Mckinsey on Finance 943

Number 32, Summer 2009

Perspectives on Corporate Finance and Strategy

McKinsey on Finance

When to divest support services

19

Reducing risk in your manufacturing footprint

5

What next? Ten questions for CFOs

2

Valuing social responsibility programs

11

McKinsey on Finance is a quarterly

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1

2


As companies shift

their attention from

fighting the crisis

to getting the most from

the recovery, CFOs

must keep executives

focused.

5


Flexibility within and

among locations can help

companies respond

to changing conditions.

11


Most companies see

corporate social

responsibility programs

as a way to fulfill the

contract between business

and society. But do they

create financial value?

19


Some companies can

reduce the cost of support

services, improve their

quality, and raise

cash to invest elsewhere.

Here’s how to tell if

your company is one

of them.

McKinsey on Finance

Number 32, Summer 2009

2

The credit crisis and its shocks to the real economy

have put chief financial officers on the front

lines, as they implement emergency measures to

help companies survive the recession. Now, as

an eventual recovery begins to seem more likely,

the CFO’s task may become still more complex.

Even for those whose companies avoided the most

severe effects of the crisis, uncertainty about

the future is abundant, and credit remains tight.

Capital and management time are available for

only a few relatively big moves, and a new appre-

ciation of risk accompanies each opportunity.

So the CFO’s judgment will be critical to push the

management team’s thinking on the opportunities

and to cast a dispassionate eye over the costs,

David Cogman,

Richard Dobbs, and

Massimo Giordano


benefits, and risks of pursuing them. Here are

ten questions we think all CFOs should be asking

themselves and their executive colleagues as the

recovery approaches. Read the questions, then visit

mckinseyquarterly.com and tell us what you think

a CFO’s priorities should be coming out of the crisis.

1. What shape will a recovery take? Even if the

worst is over—though we make no assurances

that it is—much uncertainty remains about the

recovery’s nature and pace. A steady recovery

over 12 to 18 months would pose challenges very

different from those of a tepid one over, say,

five years or even a slip back into recession. What

weight are you giving to the possibility of wage

and price inflation, high unemployment, lower

As companies shift their attention from fighting the crisis to getting the most from

the recovery, CFOs must keep executives focused.

3

international trade, or dramatic swings in

currency values? What’s more, if excess leverage

inflated demand and profitability in the years

leading up to the crash, CFOs must help managers

to understand what they should expect as

normal after the crisis has fully passed and to

set appropriate performance targets.1

2. Have you restructured enough? A weak economy

makes it easier to implement unpopular opera-

tional changes and divestitures: companies have

more leverage over suppliers, unions and

regulators are more cooperative, and employees

understand the need for change. When the

economy strengthens, these advantages will

quickly vanish. CFOs should challenge their

colleagues to examine how much more restruc-

turing might be undertaken to secure a

company’s cost position for the medium term.

3. Is your supply chain sufficiently flexible? In

2008, the key question was what would happen

if the downturn was worse than expected.

In 2009, it’s worth considering what happens

if the surprise comes on the upside. An intense

focus on reducing costs and working capital will

leave many companies incapable of responding

to a rapid pick-up in demand. Can they respond

without either bringing back high costs or

cutting the quality of their products? If not, CFOs

should take time now to consider whether their

companies may have stretched the supply chain

a little too thin.

4. Do you have a short list of acquisition targets

ready? This crisis, so far, seems to echo the expe-

rience of previous ones: equity market valu-

ations are recovering a lot faster than economic

fundamentals.2 Acquisition-minded companies

that wait for clear evidence of recovery before

moving on attractive deals may well find

themselves preempted by better-prepared

competitors and miss the opportunity entirely

as valuations bounce back.

5. Should you restart conversations with potential

alliance partners? Last year, many companies put

discussions about strategic alliances and

joint ventures on hold. This year, if the under-

lying logic of those deals remains sound, many

potential partners are finding themselves

under greater pressure to close them. Moreover,

businesses that may emerge from the recession

at a competitive disadvantage could find a quick

and effective solution in joint ventures with

companies in a similar predicament.

6. Are you ready to divest newly underperforming

businesses? There’s no room for sentimentality

in portfolio planning. The downturn changed

many industries fundamentally, and once-

strong businesses may emerge from the crisis

in a weaker competitive position. Divesting

them now may be better than spending the next

economic cycle trying to fix them. Buyers

will emerge as the market recovers—and com-

panies can free up cash for better oppor-

tunities elsewhere.

7. Do you have the financial resources needed for

an upturn? Growth requires capital. Companies

may require more working capital or have to

finance the development of additional products,

distribution channels, and marketing programs

or the acquisition of new businesses. Credit and

equity have become scarce resources, and new

financing may not be timely enough to support

the market’s full recovery. To finance growth,

CFOs should prepare a battle plan—including

ways to line up new equity, as well as bonds

and new debt—that can be activated if necessary.

CFOs in countries where the volatility and

1 See Richard Dobbs, Massimo Giordano, and Felix Wenger, “The CFO’s role in navigating the downturn,” mckinseyquarterly.com, February 2009; and Ian Davis, “The new normal,” mckinseyquarterly.com, March 2009.

2 See Richard Dobbs and Timothy M. Koller, “The crisis: Timing strategic moves,” mckinseyquarterly .com, April 2009.

4 McKinsey on Finance Number 32, Summer 2009

10. Can you sell your recovery plan to investors?

Too many companies were unprepared for the

downturn, lacking clear plans to communicate

with investors or good answers to difficult

questions from analysts. Don’t be caught with-

out a response when someone asks you

what you’re doing to capitalize on the upturn.

A few big ideas that become realities will be worth

much more than a dozen that don’t quite

get off the launch pad. Thoughtful CFOs will ask

themselves which handful of bets could have

the biggest payoffs and then mobilize the bulk of

their time, capital, and resources to make those

bets succeed.

uncertainty of the crisis have pressured the

currency should understand how a recovery will

affect the ability to raise capital.

8. Have you taken advantage of the buyers’ market

for talent and other resources? In a recession,

most companies focus on cutting costs—head

counts, discretionary marketing expenditures,

R&D, product development, and capital spending.

But all of these now cost less than they have in

a decade, especially hiring new finance profes-

sionals. Research on previous downturns3

shows that the future winners made dispropor-

tionate investments in talent, marketing,

R&D, and capital spending at exactly this point.

