JULY 22, 2014by Sebastian Stange, Alexander Roos, Jeffrey Kotzen, and Ulrich Pidun
One of the most powerful tools available to CEOs and CFOs to drive growth is their company’s approach to capital allocation across its portfolio of businesses. Unlike more operational levers for growth, decisions about capital allocation are fundamentally strategic: they determine the long-term asset base on which future value creation depends. Done correctly, capital allocation can be a highly effective means of delivering on the corporate growth ambition.
And yet, despite its importance, the way many companies allocate capital is remarkably haphazard. In our work with clients, we often encounter a variety of ineffective practices: “Democratic” capital allocation. The organization spreads investments more or less equally across business units, irrespective of their previous performance or future growth prospects. “The biggest children get the most food.” The organization allocates capital on the basis of the business unit’s size, with the biggest units in the portfolio getting the most cash, even though such businesses often have the least growth potential. “We’ve always done it this way.” The organization sets a given year’s investment budget on the basis of what was done the previous year, looking backward to past internal practice rather than forward to future business potential.
There is a better way. Research by The Boston Consulting Group and client experience suggest that capital allocation at the top value creators is characterized by two distinctive practices. First, these companies take a highly differentiated approach to allocating capital among business units in the corporate portfolio. Second, they translate strategy into action by linking strategic priorities to capital allocation, financial plans, and specific growth initiatives and by actively managing the corporate investment portfolio from the top. This approach has four steps:
Prioritizing Growth Among Business UnitsNearly all businesses grow to some extent, but not every business unit can be a corporate growth engine. The first step, therefore, is to understand the different roles of different units in the company’s overall growth portfolio and strategy
Translating Roles into ActionsIt’s one thing to define the different strategic roles of the different business units in the corporate portfolio. It is quite another to translate those roles into actions through the establishment of KPIs, performance targets, capital budgets, and, ultimately, detailed business and financial plans.
Differentiating Among Types of Growth InvestmentsWhen it comes to translating such high-level rules into the details of financial plans and budgets, different types of growth investments also need to be evaluated differently. Too often, companies evaluate every potential growth initiative in terms of NPV. But that approach can lead to an overemphasis on clearly defined, incremental short-term investments—at the cost of neglecting more long-term but strategically important investments whose NPV is uncertain or difficult to calculate.
Actively Managing the Investment PortfolioFinally, once capital allocation decisions are made, the corporate center must actively manage the investment portfolio over time to make sure that initiatives stay on track and to maximize flexibility.