In Philip Fisher's hypothetical example, two companies sell widgets for ten cents. One earns four cents per widget; the other earns one. With costs unchanged, the selling price rises to twelve cents. Their profits become six cents and three cents. The weaker company's profit triples, making its improvement look spectacular. But let the selling price fall to eight cents. The efficient company still makes money. Its rival loses money on every sale.
The profit cushion pays for more than survival. It can fund the work that keeps products useful as competitors catch up. Fisher's answer connects that money with people capable of making worthwhile changes and advantages rivals cannot readily copy. A growing research budget alone proves little. In the companies and practices he examined in the early nineteen seventies, execution determined whether spending strengthened the business.
Turn ideas into something customers want
A cost advantage can buy time while rising expenses force the industry to adjust prices. Even a company whose profits swing with the business cycle can qualify for Fisher's conservative standard if its earnings at the low point cover its needs and dividend payments to owners. The test is whether difficult years interrupt its ability to keep developing.
Development begins with customers. Marketing needs to recognize changing demand and explain products in terms of buyers' reasons for buying. It also has to measure selling costs and direct effort toward profitable products. Researchers need that knowledge, alongside production's judgment about what can be made economically. Specialists must cooperate, yet retain enough freedom to explore. Strong science can lose its lead if manufacturing or selling fails.
Financial controls help managers act before a promising expansion becomes unaffordable. Product costs reveal which sales are worthwhile. Budgets expose departures from the plan early enough to respond. Inventory and unpaid customer bills tie up money, so growing sales can consume cash even while the income statement looks healthy. Management needs to control those demands as carefully as it chooses new equipment.
The organization must keep questioning its methods before trouble forces change. As products become easy to copy, renewal replenishes the offerings that customers cannot readily obtain elsewhere. That work soon outgrows one brilliant person. Capable colleagues need authority to decide and reasons to cooperate. Managers at every level must develop successors, so improvement does not depend on the founder making every decision.
At Texas Instruments, Fisher describes workers suggesting improvements in the early, labor-intensive semiconductor operations and sharing gains through financial rewards and recognition. Mechanization reduced some opportunities for individual contributions. Management adapted by having teams estimate what they could accomplish and set their own goals, often above what management would have proposed. Employees believed their decisions mattered and their achievements would be acknowledged.
A rival could announce a participation program immediately. Earning that confidence took more. Asking for ideas while denying employees influence or rewards could leave them disillusioned. Trust, judgment and working relationships helped make the successful programs difficult to copy. Those qualities connected the company's treatment of people to its ability to improve operations.
Give competitors more to overcome
Good profits attract challengers. Fisher prefers a modest advantage that persists to spectacular returns that draw overwhelming competition. Campbell Soup illustrates how several operating advantages could reinforce one another. Its sales supported making its own cans. Regional plants reduced freight costs for a heavy, inexpensive product. Brand demand secured shelf space, helping further sales, while advertising costs were spread over many cans. A rival had to compete with the operation surrounding the soup.
Customers could still eat something else or make soup themselves, limiting Campbell's prices. Size also brings bureaucracy. And large plants making interchangeable products can provoke price cutting as producers fight to keep capacity busy. Scale helps only when its particular economics work.
Other companies can build protection through service. Buyers of expensive equipment want repairs and confidence that the supplier will remain in business. A newcomer has to build that support as well as sell an appealing machine. Expanding into unrelated businesses, meanwhile, can stretch management across unfamiliar problems without strengthening any of these advantages.
What keeping the profits accomplishes
Retained earnings are profits left in the company. They can pay for development, including failed experiments, facilities and the cash tied up in inventory and customer credit. Adequate profits can finance this work without adding fixed debt obligations or issuing new shares that reduce existing owners' proportionate ownership. Management may reasonably sacrifice some current profit for worthwhile future earnings, provided it preserves financial strength and carries out the work well.
Keeping money does not establish that it is being used productively. Fisher's illustrative shop installs air-conditioning because competitors have it and customers might otherwise leave on hot days. Once all the shops have cooling, total trade need not grow. The spending protects an existing position. That differs from creating fresh earning power, and from wasting money by expanding an inefficient operation or hoarding cash far beyond foreseeable needs.
Owners also need income. Fisher favors dependable dividends that leave room for worthwhile growth, with cautious increases the company can sustain through ordinary setbacks. Exceptional reinvestment can eventually produce larger dividend payments even when the initial payout is small. The money has to earn that result. A business able to pay its owners and keep renewing itself has made those future payments more plausible through work it can afford today.
Three things to keep
A profit cushion matters most when business conditions get worse.
Competitors can copy a program more easily than the trust that makes it work.
Retained profits must earn their place beside dependable dividends.