How to Manage Performance: Kaplan and Norton's Balanced Scorecard
After working with several pioneering technology and manufacturing companies, Robert Kaplan, a Harvard Business School professor, and David Norton, president of a management consulting firm, found that performance management was defined very narrowly, focusing almost exclusively on financial measures. They concluded that financial performance alone was insufficient to accurately measure an organization's achievement and total value and that a broader approach was needed.
In their book, The Balanced Scorecard: Translating Strategy into Action, published in 1996, Kaplan and Norton defined a scorecard model, whereby in addition to financial measures, organizational performance should include measures from a customer perspective, an internal business process perspective, and a perspective measuring employee innovation and learning.
Sometimes referred to as the four perspectives model, the name "Balanced Scorecard" was chosen to reflect the need for organizations to manage using a balanced assessment of performance measures. A good scorecard, therefore, includes a mix of core outcome measures common to most strategies, and performance drivers that reflect the uniqueness of a particular strategy. The measures and drivers selected should distinguish between long- and short-term objectives, between financial and non-financial measures, between lagging and leading indicators and between internal and external performance perspectives. Ultimately, all measures need to be tied back to financial performance. Originally conceived as a performance measurement system, executives using it encouraged the authors to further its potential as a strategic management system.
Early on, Kaplan and Norton believed that sustainable competitive advantage, both near-term and long-term, requires organizations to exploit intangible assets that are not necessarily reflected in financial measures. They believed that intangible assets possess unique hidden potential to (The Balanced Scorecard 1996, page 3):
- Develop customer relationships, improve customer loyalty and open new markets.
- Introduce innovative products and services to targeted segments.
- Produce customized products at low cost.
- Mobilize employee skills, and motivate them for continuous improvement in quality and process execution.
- Uniquely deploy and exploit emerging information technology to drive strategy and enable sustained competitive advantages.
To realize the potential of intangible assets, organizations must consider a new set of operating assumptions (The Balanced Scorecard 1996, page 4):
- "Silo" departments must yield to more efficient, cross-functional organizations that share information for improved intelligence, efficiency and specialization.
- Simple message exchange with customers and suppliers will be inadequate in some cases, driving the need for integrated information systems and process flows with external parties.
- Customers will require unique solutions and products based on their strategy and competitive landscape. Organizations must be able to respond quickly and effectively to these needs.
- Domestic boundaries no longer exist; all companies can compete on a global scale.
- Innovation and evolution of products, services and product lifecycle management must accelerate and be tightly coupled with an understanding of the competitive landscape and customer needs.
- All employees possess unique talents; organizations must exploit their expertise and cycle this energy back into the organization to learn and respond dynamically to opportunity and change. As knowledge workers, employees serve a far greater purpose and offer superior value to an organization.
As organizations seek to transform themselves based on these assumptions, they look to a variety of improvement initiatives such as (The Balanced Scorecard 1996, page 6):
- Total Quality Management
- Just-in-time (JIT) production and distribution systems
- Lean manufacturing
- Activity-based costing
- Customer-focused organizations
But many of these initiatives are also measured narrowly by quarterly and annual financial reports anchored to an aging accounting model. The Balanced Scorecard represented a new performance measurement system, and ultimately, a strategic management model, one derived from an organization's vision and strategy, and also accounts for value derived from intangible assets. It is based on the belief that cause-and-effect relationships exist between the four measurement perspectives: financial, customer, internal business process, and learning and growth. Each aids the other in realizing their respective measures, and thus the strategic objectives of the organization. To understand cause-and-effect relationships from The Balanced Scorecard perspective, think about the four perspectives in the following way:
- Invested capital (as measured in dollarsa financial measure)
- leads to the early development of an innovative, high-quality product (as measured by time to marketan internal business process measure)
- that satisfies a unique customer need (as measured by customer satisfactiona customer feedback measure)
- when produced using an improved manufacturing process (as measured by production cycle time and inventory turnsan internal business process measure)
- developed by motivated employees (as measured by employee satisfactionan innovation and growth measure)
- yields better than expected results (as measured by market sharea customer growth measure)
- satisfying investor requirements (as measured by the return-on-invested capitala financial measure).
