Read The Balanced Scorecard: Translating Strategy Into Action Online
Authors: Robert S. Kaplan,David P. Norton
Tags: #Non-Fiction, #Business
The Balanced Scorecard: Translating Strategy Into Action (9 page)
Effective financial management must address risk as well as return. Objectives relating to growth, profitability, and cash flow emphasize improving returns from investment. But businesses should balance expected returns
with the management and control of risk. Thus, many businesses include an objective in their financial perspective that addresses the risk dimension of their strategy—for example, diversifying revenue sources away from a narrow set of customers, one or two lines of business, or particular geographical regions. In general, risk management is an overlay, an additional objective that should complement whatever expected return strategy the business unit has chosen.
We have found that, for each of the three strategies of growth, sustain, and harvest, there are three financial themes that drive the business strategy:
- Revenue growth and mix
- Cost reduction/productivity improvement
- Asset utilization/investment strategy
Revenue growth and mix refer to expanding product and service offerings, reaching new customers and markets, changing the product and service mix toward higher-value-added offerings, and repricing products and services. The cost reduction and productivity objective refers to efforts to lower the direct costs of products and services, reduce indirect costs, and share common resources with other business units. For the asset utilization theme, managers attempt to reduce the working capital levels required to support a given volume and mix of business. They also strive to obtain greater utilization of their fixed asset base, by directing new business to resources currently not used to capacity, using scarce resources more efficiently, and disposing of assets that provide inadequate returns on their market value. All these actions enable the business unit to increase the returns earned on its financial and physical assets.
To view the selection of the drivers of aggregate financial objectives as cells in a 3 × 3 matrix across the three business strategies and the three financial themes, see Figure 3-1.
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The most common revenue growth measure, both for growth-and harvest-stage business units, would be sales growth rates and market share for targeted regions, markets, and customers.
Growth-stage businesses will usually emphasize expansions of existing product lines or offering entirely new products and services. A common measure for this objective is the percentage of revenue from new products and services introduced within a specified period, say two to three years. This measure has been extensively used by innovative companies, like Hewlett-Packard (HP) and the 3M Corporation. Of course, like any good measure, this objective can be achieved in both good and less good ways. The preferred way is for the new product or new product extension to be a dramatic improvement on existing offerings so that it captures new customers and markets, not just replaces sales of existing products. But if too much pressure is placed on this measure alone (less of a danger with a Balanced Scorecard), a business unit could score well on this measure by making a continuing series of incremental improvements that replace existing products but none of which offers distinct advantages to customers. Or, alternatively, and more dysfunctionally (and, fortunately, much less likely), a business unit could simply cease selling a high-volume mature product, allowing recent product sales to represent a higher fraction of total sales. To capture whether the new product or service represents a distinct improvement from existing offerings, some companies focus on the prices or gross margins from new products and services, anticipating that offerings with significantly more functionality and customer value will likely command a higher margin than mature existing products.
Figure 3-1
Measuring Strategic Financial Themes
Developing entirely new products can be very costly and time-consuming for companies, especially those in the pharmaceutical and agricultural chemical industries, with long product-development cycles, and whose products must pass through stringent governmental regulatory approval processes. Businesses in the sustain stage may find it easier to grow revenues by taking existing products and finding new applications for them—new diseases or ailments for which a drug is effective, or new crops for which a chemical offers comparable protection. Taking existing products to new applications requires that a company demonstrate effectiveness in the new application, but the basic chemistry does not have to be invented, its safety demonstrated, or its manufacturing process developed and debugged. If new product applications is an objective, the percentage of sales in new applications would be a useful BSC measure.
Taking existing products and services to new customers and markets also can be a desirable route for revenue growth. Measures such as percentage of revenues from new customers, market segments, and geographic regions would emphasize the importance of investigating this source of revenue enhancement. Many industries have excellent information on the size of the total market and of relative market shares by participants. Increasing a unit’s share of targeted market segments is a frequently used metric; it also enables the unit to assess whether its market share growth is from improved competitive offerings or just growth in the total size of the market. Gaining sales but losing share may indicate problems with the unit’s strategy or the attractiveness of its products and services.
