Staircases to growth by Mckinsey Quarterly.

Creating Value Through Growth Strategies

Instructions

** Answer these questions from references given. (You may use other’s that you feel are necessary)

** 2 pages total- not including reference page

**No cover, No introduction, No conclusion

Relying on the Staircases to growth paper, analyze each of the seven staircases. Which of the seven staircases is JP Morgan Chase Bank using to grow? Which ones would you recommend, why? Does it have enough market power so that such growth strategies may help to create value?
Which of the resources (platforms of capabilities) mentioned in this paper is JP Morgan Chase Bank implementing? Explain one by one, how they are used, could be expanded and/or could be implemented in the organization. Are they unique resources, why or why not?
Does JP Morgan Chase Bank implement the three horizons approach that McKinsey proposes? If so, how are they implemented? If not, make your own proposal for each horizon. Be creative.

References

- Baghai, M., Coley, S.C., & White, D. (1996). Staircases to growth. Mckinsey Quarterly. (Note: Be sure to read the sidebars)
- Hall, S., Musters, R., & Lovallo, D. (2012). How to put your money where your strategy is. Mckinsey Quarterly, (2), 28-38.

Staircases to growth

By Mehrdad Baghai, Stephen C. Coley, and David White with Charles Conn and Robert J. McLean

Staircases to growth

With revenue increases of 25 percent a year, how do the world’s best growth companies do it? A few steps at a time, each bringing options and new capabilities. No formulas, just astute bundling of competences, skills, assets, and relationships.

One thing about growth is clear: the literature touting its importance keeps growing, and growing, and growing. What is less clear—and often needlessly obfuscated in management jargon—is how companies grow. Take the tricky, potentially paralyzing, dilemma that confronts most senior executives contemplating growth. On the one hand there exists a chasm between their current inventory of institutional capabilities and those required to achieve their growth aspirations; on the other, taking a discontinuous, "bet-the-company" leap could send the company barrelling down a deep and dangerous crevice, ending in the thud of extinction.

Sidebar

About the research base

The Growth Initiative is one of five global taskforces McKinsey has launched in the past year to undertake applied cross-functional research and development. The initiative supplements McKinsey's continuing R&D programs in specific industries (financial institutions and energy, for example), functions (including organization and operations), and geographies (China is one). The aim is to develop distinctive and practical perspectives that help our clients increase profitability. The research is based on academic thinking, practical insights from clients, and detailed case studies of 40 successful growth companies. The case studies involve reviews of company information, annual reports, SEC filings, newspaper and magazine articles and books, and, in the majority of the cases, interviews with a cross-section of managers. The case studies of success have been supplemented by 15 cases of growth failures.

To provide some timely, practical advice on how companies can grow, we examined 40 of the world's leading growth companies to find out how they approach, and more important, implement growth strategies (see sidebar, "About the research base"). These companies—in industries from basic materials to high technology based throughout Europe, North America, and Asia—clearly know how to grow: they average 25 percent compound annual growth in sales and 32 percent in shareholder returns (from dividends and capital gains). Their response to the question "How do I get from here to there" would typically be "not by big bold leaps but by a series of measured steps." Each step makes money in its own right; each is a step up in that it adds new institutional skills that better prepare the company to open up—and take advantage of—opportunities; and each is a step roughly in the direction of a broader vision of where the company wishes to be.

When these companies look back at what they have achieved, they see not steps zigzagging all over the place but a distinctive pattern or "footprint" in the form of a staircase of manageable steps. While few—if any—single steps are dramatic in and of themselves, linking them together as a staircase of sequential growth achieves results that definitely are. None of these companies will say that, looking forward, they had perfect foresight of where the steps would lead. On the other hand they will say that each time they climbed a few they felt they had institutionalized a new set of capabilities, created new business options, and carved a competitive position for themselves that was beyond their reach when they stood at the bottom of the staircase.

The staircase approach of continuously compounding skills and options is consistent with the competitive reality of most industries. The competitive landscape is changing so rapidly that it is impossible to predict paths several years ahead. Building a staircase explicitly recognizes that the appropriate strategy for any company depends on where it is today and on the state of the world down the road. The best a company can do under these circumstances is to build appropriate capabilities and create strategic options and opportunities without pre-empting or constraining future flexibility.

Staircase of initiatives

Successful growers adopt a bifocal perspective which emphasizes both near term and long term: vision and tactics. Even though they plan within a clear strategy, they are not slaves to a mechanistic process for projecting a medium-term budget. Many low-growth companies are.

The focus on near-term steps takes advantage of the fact that, each time a company builds new skills, new opportunities open up. It means managers are able to move fast enough to exploit opportunities early, before competitors move in or conditions change. It also encourages managers to behave as entrepreneurs rather than bureaucrats, avoiding excessive deliberation and "paralysis by analysis." This does not mean they act imprudently but, simply, that they act.

While great growers are focused on immediate steps, they are not capricious. They act with informed opportunism toward a clear vision of the kind of company they are building. The Walt Disney Company (Disney), for example, requires its groups to articulate five-, ten-, and fifteen-year directional plans. Enron, the Texas-based gas company, moves quickly to maximize opportunities for its rapidly evolving gas businesses—originally toward its vision of becoming "the world's first gas major," and now with the aim of "creating energy solutions worldwide."

To achieve their aspirations, companies like these use a similar pattern over and over. The first step secures an option on an opportunity. If it shows promise, next steps test the concept further and help accumulate the confidence and skills for more steps. After a few years the concept is replicated and extended as the strategy gains momentum. Later, replication is accelerated to take full advantage of the successful formula.

Coca-Cola Amatil (CCA) is a good example of a company that has bootstrapped itself to growth in this way. Now one of Coca-Cola's flagship bottlers, in 1980 CCA was a diversified Australian conglomerate with a few small Australian Coke bottling franchises. In 1982, it bought bottling franchises in Vienna and Graz in Austria—a small step, but one that took the company into Europe. Over the next few years, CCA continued to build its Australian base by acquiring adjacent regional franchises, while divesting its interests in other businesses. By the mid-1980s, the company was in two countries, with a potential market of 25 million consumers.

Having learned about the Austrian market from Vienna and Graz, and about the benefits of consolidation from its Australian acquisitions, CCA decided to go further. Between 1987 and 1991, it bought eight contiguous Austrian franchises, consolidating operations and achieving economies of scale. In 1988, it stepped into two countries adjoining its home market—Fiji and New Zealand—and continued to consolidate Australian regional franchises. By 1991, this put CCA in four countries, exposed to 29 million people.

Each step built CCA's skills and confidence, and strengthened its reputation in The Coca-Cola Company's eyes. All three became critical as CCA moved into the next stage of growth, extending its formula into other adjoining—but undeveloped—markets: Hungary and the Czech and Slovak Republics, and Indonesia and Papua New Guinea. Lacking modern production, distribution, and marketing skills, and with low per capita consumption, these markets offered tremendous potential.