This scenario demonstrates a basic cause-and-effect model highlighting how different business perspectives impact one another. The Balanced Scorecard emphasizes the need to develop strategy, share it with all employees, and measure results as a holistic system. Financial or statistical measures from a departmental or organizational perspective are simply too narrow. Organizations that don't pay attention to cause-and-effect relationships between the four perspectives may be at a competitive disadvantage.
To better understand the Balanced Scorecard, let's take a closer look at each of the four perspectives.
Performance Measures from a Financial Perspective
An organization's financial objectives differ depending upon its business lifecycle strategy. Business lifecycles can be broadly defined, but to keep the explanation simple, Kaplan and Norton discuss the financial objectives of three typical lifecycle strategies: growth, sustain and harvest.
Growth businesses commit resources to develop and enhance new products and services, construct and expand production facilities, invest in systems and infrastructure, develop relationships, enter markets and nurture customers. They typically operate with negative cash flows and low current returns on invested capital. Financial objectives will measure percentage growth rates in revenues, sales growth by targeted markets, customer groups or geographies.
Businesses operating with a sustain lifecycle strategy are required to earn attractive returns on invested capital and to maintain or grow market share. Investment is channeled to process management and continuous improvement. Managers are asked to maximize income and operate profitably. Return-on-investment, return-on-capital employed and value-added measures are used to evaluate financial performance.
Businesses operating with a harvest lifecycle strategy are mature and warrant little incremental investment. Emphasis is on maintaining operations profitably. Any investment is expected to yield short-term returns. Financial performance is measured by reduction in working capital requirements and cash flow improvement.
- Revenue growth and mix across product and/or services lines, customer markets and pricing strategies.
- Cost reduction and productivity improvement, but not to the point where expenses are a burden that must be contained and eliminated over time. Rather the outputs of the expenses, such as indirect and support resources, should be measured to demonstrate increased efficiencies and as such are valued as assets to the organization.
- Asset utilization and strategy to improve working capital, accounts receivable, accounts payable, and inventory management. A key measure of working capital efficiency is the cash-to-cash cycle that helps organizations understand how long it takes from the time they buy goods and pay labor until the time cash receipts are received from customers.
Organizations choose financial objectives from the themes that facilitate strategy and measure performance. Depending on the lifecycle of a strategy, revenue, cost or asset management becomes the priority. The scorecard helps executives to specify the metrics by which long-term performance will be evaluated by highlighting the variables associated with business lifecycle success.
This is a traditional approach to financial performance measurement. The critical message that the co-authors emphasize is that to best realize financial objectives, an organization must understand and control how the cause-and-effect relationships of the other perspectives influence financial results. In other words, every measure selected in the scorecard should be part of a cause-and-effect relationship that, when complete, achieves the financial objectives being sought. In the cause-and-effect scenario stated earlier, the last relationship was a measurement of the financial result.
Performance Measures from a Customer Perspective
Organizations identify value propositions and deliver to targeted customers and markets. In The Balanced Scorecard, success of the value propositions is determined through five core customer outcome measures (The Balanced Scorecard 1996, page 67):
- Market share
- Customer retention
- Customer acquisition
- Customer satisfaction
- Customer profitability
Beyond aspiring to delight customers, organizations must translate their mission and strategy statements into specific market segments and customer-based objectives. Kaplan and Norton also believe there must be a focused effort in each targeted segment. They note that some managers sometimes object to this focus thinking that anyone willing to pay for goods and services is a good customer. Kaplan and Norton dismiss this attitude as short-sighted, arguing that it runs the risk of doing nothing well for anyone. The essence of business strategy is not just choosing what to do; but also choosing what not to do. Boundaries help focus resources to create distinguishable value propositions.
In The Balanced Scorecard, the relative strength or weakness of a value proposition drives the outcome of each of the five core customer measures. Realizing the desired outcome for customer acquisition, for example, demands that prospective customers perceive the organization's value proposition to be differentiated from competitors. The attributes of value, therefore, need to be addressed to drive the desired outcome. Kaplan and Norton organize the attributes of value propositions into three categories (The Balanced Scorecard 1996, page 73 - 77):
- Product/service attributes encompassing functionality, price and quality.
