When you get down to it, most of business is about placing bets—allocating resources—and making them pay off. A McKinsey Quarterly survey paints a picture of this process from the vantage points of senior corporate executives, business unit heads, and frontline managers and highlights how frequently and why a company’s plans can go awry.
A significant number of executives, for example, describe allocating funds to projects that were mistakes and should be terminated, making decisions to forgo promising investments, and making overly optimistic forecasts of sales and project completion times. Respondents also say that risk aversion is common and that companies tend to look at investments independently.
What’s being allocated?
The survey focused on four types of investments: acquisitions, “maintenance” investments needed to sustain business as usual, projects aimed at stimulating growth in existing businesses, and efforts aimed at innovation. Major commitments such as acquisitions or big bets on new products often grab the headlines. But among the respondents able to break out their resource allocation by category, almost half say that in the past three years more than 25 percent of their capital spending went toward maintenance investments. Even in industries where executives say their companies have devoted significant resources to innovation, less than a third say that more than 25 percent of the budget goes there.
Off to a good start ...
One potential reason for making poor resource allocation decisions is the criteria companies use in assessing opportunities. For example, a corporate headquarters might base its financing of business units in one year on the amount spent during the previous one, as opposed to how effectively the business unit used this money.
In addition, when asked to identify the most important factor in assessing investment alternatives, half of all corporate-level executives indicate financial criteria. Far fewer selected other options, such as strategic fit or the project leader’s reputation.
... with the right people involved ...
Given the importance of resource allocation decisions, it is probably no surprise that respondents report heavy involvement in them by a company’s most senior executives. More than 80 percent of respondents, for example, say the CEO plays an important role in investment decisions made by business units regarding R&D and capacity expansion, and more than 60 percent report heavy CEO involvement in such decisions even when they are being made on the front lines.
The figures are even higher—and corporate-level executives in addition to the CEO are more involved—when it comes to decisions about investments aimed at innovative, fundamentally new business opportunities and about pulling the plug on underperforming investments.
Consistent with this picture of heavy senior-executive involvement is the belief of survey respondents that decision making is highly centralized. Nearly 40 percent of all respondents expressing an opinion say the biggest decisions are made by just one or two people. It’s noteworthy, however, that frontline and corporate-level executives seem to differ in their perception of the complexity of obtaining approval for major investments. About two-thirds of all corporate executives with a point of view on this matter believe there are no more than two layers of decision makers between the organizational location where proposals are generated and the location where they receive final approval. In contrast, three-quarters of frontline executives perceive at least three layers of decision makers.
... leading to mixed results
Despite the good intentions and intense involvement of senior executives in resource allocation, the results appear mixed. For example, corporate-level executives responding to the survey indicate that 17 percent of the capital invested by their companies went toward underperforming investments that should be terminated and that 16 percent of their investments were a mistake to have financed in the first place. Business unit heads and frontline managers say 21 percent of investments should not have been approved and indicate another 21 percent should be terminated.
In addition to worrying about underperforming investments, a sizable number of survey respondents also indicate that a significant number of investments should have been made but were not. Corporate-level executives who have an opinion say it was a mistake not to provide funding for 21 percent of all rejected investments even though the forecast rate of return for the projects met or exceeded their companies’ benchmarks. Business unit heads and frontline managers say nearly twice as many should have received funding.
Corporate-level executives generally have a much better sense of the returns the company earned on its investments. Yet the level of awareness among senior executives doesn’t necessarily translate into effective input: when asked what best explains the approval of the company’s least successful project in recent memory, 45 percent of executives at all levels say it was approved because “a senior leader advocated the project.”
Hope and fear in corporate planning
In addition to the concerns survey respondents express about overall project performance and selection, they also describe an environment in which it’s common for estimates of project duration and sales to be excessively optimistic.
Another indication of executive optimism comes from the responses of a subset of executives who were asked to estimate a single project’s rate of return compared with other similar projects approved in the past. Roughly half say the new investment would have a return greater than 25 percent—a figure hard to reach in competitive market economies. Such findings are consistent with a strong tendency toward managerial optimism highlighted in other research.
This excessive optimism may not, however, be leading companies as far astray as it could, because many companies also seem to be risk averse. Though half of all respondents say their companies take about the right amount of risk, more than 40 percent describe their organizations as risk averse.
Interestingly, surveyed executives appear to believe their companies view quite similarly the risks inherent in investments of varying sizes. When asked to evaluate the lowest rate of return needed to get approval for a typical project with which they were familiar, executives respond with a median figure of 17 percent. Alternatively, those executives believe a project five times larger would require a return of 20 percent to receive funding, and that approval of a project one-fifth as large would require an 18 percent return.
The unimportance of size to investment evaluation seems quite consistent with another finding: nearly half of the executives surveyed say that in their organization it is common to evaluate projects independently rather than as part of a group. This approach is unlikely to lead to a sufficient understanding of corporate risk, and it runs counter to the theory that just as investors will earn better returns by assembling diversified portfolios of stocks, so companies will perform better if they view risks as part of an aggregate portfolio.
The McKinsey Quarterly conducted this survey in April and May 2007 and received responses from 2,507 executives from around the world. Of those, 26 percent were corporate-level executives, an additional 26 percent were business unit or division leaders, and 28 percent were frontline managers.