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Keep calm and allocate capital: Six process improvements

Jun 4, 2024 | Public | 0 comments

Most large corporations have annual processes to allocate capital and other resources across business units and for strategic initiatives enterprise-wide. The typical practice is to begin with a strategy or “strategic refresh,” develop a long-term (three- to seven-year) financial plan, and lay out a highly detailed budget for the first year of the plan. Unfortunately, the processes are often both muddled and rigid; they typically take months to iterate, generate reams of distracting detail—and then fail to allow for sufficient flexibility to adjust resource allocation over the year. The result: a failure to align resources with strategy.

Every company faces unique challenges. Not all of the measures we describe in this article will be appropriate in every situation, and there’s no one-size-fits-all list of process improvements. However, we find that in most cases, senior leaders should do the following:

  • As part of the strategy or strategic refresh, identify the role of each business in realizing the company’s strategy (for example, to accelerate growth, improve ROIC, or to divest) and the company’s ten to 30 most important initiatives.
  • Use a streamlined approach to develop the company’s long-term financial plan by employing a value driver model, with only a few line items for each individual business unit or product line.
  • Ensure that the long-term financial plan allocates resources to the company’s ten to 30 most important initiatives.
  • Match next year’s budget to the first year of the long-term financial plan.
  • Keep to a compact planning schedule.
  • Design in-year flexibility, at a regular cadence, to allocate more (or less) resources to existing or new initiatives.

In this article, which is part of our ongoing “Strategy to action” to help companies improve resource allocation, we explain each of these six critical process improvements.

1. Identify each business unit’s role and the most important enterprise initiatives

Every strategic refresh should address two fundamental questions: first, what is the role of each business in realizing company strategy (such as to accelerate growth, improve ROIC, or divest), and second, which specific initiatives are the highest priority for the company, within that business and across the enterprise. In our experience, we have found that the sweet spot for companies is ten to 30 essential initiatives. If the list is longer than that, it can diffuse attention and become impractical to manage. If it’s shorter, it probably misses some important initiatives that top management should be involved with.

For example, a company may announce that its strategy is to grow in Latin America. That may be a terrific idea, but without more detail it isn’t actionable. Resources can’t be allocated to catchphrases. What would a practical Latin America growth strategy look like? To start, the company should identify the specific countries it will focus on. Next, it should spell out the major considerations, such as whether the company intends to enter a country on its own (perhaps using a team in a country relatively near where it already has a presence), partner with an existing player in that market, or make an acquisition. The company should also allocate the capital needed for whichever of those options (or others) it intends to pursue. Nor is money enough. The company should identify which business or team will be accountable, name a full-time team leader, be clear about which steps are needed (for example, identifying targets and building relationships), and make sure that the initiative is not starved of money or senior-management attention.

2. Focus on a small number of key value drivers for the long-term financial plan

Most companies’ long-term financial plans include too many line items. This kind of detail slows down the process, makes iteration difficult, and can obscure the true drivers of value.

To be effective, a long-term financial plan needs to be concise. For example, there is no need for ten or more items under general and administrative (G&A) expenses; the G&A line can stand alone. In most cases, income statements for each business should include only revenues, cost of goods sold, sales and marketing, R&D, and overhead costs—without disaggregating detail. An enterprise runs on value drivers, not accounting items. An effective financial plan clearly lays out the most important value drivers for each business unit, surfacing the few key elements that are most important for profitable growth, return on capital, and other company imperatives.

What do key value drivers look like? Consider a filmmaking company: there is a lot that goes into creating successful movies over a multiyear period. But cut to the chase (as they say in Hollywood), and its model can be simplified to producing three blockbusters and five smaller films. Its most impactful value drivers are the average budgets for large and small films, marketing costs, and overhead expenses. A music subscription business, for its part, would have similarly compact but completely different key drivers: the number of subscribers, revenue per customer, and customer churn.

Many senior leaders push back on “keep it simple,” saying that it is impossible to distill their businesses into just a few drivers. But these leaders are mistaking the forest for the trees—and underestimating the costs of examining too many trees.

