Business Model Risk

From Open Risk Manual

Definition

Business Model Risk is the risk that competitors of a firm operating in a given Business Sector will develop alternative business models for delivering similar or equivalent goods or services. Also informally denoted as Disruption Risk when in extreme form. Business Model Risk is one of the components of Franchise Risk (along with Political Risk).

Identification Framework

A summary description of business model risk identification framework on the basis of [1]

1. Component 2. Description 3. Properties 4. Risk Profile
Customer Segments Customer Segments are the different groups of people or organizations an enterprise aims to reach and serve The customer segmentation is an internal attribute of the business model (Competitors may be segmenting the market differently). A key aspect of each Customer Segment is it size (number of clients). Another key aspect is the purchasing power (sometimes called wallet size) or related indicator of economic status of the Customer. Another attribute with possible relationship risk implications is the sophistication of customers (financial literacy, general knowledge of the products / services they purchase). A given customer segmentation becomes a risk when it no longer optimally reflects the realities of the client base or how the internal structure of the firm matches that client base. The impact of a such a mismatch will be downstream as ineffective or inappropriate distribution, reduced product appeal etc, which will ultimately impact revenue. Changing customer behaviour and expectations can be for a variety of reasons. For example changing demographics or economic factors. Assessing the risk of an unsuitable segmentation requires analysing current and historical patterns of client behaviour and expectations.
Value Proposition Value Propositions are the intrinsic properties of products and services that create value for a specific Customer Segment. Value Propositions have both quantitative attributes, such as price, speed of service) and qualitative ones, such as design, customer experience, novelty, brand name, effectiveness, performance and customization. The value proposition is defined per customer segment as different segments will be experiencing the product or service in different ways. Almost always the price aspect is a key contributor to the value proposition. Further, the Value Proposition is typically relative versus alternative offerings. The fundamental relationship is that higher value proposition leads (other things being equal) to more sales and revenue. As per business plan, there is an expected level of value that accrues to the customer using the product or service. This is established e.g., in pre-launch client surveys. The risk is that the actual value proposition delivered declines seriously or does not materialize, leading to loss of clients or inability to attract new clients.
Distribution Channels Distribution Channels are the means by which a company communicates with and reaches its Customer Segments to deliver its Value Proposition. Communication, distribution, and sales Channels comprise a company’s interface with customers. They require investment to setup and are optimized to meet a given Customer Segmentation. Distribution channels are expected to be available and operational as per business plan. The risk is that distribution channels become ineffective and do not fulfil their objective (even while requiring running costs to maintain).
Customer Relationships Customer Relationships describe the types of ongoing interactions a company establishes with specific Customer Segments. This business model component recognizes that in many cases the interaction with clients is not an instant and anonymous transaction (as it is for example in a trading business model) but is instead an ongoing process. The types of customer relationships include approaches such as: Personal assistance, self-service, automated service, communities, or co-creation. Customer Relationships are supported by company processes and are contributing to the Cost Structure. Relationships enable or enhance client acquisition and retention thereby contributing to the Lifetime Value of the client (See Revenue Streams). They contribute also to the Value Proposition for customers. For example, trust and loyalty to the brand or status of the firm is an aspect of the customer relationship and loss of such trust can severely impact the business model performance. Better customer relationships will in general lead to more clients and revenue. As per business plan a certain set of Customer Relationships is expected to be in place (supported by Resources and Activities). Risks associated with customer relationships: Internal of External factors affecting negatively the relationship so as to prevent it from serving the intended purpose (Reputation damage, Poor Performance); Unexpected Cost increases in supporting the relationship
Revenue Streams This component captures all financial rewards (expressed in cash or otherwise) that a company generates from each Customer Segment. Revenues may be in the form of lump-sums from sales, regular fees etc. Revenues have a natural decomposition into sales volumes (number of clients) and revenue per sale (number of products sold, revenue per product etc). A metric that is commonly used to capture revenue in a comprehensive way is Customer Lifetime Value which attempts to cumulate total profit from the lifetime of the client relationship As per business plan the revenue stream is expected to be sufficient to cover all costs and provide for a profit margin. Deviations from that expectation (rendering the firm unprofitable or even insolvent) constitute Revenue risks. Revenue risks materialize through missed sales targets (volumes) or inability to maintain prices.
