Strategy, Balanced Scorecards and Incentive Systems

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

20Strategy,Balanced

Scorecards andIncentive Systems

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Learning Objective 1

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Balanced Scorecard

Balanced scorecardsBalanced scorecards are are performance measurement performance measurement

systems or business models systems or business models that tie together knowledge of that tie together knowledge of

strategy, processes, strategy, processes, activities, and operational activities, and operational and strategic performance and strategic performance

measures.measures.

Balanced scorecardsBalanced scorecards are are performance measurement performance measurement

systems or business models systems or business models that tie together knowledge of that tie together knowledge of

strategy, processes, strategy, processes, activities, and operational activities, and operational and strategic performance and strategic performance

measures.measures.An An incentive systemincentive system

communicates strategy, communicates strategy, motivates employees, and motivates employees, and reinforces achievement of reinforces achievement of

organizational goals.organizational goals.

An An incentive systemincentive system communicates strategy, communicates strategy,

motivates employees, and motivates employees, and reinforces achievement of reinforces achievement of

organizational goals.organizational goals.

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LeadLeadFinancialFinancial

performanceperformanceFinancialFinancial

performanceperformanceLeadLeadCustomerCustomer

valuevalueCustomerCustomer

valuevalueLeadLead

Business andBusiness andproductionproduction

processprocessefficiencyefficiency



Using Leading and Lagging Indicators in Balanced Scorecards

Leading indicatorsLeading indicators are measures that identify are measures that identify future nonfinancial and financial outcomes to future nonfinancial and financial outcomes to

guide management decision making.guide management decision making.

Leading indicatorsLeading indicators are measures that identify are measures that identify future nonfinancial and financial outcomes to future nonfinancial and financial outcomes to

guide management decision making.guide management decision making.

OrganizationalOrganizationallearning andlearning and

growthgrowth


growthgrowth

Leading indicatorsLeading indicators

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Using Leading and Lagging Indicators in Balanced Scorecards

LeadLeadLeadLeadLeadLead


growthgrowth


growthgrowth





CustomerCustomervaluevalue

CustomerCustomervaluevalue

FinancialFinancialperformanceperformance

FinancialFinancialperformanceperformance

Lagging indicatorsLagging indicators are measures of the final are measures of the final outcomes of earlier management plans and outcomes of earlier management plans and

their execution.their execution.

Lagging indicatorsLagging indicators are measures of the final are measures of the final outcomes of earlier management plans and outcomes of earlier management plans and

their execution.their execution.

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Communicating Strategy to Employees

Many employees do not understand the impacts of their activities on customer value and

profitability because their jobs are narrowly defined or they do not interact directly with

customers. Communicating leading indicators in a balanced scorecard can make the effects of

employees’ actions more visible.

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Motivating Employees and Evaluating Performance

Visible leading indicators can contribute to Visible leading indicators can contribute to employees’ improved motivation and employees’ improved motivation and

commitment. At a commercial bank the commitment. At a commercial bank the following sequence may be effective.following sequence may be effective.

Visible leading indicators can contribute to Visible leading indicators can contribute to employees’ improved motivation and employees’ improved motivation and

commitment. At a commercial bank the commitment. At a commercial bank the following sequence may be effective.following sequence may be effective.

IncreasedIncreasedemployeeemployeetrainingtraining

IncreasedIncreasedemployeeemployeetrainingtraining

FasterFasterloan loan

processingprocessing

FasterFasterloan loan

processingprocessingLeads toLeads to

IncreasedIncreasedcustomercustomer

satisfactionsatisfaction

IncreasedIncreasedcustomercustomer

satisfactionsatisfactionLeads toLeads to

MoreMoreloyalloyal

customerscustomers

MoreMoreloyalloyal

customerscustomersLeads toLeads to

BetterBetterfinancialfinancialresultsresults

BetterBetterfinancialfinancialresultsresults

Leads toLeads to

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A Balanced Scorecard’s Strategic Performance Measures

VisionVisionand and

StrategyStrategy

VisionVisionand and

StrategyStrategy

Business and productionBusiness and productionprocess performanceprocess performance

At what business practicesmust we excel?

Business and productionBusiness and productionprocess performanceprocess performance

At what business practicesmust we excel?

Customer performanceHow should we appear to

our customers

Customer performanceHow should we appear to

our customers

Financial performanceFinancial performanceHow should we appear to

our shareholders?