9. Do you know what risks a recovery might bring?

Risk management and contingency planning

are typically better at highlighting day-to-day

issues than at anticipating major shifts. Yet

an economic turnaround could bring a number of

structural changes, some relatively predict-

able and with far-reaching effects. How well, for

example, do you understand your company’s

exposure to major currency or commodity price

movements? Do you know whether the health

of channels, customers, or suppliers might create

substantial structural change or whether

your company is prepared to deal with high levels

of volatility that may continue even as a

recovery builds?

David Cogman ([email protected]) is a partner in McKinsey’s Shanghai office, Richard Dobbs

([email protected]) is a partner in the Seoul office, and Massimo Giordano (Massimo_Giordano@

McKinsey.com) is a partner in the Milan office. Copyright © 2009 McKinsey & Company. All rights reserved.

Read what other people are saying at mckinseyquarterly.com, then join the conversation.

3 See Richard F. Dobbs, Tomas Karakolev, and Francis Malige, “Learning to love recessions,” mckinseyquarterly.com, June 2002.

5

Manufacturers of all types seek the same holy grail:

the strategy that delivers products at the lowest

possible total landed cost. In search of that goal,

over the past few years companies all over the

world have relocated facilities, outsourced produc-

tion to low-cost countries, invested in automation,

consolidated plants, or fundamentally redefined

relationships with suppliers.

Establishing the cheapest manufacturing footprint

becomes infinitely more elusive when basic

assumptions change fast and furiously, as they have

in the past year. Redesigning the footprint can

be the biggest and most important transformation

a manufacturer can undertake. Yet too many

managers choose the footprint by using only a single

Eric Lamarre,

Martin Pergler, and

Gregory Vainberg


set of future cost and demand assumptions. Any

manufacturing footprint exposes companies to

risks, such as changes in local and global demand,

currency exchange rates, labor and transpor-

tation costs, or even trade regulation. A wrong bet

can transform what should be a competitive

advantage into a mess of underutilized or high-

cost assets.

In our experience, the missing ingredient in many

manufacturing-strategy decisions is a careful

consideration of the value of flexibility. Companies

that build it into their manufacturing presence

can respond more nimbly to changing conditions

and outperform competitors with less flexible

footprints. As the current economic turmoil illus-

Flexibility within and among locations can help companies respond to

changing conditions.


trates, the greater the level of uncertainty, the

greater the value of flexibility. This is not surprising;

real-options theory (see sidebar, “What are

real options?”) maintains that flexibility is more

important when volatility is more intense. To

capture this value and gain the best position for

responding to future economic changes, all

companies should integrate flexibility into their

manufacturing-footprint or sourcing decisions.

Sources of flexibility

Some sectors understand the importance of flex-

ibility. Peak-demand power plants, for example,

are inherently quite costly but play an important

role in the market because they can quickly be

brought online for short periods when high energy

demand drives up electricity prices. Petroleum

refineries can alter their product mix weekly (or

even daily), basing these changes on the relative

prices of different distillates, product inventories,

and the price and availability of crude oil.

Industrial examples are less common. Honda’s East

Liberty, Ohio, plant can switch in minutes from

producing the Civic, an economical passenger car,

to the crossover sport utility CR-V. The Southeast

Asian plant of a construction-equipment manufac-

turer was designed to make two different prod-

ucts on the same assembly line. Every month, the

plant can switch production schedules to meet

Chinese, Southeast Asian, and Indian demand for

either product.

Many manufacturers, however, fail to assess the

flexibility and resilience to risk of their

manufacturing-footprint options, much less invest in

flexibility to make themselves more responsive.

Flexibility in a company’s manufacturing footprint

may take a number of forms: for instance, the

ability to adjust overall production volumes up

or down efficiently, depending on demand and

profitability; to change the production mix among

different products or models; or to adapt the

timing of production by shortening lead times or

committing the company to production volumes

later than competitors do. A flexible footprint can

also manifest itself in a company’s dispatch

optimization—its ability to adjust the country or

facility from which products or parts are sourced

in order to minimize the total landed cost at the

desired destination, given actual market conditions.

When companies build in these sources of strategic

flexibility, they can respond tactically to risks

such as changes in local demand, currency levels,

labor rates, tariffs, taxes, and transportation

costs. Toyota Motor, for instance, has increasingly

placed its manufacturing plants around the

world for maximum responsiveness to local market

conditions—starting with its NUMMI joint

venture with GM in California during the 1980s.

By 2004, Toyota realized that these efforts had

significantly reduced its overall risk exposure

(currency risk, in particular) by matching the

currencies of local costs and revenues.

Valuing and liberating flexibility

We find it useful to distinguish between two types

of flexibility. The first is flexibility within the

four walls of any given manufacturing facility. Plant

Many manufacturers fail to assess the flexibility and resilience to risk of their manufacturing-footprint options

7Reducing risk in your manufacturing footprint

flexibility might be manifested, for example, when

a manufacturing manager decides whether to

change production levels at a given factory or a

purchasing manager decides which supplier to

use. While the decision itself is simple, increasing

an individual plant’s flexibility is often fairly

expensive: for example, it can mean adding capacity,

adopting more expensive tooling to facilitate

mix changes, or negotiating more flexible labor or

supplier agreements.

The second type of flexibility, at the level of a

company’s network of plants, calls for integrating

information from around the enterprise to make

networkwide optimization decisions. One US manu-

facturer, for example, expected to serve customers

in North America from plants in North and Central

America and customers in Europe from European

plants. When demand increased in the United States,

however, falling shipping costs, a stronger US

dollar, and capacity constraints made it worthwhile

for the company to ramp up European production

as much as possible and to ship products across

the Atlantic. The specific balance of production

and transportation costs in each of the three plants

required a holistic view of the whole network (and,

in this case, a new shipping flow).

While the decisions (and the information require-

ments) for this second kind of flexibility are

more complex, increasing it may be less expensive

than building flexibility within an individual

plant. Indeed, the more complex the footprint, the

more likely that some sort of hidden network

flexibility is readily available. A company with a

multinational footprint, for example, might have

significant potential flexibility to adjust production

levels and shipping flows between different

regions in response to changing local economic

conditions. It could realize this possibility

only if it had sufficiently transparent sources of

information and made managers responsible

for exploiting them.