By 1994—now in nine countries, with 250 million consumers—CCA began moving into more and more contiguous markets: Belarus, Slovenia, Ukraine, Croatia, Switzerland, Poland, Romania, and new regions of Indonesia. In all, CCA is now in 16 countries, with a total potential market of 368 million people.

Enron has followed a similar model. In 1985 the company identified the potential in independent private power generation (IPP), but its capability was limited to some gas reserves, a pipeline network, and conventional gas contracting skills. Enron secured an option in IPP by acquiring the rights to operate a small, gas-fired cogeneration plant in Texas in 1986. The company built a bigger plant in Texas the following year. Confident the concept was valid, it undertook three more IPP ventures in other American states. In 1990-91, the company took its first truly big step by developing Teeside in the UK, the world's largest combined-cycle gas turbine plant. With its international reputation cemented by the project, and with skilled specialists on its staff, Enron expanded into India, Indonesia, Germany, China, Guatemala, and the Philippines—becoming a worldwide force in IPP.

Neither CCA nor Enron relied on huge "bet-the-company" gambles to create growth. Each step was a manageable investment that built on established capabilities and offered the potential to add new ones. Sometimes, however, it may be necessary to make large investments and stretch the company in order to preempt competitors—in scale-intensive businesses, for example. This was the case with News Corporation's BSkyB satellite television network in the UK and with Li Ka Shing's similar venture, StarTV, in Asia. Usually, however, the staircase approach enables a company to avoid such risks.

The record of successful growers makes the idea of building staircases appealing. But when you are at the bottom of your staircase, how do you begin? The constraints can seem unbreachable if you believe your opportunities are limited and your skills poor. The companies in our sample teach valuable lessons about how to view opportunities and abilities in order to break through these perceived constraints.

The opportunity pipeline

Many executives feel nervous about their ability to grow simply because they do not see many opportunities; neither do they see their companies generating profitable growth ideas. Their managers often tell them that markets are mature, core franchises under threat, and all paths to growth restricted.

Much of the growth debate fails to address how to overcome these perceived limitations. Instead, advice focuses on one strategic option or another and claims that any company that adheres to a single path will grow. One view talks about product innovation, another about stepping out into emerging growth industries, another about globalization. This approach is reminiscent of the proverbial boy with a hammer, who runs around looking for things to hit with it. Each path is a legitimate hammer, but not every company is a nail, and the hammer may not break the shackles a company feels.

No single strategy can offer a complete view of how to grow, and any approach that overemphasizes one strategy also oversimplifies the manager's challenge. Given that each company brings to growth a unique position and exposure to different kinds of opportunity, there must be many possible strategies for each to consider.

That is certainly the view taken by successful growers: they believe neither their industries nor circumstances prevent them from considering opportunities along various paths. Indeed, companies in similar positions in a given industry may see their options very differently and pursue strikingly different courses. We have seen the best companies consider seven distinct strategic degrees of freedom—and use most of them.

1. Maximizing existing customers. The first degree of freedom—and the one closest to home—is to sell more of the current product range to existing customers. This may simply mean using promotional programs to increase the frequency of purchase or use. However, it can also mean managing sophisticated cross-selling programs. State Street Boston is a good example of a company making the most of its existing customers. It has become the world's leading provider of custodial services by acting as the "outsourced back office" to pension funds and mutual funds. While many customers start out with bulk "commodity" services, however, State Street grows with these existing customers by offering them increasingly differentiated and, therefore, higher value-added services.

2. Attracting new customers. A second way for a company to grow, still without stepping into new product ranges, is by attracting new customers to its existing product range, thereby expanding the size of its customer franchise. Gillette, for instance, paid little attention to women for years. By extending the marketing of its Sensor product to women, however, it has both expanded the women's shaving market and taken 65 percent of it.

3. Innovation of products and services. Among the commonest ways to grow is the introduction of new products and services. Gillette continually moves customers up to new, improved razors that are better than competitors' offerings: from coated stainless steel blades, to twin-bladed products, to a pivoting head shaver, to a pivoting head shaver with a lubricating strip, to its revolutionary Sensor, and now Sensor Excel. Gillette has also built on its razor brand to add grooming products such as aftershave lotion, deodorant, and shaving cream.

4. Innovation of the value-delivery system. Successful companies recognize the potential in redesigning the business system by which a product or service is delivered. The Home Depot has used this path, developing a fundamentally new retail system which is more appealing to most customers than the small local hardware store (because it gives better service and wider choice) and cheaper (because of its buying power, efficient logistics, and capital productivity). In financial services, Charles Schwab pioneered the discount brokerage industry in the US after deregulation in the mid-1970s—offering price-sensitive customers fast, accurate execution of share-trading orders at substantially lower cost than full-service competitors. Schwab has continued to innovate with improvements to its delivery system such as automated telephone trading, personal computer trading, and, most recently, Internet trading.

In India, Arvind Mills has redesigned the value-delivery system for jeans. Arvind, the world's fifth-largest denim manufacturer, found Indian domestic denim sales limited because jeans were neither affordable nor widely available. At $20 to $40 a pair they were beyond the reach of the mass market, and existing distribution systems reached too few towns and villages. In 1995, Arvind introduced Ruf and Tuf—a ready-to-stitch kit of jeans components (denim, zip, rivets, leather brand patch) priced at about $6. It distributed them through 4,000 tailors, whose self-interest motivated them to market the kits to create demand for sewing services. Ruf and Tuf are now the largest- selling jeans in India by far, driving sales in Arvind's main product, denim, and netting the company a potentially powerful consumer brand.

5. Improving industry structure. Improving industry structure is a degree of strategic freedom frequently exercised by great growers, because it involves growth close to the core, that is, in similar geographies and types of business. At its simplest, this can mean buying businesses to be improved on a stand-alone basis, and some types of greenfield capacity expansion. Both can change an industry's cost and capacity dynamics. European industrial companies such as Jefferson Smurfit and CRH use this path, as do US consumer goods companies ConAgra and Sara Lee, specialty manufacturer Federal Signal, and high-tech innovator Thermo Electron.

Multiple acquisitions enable companies to create economies of scale—CCA found this with its franchises in Austria and Australia. Again, it is a course that can add up to influence the competitive dynamic of a whole industry, as Columbia/HCA's consolidation of the US hospital sector illustrates. Founded in 1987, Columbia/HCA's principal strategy has been to acquire, and often merge, hospitals in adjacent regions. Ten years later, it owns 343 hospitals, 135 outpatient surgeries, and 200 home health agencies, making it the largest healthcare services provider in the US. The same kinds of economic benefit could of course be achieved with alliances and joint ventures, removing the need to acquire the assets outright. Some industries can also be reshaped by influencing regulation.

6. Geographical expansion. The fourth strategic degree of freedom is geographical expansion, which companies can pursue either by intensifying their coverage of regions in which they already operate—as 7-Eleven Japan, The Home Depot in the US, and Australian cinema and entertainment group Village Roadshow are doing with spectacular effect—or by moving into new regions (the strategic path at the heart of globalization). Many companies in our sample have taken the latter course, including Arvind Mills, Sara Lee, Johnson & Johnson, Gillette, SAP, and Jefferson Smurfit. It can, however, be a difficult path to navigate.

