Did Deloitte discover the key to exceptional performance?
Earlier this year, Deloitte Consulting's Mumtaz Ahmed and Michael Raynor published The Three Rules: How Exceptional Companies Think . The authors set out to answer what was, in their mind, the ultimate business question—how do some companies achieve exceptional performance over the long haul? To do so, Raynor and Ahmed analyzed data on more than 25,000 companies over 45 years. Their study began with a statistical analysis to identify which companies truly achieved exceptional performance. They came up with 344 companies that qualified. But after five years of analysis, their attempt to find a consistent pattern of behavior that separated the exceptional companies from the pack led only to a series of dead ends. In collaboration with a team of researchers, the authors put a carefully chosen representative sample of 27 companies under the microscope to uncover what made these stand-out performers different. They discovered that these exceptional companies, when faced with difficult decisions, follow three rules: 1) Better Before Cheaper; 2) Revenue Before Cost; and, 3) There Are No Other Rules. Consulting caught up with Raynor to discuss the book, exceptional companies and the three rules.
Consulting: How did the book come about? Why did you write this particular book at this time?
Raynor: The pressure on managers to improve their company's performance has never been greater. It's their decisions that will determine their company's fate. We wrote the book and embarked on our research project to see if we could help managers navigate these critical decisions.
Consulting: Can you talk a little about the process, the data and the methodology you used in writing the book?
Raynor: There is a vast body of research focused on successful companies, but there are two challenges to such research that we had not yet seen overcome. First, we wanted to research only those companies that were good enough so we applied a very different set of statistical methods to 45 years of data on more than 25,000 companies. Second, if the casual connections between behavior and performance can't be upheld with rigorous data, we can't rely on its conclusions. We took great pains not to impose a pattern on the data or give into cognitive biases. We invested a great deal of time in getting the sample selection right. We can quantify the likelihood that a company has been good enough for long enough, that they've gone beyond the parameters of the system, and that they are, in fact, exceptional.
Once you've got a sample that you can trust, the question becomes what are the behavioral differences that explain the performance differences… and at that point we hit a dead end. I've written two books on innovation and one on strategic planning, and I had to let go of the notion that either of those are systematically associated with superior performance.
Sometimes they seemed to be critical and sometimes they didn't. I had to let go of my own biases, as well as letting go of what plenty of other people had said were critical for success—leadership styles, corporate culture, the need to grow, etc. With all of those factors, it just seemed to fall apart; none of it worked. We then decided to think that maybe there's something else here. I remember sitting at my desk and looking at one piece of scrap paper after another and they had all kinds of notes on them and I remember scribbling down "better, not cheaper" and "revenue not cost." I shared that with Mumtaz and he paused for a minute and said: "revenue before cheaper" and "revenue before costs." Then we were in a position to test that hypothesis statistically against our population and that proved to stand up.
Consulting: So, I guess that was sort of the 'aha' moment. Was there a point where you were concerned that the rules were a little over-
simplistic for an entire book?
Raynor: I guess they could be initially viewed that way but when you look under the hood I think that perception evaporates pretty quickly. We are, by no means, saying we have a formula to follow passively. These rules are to guide your thinking so that when you face tough decisions you can think systematically about what direction you should take to stay firmly on the path to exceptional performance. These are rules, not laws. When faced with a dilemma about which hard problems to solve, are you going to solve the better problem or the cheaper problem? We would say you should devote your time and energy into solving the better problem. We think of it as a compass. Picture yourself standing in the middle of the woods and not knowing which way leads to civilization. Well, what you would really need in that scenario would be a map, but I don't think anyone has that map. But what we're trying to do is provide you with a compass. Which way is North? This book is designed to help point you in the right direction, but you still have to chart your own path, you still have to figure out the best way to get to where you want to go, how to avoid obstacles etc. That's what I think the book does, it points you North.
