Week 8 - Overcoming Myopia & Balance Scorecard

Week 8 – Overcoming Myopia & Balance Scorecard
Overcoming Myopia
1) Measure Changes in Shareholder Value Directly
- Measure economic income or shareholder value creation directly by
estimating future cash flows and discounting them to the present value
o Difference between the beginning and ending values is a direct
estimate of the value created during the period, and thus of
economic income
- Measurement precision and objectivity are significant stumbling blocks to
the use of direct measures of economic income  managers may be
tempted to bias estimates
2) Reduce Pressure for Short Term Profit
- Reduce weight placed on the annual profit target and emphasize other,
longer-term performance indicators (i.e. market share, technological
breakthrough)
- Make short-term profits easier to achieve
o Risk: slack from managers
 Either need to trust that managers will not slack off OR
pressure should be imparted in other ways (i.e. timely non-
financial performance evaluations)
3) Extend Measurement Horizon
- The longer the period of measurement, the more congruent the
accounting measures of performance are likely to be with economic
income
o Provide incentives tied to performance measured over longer
periods
4) Improve Accounting Profit Measures
- Change measurement rules to make accounting income measures more
congruent with economic income
o Adjust depreciable lives of fixed assets, adopt current value
depreciation, charge depreciation for older assets (recognizes that
they are still in use)
o Capitalize expenditures related to long-term investments
o Recognize profits more quickly, making performance indicators
timlier
o Impute a cost of equity on income statement to reflect company’s
entire cost of capital vs. cost of debt
o Put leases on B/S to improve denominator of ROI
 However, this adds processing, reporting, and reconciliation
costs, possibly confusion costs too to develop performance
reports for control purposes
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5) Measure a Set Value of Drivers
- Short term, transaction-based orientation of accounting measures can be
balanced by focusing on other performance measures that are more
future oriented
- Ex: well-chosen nonfinancial measures can provide signals about what is
likely in the future  accomplishments in new product
development/customer satisfaction are often value drivers and therefore
leading indicators of future financial performance
6) Control Investment with Pre-action Reviews
- To control investment myopia, companies find it useful to use financial
results controls to reward improvements in short term operation
performance only
- Managers therefore feel less pressure/temptation to cut investments to
boost ST profits
- Need to distinguish
o Operating expenses: necessary to produce current-period
revenues
o Developmental expenses: incurred to generate revenues in future
periods
o If this can be done, managers asked to maximize operating income
(focus on current period sales and costs, which are good indicators
of short-term performance)
- Other companies split into today/tomorrow’s business
o Today: managers charged with making business lean, efficient, and
profitable in their competitive environment, controlled through
tight financial results controls
o Tomorrow: charged with developing new business opportunities
(products & markets) that might someday augment or replace
existing today businesses, controlled by combo of nonfinancial
performance indicators and action controls
Balance Scorecard
- Includes financial measures that tell the results of actions already taken
- Complements the financial measures with operational measures on
customer satisfaction, internal processes, and the firm’s innovation and
improvement activities
- Organizational Learning & Performance
o Employee training and education
o Employee satisfaction
o Employee turnover
o Innovativeness
o Opportunities for improvement
- Business & Production Process Performance
o New service development
o Employee productivity and error rates
o Service costs
o Process Improvements
o Supplier relations
- Customer Performance
o Customer satisfaction
o Customer retention & loyalty
o Market share
o Customer risk
- Financial Performance
o Net interest margin
o Revenue growth
o Customer profitability
o Overall ROA
- How to Build the BSC
o Step 1: Corporate Vision Statement
 Helps answer:
 Why do we exist (mission)?
 What do we want to be (vision)?
 What’s important to us (values)?
 Clarify the vision  express as integrated objectives &
measures
 Gaining Consensus  managers in one accord
 Managers should look at BSC again and ensure that vision of
company is expressed as integrated objectives and measures
and that all managers are in one accord about vision and
corresponding objectives
o Step 2: Determine Strategic Objectives
 Set targets  all users of the scorecard, determining actions
that drive targets
 Align strategic initiatives  ensuring budget support strategies
 Allocate resources  improving most critical processes,
eliminate non strategic investments
 Establish milestones  charting progress of targets and
evaluate if targets are achievable
 Should enable companies to integrate their business and
financial plans by allowing BSC users to determine actions that
would drive them towards their targets
o Sub-step: Communicating & Linking
 Communicating and educating strategy
 2 way communication, Top down (to divisions,
departments, individuals), Bottom up (to corporate HQ)
to inform higher levels of management about goals and
measures that department or divisions have derived
from the corporate strategy
 Setting goals
 Translate high level objectives to department and
individual level
 Linking rewards to performance measures
 Aligns strategy and employee performance
o Step 3: Strategy Map
o Step 4: Deriving KPIs

 Measurement that provides information on how far we have
succeeded in achieving the strategic objectives
 Are they relevant to strategic objectives? Controllable?
Actionable? Simple (easy to explain)? Credible (not easy to
manipulate)?
- Good BSC Tells a Story

o Every measure is part of a chain of cause and effect linkages
o All measures eventually link to organizational outcomes
o A balance exists between outcome measures (financial, customer) and
performance drivers (customer value, internal processes, learning and
growth)
Using Financial Results Controls in the Presence of Uncontrollable
Factors
- Controllability principle
o Employees should be held accountable only for that which they can
control or have significant influence over
o Uncontrollable factors distort performance measures and evaluations
o Uncontrollable business risks are best borne by shareholders, who are
able to diversity risks
 If managers bear risk, they should be compensated for it or
they may engage in undesirable actions to protect themselves
from risks (i.e. by engaging in game-playing or becoming
excessively risk averse)
- Choices that must be made
o What is the purpose for needed adjustments?
 Increase fixed component
 Incentive pay (ST, LT)
 Job retention
o Types of uncontrollable for which adjustments are made
 Economic & competitive factors
 “Acts of nature”
 Interdependencies  uncontrollable due to decisions made by
personnel in other parts of organization, such as higher org
levels or other organizational entities
o Who makes the adjustments?
 Immediate superior
 Upper management
 Compensation committee of BoD
 Done automatically by predetermined formulas/rules
o Which method to use to make adjustments for performance
evaluations
 Flexible performance targets (i.e. flexed budgets)
 Relative performance evaluations
 Subjective judgments
 Variance analyses
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Week 8 – Overcoming Myopia & Balance Scorecard

o Step 4: Deriving KPIs

- Good BSC Tells a Story

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