7. Stepping out into new business arenas. Many successful growers grow by competing in new arenas. They seek opportunities vertically along their industry chain, or find areas of their existing operations in which to specialize. Enron vertically integrated from gas pipelines into gas-fired power generation. State Street Boston, on the other hand, started as a bank but spotted a chance to specialize, as already noted, in the provision of custodial, accounting, and information services to pension and mutual funds.

Other companies step into new businesses to which they can apply established skills. Sara Lee has entered a range of consumer brand businesses from pantyhose to hot dogs. Federal Signal, which started in signs and signals, is now a leader in specialty vehicles too, including fire engines and street sweepers. Charles Schwab stepped from discount brokerage into the mutual fund agency business, defined contribution pension funds, financial advisory services and, most recently, direct selling of insurance.

It is clear that truly great companies—those that are able to sustain growth—pursue growth along several of these paths, often simultaneously. Many, such as Disney, use all seven degrees of freedom. (See sidebar, "Disney's use of seven degrees of strategic freedom.")

Resourcing processes to generate ideas

Sidebar

Disney's use of seven degrees of strategic freedom

Many wonder if, perhaps, Disney is a special case. While it may be, we see very similar patterns in most of our sample of growth companies. And one need only look back to its dark days in the early 1980s to note that Disney's growth has not come as a natural birthright on the strength of its assets. Disney has driven growth since then by using all seven strategic degrees of freedom. Disney, as a world-class marketer, is very good at maximizing its current customer base. It also attracts new customers, however, by going after customer franchises beyond its traditional family orientation. It started Touchstone and Hollywood Pictures, and purchased Miramax, for instance, in order to tap the teenage and adult markets. Disney also constantly innovates with products and services. Its release of three animated feature films every two years is the starting point for the introduction of thousands of merchandising products, home videos, music cassettes and discs, attractions and rides at theme parks, live theatrical productions, and even computer games. Recently, it has also announced new theme parks, including Animal Kingdom and California Adventures.

Disney has been at the forefront of most of the value-delivery system innovation in its industry. It was quick to adopt new channels for its entertainment—first television (with the Wonderful World of Disney), then cable television (with the Disney Channel), and eventually home video. It opened a new merchandising channel in the form of a chain of Disney Stores, then changed the way some people take vacations by building on its theme park business in Orlando to deliver a unique package: guests are offered day- and night-time entertainment at the Magic Kingdom Park, EPCOT, and Disney-MGM Studios, as well as hotel accommodation, restaurants, and bars. Every part of a tourist's stay can be catered for through a Disney package deal.

Geographically, Disney has grown by distributing its films, videos, and merchandise worldwide. It expanded its theme park business first from Anaheim to Florida, then Tokyo, and then France with EuroDisney. It is now extending its stores globally.

In order to improve its industry structure, Disney has largely eschewed big acquisitions (ABC excepted) in favor of more subtle vehicles. It creates cross-promotional relationships with McDonald's and Mattel based on Disney characters, for example. The company shapes its regulatory environment by working with the Florida government to secure unique property ownership and development arrangements.

Disney has a long tradition of stepping into new arenas when it sees an attractive opportunity. Its first step was from animated films into theme parks; more recently, it has moved into live entertainment (including theater and sports), cruise liners, resorts, and even residential communities such as Celebration, in Florida, and Val d'Europe, in France. Perhaps its biggest bet so far is its move to integrate vertically into television by acquiring ABC.

Recognizing the strategic degrees of freedom available for growth is important, but not enough. Companies still have to identify specific opportunities. To do so, they pour resources and senior management time into generating ideas. In this way they produce so many that competitors are left exhausted from the effort of keeping up. Not all ideas will work, but one could be the next big opportunity.

Johnson & Johnson, for example, has dozens of vice-presidents of licensing and acquisitions, many with doctorates in law or science or medicine. Their job is to identify and nurture opportunities by establishing relationships with medical entrepreneurs, venture capitalists and investment banks, research establishments, and universities. The institutions give Johnson & Johnson access to new medical technologies that might be good targets for acquisition. After development, these technologies become the products Johnson & Johnson distributes through its global salesforce.

In other environments, the processes are more organic but the focus on generating opportunities is the same. Opportunities present themselves to the Hong Kong-based Li Ka Shing group, which includes Hutchison Whampoa, through the extraordinary network of contacts Li has cultivated. He has achieved unequalled presence in China by cultivating relationships with central and regional governments, state-owned enterprises, financial institutions, overseas Chinese entrepreneurs, and western multinationals.

The process has been under way since the late 1970s. Li built the China Hotel in Guandong in 1980 before China opened up, then donated HK$850 million the following year to build Shantou University. He met Deng Xiaoping in 1986 and maintained contact after the Tiananmen Square protest in 1989. The same year Li contracted China Aviation to launch the Asiasat I satellite for StarTV. He also shares business interests with government enterprises such as CITIC and Cosco. The resulting contacts have opened opportunities that account for much of the several billion dollars he has committed to the mainland.

Assembling platforms of capabilities

Finding even the most fertile growth opportunities does not mean a company will grow. Great growers know they will profit from an opportunity only if they are capable of exploiting and protecting it. Unfortunately, most advice about how to use capabilities to grow tends to be narrow and may reinforce managers' perception that they are hindered by having limited capabilities.

Perspectives such as "skills-based strategy" and "the core competence of the corporation" rightly emphasize the importance of the skills inherent in an organization's people and processes. But neither considers what other capabilities a company might bring to bear. Great growth companies do. They recognize, and maximize, whole classes of capability ignored by traditional perspectives. They start with strong business-specific competences, but also acknowledge the importance of growth-enabling skills (in acquisitions and deal structuring, for example), privileged assets (such as infrastructure, patents, and brands), and special relationships.

Business-specific competences. Successful growers are good at what they do and have skills that make them distinctive. Disney, for example, possesses unmatched competence in character design and animation; since 1928 and the first Mickey Mouse cartoon, Steamboat Willie, Disney has led its industry. This has been the foundation for growth in filmed entertainment from which the company has grown into merchandising, music publishing, and theme parks.

Great growers do not only use such business-specific competences to make more money from existing assets; they are also able to see more value in new opportunities for which those competences are required than others do. Canada's Barrick Gold, which has quickly become the world's most profitable and third-largest gold producer, has distinctive competence in its development and operation of gold mines, for example. It uses the biggest autoclaves in the industry, runs the largest dewatering system in the world, and has exceptionally low overheads and a unique approach to exploration and development of reserves near existing mines. These are the basis of the company's growth formula: they mean Barrick is able to take mines that to others appear marginal and turn them into top performers.

Growth-enabling skills. Focusing on core competences gives a limited view of the range of attributes required for growth. Great growers are also distinguished by their mastery of more generic "growth-enabling," skills including making acquisitions, financing, risk management and deal structuring, regulatory management, and capital productivity enhancement.

