Robert James Raitt & Associates

Executive Search and Interim Leadership Talent

  
  

Frustrated by the lack of reliable data on organisational excellence, Michael E. Raynor and Mumtaz Ahmed at Deloitte Consulting undertook a statistical study of thousands of companies to empirically prove what made certain companies truly great.

 

They eventually identified several hundred companies that have done well enough for a long enough period of time to qualify as truly exceptional. This is an excerpt from the full article published in the Harvard Business Review in April 2013.

They discovered something startling: The many and diverse choices that made certain companies great were consistent with just three seemingly elementary rules:

  1. Better before cheaper – in other words, compete on differentiators other than price.
  2. Revenue before cost – that is, prioritise increasing revenue over reducing costs.
  3. There are no other rules – so change anything you must to follow Rules 1 and 2.

The rules don’t dictate specific behaviours; nor are they even general strategies. They are foundational concepts on which companies have built greatness over many years.

The team’s impetus was to remove the randomness factor from a company’s success. Randomness can crown an average company king for a year, two years, even a decade, before performance reverts to the mean. The team began with the largest database they could find. The database contained more than 25,000 companies that have traded on U.S. exchanges at any time from 1966 to 2010. They measured return on assets (ROA), a metric that reflects strong, stable performance.

They defined two categories of superior results:  Miracle Workers fell in the top 10% of ROA for all 25,000 companies. Long Runners fell in the top 20% to 40%. Companies in both categories were regarded as exceptional performers. They also identified those companies that were average for comparison purposes.

Exceptional Companies came in all shapes and sizes. 3M, with its legendary innovation and thousands of products in commercial and industrial markets, made the list, but so did WD-40, a company built on a single, unpatented product that was designed to prevent corrosion on nuclear missiles and has since become most famous as the bane of squeaky hinges. McDonald’s proved to be exceptional, but so did Luby’s, a cafeteria chain, when it had only 43 locations (it has since then grown to 100 outlets).

As the study progressed the team shifted their emphasis away from what companies did to hypothesise about how they thought.

RULE 1 – Better Before Cheaper

Every company faces a choice: It can compete mainly by offering superior nonprice benefits such as a great brand, an exciting style, or excellent functionality, durability or convenience, or it can meet some minimal acceptable standard along these dimensions and try to attract customers with lower prices. Miracle Workers overwhelmingly adopt the former position. Average companies typically compete on price. Long Runners show no clear tendency one way or other.

RULE 2 – Revenue Before Cost

Companies must not only create value but also capture it in the form of profits. Exceptional companies garner superior profits by achieving higher revenue than their rivals, through either higher prices or greater volume. Very rarely is cost leadership a driver of superior profitability.

For eight of the nine Miracle Workers in the sample, revenue was the main driver of performance.

RULE 3 – There are no Rules

This rule underscores the uncomfortable (or liberating) truth that in the pursuit of exceptional profitability, everything but the first two rules prevails. When considering all the other determinants of company performance – operational excellence, talent development, leadership style, corporate culture, reward systems there was wide variation among companies of all performance type. These other factors matter but no consistent patterns of how they mattered were found.

The absence of other rules doesn’t mean executives can shut down their thinking. You still have to search actively and flexibly for ways to follow the rules in the face of what may be wrenching competitive change. It takes enormous creativity to remain true to the first two rules.  

In pharmaceuticals the top companies have successfully moved from in-house to joint venture to open innovation, while in semiconductors we’ve seen increased capital investment and an expanding portfolio of customers, all in support of better before cheaper. In confectionary the top performers have shifted from domestic to global distribution, and in medical devices M&A  has become a cornerstone of growth. When these changes have led to superior profitability, it has been because they contributed to greater volume more than to lower costs.

Choosing to be Exceptional

The first step in making use of the rules is to get a clear picture of your company’s competitive position and profitability formula. Too many companies lack that clarity because they spend too much time comparing their present selves with their past selves. You only compete with your current rivals, not with your passed self. Benchmarking may help, but in many instances it devolves into a comparison of single dimensions – Is our product more durable? Is our R&D higher? Rather than a sophisticated analysis of the interplay of all performance dimensions.

Putting the Rules into Operation

The next time you have to allocate scarce resources among competing priorities, think which initiatives will contribute most to enhancing the non-price elements of your position and which will allow you charge higher prices or to sell in greater volume.

If your operational-effectiveness program is mostly about cutting costs, whereas your innovation efforts are mostly about separating you from the pack, go with innovation.  If, however, improving operations is about delivering levels of customer service way above your competitors, whereas innovation seems geared to doing the same for less, then invest in operations.

Equally, if an acquisition is justified in terms of economies of scale then it might be justified. If it is to realise the growth potential of a non-price position that your company has already earned then it isn’t justified.

The rules can also be a useful antidote to intuition by the MD or top management team.

Finally, the rules are specially powerful when dealing with the financial ratios that govern so many businesses and can lead to pathological consequences. In ratios such as ROA, cash flow, return on investment and economic value added, the numerator is some measure of income and the denominator is some measure of assets. When sales start to drop, it’s too easy to try to make those ratios go up by shrinking the denominator. This can be a road to disaster.  Use the rules to make the case that by and large, Exceptional Companies often, even typically, accept higher costs as the price for excellence. In fact, many of them would rather spend and invest over long periods of time into creating non-price value and generating higher revenue. When successful companies are led astray by the seeming certainties of short-run cost cutting or disinvestment, they are more likely to destroy what they most want to enhance.  

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