CHAPTER 7

THE BALANCED SCORECARD: A TOOL TO IMPLEMENT STRATEGY

THE BALANCED SCORECARD

The balanced scorecard translates an organization's mission and strategy into a
set of performance measures that provides the framework for implementing the
strategy. The balanced scorecard does not focus solely on achieving financial
objectives. It also highlights the nonfinancial objectives that an organization
must achieve to meet its financial objectives.
The scorecard measures an organization's performance from four perspectives:
(1) financial, (2) customer, (3) internal processes, and (4) learning and growth. A
company's strategy influences the measures it uses to track performance in
each of these perspectives.
Strategic information using critical success factors such as growth in sales and
earnings, cash flow, stock price, market share, product quality, customer
satisfaction, and growth opportunities provides a road map for a firm to chart its
competitive course and serves as a benchmark for competitive success. To
emphasize the importance of using strategic information, both financial and
nonfinancial, accounting reports of a firm's performance are now often based
on critical success factors in different dimensions.
Financial performance measures summarize the results of past actions and are
important to a firm's owners, creditors, employees and so forth. Nonfinancial
performance measures concentrate on current activities which will be the
drivers of future financial performance. Thus, effective management requires a
balanced prospective on performance measurement, a viewpoint that some
call the "balanced scorecard" perspective. The balance scorecard integrates
performance measures in four key areas:
(1) financial perspective,
(2) customer satisfaction,
(3) internal business processes, and
(4) innovation and learning.

A Balanced Scorecard consists of an integrated system of performance

measures that are derived from and support the company's strategy. Different
companies will have different balanced scorecards because they have
different strategies. A well-constructed balanced Scorecard provides a means
for guiding the company also provides feedback concerning the effectiveness
of the company's strategy.
It is called the balances scorecard because it balances the use of financial and
nonfinancial performance measures to evaluate short-run and long-run
performance in a single report. The balanced Scorecard reduces managers;
emphasis on short-run financial performance, such as quarterly earnings. That's
because the nonfinancial and operational indicators, such as product quality
and customer satisfaction, measure changes that a company is making for the
long run. The financial benefits of these long-run changes may not appear
immediately in short-run earnings, but strong improvement in nonfinancial
measures is an indicator of economic value creation in the future.
The balanced Scorecard is depicted in Figure 7-1.

Figure 7-1: The Balanced Scorecard

FOUR PERSPECTIVES OF THE BALANCED SCORECARD

(1) Financial Perspective. Measures of profitability and market value among

others, as indicators of how well the firm satisfies its owners and shareholders.
These financial measures show the impact of the firm's policies procedures on
the firm's current financial position and therefore its current return to the
shareholders.
Objectives Measures

Revenue Growth: Percentage of revenue from new

Increase the number of new products products Percentage of revenue from
new
Create new applications
Applications
Develop new customers and markets
Percentage of revenue from new
Adopt a new pricing strategy sources
Product and customer profitability
Cost Reduction: Unit product cost
Reduce unit product cost Unit customer cost
Reduce unit customer cost Cost per distribution channel
Reduce distribution channel cost

Return on investment
Asset Utilization: Economic value added
Improve asset utilization

(2) Customer Satisfaction. Measures of quality service and low cost, among
others, as indicators of how well the firm satisfies its customers.

Objectives Measures

Core: Increase market share Market share (percentage of market)

Increase customer retention Percentage growth of business from

Number of new customers existing customers Percentage of

repeating customers
Increase customer acquisition Increase
customer satisfaction Increase Ratings from customer surveys
customer profitability Customer profitability

Performance Value: Price

Decrease price Post purchase costs

Decrease post purchase costs Ratings from customer surveys

Improve product functionality Percentage of returns
Improve product quality On-time delivery percentage
Increase delivery reliability Aging schedule
Ratings from customer surveys
Improve product image and
reputation

3. Internal Business Processes. Measures of the efficiency and effectiveness with

which the firm produces the product or service.

