Strategy: Revenue growth or Proftability (or both!)

Price is an excellent lever which allows firms to manage their revenue and profitability simultaneously and hence is extremely crucial to a firm's long term strategy. The million dollar question is where do want to set it; to maximize revenue, to maximize profitability or some combination of both. The importance gets further magnified during economic slowdown when firms experience pressure from customers to reduce the price in order to sustain a level of revenue growth.

An increase in price (or during the downturn a reluctance to reduce the price) in general will ensure profitability (Gross margin) and may come at the expense of potential loss of revenue. Many firms commit to a certain level of average profitability as part of their corporate goal and indicate the target in their annual report. Equity analysts religiously follow these numbers and a loss in margin impacts the stock price. Managers at the behest of owners (stock-holders) stick to the margin target by systematically getting rid of low margin business (products, customers, geography, channels etc. ). However such initiatives adversely impact potential growth in revenue. Alternatively a reduction in price usually brings more business (read Revenue growth) to the firm, but with a erosion in margin. The third approach is a combination strategy which can be an optimal price for a certain minimum margin or minimum revenue growth.

Now the question is what should a firm do? An obvious response is it depends on it's individual objective and long term strategy? Yes, this is the best answer. Here I want to discuss only about those firms who in their long term strategy highlight a desire to compete with relatively larger players in the market. Analog Devices is a semiconductor device manufacturer which wants to grow and at some point compete with larger players like Texas Instrument; however one of their corporate objectives is make sure that they operate at a gross margin of at least 65%. Hence they religiously monitor their profitability at the device (product) level and try to get out of low margin business. Consequently they often loose their market-size and never able to scale up and become large enough. This is an example of incompatibility between long term strategy and short term objectives. The short term objectives of the firm even if it is entirely successful will not be able to lead it towards the long term goal. Several IT outsourcing firms in India are also making the same mistake now; focusing rigidly on their margin target in spite of having the long-term vision to compete with IBM or Accenture which are at least 5 times bigger than them. The present downturn in economy brings an opportunity for them to aggressively promote their low-cost model in front of clients and steal business away from their Big-5 competitors. However the scare of drop in profitability and too much focus on quarterly results (read myopic view) are not allowing them to pursue their long term strategy.


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