On Performance Management

As the energy industry evolves, leveraging business intelligence becomes ever
more important. The well-publicized problems of major energy traders over the
last year have spurred a renewed emphasis on steady earnings derived from tangible
assets and have underscored the importance of managing risk across the entire
spectrum of a company’s activities.

In such an environment, the strategic imperatives of reducing costs, controlling
risk, and monitoring the performance of the business portfolio become clear.
Enterprise performance management (EPM) can help organizations leverage information
to optimize value by offering a framework to identify a company’s strategic
imperatives and by developing the best measures for monitoring progress and
enabling decision-making relative to those imperatives.

There is no shortage of enterprise-level performance measures to choose from.
They include relatively recent and well-publicized measures such as economic
value added (EVA), which is the Stern Stewart approach described in “The Quest
for Value,” and the Holt Value Associates method known as cash flow return on
investment (CFROI). More traditional measures include return on invested capital
(ROIC) and earnings per share.

It would not be surprising for companies to feel some degree of confusion over
what the “right” measures are. Add to this the tendency for practitioners to
come up with the next big thing and the tendency for some firms to promote their
own measures, and the issue gets foggier still.

There is no perfect measure or set of measures — all have pros, cons,
and limitations that need to be understood. Assuming any of the measures a company
may use today possesses some fundamental merit, what ultimately matters is that
its use is understood and will get used by the organization.

In our experience, laying the groundwork for a successful program involves
the following key steps, which we’ll discuss in more detail:

• Identify the users and the intended use.
• Map the organization’s strategy, goals, and initiatives to develop the
right measures for that organization.
• Set realistic, meaningful targets that can be aligned with individual
compensation.
• Gain buy-in of the performance management initiative throughout the project.
• Keep the performance management framework simple, yet comprehensive.
• Plan for implementation from day one.

Identifying Users and Use

It is important to understand who will be using the measures and what they’ll
be used for. We have found it useful to classify measures into two categories:
enterprise-level and operational-level.

Enterprise-level measures are those used by CXOs and business unit heads in
managing the business portfolio. They provide the information necessary for
capital allocation and investment/divestment decisions and are concerned with
optimizing enterprise performance. The sensitivity of this information is greater
than at the operational level and demands a higher degree of security in its
handling.

Operational-level metrics, on the other hand, are concerned with optimizing
operational performance at the business unit, department/process, and employee
level. At the plant level, an example would be operating and maintenance cost
per megawatt-hour, and at the employee level, the percentage of time maintenance
personnel spend on productive work (often referred to as wrench time). Operational
measures are necessarily related to enterprise-level measures, as top-level
corporate performance will be driven by the performance of the operating units.

Executives also need to know what the measures will be used for and how to
use them. While this may seem obvious in principle, it is, in our experience,
less obvious in practice. In discussions we’ve had with corporate executives,
a common reprise is, “I get too many measures from too many sources — what
am I supposed to do with all of these?”

Effective measures should enable the decision-making for which they are intended
(for example, portfolio composition decisions and capital allocation decisions)
and should present sufficient information to provide a “pulse” of the enterprise
and trend progress toward achieving strategic objectives.

Presentation and context are particularly important; we have found that an
accompanying analysis describing the recent performance of a particular measure
can be extremely beneficial in helping executives interpret performance and
make (or not make, or delay) decisions.

We recommend that at an enterprise-level, the number of performance measures
be kept to no more than 10, and fewer would be fine.


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Figure 1: Levels of Performance Measures

The Right Measures

For any organization, the right measures to use are those that gauge a company’s
progress toward achieving its strategic objectives. In developing the right
measures for a company or organization, the use of a strategy map greatly facilitates
the discussion necessary to drive a select group of performance measures. The
tool, developed by Robert S. Kaplan and David P. Norton and discussed extensively
in “The Strategy-Focused Organization,” is typically best used as part of interviews
and workshops with executive stakeholders to develop the organization’s strategy,
objectives, and initiatives.

A strategy map can assist in actually developing the company’s strategy, but
is typically used to link a company’s strategy, or strategic themes, with measurable
strategic objectives and appropriate performance measures. For example, an organization’s
strategic theme could be to “deliver shareholder value within the top quartile
of its competitors through a balanced business model.”