It has become the popular wisdom that acquisitions, especially large ones unrelated to a company's main business, are risky and often destroy value. Yet almost all the companies in our sample have used acquisitions as part of their growth strategies. More than half the growth of US food company ConAgra, for example, has been driven by acquisition. The company has made more than 45 significant purchases in the past ten years alone. One core skill that pervades ConAgra is the ability to find and secure acquisitions that meet growth/return targets.

Not all companies' acquisition programs are about buying established businesses, however. They can also focus on feeding the "opportunity pipeline," with purchases aimed at patents and small businesses developing promising ideas.

Great growers also commonly exhibit skills in financing, risk management, and deal structuring. While Barrick Gold's core competence is in the operation of gold mines, Robert Wickham, then chief financial officer, recognized in 1992 that larger gold companies would need to know as much about financing as they do about metallurgy." Barrick has used gold bonds—which index interest to the gold price—to finance new mines, offloading some of the risk of developing a mine. Li Ka Shing makes his capital go further and shares risk through clever deal structuring. He reduced the initial funding needs of StarTV, for instance, by securing upfront payment from founder advertisers while deferring StarTV's payments to program suppliers, both in return for sharing the potential upside.

Finally, exceptional capital productivity skills enable great growers to make commercial successes of projects that other companies might reject. Increasing the incremental productivity of capital investment, not only increases returns on individual projects but also expands capacity and resources for further growth. Hindustan Lever's exceptional success in Indian consumer goods markets—it is the country's largest packaged goods manufacturer—is partly due to its ability to achieve sales revenues per dollar of fixed assets that are double those of the Unilever company worldwide.

Privileged assets. A company's assets, if distinctive, can bring competitive advantage in current businesses, but they can also be important in future development. Privileged assets include brands, networks, infrastructure, information, and intellectual property, and may be as important in exploiting growth opportunities as people skills and company processes.

Disney uses its proprietary intellectual property as a privileged asset. Its library of characters such as Mickey Mouse and the Lion King has underpinned development in home videos, musical recordings, merchandise retailing, and theme parks. Disney is not unique; many companies have similar intellectual property assets in the form of proprietary technology and patents. To be valuable, however, intellectual property must be recognized as such and put to use.

But in emphasizing the importance of knowledge-based assets, it is easy to overlook the contribution physical infrastructure can make. In the petroleum industry, adding gas fields to existing trunk pipeline routes is a recognized way of growing at minimal incremental cost. Some mining companies are similarly able to turn established infrastructure into a growth asset. By controlling the heavy-haul freight railroads and port infrastructure required for remote mines, they are able to develop other proximate deposits—that would not on their own justify construction of new infrastructure—at incremental cost. In gasoline retailing, oil companies have come to see their outlets as prime real estate upon which to build convenience stores and fast-food outlets.

Networks and information can similarly be a basis for growth. Established distribution networks enable their owners to piggyback new products into the market at lower cost than competitors. Hindustan Lever possesses a powerful base in the form of its distribution network into thousands of Indian villages. This has garnered the company an advantage that is particularly hard to emulate; it has better maps showing village locations and road quality than even the government mapping service. And information—databases of customers, or exclusive knowledge of markets—is increasingly used to gain advantage. Capital One, for instance, prefers to define itself as an information-based marketing company rather than as a credit card issuer.

Special relationships. Relationships are one of great growers' most important—but least talked about—capabilities, as Li Ka Shing's unrivalled position in China demonstrates. They may provide access to deals and financing, or bring complementary skills needed to develop an opportunity.

The access that carefully cultivated relationships open up is important not only in emerging markets. Bombardier, a Canadian snowmobile maker that has become the world's fourth-largest aircraft manufacturer, owes much to the strategic importance of its relationships. Building on a platform of operational excellence in other transportation manufacturing markets, Bombardier's staircase of growth in aerospace has relied on strong strategic partnerships with other aerospace technology leaders. This network allows Bombardier to share project risk and concentrate on its own strengths as designer, assembler, and marketer.

Relationships also enable companies to pool skills for the purpose of exploiting opportunities one company could not pursue alone. Village Roadshow has combined its expertise in cinema operation with Warner Brothers' European cinema sites to accelerate both companies' growth in Europe. At the same time, Village's Australian knowledge and Warner's theme park expertise have fuelled growth in Australian theme parks and resorts.

A web of complementary relationships is at the heart of the growth formula pursued by SAP, the German software maker. The complexity of SAP's products requires technical expertise at every stage of implementation. Rather than provide that itself, SAP uses partnerships—with the makers of the hardware that runs its software (IBM, Compaq, Bull, or NEC, for instance), with the vendors that sell the product and provide technical support, with the systems consultants that implement the product (Price Waterhouse, Andersen Consulting, or Ernst & Young, for example), and with the software developers that provide complementary business- or industry-specific functions. It is in the interests of each partner to increase SAP's sales: widespread adoption has made SAP R3, its leading product, the worldwide standard in integrated business software.

Breaking constraints by assembling new capabilities

It can appear that companies like these were always more capable than their competitors. Often that is not the case. Many managers setting out to grow face a gap between the abilities they have and those they need to net opportunities. By assessing their skills like a laundry list, they can only conclude that they do not have what it takes to bag the prize.

But great growers shift their attention from what they have to what they need, and go out and get it. Consider Bombardier. It won its position of the fourth-largest aerospace manufacturer in the world—dominating the market in smaller regional aircraft—by assembling and then developing the skills it needed in just ten years. It started in 1986 by acquiring Canadair. In the late 1980s, it launched improved versions of its Challenger business jet. In 1989, it bought Shorts Brothers. Shorts, the nacelle manufacturer for the Fokker 100, was a technical leader in composite materials and had underutilised manufacturing capacity. In 1992, Bombardier added 51 percent of de Havilland, another Canadian aircraft maker that brought with it a state-of-the-art paint shop and a marketing and salesforce with access to 60 commercial aircraft customers in 22 countries. When the company launched its first regional jet it was from an already established market position.

Similarly, Samsung assembled the wherewithal to enter the semiconductor business from scratch. It is a story of capability building that is daring in terms of size and strategic risk. Having studied the idea's potential in 1982, the company established an R&D centre in California the following year to collect technology information, recruit engineers, train Korean staff, and conduct initial product and process development. It also hired fresh, high-calibre Korean engineers from US high-tech companies. It licensed design technology from Micron Technology and process technology from Sharp, and then acquired the latest equipment, sending more than 70 engineers to the suppliers for training. Samsung also retained Japanese technical consultants and retired engineers to "moonlight" in technology transfer and troubleshooting. In 1986, the company also joined an R&D consortium with LG and Hyundai to conduct new basic research. Between 1987 and 1994, it invested more than $4 billion in facilities and another $300 million in product development.

In this way the company gradually closed the gap on competitors. It was four years behind Japanese rivals in entering the 64Kb DRAM market, but it launched its 256Mb DRAM chips in 1994 at the same time as industry leaders did. While the jury is still out on whether Samsung will earn exciting returns—it depends on your view of the industry's cyclical character and the cost of the company's capital—there is no debate about the remarkable speed and effectiveness with which the company accumulated the skills for a world-class semiconductor business.

