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Commentary|McKinsey Quarterly

Breaking strategic inertia: Tips from two leaders

A CFO and a business unit head explain how they overcome the barriers that all too often separate capital, talent, and other resources from vital strategic goals.

April 2012

Frameworks abound for developing corporate strategy. But there’s no textbook or theory that explains how to deliver on that strategy by shifting capital, talent, and other scarce resources from one part of a business to another. One reason is that the moves each organization must make at any point in time are unique. Another is that different senior executives have different roles to play. But that’s not to say companies can’t learn from one another—in fact, understanding the broad range of reallocation challenges faced by different executives sheds valuable light on common pitfalls and the decision-making processes for sidestepping them.

Featured here are perspectives from two different industries and corners of the C-suite. Guy Elliott, the CFO of Rio Tinto, one of the world’s biggest mining companies, discusses how it decides when and how to place its bets. And Andreas Kramvis, who heads Honeywell Performance Materials and Technologies, provides insight from a business unit perspective and outlines his novel approach to bringing strategy and resources into alignment.

Guy Elliott has been the CFO of Rio Tinto—one of the world’s most diversified mining companies, with operations on six continents and net assets of roughly $60 billion—since 2002.

Guy Elliott

Prioritizing projects and regions

We start from the proposition that we are not strategic capital allocators; we are bottom-up capital allocators. We invest not by choosing the commodity in which to put money but by choosing the project in which to put money. For example, we observed that 80 percent of the money in the copper world is made by 20 percent or less of the world’s copper mines. Our objective is for all of our mines in all of our products to be in that 20 percent because we think we’re particularly good at running large, long-life, low-cost mines.

Historically, we have not been particularly worried about which product is “in,” because in the short to medium run, copper mines may do better than nickel, or iron ore may do worse than aluminum. But on a 50-year horizon, it’s much less clear that one metal is better than another. It’s certainly true that one may have higher demand than another, but what really matters is the difference between supply and demand, and supply can often overshoot demand. The point of departure for us has been bottom-up: geologically and infrastructure driven. Is this deposit capable of being, over a long period, a low-cost, expandable operation in its industry? If it is, let’s allocate capital to it.

There’s another dimension to this, beyond just looking at our portfolio in project terms. You can also look at it as a jurisdiction portfolio. For example, a very high percentage of assets in our portfolio—approaching half—are in Australia, and about 40 percent are in North America and Europe, mostly in Canada. And then we have about 10 percent in emerging markets. As we look for new opportunities, they’re mostly in emerging markets. So that 10 percent will enlarge over time, but we need to think a bit more about the political risk and the management challenge of emerging markets versus what we might call “safer” jurisdictions.

Rebalancing the portfolio

In the middle of the last decade, we had a relatively diversified portfolio. But we then started investing heavily in what looked to be the most interesting business—iron ore, which had very high margins that have since risen even more. We also made a very big acquisition in aluminum and, as a consequence, ended up with a very lopsided portfolio: skewed toward iron ore in terms of profit and toward aluminum in terms of investment of capital. That’s caused the beta of the company to rise.

The portfolio bias toward iron ore has been very beneficial, of course. But it has unnerved investors a bit because they can’t believe the good times are going to continue forever. So we are beginning to ask ourselves questions about whether we should take action to “correct” that portfolio bias. And it’s very difficult. We could stop further investments in iron ore. But if we did that, we would be turning our back on some of the highest-return, lowest-risk investments we can make. So that looks like a perverse course of action. We also could sell some iron ore assets, but why would you sell some of your best businesses unless you really were clever enough to know precisely when the top of the cycle was? And even then, would you get the right price, given present market conditions?

Related to this is an essential part of our strategy: we don’t like to hedge. We think there are natural hedges within the portfolio. In simple terms, when the iron ore price is high, the Australian dollar is high; and when the iron ore price is low, the Australian dollar is low. Our margins are protected to some extent by this natural hedge because our costs are chiefly denominated in Australian dollars. However, there is a new phenomenon that is of concern. As Europe struggles, the currencies of countries such as Australia and Canada have become safe havens and behave differently than they have in the past. So our natural hedge may not be quite as secure as it used to be. The other imperfection of a nonhedging strategy is that from time to time, you have to make decisions about building something or buying or selling something, and that’s implicitly a hedging decision.

Of course, we can’t avoid it, because we need to replenish our growth pipeline continuously, as well as winnow our portfolio. But we don’t do it with great enthusiasm, because it involves market timing and, if we could do that well, we wouldn’t bother running a mining business; we’d just be a trading business. We did major acquisitions in 1989, 1995, and 2000 that have created many, many billions of dollars in value. But of course we didn’t buy everything at the bottom or sell everything at the top. One major acquisition—Alcan, in 2007—was strategically in line with what we were trying to do, since it was a low-cost, long-life, expandable business. But it was at the top of a cycle, which turned down immediately after we bought it. With the benefit of hindsight, we paid far too much for it in an auction.

Ensuring investment discipline

We institute checks and balances to manage internal lobbying. We have something called the Investment Committee, which approves sizable investments of any kind and consists of the chief executive, me, the head of technology and innovation, and the head of business services. In other words, it does not contain any of the divisional heads. The plan is that this committee has enough data to have a dispassionate discussion about an investment. Independence is essential: if it’s lost, we’re lost. Separation of powers is important. Is the committee completely immune to lobbying and strong characters? Of course it isn’t. But the discipline and the checks and balances are there.

In addition to that, we have two other disciplines. One of them is the information the committee gets. This committee receives three pieces of paper. We get the recommendation of the project proponent. Then we have an evaluation group that does a critique of the commercial and financial stuff, and a technical and environmental critique. We try to take the passion out of the debate.

