Senior executives seeking to gauge the effectiveness of their company’s corporate strategy might look at any number of factors: the company’s shareholder returns, its growth rate, its market share, or its price-to-earnings multiple. Yet none of these markers would tell the whole story. In fact, they might lead executives to precisely the wrong conclusions.
The one true measure of a corporate strategy is the profitability of its head office. Yes, that’s right, we’re talking about “corporate,” that “dead weight” of administrative functionaries most business unit leaders love to loathe as nothing more than an oppressive cost center that taxes the “real” parts of the business with onerous compliance requirements, excessive monitoring, redundant reporting, countless initiatives, endless meetings, and intrusive staff. Of course, in strict accounting terms, corporate headquarters is a cost center because it has no revenues. But it can and should be profitable. In fact, a profitable corporate center is both literally and figuratively at the center of corporate profit itself.
Booz & Company senior partner Ken Favaro speaks with s+b executive editor Paul Michelman about understanding the real value of corporate strategy and the head office.
Corporate Center Profitability
We define corporate center profitability as a company’s attributable performance delta—that is, the difference in financial performance that is attributable to the activities of the corporate center—less the costs of the center itself (see exhibit). By this definition, when the corporate center is profitable, the company is truly worth more than the sum of its parts—not 1 + 1 = 3 (that’s a logical impossibility), but 1.5 + 1.5 = 3, because the company’s business units (BUs) are outperforming (1.5 vs. 1) in their markets. On the other hand, a company that has an unprofitable corporate center is sending a sure signal that it’s adding no real value to the individual BU strategies (1 + 1 = 2), or worse, it’s a true hindrance to each BU being able to win in its own markets (0.5 + 0.5 = 1).
Research indicates that the performance delta is positive for 45 percent of all companies and negative for the rest. According to these figures, more than half of all companies have corporate centers that are simply not worth it. No wonder 2011 was a record year for corporate divestitures. When your company’s performance delta is negative, neither your businesses nor your shareholders see much point in having a head office!
Drivers of Corporate Center Profitability
Six key functions explain the difference between “profitable” and “unprofitable” corporate centers.
First, profitable corporate centers sparingly use centralized services such as receivables, payables, financial reporting, payroll, IT, legal, HR, R&D, manufacturing, sourcing, and sales. They know that centralization does not come free—it can slow responsiveness, increase bureaucracy, uncouple costs from the revenues they support, and dilute accountability for top- and bottom-line results—and they know that there are diminishing returns to scale economies. Unprofitable head offices tend to overcentralize and then ignore the hidden costs of having done so. Inevitably, if their first round of enterprise cost cutting included the centralization of common functions, their next round starts with tackling the “corporate overhead” that centralization unleashed.
A second key function is capital allocation. The corporate center adds value only if it can do a better job of allocating capital than the “invisible hand” of a vast, liquid, and ruthless capital market. A profitable corporate center does just that by attaining and using its inside knowledge, its ability to actively engage with the business units, its experience with the businesses that make up the company’s portfolio, and a highly disciplined process for funding business units. In these cases, businesses perform better than their peers because they have corporate leaders who are knowledgeable, informed, engaged, experienced, disciplined, and enterprising investors. Unprofitable corporate centers tend to think of capital allocation as rationing rather than investing. Inevitably, this means that some BUs will be overfunded and others underfunded. It is common to see 80 percent of a company’s value creation coming from only 20 percent of its capital base. This is usually the work of corporate doing more harm than good in substituting for the capital markets.