Objectives Measures

Innovation: Increase the number of Number of new products vs. planned

new produces Increase proprietary Percentage revenue from proprietary
products products

Decrease new product development Time to market (from start to finish)

time
Quality costs Output yields Percentage
of defective units Unit cost trends
Operations: Increase process quality Output/input(s) Cycle time and
velocity MCE

Increase process efficiency

Decrease process time First-pass yields Cost trends
Output/input Cycle time

Post sales Service:

Increase service quality
Increase service efficiency

Decrease service time

(4) Innovation and Learning. Measures of the firm's ability to develop and utilize
human resources to meet the strategic goals now and into the future.
Objectives Measures
Increase employee capabilities
Increase motivation and alignment Employee satisfaction ratings
Increase information systems Employee turnover percentages
capabilities Employee productivity (revenue /
employee) Hours of training
Strategic job coverage ratio
(percentage of
critical job requirements filled)
Suggestions per employee
Suggestions implemented per
employee
Percentage of processes with real-time
feedback capabilities
Percentage of customer-facing
employees
with on-line access to customer and
product information

Figure 7-2: Illustrative Balanced Scorecard

The Balanced Scorecard for XYZ Inc., for the Year 20X3
(Revenues in 20X1-Revenues in 20X0 + Revenues in 20X0 = (P28,750,000 -
P27,000,000) + P27,000,000 = 6.48%.
Customers increased from 40 to 46 in the year 20X1. • Yield Units of CM1
produced + Units of CM1 started x 100 = 1,150,000 + 1,450,000 x 100 = 79,3%
Features of a Good Balanced Scorecard
1. The balanced scorecard should tell the story of a company's strategy by
articulating a sequence of cause-and-effect relationships. For example, if the
objective of XYZ Manufacturing Co. is to be a low-cost producer with emphasis
on growth, the balanced scorecard describes the specific objectives and
measures in the learning and growth perspective that lead to improvements in
internal business processes. These would lead to increased customer satisfaction
and market share as well as higher operating income and shareholder wealth.
Each measure in the scorecard is part of a cause-and effect chain, a linkage
from strategy formulation to financial results.

2. It helps to communicate the strategy to all members of the organization by

translating the strategy into a coherent and linked set to understand
measurable operational targets. Managers and employees are guided
scorecard and take actions and make decisions that aim to achieve the
company's strategy.

3. In for-profit companies, the balanced Scorecard places strong emphasis

financial objectives and measures. When financial and nonfinancial
performance measures are linked, many of the nonfinancial measures serves as
leading indicators of future financial performance.

4. The balanced Scorecard should focus only on key measures to be used by

identifying only the most critical ones.

5. The scorecard should highlight suboptimal tradeoffs that managers may

make when they fail to consider operational and financial measure together.

Pitfalls in Implementing a Balanced Scorecard

Pitfalls to avoid in implementing a balanced Scorecard include the following:

1. Don't assume the cause-and-effect linkages are precise. They are merely
hypotheses. Over time, a company must gather evidence of the strength and
speed of the linkages among the nonfinancial and financial measures.

2. Don't seek improvements across all of the measures all of the time. Tradeoff
may need to be made across various strategic goals. For example, strive for
quality and on-time performance but not beyond a point at which further
improvement in these objectives may be inconsistent with long-run profit
maximization.

3. Don't use only objective measures in the balanced Scorecard. The balanced
scorecard should include both objective measures (such as operating income
from cost leadership, market share and manufacturing yield) and subjective
measures (such as customer and employee satisfaction ratings). When using
subjective measures, though, management must be careful to trade off the
benefits of the richer information these measures provide against the imprecision
and potential for manipulation.

4. Don't fail to consider both costs and benefits of initiatives such as spending on
information technology and R&D before including these objectives in the
balanced scorecard. Otherwise, management may focus the organization on
measures that will not result in overall long-run financial benefits.

5. Don't ignore nonfinancial measures when evaluating managers and

employees. Managers tend to focus on what their performance is measured by
excluding nonfinancial measures when evaluating performance reduce the
significance and importance that managers give nonfinancial measures.

6. Don't use too many measures. It clutters the balanced Scorecard and takes
attention away from the measures that are critical for implementing strategy.

