The Three Rules: How Exceptional Companies Think
Michael E. Raynor, Mumtaz Ahmed
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Finally, an answer to the ultimate business question: How do some companies achieve exceptional performance over the long term?
In every sector, there’s an outlier. In the pharmaceutical industry, it’s Merck. In discount retail, it’s Family Dollar. It used to be Wrigley in candy and Maytag in appliances. Other superstars have been hidden in plain sight, like Heartland Express in trucking or Linear Technology in semiconductors. How do these exceptional companies deliver superior performance over the long run despite facing the same constraints as competitors? What are they doing differently? What can we learn from them?
Michael E. Raynor and Mumtaz Ahmed have analyzed data on more than 25,000 companies spanning forty-five years. Their five-year study began with a sophisticated statistical analysis to identify which companies have truly exceptional performance, 344 in all.
In collaboration with teams of researchers, Raynor and Ahmed then put a carefully chosen representative sample of twenty-seven companies under the microscope to uncover what made the stand-out performers different. They found that exceptional companies, when faced with difficult decisions, follow three rules:
- Better before cheaper. They rarely compete on price.
- Revenue before cost. They drive profits through price and volume, not thrift.
- There are no other rules. Everything else is up for grabs, and they are willing to change anything to remain true to the first two rules.
The rules provide an indispensable compass that any company can use to chart its own path to greatness. Is it better to keep price down or invest in creating value that commands a higher price? Should you focus on talent and developing the abilities of your people or build processes to extend the capabilities of your organization? How about acquiring a sizable competitor to secure economies of scale—or a small start-up to gain access to new technology? According to Raynor and Ahmed, the right answers to these and just about every other question are the ones most closely aligned with the rules.
The Three Rules is built on a powerful combination of large-scale data analysis and in-depth case studies. Its guidance will increase the chance that your organization can become truly exceptional.
discipline required to remain consistently profitable on fixed-price contracts. The company’s ability to execute consistently well over decades warrants not merely respect but also admiration. What makes these choices genuine trade-offs, however, is that Micropac was unable to escape the downside. Focusing on the U.S. military made it difficult for the company to grow internationally due to security issues associated with technology transfer: barely 10 percent of the company’s revenue came from
asset base (current, fixed, other). During the streak of higher relative performance this deficit is 10.7 pp/year. Consequently, even though Medtronic’s gross margin lead falls from 15.1 pp/year to 11.8 pp/year, it pulls ahead on ROA because its costs and assets are falling faster. What did Medtronic do differently? Nothing about its relative position changed; rather, it got dramatically better at capturing the benefits of its position. For starters, the company improved product quality,
patterns in behavior at the level of relatively specific activities, many of which are the subject of ongoing and extensive research and often feature prominently on managerial agendas. Take, for example, mergers and acquisitions. The conventional wisdom has crystallized into “buyer beware,” which is certainly not bad advice, but not particularly helpful. (When would one ever think it is good not to beware?) Research on the topic is largely consistent with this view, observing that acquirers, on
success from, say, 1966 to 1970 is entirely consistent with better before cheaper, for although it enjoyed no demonstrable superiority over Eli Lilly in pharmaceuticals, it had a lower level of diversification into nonpharmaceutical businesses where its better before cheaper position was less clear. Eli Lilly, on the other hand, was strongly diversified into businesses where it was relatively less able to stake out as strong a non-price-value position as it could in pharmaceuticals: Elizabeth
expensive misstep. With Medco out of the picture as of 2004, Merck’s ROA advantage falls to very nearly what we estimated Merck’s advantage would have been without Medco during the previous decade. On both absolute and relative ROA, Eli Lilly and Merck have converged, which is no great surprise. For the prior ten years, with the exception of PBMs, the two companies had pursued similar strategies with similar behavioral outcomes: focused on pharmaceuticals, a diversified product portfolio,