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Business and Strategy

How does a business work?

Updated on · By Ahmad Nasrudin Tag:

How does a business work
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The way a business works is basically adding value. They do this by processing inputs into higher-value outputs. Next, assume the business produces goods, and you are the owner.

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Starting a business

At first, you decide what to produce. You then organize and make decisions about resources, including how to pool and organize them. Some you may have to buy, such as raw materials. Others you may be able to rent, such as machinery and buildings. To do it all, you need capital.

Your initial capital may come from your personal pocket or contributions from your family or friends. Or, you apply for a loan or raise funds from other external sources such as crowdfunding. For external funding sources, you should create a business plan to convince fund providers to be willing to put their money into your business.

You also design how the business operates. For example, you have to determine what business structure you run, whether a sole proprietorship, partnership, or limited company. Then, you organize operational activities into various business functions such as human resources, operations, marketing, and finance.

Operating a business

Once operational, your business converts inputs into outputs. We call this transformation process a production activity. For example, it could involve converting raw materials into final outputs or intermediate inputs.

Once the output is complete, you sell it to consumers in the marketplace, referring to physical locations such as stores and non-physical locations like e-commerce channels.

As compensation for sales, your business earns money. Your business uses it to hire employees, pay input suppliers and pay interest or pay off debt. Your business distributes the rest to you as dividends and holds it as internal capital (retained earnings).

Building a competitive strategy

Competitive strategy is about how you can outperform your competitors in serving consumer needs. If successful, your business makes more money, generates above-average returns, and gains a competitive advantage.

How do you compete? There are two alternative strategies:

  • Differentiation. Your business creates value by offering something unique. It can involve tangible aspects like design and features and intangible aspects like branding. Uniqueness makes customers willing to pay a premium price. And your business earns high margins.
  • Cost leadership. Your business focuses on a lower cost structure than the industry average. You offer a standard product at a price slightly below or at the industry average. Although pricing is relatively similar to competitors, your business earns higher profits because it operates more efficiently.

How does your business achieve a competitive advantage? The two key factors are resources and capabilities. Both form your business core competencies if scarce, create value, and are non-substitutable, which in turn sustain your business to gain a competitive advantage.

  • Resources represent the assets you own. If your business has special, unique assets and little or no competitors, it can underpin your competitive strategy. Examples are intellectual property, brand equity, and company reputation.
  • Capabilities refer to your business’s ability to maximize existing resources. It is inherent in your business organization, such as innovation culture, leadership style, and organizational agility. Unlike resources, competitors find it difficult to imitate your business capabilities because they are not documented as procedures.

Growing business

When you are just starting a business, your goal may be to survive. You are trying to keep operating. After success, now is the time to grow the business.

How to grow a business? There are four alternatives, considering the market and product you are targeting. They are:
  • Market penetration. You focus on existing products and markets. You are trying to increase your market share and customer base, for example, through increasing promotions or lowering prices.
  • Market development. You are targeting a new market for an existing product. For example, you sell it to a foreign market. Or you target the closest market segment.
  • Product development. You develop a new product for the existing market. For example, you can launch complementary products to existing products, or you can introduce new variants.
  • Diversification. You develop new products and target new markets. Both can be related to your current business – called concentric diversification. Or, it can be completely unrelated – called conglomerate diversification.

How can you do the alternatives above? There are two strategies:

  • Organic growth. You rely on the internal resources and capabilities of your business. It could be by opening a new factory, expanding distribution channels, increasing promotions, or establishing a subsidiary. We also call this strategy an internal growth strategy.
  • Inorganic growth. You combine what your business has with what other businesses have. It can be by taking over another business and making it a subsidiary. Or you merge with another business and leave one surviving entity. Alternatives are through joint ventures, licensing, franchising, and strategic alliances. This strategy is also known as an external growth strategy.
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