Evaluating the Success of a Strategy

To evaluate the success income into company’s strategy, we analyze changes

in operating into components that can be identified with growth, product
differentiation, and cost leadership. Subdividing the change in operating
income evaluate the success of a company's strategy is similar to variance
analysis. The Focus here, however, is on comparing actual operating
performance over two different time periods and explicitly linking it to strategic
choices. A company is considered to be successful in implementing its strategy
when the amounts of the product differentiation, cost leadership, and growth
components align closely with its strategy.
The following analytical relationships may be used:

1. Growth component
The calculations for the growth component are similar to Sales-Volume or
Quantity Factor.

Revenue effect of growth component (Quantity Factor)

Actual units of output sold this year Pxx
Less: Actual units of output sold last year xx
Increase (Decrease) xx
Multiply by: Output price last year xx
Favorable (Unfavorable) Pxx

Cost effect of growth component

Actual units of input or capacity that would
have been used to produce this year's output
assuming the same input-output relationship
that existed last year Pxx
Less: Actual units of inputs or capacity xx
to produce last year's output
Increase (Decrease) Pxx
Multiply by: Input prices last year xx
(Favorable) Unfavorable Pxx

• This will be computed for each cost element such as direct materials cost,
conversion costs, selling and customer-service cost.
2. Price-Recovery component
Revenue effect of price-recovery component (Price Factor)

Output price this year Pxx

Less: Output price last year xx
Increase (Decrease) in Output price Pxx
Multiply by: Actual units of output sold this year xx
Favorable (Unfavorable) Pxx

Cost effect of price-recovery component*

Input prices this year Pxx
Less: Input prices last year xx
Increase (Decrease)* Pxx
Multiply by: Actual units of inputs or capacity
that would have been used to produce this
year's output assuming the same input-output
relationship that existed last year xx
(Favorable) Unfavorable Pxx
* To be computed for each cost element.

3. Productivity component

Actual units of inputs or capacity

used to produce this year's output Pxx
Less: Actual inputs or capacity that would
have been used to produce this year's
output assuming the same input-output
relationship that existed last year xx
Increase (Decrease) Pxx
Multiply by: Input price last year xx
Favorable (Unfavorable)* Pxx
*Favorable if it increases operating income. Unfavorable if it decreases operati
income.

Problem 7-1: Strategy; Balanced Scorecard; Strategic Analysis

Income; Identifying and Managing Unused Capacity

Metro Corporation makes a special-purpose machine OM used in the textile.

Metro has designed the OM machine for 20X3 to be distinct from its Xitors. It has
been generally regarded as a superior machine. Metro presents e following
data for the years 20X2 and 20X3.

Metro produces no defective machines, but it wants to reduce direct materials

usage per OM machine in 20X2. Conversion costs in each year depend on
production capacity defined in terms of OM units that can be produced, not
the actual units of OM produced. Selling and customer-service costs depend on
the number of customers that Metro can support, not the actual number of
customers Metro serves. Metro has 75 customers in 20X2 and 80 customers in
20X3. At the start of each year, management uses its discretion to determine the
number of design staff for the year. The design staff and costs have no direct
relationship with the quantity of OM produced or the number of customers to
whom OM is sold.

Required:
1. Is Metro's strategy one of the product differentiation or cost
Explain briefly.
2. Describe briefly key elements that you would include in Metro's balance
scorecard and the reasons for doing so.
3. Calculate the operating income of Metro Corporation in 20X2 and 20X3.
4 Calculate the growth, price-recovery; and productivity components then
explain the change in operating income from 20x2 to 20X3.
5. Comment on your answer in requirement 4. What do these components
indicate?
6. Where possible, calculate the amount and cost of unused capacity for (a)
manufacturing, (b) selling and customer service, and (c) design at the
beginning of the year 20x3 based on year 20X3 production. If you could not
calculate the amount and cost of unused capacity, indicate why not.
7. Suppose Metro can add or reduce its manufacturing capacity in increments
of 30 units. What is the maximum amount of costs that Metro could save in 20X3
by downsizing manufacturing capacity?
8. Metro, in fact, does not eliminate any of its unused manufacturing capacity.
Why might Metro not downsize?

