The finer
points of linking resource allocation to value creation
According
to new survey results, exploring the more subjective side of investment
decision making yields five elements that correlate closely with
outperformance.
The way companies
allocate resources and
make investment decisions is critical to their ability to create shareholder
value. Our past work has focused on
the pervasive problems of biases and inertia in resource allocation—and found
that when these challenges are overcome, companies can see a lot of value as a
result. But far less investigation has
addressed the more practical side of investment decision making: the very
tactical practices companies use to reach their decisions, such as the steps
they take to provide decision makers with information they need and how they
sequence their strategic-planning activities.
A recent McKinsey
Global Survey set out to explore these questions. When we asked executives
about their companies’ decision-making processes and their performance relative
to peers, the results led us to identify four practices that correlate closely
with outperformance: tying budgets to corporate strategy, making evidence-based
decisions, setting bottom-up performance goals, and formally ranking
investments. We also found a correlation between portfolio composition and
performance: specifically, the companies where business units have similar
financial characteristics (such as growth and return on capital) tend to
outperform companies where business units have different traits. What’s more,
executives who say all five elements are at work in their companies are as much
as four times likelier than others to report outperforming their competitors.
Tying budgets to strategic plans
For all the time
managers spend developing their companies’ strategic plans, they don’t always
succeed at reflecting those strategic priorities in subsequent budgeting
decisions. For example, a company’s strategic plan may call for increasing or
reallocating R&D spending. But when management puts together an annual
budget, they may cut back on the R&D spending to meet a short-term earnings
target. Among respondents, only about 30 percent say their current budgets in
various areas—capital expenditures, product development, product launches,
geographic expansion, and spending on sales and marketing—are similar or very
similar to their companies’ most recent strategic plans.
In our analysis of
allocation practices that link to outperformance, tying budgets to strategic
plans correlates more closely with higher growth and profitability than any of
the other practices we identified. Respondents with a 75th percentile score for
tying budgets to strategy are 53 percent more likely than those in the 25th
percentile to say their companies are growing faster than competitors. In
addition, they are 29 percent more likely to describe their companies as more
profitable than competitors.
Evidence-based decision making
When deliberating over
investment and other strategic decisions, managers have many practices at their
disposal to ensure sound decision making: presentation of information that
contradicts leaders’ views, for example, and explicit discussions of the range
of potential outcomes. Only 60 percent of respondents agree that decision
makers explicitly discuss uncertainties when making resource-allocation
decisions. And only 41 percent agree that their companies consider a range of
potential outcomes or scenarios for a given investment.
When asked which
specific techniques their companies’ managers use to improve decision making,
the largest share of respondents, 59 percent, cite scenario analysis. But no
more than one-third cite any of 12 other commonly referenced checks on biases,
such as pre-mortems, postmortems, and explicit meeting rules.
Nevertheless, the
results suggest that the use of such techniques can lead to better performance.
Respondents whose companies make the most use of evidence-based decision making
are 36 percent likelier than their peers whose companies don’t use these
techniques to report growing faster than competitors. And they are 22 percent
more likely to say their companies are more profitable.
Setting bottom-up performance goals
How executives
characterize their companies’ approaches to setting performance targets, either
top-down or bottom-up, may be a matter of interpretation. Compared with their
C-level peers, business-unit heads are likelier to report that their
company-wide targets are set from the top down. The results also indicate that
larger companies tend to use more top-down target setting than smaller ones
do—which we found surprising, given the complexity and diversity of larger
companies. But it may be that large companies are more top-down-oriented to
simplify their target-setting processes.
Contrary to what larger
companies tend to do, we found that bottom-up target setting is the approach
that correlates more closely with strong performance. Respondents whose
companies do more bottom-up target setting are 26 percent likelier than those
struggling with it to agree that their companies are growing faster than
competitors. They’re also 18 percent more likely than their peers to say their
companies have a reputation for attracting world-class talent.
Formally ranking investments
When evaluating which
opportunities most warrant an investment of resources, many executives report
that their companies formally or explicitly rank potential investments—another
marker of strong performance. Nearly two-thirds report company-wide rankings of
capital expenditures, and more than half say the same for product-development
and sales-and-marketing investments. At companies that rank highest at setting
priorities for high-value investments, respondents are 20 percent likelier than
their peers who rank the lowest to report faster growth than competitors.
It is notable that
responses vary by a company’s level of complexity. About two-thirds of
respondents in the least complex companies (that is, those with three or fewer
business units) say their companies rank their marketing investments. By
contrast, only 36 percent of those at the most complex companies (those with
more than 15 business units) say the same.
Similarity of financial characteristics
Finally, a company is
likelier to outperform when its business units share characteristics of
financial performance, such as similar revenue levels, profit margins, and
returns on either capital or equity. Companies tend to have a harder time
managing businesses that are growing at different speeds or levels within the
same portfolio.
Indeed, respondents at
companies in the top quartile of our similar-characteristics factor are more
likely than those in the bottom quartile to agree that their companies are
growing faster and seeing greater profitability than competitors. In addition
to similar financial characteristics, we also tested for the degree of
relatedness—that is, similar customers, distribution systems, technology, and
manufacturing—across divisions’ assets. Relatedness emerged as a factor in its
own right, but it had only a marginal effect on performance when a company
doesn’t also have similar financial characteristics in place.
The five factors’ cumulative effects
Individually, each of
the five factors—the four practices and the similarity of business-unit
performance—has a significant impact on profitability and growth. When
combined, the factors are even more powerful.
At the companies
ranking low on all five factors, only 14 percent of respondents say their
companies are growing faster than competitors; at the companies that rank high
for all five, 54 percent report higher growth. The results are similar for
profitability: 22 percent of executives at companies ranking low on the factors
say their profits exceed competitors’, compared with 45 percent who say the
same at companies ranking high on all five.
Looking ahead
The survey results
themselves clearly suggest how managers and their companies might improve their
resource allocation and investment decision making. And while managers should
take steps to implement all five factors that contribute to overall value, the
following may be the easiest to implement in the short term:
·
Collaborate to set
performance targets. Although bottom-up target setting
correlates with stronger performance in the survey, we suspect that the best
practice lies at neither of the extremes. Top-down targets can be arbitrary
because they sometimes don’t take into consideration the market conditions that
each unit faces. Targets set using a purely bottom-up approach are susceptible
to sandbagging by the business units. Ideally, executives at headquarters (or
the corporate center) will have enough information on an individual unit’s
prospects to work with its leaders and tailor each unit’s performance targets.
To get there, some companies need to strengthen the capabilities of their
corporate centers, so their executives can work more thoughtfully with business
units on target setting and ensure that it’s a collaborative process.
·
Ensure comparable project
valuation. Although managers often already rank
investment opportunities across their entire companies, too many do not. This
is often true when business units use different assumptions when valuing their
projects, when they neglect to consider the network effects of valuation under
different scenarios, or when project proposals overstate the expected internal
rate of return in order to ensure funding. The more that companies ensure
comparable valuation, the more likely—and able—they are to meaningfully rank
opportunities and allocate resources to those with the highest potential
payoff.
·
Explicitly review financial
characteristics. We know from prior research that companies
that reallocate resources typically outperform companies with more static
resource allocation. One characteristic that is often overlooked, as companies
examine their portfolio of businesses, is the similarity of financial
performance—which our survey identified as critical. Companies should add this
to variables they consider when shaping their portfolios of businesses.
http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-finer-points-of-linking-resource-allocation-to-value-creation?cid=other-eml-alt-mip-mck-oth-1703
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