Once a company decentralizes operations, top management is no longer involved in run- ning the subunits’ day-to-day operations. Performance evaluation systems provide top management with a framework for maintaining control over the entire organization.
Goals of Performance Evaluation Systems
When companies decentralize, top management needs a system to communicate its goals to subunit managers. Additionally, top management needs to determine whether the deci- sions being made at the subunit level are effectively meeting company goals. Let’s look at the primary goals of performance evaluation systems.
Promoting Goal Congruence and Coordination
As previously mentioned, decentralization increases the difficulty of achieving goal congru- ence. Segment managers may not always make decisions consistent with the overall goals of the organization. A company will be able to achieve its goals only if each unit moves, in a synchronized fashion, toward the overall company goals. The performance evaluation system should provide incentives for coordinating the subunits’ activities and direct them toward achieving the overall company goals.
Communicating Expectations
To make decisions that are consistent with the company’s goals, segment managers must know the goals and the specific part their unit plays in attaining those goals. The perfor- mance evaluation system should spell out the unit’s most critical objectives. With a clear picture of what upper management expects, segment managers can direct their daily operating decisions so those expectations are met.
Motivating Segment Managers
Segment managers are usually motivated to make decisions that will help to achieve top management’s expectations. For additional motivation, upper management may offer bonuses to segment managers who meet or exceed performance targets. Top management must exercise extreme care in setting performance targets. For example, managers measured solely by their ability to control costs may take whatever actions are necessary to achieve that goal, including sacrificing quality or customer service. Such actions would not be in the best interests of the company as a whole. Therefore, upper management must consider the ramifications of the performance targets it sets for segment managers.
Providing Feedback
As noted previously, in decentralized companies, top management is not involved in the day-to-day operations of each subunit. Performance evaluation systems provide upper management with the feedback it needs to maintain control over the entire organization, even though it has delegated responsibility and decision-making authority to segment managers. If targets are not met at the unit level, upper management will take corrective actions, ranging from modifying unit goals (if the targets were unrealis- tic) to replacing the segment manager (if the targets were achievable but the manager failed to reach them).
Benchmarking
Performance evaluation results are often used for benchmarking, which is the practice of comparing the company’s achievements against the best practices in the industry. Compa- nies also benchmark performance against the subunit’s past performance. Historical trend data (measuring performance over time) help managers assess whether their decisions
Learning Objective 2 Describe the purpose of performance evaluation systems and how the balanced scorecard helps companies evaluate performance
Performance Evaluation System A system that provides top management with a framework for maintaining control over the entire organization.
are improving, having no effect on, or adversely affecting subunit performance. Some companies also benchmark performance against other subunits with similar character- istics. Comparing results against industry benchmarks, however, is often more revealing than comparing results against budgets or past performance. To survive, a company must keep up with its competitors. Benchmarking helps the company determine whether it is performing at least as well as its competitors.
Limitations of Financial Performance Measurement
In the past, performance measurement revolved almost entirely around financial performance. On the one hand, this focus makes sense because the ultimate goal of a com- pany is to generate profit. On the other hand, current financial performance tends to reveal the results of past actions rather than indicate future performance. For this reason, financial measures tend to be lag indicators (after the fact) rather than lead indicators (future predictors). Management needs to know the results of past decisions, but it also needs to know how current decisions may affect the future. To adequately assess the company, managers need both lead indicators and lag indicators.
Another limitation of financial performance measures is that they tend to focus on the company’s short-term achievements rather than on long-term performance because finan- cial reports are prepared on a monthly, quarterly, or annual basis. To remain competitive, top management needs clear signals that assess and predict the company’s performance over longer periods of time.
Due to the limitations of financial performance measures, companies need to also use operational performance measures, such as customer satisfaction, in their performance evaluation systems. Operational performance measures are nonfinancial measures that evaluate a firm’s performance on the basis of effectiveness and efficiency to ensure all segments of the business are working together to achieve the company’s goals.
The Balanced Scorecard
In the early 1990s, Robert Kaplan and David Norton introduced the balanced scorecard.1 The balanced scorecard is a performance evaluation system that requires management to consider both financial performance measures (lag indicators) and operational performance measures (lead indicators) when judging the performance of a company and its subunits. These measures should be linked with the company’s goals and its strategy for achieving those goals.
The balanced scorecard represents a major shift in corporate performance measurement.
Rather than treating financial indicators as the sole measure of performance, companies recog- nize that they are only one measure among a broader set. Keeping score of operating measures and traditional financial measures gives management a “balanced” view of the organization because management needs to consider other critical factors, such as customer satisfaction, operational efficiency, and employee excellence. Management uses key performance indicators—
such as customer satisfaction ratings and revenue growth—to measure critical factors that affect the success of the company. Key performance indicators (KPIs) are summary perfor- mance measures that help managers assess whether the company is achieving its goals.
The balanced scorecard views the company from four different perspectives, each of which evaluates a specific aspect of organizational performance:
• Financial perspective
Lag Indicator
A performance measure that indicates past performance.
Lead Indicator
A performance measure that forecasts future performance.