Financial performanceFinancial performanceHow should we appear to

our shareholders?

Learning and growth performanceLearning and growth performanceHow should we sustain our ability

to change and improve?

Learning and growth performanceLearning and growth performanceHow should we sustain our ability

to change and improve?

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LeadLeadLeadLead CustomerCustomervaluevalue

CustomerCustomervaluevalueLeadLeadLeadLead

Business Business andand

productionproductionprocessprocess

efficiencyefficiency

Business Business andand

productionproductionprocessprocess

efficiencyefficiency

Implementation of a Balanced Scorecard

1. Organizational learning and growtha) Employee training and education.

b) Employee satisfaction.

OrganizationalOrganizationallearning and learning and

growthgrowth1. 1. Employee trainingEmployee training2. Employee satisfaction2. Employee satisfaction3. Employee turnover3. Employee turnover4. Innovativeness4. Innovativeness5. Opportunities for 5. Opportunities for improvement improvement

OrganizationalOrganizationallearning and learning and

growthgrowth1. 1. Employee trainingEmployee training2. Employee satisfaction2. Employee satisfaction3. Employee turnover3. Employee turnover4. Innovativeness4. Innovativeness5. Opportunities for 5. Opportunities for improvement improvement FinancialFinancial

performanceperformanceFinancialFinancial

performanceperformance

Lea

dL

ead

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Evaluation of Measures of Organizational Learning and GrowthConsider the information in this table:

Incremental profit = Total benefits – Total costsIncremental profit = Total benefits – Total costsBreak-even profit = 0 = 9X - $240,000Break-even profit = 0 = 9X - $240,000

9X = $240,0009X = $240,000

Incremental profit = Total benefits – Total costsIncremental profit = Total benefits – Total costsBreak-even profit = 0 = 9X - $240,000Break-even profit = 0 = 9X - $240,000

9X = $240,0009X = $240,000

Break-even benefit level, X = $26,667 per yearBreak-even benefit level, X = $26,667 per year

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Evaluation of Measures of Organizational Learning and Growth

Information in this table considers the time value of money.

Break-even profit = .909X + .826(2X) + .751(3X) + .683(2X) + .621(X) -Break-even profit = .909X + .826(2X) + .751(3X) + .683(2X) + .621(X) -1.000($80,000) - .909($80,000) - .826($80,000)1.000($80,000) - .909($80,000) - .826($80,000)

Break-even benefit level, X = Break-even benefit level, X = $32,170 per year rounded$32,170 per year rounded

Break-even profit = .909X + .826(2X) + .751(3X) + .683(2X) + .621(X) -Break-even profit = .909X + .826(2X) + .751(3X) + .683(2X) + .621(X) -1.000($80,000) - .909($80,000) - .826($80,000)1.000($80,000) - .909($80,000) - .826($80,000)

Break-even benefit level, X = Break-even benefit level, X = $32,170 per year rounded$32,170 per year rounded

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Business and Production Process Efficiency

Organizationallearning and

growth


growthLeadLeadLeadLead

Business and production

process efficiency1. New service development2. Employee productivity and error rates3. Service costs4. Process improvements5. Supplier relations

Business and production

process efficiency1. New service development2. Employee productivity and error rates3. Service costs4. Process improvements5. Supplier relations

Customervalue

CustomervalueLeadLeadLeadLead

Financialperformance


Lea

dL

ead

Lea

dL

ead

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Customer Value


growth



Business andproduction process

efficiency


efficiency

Customer value1. Customer satisfaction2. Customer retention and loyalty3. Market share4. Customer risk

Customer value1. Customer satisfaction2. Customer retention and loyalty3. Market share4. Customer risk

LeadLeadLeadLead



Lea

dL

ead

Lea

dL

ead

20-15 Evaluation of Measures of Customer Value

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

Services meetcustomer needs

Service superior tocompetitors' service

Employees respondto special requests

Employees giveprompt service

Employees superiorto competitors'

Customer satisfaction survey – scale 1 to 5

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Financial Performance


growth




efficiency


efficiencyLeadLeadLeadLead

Customervalue

Customervalue

Financial performanceFinancial performance1. New interest margin1. New interest margin2. Revenue growth2. Revenue growth3. Customer profitability3. Customer profitability4. Overall return on assets4. Overall return on assets

Financial performanceFinancial performance1. New interest margin1. New interest margin2. Revenue growth2. Revenue growth3. Customer profitability3. Customer profitability4. Overall return on assets4. Overall return on assets

Lea

dL

ead

Lea

dL

ead

Financial measures of performance tend to be the most objective measures because most organizations have dedicated significant resources to ensure the validity of

their financial performance measures.

