Unit - II

Data Analytics

Introduction to Analytics
As an enormous amount of data gets generated, the need to extract useful insights is a must
for a business enterprise. Data Analytics has a key role in improving your business. Here are 4
main factors which signify the need for Data Analytics:

• Gather Hidden Insights:-Hidden insights from data are gathered and then analyzed with
respect to business requirements.
• Generate Reports – Reports are generated from the data and are passed on to the
respective teams and individuals to deal with further actions for a high rise in business.
• Perform Market Analysis – Market Analysis can be performed to understand the
strengths and the weaknesses of competitors.
• Improve Business Requirement – Analysis of Data allows improving Business to
customer requirements and experience.

Data Analytics refers to the techniques to analyze data to enhance productivity and
business gain. Data is extracted from various sources and is cleaned and categorized to analyze
different behavioral patterns. The techniques and the tools used vary according to the
organization or individual.

Data analysts translate numbers into plain English. A Data Analyst delivers value to their
companies by taking information about specific topics and then interpreting, analyzing, and
presenting findings in comprehensive reports. So, if you have the capability to collect data from
various sources, analyze the data, gather hidden insights and generate reports, then you can
become a Data Analyst.
 Refer to the image below:

Fig 2.1 Data Analytics

Introduction to Tools and Environment

With the increasing demand for Data Analytics in the market, many tools have emerged with
various functionalities for this purpose. Either open-source or user-friendly, the top tools in the
data analytics market are as follows.

• R programming – This tool is the leading analytics tool used for statistics and data
modeling. R compiles and runs on various platforms such as UNIX, Windows, and Mac
OS. It also provides tools to automatically install all packages as per user-requirement.
• Python – Python is an open-source, object-oriented programming language which is easy
to read, write and maintain. It provides various machine learning and visualization
libraries such as Scikit-learn, TensorFlow, Matplotlib, Pandas, Keras etc. It also can be
• language and environment for data manipulation and analytics, this tool is easily
assembled on any platform like SQL server, a MongoDB database or JSON
• Tableau Public – This is a free software that connects to any data source such as Excel,
corporate Data Warehouse etc. It then creates visualizations, maps, dashboards etc with
real-time updates on the web.
 • Qlik View – This tool offers in-memory data processing with the results delivered to the
end-users quickly. It also offers data association and data visualization with data being
compressed to almost 10% of its original size.
• SAS – A programming accessible and can analyze data from different sources.
• Microsoft Excel – This tool is one of the most widely used tools for data analytics.
Mostly used for clients’ internal data, this tool analyzes the tasks that summarize the data
with a preview of pivot tables.
• Rapid Miner – A powerful, integrated platform that can integrate with any data source
types such as Access, Excel, Microsoft SQL, Tera data, Oracle, Sybase etc. This tool is
mostly used for predictive analytics, such as data mining, text analytics, machine
learning.
• KNIME – Konstanz Information Miner (KNIME) is an open-source data analytics
platform, which allows you to analyze and model data. With the benefit of visual
programming, KNIME provides a platform for reporting and integration through its
modular data pipeline concept.
• Open Refine – Also known as Google Refine, this data cleaning software will help you
clean up data for analysis. It is used for cleaning messy data, the transformation of data
and parsing data from websites.
• Apache Spark – One of the largest large-scale data processing engines, this tool executes
applications in Hadoop clusters 100 times faster in memory and 10 times faster on disk.
This tool is also popular for data pipelines and machine learning model development.

