Managing Shareholder Value
Powerful new software tools, databases, and e-learning courses are giving companies a better chance to drive value-based management thinking deep into their organizations. These tools integrate proven management concepts such as EVA1 and the balanced scorecard into day-to-day management.
Employees typically are unable to take their businesses apart to see and manage the underlying value drivers. Moreover, a murky link exists between what people are doing — or are being asked to do — and the impact on shareholder value and company goals.
The Balanced Scorecard
One of the most important management tools to emerge this past decade is the balanced scorecard. About 50 percent of large companies in America and Europe have adopted scorecards, following the lead of Robert S. Kaplan and David P. Norton in their landmark 1992 Harvard Business Review article, The Balanced Scorecard — Measures That Drive Performance. By identifying and tracking an array of financial and nonfinancial metrics, scorecards have helped many companies to document, communicate, and gain commitment to their corporate strategy. The scorecards have made it easier for lower-level employees to grasp and support the aims of the top team. Yet, for all their value, balanced scorecards remain problematic because they are seldom implemented as Kaplan and Norton recommend.
In practice, most scorecards simply array a group of measures on a flat landscape and assign them more or less arbitrary weights. This is comparable to judging a basketball team by tracking various statistics, such as blocked shots, rebounds, assists, field goal percentage, free throws, and penalties, and then combining these statistics into a score by assigning them various weights. But victory is not determined by an arbitrary addition of statistics. It is indicated by the game score.
Tony Ebutts, the head of human resources for EDS in Europe, shares the concern that it is difficult to achieve a truly balanced scorecard without some overarching measure of success. The first question with balanced scorecards is: Are they balanced? (Motivating and Rewarding Managers Research Report. The Economist Intelligence Unit. 1999.)
Mr. Ebutts goes on to suggest that it is not easy to construct scorecards with the right mix of financial and nonfinancial measures. His point is well-taken: Scorecards will always be tricky to configure and apply without an accurate scale to weigh trade-offs among individual measures and objectives, in other words without some way to keep an overall score.
Tying bonuses to the balanced scorecard exacerbates the headache. If it doesnt affect pay, the reasoning goes, the scorecard will not likely affect behavior, and the investment will be for naught. Thus, it is tempting to think that the scorecard measures should help determine variable pay. But that is almost always a mistake because any of the individual metrics can be improved to the detriment of overall corporate value.
Michael C. Jensen, Jesse Isidor Straus Professor of Business Administration and Emeritus Harvard Business School Managing Director, put it this way (September 2000 EVA Institute, Fiuggi, Italy):
I have a simple rule when it comes to performance measurement. I have yet to find a counter-example. If it is a ratio, and it is a performance measure, it is wrong. So, if it is return on assets, its wrong. If it is unit cost, average cost, thats a ratio, and its wrong. Just remember that if it is a ratio, and if it is a performance measure, you are paying people to do bad things. Look at it carefully and you will figure it out.
The typical balanced scorecard is filled with ratios — defect rates, yield, days on hand, margins, customer satisfaction rates, and so forth. While such measures are undoubtedly useful for monitoring performance and adjusting plans, they are always misleading as corporate goals. Each of them only tells a part of the overall story.
In todays fast-paced economy, speed and flexibility are the hallmarks of successful companies. Yet, balanced scorecards can reduce a companys response time because they tend to entrench a particular set of metrics and milestones as company goals. Changing strategy is more difficult when it entails the added burden of retooling the scorecard. Tony Ebutts remarks (Motivating and Rewarding Managers Research Report. The Economist Intelligence Unit. 1999.):
Customer satisfaction and employee satisfaction are now two of our objective measures. That means youve got to start asking customers and employees exactly the same thing on a regular basis. Now, there are many times when I want to ask employees something different, but we have to keep standard measures. That way you keep it simple, but the price can be inflexibility.
Integrated EVA Scorecard
Fortunately, EVA can remedy these common scorecard deficiencies — the best way for any business to keep score. EVA is economic profit — profit the way that economists measure it. In the simplest terms, it is after-tax net operating profit, less a charge for using all capital equity as well as debt. What makes EVA so special and so powerful as a management tool is that it measures all of the ways that performance can be improved and wealth can be created. To increase EVA, managers will want to do things that will:
- Improve operating efficiency (by cutting costs and adding to profit without adding to capital);
- Enhance asset management (by reducing the investment in assets that earn less than the cost of the capital);
- Increase profitable growth (by making new investments that earn returns over the cost of capital); and
- Reduce the cost of capital (by implementing the most effective financial and investor relations strategies).