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Benefits and Costs of a Balanced Scorecard

Benefits of a balanced scorecardBenefits of a balanced scorecard

1.1. Encourages all employees to Encourages all employees to consider the impacts of their consider the impacts of their decisions on profitabilitydecisions on profitability

2.2. Appears to work in various types of Appears to work in various types of organizationsorganizations

Benefits of a balanced scorecardBenefits of a balanced scorecard

1.1. Encourages all employees to Encourages all employees to consider the impacts of their consider the impacts of their decisions on profitabilitydecisions on profitability

2.2. Appears to work in various types of Appears to work in various types of organizationsorganizations

Costs of a balanced scorecardCosts of a balanced scorecard

1.1. Choosing and validating measuresChoosing and validating measures

2.2. Training and interpretation activitiesTraining and interpretation activities

3.3. Managing many measures at onceManaging many measures at once

Costs of a balanced scorecardCosts of a balanced scorecard

1.1. Choosing and validating measuresChoosing and validating measures

2.2. Training and interpretation activitiesTraining and interpretation activities

3.3. Managing many measures at onceManaging many measures at once

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How One Organization (a Bank) Implemented a Balanced Scorecard

The bank’s cost management team led the implementation effort.

The team drafted an initial sketch based on the bank’s strategy and processes.

Then employees from all over the bank took part in designing the scorecard.

After a year of interaction with other employees, the team unveiled the scorecard.

See previous slides for the measures chosen.

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Fundamental Principles of Incentive Systems

Pay for performancePay for performance means that at least some portion of a manager’s income is not guaranteed but depends on measure(s) of

organizational performance.

An effective incentive system should motivate An effective incentive system should motivate employees to achieve the organization’s goals and employees to achieve the organization’s goals and

objectives and reward them if they do.objectives and reward them if they do.

An effective incentive system should motivate An effective incentive system should motivate employees to achieve the organization’s goals and employees to achieve the organization’s goals and

objectives and reward them if they do.objectives and reward them if they do.

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Role for Theories of Incentives and Behavior

Theory and Practice GuidelineMost individuals are motivated by self-interest.

Performance-based rewards must be greater than alternative rewards from nonperformance.

Organizations get the behavior they reward.

Performance measures and related rewards must reflect organizational goals.

Effort follows rewards. Employees must believe that their efforts influence performance.

Difficult but attainable goals motivate best.

Impossible goals are de-motivators, and so are easy goals. Make goals difficult but not impossible.

Fairness is a basis for sustained motivation.

Rewards must be linked to desired performance in a fair manner.

Manipulation undermines fairness and effort.

Performance measures must be observable and verifiable.

Different rewards can motivate effort.

Rewards must meet market conditions, and rewards must be available.

Incentive systems involve trade-offs. Minimizing the overall costs of aligning goals and monitoring behavior is a goal of incentive system design.

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Features of Performance-Based Incentive Systems

Performance-basedPerformance-basedmanagement incentivemanagement incentive

systemsystem

Performance-basedPerformance-basedmanagement incentivemanagement incentive

systemsystem

1. Absolute or1. Absolute or relative relative performance? performance?

1. Absolute or1. Absolute or relative relative performance? performance?

2. Formula-based2. Formula-based or subjective or subjective performance? performance?

2. Formula-based2. Formula-based or subjective or subjective performance? performance?

3. Financial or3. Financial or nonfinancial nonfinancial performance? performance?

3. Financial or3. Financial or nonfinancial nonfinancial performance? performance?

4. Narrow or broad4. Narrow or broad responsibility of responsibility of performance? performance?

4. Narrow or broad4. Narrow or broad responsibility of responsibility of performance? performance?

5. Current or5. Current or deferred deferred rewards? rewards?

5. Current or5. Current or deferred deferred rewards? rewards?

6. Salary, bonus 6. Salary, bonus or stock or stock rewards?rewards?

6. Salary, bonus 6. Salary, bonus or stock or stock rewards?rewards?

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Absolute or Relative Performance

Absolute performanceAbsolute performance evaluation compares evaluation compares individual performance to set objectives or individual performance to set objectives or expectations.expectations.

