To Centralize or Not to Centralize?
It’s a hard call made harder by power struggles. CEOs can force a more thoughtful debate by asking three critical questions.
October 2015 | by David Delaney
The chief executive of a European equipment manufacturer recently faced a tough centralization decision: should he combine product management for the company’s two business units—cutting and welding—which operated largely independently of each other but shared the same brand? His technical leader believed that an integrated product range would make the company’s offerings more appealing to businesses that bought both types of equipment. These customers accounted for more than 70 percent of the market but less than 40 percent of the company’s sales. “You cut before you weld,” he explained. “You get a better weld at lower cost if the cutting is done with the welding in mind.” Managers in both divisions, though, resisted fiercely: product management, they believed, was central to their business, and they could not imagine losing control of it.
The CEO’s dilemma—were the gains of centralization worth the pain it could cause?—is a perennial one. Business leaders dating back at least to Alfred Sloan, who laid out GM’s influential philosophy of decentralization in a series of memos during the 1920s, have recognized that badly judged centralization can stifle initiative, constrain the ability to tailor products and services locally, and burden business divisions with high costs and poor service. Insufficient centralization can deny business units the economies of scale or coordinated strategies needed to win global customers or outperform rivals.
Timeless as the tug-of-war between centralization and decentralization is, it remains a dilemma for most companies. We heard that point loud and clear in some 50 interviews we conducted recently with heads of group functions at more than 30 global companies. These managers had found that the normal financial and strategic analyses used for making most business decisions do not resolve disagreements about, for example, whether to impose a group-wide performance-management system. What’s more, none of the executives volunteered an orderly, analytical approach for resolving centralization decisions. In its absence, many managers fall back on benchmarks, politics, fashion—sometimes centralization is in vogue and sometimes decentralization is—or instinct. One head of IT, for example, explained that in his experience the lowest-cost solution was always decentralization. Another argued the opposite.
To help senior managers make better choices about what to centralize and what to decentralize, we have been refining a decision-making framework based on our research and experiences in the corporate trenches. It is embodied in three questions that can help stimulate new proposals, keep emerging ones practical, and turn political turf battles into productive conversations.
Each question defines a hurdle that a centralization proposal must meet. A decision to centralize requires a yes to at least one of them. While the questions set a high bar for centralization, they do not produce formulaic answers; considerable judgment is still required. They benefit companies by allowing advocates and opponents of centralization to conduct a debate in a way that helps CEOs make wiser choices. The questions can be asked in any order, but the one presented here is often natural to follow.
1. Is Centralization Mandated?
The first step is to ask whether the company has a choice. A corporation’s annual report and consolidated accounts, for example, are required by law and must be signed by the CEO, so it is impossible to delegate this task to the business divisions. In this case, the answer is yes to centralization. By contrast, centralization is not essential for compliance with health and safety laws; each division can manage its own compliance. So a proposal to appoint a head of group health and safety would get a no for this question and would need a yes from question two or three.
2. Does Centralization Add Significant Value—10 Percent?
If centralization is not mandated, it should be adopted only if it adds significant value. The problem, however, as illustrated by the product-management example, is how to judge whether it will do so. This point is particularly difficult because corporate strategies rarely provide clarity about the major sources of additional value that underpin the argument for bringing different business activities together in a group. The solution, we find, is to set a hurdle high enough so that the benefits of centralization will probably far outweigh the disadvantages, making the risks worth taking.
Specifically, we suggest asking: “Does the proposed initiative add 10 percent to the market capitalization or profits of the corporation?” This hurdle is sufficiently high to make it difficult for advocates of centralization to “game” the analysis, and thus saves the top team’s time by quickly eliminating small opportunities from discussion. Start by considering whether the activity meets the 10 percent hurdle on its own. If not, which is most often the case, you should assess whether it is a necessary part of some larger initiative that will meet the 10 percent hurdle. In practice, the answer to the 10 percent question does not require fine-grained calculations. What is required are judgments about the significance of the activity, either on its own or as part of a larger initiative.
3. Are the Risks Low?
Most centralization proposals will not pass either of the two previous hurdles: they will not be mandated and will not represent major sources of additional value. More often, the prize will be smaller improvements in costs or quality. In these cases, the risks associated with centralization—business rigidity, reduced motivation, bureaucracy, and distraction—are often greater than the value created. Hence, the proposals should go forward only if the risks of these negative side effects are low.
An initiative to centralize payroll is likely to get a yes on this hurdle. Costs can clearly be saved through economies of scale, and the risks of negative side effects are low. Payroll operations are not important to the commercial flexibility of individual business units, nor are their managers likely to feel less motivated by losing control of payroll. Moreover, the risks of bureaucratic inefficiency and distraction can be reduced to a minimum if the payroll unit is led by a competent expert who reports to the head of shared services and doesn’t take up the time of finance or HR leaders.
Any centralization proposal that does not survive at least one of our three questions should be abandoned or redesigned. To see how our approach works in practice, let’s look at two companies that recently applied it—starting with the automated cutting- and welding-equipment manufacturer, which we’ll call European Automation.