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Generating great performance requires a more dynamic approach to building and adapting a company's capabilities than merely squeezing its operations.
The McKinsey Quarterly, McKinsey & Co.
May 17, 2004
What does it mean for a company to perform well? Any definition must revolve around the notion of results that meet or exceed the expectations of shareholders. Yet when top managers speak with us privately, they often suggest that the gap between these expectations and management's baseline earnings projections is widening. Shareholders tend to think that today's earnings challenges are cyclical. Executives, who find themselves frustrated in their efforts to improve the performance of their companies no matter how hard they swim against the economic tide, increasingly see the problems as structural.
This anxiety is understandable. The overcapacity spawned by globalization shows no sign of easing in many industries, including manufacturing sectors such as aerospace, automotive, and high-tech equipment as well as service sectors such as telecommunications, media, retailing, and IT services. Combined with the increased price transparency provided by digital technology, this overcapacity has given customers greatly enhanced power to extract maximum value. The result — the ruthless price competition that rules today's markets — has convinced many top managers that profits won't rise dramatically even if demand picks up from the recession levels of recent years. In short, the performance challenge companies face isn't cyclical; it will persist for years to come.
The stakes are high. The S&P 500, despite a 40 percent decline from its peak, still trades at a P/E multiple of 15, and consensus forecasts of earnings growth average 8 percent a year — about two to three times the growth of GDP. Lower expectations may well be warranted in a competitive, deflationary economic environment, but reducing expectations of earnings growth to 4 percent would imply a reduction in corporate equity values of no less than 15 to 25 percent.
So top managers have a choice. They can try to close the performance gap by scaling back the market's expectations for future earnings — an approach that implies an acceptance of lower stock prices (and might get them fired). Or they can improve baseline earnings to meet or exceed the market's expectations. Shareholders and managers alike prefer the latter course.
Companies can find additional earnings in two ways: they can try to improve operating performance by squeezing more profit out of existing capabilities, or they can improve corporate performance by organizing in new ways to develop initiatives that could generate new earnings. By pursuing both of these approaches simultaneously, companies can take a powerful organizational step toward meeting the challenges of today's hypercompetitive global economy.
The Limits of Operating Performance
Top managers have traditionally chosen to rely on operating-performance tactics when times are hard and only during good times to undertake more fundamental performance-improvement initiatives. This predilection must change if, as we believe, the challenges facing companies are structural and persistent rather than cyclical and temporary. Companies that depend too heavily on improvements in their operating performance will run into real limits in the longer term.
To be sure, top management, pressured by intense global competition, has reacted correctly over the past few years by pushing operating performance ever harder to meet earnings expectations. Discretionary spending has been slashed, the least productive capacity eliminated, corporate overhead cut, marginal operations and businesses shed. Companies have become far more aggressive in purchasing. These steps, necessary to eliminate waste built up during the boom of the late 1990s, have bought time. But merely acting to secure increased returns from existing capabilities will yield diminishing returns and eventually become counterproductive.
Squeezing operating performance when times are tough is a tried-and-true practice, but it is inadequate in today's hypercompetitive global economy. During the entire post-World War II era, most large companies enjoyed extraordinary strength in their home markets. Their core businesses, often defined geographically, usually gave them privileged access to customers and to labor, capital, and technology. The profitability of these businesses often sufficed to support investments for expanding beyond the core.
With such extraordinary "home court" advantages, top management could set financial targets and develop long-range plans and "visions" to reach them. These plans were incorporated into the operating budgets of businesses. The home court advantage gave companies the muscle to drive their operating performance and to generate the expected profits. Given the opaqueness of the information provided to shareholders, the strength and profitability of core businesses often masked failings such as relatively poor returns from noncore businesses and ineffective corporate overhead. In other words, top executives managed to sustain the illusion that they could predict the future and could thus create expectations of future results. If times got tough, more earnings could always be squeezed from improved operating performance.
