DEBATE | Why companies should focus on profits before growth

Growth and profitability are issues faced by millions of entrepreneurs around the world. Both are important for long-term success. If a company is highly profitable but not growing, it may be an untapped opportunity for profitable growth. If a company has high growth but is not making a profit, it could mean that they are just accumulating bigger losses than their competitors. Therefore, profitable growth is undoubtedly what commercial enterprises should aim for.

How, then, do firms achieve the enviable position of having high growth and high profitability at the same time? A number of theoretical concepts such as economies of scale, experience effects, first-mover advantages and network effects indicate more or less clearly that growth leads to increased profitability. In today’s entrepreneurial ecosystems, there is often a strong emphasis on rapid growth. Start-ups should become scale-ups as if the strong network effects and advertising revenue potential that enabled the success of Facebook, Twitter, Google – and a few others – apply to other companies and industries.

Standard questioned in controversial study

In fact, empirical research has not provided convincing evidence of a general, strong relationship between growth and profitability. But with the above beliefs as the norm, it was seen as quite controversial when I and some fellow researchers published a study a number of years ago that argued the exact opposite: prioritize profitability before investing in growth.

We reached this conclusion by analyzing a large sample of Swedish and Australian companies. In the study, we analyzed how firms’ profitability and growth changed over a number of years. In summary, our analysis shows that companies achieve high growth combined with high profitability mainly if they have achieved high profitability before investing in growth. Those that embark on high growth from a low profitability base usually do not become more profitable as a result of growth, nor do they manage to sustain growth for very long. In other words, they risk becoming low performers in terms of both growth and profitability.

The study did not provide a direct answer as to why, but made a reasonable interpretation based on the results. If companies can show high profitability at a smaller size, this is likely to reflect strengths in the company’s products/services or business model. In short, the company offers something that customers value more than the cost of providing it. And competitors cannot satisfy customers to the same extent at a lower price. From that favorable starting point, they can expand without sacrificing profitability. If, on the other hand, the company tries to grow from a position of low profitability and no proven superiority, it will have to attract customers with lower prices and more intensive (=costly) marketing. Moreover, growth has to be financed externally, which is more expensive than using its own profits. That doesn’t sound like a recipe for improved profit margins, does it?

Focus on profit before growth

But while the results were strong and held across subgroups, the study had some limitations. The data came from the 1990s, covered only two countries, and the longest time horizon covered was three years. Maybe the payoff comes later? For these reasons, doubters had reason not to be convinced.

Now, those reasons for doubt have been erased by stronger evidence from a study of over 650 000 companies in 28 countries over the period 2011-2019. In Questioning the Growth Dogma: A Replication Study, researchers Cyrine Ben-Hafaïedh and Anaïs Hamelin repeat and extend our original study, finding impressively consistent support for the original findings and conclusions:

– Separately in each of the 28 (European) countries studied
– Across all industry sectors and firm age and size classes studied
– Across all time horizons covered by the data (up to 7 years)
– With multiple, alternative ways of measuring growth and profitability
– With the original and several other analytical techniques

Results also apply to technology-based companies

Yet one might expect that some doubters would still insist that the results do not apply to, for example, technology-based companies that they believe need to scale up quickly to win the market, often with the help of venture capital investment. But there is in fact an earlier replication study of growth and profitability transitions among biotech firms by Professor Malin Brännback and colleagues where the conclusions remained the same.

This means the case is settled – focus on profits before growth! In fact, few if any conclusions in business research are as strongly supported by data as this one. Of course, there are companies that are exceptions, but how many are they? Given the overwhelming evidence we now have from 30 countries, three time periods and different industries, company ages and size classes, it’s time for those who believe in the soundness of the growth-first/grow-at-any-cost strategy to show us their solid, systematic evidence for that position. Or simply reconsider it.

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About Per
Per Davidsson is Professor of Entrepreneurship at Jönköping International Business School and at Queensland University of Technology, Brisbane, Australia. He has repeatedly been ranked as one of the top 10 entrepreneurship researchers globally.

More reading
Ben-Hafaïedh & Anaïs Hamelin large replication study (abstract)

Contact the authors for the full article

Brännback et al Biotech replication (abstract)

The original study by Davidsson et al.

An 8-minute cartoon video based on the original study