Apart from the above-mentioned capabilities, a Data Analyst should also possess skills
such as Statistics, Data Cleaning, Exploratory Data Analysis, and Data Visualization. Also, if
you have knowledge of Machine learning, then that would make you stand out from the
crowd.
Application of Modeling In Business:

A statistical model embodies a set of assumptions concerning the generation of the

observed data, and similar data from a larger population.
A model represents, often in considerably idealized form, the data-generating process.
Signal processing is an enabling technology that encompasses the fundamental theory,
applications, algorithms, and implementations of processing or transferring information
contained in many different physical, symbolic, or abstract formats broadly designated as
signals.
It uses mathematical, statistical, computational, heuristic, and linguistic representations,
formalisms, and techniques for representation, modelling, analysis, synthesis, discovery,
recovery, sensing, acquisition, extraction, learning, security, or forensics.
In manufacturing statistical models are used to define Warranty policies, solving various
conveyor related issues, Statistical Process Control etc
Databases & Types of Data and variables
Data types:-
Data types refer to an extensive system used for declaring variables or functions of
different types. The type of a variable determines how much space it occupies in storage and
how the bit pattern stored is interpreted.
Data :-
Data is the science of analyzing raw data in order to make conclusions about that
information. Many of the techniques and processes of data analytics have been automated into
mechanical processes and algorithms that work over raw data for human consumption.
Qualitative Data

Data that are not easily reduced to numbers, Data that are related to concepts,
opinions, values and behaviors of people in social context, Transcripts of individual
interviews and focus groups, field notes from observation of certain activities, copies of
documents, audio/video recordings.

Nominal Data:-

Nominal data is defined as data that is used for naming or labelling variables, without any
quantitative value. It is sometimes called “named” data - a meaning coined from the word
nominal.
Ordinal Data:-

Ordinal data is a kind of categorical data with a set order or scale to it. For example,
ordinal data is said to have been collected when a responder inputs his/her financial happiness
level on a scale of 1-10. In ordinal data, there is no standard scale on which the difference in
each score is measured.

Symmetric:-

Symmetric measures of association take on the same value, no matter which variable is
the independent variable and which is the dependent variable. ... For example, there may be a
non-linear relationship between the two variables.

Asymmetric:-

Which Measure to Use. Note that some statistics take on different values, depending on
which of the two variables is the independent variable and which is the dependent variable.
These are called asymmetric measures of association. ... For example, there may be a non-linear
relationship between the two variables.

Qualitative Data

The aim is to classify features, count them, and construct statistical models in an attempt
to explain what is observed. Researcher knows clearly in advance what he/she is looking for.
Recommended during latter phases of research projects. The design emerges as the study
unfolds. Researcher uses tools, such as questionnaires or equipment to collect numerical data.
Data is in the form of numbers and statistics. Objective: seeks precise measurement& analysis of
target concepts, e.g., uses surveys, questionnaires etc. Quantitative data is more efficient. able to
test hypotheses. but may miss contextual detail. Researcher tends to remain objectively separated
from the subject matter.
Discrete

All data that are the result of counting are called quantitative discrete data. These data take
on only certain numerical values. ... All data that are the result of measuring are quantitative
continuous data assuming that we can measure accurately.

Continuous

Continuous data technically have an infinite number of steps, which form a continuum.

DATA MODELLING TECHNIQUES

Data modelling is nothing but a process through which data is stored structurally in a
format in a database. Data modelling is important because it enables organizations to make data-
driven decisions and meet varied business goals.
The entire process of data modelling is not as easy as it seems, though. You are required to have
a deeper understanding of the structure of an organization and then propose a solution that aligns
with its end-goals and suffices it in achieving the desired objectives.

TYPES OF DATA MODELS

Data modeling can be achieved in various ways. However, the basic concept of each of them
remains the same. Let’s have a look at the commonly used data modeling methods:

1. Hierarchical model
2. Relational model
3. Network model
4. Object-oriented model
5. Entity-relationship model
 1 Hierarchical model
As the name indicates, this data model makes use of hierarchy to structure the data in a
tree-like format. However, retrieving and accessing data is difficult in a hierarchical database.
This is why it is rarely used now.

Diagram of Hierarchical model

2. Relational model

Proposed as an alternative to hierarchical model by an IBM researcher, here data is

represented in the form of tables. It reduces the complexity and provides a clear overview of the
data.
Example of Relational model
 3 Network model
The network model is inspired by the hierarchical model. However, unlike the
hierarchical model, this model makes it easier to convey complex relationships as each record
can be linked with multiple parent records.