Not all capability assembly is so dramatic. Charles Schwab's California pilot program in direct insurance sales, for example, combines the life insurance products of Great West Life with its own telephone sales representatives and customer relationships. If successful, the business could be extended to all Schwab customers across North America.

One key to putting together skills is to combine them in bundles that are tough for competitors to copy, because if competitors can imitate them, you cannot protect the value of your businesses. At Disney it is the combination of competences (animation, financial management, and theme park operation), privileged assets (cartoon characters, brand names, and resort properties), and special relationships (with promotional partners, entertainment talent, and the Florida government) that distinguish it.

A company need not possess strengths in all areas of a business—just in the areas impor-tant to making money. Growers distinguish between attributes that garner value and those that are simply necessary to play the game. Enron became a world leader in international private power generation because it saw that profit did not depend on construction and operation skills, but on deal structuring and risk allocation. So in the early years it was unimportant that the company was not distinguished at building and operating power stations, because instead it was good at coordinating and negotiating fuel supply contracts, electricity sales contracts, financing packages, government guarantees, and construction contracts—skills few utility competitors possessed. Operating skills, on the other hand, could be acquired through tender.

Sidebar

Leading growth

Kickstarting and sustaining profitable revenue growth is tough. The harsh statistical reality is that only 10 percent of companies with above-average growth will sustain it for more than ten years. Executives who aspire to grow profitably and sustainably are therefore betting against the odds. A sound growth strategy is important. But it is a long way from a successful growth program.

Why do so few growth programs succeed? And what can leaders do to change the odds in their favor? These are the questions we have sought to answer with research into 40successful growth companies, supplemented by research into 15 failures.

The first reason for failure is that many management teams do not integrate and balance the aspirational, strategic, and organizational imperatives of growth. Some executives begin in the wrong place, developing bold strategies before they have "earned the right to grow" by ensuring that current operations are profitable and competitive. Others invest in generating ideas before they have the people, incentives, and structure to move from concept to reality. Yet others focus on building ambition and entrepreneurship but neglect to impose the discipline of choosing between strategic alternatives.

The second reason for failure is that executives find it difficult to concurrently manage initiatives with different pay-off horizons. It is not an easy job. Some companies protect and extend their core business well in the short term, but neglect to invest adequately to secure growth over the longer term. Not surprisingly, growth begins to stall after three to five years. Others get so excited by building momentum in the emerging growth engines that will underpin profitability three to six years out that they pay insufficient attention to today's core—and begin to lose the ability to generate cash and the stakeholder confidence required to sustain the right to grow.

Leadership across three dimensions

Successful growth leaders balance and integrate their efforts across three dimensions. They build a stretching commitment to growth throughout their organization, drive development of new growth engines, and cultivate the environment of entrepreneurship in which growth thrives.

All companies manage across these priorities to some extent. But the most successful are distinguished by the intensity and balance with which they pursue the nine actions that underpin the aspirational, strategic, and organizational imperatives. Disney's growth, for instance, has been driven by the skillful operationalization of all nine dimensions of strong growth programs.

Commit to growth

•Earn the right to grow. Growers must earn the right to grow, then maintain it. They relentlessly pursue operational excellence to underpin their growth efforts, and divest underperforming or distracting businesses. They earn investors' confidence through clear and consistent communication about growth programs.

•Raise the bar through stretching targets and values. Growers aim high. Many set profit targets well beyond industry averages. Others articulate and embrace stretching aspirations based on what they want their company to become. All balance targets and aspirations with strong corporate values. These can be critical to prevent an organization shaking apart under the strains of growth.

•Embrace an expansive mindset. Growth companies do not believe their business environments limit growth. They reject traditional market definitions, challenge conventional wisdom, and break constraining mindsets so that they are less likely to miss opportunities a more orthodox mindset might obscure. They push their passion for growth throughout the organization to motivate employees.

Build growth engines

•Fill the opportunity pipeline. Growers gush with ideas, and recognize that they will need more and more to keep up the pace of growth. They understand there are multiple degrees of strategic freedom, and invest in the search for opportunities along as many of them as possible.

•Assemble a platform of capabilities. Companies that think about their capabilities only in terms of business competences are missing much of their potential competitive advantage. Growers build from a broader platform of capabilities which includes privileged assets, special relationships, and growth-enabling skills. And if they are missing the capabilities they need to exploit an opportunity, they assemble them through partnerships, acquisitions, or internal development.

•Climb a staircase of initiatives. Growers do not let themselves get stuck in a morass of strategic planning and medium-term budgeting. While they are committed to a long-term vision, they focus on near-term steps. They evolve by linking these small, manageable steps in series. Each builds new capability and opens new horizons.

Cultivate entrepreneurship

•Create a connected set of small communities. People in growth organizations do not sit in crowds; they run in teams. Growth companies organize around small accountable communities—such as independent operating companies—which replicate the speed and flexibility of small companies and foster a greater sense of ownership and pride in achievement. At the same time they achieve the reach and resources of a large corporation by sharing brands, infrastructure, relationships, people, and best practices.

•Breed business builders. Growth requires entrepreneurs: people who want to build their own businesses regardless of the challenges. But they are scarce, and many companies' greatest growth constraint is not having enough of them. So growers bring in new blood from outside and put in place systems to nurture new entrepreneurs and leaders from the inside.

•Design reinforcing systems and incentives. Growth is hard work, so the pay-off must be clear. Growers reward success handsomely by giving top performers increased responsibility, variable compensation, and equity distributions. They also penalize mediocrity.

They ensure that other systems reinforce their aspirations. Planning, budgeting, capital allocation, and performance yardsticks are designed to provide support and manage risk.

Leadership across three time horizons

Growth leaders manage concurrently across three time horizons. They aim to defend and extend their current core business to pay off in the short term, work hard today to build momentum in new or emerging businesses which will underpin medium-term profit growth, and devote time and resources to explore and secure options for long-term profit growth.

The number of years in each horizon will vary among industries. In slowly evolving, capital-intensive basic materials sectors such as pulp and paper or chemicals, the tail of the first horizon may be five or ten years out. Hyper-evolutionary software, electronics, or Internet businesses may see their third horizon as close as five years away.

The challenge is to balance today's efforts across all three time horizons in proportions appropriate to industry context. Managing the tensions inherent in simultaneously attending to all three is easy to advocate, hard to do. The types of targets, strategies, people, performance metrics, and incentive systems appropriate to creating medium- or long-term options are often at odds with those needed to drive short-term performance. Bringing all this together across three dimensions and three time horizons takes judgment, courage, and tolerance of ambiguity.

The right balance for any particular company, of course, depends on the industry and the company's starting position. Companies whose growth has stalled must pay particular attention to initiatives to kickstart growth in the short term. Companies with sound core businesses but few long-term options may pay more attention to horizons two and three, particularly if their industries are changing quickly. Neither type, however, can afford to ignore any of the three.