Answer:
1. Metro Corporation follows a product differentiation strategy in 20X3. Metro's
OM machine is distinct from its competitors and generally regarded as superior
to competitors' products. To succeed, Metro must continue to differentiate its
product and charge a premium price.

2. Balanced Scorecard measures for 20x3 follow:

Financial Perspective
(1) Increase in operating income from charging higher margins
(2) Price premium earned on products

These measures indicate whether Metro has been able to charge premium
prices achieve operating income increases through product differentiation.

Customer Perspective
(1) Market share in high-end special-purpose textile machines
(2) Customer satisfaction
(3) New customers

Improvements in these customer measures are leading indicators of superior

financial performance.

Internal Business Process Perspective

(1) Manufacturing quality
(2) New product features added
(3) Order delivery time

Improvements in these measures are expected to result in more satisfied

customers and in turn superior financial performance.

Learning and Growth Perspective

(1) Development time for designing new machines
(2) Improvements in manufacturing processes
(3) Employee education and skill levels
(4) Employee satisfaction Improvements in these measures have a cause-and-
effect relationship with improvements in internal business processes, which in turn
lead to customer satisfaction and financial performance.

3. Operating income for each year is as follows:

4. The Growth Component
Direct materials costs that would be required in 20x3 to produce 210 units
instead of the 200 units produced in 20X2, assuming the 20X2 input-output
relationship continued into 20X3, equal 315,000 kilogram (300,000 + 200 x 210).
Manufacturing conversion costs and selling and customer-service costs will not
change since adequate capacity exists in 20X2 to support year 20X3 output and
customers. R&D costs would not change in 20X2 if Metro had to produce and
sell the higher 20X3 volume in 20X2.

The cost effects of growth component are:

Direct materials costs (315,000 - 300,000) X P8 = P120,000 U
Manufacturing conversion costs (250 - 250) X P8,000 = 0
Selling and customer-service costs (100 - 100) P25,000 = 0
Design costs (12-12) x P100,000 = 0
Cost effect of growth component P120,000 U

In summary, the net increase in operating income as a result of the growth

component equals:

Revenue effect of growth component P400,000 F

Cost effect of growth component 120,000 U
Increase in operating income due to growth component P280.000 F

The Price-Recovery Component

Direct materials costs (P8.50
Manufacturing conversion costs
Selling and customer-service costs
Design costs
Total cost effect of price-recovery component
-P8) x 315,000 = P157,50 U
(P8,100 – P8,000)X 250 = 25,000 U
(P9,900 - P10,000) x 100 = 10,000 U
(P101,000 - P100,000) x 12 = 12.000 U
P184.500 V

In summary, the net increase in operating income as a result of the price

recovery component equals:

Revenue effect of price-recovery component P420,000 F

Cost effect of price-recovery component 184,500 U
Increase in operating income due to price-recovery component P235.500 F

The Productivity Component

5. The analysis of operating income indicates that a significant amount of the

increase in operating income resulted from Metro's product differentiation
strategy. The company was able to continue to charge a premium price white
growing sales. Metro was also able to earn additional operating income by
improving its productivity.

6. The amount and cost of unused capacity at the beginning of year 20x3
based on year 20X3 production follows:

• The absence of a cause-and-effect relationship makes identifying unused

capacity for discretionary costs difficult. Management cannot determine the
R&D resources used for the actual output produced to compare R & D capacity
against.
7. Metro can reduce manufacturing capacity from 250 units to 220 (250 - 30)
units. Metro will save 30 x P8,100 = P243,000. This is the maximum amount of costs
Metro can save in 2013. It cannot reduce capacity further (by another 30 units
to 190 units) because it would then not have enough capacity to manufacture
210 units in 20X3 (units that contribute significantly to operating income).
8. Metro may choose not to downsize because it projects sales increases that
would lead to a greater demand for and utilization of capacity. Metro may
have also decided not to downsize because downsizing requires a significant
reduction in capacity. For example, Metro may have chosen to downsize some
more manufacturing capacity if it could do so in increments, of say, 10, rather
than 30 units. Also, Metro may be focused on product differentiation, which is
key to its strategy, rather than on cost reduction. Not reducing significant
capacity also helps to boost and maintain employee morale.

