The Three Rules
There are many quick-fix books on management. But the one titled The Three Rules: How Exceptional Companies Think, is very different. Not because it has been researched and written by two of my colleagues, but for the reason that it simply states the results of the research with an insightful punchline. It is co-authored by Mumtaz Ahmed, who is the chief strategy officer of Deloitte, US, and Michael Raynor, a director of Deloitte.
After researching 25,000 companies from literally hundreds of industries across a time horizon of 45 years, Ahmed and Raynor found some simple insights as to how they had an exceptional performance over a long period of time. They captured them in three rules for use by companies that aspired to be exceptional:
Rule 1: Better before cheaper; compete on differentiators other than price. Rule 2: Revenue before cost; drive superior profitability with emphasis on higher prices and higher volumes, not lower cost. Rule 3: There are no other rules; change anything/everything in order to abide by the first two rules.
The first insight tells you that your company should not compete just on price. If you are low-balling or discounting all the time, your quality is bound to suffer. If you have no differentiation, then imitators will come and pay you by the same coin. That is not to say that you should not strive to be a cost leader. However, cost is fact while price is a policy. Even the cheapest cost producer can create a unique set of values that differentiate it from its competitors. If it does not, its competitive advantage will be eroded in the long run.
A classic example, in this case, would be of the leading IT services companies in India. They have a growing pressure on costs. Some of their cost elements are impacted by imported inflation such as cost of hardware, networks and software licenses. Because of tough competition for experienced and top-flight talent, the payroll costs go up by 8 per cent to 12 per cent every year. Therefore, theoretically, the cost arbitrage should get eroded if the overseas client is not willing to pay an annual 8 per cent to 12 per cent increase in hourly rates, which it rarely does. This is how exceptional companies in the IT services industry become innovative.
First, they recruit thousands of fresh engineers from campuses every year. They grow by 15-20 per cent in terms of head count. The base of the pyramid is flatter every year and they reap economies of scale. Ram was doing a particular type of work last year. He has received a 10 per cent pay hike this year. But he is not doing the same work. A newer and cheaper resource has replaced him as he has moved up.
The second innovation is in the industrialisation in processes and what is called “componentisation”. If an Indian software company has developed a software for a particular application in say a garment manufacturing company, it is able to reuse the code by up to 70-80 per cent in certain instances. The cost, therefore, goes down every time a similar application is implemented in the same industry.
Often companies in America and Europe drive a tough bargain and wrestle down the Indian vendor to a fixed fee. In such situations, Indian firms that have industrialised their processes make more profits because they can complete the project at a much lower cost by use of replicable components of work. It is a win/win model because the customer gets a fixed price contract in which the price is lower than what would cost him if he were to hire a firm to develop the same software from scratch on a time and materials basis. The vendor makes a higher profit because he can reuse the components and leverage his investment and experience from previous projects.
Sometimes global consulting companies have pre-configured industry solutions in packages such as SAP and Oracle. These “sandboxes” help the client company to jump-start their projects and reduce the cycle time as well as risks of implementation. For large commercial applications, there is no “plug and play” software yet as some degree of customisation is always required. But if there is a pre-configured sandbox, it helps immensely. Exceptional performers find ways of delighting the customer without having to be the cheapest in the market.
The second and last rule is to have profitability that is higher than other players by playing the premium price and volume game. Until now, Apple has been a great example of revenue before cost. It has not dropped its products’ prices, rather it has charged premium prices in every market and made tonnes of money. Any company like Apple that constantly innovates and creates its own uncontested market space can succeed in charging premium prices and yet drive volumes.
Two professors of the international graduate business school INSEAD — Chan Kim and Renee Mauborgne, wrote a book in 2004 called The Blue Ocean Strategy. Based on a study of 150 strategic moves spanning more than 100 years and 30 industries, the authors argued that lasting success comes from creating ‘blue oceans’, that is, untapped and uncontested new market spaces ripe for growth. The other trick in the book is to eschew the bloody red oceans infested by cost-cutting rivals and sharks. In the context of our example of the IT services industry, some parts of the industry will be “commoditised” or invaded by lower cost competitors in countries such as the Philippines. In such cases, exceptional companies will either vacate the “red ocean” spaces or offshore selected operations to new geographies.
To sum up, remember the rules; better before cheaper and revenue before cost.There are no other rules.
(The writer is managing director of Deloitte Consulting, India. These are his personal views)