Consulting: The rules seem to fly in the face of those companies, such as Wal-Mart, whose entire business model—and success—is predicated on bringing the absolute cheapest goods to the market…
Raynor: I'm not going to speak to any one company specifically, but what I can say is that when you look at the leading discount retailers, it very often turns out that they aren't exceptional performers. So, you need to put every company's performance through the kind of statistical analysis we do before you can say which ones are and aren't exceptional. Once we do that, we discover that very often they are not exceptional performers. In the book, we go through the samples of exceptional companies identified by 19 other popular success studies, what we found that very few of those companies that they deemed exceptional performers were actually exceptional, at least not by our standards. In fact, only 8 percent were, and we used only the data that was available to the researchers at the time and we put the companies through our analysis. So, when someone says to me that such and such a company is competing on price, there's a pretty good chance we wouldn't identify them as exceptional. We're not talking about survival, but exceptional performers. There are, obviously, several surviving companies that don't meet our definition of exceptional. Some people may say, well, didn't we already know that you shouldn't compete on price? And the answer is, in fact, no; I don't think we really knew that. Talk to the leading discount retailers and they'll all tell you that price leadership is central to their competitiveness.
Consulting: The book highlights several case studies. Which ones stand out for you?
Raynor: The one that I turn to over and over again is Heartland Express. They are a long-haul trucking business, which is not usually an industry known for its innovation or dynamism. When you look under the hood, so to speak, you see that this is a company that has enjoyed extraordinary profitability over a very long time, more than 25 years, and it's been able to re-invent itself and its business in order to preserve its success. These guys were an extraordinarily run company and enjoyed massive profits for a long time, but then that tails off. Essentially what happened, because of deregulation and some other factors, the rest of the industry caught up. What we see at that point is the complete re-invention of its business. Heartland goes from the majority of its tonnage being driven by contractors to being driven by employees; they go from having no distribution centers to about a dozen over four years; they go from no acquisitions over 15 years to three major acquisitions that triples their size over three years; they go from a narrow geographic footprint to a much broader geographic footprint. And they changed everything in order to preserve "better before cheaper" and "revenue before cost".
The last piece of this, which is absolutely stunning, from 1985 to 1994 Heartland was enjoying 9.6 percentage points ROA (return on assets) advantage, two-thirds of which is attributable to superior margin and one-third attributable to superior outfit turnover. If you're going to have high margins, you're probably going to have low turnover. Well, during this period they were enjoying such massive ROA advantages, they had high margin and high turnover. Then, if you look from 1995 to 2010, they realized the world's changed and also realized they could have lower outfit turnover in order to maintain their superior return on sales, which will be driven by vastly superior gross margins. That's just unbelievable.
Consulting: It seems easier to go back and discover what these companies did right over the course of a successful run rather than use these rules as the tenets of starting and running a company. In other words, aren't there plenty of companies that follow these rules and fail?
Raynor: I never said nothing else matters. Several other factors, such as culture, leadership, markets and technology matter. Of course they do. They are crucially important, but there's no systematic way to pursue those things in order to increase the probability of success. My claim is that all of those choices one makes with respect to all those other dimensions should be seen through the prism of those first two rules. That's why we have the third rule. We started with the reverse of the third rule. We started with the notion that we'd find the key of how to be exceptional with other factors and we couldn't find it.
Consulting: And I know you spend some time in the book pointing out counter examples, correct?
Raynor: Yes, we do. We talk about Weis Markets, which was a price leader and a cost leader but does quite well. I wouldn't suggest for a minute that you can't swim upstream and do quite well. And we also have Whole Foods, which is a company that has a clear "better before cheaper" and "revenue before cost" position and yet has had average profitability over time.
Consulting: Are these rules applicable with your own clients, and even with your fellow consultants within Deloitte?
Raynor: I think so. The conversations about this have to come to the forefront of the conversation. "Better Before Cheaper" and "Revenue Before Cost"… there's something there, they're not just bumper stickers. Those words are connected to something important and substantial about the decisions leaders make and where the senior management agenda spends its resources, money and time to try to achieve greatness. Without really peeling the onion, those phrases—"Better before Cheaper" and "Revenue Before Cost"—sounds no more insightful than "Get the Right People on the Bus."
Consulting: So many business books set out to tell the reader how to act, it strikes me that this one is more designed to teach the reader how to think? Is that accurate?
Raynor: I would say that's exactly right. What does it mean for your company to be better? Well that answer is going to be different for every company. We can help you figure it out. Or we can help you find the right question to answer. That's very valuable. We try to take very seriously a lot of the guidance of what constitutes a scientifically credible approach to this type of hairball problem. We didn't get it perfect… no one ever will. We do think we've made some important advances in how to think about things like sample selection—how do you actually identify companies that are exceptional so you can actually study what you think you're studying? It's an important premise and it's one that appears to be false all too frequently. We've been very transparent about our research, our methodology and our data. Readers, ultimately, can make up their own minds if we've done a good job.
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