Flexible evolution of a business

Not all combinations of opportunity and capability lead to successful long-term staircases. In fact, the flexibility to cut short an unsuccessful series of steps is an attractive feature of the staircase approach. Consider Lend Lease, a consistently growing Australian company. Having started in construction and property development, by the early 1980s Lend Lease had developed expertise in fund management through its wholly owned property trust. In 1982, the company spotted an opportunity in the approaching deregulation of financial services. It began with two modest steps: it bought 25 percent of Australian Bank, the first new trading bank established in Australia for 50 years, and a minority stake in MLC, a poorly performing insurance and fund management company. The investment in Australian Bank, while profitable, proved fruitless as a step into retail financial services, and Lend Lease sold its stake in 1988. MLC was a different story. Lend Lease has built it into the fourth-largest fund manager in Australia through a staircase of profit improvements and acquisitions.

Such flexibility provides one of the main advantages of the staircase approach. Over the medium term, it is possible for companies to transform their range of skills and business portfolio with limited risk. Indeed, it is a recurring theme among our sample of companies: they evolve their businesses over relatively short periods by pursuing options their new skills have opened up.

Many low-growth companies, in contrast, feel held back by advice to "stick to their knitting" and remain "focused." But no one disputes the evolution of Disney's knitting from cartoon animation into theme parks and television programming, or from theme parks into resorts, even though such an evolution might seem to fly in the face of advice to focus. Moreover, Disney's evolution shows few periods of unmanageable stretch.

Many other great growers have evolved in a similar way. Hutchison Whampoa has developed from Hong Kong-based container terminals to electricity generation, retailing, and telecommunications in China, Canada, and the UK. Bombardier grew from a specialized manufacturer of snowmobiles into a world-leading maker of regional business jets and regional aircraft. Johnson & Johnson has extended into an extraordinary array of medical technologies. Gillette has added grooming products, small electrical appliances, and toothbrushes, and now batteries, to its core razor business. Federal Signal started in electrical signage and signals, and is now also a leading maker of specialized vehicles. Lend Lease, from its origins in construction, became a fully integrated international property company with a strong domestic financial services business. Charles Schwab has extended from discount brokerage into selling a range of financial products and services. The records of all of them suggest that truisms such as "stick to the knitting" and "focus on core competences" are prescriptions that require careful interpretation.

How to put your money where your strategy is By: Hall, S., Musters, R., Lovallo, D., McKinsey Quarterly, 00475394, 2012, Issue 2

Most companies allocate the same resources to the same business units year after year. That makes it difficult to realize strategic goals and undermines performance. Here's how to overcome inertia.

Picture two global companies, each operating a range of different businesses. Company A allocates capital, talent, and research dollars consistently every year, making small changes but always following the same broad investment pattern. Company B continually evaluates the performance of business units, acquires and divests assets, and adjusts resource allocations based on each division's relative market opportunities. Over time, which company will be worth more?

If you guessed company B, you're right. In fact, our research suggests that after 15 years, it will be worth an average of 40 percent more than company A. We also found, though, that the vast majority of companies resemble company A. Therein lies a major disconnect between the aspirations of many corporate strategists to boldly jettison unattractive businesses or double down on exciting new opportunities, and the reality of how they invest capital, talent, and other scarce resources.

For the past two years, we've been systematically looking at corporate resource allocation patterns, their relationship to performance, and the implications for strategy. We found that while inertia reigns at most companies, in those where capital and other resources flow more readily from one business opportunity to another, returns to shareholders are higher and the risk of falling into bankruptcy or the hands of an acquirer lower.

We've also reviewed the causes of inertia (such as cognitive biases and politics) and identified a number of steps companies can take to overcome them. These include introducing new decision rules and processes to ensure that the allocation of resources is a top-of-mind issue for executives, and remaking the corporate center so it can provide more independent counsel to the CEO and other key decision makers.

We're not suggesting that executives act as investment portfolio managers. That implies a search for stand-alone returns at any cost rather than purposeful decisions that enhance a corporation's long-term value and strategic coherence. But given the prevalence of stasis today, most organizations are a long way from the headlong pursuit of disconnected opportunities. Rather, many leaders face a stark choice: shift resources among their businesses to realize strategic goals or run the risk that the market will do it for them. Which would you prefer?

Weighing the evidence

Every year for the past quarter century, US capital markets have issued about $85 billion of equity and $536 billion in associated corporate debt. During the same period, the amount of capital allocated or reallocated within multibusiness companies was approximately $640 billion annually -- more than equity and corporate debt combined.1 While most perceive markets as the primary means of directing capital and recycling assets across industries, companies with multiple businesses actually play a bigger role in allocating capital and other resources across a spectrum of economic opportunities.

To understand how effectively corporations are moving their resources, we reviewed the performance of more than 1,600 US companies between 1990 and 2005.2 The results were striking. For one-third of the businesses in our sample, the amount of capital received in a given year was almost exactly that received the year before -- the mean correlation was 0.99. For the economy as a whole, the mean correlation across all industries was 0.92 (Exhibit 1).

In other words, the enormous amount of strategic planning in corporations seems to result, on the whole, in only modest resource shifts. Whether the relevant resource is capital expenditures, operating expenditures, or human capital, this finding is consistent across industries as diverse as mining and consumer packaged goods. Given the performance edge associated with higher levels of reallocation, such static behavior is almost certainly not sensible. Our research showed the following:

Companies that reallocated more resources -- the top third of our sample, shifting an average of 56 percent of capital across business units over the entire 15-year period -- earned, on average, 30 percent higher total returns to shareholders (TRS) annually than companies in the bottom third of the sample. This result was surprisingly consistent across all sectors of the economy. It seems that when companies disproportionately invest in value-creating businesses, they generate a mutually reinforcing cycle of growth and further investment options (Exhibit 2).
Consistent and incremental reallocation levels diminished the variance of returns over the long term.
A company in the top third of reallocators was, on average, 13 percent more likely to avoid acquisition or bankruptcy than low reallocators.
Over an average six-year tenure, chief executives who reallocated less than their peers did in the first three years on the job were significantly more likely than their more active peers to be removed in years four through six. To paraphrase the philosopher Thomas Hobbes, tenure for static CEOs is likely to be nasty, brutish, and, above all, short.

We should note the importance of a long-term view: over time spans of less than three years, companies that reallocated higher levels of resources delivered lower shareholder returns than their more stable peers did. One explanation for this pattern could be risk aversion on the part of investors, who are initially cautious about major corporate capital shifts and then recognize value only once the results become visible. Another factor could be the deep interconnection of resource allocation choices with corporate strategy. The goal isn't to make dramatic changes every year but to reallocate resources consistently over the medium to long term in service of a clear corporate strategy. That provides the time necessary for new investments to flourish, for established businesses to maximize their potential, and for capital from declining investments to be redeployed effectively. Given the richness and complexity of the issues at play here, differences in the relationship between short- and long-term resource shifts and financial performance is likely to be a fruitful area for further research.