Internal Business Process Performance

Most of the performance measures are self-explanatory. However, three are
delivery cycle time, throughput time, and manufacturing cycle efficiency
(MCEY These three important performance measures are discussed below.

Figure 7-3: Delivery Cycle Time and Throughput

(Manufacturing Cycle) Time
Delivery Cycle Time. The amount of time from when an order is received from a
customer to when the completed order is shipped is called delivery time cycle.
This time is clearly a key concern to many customers, who would like the delivery
cycle time to be as short as possible. Cutting the delivery cycle time may give a
company a key competitive advantage - and may be necessary for survival.
Consequently, many companies would include this performance measure on
their balance scorecard.
Throughput (Manufacturing Cycle) Time. The amount of time required to raw
materials into completed products is called throughput time, or manufacturing
cycle time. The relation between the delivery cycle time and the through
(manufacturing cycle) time is illustrated in the diagram above.

As shown in the diagram, the throughput time, or manufacturing cycle time, is

of process time, inspection time, move time, and queue time. Process is the
amount of time work is actually done on the product. Inspection time e the
amount of time spent ensuring that the product is not defective. Move time is
the time required to move materials or partially completed products from
workstation to workstation. Queue time is the amount of time a product spends
waiting to be worked on, to be moved, to be inspected, or to be shipped.
As shown at the bottom of the diagram, only one of these four activities adds
value to the product-process time. The other three activities - inspecting, moving,
and queuing-add no value and should be eliminated as much as possible.

Manufacturing Cycle Efficiency (MCE). Through concerted efforts to eliminate

the non-value-added activities of inspecting, moving, and queuing, some
companies have reduced their throughput time to only a fraction of previous
levels. In turn, this has helped to reduce the delivery cycle time from months to
only weeks or hours. Throughput time, which is considered to be a key measure
in delivery performance, can be put into better perspective by computing the
manufacturing cycle efficiency (MCE). The MCE is computed by relating the
value-added time to the throughput time. The formula is:

MCE = Value-added time/ Throughput (manufacturing cycle) time

If the MCE is less than 1, then non-value-added time is present in the production
process. An MCE of 0.5, for example, would mean that half of the total
production time consisted of inspection, moving, and similar non-value-added
activities. In many manufacturing companies, the MCE is less than 0.1 (10%),
which means that 90% of the time a unit is in process is spent on activities that
do not add value to the product. By monitoring the MCE, companies are able
to reduce non-value added activities and thus get products into the hands of
customers more quickly and at a lower cost.

Illustrative Problem 7-2: Measures of Internal Business Process

Southwest Company keeps careful track of the time relating to orders and their
production. During the most recent quarter, the following average tin recorded
for each unit or order:

Days

Wait time 17.0

Inspection time 0.4

Process time 2.0

Move time 0.6

Queue time 5.0

Goods are shipped as soon as production is completed.

REQUIRED:

1. Compute the throughput time, or velocity of production.

2. Compute the manufacturing cycle efficiency (MCE).

3. What percentage of the production time is spent in non-value-added

activities?

4. Compute the delivery cycle time.

Solution:

1. Throughput time = Process time + Inspection time + Move time +Queue time

= 2.0 days + 0.4 days + 0.6 days + 5.0 days

 = 8.0 days

2. Only process time is value-added time; therefore the computation of the MCE
would be as follows:

MCE = Value-added time/ Throughout Time = 2.0 days/8.0 days = 0.25

Thus, once put into production, a typical unit is actually being worked on only
25% of the time.

3. Since the MCE is 25%, the complement of this figure, or 75% of the production
time, is spent in non-value-added activities.

4. Delivery cycle time = Wait time + Throughput time = 17.0 days + 8.0 days =
25.0 days