Analyzing the Predominant Business Equation : Revenue = Capacity x Efficiency x Cost-Plus Price.

“Analyzing” the Predominant Business Equation

In Greek language, analyze means “cut to pieces,” which we will proceed to do with this theory before positing a better theory. When you think about the traditional theory of an enterprise, you would no doubt construct a model similar to this:

Revenue = Capacity x Efficiency x Cost-Plus Price

Since this model dominates the thinking of business leaders to this day, it is worth explaining the model in greater detail in order to understand both its strength and—as will be increasingly detailed—its fundamental weaknesses.

Consider a professional service firm, such as accounting, legal, architecture, engineering, consulting, or advertising; the archetypal pyramid firm model rested on the foundation of leveraging people power, in effect their “capacity.” The theory is this: Since the two main drivers of profitability are leverage (number of team members per owner and the hourly rate realization, a form of cost-plus pricing), if each partner could oversee a group of professionals, this would provide the firm with additional capacity to generate top-line revenue, and thus add to the profitability and size of the firm. If a firm wanted to add to its revenue base, it had two primary choices: It could work its people more hours, or it could hire more people. It is no secret which choice the average firm tends to choose, much to the chagrin of its already overworked team members. In most firms, the partners wait until demand is bursting at the seams before they add more professionals.

Now compare this practice with respect to capacity in other industries— this process of adding capacity after revenue is backward. If you think of any other industry or company—from Intel to General Electric, from FedEx to Microsoft—capacity is almost always added before revenue. Consider specifically FedEx: Before Fred Smith could deliver his first overnight package, he had to have trucks, drivers, airplanes, and facilities throughout the country, all at enormous fixed costs (indeed, those large fixed costs almost bankrupted FedEx in the early days). Most organizations operate with capacity to spare, which is vital in order to maintain flexibility in changing market conditions.




For now, let us look at the second element in the old theory—efficiency. Efficiency is a word that can be said with perfect impunity, since no one in their right mind would dispute the goal of operating efficiently. In fact, it is well known that in free market economies, efficiency is critical since it ensures that a society’s resources are not going to waste. It is also well established that different levels of productivity largely explain differences in wages across countries. An American farmer will earn more plowing with a tractor than a Cuban farmer with an ox and hand plow; the American farmer is more productive, hence higher wages and more profits.

There is no doubt that increasing efficiency—or at least not sliding into inefficiency—is important. But the pendulum has swung too far in the direction of efficiency over everything else. It seems that innovation, dynamism, customer service, investments in human capital, and effectiveness have all been sacrificed on the altar of efficiency. It is critical to bear in mind that a business does not exist to be efficient; rather, it exists in order to create wealth for its customers.

Peter Drucker is fond of pointing out that the last buggy whip manufacturers were models of efficiency. So what? What happens if you are efficient at doing the wrong things? That cannot be labeled progress. In fact, one indicator that an industry is in the mature or decline stage of the product/service life cycle is when it is also most likely at the apogee of its theoretical level of efficiency.

The point is this: In industry after industry, the history of economic progress has not been to wring out the last 5 to 10percent of efficiency, but rather to change the model in order to more effectively create wealth. From Walt Disney and Fred Smith, to Bill Gates and Larry Ellison—these entrepreneurs did not get where they are by focusing on efficiency. All of these entrepreneurs created enormous wealth by delivering more effectively what customers were willing to pay for, not by focusing on efficiency.

Next is cost-plus pricing, a direct cousin of the DuPont return on investment formula. But the real ancestor of cost-plus pricing is the Labor Theory of Value, posited by economists of the eighteenth century and Karl Marx in the late nineteenth century. This theory was almost immediately shown to be false—in terms of its ability to explain, predict, or prescribe—as a method of determining value in a marketplace. Fortunately, a better theory was posited, known as the Subjective Theory of Value—that is, ultimately, the person paying for an item, not the seller’s internal overhead, desired profit, or labor hours, determines the value of anything. Value, like beauty, is in the eye of the beholder.

The offense of believing internal costs have anything to do with value is serious. A business should be judged—and pricebased—on the results and wealth it creates for its customers. The cost-plus pricing paradigm is not worthy of businesses operating in an intellectual capital economy, and it is time we throw it on the ash heap of history. It is an idea from the day before yesterday.

Last, consider revenue. It is one thing to get more business, it is quite another to get better business. The “bigger is better” mentality is an empty promise for most companies. Acquiring more customers is not necessarily better. Growth simply for the sake of growth is the ideology of the cancer cell, not a strategy for a viable, profitable company. It is worth looking at the historical origins of this market-share myth. In the late 1800s and early 1900s, market share theory was an excellent rationale for antitrust enforcements. For business leaders, you can certainly see it in the algebraic effect of greater revenue in the equation. Once fixed costs are covered, any marginal revenue will contribute to the bottom line. Of course, this implicitly implies that any customer is a good customer, which is certainly a debatable proposition.

One widely quoted study is that by Harvard Business School professor Robert D. Buzzell, who in 1975 published an article in Harvard Business Review: “Market Share—A Key to Profitability.” This article provided empirical evidence that companies that had dominant market share had higher profitability levels. Of course, if one is not grounded in theory, then it is easier to confuse cause and effect by merely observing the manifestations of a competitive advantage. Height and weight are closely associated but you will not grow taller by eating more. Market share is the result of a sustainable competitive advantage, not the cause.

BMW has approximately 1 percent market share, selling 213,127 vehicles in the United States in 2001, while recording a profit $1.87 billion, greater than any other car company in the world. In 1999, Ford Motor earned a record $7.2 billion, and yet its market share decreased from 25.7 to 23.8 percent. By encouraging customers to trade up to higher-margin vehicles, it sold 420,000 fewer low-margin cars, while selling 600,000 more high-margin vehicles. Other traditional marketing and sales leaders, such as Procter & Gamble, Southwest Airlines, and General Electric, began to switch their focus from top-line revenue growth and market share to increasing profitability.

Southwest Airlines is a leader in the low-fare travel niche, and it has  remained focused on that niche like a laser beam. As former CEO Herb Kelleher pointed out, “Market share has nothing to do with profitability. Market share says we just want to be big; we don’t care if we make money doing it. That’s what misled much of the airline industry for fifteen years, after deregulation. In order to get an additional 5 percent of the market, some companies increased their costs by 25 percent.

That’s really incongruous if profitability is your purpose” (Freiberg and Freiberg, 1996: 49). If market share explained profitability, General Motors, United Airlines, Sears, and Philips should be the most profitable companies in their respective industries. Yet they have all turned in mediocre profitability records. Growth in profitability usually precedes market share, not vice versa. Wal-Mart, for example, was far more profitable than Sears, long before it had a sizeable market share. It seems profitability and market share grow in tandem with a viable value proposition that customers are willing to pay for. The road to hell is paved with the pursuit of volume. Do not make this mistake. More often than not, less is more.

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