August 18, 2010

The link between profits and organizational performance

McKinsey research indicates that organizational and financial performance are strongly related.

Executives often worry that work on “soft” management issues is not only hard to quantify but also difficult to justify with boards and skeptical “short-termist” investors. Reassuringly, however, McKinsey research highlights the way initiatives to boost talent, strengthen values, and reinforce corporate culture appear to directly improve the bottom line.

We recently analyzed hundreds of global businesses whose employees and managers participated in an extensive (and ongoing) organizational survey.1 For each of these businesses we established an organizational profile—an assessment of corporate effectiveness in nine key areas that, we believe, underpin organizational excellence (Exhibit 1). We then compared the results with various aspects of these companies’ financial performance.2

Significantly, we found that companies ranking in the top quartile for overall organizational quality (a straight average of the nine areas) were more than twice as likely as those in the bottom quartile to have above-average margins for their industry (as measured by earnings before interest, taxes, depreciation, and amortization). Other metrics—including the ratio of net income to sales and growth in enterprise value—also helped us identify the correlation between good organizational performance and above-average financial results (Exhibit 2). The research strongly reinforces our belief that a robust organization is a critical foundation for a healthy company: one that not only delivers immediate results but can also repeat this kind of performance years into the future (see “Anatomy of a healthy corporation”).

Next, we analyzed the nine areas of organizational effectiveness individually. We found that a ranking in the top quartile in any area was correlated with better financial performance, but not all areas were equal in this respect. In the case of coordination and control, top-quartile companies were 2.7 times more likely than bottom-quartile ones to have above-average margins. At the other extreme, for motivation, external orientation, and environment and values, companies in the top quartile were only 1.8 times more likely to have them.

It’s interesting that we observed a strong linear relationship between organizational and financial performance for five of the nine areas: capabilities, direction, accountability, innovation, and coordination and control. Such findings imply that efforts to improve those organizational qualities should pay off directly. However, the picture presented by the data on three areas—leadership, external orientation, and environment and values—was less clear: the correlations between these three and above-average financial performance weren’t limited to the top quartile. Perhaps it’s enough for companies to ensure that they are not at the bottom of the class; further effort might be wasted.

We did not find a linear relationship between organizational and financial performance when it came to motivation, the ninth area. While companies that motivate their employees in truly distinctive ways appear to enjoy a financial upside, there wasn’t much difference between average motivators and those in the bottom quartile; both groups were equally likely to outperform other companies in the sample financially. This finding may reflect the fact that very few of our respondents reported being unmotivated to a significant extent—a sign that today’s highly mobile labor market frees dissatisfied employees to find other work quickly.

To be sure, many factors drive financial performance, and evidence of correlation is not evidence of causality. Therefore we have intentionally declined to isolate the financial impact of organizational performance on individual companies. Still, the correlations we identified are striking, as they strongly suggest that companies pay a financial penalty for weak organizational performance and that strong organizational performance reaps financial dividends.

Improving a company’s organizational capabilities is a complex challenge, given the variety of practices available to achieve excellence in each of the nine categories (our survey highlights more than 40 practices in all). Previous McKinsey research suggests that excellence in only 3 to 5 practices is sufficient to have a real impact.3 Moreover, we find that the use of practices in certain combinations tends to be even more effective. Companies can now pursue such efforts with the knowledge that the resulting improvements will have a positive impact on the bottom line.

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