A 2013 Deloitte report, Success or Struggle?, observed that despite high profits and stock valuations, the reality for many companies is far from upbeat. Strong competitors keep appearing from all corners of the world. Advances in technology are eroding the prevailing business models in industry after industry. Companies are under intense pressure, as they struggle to defend their vulnerable revenues and market share while pursuing elusive new opportunities and profitable growth.
“Companies are broken and many don’t know,” reads the provocative opening line of the Deloitte report. It highlights the paradox that “Many companies are reporting record profits, but longer-term trends suggest they are struggling.” As an indicator of such struggles the report cites the topple rate, which measures how rapidly companies lose their leadership position. The topple rate has increased by almost 40 percent since 1965. The tenure of companies on the S&P 500 was 61 years in 1958; it’s now 18 years. If these trends continue, 75 percent of the S&P 500 companies will have changed over the next 15 years.
It’s been getting harder for even successful companies to maintain their leadership positions. I remember reading In Search of Excellence: Lessons from America’s Best Run Companies when it first came out in 1982, - one of the most influential business books of all time. The book examined 43 of the Fortune 500 top-performing US companies, highlighting what made them great and what management lessons could be learned from them. Similarly, Built to Last: Successful Habits of Visionary Companies, became an influential business best-seller in 1994 as it took and in-depth look at 18 companies which it identified as visionary.
These two books studied over 50 of the most successful companies of the past few decades. How did these presumably best-managed companies fare over time? By 2006, about 20% were out of business, almost half were struggling and a only a third were still high performers, according to Beyond Performance: How Great Organizations Build Ultimate Competitive Advantage, a book published in 2011 by McKinsey’s Scott Keller and Colin Price.
Beyond Performance is about a decades-long study of Organizational Health conducted by McKinsey’s Organization Practice group. Keller and Price define organizational health as “the ability of your organization to align, execute, and renew itself faster than your competitors can,” that is, “adapting to the present and shaping the future faster and better than the competition, . . . [and creating] a capacity to learn and keep changing over time.” The study, - one of the biggest research projects in the field of management, - aims to understand the relationship between organizational health and the quantitative financial and operational business performance measures which companies normally track, including net operating profit, return on capital employed, total returns to shareholders, net operating costs, and stock turns.
Organizational health encompasses relatively soft measures, such as leadership, skills, coordination and innovation capabilities, which have often been based on opinion and conjecture rather than on hard numbers. McKinsey adopted a more objective, facts-based, data-science-oriented approach to organizational health by developing an Organizational Health Index, comprised of 37 different management practices grouped into 9 different elements: Direction, Leadership, Culture and Climate, Accountability, Coordination and Control, Capabilities, Motivation, External orientation, and Innovation and Learning.
They then conducted an extensive survey to quantify the state of adoption of these 37 management practices, and received over 600,000 responses from more than 500 organizations around the world. In addition, they surveyed around 7,000 senior leaders to learn about their experiences with transformational change, conducted 30 one-on-one interviews with CEOs and senior execs, analyzed the results of over 100 McKinsey client engagements on the topic, and reviewed more than 900 books and articles.
The analysis uncovered that three key attributes are fundamental to organizational health:
- Internal Alignment: “The organization has a compelling vision and a well-articulated strategy that is supported by its culture and climate.”
- Quality of execution: “The organization demonstrates excellence in executing its strategy and delivering its services.
- Capacity for renewal: “The organization is effective at understanding, interacting with, adapting to, and shaping its situation and external environment.”
It found a strong positive correlation between organizational health and performance. “Companies in the top quartile of organizational health are 2.2 times more likely than lower-quartile companies to have an above-median EBITDA margin [earnings before interest, taxes, depreciation, and amortization], 2.0 times more likely to have above-median growth in enterprise value to book value, and 1.5 times more likely to have above-median growth in net income to sales.”
“The results within individual organizations mirror the results from our large sample of companies. At a multinational oil corporation, for example, we analyzed correlations between performance and organizational health across 16 refineries. We found that health accounted for 54 percent of the variation in performance.”
In addition, the study analyzed the survey data from the near 7000 senior executives who have been through organizational-change programs:
“Data from one survey, on why change programs fail, showed that what we might see as the usual suspects - inadequate resources, poor planning, bad ideas, unforeseen external events - account for less than a third of the failures. More than 70 percent resulted from poor organizational health, manifested in symptoms such as negative employee attitudes and unproductive management behavior. Furthermore, our 2010 survey of executives at companies undergoing transformations revealed that organizations focusing on both performance and health rated themselves as nearly twice as successful as those focusing on health alone and nearly three times as successful as those focusing on performance alone.”
McKinsey has continued to survey employees and senior executives around the world. Their latest research reveals that the linkage between health and performance is significantly larger than previously thought. “When we compared the health metrics of more than 270 publicly traded companies with their financial-performance metrics, we found that the healthiest generated total returns to shareholders that were three times higher than those of companies in the bottom quartile and over 60 percent higher than those of companies with middle of the road health profiles.”
The research further showed that the healthiest overall companies had a distinct organizational culture as opposed to trying to be great in all 37 management practices. The top companies were truly great in a few of the management practices, and good-enough or middle-of-the-road in the rest. The analysis identified that most healthy organizations follow one of these four combinations of practices which reflect their particular management style:
- Leader-driven: “leaders are the catalysts for performance, setting high expectations and supporting the organization in achieving them.”
- Market-focused: “shaping market trends and building a portfolio of strong and innovative brands keep the business ahead of the pack.”
- Execution Edge: “discipline, sound execution, and continuous improvement are the foundation for great performance.”
- Knowledge Core: “talent and knowledge are the organization’s most important assets, and it develops and deploys them effectively.”
The companies that were strongly aligned with one of these management styles had significantly higher health and business performance scores than companies with mixed or random styles. No company has the capacity or management time to be really good at all 37 practices. According to McKinsey, the best approach is for a company to pick the management style that best fits their strengths, aspirations and culture, excel in the key practices required by that style, and not worry a lot about the rest other than making sure that no practice is broken, that is, no score should be in the bottom quartile.
Perhaps the reason that so many of the In Search of Excellence companies did not do so well over time is that while their performance was really good, their organizational health was not, and it eventually caught up with them. How many of today’s leading companies are similarly not quite so healthy despite their strong financial performance, - but don’t know it?
As the leaders of the McKinsey study point out: “business, and even society as a whole, will improve when organizations begin to report - and be judged - on their health just as frequently and rigorously as they are on their performance.”