Diagram of Network model

4 Object-oriented model
This database model consists of a collection of objects, each with its own features and
methods. This type of database model is also called the post-relational database model.
 Example of Object-oriented model

5. Entity-relationship model
Entity-relationship model, also known as ER model, represents entities and their
relationships in a graphical format. An entity could be anything – a concept, a piece of data, or
an object.
Importance of Data Modeling:
Now that we have a basic understanding of data modeling, let’s see why it is important.
Importance of Data Modeling
• A clear representation of data makes it easier to analyze the data properly. It provides a
quick overview of the data which can then be used by the developers in varied
applications.
• Data modeling represents the data properly in a model. It rules out any chances of data
redundancy and omission. This helps in clear analysis and processing.
• Data modeling improves data quality and enables the concerned stakeholders to make
data-driven decisions.
Since a lot of business processes depend on successful data modeling, it is necessary to adopt the
right data modeling techniques for the best results.

Best Data Modeling Practices to Drive Your Key Business Decisions

1-Have A Clear Understanding Of Your End-Goals And Results
2-Keep It Good and Simple and Scale As You Grow
3- Keep Organize Your Data Based On Facts, Dimensions, Filters, and Order
4- Keep As Much As Is Needed.
5- Cross Checking Before Continuing
6- Let them evolve
7- The Wrap Up

Best Data Modeling Practices to Drive Your Key Business Decisions

1-Have A Clear Understanding Of Your End-Goals And Results
You will agree with us that the main goal behind data modeling is to equip your
business and contribute to its functioning.
As a data modeler, you can achieve this objective only when you know the needs of
your enterprise correctly.
 It is essential to make yourself familiar with the varied needs of your business so that you
can prioritize and discard the data depending on the situation.
Key takeaway:
Have a clear understanding of your organization’s requirements and organize your data
properly.

2-Keep It Good and Simple and Scale As You Grow:

Things will be sweet initially, but they can become complex in no time. This is why it is
highly recommended to keep your data models small and simple, to begin with.
Once you are sure of your initial models in terms of accuracy, you can gradually
introduce more datasets.
This helps you in two ways. First, you are able to spot any inconsistencies in the initial
stages. Second, you can eliminate them on the go.
Key takeaway:
Keep your data models simple. The best data modeling practice here is to use a tool
which can start small and scale up as needed.

3- Keep Organize Your Data Based On Facts, Dimensions, Filters, and Order
You can find answers to most business questions by organizing your data in terms of four
elements – facts, dimensions, filters, and order.
Let’s understand this better with the help of an example. Let’s assume that you run four
e-commerce stores in four different locations of the world. It is the year-end, and you want to
analyze which e-commerce store made the most sales.
In such a scenario, you can organize your data over the last year. Facts will be the overall
sales data of last 1 year, the dimensions will be store location, the filter will be last 12 months,
and the order will be the top stores in decreasing order.
This way, you can organize all your data properly and position yourself to answer an
array of business intelligence questions without breaking a sweat.
Key takeaway:
 It is highly recommended to organize your data properly using individual tables for
facts and dimensions to enable quick analysis.

4- Keep As Much As Is Needed.

While you might be tempted to keep all the data with you, do not ever fall for this trap!
Although storage is not a problem in this digital age, you might end up taking a toll over your
machines’ performance.
More often than not, just a small yet useful amount of data is enough to answer all the
business-related questions. Spending huge on hosting enormous data of data only leads to
performance issues, sooner or later.

Key takeaway:
Have a clear opinion on how much datasets you want to keep. Maintaining more than
what is actually required wastes your data modeling, and leads to performance issues.