During the 1990s, executives in many an industry bet that they could exploit this home court strength to become scale-based winners in the global marketplace. Profits made in home markets subsidized the massive international expansion. It is no coincidence that the industries embracing this strategy — aerospace, automotive, high-tech equipment, investment banking, IT services, media, telecommunications — now populate the list of industries facing structural overcapacity. As barriers to global competition have fallen, so has the home court advantage. As a result, the performance problems that now plague so many companies lie not so much in peripheral as in core businesses.
Fat profits from core businesses in home markets have disappeared. European telecom service providers find that their formerly loyal customers are "rate shopping." US airlines can no longer rely on business travel to subsidize discounts for the mass market. Nor are these problems unusual.
The Risk of Reckless Conservatism
The instinct of companies facing pressures is to retreat to their core businesses, but this is not a practical strategy when the core itself is under attack. What is needed is fundamental innovation embracing not only where and how companies compete but also new ways of organizing and managing them. Making such changes is difficult. Implementing them calls for investment — not easy in an era of overreliance on operating-performance pressure.
Companies typically attempt to boost their earnings by cutting discretionary spending so much that potentially productive long-term investments are compromised. Managers often can't use their own judgment to make even "no-brainer" decisions that could yield important performance gains. We frequently encounter and hear of business leaders who won't spend money on new initiatives even if they are certain to produce large returns (sometimes, in our experience, two or three times the amount invested) within 18 months. Some companies we know have deferred their spending on necessary but unbudgeted new sales personnel, though failing to hire such people means losing substantial revenues the following year and weakens their market position in specific product areas. Other companies have declined to consolidate call centers and to move them offshore — a move that would secure significant ongoing savings in operating costs — because doing so might mean overspending this year's expense budget.
Line managers often lack the freedom to spend money unless their companies seem likely to recover the investment within the current budget year. When such minor decisions are deferred, it is obviously unthinkable to undertake truly important projects, such as investing to build promising new businesses or rewriting the legacy software of core computer operating systems to improve their performance and to reduce longer-term systems costs.
When we raised this point to top managers, they typically expressed horror that such "uneconomic" behavior was taking place. Yet these same top managers are often unwilling to allow exceptions to discretionary expense controls for fear of eroding "make-budget" discipline and suffering the consequent risks to quarterly earnings. The truth is that in many companies, cuts to discretionary spending in core businesses have gone far beyond eliminating waste. Essential maintenance has been cut, and the penalty will be paid in lost revenues and higher costs in the future. In the worst cases, many companies have begun milking their core franchises so much that a future collapse in earnings and even a loss of independence are inevitable.
Extreme operating pressures force line managers to make do with existing capabilities despite the need to adapt businesses to a relentlessly changing marketplace. Managers facing such pressures inevitably lack the resources to explore and experiment. In this environment, how will companies innovate?
Organizing for Corporate Performance
One of the most effective ways a company can respond to today's challenges is to put in place corporate-performance processes to complement their current operating-performance practices. By improving both kinds of performance simultaneously, companies can maximize their chances of closing the gap between the short- and long-term expectations of shareholders and management. Most companies will have to develop dynamic company-wide performance-management processes to make themselves more effective by allocating scarce resources to the best opportunities available. Such processes must be as disciplined as the operating processes used to manage current earnings.
By definition, corporate-performance management involves corporate- and not just business-level managers. (By corporate-level management, we mean general managers who can trade off current versus future earnings and manage expectations for results. At many companies, only the CEO has such responsibilities, but in others they can be vested in group-level managers or in managers of large businesses.)
Unlike operating performance, which can be driven by "vertical" line-management processes, corporate performance requires "horizontal" processes involving company-wide collaboration to generate and share ideas, establish accountability, and help allocate resources effectively. (The research budgets of pharmaceutical companies and the exploration-and-production capital budgets of petroleum companies drive much of the long-term performance in these two industries. Well-managed companies in them often administer such budgets with great discipline and intensity, which we think should be applied to all important initiatives that drive long-term performance.)