Particular strategic objectives to deliver this performance could be to maintain
predictable cash streams or optimize the asset base. The associated performance
measures could include free cash flow and ROIC. Of course, one could question
whether these are the ideal measures for the intended purpose. Perhaps knowledgeable
practitioners would view other metrics, such as EVA, as more useful.

Regardless, the introduction of free cash flow and ROIC represents a step forward
from a strict earnings-per-share mentality and should be viewed as progress
toward driving value-based behavior within the organization.

Good practices related to effective performance measure development and implementation
include:

• Focus on the vital few — keep the number of measures to a minimum.
• Provide a balanced set of measures.
• Leading versus lagging (i.e., predictive versus backward-looking)
• Financial and nonfinancial
• Objective and subjective (e.g., safety versus corporate perception)
• Ensure measures reflect stakeholder requirements.
• Provide a dashboard view of the measures.

Using these “good practices,” a balanced-scorecard approach comprising financial
and nonfinancial measures works well for developing an effective performance
management framework. Common nonfinancial measures are those used to gauge the
effectiveness of corporate initiatives, but for which information does not come
from the financial statements. In our work, we have helped clients with the
following categories of measures (examples of measures are shown in parentheses):

Customer-Related

• Market share (total megawatt-hour sales in a given region)
• Revenue growth (annualized revenue growth rate, overall and by customer
class)
• Customer profitability (net income per megawatt-hour sold by customer
class)
• Customer satisfaction (index based on weighted average of national percentile
rankings among residential, commercial, and key account customers)

Internal/Process-Related

• Risk management (value at risk, or VaR)
• Asset utilization (return on assets, or ROA)
• Environmental compliance (NOx and SOx emissions)

Employee-Related

• Leadership development (number of successors that possess the skills,
knowledge, and experience required to fill a leadership position)
• Safety (OSHA-recordable case rate)
• Job satisfaction (employee turnover)

While we consider these types of measures as representative and appropriate
within the energy industry, particularly at the senior-executive level, each
company’s individual business strategy and needs should ultimately shape the
final selection of suitable performance measures. For example, enterprise risk
management has become a primary issue for almost every major energy company.

This focus has resulted in the need to develop a scorecard that quantifies
measures and targets, inclusive of risk alerts across every relevant category
applicable to the business. Key categories of risk may include financial, market,
credit, environmental, organizational, and operational. We have worked with
energy companies to develop a scorecard from the overall scorecard for the business.


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Figure 2: Strategy Map

Realistic, Meaningful Targets

Target-setting can be a contentious issue in many organizations. After all,
once a target is set, there are implications to missing it as well as exceeding
it, and there are always the questions over what type of conduct the target
may really be driving. Related to this is the concept of tying targets to incentive
compensation, which is necessary but can be equally problematic. That being
said, it is clear that a company needs to establish targets if it hopes to have
any control over achieving its performance objectives.

For financial measures such as free cash flow and ROIC, some companies use
internally generated targets derived from the company’s annual budget or forecast.
Figures for individual business units may initially be difficult to obtain,
depending on how the company rolls up its numbers, but can usually be generated
for at least the major business units. Internal targets can typically be monitored
and measured on a monthly basis since information comes directly from the financial
statements and company systems. A monthly reporting capability provides a company
with significant information from which to understand and guide performance.

Externally generated targets also play an important role in performance management.
Such targets can be generated by benchmarking performance against competitors
from a peer group comparable in size, business composition, and strategy and
then targeting the top quartile value from the peer group.

These targets add an additional dimension to performance measurement against
internal targets, especially for measures that by nature are relative versus
absolute (e.g., measures that are expressed as a percentage, such as ROIC, versus
free cash flow or earnings). For these types of measures, the internally generated
target tells the company how well it’s doing relative to its own goals, while
the external target tells it if it could be doing even better in comparison
to the company’s peers.

For either internal or external targets, it’s necessary to make sure that the
targets chosen don’t act to produce undesired conduct. ROIC, for example, can
be increased in the short term by deferring needed investments, but at the cost
of inefficient plant or factory performance and costly breakdowns. Targets like
this need to be balanced with additional lower-level metrics, such as process
efficiency and cost measures, quality, and capacity utilization measures.

