be used by another company. Some standard products include songs, images, or technology. The seller retains complete control of the copyright of the product and service. It is commonly confused with the subscription business model, but they are different.
The main difference between the two is that subscription runs for a fixed period, whereas licensing runs in perpetuity until one party terminates it. A typical example is computer software, where companies enter into licensing agreements with the owners to use them.
A key component of licensing is the agreement which outlines the terms under which a party might use the property owned by the other one. The term property can refer to multiple things, but here, it leans towards intellectual property such as patents and trademarks for this context. The agreement specifies all the granular details under which the licensing parties may use properties.
Licensing revenue model is a great way to commercialize inventions and excellent products, provided they can offer value to customers.
Commission
This is a model where a business acts as a middleman between the seller and buyer and earns a cut of the amount sold. It applies both in traditional and online business models, with the latter becoming very popular.
The middleman helps to get the word out about the product and service, using their resources and claims a percentage of the amount once someone in their network makes a purchase. Traditionally, it was used by real estate agencies that connected buyers and sellers. Here, a seller would list their property with the agency and then pay them a percentage when someone buys it. Here, the model made financial sense since the transactions were few and involved large amounts of money.
In the online world, commission revenue models can be applied to products that do not cost a lot of money, and businesses can try to move large volumes for them to get a sustainable amount of money. The marketplace model is another twist to the commission revenue model, where sellers list their goods and services, and the marketplace owners get a percentage of the amount sold.
The advantage of the commission model is that businesses can attract more suppliers and connect them to potential buyers. As long as the platform is well maintained, the business makes money without producing anything.
The downside is the value perception of the buyer and seller. The seller knows they will make less selling through the commission business, and if you do not offer them enough value, they can find a way to interact independently and complete the transaction. As a result, commission-based businesses should always find a way to give value to both parties to keep them from leaving.
Freemium
This is a model where a business offers both free and premium models. It is challenging to work with since the premium features should be alluring, and the free ones should be good enough to convince customers to upscale.
An example is Dropbox, which offers free resources and requires you to pay for additional ones if you wish to upgrade.
One advantage of this model is that the free features are catchy and grab the user’s attention at first glance. You can leverage them to build a steady customer base and gain trust.
The challenge, however, is to convert the free to premium users. You need to strike a balance between giving them just enough to upgrade to the premium plan. Giving out abundant resources for the free plan will keep users happy in that tier and keep them from upgrading to the paid ones.
Donation
This revenue model is on the rise, thanks to the online community that continues to appreciate value. It is common for nonprofits, independent news outlets, and online media, among others. Here, the entity offers value for interested audiences and, rather than charge them for it, asks for them to donate and support operations.
Some companies using this model incentivize donations by making members who donate part of an exclusive club where they receive additional exclusive content. This helps to lock in the regular donators, which guarantees the company a small recurring revenue stream.
What Costs are Associated with Revenue Models?
A good revenue model is not about getting the most out of customers but also offering value. This way, the revenue model cannot be unidirectional, as the business has to incur some costs to sustain it. Once you establish all the costs, it is easier to do the mathematics and get an optimal price for your products or services.
Cost of Revenue
This is how much it costs to produce the goods and services. It depends on the revenue model and the type of goods and services sold. It can comprise testing, manufacturing for software; this could be the development cycle, cost to get resources such as cloud storage and hosting environments. Regardless of what you produce, overheads will always come into the picture. The cost of revenue is often confused with the cost of goods, but the former is a comprehensive metric that gives an accurate picture. SaaS companies commonly use it where every other cost outside the traditional production line has to be accounted for.
Labor Costs
You need to hire experts to help you get a product or service to market, which adds to revenue. An underpaid workforce is unhappy and might not go all out to ensure you get the best version of the product or service out there. It all varies on the people involved in different phases of the production period.
