How nimble resource allocation can double your company’s value
Companies
that actively and regularly reevaluate where resources are allocated create
more value and deliver higher returns to shareholders.
“Dynamic resource reallocation” is a mouthful, but its meaning is simple: shifting
money, talent, and management attention to where they will deliver the most
value to your company. It’s one of those things, like daily exercise, that
helps us thrive but that gets pushed off our priority list by business that
seems more urgent.
Most senior executives understand the
importance of strategically shifting resources: according to McKinsey
research, 83 percent identify it as the top management lever for spurring
growth—more important than operational excellence or M&A. Yet a third of
companies surveyed reallocate a measly 1 percent of their capital from year to
year; the average is 8 percent.
This is a huge missed opportunity because
the value-creation gap between dynamic and drowsy reallocators is staggering
(exhibit). A company that actively reallocates delivers, on average, a 10
percent return to shareholders, versus 6 percent for a sluggish reallocator.Within
20 years, the dynamic reallocator will be worth twice as much as its less agile
counterpart—a divide likely to increase as accelerating digital disruptions
and growing geopolitical uncertainty boost the importance of nimble
reallocation.
Why this disconnect? In my experience,
executives struggle to figure out where they should
reallocate, how much they should reallocate, and how to
execute successful reallocation. Additionally, disappointment with earlier
reallocation efforts can push the issue off top management’s agenda.
To get real value from resource
allocation, executives should follow four important principles.
1. Go
granular
Beware the tyranny of averages. A single
unit may have lines of business or geographic pockets with very different
returns. It’s not uncommon to see a 10 percent decline in one area while
another is experiencing triple-digit growth. In fact, the variability is often
much more significant across granular market segments within one business unit
than across large business units.
Segmenting the company and defining
the level of granularity can be something of an art, as top
executives can’t debate trade-offs across thousands of micromarkets (although
some functions, such as marketing and sales, should). You need to drill down to
the smallest meaningful business, where a shift in resources will
produce a material impact for the overall company (likely more than 1 percent
of total revenues). Additionally, each segment you isolate should have a
distinct external market—say, premium sports cars in the United Kingdom—even if
some resources are not fully divisible. For example, R&D might be shared
across premium sports cars regardless of country, but not the marketing
spending.
2.
Focus on value creation
Sometimes investments have a direct
business case and you can quantify the net present value of all future cash
flows associated with it. A project to invest in a new mine, or to develop a
new vehicle, may look like that. In other cases, the overall economic profit
(profit created above the cost of capital) of a segment may be an excellent and
more consistent method to assess ongoing value creation. Assessing which
segments deserve more or less money and attention requires the right metrics.
One of my favorite and relatively simple
return-on-investment (ROI) metrics is calculating cumulative expected economic
profit and dividing it by the cumulative (financial) resources it will require
to produce (for instance, invested capital, additional R&D, or sales and
marketing). How quickly the investment pays off will vary according to the
business life cycle. For example, fast-moving-consumer-goods or services
companies may take fewer than three years to realize most of the returns from a
major investment, whereas products that are more complex may take longer.
3.
Overcome biases
Start by acknowledging that everyone has
biases. Resource-allocation decisions tend to be heavily affected by these
biases: executives are often overconfident, believing they can reverse and
improve on past performance, and find it hard to back away from big bets, even
when those investments fail to deliver. At the same time, they attribute too
much risk to new opportunities and can be slow to embrace them.
Any resource-allocation exercise must be
grounded in hard data so that decisions are driven by facts and logic. Some
common techniques to overcome biases include these:
·
forcing the prioritization of opportunities based on their value
creation or ROI
·
committing to a minimum annual reallocation—and moving some cash
into the bank for new allocations
·
role-playing scenarios that force executives to debate against
their natural interest or to allocate resources to anonymous business segments
that may or may not be their own
My favorite technique is reanchoring,
which removes management’s optimistic “hockey stick” projections of rapid
improvement. This is done by building a model based on outside forecasts and
assuming there will be no improvement in performance; leaders then debate
whether it is still an attractive investment. If it’s not attractive, it’s
important to test the confidence that a big improvement is achievable before
continuing to invest.
4. Be
agile
In this volatile business environment,
resource allocation should be regularly adjusted, especially when major events
occur, such as June’s Brexit vote or last year’s sudden oil-price decline. Some
businesses have a systematic stage-gating process for investments. Typically,
when developing new products and services, you hold off some of the investment
until there is evidence that it is yielding results. The strategic-planning
process needs to recognize material uncertainties—both external (demand growth,
competitive launches, regulation) and internal (new technology, changes in
talent)—and establish clear threshold levels at which decisions on resource
deployment would be revisited.
Some argue that this agile approach
creates too much change and does not provide enough time and commitment for new
business initiatives to flourish. But by clarifying the metrics for weighing
whether investments are paying off, you improve the quality of your governance,
deal with genuine uncertainties, and can reevaluate quickly when unforeseen
events inevitably occur. By setting clear expectations for value creation in
each segment and by clarifying the major assumptions about market evolution and
internal performance that underpin those expectations, you ensure that
theresource-allocation process is continuous rather than cyclical.
Ultimately, even with the best intentions,
resource reallocation can fall victim to organizational inertia and internal
power dynamics. In companies where unit heads run their businesses like
fiefdoms, with little input from those outside the walls unless they fail to
make their numbers, the challenge is particularly daunting.
Managers whose businesses are performing well will
naturally resist the argument that their resources might produce even better
returns elsewhere. To change the conversation, try showing them the potential
impact of reallocation on share price. In one case, the chief financial
officer of a large company demonstrated that just 1 percent more growth in more
attractive segments could raise the share price by 30 percent.
By Yuval Atsmon
http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/how-nimble-resource-allocation-can-double-your-companys-value?cid=other-eml-alt-mip-mck-oth-1608
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