1. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 20 Strategy, Balanced Scorecards and Incentive Systems

2. 20-2 Learning Objective 1

3. 20-3 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. 20-4 Lead Financial performance Lead Customer value Lead Business and production process efficiency Using Leading and Lagging Indicators in Balanced Scorecards Leading indicators are measures that identify future nonfinancial and financial outcomes to guide management decision making. Organizational learning and growth Leading indicators

5. 20-5 Using Leading and Lagging Indicators in Balanced Scorecards Lead Organizational learning and growth Business and production process efficiency Customer value Financial performance Lagging indicators are measures of the final outcomes of earlier management plans and their execution.

6. 20-6 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. 20-7 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. Increased employee training Faster loan processing Leads to Increased customer satisfaction Leads to More loyal customers More Leads to BetterfinancialresultsBetterfinancialresults

8. 20-8 A Balanced Scorecard’s Strategic Performance Measures VisionandStrategyVisionandStrategy Business and production process performance Business and production process performance At what business practices must we excel? Customer performance How should we appear to our customers Financial performance Financial performance How should we appear to our shareholders? Learning and growth performance Learning and growth performance How should we sustain our ability to change and improve?

9. 20-9 Learning Objective 2

10. 20-10LeadLead Customer value LeadLead Business and production process efficiency Implementation of a Balanced Scorecard 1. Organizational learning and growth a)Employee training and education. b)Employee satisfaction. Organizational learning and growth 1. Employee training 2. Employee satisfaction 3. Employee turnover 4. Innovativeness 5. Opportunities for improvement Organizational learning and growth 1. Employee training 2. Employee satisfaction 3. Employee turnover 4. Innovativeness 5. Opportunities for improvement Financial performance Lead

11. 20-11 Evaluation of Measures of Organizational Learning and Growth Consider the information in this table: Incremental profit = Total benefits – Total costs Break-even profit = 0 = 9X - $240,000 9X = $240,000 Incremental profit = Total benefits – Total costs Break-even profit = 0 = 9X - $240,000 9X = $240,000 Break-even benefit level, X = $26,667 per year

12. 20-12 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 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. 20-13 Business and Production Process Efficiency Organizational learning and growth LeadLead Business and production process efficiency 1. New service development 2. Employee productivity and error rates 3. Service costs 4. Process improvements 5. Supplier relations Business and production process efficiency 1. New service development 2. Employee productivity and error rates 3. Service costs 4. Process improvements 5. Supplier relations Customer value LeadLead Financial performance LeadLead

14. 20-14 Customer Value Organizational learning and growth LeadLead Business and production process efficiency Customer value 1. Customer satisfaction 2. Customer retention and loyalty 3. Market share 4. Customer risk Customer value 1. Customer satisfaction 2. Customer retention and loyalty 3. Market share 4. Customer risk LeadLead Financial performance LeadLead

15. 20-15 Evaluation of Measures of Customer Value Customer satisfaction survey – scale 1 to 5

16. 20-16 Financial Performance Organizational learning and growth LeadLead Business and production process efficiency LeadLead Customer value Financial performance 1. New interest margin 2. Revenue growth 3. Customer profitability 4. Overall return on assets LeadLead 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.

17. 20-17 Learning Objective 3

18. 20-18 Benefits and Costs of a Balanced Scorecard Benefits of a balanced scorecard 1.Encourages all employees to consider the impacts of their decisions on profitability 2.Appears to work in various types of organizations Benefits of a balanced scorecard 1.Encourages all employees to consider the impacts of their decisions on profitability 2.Appears to work in various types of organizations Costs of a balanced scorecard 1.Choosing and validating measures 2.Training and interpretation activities 3.Managing many measures at once Costs of a balanced scorecard 1.Choosing and validating measures 2.Training and interpretation activities 3.Managing many measures at once

19. 20-19 Learning Objective 4

20. 20-20 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. 20-21 Learning Objective 5

22. 20-22 Fundamental Principles of Incentive Systems Pay for performance 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. 20-23 Role for Theories of Incentives and Behavior

24. 20-24 Learning Objective 6

25. 20-25 Features of Performance-Based Incentive Systems Performance-based management incentive system 1. Absolute or relative performance? 2. Formula-based or subjective performance? 3. Financial or nonfinancial performance? 4. Narrow or broad responsibility of performance? 5. Current or deferred rewards? 6. Salary, bonus or stock rewards? 6. Salary, bonus or stock rewards?

26. 20-26 Absolute or Relative Performance Absolute performance evaluation compares individual performance to set objectives or expectations. Absolute performance evaluation compares individual performance to set objectives or expectations. Relative performance evaluation compares an individual’s performance to that of others. Relative performance evaluation compares an individual’s performance to that of others.

27. 20-27 Formula-Based or Subjective Performance A performance evaluation formula computes rewards earned for specific achievements. A performance evaluation formula computes rewards earned for specific achievements. Subjective performance evaluation uses non- quantified criteria not captured by formulas. Subjective performance evaluation uses non- quantified criteria not captured by formulas. Evaluation Group

28. 20-28 Financial or Nonfinancial Performance Financial performance reflects the achievement of financial goals, such as... Cost control Cost control Revenue growth Revenue growth Earnings Earnings Residual income Residual income Adding nonfinancial measures to the incentive system Gets managers to focus on the leading indicators of profit Gets managers to focus on the leading indicators of profit Gives recognition of the time lags between nonfinancial and financial performance Gives recognition of the time lags between nonfinancial and financial performance

29. 20-29 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. 20-30 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. 20-31 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 stress performance-based compensation. Some common performance-based compensation plans include:

32. 20-32 Learning Objective 7

33. 20-33 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. 20-34 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. 20-35 Learning Objective 8

36. 20-36 Theories of Incentives and Behavior 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

37. 20-37 End of Chapter 20