Capitalism is for lovers too

February 8, 2011: 11:01 AM ET

While many companies often resort to shaving employee benefits and squeezing their suppliers to cut costs and turn a profit, others are showing that you can turn an even greater profit by building business relationships that last.

By Raj Sisodia, contributor

(ManagementInnovationeXchange) -- I would not give a fig for the simplicity on this side of complexity, but I would give my life for the simplicity on the other side of complexity. --Oliver Wendell Holmes

When it comes to managing costs, most companies operate with a simple model. They start by trying to maximize their gross margins so that they have a high cushion for spending in areas where they feel they need to spend heavily in order to compete, such as advertising and promotions. But a growing number of high-performing companies are showing that there is a better way to manage spending and improve performance. These companies live and operate on the other side of complexity.

Over the past several years, we have studied a group of companies that defy conventional wisdom and, at first glance, seem to perform financial alchemy. These companies pay their rank-and-file employees much better than their peers, have suppliers who are profitable, invest heavily in their communities, pay taxes at a higher rate, provide terrific customer service, invest in making their operations more environmentally sustainable and do not foist costs onto society. With all this spending, it would seem that there would be less left over for investors.

On the contrary, we have found that these companies dramatically outperformed the market over a 10-year period, by an astounding 9-to-1 ratio (see our book Firms of Endearment: How World Class Companies Profit from Passion & Purpose). We refer to this business philosophy as "Conscious Capitalism."

We have been working to understand how conscious businesses are able to operate with superior financial results while creating many forms of wealth and well-being for all of their stakeholders, including society. It boils down to something quite simple: these companies knowingly operate with lower gross margins, but are still able to achieve higher overall margins than their traditional competitors.

Most companies try to maximize their gross margin by looking for the cheapest suppliers they can find, and then using whatever bargaining power they have to squeeze them as much as they can to get even lower prices. As a result, they end up with low-quality suppliers who struggle to stay profitable, and who can not afford to invest in new technologies or anything else that will improve their quality or make their products more innovative.

Most companies also try hard to keep their payrolls down, minimizing what they pay to their rank-and-file employees, and are stingy with critical benefits such as health insurance. They try to use part-time employees as much as possible, keeping them under the threshold where they would qualify for any kind of benefits. They provide minimal training to their employees, and accept high employee turnover as inevitable.

Conscious businesses are very selective about their suppliers, looking for innovative, quality-focused companies that also operate in a conscious manner. They enter into mutually beneficial long-term partnerships with their suppliers. Suppliers are well paid, and in turn pay their own suppliers and employees well. For example, Costco (COST) is very selective when it comes to picking suppliers, but once they select a supplier, the two parties work closely and are in it together for the long haul.

Conscious businesses also pay their employees above the industry norm and are generous with benefits. Since their direct costs are higher, the gross margin of a conscious business is typically lower than average.

The next item on a company's income statement is the "general and administrative" line, and this is where conscious businesses really shine. Traditional businesses squander their hard won but ill-gotten high gross margins by having to spend heavily on marketing, managerial overhead, legal fees and high levels of executive compensation. They incur high recruiting and training costs due to high employee turnover. Their employees are disengaged and unproductive. Their product quality is suspect, leading to low customer loyalty and high levels of product returns.

Conscious businesses typically have to spend very little on marketing. This is because they have legions of satisfied customers who are advocates for the company. We have found that many conscious businesses spend as little as 10 to 25% of the industry average on marketing. This represents an enormous savings, at a time when marketing costs have been growing rapidly for most companies.

Retailer Jordan's Furniture spends a quarter of the industry average on marketing (as a percentage of revenues) but achieves sales per square foot that are six times higher. Such companies receive the benefit of the best kind of marketing there is, free marketing, not only from their customers but from their employees, their suppliers, their communities and the media.

Conscious businesses typically operate with low levels of employee turnover, thus saving on new employee hiring and training. Turnover at The Container Store, a perennial on Fortune's Best Companies to Work For list, is in the low single digits, in an industry where turnover often exceeds 100%. Employees at such companies are loyal, experienced, highly engaged and productive. Such businesses take great care to hire people whose personal passions are aligned with the corporate purpose. At a time when overall employee engagement levels are shockingly low, conscious businesses have employees who are loyal, passionate, energetic and creative.

Conscious businesses have lower administrative costs because they strive to eliminate expenses that don't add value, gathering ideas from their employees and suppliers about how to do so. They also look to control essential expenses, such as healthcare costs, not through across-the-board cuts, but through ways that benefit the company and its employees. Whole Foods Market (WFMI) is combating rising healthcare costs through a range of employee wellness initiatives that go way beyond what you would find at a typical company, offering employees who maintain low blood pressure and cholesterol levels deeper employee discounts, as an example.

Conscious companies typically operate with much leaner management structures than traditional businesses. They have created systems in which the right people are doing the right jobs and are given autonomy.

And finally, conscious companies operate in a system of very high trust between all stakeholders, and thus their legal costs are much lower than the norm. They understand their customers deeply, produce outstanding products (due in no small part to the fact that they have world class suppliers) and thus have much lower levels of product returns.

Senior executives at conscious companies are modestly paid relative to their peers at other companies. For example, Whole Foods Market has adopted a policy that no one can be paid more than 19 times the average salary (the typical ratio at publicly traded companies is 450-500 times). The only way for executives to earn more at such companies is to raise the average salary of all employees.

We must never forget that businesses create and destroy many kinds of wealth and well-being. Too many of them generate financial wealth at the expense of social, cultural, environmental, intellectual, physical and spiritual well-being. Conscious capitalism is about doing business with a spectrum of positive effects, not having one positive "main" effect and many negative "side" effects.

Conscious businesses spend money where it makes a positive difference. They don't waste money on unnecessary advertising, gimmicky promotions and the revolving door of high employee and supplier turnover. They make a positive impact on the world. It is simply a better way to win.

Raj Sisodia is a professor of marketing at Bentley University and the author of the bestselling books Firms of Endearment: How World Class Companies Profit from Passion and Purpose (with David Wolfe and Jagdish Sheth) and The Rule of Three (with Jagdish Sheth). He is a founding member of the fast-growing conscious capitalism movement and cofounder and chairman of the Conscious Capitalism Institute.

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