Managing Business Model Risk

The different elements of a business model – revenues, costs, profits, cash flows and investments – should combine to generate a sustainable competitive advantage. As Mullins and Komisar mention (“Getting to Plan B” Hard Business School Press, 2009), a business model must deliver something that is crystal clear and which customers value. A business model must imitate other comparable and well functioning business models but should also be innovative and different where it matters. The starting point is a clear and credible customer promise.
The different business model elements must work seamlessly. Often different parts of the organization focus on different elements revenues, costs, cash flows. As a result, decision making becomes disjointed.
An equally important aspect of managing business model risk is flexibility. When the future is uncertain, planning cannot be perfect. Indeed, too much planning and fine tuning can lead to distraction and loss of focus. Most plans are born out of initial enthusiasm, hope and assumptions rather than hard evidence or data. That is why the initial plan often fails for most entrepreneurs. It is the entrepreneurs who can quickly realize the problems with the current business model and move to Plan B and later on to Plan C that ultimately become successful entrepreneurs.
According to Mullins and Komisar, an effective approach to managing business model risk has four ingredients – Analogs, Antilogs, Leaps of faith and Dashboards. Analogs refer to successful companies which are worth mimicking. Antilogs are companies that serve as reference points for how to be different. Instead of starting from scratch, by studying analogs and antilogs, business risk can be greatly minimized. Unfortunately, all the information needed for a new business/project cannot come from analogs and antilogs. This is where leaps of faith come in. These refer to crucial beliefs and assumptions made while starting the business. These beliefs and assumptions need to be tested by a process called dashboarding. Around the assumptions, hypotheses must be created and tested using metrics. Dashboards help in focusing the company’s attention on critical issues and ensuring that precious resources are focused on removing the critical risks. Dashboards also represent a way of systematically responding to the real life data the company generates.

Managing Investment Model Risk

The investment model refers to the money needed to enter the business and sustain the operations of the company till it achieves breakeven cash flow. Risk can be reduced by minimizing the upfront investment required. According to Mullins & Komisar, (“Getting to Plan B” Harvard Business Press, 2009) a few key questions must be addressed while managing investment model risk:
§ What are the hard assets – facilities, equipments, needed?
§ What are the development activities that must be completed before launching the product/service in the market place?
§ What are the investments that can be delayed or eliminated?
§ How much revenue and gross margin will the business generate to contribute to the ongoing costs?
Raising money is usually difficult. So the less the money the business needs, the better. Venture capital comes at a price. Venture capitalists are quite likely to demand their pound of flesh. For a small contribution they may demand a high equity stake in the start up. So the investment model must be built carefully to avoid an overdose of the capital. At the same time, the capital base should not be so small that the company runs out of cash before the operations stabilize.

Managing Working Capital Model Risk

Working capital is the cash a company needs to keep its business running. This includes paying for raw materials, making salary payments, etc. To assess working capital model risk, , a company must examine carefully both its current assets and current liabilities.
Current assets include cash, cash equivalents, accounts receivable and inventory. Current assets represent money that is available to the company.
Current liabilities include accounts payable and short term debt. Current liabilities represent the organizational commitments that the company will have to meet in the near future, typically within one year.
The difference between current assets and current liabilities is nothing but the working capital. Capital has a price. So the better the company manages its working capital, the less external capital it will have to raise. If a business can manage with little working capital, it is a great situation to be in. A few key questions must drive working capital model risk, according to Mullins and Komisar (“Getting to Plan B”, Harvard Business Press, 2009).
§ How can customers be encouraged to pay quickly?
§ How much inventory must be maintained to run the business effectively?
By keeping working capital needs low or negative, a company can put itself in an enviable situation. On the other hand, heavy working capital needs add to the business risk.

Managing Operating Model Risk

A key ingredient of business risk is operating costs. These are all the costs that must be incurred in addition to COGS. If these costs are not kept in check, the company can go bankrupt. There are some key questions which must be addressed while managing operating model risk according to Mullins & Komisar (“Getting to Plan B” Harvard Business School Press, 2009).
§ What level of cost as a percentage of sales must be incurred in the different cost categories?
§ What costs can be reduced or eliminated completely?
§ What costs may have to be increased to make the business strategy more effective?
In many industries, there are various costs that can be eliminated simply by doing things differently. On the other hand, in a few industries, where the customers want the very best, costs may have to be increased to maximize customer delight. The use of technology to automate processes, minimize human error and reduce labour costs is a popular theme in operating model risk management.

Managing the Gross Margin Model Risk

Gross margin is nothing but the difference between revenue and cost of goods sold (COGs). COGs include all the expenses directly related to producing or delivering whatever it is that a company sells. Other costs are excluded from COGs. To assess the gross margin model risk, the following questions must be addressed:
§ How large is the spread between the price and COGs?
§ How should the margin be managed across the product line?
§ How sustainable is the gross margin?
Ref : John Mullins and Randy Komisar , “Getting to Plan B”, Harvard Business Press, 2009

Managing Revenue Model Risk

No business can sustain itself without generating adequate revenues. According to Mullins & Komisar( “Getting to Plan B” Harvard Business Press, 2009) a few key questions need to be addressed while assessing revenue model risk:
§ Who will buy?
§ What will they buy?
§ What pain is the business resolving for the customers?
§ In what way is the business delighting the customers?
§ How soon, how often and how much (many) will customers buy?
§ What is the price the customers are prepared to pay?
If a business is not solving a customer problem or adding to customer delight, revenues will be difficult to sustain. Revenue projections must be made carefully. The business forecast must be compared with that of comparable companies. Assumptions must be validated by building hypotheses and testing them using all available data.

Understanding Business Risk

Business risk refers to the probability of a business not being able to sell its products and services at a price which is sufficiently remunerative. The world of business risk is less amenable to quantification, compared to financial risk. Business risk often lies in the domain of the strategists where as financial risk lies in the purview of the treasurer/chief risk officer/chief financial officer. While business risk is less quantifiable, efforts should not be spared to understand it properly. A framework provided by John Mullins and Randy Komisar (Read their book “Getting to Plan B” Harvard Business Press, 2009 for more details) is very useful in this regard. According to Mullins and Komisar, five ingredients make up a business model:
§ Revenue model – Which customers will buy the company’s product and at what price?
§ Gross margin model – What proportion of the revenue will be captured by the company after deducting the cost of goods and services (COGs).
§ Operating model – Besides COGs, what are the other costs incurred by the company?
§ Working capital model – How much working capital is needed to run the business?
§ Investment – What are the upfront commitments which must be made to build and run the business?

Understanding business risk

Business risks refer to the risks a company willingly assumes to create a competitive advantage and add value for shareholders. These are the risks which arise in the design, development, production and marketing of products. In other words, business risk refers to the uncertainty about the demand for a company’s products and services. Some of these risks may arise due to internal factors while others may be due to the environment.

Risks arising due to internal factors include:
§ Product development choices
§ Marketing strategies
§ Organizational structure

Risks emanating from external factors include:
§ Macro economic risk
§ Competition risk
§ Technological risk