Last week we talked about the importance of putting “better” before “cheaper,” which was the conclusion of an immense scientific study conducted by the Harvard Business Review. Today, we’ll talk about the second rule that exceptionally high-performing businesses use to maximize their Return on Assets (ROA): put increased revenue before minimized costs.
In their analysis of over 25,000 companies from 1966 to 2010, they found that cost leadership was almost never responsible for leadership in profitability.
While it makes sense in theory that you can increase profit margins by cutting costs (and indeed this is possible), companies that put this strategy first essentially never made it into the top 40% ROA long enough to separate their success from a fluke.
There are only two basic ways to increase revenue:
- Charge higher prices
- Increase number of sales
Just like with the first rule, the number of contexts in which this could be achieved is extremely diverse.
Most of us wouldn’t think of Family Dollar, a discount retailer, as a company that succeeds by charging higher prices, but that’s exactly what they’ve done, by offering a wider range of products and more convenient locations. It costs a lot more to run Family Dollar than any of their competitors are willing to spend, but they make up for the losses with higher prices that their customers are willing to pay.
Six of the eight (yes, 8 out of 25,000) who managed to stay in the top 10% for a significant amount of time did so by charging higher prices, but two of them did it by boosting sales. One of them was pharmaceutical company Merck.
Merck staunchly follows the first rule, refusing to compete with lower prices, but can’t follow the second rule by charging higher prices. The price ceilings are just too low, and consumers will not spend more. Instead, Merck competes by growing its number of sales, staying ahead with patented products that are very costly to develop.
They still focus on maximizing revenue, but not by charging higher prices.
The Exception to the Rules
Out of all 25,000 companies, the team of researchers only found one business that broke the rules and remained successful: a grocery chain called Weis. It managed to succeed by being one of the first to sell lower cost in-house label products that also cost much less to produce. This strategy made them successful for 28 years, but they eventually lost their position in the ‘80s, when other grocers followed suit and started doing the same thing.
The trouble with competing by reducing costs and prices is that somebody else can always come around and do things more efficiently than you do. When you can’t compete on anything but reduced costs and lower prices, your business is expendable.