What are real options?

Real-options theory has its roots in the model developed for

financial options by Fischer Black and Myron Scholes and

later modified by Robert Merton. A company can use similar

models to value business or capital decisions that give it

the right, but not the obligation, to undertake a specific action

later, depending on how circumstances evolve. These

real options include expanding or shutting down a factory or

selling or acquiring an asset.

The idea of real options is very intuitive—a small investment

now “just in case” can pay off significantly, especially if

the level of uncertainty is large. Managers often treat standard

real-options calculations with suspicion, however, since

the mathematical analysis requires simplifying assumptions

about exactly how flexibility would be captured. Our

approach to managing a company’s manufacturing footprint

is an application of the real-options idea but grounded in

very concrete analysis of the operational decisions managers

must make to capture flexibility.


Consider the example of a heavy-equipment manu-

facturer exploring potential new footprints to

reduce its cost base and maintain its competitive

position against low-cost entrants. The leading

new footprint option—to build new plants in devel-

oping countries and to reallocate the product

mix and capacity of existing plants—was clearly

more cost-effective given the expected evolution

of demand and costs. Nonetheless, increased cur-

rency exposure and transportation flows would

significantly raise the company’s overall level of

risk. Once managers incorporated flexibility

into their analysis, however, the new footprint

option became significantly more attractive.

They then realized that a more geographically diver-

sified footprint would enable them to respond

more easily to unexpected changes in costs or

demand—an ability that lowered both the

expected unit cash cost and the uncertainty. In

effect, the new footprint provided very concrete

and valuable real options. Capturing them required

an incremental increase in investment, but the

lower unit costs and greater flexibility were clearly

worthwhile.

In this instance, flexibility improved the case

for what was already a worthwhile new footprint

investment. But suppose that had been one

of two possible new footprint options. Basing the

decision between them solely on expected

costs, without considering flexibility—as many

companies do—would probably have made

the company choose the costlier option (exhibit).

What should companies do?

The example above shows that if companies take

risk and flexibility into account when they make

manufacturing-footprint decisions, they can make

better ones, particularly under high uncertainty.

To capitalize on that opportunity, companies must

take several steps.

Phase 1: Modeling landed costs

The starting point for exploring manufacturing-

footprint options is a detailed landed-cost

model for all options under consideration. To under-

stand the cost of manufacturing and delivering a

unit of each product to each destination, managers

must also understand the marginal costs of

Exhibit

Considering flexibility

Evaluating the flexibility of various potential manufacturing footprints can help companies choose among their options.

Unit cost by footprint options; index: expected value of existing footprint = 100

Option A

Before flexibility analysis

After flexibility analysis

Option B Option A Option B

Net present value 100 120 150 125

130

88 8590

0

MoF 31 2009FootprintExhibit 1 of 1Glance: Evaluating the flexibility of various potential manufacturing footprints can help companies choose among their options. Exhibit title: Considering flexibility

103

75

98

72

82

91

73

84

Expected value of existing footprint

96

72

110

70

50

80% confidence interval Expected value

9Reducing risk in your manufacturing footprint

producing and shipping more or fewer units.

This is trickier than it seems, since the financial

systems of many companies tend to track the

required factor cost items only on a plant-by-plant

level. Cutting the numbers with sufficient gran-

ularity will require a combined effort involving the

finance function and the shop floor, as well as

the design team for the options being considered.

Phase 2: Exploring risk and flexibility

In this phase, managers need to assess the risks

affecting costs and demand. Some risks can

be assessed fairly easily: for example, local GDP

growth may influence local industry demand

directly, and the evolution of local labor rates may

feed straight into factor costs. Others risks are

a bit more challenging, since they affect more than

one element of the cost base. Energy prices, for

instance, typically appear not only as a direct manu-

facturing cost but also as a contributor to trans-

portation costs—both in shipping products to end-

user markets and in shipping modules or parts

from factories or suppliers to assembly. Currency

risk, which can be particularly difficult to assess

accurately, is often a critically important consid-

eration as well.

Besides understanding the risks, managers need

to understand the sources of flexibility in each

footprint option. Which combinations of produc-

tion volume, mix, dispatch, and timing are

available for each? How is flexibility constrained—

for example, by maximum production capacity

or transportation bottlenecks? What can be done

within the four walls of an individual plant and

at the level of the plant network? The heavy-

equipment manufacturer discussed above built

its model for over 60 products, a dozen geographic

regions, and 50 partially correlated risk factors.

In our experience, the principal difficulty in this

phase is tracking the impact of different risk

factors and flexibility decisions through all of the

line items. Effects can be hidden—for instance,

increases in the price of energy affect costs not

only for manufacturing but also for transpor-

tation, as well as supplier costs that may be passed

on through escalation clauses.

Phase 3: Quantifying the trade-offs

To make the cost and flexibility trade-offs for

different footprint options, companies must

combine the risks and sources of flexibility with

base-case demand predictions and landed-

cost models. A variety of analytical techniques are

available. If just a handful of largely independent

uncertainties really matter, managers may need

only a simple computation of the economics of

each footprint option in a small set of scenarios.

When the number of variables is larger and their

relationships are more complicated, probabilistic

modeling often makes more sense, as it did for

the heavy-equipment manufacturer. In such cases,

it’s essential to program the model with rules

for the managerial flexibility each footprint option

allows—rules such as “if demand exceeds capacity,

start a third shift” or “ship units from Mexico if

they turn out to be cheaper than units from

Indonesia.” The heavy-equipment manufacturer

ran several thousand Monte Carlo scenarios

on its model, recalculating capacity and dispatch

flows according to economic conditions.

Both scenario analysis and probabilistic modeling

are only as good as the quality of a company’s

understanding of its key assumptions. What’s needed

is a combination of what-if analysis, external

data, expert predictions, stress testing, and extrap-

olation from the available historical data.

Phase 4: Making the choice and

improving value

The calculations described above often clarify

which footprint choice is best under a broad


Finally, it’s worth stressing that the work doesn’t

stop with adjusting the network. Managers face

a constant stream of decisions, such as investing

in modernization, adding new capacity, and

introducing new products. That’s in addition to more

day-to-day decisions in production planning to

capture the value of—and preserve—the network’s

flexibility. Making such decisions typically

requires the use of ongoing coordination mech-

anisms across plants, appropriate steps to

measure and plan capacity, and the adjustment of

metrics that emphasize the value of the whole

enterprise, as opposed to individual plants. Such

activities, worthwhile in themselves, are doubly

important if network flexibility is a key part of a

new footprint’s value.

