KEY CONCEPT

Does your organization keep allocating the same resources to the same business units year after year? Such inertia makes it difficult to realize strategic goals and ultimately undermines performance and profitability. The answer is to regularly adjust resource allocation, but, according to this Idea, failure to pursue active reallocation policies is due to multiple causes.

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IDEA SUMMARY

Companies that regularly evaluate the performance of business units, acquire and divest assets, and adjust resource allocations based on each division’s relative market opportunities have a significant edge over those that do not; according to Stephan Hall, Dan Lovallo and Reiner Musters, they will be worth an average of 40% more after 15 years. In an article published in McKinsey Quarterly, Hall, Lovallo and Musters propose that when capital and other resources flow more readily from one business opportunity to another, returns to shareholders are higher and the risk of economic failure is reduced and growth can be sustained.

However, they also suggest that most companies fail to do this effectively, and that enormous amounts of strategic planning too often result in only modest resource shifts. Through a review of the performance of more than 1,600 US companies from 1990–2005, they found that the failure to pursue a more active allocation agenda is a result of organizational inertia that has multiple causes, including cognitive biases and corporate politics.

• Cognitive biases: Biases such as anchoring (i.e. the tendency to use any number as an anchor for future choices) and loss aversion are major contributors to the inertia that prevents more active reallocation. Losses, for example, hurt at least twice as much as equivalent gains give pleasure. This reduces the appetite for taking risks, making it painful for managers to give up resources.
• Corporate politics: The interests of senior executives and those of their divisions or business units are often tightly aligned, resulting in the former’s ability to attract capital significantly influencing their personal credibility. Anyone who wins fewer resources than he/she did the year before is invariably seen as weak. Even if a reduction in resources to their division benefits the company as a whole, ambitious leaders are unlikely to agree without a fight.

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BUSINESS APPLICATION

Hall, Lovallo and Musters suggest four steps that can materially improve a company’s resource allocation and its connection to strategic priorities:

1. Have a target corporate portfolio: this need not be slavish or mechanistic and can be a powerful forcing device to move beyond generic strategy statements. It is also vital to put in place mechanisms for revisiting and adjusting these targets over time.
2. Use all available resource reallocation tools: allocation comprises four fundamental activities: seeding (entering new business areas); nurturing (building up an existing business through follow-on investments); pruning (taking resources away from an existing business); and harvesting (selling whole businesses that no longer fit a company’s portfolio or undertaking equity spin-offs).
3. Adopt simple rules to break the status quo: putting in place simple decision rules can help minimize political infighting, because they change the burden of proof from “what we did last year” to one that makes it impossible to maintain the status quo; for example, putting a certain percentage of an organization’s portfolio up for sale each year to maintain vibrancy—something practiced annually by Lee Raymond (CEO of Exxon Mobil from 1995–2005)
4. Implement processes to mitigate inertia: systematic processes can strengthen allocation activities, such as revisiting a company’s businesses periodically and engaging in a process similar to the due diligence conducted for investments.

Putting in place a combination of the targets, rules, and processes outlines above may also require rethinking the roles of an organization’s strategic and financial-planning teams. This is acknowledged by Hall, Lovallo and Musters as far from a trivial endeavour; however, the long-term rewards of escaping the tyranny of inertia and creating more dynamic portfolios makes the effort worthwhile. 

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REFERENCES

How to Put Your Money Where Your Strategy Is. Stephan Hall, Dan Lovallo & Reiner Musters. McKinsey Quarterly (March 2012).

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