In search of a better stretch target

Here is a brief excerpt from an article written by Ryan Davies, Hugues Lavandier, and Ken Schwartz for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.

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Aggressive goals can dramatically improve a company’s performance. But unachievable goals can do more harm than good. Here’s how to stretch without breaking.

The urge to improve is innate in most companies, where better service, stronger performance, and faster operations are inextricably tied to earnings, bonuses, and shareholder returns. The impetus is so strong, in fact, that the practice of setting stretch targets for a company’s performance has become emblematic for the grit and aggressiveness expected of a modern executive. Managers take pride in seeking to achieve the unthinkable.

Sometimes they succeed, surprising even themselves with how much stretch targets can improve performance. But there are limits to how far they can push. The wrong metrics can sap motivation and undermine performance.1Targets set along one metric without regard for the effect on performance elsewhere can destroy value. And broad-based aggregate measures of profit margin, operating profit, and earnings per share are only loosely linked to valuation. One CFO recently admitted to us that his multibillion-dollar global company would hit its quarterly goals for earnings before interest, taxes, depreciation, and amortization (EBITDA), but only at the cost of reducing its operating cash flow. Signs of unhealthy stretch targets can be quite clear—and any of them can lead to poor behaviors, distracting senior managers and having no impact on value.

Healthy stretch targets start with using the right kinds of metrics: achievable, focused, transparent, and grounded in objective data tied to value creation. But even the right kinds of metrics can destroy value when managers neglect best practices. In our experience, a healthier stretch requires companies to calibrate targets against cross-functional trade-offs. It demands that executives build trust with employees, rewarding success rather than always moving the goal up, but also that they confirm that employees succeed fairly. And it requires that there be no stigma attached to bringing out bad news, so that employees are encouraged to be transparent about their progress.

Calibrate cross-functional trade-offs between targets

The larger and more complex a company is, the more likely one unit or function’s stretch targets will affect the performance of others. For example, reducing inventory levels to meet a working-capital target can make it hard to fill orders if a company’s production system, its demand, and its suppliers are not stable enough—and that can lead to lost sales. Conversely, if a sales team pushes for 7 percent growth in a market that is growing at 4 percent, for example, it’s likely to chase as many deals as possible. Since the team can’t sell what the company doesn’t have, they’ll have to initiate production even for deals that are more likely to fall through. That, in turn, affects performance up and down the supply chain—with negative consequences for the company’s cash-conversion rate, depending on how much unsold inventory piles up.

CFOs—or other C-suite managers—can set targets from a cross-functional perspective across the entire business, but they often lack a functional or business-unit perspective on the details. The business-unit leaders they rely on for those details often promote different metrics depending on their own siloed vantage points. In the end, managers often resort to targets anchored in past performance, catchy slogans, or just lazy application. We often see them simply adding a flat percentage-point increase to last year’s results, averaging performance levels across an entire group, or setting sales targets based on growth assumptions oblivious to the pace of the market (exhibit). Managers at one Asian company arbitrarily targeted 25 percent growth per year for 25 years—apparently unencumbered by the mathematical implications. And managers at a global manufacturer decided that tripling inventory turns would be an inspirational target, even though the company was already better than most of its peers and the target was physically impossible.

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Here is a direct link to the complete article.

Ryan Davies is a partner in McKinsey’s Washington, DC, office. Hugues Lavandier is a partner in the New York office, where Ken Schwartz is an associate partner.

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