5- Cross Checking Before Continuing

Data modeling is a big project, especially when you are dealing with huge amounts of
data. Thus, you need to be cautious enough. Keep checking your data model before continuing to
the next step.
For example, if you need to choose a primary key to identify each record in the dataset
properly, make sure that you are picking the right attribute. Product ID could be one such
attribute. Thus, even if two counts match, their product ID can help you in distinguishing each
record. Keep checking if you are on the right track. Are product IDs same too? In that ace, you
will need to look for another dataset to establish the relationship.
Key takeaway:
It is the best practice to maintain one-to-one or one-to-many relationships. The many-to-
many relationship only introduces complexity in the system.
6-Let them evolve
Data models are never written in stone. As your business evolves, it is essential to
customize your data modeling accordingly. Thus, it is essential that you keep them updating over
time.
The best practice here is to store your data models in as easy-to-manage repository such
that you can make easy adjustments on the go.
Key takeaway:
Data models become outdated quicker than you expect. It is necessary that you keep them
updated from time to time.

7-The Wrap Up
Data modeling plays a crucial role in the growth of businesses, especially when you
organizations to base your decisions on facts and figures.
To achieve the varied business intelligence insights and goals, it is recommended to
model your data correctly and use appropriate tools to ensure the simplicity of the system.

MISSING DATA:
Missing data is always a problem in real life scenarios. Areas like
machine learning and data mining face severe issues in the accuracy
of their model predictions because of poor quality of data caused by
missing values. In these areas, missing value treatment is a major
point of focus to make their models more accurate and valid.

When and Why Is Data Missed?

Let us consider an online survey for a product. Many a times, people
do not share all the information related to them. Few people share
their experience, but not how long they are using the product; few
people share how long they are using the product, their experience but
not their contact information. Thus, in some or the other way a part of
data is always missing, and this is very common in real time.
Missing values are a common occurrence, and you need to have a strategy for treating
them. A missing va signify a number of different things in your data. Perhaps the data
was not available or not applicable or the ev not happen. It could be that the person
who entered the data did not know the right value, or missed filling i mining methods
vary in the way they treat missing values. Typically, they ignore the missing values, or
exclu records containing missing values, or replace missing values with the mean, or
infer missing values from e values.

Missing Values Replacement Policies:

Ignore the records with missing values.
Replace them with a global constant (e.g.,―?‖).
Fill in missing values manually based on your domain knowledge.
Replace them with the variable mean (if numerical) or the most frequent value
(if categorical).
Use modeling techniques such as nearest neighbors, Bayes‘ rule, decision tree,
or EM algorithm.

In statistics, missing data, or missing values, occur when no

data value is stored for the variable in an observation. Missing data
are a common occurrence and can have a significant effect on the
conclusions that can be drawn from the data.

Missing data can occur because of non response: no information is

provided for one or more items or for a whole unit ("subject"). Some
items are more likely to generate a non response than others: for
example items about private subjects such as income. Attrition is a
type of missingness that can occur in longitudinal studies—for instance
studying development where a measurement is repeated after a certain
period of time. Missingness occurs when participants drop out before
the test ends and one or more measurements are missing.

Data often are missing in research in economics, sociology, and

 political science because governments or private entities choose not to,
or fail to, report critical statistics, or because the information is not
available. Sometimes missing values are caused by the researcher for
example, when data collection is done improperly or mistakes are
made in data entry.

These forms of missingness take different types, with different impacts

on the validity of conclusions from research: Missing completely at
random, missing at random, and missing not at random. Missing data
can be handled similarly as censored data.

Types of missing data:

Understanding the reasons why data are missing is important for

handling the remaining data correctly. If values are missing
completely at random, the data sample is likely still representative of
the population. But if the values are missing systematically, analysis
may be biased. For example, in a study of the relation between IQ and
income, if participants with an above-average IQ tend to skip the
question ‗What is your salary?‘, analyses that do not takeinto account
this missing at random may falsely fail to find a positive association
between IQ and salary. Because of these problems, methodologists
routinely advise researchers to design studies to minimize the
occurrence of missing values. Graphical models can be used to
describe the missing data mechanism in detail.

