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How good management raises productivity

Stephen J. Dorgan and John Dowdy
Effective management has long been thought to make companies more efficient. Heres proof.
Governments around the world are committed to raising productivity to improve economic performance. As the research of the McKinsey Global Institute (MGI) has demonstrated repeatedly over the past decade, productivity at the sector level is driven by the degree to which companies are exposed to competition. Hence, the argument goes, governments should remove barriers to competition, such as excessive regulation, if higher productivity is the goal. Do managers also have a part to play? It has always been assumed that good management increases productivity, but this proposition has never really been proved. However, a new McKinsey study of the manufacturing sector reveals clear evidence of a link between the two. Three management techniques have long been thought to improve a companys performance: lean manufacturing, which minimizes waste; talent management, EXHIBIT 1 which attracts and Good management is rewarded retains high-caliber people; and perforComparison of management score with return on capital employed (ROCE), percent mance management, Poor financial performance Good financial performance1 which rewards employNumber of 100% = 2 19 53 26 0 ees who meet set goals. companies To assess and measure 27 40 50 the impact of these management techniques, 100 we interviewed the 73 60 50 directors of operations 0 or of manufacturing 1 2 3 4 5 at 100 companies in Lowest Highest France, Germany, the Management score United Kingdom, and 1 5-year ROCE greater than sector average. the United States.1 The
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KEVIN CURRY

The companies in our sample were randomly selected from manufacturing enterprises listed on each countrys leading stock exchange.

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interview process was double-blind: subjects didnt know how their management practices were being assessed and measured, and the interviewers werent aware of the companies financial performance. The companies were awarded a score for their use or nonuse of each management techniquescores ranging from 1 (which meant that it wasnt used) to 5 (reflecting best practice). We then compared each companys score over a period of five years (19952000) with several key financial metrics, the most important being return on capital employed (ROCE) relative to the sector.2 The results showed that companies with the highest management scores outperformed their sector (Exhibit 1). The correlation between a companys management practices and its financial performance was significant (at the 95 percent confidence level): a one-point improvement in performance across all three management techniques, for example, generated a 5.1 percent increase in ROCE for companies, independent of sector. Over the same five-year period, this improvement would equal the creation of $400 billion in value for the US manufacturing sector, or a total of $700 billion for all four countries in our sample. If management practices affect a companys financial performance, you would expect them to have an impact on sector productivity as well. Our statistics confirm this assumption. National differences in levels of total factor productivity (a combination of labor productivity and capital productivity) are well documented: the United States performs well, the United Kingdom relaEXHIBIT 2 tively poorly. Our study showed a strong correla- A positive correlation tion between these 150 United States national productivity 140 rankings and manage130 ment practices, with Germany the US companies in our 120 study earning the highest France 110 average management100 performance scores and United Kingdom 90 the UK companies the lowest (Exhibit 2). This 80 2.7 2.9 3.1 3.3 correlation suggests that Average management score if the UK manufacturing Source: National Institute of Economic and Social Research; McKinsey analysis sector were to increase
Total factor productivity, index: United Kingdom = 100
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3.5

We chose this as our primary metric because it eliminates the influence of different national tax regimes on financial performance and isnt influenced by the sector in which the company operates (some sectors, of course, have higher returns than others).

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its management-performance score by just one point, it could achieve an 80 percent increase in its total factor productivityand a level of productivity far above that of the United States. For companies pondering how they can increase their productivity, this finding is important. To boost their labor productivity, and hence their total factor productivity, manufacturing companies are now inclined to lobby for tax breaks on capital investments, but our study shows that the same goals could be achieved, at little or no cost to governments or the sector, if managers managed better. How best to encourage them to do so? Since the US companies in our survey had the highest average management scores, it might appear safe to assume that plenty of competition in an economy promotes good management practice. Yet we couldnt find any direct correlation between the level of competitive intensity3 and the adoption of good management practices by the companies in our sample. Clearly, there are well- and poorly managed companies in both competitive and less competitive environments. But we EXHIBIT 3 did find a strong corThe strong get stronger relation between the extent to which manage0.8 ment practices affect a United States companys financial per0.6 formance and the level of competitive intensity 0.4 (Exhibit 3). In other United Kingdom words, good manageFrance ment practices have a 0.2 Germany more pronounced impact on the bottom line in a 0 3 5 6 7 8 4 competitive environment.
Correlation between return on capital employed and management score Level of competitive intensity1
Average annual entry rate of manufacturing companies into sector. Source: Ana Martn and Jordi Jaumandreu,Entry, exit, and productivity growth in Spanish manufacturing during the eighties, 1999; McKinsey analysis
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For managers in less competitive environments, the news is hardly encouraging: no matter how hard these companies try, their efforts will have little impact as compared with factors, such as regulation, that are more important in determining their financial performance.
Our metric for the competitive intensity of different countries was the average annual entry rate of companies into the manufacturing sector, as presented by Ana Martn and Jordi Jaumandreu in Entry, exit, and productivity growth in Spanish manufacturing during the eighties, September 1999 (www.uned.es/dpto-analisis-economico2/fichprof/amartin/Entryexit.PDF).

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But there is a note of comfort. When a government does decide that the economy needs more competition, companies with sound management practices will be ready to move ahead of the pack. The highest productivity levels are likely to be achieved only when governments create the right competitive conditions and managers use the best management techniques.

Stephen Dorgan is a consultant and John Dowdy is a director in McKinseys London office.