Operating Models

Different businesses adopt different business models in terms of strategies of pricing, volume and service being deployed.

• Walmart and McDonald’s have a Low Price, Low Margin, High Volume model. They sell products at a low price, their profitmargins are low and therefore they must generate high volumes(meaning they must sell a lot of products to a lot of people) toachieve profitability.

• The Ritz Carlton and Neiman Marcus have a High Price, High Margin and High Service model. Their prices are steep, but theyoffer exceptional service which requires high overhead costs. TheRitz Carlton will serve far fewer customers than a Holiday Inn,but they will make a satisfactory profit because of their highermargins.

• Most other models fall somewhere in between.

You must choose a model that best fits what you are offering and what your customers want. You also need to determine which key customers you will focus on. When you try to serve and please everybody, you end up not pleasing anyone.

Let’s look at Costco and Whole Foods to understand their models and financial performance.

For Fiscal Year 2014,Costco has annual sales of $113 billion while Whole Foods ismuch smaller, but still does a very respectable $14 billion.Costco prides itself in providing very attractive prices: hence itkeeps prices low, which result in a low Gross Margin of only 13%. Itmust therefore keep its Operating Expenses very, very, low at 10%. Thisleads to an Operating Margin of 3%. Because it has high sales / store, itsfixed asset / sales ratio is only 13%, which means that it generates $100of sales for $13 of fixed assets. Costco is an excellent example of a lowprice, low margin and high volume business.

Whole Foods provides high quality natural products at a relatively higher price. They earn a Gross Margin of 36%, but they also provide a higher level of service, which costs 29%, resulting in an Operating Margin of 7%. Because it has many smaller stores it needs $21 of fixed capital to support $100 of sales.

Both of these companies are profitable and do a good job meeting the differing needs of their customers. The point to be underscored isthat there are many ways to develop profitable business models.

Let’s look at one more example. Apple is mostly a hardware company, albeit an upscale hardware company. Its Gross Margin is 39%, but because it outsources most of its production, its Operating Expense is only 10%, giving it an Operating Margin of 29%. Microsoft, in contrast, is a software company with a high Gross Margin of 69% despite wasting a ton of money on its extraneous businesses. With its bloated bureaucracy, Operating Expenses are 37%, but this still delivers a very healthy Operating Margin of 32%.

One is a hardware company and the other a software company. Both find ways to serve their customers while making a lot of money in the process. The trick is to find the business model that will work for you, while deeply satisfying your customer.

Verinder Syal, Author:Discover The Entrepreneur Within

Written by Verinder Syal
Verinder is the Principal at Thoughtful Simplicity, an award-winning teacher at Northwestern University, and the author of Discover The Entrepreneur Within.