Scarce resources now include not only capital but also discretionary spending as well as the talent and management focus needed to find, nurture, and manage new projects that could boost future performance. Major corporate-wide initiatives, such as programs to improve the management of client relationships and to create new product-development and corporate-purchasing processes, would all be part of the effort.
Accountability for performance should reside in the corporation's "top of the house," which is best able to determine what trade-offs between current and future performance are acceptable and is responsible for managing expectations of future results. The top of the house should be construed not as the two or three most senior executives but rather as the entire senior-management team, probably including major business leaders and key functional staff — from 15 to 25 people.
Line and top management should be made collectively accountable for the trade-offs between short-term operating-performance objectives and the discretionary spending and talent investments needed to take on major new initiatives. The burden should not be imposed almost exclusively on line managers — as happens today when top managers "jam down" budget cuts. Individual businesses would probably sponsor many of the best ideas for improving corporate performance. The resources needed to pursue them might involve separate discretionary budgets and full-time staffs drawn from throughout the company. Even a high-impact initiative involving only a single business should be a priority for the whole corporation.
Finding the Best New Initiatives
Effective corporate-performance management improves the way a company identifies and selects its best new initiatives, provides the resources they need, and ensures that once launched they are managed intensively. Consider a chief of technology contemplating a multiyear initiative to rewrite the legacy software of a core operating system that several businesses use, such as a demand-deposit system in a bank or a network-management system in a telecom company. Today, because of operating-performance pressures, such a project might never obtain funds, or the manager concerned might decide to undertake it on his or her own initiative, financing it by allocating the costs to several businesses and developing it over a period of two to three years. Senior management in the affected businesses might have little to do with the effort, only becoming involved when it ran over budget, fell behind schedule, or failed to deliver some of the promised results — or all three.
Under the corporate-performance approach, by contrast, the company's top 15 or 20 executives might meet once a month in a corporate-performance council to review and revise all ongoing projects. Ideas for initiatives would bubble up through the company, and the council would approve the most promising ones. The project to rewrite the core operating system would likely be presented to the council by the head of technology or by leaders of the businesses concerned. It would be subject to open debate before it began rather than executed in isolation. Sponsorship and accountability would be assigned early in the process, and the project would be subject from its inception to regular and frequent reviews, including formal scrutiny by the entire council.
This kind of organization can link the generation of new ideas and initiatives more dynamically to oversight and action by senior and top management. The most relevant business or functional managers would typically sponsor new initiatives. Those cutting across the entire company might have top-management sponsors; those involving conflicts between different managers might be assigned to independent sponsors with fresh perspectives.
A Portfolio of Initiatives
Giving a top-and senior-management team the responsibility for deciding which initiatives to improve and which to reject ensures that a company's corporate-performance projects reflect its broader performance agenda rather than pressures to meet quarterly earnings targets by managing day-to-day operations. A set of tools we have developed to categorize and measure initiatives (see "The Basics of Corporate Performance," at the end of this article) can help managers convert the concept of corporate performance into an operational reality. At the heart of our approach is the development and management of individual new ideas into a corporate "portfolio of initiatives" that can drive a company's longer-term performance by aligning projects with the fluid and risky external environment. (See Lowell L. Bryan, "Just-in-Time Strategy for a Turbulent World," The McKinsey Quarterly, 2002 Number 2.) All activities that could have a material impact on a company's market capitalization become part of the process. We have found that, typically, 20 to 40 initiatives fall into this category.
Ideally, the entire senior-management group would play a role in choosing which initiatives to pursue, to accelerate, or to discontinue; decisions would not be made by individuals or during one-on-one conversations with the president or the CEO. Of course, if consensus proved impossible to reach, top management would ultimately rule on the issues, but it is vitally important to have open debate on the critical ones. These decisions will determine the company's long-term performance, so most of the senior leadership team must be involved in making them.