Why companies get stuck

Why do so many companies undermine their strategic direction by allocating the same levels of resources to business units year after year? The reasons vary widely, from the very bad -- companies operating on autopilot -- to the more sensible. After all, sometimes it's wise to persist with previously chosen resource allocations, especially if there are no viable reallocation opportunities or if switching costs are too high. And companies in capital-intensive sectors, for example, often have to commit resources more than five years ahead of time to long-term programs, leaving less discretionary capital to play with.

For the most part, however, the failure to pursue a more active allocation agenda is a result of organizational inertia that has multiple causes. We'll focus here on cognitive biases and corporate politics, but regardless of source, inertia's gravitational pull is strong -- and overcoming it is critical to creating an effective corporate strategy. As author and Kleiner Perkins Caufield & Byers partner Randy Komisar told us, "If corporations don't approach rebalancing as fiduciaries for long-term corporate value, their life span will decline as creative destruction gets the better of them."

Cognitive biases

Biases such as anchoring and loss aversion, which are deeply rooted in the workings of the human brain and have been much studied by behavioral economists, are major contributors to the inertia that prevents more active reallocation.3 Anchoring refers to the tendency to use any number, even an irrelevant one, as an anchor for future choices. Judges asked to roll a pair of dice before making a simulated sentencing decision, for example, are influenced by the result of that roll, even though they deny they are.

Within a company, last year's budget allocation often serves as a ready, salient, and justifiable anchor during the planning process. We know this to be true in practice, and it's been reinforced for us recently as we've played a business game with several groups of senior executives. The game asked participants to allocate a capital budget across a fictitious company's businesses and provided players with identical growth and return projections for the relevant markets. Half of the group also received details of the previous year's capital allocation. Those without last year's capital budget all allocated resources in a range that optimized for the expected outlook in market growth and returns. The other half aligned capital far more closely with last year's pattern, which had little to do with the potential for future returns. And this was a game where the company was fictitious and no one's career was at risk!

In reality, anchoring is reinforced by loss aversion: losses typically hurt us at least twice as much as equivalent gains give us pleasure. That reduces the appetite for taking risks and makes it painful for managers to give up resources.

Corporate politics

A second major source of inertia is political. There's often a tight alignment between the interests of senior executives and those of their divisions or business units, whose ability to attract capital can significantly influence the personal credibility of a leader. Indeed, because executives are competing for resources, anyone who wins less than he or she did last year is invariably seen as weak. At the extreme, leaders of business units and divisions see themselves as playing for their own "teams" rather than for the corporation as a whole, making it challenging to reallocate resources significantly. Even if a reduction in resources to their division benefits the company as a whole, ambitious leaders are unlikely to agree without a fight. As one CEO told us: "If you're asking me to play Robin Hood, that's not going to work."

Overcoming inertia

Tempting as it is to believe that one's own company avoids these traps, our research suggests that's unlikely. Our experience also suggests, though, that taking steps such as those described below can materially improve a company's resource allocation and its connection to strategic priorities. These imperatives apply not just to capital but also to other scarce resources, such as talent, R&D dollars, and marketing expenditures (as shown in Exhibit 3, for advertising spending by one consumer goods company). All of these also are subject to the forces of inertia, which can undermine an organization's ability to achieve its strategic goals. Consider one company we know that prioritized expanding in China. It set an ambitious sales growth target for the country and planned to meet it by supplementing organic growth with a series of acquisitions. Yet it identified just three people to spearhead this strategic imperative -- a small fraction of the number required, which is typical of the problems that arise when the link between corporate strategy and resource allocation is weak. Here are four ideas for doing better.

1. Have a target corporate portfolio.

There's a quote attributed to author Lewis Carroll: "If you don't know where you are going, any road will take you there." When it comes to developing an allocation agenda, it's helpful to have a target portfolio in mind. Most companies resist this, for understandable reasons: it requires a lot of conviction to describe planned portfolio changes in anything but the vaguest terms, and the right answers may change if the broader business environment turns out to be different from the expected one.

In our experience, though, a target portfolio need not be slavish or mechanistic and can be a powerful forcing device to move beyond generic strategy statements, such as "strengthen in Asian markets" or "continue to migrate from products to services." Identifying business opportunities where your company wants to increase its exposure can create a foundation for scrutinizing how it allocates capital, talent, and other resources.

Setting targets is just a starting point; companies also need mechanisms for revisiting and adjusting them over time. For example, Google holds a quarterly review process that examines the performance of all core product and engineering areas against three measures: what each area did in the previous 90 days and forecasts for the next 90 days, its medium- term financial trajectory, and its strategic positioning. And the company has ensured that it can allocate resources in an agile way by not having business units, which diminishes the impact of corporate politics.4

Evaluating reallocation performance relative to peers also can help companies set targets. From 1990 to 2009, for example, Honeywell reallocated about 25 percent of its capital as it shifted away from some existing business areas toward aerospace, air conditioning, and controls. Honeywell's competitor Danaher, which was in similar businesses in 1990, moved 66 percent of its capital into new ones during the same period. Both companies achieved returns above the industry average in these years -- TRS for Honeywell was 14 percent and for Danaher 25 percent. We're not suggesting that companies adopt a mind-set of "more is better, and if my competitor is making big moves, I should too." But differences in allocation levels among peer companies can serve as valuable clues about contrasting business approaches -- clues that prompt questions yielding strategic insights.

2. Use all available resource reallocation tools.

Talking about resource allocation in broad terms oversimplifies the choices facing senior executives. In reality, allocation comprises four fundamental activities: seeding, nurturing, pruning, and harvesting. Seeding is entering new business areas, whether through an acquisition or an organic start-up investment. Nurturing involves building up an existing business through follow-on investments, including bolt-on acquisitions. Pruning takes resources away from an existing business, either by giving some of its annual capital allocation to others or by putting a portion of the business up for sale. Finally, harvesting is selling whole businesses that no longer fit a company's portfolio or undertaking equity spin-offs.

Our research found that there's little overall difference between the seeding and harvesting behavior of low and high reallocators. This should come as little surprise: seeding involves giving money to new business opportunities -- something that's rarely resisted. And while harvesting is difficult, it most often occurs as a result of a business unit's sustained underperformance, which is difficult to ignore.

However, we found a 170 percent difference in activity levels between high and low reallocators when it came to the combination of nurturing and pruning existing businesses. Together, these two represent half of all corporate reallocation activity. Both are difficult because they often involve taking resources from one business unit and giving them to another. What's more, the better a company is at encouraging seeding, the more important nurturing and pruning become -- nurturing to ensure the success of new initiatives and pruning to eliminate flowers that won't ever bloom.

Consider, for example, the efforts of Google CEO Larry Page, over the past 12 months, to cope with the flowering of ideas brought forth by the company's well-known "20 percent rule," which allows engineers to spend at least one-fifth of their time on personal projects and has resulted in products such as AdSense, Gmail, and Google News. These successes notwithstanding, the 20 percent rule also has yielded many peripheral projects, which Page has recently been pruning.5

3. Adopt simple rules to break the status quo.

Simple decision rules can help minimize political infighting because they change the burden of proof from the typical default allocation ("what we did last year") to one that makes it impossible to maintain the status quo. For example, a simple harvesting rule might involve putting a certain percentage of an organization's portfolio up for sale each year to maintain vibrancy and to cull dead wood.

