Types of Business Models
In business there are four distinct business models. Just about any business can be identified with one of the four. The following are the four types of business models:
- Low-Volume, Hi-Margin
- Hi-Volume, Hi-Margin
- Low-Volume, Low-Margin
- Hi-Volume, Low-Margin
No single model is the best or the worse. Each works in their respective industries. In general, the models exist by default and it is highly improbable that you can move your small business into another one of the types without changing the particular business sector/industry. An illustration is appropriate.
Wal-Mart is by far the most significant retail player in the world-wide market. They control about > 11% of all retail. They definitely follow the Hi-Volume, Low-Margin model mostly out of default. All of their competition uses the same model. There is no way that Wal-Mart can shift their model to Hi-Volume, Hi-Margin format. Their customer retention would fall dramatically if they raised their prices. But, this model works with this particular industry.
At the other corner sits Boeing. Here, it is low-volume with a hi-margin. Nobody is going to mass produce huge airplanes; it literally takes several years from start to finish constructing an airplane. Quality control is a cornerstone of their business and even a little error can cause huge repercussions. They could go to the low-volume low-margin section but the overhead costs would cause the company to lose money. If this happens, they would go out of business. Out of necessity, this type of industry exists using this model.
Some businesses lean more towards one of the four but may have elements of two of the business models within its structure. It isn’t as if every business has to fall distinctively within one of these four types. But some bleeding over exists between two of the types is rare not the rule.
The following sections below explain the four types of business models and provide examples of businesses that use this model. In addition, this article elaborates as why the model is successful in the respective industries and that no single model is absolutely the best.
This part of this article is detailed and very lengthy. I’m sorry, but I’m not a part of the instant gratification generation that believes complex problems can be solved with simple solutions. This article is educational in nature and thus, the reader should avail himself to this to ensure a full understanding of the four types of business models.
Low-Volume, High-Margin Business Activity
An extreme example of this type of business is a shipyard. Imagine how long it takes to build an aircraft carrier. In reality, it takes a little over 8 years from start to finish. Prior to laying the keel, there are several years of engineering and material requisition requirements to build the carrier in an efficient manner. Then there is the construction period and the testing period before final delivery is made to the Navy. In effect, one product taking 8 years employing several thousand workers has to cover its share of the overhead and profit for the company. To do this, the final product may have hard costs of materials and labor that is half of the final price charged to the Navy. The bulk of the sales price has to cover all the equipment used, facility costs, general overhead, licensing (the government just doesn’t let anyone handle nuclear material), taxes, and a host of other costs to run a shipyard.
The following are more examples of low-volume, hi-margin businesses:
- Aircraft manufacturing – Boeing
- Heavy Equipment manufacturing – Caterpillar, Komatsu, Hitachi & Volvo
- Military Equipment manufacturing
- Large Industrial/Commercial Contractors – Bechtel, Fluor & Kiewit
- Heavy Transportation – shipping lines, railways
- Engineering Design/Build Companies
- Metal Fabrication
- Marine Fabrication/Construction
- Home Construction/Remodelers/Renovators
There are certain business attributes that force the industry to exercise this model. They are:
- Significant initial capitalization (financially, perseverance, knowledge)
- Almost all work is project based and requires extended time periods to complete
- Highly complex interactions and resource management
- Little competition
Notice that in this model, although it is a low volume company, the term reflects the physical quantity, not the dollar value. Go back to the shipyard, an aircraft carrier is ONE item (low volume) but the sales price is nearly $6,000,000,000. That’s billions of dollars.
In small business, it is really the same concept. For construction, it is ONE house, but it is an expensive item. It is the only way that a company can cover the indirect and overhead costs associated with running a construction company. For more information involving the details of a construction company profit and loss statement read: What is a Reasonable Profit in Construction?
Now on the flip side of this are industries that have high volume and high margins.
High-Volume, High-Margin Business Activities
Absolutely this is the preferred type of business model to have due to the contribution value both extremes bring to the company. But these types of companies are not as common and often have significant capital barriers to start operations. Mostly they are in the professional services industry such as law, accounting, engineering, and in some of the medical specialties. In general, the margins are in the 40 to 50% range. This is mostly attributable to variable costs as the primary cost. The following are some other examples of these types of businesses:
- Coffee Retail/Coffee Supply
- Software Manufacturing
- Entertainment (Music Albums, Movies, Videos, Games)
- Hospitality Based Businesses (Hotels, Motels, Golf Courses etc.)