A typical senior-management group would include top management, major line managers, and critically important functional staff managers, including the heads of the finance, human-resources, marketing, and technology departments — in other words, any member of management with important knowledge needed to inform the debate and to help implement decisions when they are made.
Once formed, this senior-management body should convene at least once a month for a full day; a typical meeting might examine four or five initiatives in various stages of implementation. Every six months or so, the group might review the entire active portfolio of initiatives and determine whether baseline projections of their results met the long-term expectations of the company's shareholders as expressed in its stock price.
Certain initiatives, particularly those that could adapt the company's core business model to changing circumstances, are essential to any corporate-wide portfolio. Such initiatives might include major technology projects, the redesign of the company's core operating model, offshoring decisions, and major marketing changes. Strategic initiatives, such as acquisitions, divestitures, and the building of new businesses, are essential as well.
A particularly important part of the portfolio mix should be initiatives to communicate with and influence the expectations of major stakeholders — customers, regulators, the media, employees, and, above all, shareholders and directors. The involvement of all parts of the company in this area is essential, since strong corporate performance means results that meet or exceed the stakeholders' expectations.
Executed effectively, the process will keep line managers under intense pressure to improve the operating performance of their units. But it will also enable them to propose initiatives requiring major discretionary spending and staffing to a group of executives with a broad sense of the company's overall strategy and performance expectations as well as the power to commit the resources needed. Since managers with big ideas for improving corporate performance would be emancipated from the constraints of their own operating budgets to develop these ideas, they would be encouraged to come forward even if they had difficulty making their budgets. Indeed, the process might become so much a part of the corporate culture that managers wouldn't be deemed to be performing well without sponsoring new initiatives and effectively helping to carry them out.
This approach to decision making can also improve the way companies time and sequence their investments, for everyone involved in debating and reviewing critical initiatives will have the information needed to understand the relevant issues. Such an understanding makes it easier to set priorities and to make the right decisions at the right time with the right information.
Besides developing and launching new initiatives in this way, the improvement of corporate performance involves knowing when to accelerate initiatives that are working and ruthlessly eliminating those that are not. The explicit involvement of all senior managers means that decisions are transparent to all, so it is easier to move quickly to capture new opportunities or to cut losses. The management of risk-and-reward trade-offs improves because a corporate-wide process elicits the views and knowledge not only of the initiatives' champions but also of the entire leadership team. Often, skeptics can see the trade-offs more clearly than advocates can.
Obviously, the resources required to undertake corporate-performance initiatives that involve discretionary spending and staffing must come from somewhere. To make this approach work, a company must carve out a discrete corporate-performance budget and form a project-management office to direct the process. The discretionary funds needed can come only from operating budgets, and the people needed to drive the initiatives will be recruited either by tapping internal talent or by spending money to recruit new talent from the outside. When an initiative succeeds and goes operational, its ongoing activities and staff are moved out of the discrete corporate-performance budget and put back into the operating budget. Unsuccessful initiatives are terminated.
The corporate-performance approach, in sum, differs fundamentally from attempts to use a single process both to improve existing capabilities and to develop new ones. It involves major changes in the way top and senior managers collaborate and in their individual and collective accountability.
A corporate-performance management process will not by itself solve the challenges that managers face today, but it can certainly help. Any decision to shift resources from operating-performance to long-term corporate-performance investments is difficult to make. The advantage of a corporate-performance management process is that such decisions are made explicitly and comprehensively by top managers responsible for driving a company's longer-term performance rather than implicitly by line managers under intense pressure to meet short-term operating-performance demands.
Lowell Bryan is a director in McKinsey's New York office, and Ron Hulme is a director in the Houston office.
The Basics of Corporate Performance
To turn the concept of corporate performance into an operational reality — and to sustain it — managers must build new businesses, adapt existing ones, continually reshape corporate business portfolios for maximum growth, and, at the same time, keep an eye on crucial strategic functions. What is the best way of inspiring employees to develop and carry out new initiatives? How should a company communicate with its core shareholders to guarantee that their expectations are in tune with baseline management forecasts? How fast or how slowly should strategic change be pursued?