The authors would like to thank Vijai Raghavan for his contributions to this article.

Eric Lamarre ([email protected]) is a partner in McKinsey’s Montréal office, where Martin Pergler

([email protected]) and Gregory Vainberg ([email protected]) are consultants.

Copyright © 2009 McKinsey & Company. All rights reserved.

range of situations. Some options might provide the

lowest landed costs even in the face of broad

swings in economic conditions. In other cases, one

option beats out others only because greater

flexibility helps a company adapt more successfully

to certain kinds of change, such as increased

competition or regional fluctuations in demand.

A footprint that seems more expensive or that

requires a higher level of investment might be worth-

while for the extra flexibility.

Debating these possibilities will probably gen-

erate additional ideas to enhance a company’s flexi-

bility. Managers of a liquid-natural-gas (LNG)

supplier, for instance, were considering whether

efforts to acquire or develop a number of gas

fields, pipelines, and LNG terminals would provide

greater flexibility in responding to regional

imbalances in demand. Analysis confirmed that

they would do so but also showed that the

company could capture extra value by improving

its dispatch capabilities to change network

flows in its whole portfolio of assets. The company

believed that this additional network flexibility,

requiring only new managerial skills and infor-

mation systems but no physical modifications,

would have an economic value easily exceeding the

additional investment.

11

Companies face increasing pressure from govern-

ments, competitors, and employees to play a

leading role in addressing a wide array of environ-

mental, social, and governance issues—ranging

from climate change to obesity to human rights—

in a company’s supply chain. Over the past

30 years, most of them have responded by devel-

oping corporate social responsibility or sus-

tainability initiatives to fulfill their contract with

society by addressing such issues.1

Gathering the data needed to justify sustained,

strategic investments in such programs can be

difficult, but without this information executives

and investors often see programs as separate from a

company’s core business or unrelated to its share-

Sheila Bonini,

Timothy M. Koller, and

Philip H. Mirvis


holder value. Some companies have made great

progress tracking operational metrics (such as tons

of carbon emitted) or social indicators (say, the

number of students enrolled in programs) but often

have difficulty linking such metrics and indicators

to a real financial impact. Others insist that the

effects of such programs are either too indirect

to value or too deeply embedded in the core business

to be measured meaningfully: for example, it

can be very hard to separate the financial impact of

offering healthier products from the impact of

other aspects of the brand, such as quality and price.

Yet many companies are creating real value through

their environmental, social, and governance

activities—through increased sales, decreased

Most companies see corporate social responsibility programs as a way to fulfill the

contract between business and society. But do they create financial value?

1 We have chosen to use the term “environmental, social, and governance” because more common terms, such as

“corporate social responsibility” and “sustainability,” have a narrower connota- tion. The term environmental, social, and governance is also increasingly used by investors to refer to a broader set of programs that we observed in the companies mentioned in this report.


2 To better understand the relationship between environmental, social, and governance activities and value creation, we surveyed 238 CFOs, investment professionals, and finance executives from a full range of industries and regions. The survey was conducted in conjunction with a survey of 127 corporate social respon-sibility and sustainability professionals and self-described socially responsible institutional investors that were reached through the Boston College Center for Corporate Citizenship. Both surveys were in the field in December of 2008. To get a bottom-up view, we also constructed case studies of 20 companies with leading environmental, social, and governance programs in a number of industries.

3 See “Valuing corporate social responsibility: McKinsey Global Survey Results,” mckinseyquarterly.com, February 2009.

costs, or reduced risks—and some have developed

hard data to measure even the long-term

and indirect value of environmental, social, and

governance programs.2 It’s not surprising that

the best of them create financial value in ways the

market already assesses—growth, return on

capital, risk management, and quality of manage-

ment (Exhibit 1). Programs that don’t create

value in one of these ways should be reexamined.

How environmental, social, and

governance programs create value

The most widely known way that environmental,

social, and governance programs create value

is by enhancing the reputations of companies—

their stakeholders’ attitudes about their

tangible actions—and respondents to a recent

McKinsey survey agree.3

Moreover, it has long been clear that financially

valuable objectives—such as better regulatory

settlements, price premiums, increased sales, a

reduced risk of boycotts, and higher retention

of talent—may depend, at least in part, on a com-

pany’s reputation for environmental, social,

and governance programs that meet community

needs and go beyond regulatory requirements

or industry norms.

However, environmental, social, and governance

programs can create value in many other ways

that support growth, improve returns on capital,

reduce risk, or improve management quality.

Breaking out the value of these activities enables

companies to communicate it to investors and

financial professionals.

Growth

Our case studies highlighted five areas in

which these programs have a demonstrable impact

on growth.

New markets. IBM has used environmental, social,

and governance programs to establish its

presence in new markets. For example, the company

uses its Small and Medium Enterprise (SME)

Toolkit to develop a track record with local stake-

holders, including government officials and

nongovernmental organizations (NGOs). In part-

nership with the World Bank’s International

Finance Corporation, India’s ICICI Bank, Banco

Real (Brazil), and Dun & Bradstreet Singapore,

IBM is using the service to provide free Web-based

resources on business management to small

and midsize enterprises in developing economies.

Overall, there are 30 SME Toolkit sites, in

16 languages. Helping to build such businesses not

only improves IBM’s reputation and relation-

ships in new markets but also helps it to develop

relationships with companies that could

become future customers.

New products. IBM has also developed green data-

center products, which help the company grow

by offering products that meet customers’ enviro-

nmental concerns. A new collaboration between

IBM and the Nature Conservancy, for example,

is developing 3D imaging technology to help

Environmental, social, and governance programs can create value in many other ways that support growth, improve returns on capital, reduce risk, or improve management quality

13Valuing social responsibility programs

advance efforts to improve water quality. This

project applies IBM’s existing capability in sensors

that can communicate wirelessly with a central

data-management system in order to provide deci-

sion makers with summaries that improve water

management. At the same time, it also addresses

an important environmental need—and creates

a new business opportunity for IBM.