- Customer relationships garnered from the tangible results of commerce transactions, such as timely responses, delivery and professionalism.
- Image and reputation reflecting intangible factors that attract customers and create loyalty as garnered from advertising, image and brand, and the perceived quality of the good or service.
Formulating strategy and performance measures, therefore, from the customer perspective of The Balanced Scorecard, requires organizations to:
- target customer and market segments;
- differentiate value propositions across the three value categoriesproduct services attributes, customer relationships, and image and reputation;
- and focus marketing, operational logistics and product and service development efforts to achieve success as determined by the five core customer measurescustomer acquisition, customer satisfaction, customer retention, customer profitability and market share.
Performance Measures from an Internal Business Process Perspective
From the internal business process perspective, Kaplan and Norton believe that performance measurement systems for many organizations focus too heavily on departmental measures. The Balanced Scorecard approach emphasizes the measurement of integrated processes across an organization. Cost, quality, throughput and time measures should be defined for processes that span multiple departments, such as procurement, production planning and control, order fulfillment, and others. Indeed, this model can be externalized to include customers, suppliers and other partners. (Cross-organizational process design impacts the workforce behavior and ushers in a new way of thinking about how individual, group and organizational objectives are managed and achieved.)
Organizations should focus on cross-organizational processes that are most critical for achieving customer and shareholder value. Management and measurement of these processes should be addressed by looking at them as end-to-end value chains that start with customer need and end with customer satisfaction.
All businesses have unique ways of creating customer value. But Kaplan and Norton highlight common denominators that define a generic value chain model. They suggest using this generic model as a starting point and template for organizations to model their unique performance measures for business processes.
Kaplan and Norton's value-chain is a generic, high-level process representation. It starts with innovation processes, where customer needs and markets are identified, and then products and services are designed to meet these needs. It proceeds to operations processes where products and services are crafted and delivered, and concludes with post sale services to assure that customer needs are meet, and if not, engages corrective actions to result in customer satisfaction.
Kaplan and Norton believe operations and post-sale services processes are important but view them somewhat generically in The Balanced Scorecard, only briefly reviewing the activities and performance measures unique to each. They advise pursuing other established business improvement initiatives like Total Quality Management (TQM) that use well-defined scientific practices and measures. In recent years, other business process management and improvement methods have matured to offer the process measurement details missing in The Balanced Scorecard. Methodologies such as Six Sigma, ISO 9000, Capability Maturity Model (CMM) and Supply Chain Operations Reference (SCOR) model from the Supply Chain Council, among others, are used by leading global companies to design, measure and manage the performance of critical quality management initiatives and business processes.
The co-authors do describe in detail various techniques used in the innovation process to perform and measure market and customer research, applied research, and product R&D. Here, their message emphasizes the need for organizations to understand and anticipate customer need.
To realize ambitious customer objectives, The Balanced Scorecard illustrates through several examples the need for organizations to develop internal business processes that capture a deep understanding of customer needs, requirements, challenges and desires; and the need to be recognized by the customer that this knowledge is sufficient and accurate. Lacking such processes and such knowledge can cause the customer to seek alternatives. Lacking such recognition can cause misunderstanding, confusion and frustration, potentially harming the relationship.
This assumes, of course, that the customer in fact knows what they need. Sometimes customers are uncertain about the outcomes they seek, knowing only that they need innovative solutions. In these circumstances, the organization must possess sufficient intelligence and knowledge of the environment to anticipate the need, suggest such innovation and be recognized for its expertise.
In any case, organizations must use their internal business processes and the employees closest to the customer to constantly build upon their knowledge of the customer and the market. Organizations must master customer solution development processes and analyze them to reveal new and unique processes that support a known need, or produce innovative value in the eyes of the customer. This level of effort propels organizations to outperform competitors and creates distinctive and sustainable competitive advantage.