Buy-In and Managing Change

Implementing an enterprise performance management framework can be a significant
change in the way executives and managers evaluate business and employee performance.
As a result, continuous communication and feedback must occur to develop performance
measures that are accepted and embraced. When users are involved in the development
process, they gain a better understanding of the company’s strategy and the
reasons for selecting the particular performance measures.

Figure 3: Sample Financial Measure for Utilities

Be Simple, Yet Comprehensive

The best measures for a given company are those it will actually use and understand.
For this reason, performance measurement and management should be approached
as an evolutionary process, where the introduction of more sophisticated measures
occurs in stages rather than all at once. Using this approach permits flexibility
in establishing and modifying performance measures as necessary over time.

In one case, a large client active in generation, transmission, distribution,
and trading resisted an EVA approach due to the complexities of implementation
and acceptance by users, especially as it applied to the regulated side of the
business. Progress in driving value-based conduct eventually came by achieving
buy-in on ROIC and free cash flow, derived from standard financial statements.

For resistant organizations, deriving measures based on readily available accounting
information requiring little additional manipulation is advisable. We have developed
a maturity profile that scores companies on various components of their performance
management program, which include the type of performance measures currently
in place, the degree to which measures have been cascaded through the organization,
the integrity and timeliness of the data, the governance structure associated
with the program, and the data available through existing systems.

When used as a diagnostic tool at the beginning of a project, the insights
gained can help determine the receptivity of the company to new measures, its
ability to implement them, and potential opportunities for improvements. In
Figure 4, the outer line represents “best practice” level of performance (Level
4), while a company’s actual performance in a given area would be shown at a
level between one and four.

Figure 4: Performance Management Maturity Model

Implement from Day One

Measures need to be timely and cost-effective. Most large corporations close
their books monthly and have a well-defined schedule as to what data will be
available when. Knowing this schedule as well as the degree of additional manipulation
required to produce a given measure can be a great help in determining the timeliness
with which measures can be delivered to their audience.

Obtaining the necessary data from existing systems is ideal. In doing so, it
is wise to assess the suitability of installed accounting and information systems
in delivering the required data. In some instances, current systems deliver
only limited information (e.g., earnings by business unit) on a quarterly basis.
Measures such as free cash flow and ROIC may require information on a monthly
basis from the balance sheet, income statement, and cash flow statement, depending
on how they have been defined, which may be beyond the ability of some systems.

For more sophisticated measures such as EVA and CFROI, additional data manipulation
beyond what is available in financial reporting systems will be required. Having
an owner for each measure with the responsibility for producing the required
calculations by a certain date every month, for example, will foster accountability.


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Figure 5: Displaying Performance Measures

The foregoing considerations point to the need for a gap analysis and formal
governance model. A simple gap analysis derived from interviews with accounting
and finance personnel is a useful tool in assessing data needs and availability,
while a governance model designed with the input of key stakeholders (e.g.,
those with responsibility for producing the measures) and detailing, at a minimum,
the timing of data and measure availability, accountability, data integrity,
and required security features, will clarify roles and responsibilities.

Web technology provides an ideal delivery vehicle. IBM Business Consulting
Services has used a main page showing a view of all of the measures in a scorecard
format, with the possibility for alerts on each measure to inform management
when targets are exceeded or missed. There should also be a separate primary
view for each measure in graphical format and with accompanying analysis. From
this view, “drill downs” can be designed to view the measure at a greater level
of detail (e.g., to view its composite components) or to see the relative contribution
of various business units. There are several other ways to deliver the final
information.

To repeat a premise stated at the beginning of this article, the best measures
are those that are understood and get used. To help ensure the right measures
are defined and leveraged, we offer the following guidelines that summarize
several of the key points and practices already discussed:

• Obtain client sponsorship at the highest levels of the organization.
• Keep primary stakeholders involved throughout the process.
• Keep recommended measures set to a “vital few.”
• Establish business owners/champions for each measure.
• Use a strategy map as a tool for prompting discussion and identifying
the “right set” of measures for a company.
• Determine that the performance management framework is simple yet comprehensive,
and flexible and adaptable to meet evolving information requirements.

By maintaining a focus on simplicity and usability, companies will be well-positioned
for success as they undertake their performance management effort.