What drives next year's profit?

chris-liverani-dBI_My696Rk-unsplash Credit: Chris Liverani on Unsplash
A new study by Abhi Bhattacharya, Neil A. Morgan and Lopo L. Rego reported in the Journal of Marketing explores the relationship between market share and future profit, seeking to explain why the relationship exists.

"Examining why and when market share drives profit" aims to explain next year's profit (t+1) based on this year's variables (t). This is important because ensures that if a relationship is identified we can be reasonably sure that it is a causal one.

Advertising and R&D spend relate to future profits
In seeking to highlight the role of market share in driving future profit the authors compare two models, one using firm size, advertising spend, R&D spend, and market growth and the other adding market share to those same variables. Reassuringly, firm size, advertising spend, and R&D spend are significantly related to profit reported in the following year.

Three causal mechanisms underlie market share
Adding market share finds that it too has a significant relationship with next year's profit, although I do note that the explanatory power of the overall model does not improve. It seems that market share may be accounting for some of the variance otherwise attributed to firm size, advertising spend, and R&D spend. Importantly, the analysis finds that value market share predicts future profits while volume share does not.
Further model variations test the explanatory power of three causal mechanisms underlying the influence of market share:
  1. Market power, i.e., the ability to raise prices more than the category average when costs rise. I might describe this as pricing power, but either way, higher market share firms might be expected to have more influence with suppliers, sellers, and end-customers and so command a higher price point.
  2. Operating efficiency, i.e., the lower the firm's operating expense compared to its sales, the more efficient the firm. The hypothesis is that higher market share firms can lower costs and either deliver better value for customers or realize stronger margins.
  3. Perceived quality, i.e., the quality of the different firms as perceived by end-consumers. The assumption is that market share is used as a substitute for quality, particularly when customers have a limited ability to judge the real quality of a good or service. The quality ratings used come from the Equitrend database.
To cut a long story short, all three of the mechanisms are found to be significant predictors of firm profit, and notably the main effect of market share becomes insignificant in conjunction with these three. However, market power and quality signaling were more widely applicable than operational efficiency. The authors conclude,

"Thus, none of the three theories from which the hypothesized mechanisms arise is "correct" or "incorrect", but market power and quality signaling generally explain more of the variance in the market share-profit relationship across firms and industries."

Cost-side and demand-side benefits

In their conceptual framework, the authors suggest that operating efficiency is a cost-side benefit, quality signaling is a demand-side benefit, and market power could be either. Based on my own (admittedly far less sophisticated) analysis of the relationship between financial performance and attitudinal metrics, these hypotheses make sense and start to point us in the direction of specific consumer-driven metrics that might help drive future profit.

I look forward to what the next paper from Abhi Bhattacharya, Neil A. Morgan and Lopo L. Rego has to tell us. But what are your thoughts?



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August 13, 2022

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