Operational Performance Measure
A nonfinancial performance measure that evaluates effectiveness and efficiency to ensure all
segments of the business are working together to achieve the company’s goals.
Balanced Scorecard
The performance evaluation system that requires management to consider both financial performance measures and operational
performance measures when judging the performance of a company and its subunits.
Key Performance Indicator (KPI) A summary performance measure that helps managers assess whether the company is achieving its goals.
The company’s strategy affects and, in turn, is affected by all four perspectives. There is a cause-and-effect relationship linking the four perspectives.
Companies that adopt the balanced scorecard usually have specific goals they wish to achieve within each of the four perspectives. Once management clearly identifies the goals, it develops KPIs that can assess how well the goals are being achieved. That is, it measures actual results of KPIs against goal KPIs. The difference is the variance. Management can focus attention on the most critical variances and prevent information overload. Manage- ment should take care to use only a few KPIs for each perspective. Let’s look at each of the perspectives and discuss the links among them.
Financial Perspective
This perspective helps managers answer the question “How do we look to investors and creditors?” The ultimate goal of for-profit companies is to generate income. Therefore, company strategy revolves around increasing the company’s profits through increasing revenue growth and productivity. Companies grow revenue by introducing new products, gaining new customers, and increasing sales to existing customers. Companies increase productivity through reducing costs and using the company’s assets more efficiently. The financial perspective focuses management’s attention on KPIs that assess financial objec- tives, such as revenue growth and cost cutting. The latter portion of this chapter discusses the most commonly used financial perspective KPIs in detail.
Customer Perspective
This perspective helps managers evaluate the question “How do customers see us?” Evalu- ating customer satisfaction is critical to achieving the company’s financial goals outlined in the financial perspective of the balanced scorecard. Customers are typically concerned with four specific product or service attributes: (1) the product’s price, (2) the product’s quality, (3) the product’s performance and service, and (4) the product’s delivery time. Because each of these attributes is critical to making the customer happy, most companies have specific objectives for each of these attributes.
Internal Business Perspective
This perspective helps managers address the question “At what business processes must we excel to meet customer and financial objectives?” The answer to this question incorporates three factors: innovation, operations, and post-sales service. All three factors critically affect customer satisfaction, which will affect the company’s financial success.
Satisfying customers once does not guarantee future success, which is why the first important factor of the internal business perspective is innovation. Customers’ needs and wants constantly change. Just a few years ago, self-driving cars and 3-D printers did not exist. Companies must continually improve existing products and develop new products to succeed in the future.
The second important factor of the internal business perspective is operations. Lean and effective internal operations allow the company to meet customers’ needs and expecta- tions and remain competitive.
The third factor of the internal business perspective is post-sales service. Claims of excellent post-sales service help to generate more sales.
Learning and Growth Perspective
This perspective helps managers assess the question “How can we continue to improve and create value?” The learning and growth perspective focuses on three factors: (1) employee capabilities, (2) information system capabilities, and (3) the company’s “climate for action.”
The learning and growth perspective lays the foundation needed to improve internal
business operations, sustain customer satisfaction, and generate financial success. Without skilled employees, updated technology, and a positive corporate culture, the company will not be able to meet the objectives of the other perspectives.
Let’s consider each of these factors. First, because most routine work is automated, employees are freed up to be critical and creative thinkers who, therefore, can help achieve the company’s goals. The learning and growth perspective measures employees’ skills, knowledge, motivation, and empowerment. Second, employees need timely and accurate information on customers, internal processes, and finances; therefore, KPIs measure the maintenance and improvement of the company’s information system. Finally, management must create a corporate culture that supports and encourages communication, change, and growth. For example, a company may use the balanced scorecard to communicate strategy to every employee and to show each employee how his or her daily work contributes to company success. Exhibit 24-3 summarizes the balanced scorecard and gives examples of KPIs for each perspective.
Exhibit24-3 | Balanced Scorecard
Financial
Customer
Internal Business
Increase company profits through increasing revenue growth and productivity
Improve customer satisfaction for long-term success
Improve internal efficiency and effectiveness to achieve profitability and customer satisfaction through:
Retain skilled employees, update technology, and create a positive corporate culture to provide a foundation for improved internal operations, sustain customer satisfaction, and generate financial success Learning and Growth
Perspective Strategy Common Key Performance
Indicators (KPIs)
• Net income
• Sales revenue growth
• Gross margin growth
• Cash flow
• Return on investment
• Residual income
• Innovation
• Operations
• Post-sales service
• Customer satisfaction ratings
• Percentage of market share
• Increase in number of customers
• Number of repeat customers
• Number of customer complaints
• Rate of on-time deliveries
• Percentage of sales returns
• Number of new products developed
• New-product development time
• Manufacturing cycle time
• Defect rate
• Number of units produced per hour
• Number of warranty claims received
• Average repair time
• Average wait time for a customer service representative
• Hours of employee training
• Number of cross-trained employees
• Percentage of computer downtime
• Percentage of processes with real-time feedback on quality, cycle time, and cost
• Employee satisfaction
• Employee turnover
• Number of employee suggestions implemented
HOW DO COMPANIES USE RESPONSIBILITY