New customers. Telefónica has been developing

new products and services geared to customers

over the age of 60. To help overcome what the

company calls a “knowledge barrier,” it has collab-

orated with associations for older people in an

effort to introduce retired men and women to the

benefits of new technologies—for example,

teaching them to communicate with grandchildren

living abroad. The company meets a social need

by helping this population use modern technologies

and services while building a customer base in

an underpenetrated market.

Exhibit 1

Quantifiable value

The best environmental, social, and governance programs create financial value for a company in ways that the market already assesses.

MoF 32 2009Valuing ESGExhibit 1 of 2Glance: The best environmental, social, and governance programs create financial value for a company in ways that the market already assesses. Exhibit title: Quantifiable value

Growth

Value in environmental, social, and governance (ESG) programs

New markets

New products

New customers/market share

Innovation

Reputation/differentiation

Access to new markets through exposure from ESG programs

Offerings to meet unmet social needs and increase differentiation

Engagement with consumers, familiarity with their expectations and behavior

Cutting-edge technology and innovative products/services for unmet social or environmental needs; possibility of using these products/services for business purposes—eg, patents, proprietary knowledge

Higher brand loyalty, reputation, and goodwill with stakeholders

Returnson capital

Operational efficiency

Workforce efficiency

Reputation/price premium

Bottom-line cost savings through environmental operations and practices—eg, energy and water efficiency, reduced need for raw materials

Higher employee morale through ESG; lower costs related to turnover or recruitment

Better workforce skills and increased productivity through participation in ESG activities

Improved reputation that makes customers more willing to pay price increase or premium

Riskmanagement

Regulatory risk

Public support

Supply chain

Risk to reputation

Lower level of risk by complying with regulatory requirements, industry standards, and demands of nongovernmental organizations

Ability to conduct operations, enter new markets, reduce local resistance

Ability to secure consistent, long-term, and sustainable access to safe, high-quality raw materials/products by engaging in community welfare and development

Avoidance of negative publicity and boycotts

Management quality

Leadership development

Adaptability

Long-term strategic view

Development of employees’ quality and leadership skills through participationin ESG programs

Ability to adapt to changing political and social situations by engaging local communities

Long-term strategy encompassing ESG issues


Market share. Coca-Cola has shown how a company

can use enlightened environmental practices

to increase its sales. Its new eKOfreshment coolers,

vending machines, and soda fountains are far

more environmentally friendly than the ones they

replaced: they not only eliminate the use of

hydrofluorocarbons (greenhouse gases) as a refrig-

erant but also have a sophisticated energy-

management device that Coca-Cola developed to

reduce the energy these machines consume.

Together, these innovations increase the equip-

ment’s energy efficiency by up to 35 percent.

The company highlights the benefits to retailers—

especially the financial savings from energy

efficiency—and requests prime space in their out-

lets in return for providing more efficient systems.

Innovation. Dow Chemical has committed

itself to achieving, by 2015, at least three

breakthroughs in four areas: an affordable and

adequate food supply, decent housing,

sustainable water supplies, or improved personal

health and safety. All have a connection to an

existing or planned Dow business. The company

has already made progress in its Breakthroughs

to World Challenges initiative, for example,

by utilizing its understanding of plastics and

water purification to supplement its venture

capital investment and loan guarantee support

to a social entrepreneur in India who has

developed an inexpensive community-based

water filtration system. The initiative’s

ultimate goal is a new business model to sell new

products at reasonable prices, meeting social

needs while contributing to Dow’s bottom line.

Returns on capital

We have seen companies generate returns on capital

from their environmental, social, and governance

programs in several ways—most often through oper-

ational efficiency and workforce efficiency.

Operational efficiency. These programs can help

companies realize substantial savings by meeting

environmental goals—for instance, reducing

energy costs through energy efficiency, reducing

input costs through packaging initiatives, and

improving processes. Such efficiencies often require

upfront capital investments to upgrade tech-

nologies, systems, and products, but returns can

be substantial.

Novo Nordisk’s proactive stance on environmental

issues, for example, has improved its operational

efficiency. In 2006, the company set an ambitious

goal: reducing its carbon dioxide emissions by

10 percent in ten years. In partnership with a local

energy supplier, Novo Nordisk has identified

and realized energy savings at its Danish produc-

tion sites, which account for 85 percent of the

company’s global carbon dioxide emissions. It uses

the savings to pay the supplier’s premium price

for wind power. In three years, the effort has elim-

inated 20,000 tons of carbon dioxide emissions,

and by 2014 green electricity will power all of the

company’s activities in Denmark. In this way,

Novo Nordisk is not only reducing its emissions,

increasing the energy efficiency of its opera-

tions, and cutting its costs but also helping to build

Denmark’s market for renewable energy.

Workforce efficiency. Best Buy has undertaken

a targeted effort to reduce employee turnover, part-

icularly among women. In 2006, it launched the

Women’s Leadership Forum (WoLF), which shows

groups of female employees how they can help

the company to innovate by generating ideas, imple-

menting them, and measuring the results. These

innovations—which largely involve enhancing the

customer experience for women by altering the

look and feel of Best Buy stores and modifying their

product assortment—have significantly boosted

sales to women without decreasing sales to men.


Besides fostering innovation, the program helps

women to create their own corporate support

networks and encourages them to build leadership

skills by organizing events that benefit their

communities. In the program’s first two years, turn-

over among women decreased by more than

5 percent annually.

Risk management

Companies often see environmental, social, and

governance issues as potential risks, and many

programs in these areas were originally designed

to mitigate them—particularly risks to a com-

pany’s reputation but also, for example, problems

with regulation, gaining the public support

needed to do business, and ensuring the sustain-

ability of supply chains. Today, companies

manage many of these risks by taking stands on

questions ranging from corruption and fraud

to data security and labor practices. Creating and

complying with such policies is an extremely

important part of risk management, though one

that isn’t likely to be a source of significant

differentiation. But leading companies can dif-

ferentiate themselves by going beyond the

basics and taking a proactive role in managing

environmental, social, and governance risks.

Such an approach can have an important and

positive financial impact, since negative envi-

ronmental, social, and governance events can have

significant potential cost.

