The McKinsey model, developed by leading management consultants McKinsey & Company, is a comprehensive approach to value-based management. This approach is based on the discounted cash flow principle, which is a direct measure of value creation.
McKinsey Model of Value Based Management focuses on the identification of key value drivers at various levels of the organization, and places emphasis on these value drivers in all the areas, i.e. in setting up of targets, in the various management processes, in performance measurement, etc.
Value based management is a model that allow managers to run a business focusing on the creation, improvement, and delivery of value. According to Copeland, Roller and Murrin, value-based management is
“an approach to management whereby the company’s overall aspirations, analytical techniques, and management processes are all aligned to help the company maximize its value by focusing management decision-making on the key drivers of value”.
According to McKinsey Model of Value Based Management, the key steps in maximizing the value of a firm are as follows:
- Identification of value maximization as the supreme goal
- Identification of the value drivers
- Development of strategy
- Setting of targets
- Deciding upon the action plans
- Setting up the performance measurement system
1. Value Maximization – The Supreme Goal
A firm may have many conflicting goals like maximization of PAT, maximization of market share, achieving consumer satisfaction, etc. The first step in maximizing the value of a firm is to make it the most important goal for the organization. It is generally reflected in maximized discounted cash flows. The organisation’s activities can be classified into financial and non-financial types. The former helps the senior management sustain focus, while the latter motivates the entire workforce. Non-financial activities include product development, customer satisfaction and quality improvement efforts, which are normally consistent with the financial goal of value maximization. In case of conflict between financial and non-financial goals, financial goals are given precedence.
2. Identification of the Value Drivers
The important factors that affect the value of a business are referred to as key value drivers. It is necessary to identify these variables for value-based management. The value drivers need to be identified at various levels of an organization, so that the personnel at all levels can ensure that their performance is in accordance with the overall objective. The other objectives of a firm mentioned above may act as value drivers at some level of the organization. For example, degree of innovation in products may be identified as the value driver for the design department. The three main levels at which the key value drivers need to be identified are:
- The generic level: At this level, the variables that reflect the achievement or non-achievement of the value maximization objective most directly are identified. These may be the return on capital employed or operating margin or the net profit margin, etc.
- The department level: At this level, the variables that guide the department towards achieving the overall objective are identified. For example, for the sales department, the key value drivers may be achieving the optimum product mix, maximizing market share, etc.
- The grass roots level: At the grass roots level, the variables that reflect the performance at the operational level are identified. These may be the level of capacity utilization, cost of managing inventory, etc.
3. Development of Strategy
The next step is to develop strategies at all levels of the organization, which are consistent with the goal of value maximization, and lead to the achievement of the same. The strategies should be aimed at and give directions for the achievement of the desired level of the key value drivers.
4. Setting of Targets
Development of strategies is followed by setting up of specific short-term and long-term targets. These should be specified in terms of the desirable level of key value drivers. The short-term targets should be in tune with the long-term targets. Similarly, the targets for the various levels of the organization should be in tune. They should be set both for financial as well as non-financial variables.
5. Deciding upon the Action Plans
Once the strategy is in place and the targets have been determined, there is a need to specify the particular actions that are required to be undertaken to achieve the targets in a manner that is consistent with the strategy. At this stage, the detailed action plans are laid out.
6. Setting up the Performance Measurement System
The future performance of personnel is affected by the way their performance is measured, to a large extent. Hence, it is essential to set up a precise and unambiguous performance measurement system. A performance measurement system should be linked to the achievement of targets and should reflect the characteristics of each individual department.
Value based management focus on value creation, but managers can take it not only for shareholders’ value but also for value creation that can benefit stakeholders. Developing communities in markets where firms compete can become an important driver of value creation to achieve superior performance.
- What is value-based management? (McKinsey & Company)