The acronym BASICS can serve as a useful mnemonic for the approach we recommend below. Not all aspects of it may be relevant at a given moment, but our experience suggests that ignoring any dimension can greatly slow or even derail otherwise successful companies.
Build new businesses. Our research shows that the most successful corporate performers of the past 20 years have put considerable emphasis on building new businesses instead of focusing on core areas that could not indefinitely sustain growth that was sufficient to meet shareholder expectations. For example, as IBM's hardware operations came under pressure, beginning in the late 1980s, the company relentlessly focused on its Global Services unit, which now provides 40 percent of its revenues and 50 percent of its profits. And in the late 1990s, Wal-Mart developed what is now the largest US grocery-retailing enterprise.
Adapt the core. CEOs put the future performance of their companies at risk if, in addition to building new businesses, they don't adapt core businesses to changing markets. For example, National Westminster — thought of by many as Britain's best retail bank in the mid-1980s — was taken over by the much smaller Royal Bank of Scotland in 2000 because of a failure to tackle the high cost base of the core retail business. Adapting core businesses to change, often by implementing best practices such as lean manufacturing and supply chain management, helps proactive companies avoid this fate. Change is sometimes driven by megatrends — for instance, outsourcing or offshoring. In other cases, companies (GE is a good example) proactively implement broad performance-improvement initiatives that single-handedly raise the bar for entire industries.
Shape the portfolio and ownership structure. M&A, divestitures, and financial restructurings are rightly considered to be among the foremost tasks of corporate strategists. In the wake of the boom of the late '90s, however, tough market conditions have left many companies gun-shy about major moves. Yet reshaping portfolios remains vitally important: research shows that companies that actively manage them through repeated transactions have on average created 30 percent more value than those companies that engage in very few. (See Neil W.C. Harper and S. Patrick Viguerie, "Are You Too Focused?", The McKinsey Quarterly, 2002 Number 2.) Furthermore, best-performing companies balance their acquisitions and divestitures instead of having a preponderance of either.
Inspire performance and control risk. Management must guide individual and collective action so that they harmonize with a company's overall strategy and values. Too often, attention is focused solely on formal systems and processes, such as organizational structures, budgets, approval processes, performance metrics, and incentives. We have found that an exceptional performance ethic can be built with a mix of "hard" and "soft" processes: fostering individual understanding and conviction, developing training and capability-building programs, and providing forceful role models.
Communicate corporate strategy and values. Even if a company gets everything else right in its strategy, it risks dropping the ball if it can't communicate effectively. The ability to anticipate the likely reactions of investors is particularly important: key shareholders have in recent years derailed the restructuring or merger plans of several companies, and large declines in share prices have claimed the jobs of many CEOs who failed to manage or meet the expectations of their shareholders. Tailoring communications analyses to this constituency's perspective can work very well. Of course, investor communications are only part of the story. Building support among external constituencies such as consumers, regulators, and media as well as internal stakeholders, which include the board of directors, senior management, and employees, is critical to executing strategy successfully.
Set the pace of change. Companies with otherwise successful plans often stumble by moving too slowly on strategy or too quickly on organizational change. Sequence and pacing are difficult to judge; the factors that affect them include management's aspirations, external market conditions, and the organization's capacity to execute a number of initiatives simultaneously. Decisions about the pace of change influence how many initiatives a company runs as well as their complexity. In a short-term turnaround, it is hard to run more than four or five key initiatives; in many cases, two or three are preferable. But in a two- to three-year corporate-performance program, 15 to 20 corporate-wide initiatives may be necessary. —Renee Dye, Ron Hulme, and Charles Roxburgh
Renee Dye is an associate principal in McKinsey's Atlanta office, Ron Hulme is a director in the Houston office, and Charles Roxburgh is a director in the London office.