Strategy, Balanced Scorecards and Incentive Systems

1. 20 Strategy,Balanced Scorecards andIncentive Systems

2. Learning Objective 1

3. Balanced Scorecard Balanced scorecards are performance measurement systems or business models that tie together knowledge of strategy, processes, activities, and operational and strategic performance measures. An incentive system communicates strategy, motivates employees, and reinforces achievement of organizational goals.

4. Business andproductionprocessefficiency Customervalue Financialperformance Lead Lead Lead Leading indicators Using Leading and Lagging Indicators in Balanced Scorecards Leading indicators are measures that identify future nonfinancial and financial outcomes to guide management decision making. Organizationallearning andgrowth

5. Using Leading and Lagging Indicators in Balanced Scorecards Lagging indicators are measures of the final outcomes of earlier management plans and their execution. Organizationallearning andgrowth Business andproductionprocessefficiency Customervalue Financialperformance Lead Lead Lead

6. 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.

7. Fasterloan processing Increasedcustomersatisfaction More loyalcustomers Better financial results Leads to Leads to Leads to Leads to Motivating Employees and Evaluating Performance Visible leading indicators can contribute to employees’ improved motivation and commitment. At a commercial bank the following sequence may be effective. Increasedemployeetraining

8. A Balanced Scorecard’s Strategic Performance Measures Financial performanceHow should we appear toour shareholders? Vision and Strategy Business and productionprocess performanceAt what business practicesmust we excel? Customer performanceHow should we appear toour customers Learning and growth performanceHowshould we sustain our abilityto change and improve?

9. Learning Objective 2

10. Organizational learning and growth Employee training and education. Employee satisfaction. Business andproductionprocessefficiency Customervalue Lead Lead Lead Financialperformance Implementation of a Balanced Scorecard Organizationallearning and growth 1. Employee training2. Employee satisfaction3. Employee turnover4. Innovativeness5. Opportunities for improvement

11. Evaluation of Measures of Organizational Learning and Growth Consider the information in this table: Incremental profit = Total benefits – Total costsBreak-even profit = 0 = 9X - $240,000 9X = $240,000 Break-even benefit level, X = $26,667 per year

12. 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) - 1.000($80,000) - .909($80,000) - .826($80,000)Break-even benefit level, X = $32,170 per year rounded

13. Business and production process efficiency 1. New service development2. Employee productivity and error rates3. Service costs 4. Process improvements5. Supplier relations Customervalue Lead Lead Lead Financialperformance Business and Production Process Efficiency Organizationallearning andgrowth

14. Customer value 1. Customer satisfaction2. Customer retention and loyalty3. Market share 4. Customer risk Business andproduction processefficiency Lead Lead Lead Financialperformance Customer Value Organizationallearning andgrowth

15. Evaluation of Measures of Customer Value Customer satisfaction survey – scale 1 to 5

16. Business andproduction processefficiency Customervalue Lead Lead Lead Financial performance1. New interest margin2. Revenue growth3. Customer profitability4. Overall return on assets Financial Performance 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. Organizationallearning andgrowth

17. Learning Objective 3

18. Benefits and Costs of a Balanced Scorecard • Benefits of a balanced scorecard • Encourages all employees to consider the impacts of their decisions on profitability • Appears to work in various types of organizations • Costs of a balanced scorecard • Choosing and validating measures • Training and interpretation activities • Managing many measures at once

19. Learning Objective 4

20. 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.

21. Learning Objective 5

22. Fundamental Principles of Incentive Systems Pay 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 employees to achieve the organization’s goals and objectives and reward them if they do.

23. Role for Theories of Incentives and Behavior

24. Learning Objective 6

25. Features of Performance-Based Incentive Systems 1. Absolute or relative performance? 3. Financial or nonfinancial performance? 5. Current or deferred rewards? Performance-basedmanagement incentivesystem 2. Formula-based or subjective performance? 4. Narrow or broad responsibility of performance? 6. Salary, bonus or stock rewards?

26. Absolute performance evaluation compares individual performance to set objectives or expectations. Relative performance evaluation compares an individual’s performance to that of others. Absolute or Relative Performance

27. A performance evaluation formula computes rewards earned for specific achievements. Subjective performance evaluation uses non-quantified criteria not captured by formulas. EvaluationGroup Formula-Based or Subjective Performance

28. Financial performance reflects the achievement of financial goals, such as . . . Cost control Revenue growth Earnings Residual income Adding nonfinancial measures to the incentive system Gets managers to focus on the leading indicators of profit Gives recognition of the time lags between nonfinancial and financial performance Financial or Nonfinancial Performance

29. 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.

30. 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).

31. Salary, Bonus or Stock Rewards Some companies stress salary while others stress performance-based compensation. Some common performance-based compensation plans include: • Cash bonuses –the most liquid and immediate • Stock awards –usually not redeemable right away • Stock appreciation rights –confer a bonus to employees based on increases in stock price for a predetermined number of shares • Stock options –give an individual the right to purchase a number of shares at a specified price over a specified time period

32. Learning Objective 7

33. Ethical Aspects of Incentives and Compensation A mismatch of executive pay and firm performance has been widely observed in many types of organizations. In some cases, the mismatch is the result of poorly designed incentive systems that generate high rewards even when stockholders lose money. It is likely that regulatory actions will more closely align executive pay and performance, but ultimately it is difficult to mandate integrity or ethical behavior.

34. Incentive Plans in Nonprofit Organizations Despite differences between for-profit and nonprofit organizations, nonprofit organizations increasingly use features of executive incentive plans developed in the private sector.

35. Learning Objective 8

36. Expectancy 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 Theories of Incentives and Behavior

37. End of Chapter 20