Renowned consultant Peter Drucker agrees that EVA encompasses the totality of business performance. In The Information Executives Really Need,2 Drucker wrote, EVA measures, in effect, the productivity of all factors of production.
Translation: EVA is the balanced scorecard. It is the measure that gives proper weight to and integrates all the pluses and minuses of a decision into a decisive overall score. For instance, EVA properly pits the benefit of greater customer satisfaction and sales revenue against the total operating and capital costs of servicing the additional business. Put another way, anything that anyone can do to do better must show up as an improvement in EVA. No other measure or combination of measures has that unique property.
EVA should be the overriding goal and unifying force in structuring balanced scorecards. Sadly, it is often overlooked. Robert Kaplan and David Norton, scorecard co-inventors, strongly concur with this crucial point (Kaplan, On Balance. CFO Magazine. February 2001):
We start with the destination. What are we trying to achieve? We feel that for-profit companies should be delivering great financial performance. Were certainly very comfortable with the newer financial metrics like EVA and other shareholder-based objectives as the overarching objective.
In the CFO article, Kaplan added: If you were just using earnings or net income, youd run into problems of over-investment — investing too much in capital to generate earnings or net income. Kaplan and Norton correctly recognize that selecting the right financial measure and using it as the overriding objective is critical to getting scorecards right; most companies have not done that.
To ensure that scorecards are constructed as the originators have intended, we propose to re-label them Integrated EVA Scorecards. Whats the difference? Essentially they are scorecards done right. One, increasing EVA is the paramount measure of success. EVA is placed at the pinnacle of the pyramid. Business strategies and operational excellence are subordinated to the goal of increasing the companys overall EVA profits. With this constraint, lofty business goals must prove their mettle in providing more EVA.
Second, a time dimension is introduced into the scorecard. Managers should be responsible for generating ideas and taking steps that will improve EVA in the near and long term. The overlapping twin peaks of the integrated scorecard delineate three successive time intervals: the budget period covering just next year; the medium-term period of two to three years; and the longer-range period of three to five years. By coding this timeline structure into the scorecard, managers are virtually forced to consider a wider range of actions and opportunities.
Of course, managers will always find ways to bolster EVA by improving the cost structure and asset utilization within their current business model. Such optimization programs come as naturally as breathing, and usually pay off quickly. But the time-arrayed scorecard also prompts managers to think about more challenging avenues, such as exploiting the profitable growth opportunities contained within their current business model. Such opportunities can arise from expanding the capacity to generate revenue, but also by making investments that lead to a lower-cost and/or higher-quality production function.
The biggest potential timeline payoff, however, is to help management avoid the innovators dilemma. As Harvard Professor Clay Christensen has noted, except for a rarified few, most companies have failed to create entirely new businesses or business models, especially in areas that might undermine their existing lines.3 Small, nimble upstarts almost always take away the industry lead from the established leaders. Wal-Marts overturning of Sears and Dells ascendancy in the PC business are two obvious examples. Placing an explicit responsibility on the scorecard for improving EVA over a three- to five-year horizon by making selective, experimental cannibalizing investments may be one way to encourage true innovation and longer-range thinking.
A third unique element to the integrated scorecard (indeed, it is what makes it integrated) is that the action steps, operational metrics, and strategic milestones that comprise the companys business plan are directly linked to the EVA twin peaks. This requires configuring the scorecard to induce a gradient or bias for actions that generate near- and long-term EVA improvements, something that again is consistent with best practices. If you look at the logic of the scorecard, the arrows all end up with financials, says co-innovator David Norton.4
Constructing the scorecard with an attitude, as Bennett Stewart like to put it, serves to remind managers that individual metrics and milestones, such as market share gains and faster cycle times, are not ends but means to the end of producing more economic profit. The scorecard metrics, managers realize, are useful to set direction and concentrate effort, and to pinpoint problems and uncover opportunities, but they are not goals per se. With this insight, managers have a powerful decision tool at hand. Rather than judging scorecard impact, they choose the actions that they believe will produce the greatest present value stream of future EVA.
Of course, people will pay the most attention to what they are paid to do. Accordingly, our final recommendation is to use EVA to determine the size of bonus pools throughout the company and to allow the bonus pool allocations to be influenced by the attainment of specific results on an individuals scorecard. That way everyone can work hard on the things they control without losing sight of their greater responsibility to contribute to EVA.
When EVA is fixed as the North Star in the scorecard, all the other metrics, milestones, and strategies can more easily rotate around it. By stating clearly what cannot change — the goal of creating more EVA — the integrated scorecard facilitates revisions where and when they are needed.