In our experience, many senior leaders push back on “keep it simple,” saying that it is impossible to distill their businesses into just a few drivers. But these leaders are mistaking the forest for the trees—and underestimating the costs of examining too many trees. It isn’t possible to achieve 100 percent certainty in a complex business; regardless of industry, a competitive landscape is constantly shifting and usually can’t be predicted to a few percentage points. Parsing excessive line items, meanwhile, takes away time that could be better spent managing issues that have more of an impact, and yields diminishing returns. Often, the extra detail delivers no benefits at all.

While the number of line items should be kept to a minimum, the number of business units or product lines should be sufficiently granular to aid the allocation of resources based on the roles, objectives, and needs of each business unit. For example, a division with a fast-growing business unit and a mature or shrinking business should be divided into two businesses, so that top management can ensure that each has the right goals and resources (even if the division leader remains responsible for execution). In practice, a large corporation’s long-range financial plan should typically cover 20 to 50 product lines or business units.

3. Ensure that resources are allocated to the most important priorities

We’ve been surveying senior leaders for years, and a majority of them report that their organizations are underinvesting. Digging deeper, this usually means that companies don’t allocate the proper resources to the most important strategic initiatives, especially growth initiatives. Often, the long-range financial plan simply states the targets and financial projections for each business unit.

A better approach is to be clear on targets and have the long-range financial plan highlight the specific resources that are allocated to the highest-priority initiatives, whether they are enterprise-wide or within a particular business unit, to make sure those targets are met. This typically requires the company to allocate resources among its business units differently from how it had in prior years, regardless of legacy spending or “fairness.”

For example, one major consumer-packaged-goods company took away the “base” level of spending for some of its legacy European operations because of their lack of growth and relatively low returns on capital. Instead, the company allocated those resources to three specific initiatives in Latin America. And at one leading retailer, the CEO personally ensures the full funding and management of the company’s top six enterprise initiatives, in addition to spending almost one day per week on those initiatives.

4. Base this year’s budget on the first year of the long-term financial plan

Remarkably, the prolonged financial-planning process usually ends with a year one budget that does not tie to the long-range financial plan; instead, the year one budget is often closer to the last year’s budget. In a McKinsey survey of over 1,200 executives, less than one-third of participants reported that their company’s budgets were similar or very similar to their most recent strategic plans. Another study revealed a striking 90 percent correlation in investment spending from year to year. While some degree of year-to-year correlation is to be expected, it’s clearly impossible for a company to boldly reallocate capital (an approach that our research shows creates the most value for companies on the whole) when it keeps allocating capital to essentially the exact same things.

While the year one budget should be more detailed than the long-term financial plan, the top-line revenues, profits, and cash flows for each unit should always match year one of the long-term plan. Two techniques are useful for making this happen. First, start building the budget based on the initial year of the financial plan, rather than on last year’s budget or current year’s results. Second, require that only the CEO and CFO have authority to approve deviations from the long-range plan. Without that rigor, resource allocation tends to dissipate in a fog of war.

5. Compress the time frame for the entire planning process

Financial planning can be a never-ending story. A senior team starts with a strategic refresh in the first quarter, followed by a long-term financial plan that kicks off in the second quarter, and finishes toward the end of the third quarter. Meanwhile, the budget for the next year begins in the third quarter and wraps up at the turn of the year—or even later. This prolonged timeline invites unnecessary draft turning and complexity, and diminishes the forcing-mechanism value of having to make a decision on the most important initiatives and value drivers.

The resource allocation process should be synchronized and as short as possible, with each step taking a maximum of two months. These steps should be scheduled as late in the year as possible, while still allowing ample time for rigorous analysis and meaningful debate. The entire process should also be contiguous.

One consumer retail company’s process serves as an example of an inefficient resource allocation timeline. The company conducts its annual strategic refresh in April or May, followed by long-term financial planning in September and October. Finally, after about two more months of hiatus, the budgeting process takes place from December until March for the calendar year that has already begun. Each step in the process is excessively time consuming and remarkably disconnected from one another. A consumer-packaged-goods company, by contrast, demonstrates a more effective resource allocation timeline. The company initiates its annual strategic refresh in May, which drives the long-term strategic financial plan and resource allocation process conducted from June until September. The long-term strategic financial plan flows into the annual budgeting process, which starts in October and ends in November.