Missing completely at random:

Values in a data set are Missing Completely at Random (MCAR) if

the events that lead to any particular data-item being missing are
independent both of observable variables and of unobservable
parameters of interest, and occur entirely at random. When data are
MCAR, the analysis performed on the data is unbiased; however, data
 are rarely MCAR.

In the case of MCAR, the missingness of data is unrelated to any study

variable: thus, the participants with completely observed data are in
effect a random sample of all the participants assigned a particular
intervention. With MCAR, the random assignment of treatments is
assumed to be preserved, but that is usually an unrealistically strong
assumption in practice.

Missing at random:

Missing at random (MAR) occurs when the missingness is not

random, but where missingness can be fully accounted for by variables
where there is complete information.MAR is an assumption that is
impossible to verify statistically, we must rely on its substantive
reasonableness.[8]An example is that males are less likely to fill in a
depression survey but this has nothing to do with their level of
depression, after accounting for maleness. Depending on the analysis
method, these data can still induce parameter bias in analyses due to
the contingent emptiness of cells (male, very high depression may have
zero entries). However, if the parameter is estimated with Full
Information Maximum Likelihood, MAR will provide asymptotically
unbiased estimates.

Missing not at random:

Missing not at random (MNAR) (also known as nonignorable

nonresponse) is data that is neither MAR nor MCAR (i.e. the value of
the variable that's missing is related to the reason it's missing).To
extend the previous example, this would occur if men failed to fill in a
depression survey becauseof their level of depression.

Techniques of dealing with missing data:

Missing data reduces the representativeness of the sample and can

therefore distort inferences about the population. Generally speaking,
there are three main approaches to handle missing data: Imputation—
where values are filled in the place of missing data, omissionwhere
samples with invalid data are discarded from further analysis and
analysis—by directly applying methods unaffected by the
missingvalues.

In some practical application, the experimenters can control the level

of missingness, and prevent missing values before gathering the data.
For example, in computer questionnaires, it is often not possible to
skip a question. A question has to be answered; otherwise one cannot
continue to the next. So missing values due to the participant are
eliminated by this type of questionnaire,though this method may not be
permitted by an ethics board overseeing the research. In survey
research, it is common to make multiple efforts to contact each
individual in the sample, often sending letters to attempt to persuade
those who have decided not to participate to change their
minds.However, such techniques can either help or hurt in terms of
reducing the negative inferential effects of missing data, because the
kind of people who are willing to be persuaded to participate after
initially refusing or not being home are likely to be significantly
different from the kinds of people who will still refuse or remain
unreachable after additional effort.

In situations where missing values are likely to occur, the researcher is

often advised on planning to use methods of data analysis methods that
are robustto missingness. An analysis is robust when we are confident
that mild to moderate violations of the technique's key assumptions
will produce little or no bias, or distortion in the conclusions drawn
about thepopulation.
Imputation:
Imputation (statistics):

Some data analysis techniques are not robust to missingness, and

require to "fill in", or impute the missing data. Rubin argued that
repeating imputation even a few times (5 or less) enormously improves
the quality of estimation. For many practical purposes, 2 or 3
imputations capture most of the relative efficiency that could be
captured with a larger number of imputations. However, a too-small
number of imputations can lead to a substantial loss of statistical
power, and some scholars now recommend 20 to 100 or more.Any
multiply-imputed data analysis must be repeated for each of the
imputed data sets and, in some cases, the relevant statistics must be
combined in a relatively complicatedway.

The expectation-maximization algorithmis an approach in

which values of the statistics which would be computed if a
complete dataset were available are estimated (imputed), taking
into account the pattern of missing data. In this approach, values
for individual missing data-items are not usually imputed.

NEED FOR BUSINESS MODELING

What Is a Business Model.
A business model is a company's plan for making a profit. It identifies the products or
services the business will sell, the target market it has identified, and the expenses it anticipates.

