Excerpted from The Three Rules: How Exceptional Companies Think by Michael Raynor and Mumtaz Ahmed. Published by Portfolio/Penguin. Copyright © Deloitte Development LLC, 2013.
Our first rule is "Better Before Cheaper": being price competitive is far from irrelevant but when it comes to position in a market, exceptional performance is caused most often by greater non-price value rather than lower price.
There are two dimensions of value along which any company can differentiate itself: price value and non-price value. Our research reveals that exceptional companies typically focus on non-price value, even if that means they have to charge higher prices. Price-based competition is a legitimate strategy. We have found, however, that competing with better, rather than cheaper is systematically associated with better long-term performance.
A big part of why we say a non-price position is a material cause of exceptional performance – we found that when exceptional companies abandoned a non-price position, their performance subsequently suffered. For example, in the appliance industry, Maytag delivered a two-decade run of superior profitability that ended in 1986. Its non-price position was defended by a painstakingly constructed combination of product excellence, effective advertising, and high-touch distribution. Its products consistently won superior ratings from Consumer Reports: the Maytag Repairman, who spent his days idled by the legendary quality of Maytag's clothes washers, became an icon of American advertising; and a distinctive network of more than ten thousand independent retailers proved a highly effective sales channel. In contrast, Whirlpool spent that same twenty-year period manufacturing appliances for Sears, whose Kenmore brand competed with Maytag largely on price.
Thanks to its non-price position, Maytag enjoyed twenty consecutive years of Miracle Worker performance. Then, beginning in the mid-1980s, consolidation in the retail channel led to the rise of the so-called big box stores. These retailers tended to carry fewer brands and so preferred those manufacturers with a full range of products, ideally across multiple price points. Maytag had only a relatively a high end line of washers and dryers. Fearful of being dropped by the newly powerful channel, it diversified its product line, largely through acquisitions, such as the 1980 purchase of Magic Chef. The gambit failed, however. The company's performance declined substantially and steadily, to the point that Maytag was acquired by Whirlpool in 2004.
When Maytag diversified, it took on mid and lower tier brands. This gave the company heft on a distribution landscape that had shifted from a scattered network of independent businesses to a small number of much larger retailers. However, it cost the company something much more valuable: its non-price position relative to Whirlpool and eventually non-U.S. competitors such as LG from Korea and Haier from China.
It turns out that just as there is a pattern for how companies create value (better before cheaper) there is a pattern in how they capture value. A revenue advantage can be driven by higher unit price or higher unit volume, and exceptional companies tend to rely more on price. And so rule number two is Revenue Before Cost.
"Revenue Before Cost" (the second of the three rules) – has the merit of providing meaningful guidance because the opposite could have been true: lower cost might systematically have driven superior profitability. Instead, we found that superior profitability is driven by higher revenue, in many cases earned by incurring higher cost. Of the eight exceptional companies with revenue-driven exceptional performance, six relied primarily on higher prices, while two (Merck and Wrigley) relied on volume. Better still, these findings are reflected in our analysis of the full population of exceptional companies.
Knowing this, managers facing tough investment decisions can now play the percentages much more consistently. Exceptional companies realize that non-price value must be earned repeatedly and continuously. Regardless of industry, that translates far more often than not into a significant and ongoing investment in assets or other expenditures. Short-run pressure to improve profitability through cost cutting is very often a double-edged sword, and the wrong edge is sharpest. Achieving exceptional results can demand the courage to incur higher cost, even to the point of a cost disadvantage.
You heard that right: a cost disadvantage. Whether they are driving revenue through price or volume, exceptional companies tend to have higher cost on at least on some dimensions – even when they are competing for seemingly price-sensitive markets. The willingness to incur higher cost allows exceptional performers to create, preserve and exploit their non-price value positions by charging higher prices or by generating higher volume.
Both Merck and Eli Lilly occupy non-price value positions in the pharmaceutical industry, competing on the basis of the clinical effectiveness of their patent-protected medications in the therapeutic areas they focus on. Neither can be said to have a price-based position.
Through the early 1990s, the difference in their profitability can be attributed to Merck's choice to globalize earlier, more successfully and much more aggressively than did Eli Lilly: Merck was generating 50 per cent or more of its $10-billion in pharmaceutical sales from non-U.S. markets, while Eli Lilly was generating barely 30 per cent of its $6-billion from non-U.S. sales. Prices in these markets were often lower than in the U.S., but Merck never competed on price relative to the alternatives in those markets. In other words, Merck drove revenue through higher volume, but it drove volume through non-price value, not low prices.
Selling into markets with lower price ceilings forced Merck to accept higher relative COGS [cost of goods sold], which explains why Merck's gross margins were lower than Eli Lilly's. However, these markets also had structurally lower selling costs, while Merck's fixed R&D expenses were spread across a much larger sales base. Economies of scale in drug manufacturing meant that Merck had a lower relative asset base, resulting in higher asset turns than Eli Lilly.
In addition, Merck leveraged its R&D and manufacturing base to diversify its product portfolio more than did Eli Lilly. By some measures, Merck was three times as diversified, but in ways that leveraged a more nearly common asset base, creating the volume required to drive a significant efficiency advantage.
In other words, Merck's profitability advantage was not a function of lower costs at a given volume, but of greater efficiencies thanks to higher volume resulting from customer demand generated by non-price value. The result was a decades-long run of revenue growth that made Merck's core pharmaceutical business more than twice the size of Eli Lilly's by 2010, up from barely more than 8 per cent larger in 1985.
No matter what industry they are in, driving revenue comes first, and exceptional companies are willing to invest and incur the costs required to drive either price or volume for higher revenue than their competitors.
Michael E. Raynor is a director at Deloitte Services LP. His research and client work is focused on strategy and innovation in a wide variety of industries. He is the author or coauthor of three best-selling and critically-acclaimed books, including The Innovator's Solution.
Mumtaz Ahmed is a strategy practitioner in Deloitte Consulting LLP and the chief strategy officer of Deloitte LLP, responsible for the firm's strategy, corporate development, innovation, eminence, and brand.