Relative performanceRelative performance evaluation compares an evaluation compares an individual’s performance to that of others.individual’s performance to that of others.

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Formula-Based or Subjective Performance

A performance evaluation formula computes A performance evaluation formula computes rewards earned for specific achievements.rewards earned for specific achievements.

Subjective performance evaluation uses non-Subjective performance evaluation uses non-quantified criteria not captured by formulas.quantified criteria not captured by formulas.

EvaluationGroup

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Financial or Nonfinancial PerformanceFinancial Financial performance reflects the achievement of performance reflects the achievement of

financial goals, such as . . .financial goals, such as . . . Cost controlCost control Revenue growthRevenue growth EarningsEarnings Residual incomeResidual income

Adding Adding nonfinancialnonfinancial measures to the incentive system measures to the incentive system Gets managers to focus on the leading indicators of Gets managers to focus on the leading indicators of

profitprofit Gives recognition of the time lags between Gives recognition of the time lags between

nonfinancial and financial performancenonfinancial and financial performance

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Narrow or Broad Responsibility of Performance

Incentives work best when individuals see a strong link between their actions and performance results. Many companies reward division managers for both business unit and companywide performance.

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Current or Deferred Rewards Rewards can be given now, based on current

performance (immediate cash bonus when residual income increases in this period). These rewards are closely linked with a manager’s

present efforts and the organization’s present performance.

The performance criteria can be subjected to manipulation.

Or rewards can be given later if sustained performance is desired (cash or stock rewards payable at the end of several years). They encourage managers to stay for a while. They help managers focus on the long term (as

long as it is not too remote).

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Salary, Bonus or Stock Rewards

1. Cash bonuses – the most liquid and immediate

2. Stock awards – usually not redeemable right away

3. Stock appreciation rights – confer a bonus to employees based on increases in stock price for a predetermined number of shares

4. Stock options – give an individual the right to purchase a number of shares at a specified price over a specified time period

Some companies stress salary while others stressperformance-based compensation. Some common performance-based compensation plans include:

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Ethical Aspects of Incentives and Compensation

A mismatch of executive pay and firm performance has A mismatch of executive pay and firm performance has been widely observed in many types of organizations. In been widely observed in many types of organizations. In

some cases, the mismatch is the result of poorly some cases, the mismatch is the result of poorly designed incentive systems that generate high rewards designed incentive systems that generate high rewards

even when stockholders lose money.even when stockholders lose money.

A mismatch of executive pay and firm performance has A mismatch of executive pay and firm performance has been widely observed in many types of organizations. In been widely observed in many types of organizations. In

some cases, the mismatch is the result of poorly some cases, the mismatch is the result of poorly designed incentive systems that generate high rewards designed incentive systems that generate high rewards

even when stockholders lose money.even when stockholders lose money.

It is likely that regulatory actions will more closely It is likely that regulatory actions will more closely align executive pay and performance, but align executive pay and performance, but

ultimately it is difficult to mandate integrity or ultimately it is difficult to mandate integrity or ethical behavior.ethical behavior.

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Incentive Plans in Nonprofit Organizations

Despite differences between for-profit and Despite differences between for-profit and nonprofit organizations, nonprofit organizations nonprofit organizations, nonprofit organizations increasingly use features of executive incentive increasingly use features of executive incentive

plans developed in the private sector.plans developed in the private sector.

Despite differences between for-profit and Despite differences between for-profit and nonprofit organizations, nonprofit organizations nonprofit organizations, nonprofit organizations increasingly use features of executive incentive increasingly use features of executive incentive

plans developed in the private sector.plans developed in the private sector.

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Theories of Incentives and BehaviorExpectancy theory (from applied psychology)

People are motivated to act in ways that they expect to provide them with desired rewards and to prevent the penalties they wish to avoid.

So incentive plans must: Provide the proper

rewards and penalties Make it likely that the

desired behaviors will lead to those rewards or penalties

Agency theory (from financial economics)

An employee contracts with an employer to perform certain work, and the employer wants to be sure that the work is duly and well performed.

So incentive plans must: Motivate the employee

to work Align the employee’s

goals with the employer’s

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End of Chapter 20

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Strategy, Balanced Scorecards and Incentive Systems