When Lee Raymond was CEO of Exxon Mobil, he required the corporate-planning team to identify 3 to 5 percent of the company's assets for potential disposal every year. Exxon Mobil's divisions were allowed to retain assets placed in this group only if they could demonstrate a tangible and compelling turnaround program. In essence, the burden on the business units was to prove that an asset should be retained, rather than the other way around. The net effect was accelerated portfolio upgrading and healthy turnover in the face of executives' natural desire to hang on to underperforming assets. Another approach we've observed involves placing existing businesses into different categories -- such as "grow," "maintain," and "dispose" -- and then following clearly differentiated resource-investment rules for each. The purpose of having clear investment rules for each category of business is to remove as much politics as possible from the resource allocation process.

Sometimes, the CEO may want a way to shift resources directly, in parallel with regular corporate processes. One natural-resources company, for example, gave its CEO sole discretion to allocate 5 percent of the company's capital outside of the traditional bottom-up annual capital allocation process. This provided an opportunity to move the organization more quickly toward what the CEO believed were exciting growth opportunities, without first having to go through a "pruning" fight with the company's executive-leadership committee.

Of course, the CEO and other senior leaders will need to reinforce discipline around such simple allocation rules; it's not easy to hold the line in the face of special pleading from less-favored businesses. Developing that level of clarity -- not to mention the courage to fight tough battles that arise as a result -- often requires support in the form of a strong corporate center or a strategic-planning group that's independent of competing business interests and can provide objective information (for more on the importance of the corporate center to resource reallocation, see "The power of an independent corporate center," on page 39).

4. Implement processes to mitigate inertia.

Systematic processes can strengthen allocation activities. One approach, explored in detail by our colleagues Sven Smit and Patrick Viguerie, is to create planning and management processes that generate a granular view of product and market opportunities.6 The overwhelming tendency is for corporate leaders to allocate resources at a level that is too high -- namely, by division or business unit. When senior management doesn't have a granular view, division leaders can use their information advantage to average out allocations within their domains.

Another approach is to revisit a company's businesses periodically and engage in a process similar to the due diligence conducted for investments. Executives at one energy conglomerate annually ask whether they would choose to invest in a business if they didn't already own it. If the answer is no, a discussion about whether and how to exit the business begins.

Executives can further strengthen allocation decisions by creating objectivity through re-anchoring -- that is, giving the allocation an objective basis that is independent of both the numbers the business units provide and the previous year's allocation. There are numerous ways to create such independent, fact-based anchors, including deriving targets from market growth and market share data or leveraging benchmarking analysis of competitors. The goal is to create an objective way to ask business leaders this tough question: "If we were to triangulate between these different approaches, we would expect your investments and returns to lie within the following range. Why are your estimates so much higher (or lower)?"

Finally, it's worth noting that technology is enabling strategy process innovations that stir the pot through internal discussions and "crowdsourcing." For example, Rite-Solutions, a Rhode Island-based company that builds advanced software for the US Navy, defense contractors, and first responders, derives 20 percent of its revenue from businesses identified through a "stock exchange" where employees can propose and invest in new ideas (for more on this, see "The social side of strategy," on page 82).

Much of our advice for overcoming inertia within multibusiness companies assumes that a corporation's interests are not the same as the cumulative resource demands of the underlying divisions and businesses. As they say, turkeys do not vote for Christmas. Putting in place some combination of the targets, rules, and processes proposed here may require rethinking the role and inner workings of a company's strategic- and financial-planning teams. Although we recognize that this is not a trivial endeavor, the rewards make the effort worthwhile. A primary performance imperative for corporate-level executives should be to escape the tyranny of inertia and create more dynamic portfolios.

FOOTNOTE

1 See Ilan Guedj, Jennifer Huang, and Johan Sulaeman, "Internal capital allocation and firm performance," working paper for the International Symposium on Risk Management and Derivatives, October 2009 (revised in March 2010).

2 We used Compustat data on 1,616 US-listed companies with operations in a minimum of two distinct four-digit Standard Industrial Classification (SIC) codes. Resource allocation is measured as 1 minus the minimum percentage of capital expenditure received by distinct business units over the 15-year period. This measure captures the relative amount of capital that can flow across a business over time; the rest of the money is "stuck." Similar results were found with more sophisticated measures that control for sales and asset growth.

3 See Dan Lovallo and Olivier Sibony, "The case for behavioral strategy," mckinseyquarterly.com, March 2010.

4 For more, see James Manyika, "Google's CFO on growth, capital structure, and leadership," mckinseyquarterly.com, August 2011.

5 See Claire Cain Miller, "In a quest for focus, Google purges small projects," nytimes.com, November 10, 2011.

6 See three publications by Mehrdad Baghai, Sven Smit, and S. Patrick Viguerie: "The granularity of growth," mckinseyquarterly.com, May 2007; The Granularity of Growth: How to Identify the Sources of Growth and Drive Enduring Company Performance, Hoboken, NJ: Wiley, 2008; and "Is your growth strategy flying blind?," Harvard Business Review, May 2009, Volume 87, Number 5, pp. 86-97.

Exhibit 2: Companies with higher levels of capital reallocation experienced higher average shareholder returns.

A: Companies' degree of capital reallocation (n = 1,616 companies)

B: Total returns to shareholders, compound annual growth rate,

1990-2005, %

A B

---------------

High 10.2

Medium 8.9

Low 7.8

GRAPH: Exhibit 1: Capital allocations were essentially fixed for roughly one-third of the business units in our sample.

GRAPH: Exhibit 2: Companies with higher levels of capital reallocation experienced higher average shareholder returns.

GRAPH: Exhibit 3: Inertia may affect the distribution of other scarce resources, such as advertising spending.

PHOTO (COLOR)

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By Stephen Hall; Dan Lovallo and Reinier Musters

Stephen Hall is a director in McKinsey's London office. Stephen Hall would like to acknowledge the contributions of Michael Birshan, Marja Engel, Mladen Fruk, John Horn, Conor Kehoe, Devesh Mittal, Olivier Sibony, and Sven Smit to this article.

Dan Lovallo is a professor at the University of Sydney Business School, a senior research fellow at the Institute for Business Innovation at the University of California, Berkeley, and an adviser to McKinsey. Dan Lovallo would like to acknowledge the contributions of Michael Birshan, Marja Engel, Mladen Fruk, John Horn, Conor Kehoe, Devesh Mittal, Olivier Sibony, and Sven Smit to this article.

Reinier Musters is an associate principal in the Amsterdam office. Reinier Musters would like to acknowledge the contributions of Michael Birshan, Marja Engel, Mladen Fruk, John Horn, Conor Kehoe, Devesh Mittal, Olivier Sibony, and Sven Smit to this article.