The genius’ opinion
To paraphrase the wise words of Albert Einstein “If you cannot explain it simply, you do not understand it.” In my opinion business is simple if you set it up to be simple. When things get too complex and we have too many moving parts, the risk of failure goes up exponentially. For example, every time a human is needed to perform a task in a business system, there is a 2% chance of failure. This 2% is just random human error, perhaps they misread a number on a page, perhaps they forget to push a button, or perhaps they were sick on a given day and didn’t show up to work. Anytime a human has to become involved in a business process, there is a 2% chance that the process will fail. If you have a complex system with 10 people involved, every time that system is executed there is a 20% chance that the system will fail. If you can automate 9 people out of the system then the human chance of failure goes from 20% down to 2%.
As a rule of thumb in my business, I like to have as few people involved as possible and as few moving parts as possible. Simplicity always wins over complexity when it comes to business.
To keep things simple, there are only two fundamental business models in the world. Every entrepreneur must make a choice between choosing:
- A Distributor Model OR
- A Production Model
The Distributor Model:
The distributor model is one of the fastest and lowest risk business models available. Distributors use other people’s goods and services and distribute them for commissions. Distributors produce virtually no products because they use other people’s products and many times, they can avoid tying up cash in inventory. Distributor model businesses have low capital requirements to start and because they require little capital, the risk is low as well. Since distributors do not get caught up in the production cycle, they can be very high velocity businesses that can make profit right from day 1. Distributors move product by creating and managing a sales force or distribution channel. They then market, brand and sell other people’s products through their channels and make sizeable commissions for moving product – the hardest work of all. Since these businesses are so light to start and they can often create cash right away, these types of businesses often require no financing or can quickly obtain financing because they have cash flow very early on.
Companies that use a distributor model are:
- Wal-Mart – The world’s largest retailer. Wal-Mart does not own the products on its shelves, the producers of the products own the inventory until Wal-Mart sells it. Once the sale is made, Wal-Mart takes it’s profit and the producers get paid. Wal-Mart is a retail distribution super giant that can dictate shrewd terms and prices to it’s suppliers and they are so large that they can get away with outlandish demands.
- McDonalds – McDonald’s restaurants are often independently owned by franchisees who distribute and sell McDonald’s products. When you own a McDonalds you sell their food, their marketing, their brand – not your own. The beauty with McDonald’s is, their food is recognized around the world and always in high demand. The stores themselves produce nothing, everything is brought it, cooked or assembled and sold.
- Virgin – Sir Richard Branson owns nearly 400 companies under the Virgin brand. Many of his companies are Venture Capital deals where other entrepreneurs approach Branson for funding and he invests in the entrepreneur with capital and licenses out his brand “Virgin” to stimulate sales. Nearly everything Virgin does from cell phone towers, airplanes, to cola is owned and outsourced to another company. Branson is a brilliant marketer and smart enough to stay out of the production business for the most part. He is the epitome of the “own nothing and control everything strategy.”
- Coca Cola – Coca Cola has one of the smartest business models in the world. They have a massive, timeless, exciting brand and proprietary sugary syrup that they sell to hundreds of smaller “bottling companies” around the world. Many of the smaller bottling companies have different strategies in different regions and operate on their own while purchasing the proprietary syrup from the mother company. Coca Cola has one of the best supply chains in the world and they can even operate in politically unstable areas because every distributor who touches the product along the way gets paid.
- MLM Companies – Amway, one of the world’s biggest Multi Level Marketing companies has a brilliant distribution model. They have thousands and thousands of independent marketers who market their products and sell them locally. The marketers themselves produce nothing and products sold are either drop shipped to the customer or directly to the end consumer. Multi Level Marketing is one of the best distribution models ever and one model that will become increasingly popular in the 21st century as the job market continues to become more volatile in North America.
- Real Estate Brokers, Real Estate Agents, Bird Dogs, Wholesalers, Property Managers – In real estate some of the quickest, easiest, lowest risk money comes from distributing other people’s real estate. There are many ways to control other people’s real estate and earn sizable commissions or fees without taking on the risk of owning the property. Many of the best real estate entrepreneurs have a distribution income through one of the above sources to supplement their business and portfolio.