A new business in development has to have a business model, if only in order to

attract investment, help it recruit talent, and motivate management and staff. Established
businesses have to revisit and update their business plans often or they'll fail to anticipate trends
and challenges ahead. Investors need to review and evaluate the business plans of companies that
interest them.
Types of Business Models
There are as many types of business models as there are types of business. Direct
sales, franchising, advertising-based, and brick-and-mortar stores are all examples of traditional
business models. There are hybrids as well, such as businesses that combine internet retail with
brick-and-mortar stores, or sporting organizations like the NBA.

Within these broad categories, each business plan is unique. Consider the shaving
industry. Gillette is happy to sell its Mach3 razor handle at cost or lower in order to get steady
customers for its more profitable razor blades. The business model rests on giving away the
handle to get those blade sales. This type of business model is actually called the razor-
razorblade model, but it can apply to companies in any business that sells a product at a deep
discount in order to supply a dependent good at a considerably higher price.

The Advantages of a Business Model

Successful businesses have adopted business models that allow them to fulfill client
needs at a competitive price and a sustainable cost. Over time, many businesses revise their
business models from time to time to reflect changing business environments and market
demands.

One way analysts and investors evaluate the success of a business model is by looking at
the company's gross profit. Gross profit is a company's total revenue minus the cost of goods
sold. Comparing a company's gross profit to that of its main competitor or its industry sheds light
on the efficiency and effectiveness of its business model.

Gross profit alone can be misleading, however. Analysts also want to see cash flow or net
income. That is gross profit minus operating expenses and is an indication of just how much real
profit the business is generating.

The two primary levers of a company's business model are pricing and costs. A company
can raise prices, and it can find inventory at reduced costs. Both actions increase gross profit.
 Nevertheless, many analysts consider gross profit to be more important in evaluating a
business plan. A good gross profit suggests a sound business plan. If expenses are out of control,
the management could be at fault, and the problems are correctable. As this suggests, many
analysts believe that companies that run on the best business models can run themselves.
Examples of Business Plans
Consider a comparison of two competing business plans. Both companies rent and sell
movies. Before the advent of the Internet, both companies made $5 million in revenues after
spending $4 million on their inventories of movies.

That means that each company makes a gross profit calculated as $5 million minus $4
million, or $1 million. They also have the same gross profit margin, calculated as gross profit
divided by revenues, or 20%.

After the advent of the Internet, Company B decides to offer streaming movies online
instead of renting or selling physical copies of movies. This change disrupts the business model
in a positive way. The licensing fees do not change, but the cost of holding inventory is down
considerably. In fact, the change reduces storage and distribution costs by $2 million. The new
gross profit for the company is $5 million minus $2 million, or $3 million. The new gross profit
margin is 60%.

Meanwhile, Company A is stuck with its lower gross profit margin, and its sales will
soon begin sliding downwards. It failed to update its business plan. Company B isn't even
making more in sales, but it has revolutionized its business model, and that has greatly reduced
its costs.

The Disadvantages of Business Models

Joan Magretta, the former editor at the Harvard Business Review, suggests there are two
critical factors in sizing up business models. When business models don't work, she states, it's
because the story doesn't make sense and/or the numbers just don't add up to profits.
 The airline industry is a good place to look to find a business model that stopped making
sense. It includes companies that have suffered heavy losses and even bankruptcy.

For years, major carriers such as American Airlines, Delta, and Continental built their
businesses around a "hub-and-spoke" structure, in which all flights were routed through a
handful of major airports. By ensuring that most seats were filled most of the time, the business
model produced big profits.But a competing business model arose that made the strength of the
major carriers a burden. Carriers like Southwest and JetBlue shuttled planes between smaller
airports at a lower cost. They avoided some of the operational inefficiencies of the hub-and-
spoke model while forcing labor costs down. That allowed them to cut prices, increasing demand
for short flights between cities.

Need for Business modeling

What Is a Business Model.
A business model is a company's plan for making a profit. It identifies the products or
services the business will sell, the target market it has identified, and the expenses it anticipates.