Regulation. In most geographies, regulatory policy

shapes the structure and conduct of industries

and can dramatically affect corporate profits, some-

times dwarfing gains from ordinary operational

measures.4 It is therefore critically important for

companies to manage their regulatory agenda

proactively—ideally, by having a seat at the table

when regulations for their industries are con-

templated and crafted. To build the necessary trust

with regulators and to secure a voice in the ongoing

discussion, it helps to have solid relationships with

stakeholders and a reputation for strong

performance on environmental, social, and

governance issues.

Verizon, for instance, very actively manages its

relationships with stakeholders and strives to

establish regular contacts and strong ties with

policy makers. To help formulate sound—and

favorable—energy and climate policies, the company

has also sponsored research on the way infor-

mation communications technology promotes energy

efficiency. They sponsored the research behind

the Smart 20205 report, for example, which report

explains in detail how this technology, together

with broadband Internet connections, can help the

United States to reduce carbon emissions by

22 percent and reliance on foreign oil by 36 per-

cent by no later than 2020.

Public support. To operate in a country or business,

companies need a modicum of public support,

particularly on sensitive issues. Coca-Cola, for

example, has been proactive in identifying the risks

to its business posed by water access, availability, and

quality. In 2003, Coca-Cola began developing

a risk-assessment model to measure water risks

at the plant level, such as supply reliability,

watersheds, social issues, economics, compliance,

and efficiency. The model helped Coca-Cola

to quantify the potential risks and consequently

enabled the company to put sufficient resources

into developing and implementing plans to mitigate

those risks. It now has a global water strategy in

place that includes attention to plant performance,

watershed protection, sustainable water for

communities, and building global awareness. Their

actions help avoid potential backlash over water

usage as well as potential operational issues from

water shortages.

4 See Scott C. Beardsley, Luis Enriquez, and Robin Nuttall, “Managing regulation in a new era,” mckinseyquarterly.com, December 2008.

5 SMART 2020: Enabling the Low Carbon Economy in the Information Age, The Climate Group and the Global eSustainability Initiative (GeSI), 2008.


Supply chains. Some companies have moved

beyond focusing on the risks from the day-to-

day practices of their suppliers and now consider

the suppliers’ long-term sustainability as well.

Under Nestlé’s Creating Shared Value strategy, for

instance, a business has to make sense for all

its stakeholders. As an example, Nestlé works

directly with the farmers and agricultural

communities that supply about 40 percent of its

milk and 10 percent of its coffee. To ensure its

direct and privileged access to these communities,

Nestlé promotes their development by building

infrastructure, training farmers, and paying fair

market prices directly to producers rather than

middlemen. In return, the company receives higher-

quality agricultural ingredients for its products.

These strong relationships also give Nestlé’s fac-

tories a reliable source of supply, even when the

overall market runs short. When the price of milk

powder soared in 2007, for example, Nestlé’s

direct links to farmers mitigated its supply and

price risks in certain parts of the world and

protected the interests of all stakeholders—from

farmers to consumers.

Management quality

CFOs and professional investors often see high-

performing environmental, social, and governance

programs as a proxy for the effectiveness of

a company’s management. They may be onto some-

thing. In our observation, these programs can

have a strong impact in all three areas that investors

typically consider important: leadership strength

and development, both at the top and through the

ranks; the overall adaptability of a business; and

the balance between short-term priorities and a

long-term strategic view.

Leadership development. IBM’s Corporate Service

Corps sends top-ranked rising leaders to work

pro bono with NGOs, entrepreneurs, and govern-

ment agencies in strategic emerging markets.

The program has already improved the leadership

skills of its participants in a statistically signifi-

cant way; raised their cultural intelligence, global

awareness, and commitment to IBM; and given

the company new knowledge and skills. In a recent

evaluation, nearly all participants indicated

that their involvement with the corps increased the

likelihood that they would stay at IBM.

Adaptability. Companies flexible enough to meet

unforeseen challenges—for instance, by remaining

in countries or communities during times of

crisis or conflict—often reap long-term benefits, such

as strong relationships and credibility with local

communities. Environmental, social, and govern-

ance programs are one way to boost this kind

of resiliency. Cargill, for example, is currently main-

taining its presence and operations in Zimbabwe

under difficult conditions; instead of paying its local

employees in the country’s very unstable cur-

rency, it compensates them with food parcels and

fuel vouchers. The company makes similar long-

term investments in local communities in the other

66 countries where it operates.


A long-term strategic view. Companies that take

a long-term view use environmental, social,

and governance activities to anticipate risks from

emerging issues and to turn those risks into

opportunities. Novo Nordisk, for instance, manages

itself according to principles of a triple bottom

line—an economically viable, environmentally

sound, and socially responsible approach to

business. The company, for example, has not only

made investments to prevent, diagnose, and

treat diabetes and to build up the related health

care infrastructure but has also used these

investments to strengthen its position in mature

markets and to develop its business in new ones.

Assessing value

Although many executives and investors believe

that much of the impact of environmental, social,

and governance programs is long term and

indirect—and thus nearly impossible to measure—

our research suggests otherwise. Companies

can directly value the financial effects of many such

programs, even in the short term; the impact

of environmental programs, for example, can often

be measured quickly with traditional business

metrics such as cost efficiency. Companies that

understand the pathways to value and identify

the short- and long-term effects of environmental,

social, and governance programs will succeed

in defining a few targeted metrics to assess

them (Exhibit 2).

One such company, Telefónica, having found that its

customers’ purchasing decisions and loyalty are

driven in part by perceptions of its environmental,

social, and governance activities, decided to inte-

grate the results of an annual reputation survey into

its business strategy. Since then, Telefónica has

identified its reputation shortfalls, aligned its busi-

ness strategy with efforts to close them, created

Exhibit 2

Direct and indirect dividends

Environmental, social, and governance programs can have direct and indirect financial effects on companies.

MoF 32 2009Valuing ESGExhibit 2 of 2Glance: Environmental, social, and governance programs can have direct and indirect financial effects on companies. Exhibit title: Direct and indirect dividends

Source: Interviews with Campbell Soup executives; McKinsey analysis

Food and beverage innovation

Access to and relationships with retailers

Brand portfolios and brand loyalty

Relationships with consumers, nongovernmental organizations (NGOs), and other influencers

Business driver

Example of environmental, social, and governance (ESG) program: Campbell Soup’s partnership with American Heart Association

Increased sales

Increased sales

Increased sales

Increased sales

Avoidance of risk

Goodwill

Goodwill

Direct Indirect

Financial impact

Goodwill

New products

New sales opportunities with current retailers

New customers and stronger consumer loyalty

New sales opportunities created through trusting partnerships

Effect of ESG programs on business driver

Stronger relationships with current retailers

Better brand awareness, preference, and image

Lower risk of attack from vocal representatives of NGOs

Access to new retailers


action plans to improve its reputation (for instance,

by developing new products and services or adapting

existing ones), and monitored any improvement.