The second discipline is a postinvestment review. After a period of some years, we go back to the original proposal and calculate what the return has been, which original estimates were wrong, which challenge was underestimated, what came out better than expected. From numerous postinvestment reviews we learn what we tend to get wrong and what we tend to get right. That’s an important discipline in any capital-intensive company because otherwise you don’t learn from your mistakes. For us it’s particularly important. We invest a few billion dollars in year one, and that makes or breaks our returns on that project for the next 50 years. The upfront decision is critical, since there are endless people who in their enthusiasm say, “Well, there’s a big strategic merit to this project that overrides the returns,” or “Don’t worry about these risks—we must be big in Brazil,” or “We must be in the nickel business,” or whatever it is.

Finally, our experience is that regular investments—as opposed to one-offs—succeed better. That’s also true of divestments. It’s the same principle as time–cost averaging. Successful investors don’t buy their whole stake at once and sit on it. They move into it gradually and, when they want to sell, move out of it gradually. In an ideal world, that’s how I would like to invest, even though, of course, that’s not possible in a big acquisition or disposal.

About the authors

This commentary is based on an interview with Stephen Hall, a director in McKinsey’s London office; and Dan Lovallo, 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.

Andreas C. Kramvis is the president and CEO of Honeywell Performance Materials and Technologies, which has recorded double-digit margin improvements for each of the past six years. He is the author of Transforming the Corporation: Running a Successful Business in the 21st Century (Randolph Publishing, September 2011).

Andreas C. Kramvis

Resource allocation at the business unit level

When you are in a business unit, you are much closer to your markets than the corporate entity is. Your knowledge of how to invest should be much sharper as well. Through rapid reallocation of your existing resources, you should be able to capitalize on opportunities more quickly than if you needed to apply for funds through a corporate capital process. The last thing you want to do is go hat in hand to corporate asking for capital when your businesses are not running well.

What I emphasize to teams is that if a business performs well, it will get all the capital it needs from the company, and then some. You need to turn the problem on its head and say there really never is a shortage of capital—there is a shortage of returns. If you achieve high returns, money will chase you.

There are plenty of opportunities to reallocate resources and create short-term opportunities to drive higher returns. You might have a plant that is outdated or pockets of investment dollars in areas that are no longer relevant. In one of my previous jobs, we had a very large plant that was uncompetitive, but the company kept putting money into it rather than pursuing the next technology. We stopped making those investments and diverted those funds to the new technologies; in a short period of time, we were able to supplant those operations with a state-of-the-art plant that had better cycle times, less waste, lower costs, and a greater ability to roll out innovative products. In other words, we funded the new plant ourselves by using funds that were previously being applied to areas without an upside.

Beyond capital

Most people think that reallocation only means the reallocation of capital. Granted, this is important. At the same time, I also like to think about the reallocation of people and mindshare. Believe it or not, the latter type of reallocation has the biggest impact.

A company that fails to organize its people the right way is most likely to require what you might call “hard reallocations,” such as divestments or portfolio overhauls. Reorienting people is difficult, but that’s what makes it so important to focus on. Moving your best managers, researchers, salespeople, and so on from low-growth or failing businesses to areas with higher growth and profit potential can be one of your most effective levers as a business leader.

Myriad issues stand in the way of achieving a dynamic reallocation. You can throw the whole management book at this and it may not suffice. Culture and organizational politics can stand in the way; so can sheer inertia. Managers can be as slow to change as their organizations, and misperceptions of what is important to them can linger for a long time, despite strong evidence to the contrary. You could even have the wrong business model in place, which means your processes are wrong and your ability to make good decisions is seriously impaired.

Shifting resources one ‘decision week’ at a time

To ensure that your organization is constantly reallocating resources from weak areas to promising ones, you need a systematic operating method. Most companies have a rhythm of meetings and performance reviews but spend much of their time looking in the rearview mirror: What was last month’s performance? What was last year’s performance? I believe you need to impose an operating mechanism that reallocates resources in real time and that educates your organization and instills core capabilities.

One operating mechanism I’ve found helpful is something I call “business decision week.”1 We run BDW ten times a year, and we take its name seriously: decisions are actually made on the spot in real time. Attendance is mandatory for my direct-leadership team. Confidentiality limits the number of people who can be in attendance at some sessions, but for others there is no reason not to have a large number of managers listen in. The discussions are lively, and listening in can be a great learning opportunity.

I will not take a meeting outside BDW to discuss a project requiring capital approvals. Similarly, I will not take a separate meeting about resources for a new project involving research and development. Having one-off meetings and decisions would waste a lot of time and defeat the objective of this open system, in which all the key people must be present and comment on the matter at hand.

Business decision week forces my leadership team to look out the windshield. What are the biggest opportunities we should concentrate on? What capabilities do we need in order to pursue them? Where are our people wasting time, and where should they be spending more time today? How about in six months? We try to place management time and focus on areas where we can grow, rather than focusing on firefighting and activities with low potential.

I often think of BDW as analogous to the processor of a computer: the know-how it instills is the software. By building know-how, business decision weeks grow increasingly productive, and they enhance the organization’s ability to prepare for future challenges.

An example of how BDW helped my current business was in rethinking the engineering processes to help us understand the costs and risks involved in major capital projects. We started our discussions with a desire to reach a common vocabulary and set of metrics, so that each month, our business leaders could fully understand where our engineering resources were being applied. With each passing month, the discussion grew more sophisticated—we turned our attention toward reallocation of these resources to achieve the most critical objectives faster and discussion of which capabilities we will most need in the future. Now we’re focusing our attention on the biggest projects: the construction of new plants around the world. This is a significant undertaking, and one we would not have been prepared for without having both the processor and the software of business decision week in place.

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