3 Rules for Understanding How Value Leads to Better Performance
June 6 2013 by Michael E. Raynor and Mumtaz Ahmad
Knowing this, CEOs 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% or more of its $10 billion in pharmaceutical sales from non-U.S. markets, while Eli Lilly was generating barely 30% 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, 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% 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. Raynoris a director at Deloitte Services LP. Mumtaz Ahmedis a strategy practitioner in Deloitte Consulting LLP and the chief strategy officer of Deloitte LLP. They are coauthors of The Three Rules: How Exceptional Companies Think, which was based on a study of 25,000 companies from hundreds of industries covering 45 years. www.thethreerules.com