This approach has helped the company to improve

its reputation, and the corresponding sales, in

a significant way. An internal study shows that in

2006 and 2007, 11 percent of the change in the

financial performance of the company reflected

changes in its reputation.

UnitedHealth is another company that has assessed

the impact of its environmental, social, and

governance work. Its social responsibility dash-

board includes metrics for workplace engage-

ment, ethics, and integrity; supplier diversity; envi-

ronmental impact; employee–community

involvement; stakeholders’ perspectives on social

responsibility; and community giving. All of

these metrics track the company’s progress in

meeting its social mission: helping people live

healthier lives. Currently, UnitedHealth’s board

and senior executives use the dashboard to

measure the company’s performance and to guide

discussions on future priorities, programs,

resources, and results. In the future, the dash-

board will be made available to customers

and other public audiences to demonstrate the

company’s environmental, social, and governance

commitments and progress.

Companies need broad legitimacy in the societies

where they operate if they are to sustain their long-

term ability to create shareholder value. Equally

important, society depends upon big business to

provide critical economic and other benefits.

This relationship forms the basis of an overarching

contract between business and society. Over

the past few years, responses to the social, environ-

mental, and governance concerns of politicians,

regulators, lawyers, and consumers have reshaped

the core businesses of major companies in many

sectors: agribusiness, chemicals, fast food, mining,

oil, pharmaceuticals, and tobacco, to name just

a few. As the social contract has come under more

and more pressure, companies are realizing that

they just can’t ignore environmental, social, and

governance issues.

The authors wish to thank Noémie Brun, Thomas Herbig, and Michelle Rosenthal for their contributions to

this research.

Sheila Bonini ([email protected]) is a consultant in McKinsey’s Silicon Valley office, and Tim Koller

([email protected]) is a partner in the New York office; Philip Mirvis is a senior research fellow

at Boston College’s Center for Corporate Citizenship. Copyright © 2009 McKinsey & Company. All rights reserved.

This article has been adapted from “Valuing corporate social responsibility and sustainability,” a white paper published

by the Boston College Center for Corporate Citizenship, March 2009.

19

Is a hidden gem eluding your portfolio evaluation

process? Most companies periodically scan their

operations to ensure that they are the best owners

and in the process identify businesses that can

be divested to raise capital for other opportunities.

But these companies typically overlook support

services, viewing them instead as cost centers—

which focus on cost reductions or outsourcing—

rather than as business units ripe for divesting.

The distinction is an important one. In many cases,

it makes sense to outsource individual service

activities, including commoditized corporate func-

tions (such as finance and accounting, HR, and

purchasing), IT functions (the help desk, infrastruc-

ture operations, applications management),

and industry-specific functions (booking and fare

Petter Østbø,

Tor Jakob Ramsøy, and

Anders Rasmussen


management for airlines, payments processing

for banks). Yet when a company aggregates support

services into a single unit, it may constitute an

attractive business that can be sold outright, with

a value greater than that of a five- to eight-year

contract for continued support services. The selling

company reduces its operating costs, raises

capital, and removes assets from its balance sheet.

The purchasing company acquires assets, know-

how, and perhaps an attractive geographic foot-

print, as well as a new support services client.

Nonetheless, even executives who understand

the idea in theory worry that the practical

obstacles to divesting—tight credit and a weak

market for assets—outweigh the benefits or

that the seller will have to pay more for these

services after the divestiture.

Some companies can reduce the cost of support services, improve their quality, and

raise cash to invest elsewhere. Here’s how to tell if your company is one of them.


For companies that meet certain prerequisites, how-

ever, the opportunity can be significant, and

there are plenty of eager buyers for shared-services

units that offer real value. In our research into

more than 30 recent transactions, the divesting

companies generated, on average, an immediate

cash injection of 250 percent of book value. There

were also immediate cost savings of up to 40 per-

cent, followed by annual additional reductions of

over 2 percent, and even, in most cases, improve-

ments in quality.1 These numbers match up well with

the latest transaction multiples for similar types

of assets—and divestments of shared-services units

also embody hidden opportunities for value,

so the benefits probably exceed those of open-

market transactions.

Who should divest?

Not all companies should consider divesting

a captive support services center. Before a sale

attracted buyers, many companies would first

need to develop their own capabilities internally

or to improve the organization of their shared-

services units. That is especially true for companies

whose support services are still dispersed among

various business units or only loosely controlled by

a central unit, as well as those whose business

processes aren’t standardized or whose fragmented

IT systems are based largely on legacy applica-

tions and must therefore be cleaned up. Further-

more, companies facing a large, imminent

restructuring (such as the divestiture or acquisition

of a major business) may also find it better to

keep their services internal so that they retain

control over quality, avoid adding complexity

to the difficulties of the transition phase, and reduce

the risk of losing key people.

Obviously, if a unit has unique capabilities or a

company has unusual service requirements, selling

the unit outright would put the company at a

disadvantage when it negotiated subsequent service

agreements with the new owner, which would

have the leverage to demand whatever terms it

wanted. In our experience, however, sellers

usually have enough qualified alternate providers

to make the subsequent negotiations competitive.

We have also found that the companies best posi-

tioned to divest have service centers mature

enough to permit a change of control: such a unit

is a separate entity, with an existing sales and

service culture; has a product catalog with clear

service-level agreements (SLAs) regulating

the type of service the buyer receives, as well as its

quantity and quality; and provides at least

30 percent of the selling company’s needs. Finally,

the unit’s growth shouldn’t be strategically

important to the success of that company, which

must also be willing and able to manage the

resulting service contracts.