Figure 1: The Integrated EVA Scorecard via Hyperion Performance Scorecard
EVA Software Solution
Stern Stewart recommends beginning scorecard implementation by gaining a detailed understanding of the historical performance of the company and its competitors. What has been the intrinsic growth rate, rate of return, and value added of each of the companys markets? Are the industry sectors growing or shrinking in economic prominence? Is the company gaining or losing share of total industry value added? What are the underlying financial and operating characteristics that best separate industry winners from losers? Hyperion has developed Hyperion Performance Scorecard to help users link top management strategy to the action steps required to accomplish them and, in turn, to the people or teams responsible for carrying them out.
Figure 2: Layers of Information Architecture
Driven vs. Educated Workforce
Kaplan and Norton see the balanced scorecard as a good way to document, coordinate, and communicate the corporate strategy. Done well, a scorecard can be an indispensable aid to planning. But the Peter Principle often promotes the use of scorecards beyond their intended purpose: specifically, when managers begin to use them as decision tools. Instead of restraining the scorecards simply to chronicle strategy, some people take them too literally and begin to mold decisions around the metrics on the report. That is a mistake.
The tendency for scorecards to spill over into the decision-making realm is an unfortunate holdover from Industrial-era management. In the smokestack economy, workers below an elite corporate office were treated as functionaries who carried out orders and dutifully reported information and exceptions to the all-knowing top team for reaction. Mushroom management (keeping workers in the dark) required the top team to break down the complexities of the strategy and the financial trade-offs into a series of baby-sized ideas and operational measures suitable for an illiterate workforce.
We call this cynical management practice the driven workforce model. It says that employees ought to be herded to the best behaviors by stringing bright lights along the path they should follow. In the wrong hands, balanced scorecards simply prolong this lamentable tradition.
Todays economy is filled with empowered knowledge workers. An aristocratic, top-down, corporate-centric approach is not likely to be the best. Because todays workers thirst for knowledge and involvement, an appealing alternative is the educated workforce. It posits teaching managers and employees about finance, economics, value, and strategy. In short, adding to their companys stock of human capital. It proposes to engage them as active agents in processing information, making decisions, and even shaping strategy from the ground up. This approach builds loyalty to the firm and establishes a common language and framework that becomes a permanent part of the culture. It also decreases the necessity of using measures to substitute for an employees own judgment, analysis, and intuition. In short, education can substitute for metrics.
A company possessing knowledgeable workers can simply ask them to use their irreplaceable local knowledge and information base to take the decisions and adopt the strategies that will enhance shareholder wealth by increasing the firms EVA. Herb Kelleher at Southwest Airlines is one of the more obvious proponents of this highly decentralized approach (A Culture of Commitment. Herb Kelleher. Leader to Leader. Drucker Foundation Books. March 1999.):
Whats the secret to building a great organization? How do you sustain consistent growth, profits, and service in an industry that can literally change overnight? And how do you build a culture of commitment and performance? I can answer basically in two words: be yourself.
That is both a simple and a profoundly difficult goal. It means spending less time benchmarking best practices and more time building an organization in which personality counts as much as quality and reliability. A financial analyst once asked me if I was afraid of losing control of our organization. I told him Ive never had control and I never wanted it. If you create an environment where the people truly participate, you dont need control. They know what needs to be done, and they do it.
The freedom, informality, and interplay that people enjoy allows them to act in the best interests of the company. For instance, when our competitors began demanding tens of millions of dollars a year for us to use their travel agents reservations systems, I said, forget it; well develop an electronic, ticketless system so travel agents wont have to hand-write Southwest tickets — and we wont be held hostage to our competitors distribution systems.
It turned out that people from several departments had already gotten together, anticipated such a contingency, and begun work on a system, unbeknownst to me or the rest of our officers. That kind of initiative is possible only when people know that our companys success rests with them, not with me.
Such empowered employees can be trained to use software tools that will help them to project the outcomes they expect as they undertake various initiatives, and to choose the ones that will add the most to EVA regardless of the impact on other metrics. Developing a financially literate workforce has, until now, been a somewhat forbidding exercise. But online courses are making it possible to educate even a large workforce with engaging, high-quality finance training at an affordable cost.
Conclusion
The sine qua non of the new economy is software and the Internet. These two technologies codify and transfer knowledge and accelerate the pace of development and economic growth. Smart companies will tap into a whole range of new-economy resources to help them communicate, coordinate, train, and plan more effectively and, ultimately, to make better business decisions and increase shareholder value.
