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Dynamic Capital Management

 

Most organizations allocate capital in the annual budget, though they may not allocate much of that capital to specific projects. In other words, a percentage of allocated capital is subject to further approval procedures. In this way, the internal bank is only open for four to six weeks a year—when budget allocations are agreed on—which, in a fast-changing world, is a major impediment to any organization that needs to respond rapidly to threats and opportunities.

In a   McKinsey survey of 2,207 executives, only 28 percent said that the quality of strategic decisions in their companies was generally good, 60 percent thought that bad decisions were about as frequent as good ones, and the remaining 12 percent thought that good decisions were altogether
infrequent.a The obvious question is why? McKinsey researchers used regression analysis to calculate how much of the variance in decision outcomes was explained by the quality of the process and how much by the quantity and detail of the analysis. The answer: process mattered more than analysis—by a factor of six. This finding does not mean that analysis is unimportant, as a closer look at the data reveals: almost no decisions in the sample made through a very strong process were backed by very poor analysis. Why? Because one of the things an unbiased decision-making process will do is ferret out poor analysis. The reverse is not true; superb analysis is useless unless the decision process gives it a fair hearing.
To get a sense of the value at stake, McKinsey also assessed the return on investment (ROI) of decisions characterized by a superior process. The analysis revealed that raising a company’s game from the bottom to the top quartile on the decision-making process improved its ROI by 6.9 percentage points. The ROI advantage for top-quartile versus bottom-quartile analytics was 5.3 percentage points, further underscoring the tight relationship between process and analysis. Good process, in short, isn’t just good hygiene; it’s good business.

Another problem is that most organizations don’t track investments effectively. One report concluded that as many as 75 percent of IT organizations had little oversight over their project portfolios and employed unrepeatable, chaotic planning processes.2 The reality is that manyorganizations spend billions on the wrong businesses, products, and projects. The amount of waste is huge.
How much to invest in one business or another, how much to invest in new products or new ventures, and how to evaluate performance across the strategic portfolio are issues that go to the core of effective corporate strategy. These are truly strategic choices that once made are difficult or costly to reverse.
The trouble is that only a few people, often with their own political agendas, make these types of decisions, and their batting averages are generally poor. While operating through only a handful of large divisions has long been an effective way to prepare managers for the top jobs and to limit the number of direct reports the CEO has to manage, the divisions make it difficult for managers to see clearly where value is actually created or destroyed. The division and functional heads usually decide whether and where to place investment funds and how to make key trade-offs between innovative— but long-term—growth opportunities and short-term demands to meet the numbers. The evidence suggests a bias toward meeting short-term demands. One McKinsey study concluded that only 59 percent of financial executives would pursue a positive net present value if it meant missing quarterly earnings targets. Even worse, 78 percent said they would sacrifice value—in some cases, a lot of value —in order to smooth earnings.
The outcome is a host of missed opportunities and a managerial blind spot where high-performing units mask the performance of poor-performing ones. The problem is that senior executives are often unaware that the decisions have been made. The outcome is that there is little transparency in decision making or value creation.
One way that leaders can overcome the traditional resource-allocation system is to see the organization through the lens of a resource portfolio made up of many small self-managed teams (  figure  ). The primary change is to create hundreds of value centers around product lines and market niches. By making teams accountable for creating value and justifying their capital usage, firms are more likely to make better resource-allocation decisions and cut huge amounts of waste.

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In one example, a large health-care company analyzed one of its divisions by the type of disease to be treated, rather than by the classic functional structure of research, development, sales, and production. This meant adding up all the products the division used to treat each disease, the specialized sales forces serving specialist professionals around the globe, and the development teams working on new medical devices.
In another example, a European bank identified more than fifty value centers where it had once had nine divisions. Each center was built around related products, segments, or geographical boundaries.
Examples included consumer finance, asset management for institutional clients such as pension funds, or wealth management for wealthy individuals.4 The bank’s aim was to give value-center teams’ profit-and-loss responsibility, as if each was a stand-alone business. Senior executives benefited by having more detail and understanding of where the bank was creating and destroying value—detail that was previously hidden in budgets and other performance reports. The platform also provided more value-based strategic discussions and improved both accountability and transparency throughout the organization. For example, if there had been any cross-subsidies, they would have become clear. The result was better portfolio management and more control of strategic resources. In effect, leaders saw the investment portfolio through the lens of value centers and operated more like a venture capital company than a central banker. They expected divisional leaders to constantly experiment and spawn new value centers.
While managing so many value centers might appear to increase the CEO’s workload, the reverse is often the case. Focusing more on each value center actually increases transparency because both senior executives and value-center managers find it easier to identify and monitor a few KPIs that drive performance improvement, as well as to make more straightforward decisions. In essence, the CEO can use value centers to eliminate several management layers. Instead of aggregating plans and results into complex divisions and then spending time understanding their performance, the CEO is able to make a larger number of more rapid, more insightful, and more value-based decisions at the value-center level.
To support this more dynamic organization, leaders need to replace the annual budget resource-allocation process. Instead, they need to provide resources when required and justified so that resources can follow the best current ideas. Rolling planning reviews, supported by rolling forecasts, offer a better management platform for overseeing this more dynamic resource management process.
American Express didn’t know how much of its discretionary spending was on worthwhile projects. Nor did it know if it was optimizing risk across its portfolio. It tracked its investment initiatives on thousands of spreadsheets, but no one could collate the whole picture. By moving from annual budgets to rolling forecasts and from making investment decisions twice a year to 24/7, the company was able to not only speed up the concept-to-launch cycle from months to days but also better manage its portfolio so that it wasted less capital and better managed risk.
American Express also moved more resource decisions to frontline teams (below agreed-on thresholds), with the board or an appointed subcommittee in control of the strategic project portfolio and the prioritization of resources. The investment committee is constantly looking at rolling forecasts and releasing funds on the basis of capacity plans and strategic initiatives. This process tells it what funds are available, how many funds are already committed, and what is left to release into the system. This approach has cut costs dramatically, as capacity is not fixed months or years in advance or based on unrealistic assumptions.
To facilitate these changes, a company needs to realign the management information system around horizontal data flows that cope with sometimes hundreds of profit-and-loss accounts. The data flows should also be able to show peer comparisons, KPIs, economic profit, trends, and forecasts.

– To ensure that resources follow the best current opportunities. In most organizations, the best political operators, rather than the most innovative teams, acquire and spend resources. The aim is to change this approach and provide resources to entrepreneurial teams as and when justified.
– To improve the alignment between investments and strategy. Managers reduce waste by ensuring that they derive all investments from a clearly thought-out strategy. Some use the balanced scorecard to provide a robust framework for supporting this process.
– To reduce waste in both operating costs and capital expenditure. Most operating managers see budgets as a “license to spend.” But when managers use resources only as required, they are less likely to overspend. Moreover, with no budget to act as a floor for costs, managers can seek permanent reductions in their continuous quest for higher levels of efficiency and profitability. The elimination of budget provisions on their own could save most large companies huge amounts.
– To enable faster response. Companies can make small-ticket decisions instantly and large decisions every month or so. Thus, new ideas can be fast-tracked to implementation and impact in days and weeks rather than months and years.

 

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