Business Modeling – Why and How

Have you ever wondered how to quantify the impact of decisions you might want to consider for your business but just weren’t sure how to get your hands around it?   Sure, most of your day to day decisions are pretty straight forward.   For example, when a supplier’s prices go up you can respond in a variety of ways but you will first consider the pros and cons of each possible action.  Or, think about a time when a key employee asked for a raise.  Again, a number of things went through your mind before you made a decision.   I’m sure you reflected on how loyal that person has been and how good a job they have been doing.  But you probably also considered whether he/she had been getting better at their job, i.e. becoming more efficient and productive, if the person is a good “team player”, and if he/she figured in your plans for the future of the company.

The act of considering truly strategic decisions requires similar due diligence.  The difference is that strategic decisions have bigger ramifications on the business and on you.  And, it is often more difficult to measure the impact of a strategic decision because it may affect many aspects of the organization that aren’t as obvious as the examples mentioned above and also because there are usually more unknowns that require assumptions to be made before a result can be determined.

The idea of creating a quantitative model for strategic planning and decision making becomes appealing because it provides an opportunity for business leaders to see just how a decision would impact the business using a model not the business itself.   And, because it is a model, a user can test decisions with many different sets of assumptions about the unknowns in a process called “what if analysis”.  It’s like a game and by playing it the user can eventually determine an optimal course of action before the critical decision is actually made.  Having the ability to do that may well spell the difference between success and failure in meeting business goals and your own personal goals.

What kind of decisions might a business owner make where a business model would be helpful?  Here are a few examples.

  • Should a new product line be added or, conversely, should one be eliminated?
  • Should the company seek to expand into other markets, domestic or foreign or, should it get out of markets it is currently in?
  • How will an investment in technology affect company value?

So, how does one create a business model?  The model itself must reflect the way the business works and include all the interrelationships that are inherent in it.  And, it must provide opportunities for a user to test various assumptions about conditions or situations that affect it.

Models are often created in a program such as Microsoft Excel because they are based on the quantification of the business.  The bigger the business the more complex the model usually is.  The act of creating a model in itself can be very enlightening to a business owner because it defines interrelationships in the business that may be significant but that are not always obvious.  For example, a company that has multiple warehouses my not realize the true cost of its inventory.  Or, receivables that have been granted to some customers may be costing you more than you think.  There are many issues and relationships that will be defined and brought to light in creating a model.

The first step in creating a model is to find someone who has expertise in creating business models.  The person may already be on staff or you may need to bring someone in from outside.  Then, let the person ask questions of anyone about how things really work in the business.  This is where an outside person can often do best because he/she brings no pre-conceived ideas.   Then let the person create the model.

Here are some features of a good business model that are essential:

  • Historical data for 2-4 years is ideal because it helps define trends
  • The model should start with the identification of non-financial metrics like; number of clients, productivity per persons (e.g. number of widgets / person / day, etc.)
  • The identification and incorporation of the company’s key operational and financial metrics
  • The ability for a user to test assumptions about those metrics and any and all of the non-financial metrics
  • A summary report that shows inputs and results in terms of sales, gross and net profit margins, cash flow, key financial ratios, etc.

If you like to know more about business modeling and how it can help you, contact me at dcasebere@b2bcfo.com.

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