The Production Model
Production is one of the most alluring and often attractive business models for novice entrepreneurs. Production style companies create their own products and services and then they look for distributors to sell them to end-users. Producers create products and inventory and because of this, they have large capital requirements to start and they have a high degree of risk. Since they enter the production cycle, their business model is much slower and lower velocity than a distribution model and it can take years or even decades sometimes to turn a profit. Since most producers are so heavily invested in production, they often have to rely on distributors to sell and move their inventory. If the product and management team are new to production, it can be extremely difficult to finance these types of companies because their earnings are typically zero in the beginning and they may not have cash flow for years. It may take years for a production company to become proven and viable for financing. When production companies do finally get their product ready for market, they often sell it at a wholesale price to a retailer or distributor who will mark it up and sell it at full retail value.
Companies that use Production Models:
- Food companies – Traditional food companies that process and make foods for consumers to eat such as McCains, General Mills, or Kelloggs have huge industrial age production facilities, thousands of workers, trucks, plant equipment, intellectual property, land, and inventory. The start up costs of getting into food production are often quite high and because there is so much money tied up in production, it can be difficult to start a production based food company.
- Farms- Farms like traditional food companies take massive amounts of resources to start and maintain. Vast amounts of land are required, plus machinery, technical know-how, seeds or livestock, storage and inventory. The farming business is so tough that many governments subsidize their farmers to keep food on the table for the nation and profit margins are slim which makes the risk level very high.
- Media Production companies (Rock bands, music studios, movies, television, video games) – Media production is a dream for many young entrepreneurs. Entrepreneurs with a love of music, movies, television or video games will spend considerable resources to create their art and their product. Once the product is produced, 99% of these entrepreneurs have no knowledge of distribution and their work never sees the light of day. I learned this the hard way with my rock’n’roll business. Production is easy, profitable distribution of your production is another story all together.
- Software, intellectual property, books – Software, intellectual property and books are all very labor intensive to produce. Once the product is ready for market and all of the resources have been spent on production, the profitability of the venture relies 100% on distribution. Consider a company like Facebook that developed the leading online social networking platform between 2004 and 2014. Facebook had no revenue, and only focused on production of their product. They did several rounds of venture capital funding and lost millions and millions of dollars. The investors who invested in Facebook placed their money with the company hoping that one-day Facebook would become a profitable product. At the time of writing, we still do not know if Facebook will become profitable in the long term. Currently, Facebook is publicly traded and worth billions of dollars. However, in the technology world, just because a company is worth billions of dollars does not mean that it is profitable.
- Widgets, manufacturing – Manufacturing has always, and likely will always be the base of a healthy economy. When raw materials are produced into finished goods, value is added, jobs are created and the economy and community become wealthier. Widgets are a fancy name for hard goods. A widget can be a computer; it can be a bottle opener, a keychain, or just about any hard product. Unfortunately many manufacturers have left North America and have gone overseas to China, India or other Asian countries in pursuit of cheap labor and looser government regulations. These manufacturers or factories are made up of land, buildings, equipment, skilled and unskilled workers, intellectual property and trade secrets. Once a factory moves overseas, it can be very difficult to start it up again because the start up resources can be staggering.
- Real estate development, property flippers, rental real estate – When most people think of making money in real estate investing they think of 3 things 1) Rental Properties 2) Flipping properties (buy fix and sell) and 3) Developing real estate, perhaps building condos or new homes. All of these methods can make sizable profits for investors and all are viable strategies. These strategies are all production type models that take significant resources to start. Much like factories or farms, production real estate requires land, capital, debt (perhaps a mortgage), management, construction teams, marketing professionals etc. The resources required to produce real estate are enormous and this is why real estate production businesses are typically slow moving companies because they are so heavy with resources that they are hard to move.
Distribution vs. Production – Which Model is Better?
Production and Distrubtion business models are in many ways opposite from one another. One produces products, the other doesn’t; one holds inventory, the other doesn’t; one has a production cycle, the other doesn’t. Both models have advantages and disadvantages, but which model is superior?
Distribution and Production are uniquely different and neither model is exclusively better than the other. Production companies typically enjoy higher margins because they produce their products from scratch and enjoy the benefits of adding value to raw resources. Distribution companies can make profit right away, sell fast and don’t hold the same level of risk that production companies have.
Although production and distribution models are somewhat equal in advantages and disadvantages, there is a perfect blended business model that offers the speed and advantages of distribution with the profit margins of production.
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Stefan Aarnio, award winning real estate investor, entrepreneur, author and coach was recently inducted into the Rich Dad Hall of Fame. His book, “Money People Deal: The Fastest Way to Real Estate Wealth” is currently available on moneypeopledeal.com. To learn more about Stefan Aarnio please visit StefanAarnio.com