Some companies have attempted to realize synergies from their different strategic business units by having them cooperate to develop new products
or to sell projects to customers. Whether the company strategy is to increase technology transfer across divisions or to increase sales to individual customers from multiple business units within the company, the objective can be translated into the amount of revenue generated from cooperative relationships across multiple business units.
For example, Rockwater was one of six engineering divisions within Brown & Root Energy Services. The other divisions all supplied engineering services of some type, typically to large oil and gas companies, with the services ranging across basic and applied engineering design, pipeline fabrication, pipeline installation (Rockwater), and pipeline maintenance and services. Historically, these divisions had operated as independent companies. When Norman Chambers was promoted from president of Rockwater to president of Brown & Root Energy Services, he asked that each company adopt, as a financial objective, an increase in the share of business won by collaboration. His long-term goal was to offer turnkey service to customers: from initial project design through long-term operations and maintenance of hydrocarbon pipeline facilities.
These examples mirror the experience of several businesses that are attempting to break away from undifferentiated commodity-like selling arrangements, driven principally by price, to offering products and services that satisfy particular customers’ needs. The businesses may state that their strategy is to move to a more differentiated strategy. But if their financial measurements are only aggregate sales, profits, and ROCE, they may be achieving short-term financial targets but not succeeding in their strategy. They need to distinguish how much of their sales is coming from competitively priced offerings versus the sales made at a premium or through long-term relationships because of value-added features and services.
Extending this idea, businesses may choose to increase revenues by shifting their product and service mix. For example, a business may feel that it has a substantial cost advantage in selected segments, where it can win business away from competitors by offering significantly lower prices. If it is following this low-cost strategy, it should measure the growth of sales in the targeted segments. Alternatively, a business may choose a more differentiated strategy, deemphasizing low-price offerings and attempting to shift its product and service mix more toward premium priced items. This business
could choose to measure the growth in sales and the percentage of total sales in the premium segment. Metro Bank, for example, adopted a strategy to increase the number of fee-based products it sold and tracked the success of this strategy with a measure of revenue growth from these products and services.
Finally, revenue growth, especially in mature, perhaps harvest-stage business units, may be realized by raising prices on products, services, and customers where revenues are not covering costs. Such situations are now much easier to detect as companies implement activity-based cost (ABC) systems that trace costs, profits, and even assets employed down to individual products, services, and customers. Some companies have discovered, especially for specialized, niche products or particularly demanding customers, that prices can be increased, or, equivalently, large discounts eliminated, without losing share, to cover the costs of features and services on currently unprofitable products and customers. Profitability by product, service, and customer, or the percentages of unprofitable products and customers, provide signals (not necessarily the only signals) on the opportunity for repricing, or the success and failure of past pricing strategies. For highly homogeneous products and services, a simple price index, such as net revenue per ton, price per call, or price per unit, will reveal the trends in pricing strategy for the company and the industry.
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In addition to establishing objectives for revenue growth and mix, a business may wish to improve its cost and productivity performance.
Business units in the growth stage are unlikely to be heavily focused on cost reduction. Efforts to reduce costs through dedicated automation and standardized processes may conflict with the flexibility required to customize new products and services for new markets. Therefore, the productivity objective for growth-stage businesses should focus on revenue enhancement—say revenue per employee—to encourage shifts to higher-value-added products and services and to enhance the capabilities of the organization’s physical and personnel resources.
For sustain-stage businesses, achieving competitive cost levels, improving operating margins, and monitoring indirect and support expense levels will contribute to higher profitability and return-on-investment ratios. Perhaps the simplest and clearest cost reduction objective is to reduce the unit cost of performing work or producing output. For firms with relatively homogeneous output, supplying a simple target for reducing cost per unit can suffice. A chemical company can establish targets for cost per gallon or cost per pound produced; a retail bank can aim for a lower cost per transaction (processing a deposit or a withdrawal) and a decreased cost per customer account sustained; and an insurance company can measure cost per premium processed or per claim paid. Since the cost of performing activities or producing outputs may use resources and activities from many different departments in an organization, an activity-based process-oriented costing system will likely be required for accurate measurement of the unit cost of processing transactions and producing output.