Key Resources Key Resources are the company assets and liabilities required to implement a certain business model. These resources allow an enterprise to create and offer its Value Proposition, reach markets, maintain relationships with Customer Segments, and earn revenues. Resources can be owned or leased by the company or acquired from key partners. A formal (but certainly not exhaustive) catalog or Key Resources is captured in the ”balance sheet” of the firm which is a snapshot of what constitutes the company (stock) at any given moment. As per plan there is an expectation that a list of required resources are in place and contributing as intended to the execution of the plan. Resource linked Risks emerge as realization that those expectations are not met.
Key Activities While Key Resources are a snapshot of what constitutes the firm, Activities are akin to a flow description of the firm. Activities capture the main processes that must be in place to make the business model work. Activities include research and development, production, marketing, sales, service provision, maintenance, support etc. As with Resources, ceteris-paribus, more and higher quality Activities support more production and ultimately more revenue. As per business plan the expectation is that there are in place adequate Resources to enable the Activities required and those perform as expected in the course of planned period.
Key Partnerships Partnerships is the network of suppliers and partners that help make the business model work. Companies create alliances to optimize their business models, reduce risk, or acquire resources As per business plan, there will be a list of partners that are expected to be providing critical resources or activities. Risks associated with partnerships involve unexpected developments that deviate from the plan
Cost Structure The Cost Structure describes all costs incurred to implement and operate a business model. Costs are required for creating value using Resources and Activities, delivering value via Distribution Channels and maintaining Customer Relationships. A business model will involve a mix of diverse cost elements: Customer Acquisition Cost (abbreviated to CAC) refers to the resources that a business must allocate (financial or otherwise) in order to acquire an additional customer (this includes research and marketing costs); Fixed Productions Costs that are known a-priory (at least for a certain period) such as fixed salaries, rents, operational costs with agreed price levels etc; Variable Production Costs that are not known a-priory and can be linked to market variables, production volumes, variable remuneration components etc. As per business plan, there is a projected expected cost structure that takes into account current and historical observed cost levels. A primary risk factor associated with the cost structure is that variable costs will be larger than expected. In turn higher variable costs may be depend on higher compensation levels due to labour market conditions, external market prices for resources or services etc.
Competitors Competitors is the set of all external organizations that operate or have the potential to operate in providing competing Value Propositions to Customers Competitors may operate under similar or distinct business models. They may have substantially different track record, resources, partnerships, distribution channels and customer relationships. The key metric linked to a competitive landscape is the market share of each participant, but the net profitability of each is also an important metric. Competition increases the risk profile of any given business model by stressing practically all business model elements. An existing level of competition and corresponding market share distribution must be incorporated in the business plan as per expectation. Uncertainty is linked to adverse (for the firm) developments in the ability of existing or new competitors to increase market share or operate more profitably.

Regulatory Expectations

In the context of the financial services sector, supervisors do not look solely at capital adequacy at a single point in time, but rather they assess banks’ business models and whether or not their profitability is stable enough to support safety and soundness. To understand and analyse banks’ conditions, most supervisors conduct Business Model Analysis as part of their supervisory review process.


Issues and Challenges

  • The challenge of defining business model risk stems primarily from the lack of common definition of what constitutes a Business Model but also characterizing the precise impact of market conditions and the competitive landscape.
  • Business model risk is frequently defined too narrowly (as earnings / revenue risk) which does not permit a deeper analysis of the relevant risk factors

See Also

References

  1. Open Risk White Paper: Identification Framework for Business Model Risks, Jan 2016

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