Performance Measures from a Learning and Growth Perspective
In the learning and growth perspective of The Balanced Scorecard, resourceful and motivated employees drive achievement in the other three perspectives. Organizations that focus solely on financial objectives often treat investments to motivate and improve people as expenses to be eliminated when financial performance declines. The Balanced Scorecard stresses the importance of investing in the future. That includes investing in the capabilities, productivity and motivation of employees and measuring the outcome of these investments by determining the rates of employee (The Balanced Scorecard 1996, page 129):
Most organizations should and do measure employee satisfaction, retention and productivity, and influence behavior with targeted incentives. All can be measured in several ways. Employee satisfaction is typically measured by retention or the rate of staff turnover. The simplest and most common measure of productivity is revenue per employee. But managers indifferent to such workforce measures sometimes make simple tactical changes to improve the outcome without really improving the results. For example, outsourcing some functions may improve employee productivity measures simply because there are fewer employees on the books. This doesn't mean that productivity actually improves or that customer objectives are being met.
Ideas for improving the customer experience and realizing customer objectives must increasingly rely on input from the employees closest to both the customer and the organization's internal processes. Employees must be engaged so that their minds and creative capabilities can be applied to achieve customer and organizational objectives. Here, Kaplan and Norton acknowledge the importance of aligning people, processes and technology to support strategic objectives. To do so, organizations must consider investment in three categories that enable learning and growth (The Balanced Scorecard 1996, page 127-146):
- Employee capabilitiesas customer needs change, internal processes must respond, and investment is needed to apply employee knowledge and creative skills to help facilitate change, retrain and re-skill employees if required to realize evolving objectives.
- Information system capabilitiesinvestment is needed to support the workforce by providing it with strategic information necessary to be knowledgeable about changing conditions and to be responsive to customers.
- Motivation, empowerment and alignmentmethods and practices to motivate, empower, reward and align the efforts of employees across the organization are required to achieve customer and organizational objectives.
Kaplan and Norton note that most organizations have devoted little effort to measuring the outcomes or drivers regarding employee skills, strategic information availability and organizational alignment. Efforts that advance, re-train or re-skill employees are often overlooked when developing strategic objectives. Exposing strategic information that can potentially impact employee job performance is inadequately planned. Aligning individuals, teams and departments or groups with the organization's strategy to drive long-term objectives is inconsistent and sporadic.
Organizations must shift workforce thinking and behavior. Merely executing planned processes and reacting to customer requests is inadequate. Rather, organizations should proactively anticipate customer needs, and then market an expanded set of products and services to them. This may require re-training, new skills or realignment of the organization and its resources. The Balanced Scorecard offers techniques and measures by which transformation can be assessed. Those of note include:
- Strategic job coverage: an analysis that maps the skills required of employees by job families, such as sales, services and operations. It helps determine the extent to which these skills match what is needed to exceed customer perspective measures. The result of which may be to assign new roles and responsibilities, require new skills or re-training.
- Strategic information availability: an analysis of the information used by employees, measuring its quality, accuracy and timeliness critical to enhance knowledge, improve judgment and make decisions relative to each job family.
- Percentage of business processes achieved: an analysis of business process execution that meets performance measures. Those that don't achieve target rates may suggest that employee execution is lacking, requiring renewed focus on workforce skills and capabilities for those processes.
- Percentage of key employees aligned to the scorecard objective: an analysis of how business strategy and scorecard practices are disseminated throughout the organization. The key principle of the scorecard is to align all aspects of an organization to reach strategic objectives. Top heavy concentration of objectives at executive and managerial levels should be avoided with responsibilities dispersed to key employees in the job families that most influence value chain performance and customer satisfaction.
Aligning an organization to a shared vision with common direction requires communication and education programs, so that all employees understand the strategy and required behaviors to meet it. The strategy then needs to be translated into personal and team objectives to drive that behavior. The Balanced Scorecard permits and enables all employees within an organization to understand its strategy and shows how individual action influences the "big picture" perspective across financial, customer, business process and learning and growth perspectives. Reward systems then need to be established to motivate the behavior.
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