Scientific study reveals the 3 rules all exceptional companies follow

25 Sep 2015

In their new book "The Three Rules", Raynor & Ahmed answer the ultimate business question, "How do a few companies achieve exceptional performance over the long term?" In every industry, there is a stand-out company that delivers exceptional profits and performance. So what makes them different? Data has been analysed on more than 25,000 companies spanning 45 years to uncover what makes a company highly profitable. It was found that exceptional companies follow 3 rules, "better before cheaper", "revenue before cost", and "there are no other rules". Take a look.

Here are the 3 rules:

  • Better before cheaper - Select a non-price position and compete on value, not price.
  • Revenue before cost - Prioritise increasing revenue over reducing costs.
  • There are no other rules - Be willing to change anything else to stay aligned with rules 1 and 2.

Rule 1 is about creating value for the customer and Rule 2 is about capturing value from the customer. Rule 3 explains that no other rules were found to apply universally, so everything else is on the table for change.

The rules were rigorously formulated from a study of 25,000 companies. The authors explain that while it is certainly possible to run a successful company without following these rules, exceptional long-term high performance over a long period (top 1%) requires close adherence to these rules.

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Rule 1 - Better before Cheaper

Better before cheaper means adopting a non-price position customers are willing to pay for, rather than competing on price. Price is still important, but not more important than increasing the non-price value customers receive (examples of value include performance, service, efficiency, speed, quality, comfort, etc).

The research shows that companies with non-price performance positions tend to be more profitable over the long-term. It has also been shown that shifting from a non-price position to a price based position is normally associated with a decline in performance.

Defining what your customers think of as "better" is relative to your competition. As such it is important here to compare only with your direct competition. For example, a budget motel chain is competing with other budget motel chains, not high-end hotels.

An example of better before cheaper is the allocation of resources for R&D. Better to invest limited R&D resources in developing innovations that support and protect a non-price position, rather than on innovations that may help to reduce costs. A reduction of costs may enable you to increase your profits. However, you are not providing new value to your customers.

Rule 2 - Revenue before Cost

Revenue before Cost is about defining the profitability formula of your business. Profitability increases when revenue increases, costs decrease, or assets decrease. It has been found that exceptional companies typically achieve higher profitability through revenue increases, even if this means higher costs or a greater asset base to support. Revenue can be increased through higher prices or greater volume. Cost management is still crucial but takes second priority to increasing revenue through greater volume or higher prices.

A surprising finding of the research is that often exceptional companies are at a "cost disadvantage" from competitors, as they are prepared to incur higher costs in order to drive higher prices or greater volumes.

Rule 3 - There are no other rules

Rule 3 tells you what you shouldn't do, meaning that no matter what situation your business faces, adhere to rules 1 and 2 It also means that in following rules 1 and 2, everything else is "on the table" for change, be it your market, technology, people, processes, products or services. Over time companies are forced to reinvent themselves to remain competitive. Those companies that remain exceptional, make changes that follow rule 1 and 2 consistently.

How to apply the rules

The rules can help you make decisions about how best to position your business and capture value from customers. Here are some examples of the rules in action.

Should you focus on your core market or enter new markets?

Exceptional companies studied showed no preference either way. They focus instead on expansion into markets that enabled them to exploit their non-price position and increase revenue through higher prices or greater volume in those markets.

Should we acquire a new asset or company?

Exceptional companies typically only make acquisitions that support and protect their non-price position. Economies of scale on its own is not necessarily a good reason for an acquisition, if it does not assist your company to exploit a non-price position that drives volume or higher prices.

Should we diversify into new products, services or markets?

Does the diversification protect or extend a successful non-price position? Diversification is not necessarily bad, as long as it supports your non-price performance (for example through complementary products or better service that enhance the value of your core product).

Some final words

It is possible to run a successful company that competes on price and focuses on minimising costs. However rarely are these companies exceptional (top 1%) performers measured by profitability. Better to tackle the hard problem of developing a non-price position customers will pay for, and then exploiting this position through higher prices or greater volume of sales. Adherence to the rules does not guarantee success, however, they do seem to be a necessary condition for exceptional profitability. Take a look at the book for a detailed treatment of the rules, as well as the website