Research suggests that the highest revenue growth rate does not necessarily generate the highest profitability. That makes one think twice about growth and how to align profit growth with revenue growth.
From a shareholder point of view there is a strong correlation between return and growth rate. So investing in companies with a high growth rate seems a good investment strategy. The question is, whether this is also true for a privately held company. After all, the share price of a listed company includes expectations for the future and there is a tendency to extrapolate trends into the future. This is relevant for an outside shareholder that can take profit by selling the stock any time. This is different for an entrepreneur who puts his own money in the company, has no external market valuation and is in essence depending on cash generation from the company. He should focus on the real profitability of the company, not necessarily the short term valuation.
The correlation between profitability (instead of share price) and growth rate is very different:
The numbers show that profitability growth comes under pressure when the revenue growth rate of the company exceeds 20% per year.
This suggests that there is a clear long term 'sweet spot' for growth somewhere between 10 and 25% per year.
These numbers raise as many questions as they answer.
- Why is profitability declining when growth rates go beyond 20% per year? The concept of leverage should bring us an increase of profitability with an exponential pattern. This clearly suggests that there is a limit in economies of scale.
- How could we overcome the negative effects of growth?
Investopedia suggests several reasons for this phenomenon of dis-economies of scale:
- Inefficient managerial or labor policies
- Deteriorating transportation networks.
- Distribute goods and services in progressively more dispersed areas.
We are not convinced of number 3 and 4, because growth can generate significant economies of scale in distribution as well. It all depends whether growth is generated by extending geographical reach or increase of market share within the existing area. There are strong indications for the general relevancy of number 1 and 2.
Parkinson discovered his Law in which he showed that growth of organizations is not directly related to growth of output. Actually, his research showed that staff expanded between 5-6.5% per year regardless of the increase of output. He gave 2 main reasons:
- Management (he called them 'officials'; he did his research in the navy) wants to multiply subordinates, not rivals; and
- Managers make work for each other.
We all recognize the bureaucracy of large organizations. This is precisely the reason why we emphasize the need for cultivating simplicity and frugality. Any form of organizational expansion that does not contribute to the output of the organization as a whole should be eliminated. Focus on the constraint for bottom line contribution and subordinate everything else to this resource. Download our article "Strategic Planning for Exponential Growth" for further reading.