Equipment Costs
Traditional production lines have to spend a lot on equipment, compared to modern SaaS companies that can get resources on demand. However, equipment costs still factor in and include app development tools, space on servers, and firmware. Additional services include subscription services bought to manage the production line, such as Slack, Trello, or Hubstaff. These are arguably the most straightforward costs to forecast.
Prototyping Costs
This is a fundamental and expensive part of any production journey. Testing a product or beta version of the software is critical as it can trigger massive changes in the entire production process. Some changes are recorded once significant strides have been made in the process, and reversing this can take a lot of resources. The costs usually include a base level cost and iteration costs. When planning for these costs, it is advisable to plan for several iterations as you won’t get everything right the first time. Customer needs always change and new things always come up, and if you stay rigid, the competition will get ahead of you.
Advertising and Marketing Cost
For any product or service to sell, you need to take it to market. Here is where advertising and marketing costs come in as they raise awareness about the product or service and try to sell the value to customers. These costs vary significantly, with some of the factors that determine how much you will spend here include; the size of the respective teams, the scale of exposure you need, and the method you will employ. A more comprehensive marketing campaign including digital, radio, TV, and print will cost more than a highly targeted digital one.
How to Pick the Best Revenue Model?
The revenue models listed above are by no means exclusive, as new ones keep on coming up. Some businesses combine the defined ones and borrow features to create combinations that work for them as well. It is advisable to stay alive to the changes affecting your revenue model and innovate to either improve or generate new revenue models.
Some things to keep in mind include;
Address Real Painpoints
Think of the solutions you offer customers as either painkillers or vitamins. Painkillers address real pain, whereas vitamins supplement and are nice to have. Assess whether the solution you offer addresses a real customer pain point. This is the only way to build a sustainable revenue model. It is easy to get carried away with your ideas and technological processes and forget the buck starts and ends with the customer. Aim to base your revenue models on customer pains, and you will get good returns from it.
Understand the Market
As a business, you operate in a whole ecosystem with multiple players and do extensive market research. First, establish the profile of your customers and make a revenue model based on what they prefer. Understanding the market also entails looking at the competition as the chances are high that other businesses offer a similar solution to yours. Interrogate your solution objectively and see how it sits within the competition and the whole ecosystem. From here, you will understand the strong points you can leverage and potential loopholes that will derail your revenue model.
Let the Product Lead
In most instances, the product dictates the best revenue model for it. Knowing this is as important as understanding the market. If you have a collection of software products, would opting for the subscription model be the better option. Look at how the product compares to the competition and its feature set, as these are what solve the pain points. For products that are not straightforward, consider partnerships you can take advantage of to bring it to the market.
Be Ready to Change
The business world is changing, and we have witnessed drastic shifts that have forced companies to reinvent their business models, let alone the revenue models. As a result, do not be rigid with the model as the unexpected will always happen. You can start with a subscription model and then see opportunities in the affiliate model, offering additional returns. The bottom line is that you should be ready to shift the revenue model and bring in additional ones that can complement revenue or even change the entire model.
Frequently Asked Questions
Question: What is the difference between revenue and profit?
Answer: Revenue is the total amount of income generated by the sales of goods and services to customers. Think of it as gross income. Profit is the amount of money obtained after deducting costs, debts, and any business expenses.
Question: What does a typical revenue model include?
Answer: A revenue model is a structure that expounds on how the company plans to earn money. It starts by specifying the value proposition to customers, the plan to generate money, the actual sources of this money, and the target customers who will consume the products and services offered.
Question: What is the best revenue model for startups?
Answer: A good revenue model helps your business remain sustainable and leaves some to fund your scale process. As a result, some traditional one like production might be capital intensive in the first few years until you achieve economies of scale. Modern models like affiliate and commission-based are less capital intensive and won’t require much to set up and run.
Conclusion
Some of the standard revenue models are listed here and do some due diligence before selecting one. Note that a revenue model is at the heart of the larger business model and will help you grow or not. Do not be stuck in the past and strive to innovate and improve the model as the competition will do the same, and you do not want to be surpassed.
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