A new business in development has to have a business model, if only in order to

attract investment, help it recruit talent, and motivate management and staff. Established
businesses have to revisit and update their business plans often or they'll fail to anticipate trends
and challenges ahead. Investors need to review and evaluate the business plans of companies that
interest them.

Types of Business Models

There are as many types of business models as there are types of business. Direct
sales, franchising, advertising-based, and brick-and-mortar stores are all examples of traditional
business models. There are hybrids as well, such as businesses that combine internet retail with
brick-and-mortar stores, or sporting organizations like the NBA.
 Within these broad categories, each business plan is unique. Consider the shaving
industry. Gillette is happy to sell its Mach3 razor handle at cost or lower in order to get steady
customers for its more profitable razor blades. The business model rests on giving away the
handle to get those blade sales. This type of business model is actually called the razor-
razorblade model, but it can apply to companies in any business that sells a product at a deep
discount in order to supply a dependent good at a considerably higher price.

The Advantages of a Business Model

Successful businesses have adopted business models that allow them to fulfill client
needs at a competitive price and a sustainable cost. Over time, many businesses revise their
business models from time to time to reflect changing business environments and market
demands.

One way analysts and investors evaluate the success of a business model is by looking at
the company's gross profit. Gross profit is a company's total revenue minus the cost of goods
sold. Comparing a company's gross profit to that of its main competitor or its industry sheds light
on the efficiency and effectiveness of its business model.

Gross profit alone can be misleading, however. Analysts also want to see cash flow or net
income. That is gross profit minus operating expenses and is an indication of just how much real
profit the business is generating.

The two primary levers of a company's business model are pricing and costs. A company
can raise prices, and it can find inventory at reduced costs. Both actions increase gross profit.

Nevertheless, many analysts consider gross profit to be more important in evaluating a

business plan. A good gross profit suggests a sound business plan. If expenses are out of control,
the management could be at fault, and the problems are correctable. As this suggests, many
analysts believe that companies that run on the best business models can run themselves.
Examples of Business Plans
Consider a comparison of two competing business plans. Both companies rent and sell
movies. Before the advent of the Internet, both companies made $5 million in revenues after
spending $4 million on their inventories of movies.

That means that each company makes a gross profit calculated as $5 million minus $4
million, or $1 million. They also have the same gross profit margin, calculated as gross profit
divided by revenues, or 20%.

After the advent of the Internet, Company B decides to offer streaming movies online
instead of renting or selling physical copies of movies. This change disrupts the business model
in a positive way. The licensing fees do not change, but the cost of holding inventory is down
considerably. In fact, the change reduces storage and distribution costs by $2 million. The new
gross profit for the company is $5 million minus $2 million, or $3 million. The new gross profit
margin is 60%.

Meanwhile, Company A is stuck with its lower gross profit margin, and its sales will
soon begin sliding downwards. It failed to update its business plan. Company B isn't even
making more in sales, but it has revolutionized its business model, and that has greatly reduced
its costs.

The Disadvantages of Business Models

Joan Magretta, the former editor at the Harvard Business Review, suggests there are two
critical factors in sizing up business models. When business models don't work, she states, it's
because the story doesn't make sense and/or the numbers just don't add up to profits.

The airline industry is a good place to look to find a business model that stopped making
sense. It includes companies that have suffered heavy losses and even bankruptcy.

For years, major carriers such as American Airlines, Delta, and Continental built their
businesses around a "hub-and-spoke" structure, in which all flights were routed through a
handful of major airports. By ensuring that most seats were filled most of the time, the business
model produced big profits. But a competing business model arose that made the strength of the
major carriers a burden. Carriers like Southwest and JetBlue shuttled planes between smaller
airports at a lower cost. They avoided some of the operational inefficiencies of the hub-and-
spoke model while forcing labor costs down. That allowed them to cut prices, increasing demand
for short flights between cities.