A process that runs from May to November is better than one that runs all year long and into the next, but it can still be significantly improved. First, any gaps in the processes should be eliminated; the longer plans sit, the more stale and less urgent they become. Second, decision makers should realize that multiple iterations are a tax on their time—they should receive one or two bites of the apple, and put in the work up front to make sure there aren’t excessive numbers of drafts. Finally, the second quarter is simply too soon to start; it provides an unnecessary cushion, at the expense of harder deadlines and greater focus.

Nothing so concentrates the mind as 24 weeks to finish a strategic refresh, a long-term financial plan, and year one of next year’s budget.

Precise timelines will vary depending on the enterprise—which in turn depends on its industry (technology companies, for example, move much faster). But to borrow from the old saying, nothing so concentrates the mind as 24 weeks to finish a strategic refresh, a long-term financial plan, and year one of next year’s budget. In most cases, a company should begin its strategic refresh shortly after midyear and complete the refresh before the end of the third quarter; immediately commence its long-term strategic financial plan once the refresh is completed; and then, when the long-term strategic plan is done, immediately turn to its budget for the upcoming year. For a company whose fiscal year matches the calendar year, the process would begin after midyear and finish in mid-December (exhibit). Across industries, CFOs of companies that have more compact timelines report that they outperform their peers on numerous dimensions.

Companies can aspire to a much faster and more compact resource allocation timeline.

6. Build in year-round resource allocation

Budgets are never perfect—which is exactly what one would expect, since circumstances change over the course of the year. For many companies, the approach to in-year flexibility is to allocate the resources to each division or unit leader and give them the decision rights to reallocate among lines they control, as they see fit. This, however, creates a perverse incentive for divisions or business units to hoard resources they don’t need, spend it on lower-priority items or, even worse, underinvest in strategic initiatives to meet short-term targets.

To prepare for inevitable changes in the number of resources needed and available during the year, the authority for meaningful flexibility in resource allocation should belong only to senior leaders, at the enterprise level. An investment committee, including the CEO and CFO (and ideally only one to three additional voting members, with the CEO making the deciding call) should meet monthly to make important in-year investment decisions. These monthly meetings should be for decisions, not for progress updates or general reviews. The agenda should address only those matters that require a decision—and the result should never be “deciding to decide.” Key decisions that the committee may make during these meetings can involve allocating funds for stage-gated projects or projects that were provisionally approved during the annual planning process, discontinuing projects that aren’t likely to meet their objectives, and approving new projects that arose after the annual planning cycle.

Flexibility usually requires setting a reserve of unallocated funds that can be used during the year for new initiatives that were not anticipated during the planning process. Withdrawals from the reserve should be authorized only by the CEO or investment committee and must align with well-defined criteria, such as affirming that the release is for a strategically vital initiative or covering essential external costs, such as dealing with natural disasters. While there is no universally applicable percentage for the “right” amount to reserve, a general guideline is to set aside 5 to 20 percent of the corporation’s budget. For businesses operating in sectors with longer project lead times and minimal market volatility, such as utilities, a strategic reserve of about 5 percent of the budget may be sufficient. Conversely, industries characterized by rapid market changes and fluid resource allocation, like software, may find a reserve of approximately 20 percent more appropriate. Consumer-packaged-goods companies, for example, may encounter a newly launched campaign that fails to meet its targets or a competitor that launches a new product that senior leaders did not anticipate. As situations arise, the investment committee should reallocate resources quickly, opening up opportunities for other businesses and initiatives throughout the year.

Certain projects are easier to stage-gate during the formal planning cycle, such as pharmaceutical companies preparing to make significant investments in marketing once regulatory approvals are obtained. Other allocations of capital may be approved only provisionally because they require further analysis (for example, proof of concept for a new technology, or decisions to drill to a gas or petroleum deposit); in those cases, the investment committee should withhold that capital for in-year allocation. The key is to build in flexibility. An effective resource allocation process anticipates change and maintains at least a monthly cadence—and ideally, one that is more frequent than that.

The processes for turning strategy into action should be radically simple. The most effective processes clearly spell out the strategy and the role of each business in achieving that strategy, identify the most important value drivers, ensure that the most important initiatives have the resources they need, insist that the budget matches the first year of the long-term financial plan, keep to a compact planning schedule, and design and demonstrate in-year flexibility. After all, managing a large corporation is already complicated enough.

The post "Keep calm and allocate capital: Six process improvements" appeared first on McKinsey Insights


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