Some organizations have multiple channels by which customers can conduct transactions with them. For example, retail banking customers can transact manually with in-branch tellers, through automatic teller machines (ATMs), and electronically by phone and computer. The cost to the bank of processing transactions via these various channels is very different. For manufacturers, some ordering from suppliers can be done traditionally, with a purchasing person calling for bids from external suppliers, evaluating the bids, selecting the best one, and then negotiating terms of delivery. Alternatively, the manufacturer could establish long-term relationships with certified suppliers, provide electronic data interchange (EDI) between the manufacturing process and the supplier, with the supplier taking responsibility for providing the required goods on time and directly to the production process. The cost of an EDI transaction is much lower than a traditional purchase transaction performed manually. Thus, an especially promising method for reducing costs is to shift customers and suppliers from high-cost manually processed channels to low-cost electronic channels. If this cost-reduction strategy is deployed by a business unit, it can measure the percentage of business it transacts through the various channels, with a goal of shifting the mix from high-to low-cost channels. Thus, even without any efficiency improvements in the underlying processes (an unrealistically conservative assumption),
just shifting to more efficient processing channels can significantly increase productivity and lower the cost of doing business.
Many organizations are now actively trying to lower their selling, general, and administrative expenses.
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The success of these efforts can be measured by tracking the absolute amount of these expenses or their percentage to total costs or revenues. For example, if managers feel that their support spending is too high relative to competitors’ and relative to the customer benefits being generated, they could set objectives to reduce, say, administrative expenses as a percentage of sales, or distribution or marketing and selling expenses. Objectives to reduce spending and expenses levels, however, should be balanced, on the scorecard, by other measures, say of customer responsiveness, quality, and performance, so that cost cutting does not interfere with achieving important customer and internal process objectives.
We admit, however, not being completely comfortable with this type of measurement since it implicitly assumes that these expenses are a “burden” on the organization that must be contained and eliminated over time. Ideally, organizations should attempt to measure the outputs produced from their indirect and support resources. They should try not just to reduce the spending and supply of these resources, but to increase their effectiveness—more customers, more sales, more transactions processed, more new products, better processes—as well as the efficiency of the work done by these resources—how much output and benefits these resources produce for a given level of input resources. These productivity-like measurements require that the organization analyze the work being performed by support resources, attempt to quantify the output produced, and then derive measures of the quantity and quality of the output produced as well as the ratio of outputs produced to inputs consumed. Activity-based cost analysis provides just such a linkage between spending on indirect, support, and administrative resources, and the activities and business processes performed by these resources and the outputs they produce and service. Viewed from this perspective, the somewhat artificial distinction, prevalent in many organizations today, between direct and indirect costs can be eliminated.
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Objectives, such as return-on-capital employed, return-on-investment, and economic value-added, provide overall outcome measures of the success
of financial strategies to increase revenues, reduce costs, and increase asset utilization. Companies may also wish to identify the specific drivers they will use to increase asset intensity.
Working capital, especially accounts receivable, inventory, and accounts payable, is an important element of capital for many manufacturing, retail, wholesale, and distribution companies. One measure of the efficiency of working capital management is the cash-to-cash cycle, measured as the sum of days cost-of-sales in inventory, days sales in accounts receivable, less days purchases in accounts payable (see Figure 3-2). The theory behind this measure is simple. The company purchases materials or products (and, for manufacturing companies, pays labor and conversion costs to produce finished goods). The length of time from when the purchases are made until they are sold represents the length of time capital is tied up in inventory. From this can be subtracted the length of time from purchasing materials and labor and conversion resources until cash payment must be made (the days purchases in accounts payable). The days sales in accounts receivable measures the length of time from when a sale is made until cash for it is received from customers. Thus the cash-to-cash cycle represents the time required for the company to convert cash payments to suppliers of inputs to cash receipts from customers. Some companies operate with negative cash-to-cash cycles; they pay suppliers after receiving cash from customers. In effect, by matching inventories extremely closely to final sales, collecting quickly from customers, and negotiating favorable terms with suppliers, they are able to supply, not consume, capital from their day-to-day operating cycle. While many companies will find it difficult, if not impossible, to have zero or negative cash-to-cash cycles, the goal of reducing the cash cycle from current levels can be an excellent target for improving working capital efficiency.
Figure 3-2
Cash-to-Cash Cycle