An example of a large company with a high margin and a high volume is Apple. The I-Phones costs less than $250 to manufacture and get to market. Retail prices run in excess of $500 for the device. Apple sells nearly 100 million units per year. This is a rare business model that has driven the stock price off the charts.
This type of business model is ideal. Typically in these types of business models, the overhead and capitalization costs are higher than other models. This is mostly attributable to the marketing and advertising budgets. Often the marketing and advertising costs easily exceed the differential with the low-volume high-margin industries. In addition, competition is keen as others seeking to enter this type of business model seek the same high margins this model provides. In effect, competition is keen.
Another factor necessitating the high-margin requirements relates to higher than normal fixed costs. In many of these types of operations, fixed costs are recorded in the overhead section of the profit and loss report and therefore are not a function of cost of sales.
High-Volume, Low-Margin Business Activities
This type of business model is traditionally seen in the retail and other consumer based product businesses. The following is a list of businesses that use this model:
- Convenience Stores
- Gas Stations
- Grocery Stores
- Fast Food Restaurants
- Retail Outlets
- Transportation (Bus Lines, Distribution, Taxis, etc.)
- Service Based Operations in More Discretionary Income Dependent Areas of Business
- Nail Salons
- Hair Salons
- Massage Parlors
An interesting business attribute is the low capitalization threshold to enter the market. I know, a lot of you are saying that it does take a lot of capital to get into any of the above. But in the spectrum of capitalization across the various types of business activities, these businesses are on the left hand side of the curve. The low-volume high-margin operations are at the extreme right side of the spectrum. Think about, it takes a tremendous amount of money to construct a shipyard.
One last interesting fact about these types of businesses; this is most common form of business in our consumer based society. This reflects several business attributes:
- Easy entry for small business
- Low capitalization barriers
- Low knowledge thresholds
- Many support systems
- Reduced government compliance requirements
In this type of model, the gross margin in absolute dollars is a direct reflection on volume. Competition is significantly keen. The best example of this are gas stations. In general, most gas retailers only have about an 18 cent contribution margin per gallon of gas sold. When the station down the street has his price 10 cents lower, he is really trying to garner market share that week.
By the way, the number one company in the world using this business model. You guessed it: Wal-Mart.
Based on this, you would think that it would really be tuff in your low-volume, low-margin business activity. Why would anyone get involved in that type of business model? Let’s find out.
Low-Volume, Low-Margin Business Activities
This one is the most interesting of all the business types. With low-volume low-margin operations the reader would wonder how on earth you would make a profit. Well, it turns out that there is another way to look at the equation. Less experienced business entrepreneurs always think in terms of margin as a percentage of sales. Experience and a little more sophistication teaches us that it is really about the absolute dollars. Which would you rather have?
- Sales of 200 units in one day at 18% margin or
- One unit at 13%?
Answer: It depends on the sales price. Assume that in A, the sales price is $7 per unit which means that we have sales of $1,400 and the dollar contribution margin is $252 (this is your high-volume, low-margin business model). OR in B, the sales price is $14,000 with a contribution margin of 13% which is $1,820.
I’ll take the $1,820. What industries fall into the type of model? Typically your household goods and high ticket items follow this model:
- Auto Retail
- RV Dealerships
- Marine Dealerships
- Appliance Sales
- Jewelry and Luxury Goods Retail
These industries typically have higher overhead costs and compliance related costs. Since buyers of the product are rare, advertising becomes a significant portion of overhead costs. Just watch TV for half an hour and about a 1/3 of your commercials relate to the local auto dealerships trying to convince you they are the best.
The negative attribute of this model is the higher than normal risk associated with acquiring customers. Any reduction in market share can wreak havoc with the financial profitability of the business.
Summary – Types of Business Models
Some businesses will fall in the marginal areas of one or more of the models above. A good example is a furniture retailer. In general, furniture has a high margin with low volume. But many furniture outlets try to shift their model towards higher volume with lower margins; thus the constant bombardment of advertising from them with their endless sales.
Overall, each of the models described above works for particular industries. The shear nature of the industry forces their hand into the respective model. When you think about your business, which model do you fall into? Act on Knowledge.
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