Even among companies that meet these prereq-

uisites, divesting a support services unit is

attractive only if the benefits exceed the value that

could be created through a simple outsourcing

contract. For sellers, this means finding a buyer

that can provide quality services at a cost lower

than the current one, offer a service contract suffi-

ciently flexible to adjust for changes in technology

and usage patterns, and pay a premium high enough

to justify the permanent transfer of control and

ownership of all assets. Buyers actually have shown

a willingness to pay such a premium for support

services units that offer value creation opportu-

nities similar to those of any other acquisition

(exhibit). Attractive units must have the ability to

function as businesses on their own, a desirable

geographic footprint (from an operational or a

customer-facing perspective), industry-specific

capabilities that would strengthen a service pro-

vider’s offering, significant growth potential,

or unique intellectual property.

1 To obtain these numbers, we studied press releases of the transactions, comparing the information in those documents with financial accounts (such as quarterly reports and investor presentations) and conducting interviews with executives at these companies or with entities familiar with the process.

21When to divest support services

Examples of successful sales abound. Take, for

example, WNS, the support services unit of British

Airways. WNS was a wholly owned subsidiary of

BA until April 2002, when the airline sold 70 percent

of its shares to the private-equity firm Warburg

Pincus. Under Warburg Pincus, WNS was able to

expand its offering of finance and accounting,

HR, and benefits-management services to numbers

of new clients. Another example of such a sale

involves the private-equity firms Cinven and BC

Partners, which acquired Amadeus Global Travel

Distribution, the ticketing arm of Scandinavian

Airlines System (SAS), Lufthansa, Iberia, and

Air France, in 2005. Since then, Cinven has success-

fully worked with the company’s management to

enlarge the business and reduce operational costs.

In 2007, Cinven recapitalized Amadeus, earning

1.6 times its original investment. And when the Euro-

pean service provider Capgemini acquired

Unilever’s Indian support center, Indigo, it quickly

became a platform for establishing the company’s

offshore business process outsourcing services.

Not all companies meet the prerequisites, and those

that don’t should wait. One Fortune 200 basic-

materials company first evaluated the idea of selling

its support services center four years ago but

decided that the unit didn’t serve enough of the

company—or offer enough services to the internal

clients it did serve—to attract the right potential

buyers. Further, the company was divesting a

major division and decided it couldn’t risk losing

direct control over its support services until

the restructuring was complete. Recently, after

addressing those issues, the company divested

its support services center.

Who is the best owner?

In our experience, many companies will be inter-

ested in acquiring a mature support services

center. The trick is to negotiate only with potential

buyers for which it would have real value. The

seller must understand that value for a wide range

of companies—including service providers and

financial buyers, such as private-equity firms—and

develop a short list of no more than five candi-

dates that would be invited to negotiate. A team

that includes the CIO or the head of support

services, the CFO—and, for larger deals, the CEO—

usually conducts this kind of effort.

At the outset, the team should determine whether

its own company is the unit’s best owner by

developing a realistic three- to five-year business

plan based on the assumption that the unit would

be free to serve any customer and that resources

would be available to support its growth. The plan

should account for the unit’s growth opportunities

and for cost and quality improvements that would

take its performance to best-practice levels. If the

Exhibit

What buyers want

Buyers have been willing to pay a premium for support-services units that offer value creation opportunities similar to those of any other acquisition.

Average premium for acquisition of support services unit, ratio of premium to book value

Source of value

MoF 32 2009Shared ServicesExhibit 1 of 1Glance: Buyers have been willing to pay a premium for support-services units that offer value creation opportunities similar to those of any other acquisition. Exhibit title: What buyers want

1Based on >30 deals with average value of $1.9 billion, among all types of companies.

Source: Interviews; company financial statements; McKinsey analysis

Stand-alone growth potential and low-cost locations 330

Unique intellectual property 204

Customer acquisition or distressed sale

Industry capabilities 140

60


plan would help the center generate more value

than it is currently expected to create, the team

must decide whether the company has sufficient

resources to make the necessary investments and

add the needed capabilities, taking into account

its hopes for other business units. If the plan would

require a disproportionate focus on the support

services center or would be challenging to execute—

given, for example, the natural constraints

to serving competitors—then there is probably a

better owner, and the company should consider

divesting the unit.

Negotiating the deal

When the time comes for the company to divest, its

executives must manage two competing challenges:

getting the best possible cash payment for the sale

of the business and the best possible terms for

a five- to eight-year service contract. The key to

success is negotiating the service contract and

the sales price at the same time—typically, by invit-

ing a short list of credible buyers (those with

the size, reputation, and ability to provide contrac-

tual quality and service guarantees) to an

auction that sets the price both of the unit and of

the service contract’s most important products

and SLAs. The top one to three bidders should sub-

sequently be invited to participate in detailed

open-book negotiations.

An excessive number of candidates can be

a problem. A large multinational that began the

process with more than 25 bidders found it

impossible to evaluate them, because it couldn’t

properly negotiate both the sale and the service

contract for so many bidders at the same time.

After a six-month auction failed to produce

appropriate results, the multinational decided to

enter into detailed negotiations with only

two parties. It reached an attractive agreement

within two months.

Negotiation mechanics for the sale—due diligence,

valuations, and so forth—are the same as those

for any other divestiture, with a notable exception:

the seller must be confident that a buyer will

stand by its long-term contractual obligations and

its guarantees if issues arise with the quality of

service. This type of transaction also differs from a

standard one in that the value transferred depends

on more than the amount of the up-front payment

for the sale; other important considerations

include the size of the initial and ongoing cost reduc-

tions, the length of the service contract, and the

investment needed to transfer hardware, software,

and employees.

The challenges of negotiating the service contract

resemble those of any straightforward outsourcing

contract. Sellers often include specific require-

ments, such as limiting the use of offshore employees

and mandating a presence at certain locations.

(One US financial institution, for example, required

the buyer to keep nearly 100 employees in the

seller’s US offices and to allocate a certain number

of employees in the buyer’s offshore offices to

work solely on the seller’s account.) Once the trans-

action closes, the seller must keep key people

from its former captive to ensure that it has the

contract-management skills it will need and

understands the systems and processes it has sold.

Petter Østbø ([email protected]) is an associate principal in McKinsey’s Oslo office, where Tor Jakob

Ramsøy ([email protected]) is a partner; Anders Rasmussen (Anders_Rasmussen@McKinsey

.com) is a partner in the Copenhagen office. Copyright © 2009 McKinsey & Company. All rights reserved.

23When to divest support services

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