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Strategy, Balanced Scorecards, and Incentive Systems


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Using Leading and Lagging Indicators in Balanced Scorecards


Leading indicators are measures that identify future nonfinancial and financial outcomes to guide management decision making.
Organizational learning and Lead growth Business and production Lead process efficiency

Customer value

Lead

Financial performance

Leading Indicators
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Using Leading and Lagging Indicators in Balanced Scorecards


Lagging indicators are measures of the final outcomes of earlier management plans and their execution.
Organizational learning and Lead growth Business and production Lead process efficiency

Customer value

Lead

Financial performance

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Balanced Scorecard
Balanced scorecards are performance measurement systems or business models that tie together knowledge of strategy, processes, activities, and operational and strategic performance measures. An incentive system communicates strategy, motivates employees, and reinforces achievement of organizational goals.
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Communicating Strategy to Employees


Many employees do not understand the impacts of their activities on customer value and profitability because their jobs are narrow or they do not interact directly with customers. Communicating leading indicators in a balanced scorecard can make the effects of employees more visible.

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Motivating Employees and Evaluating Performance


Visible leading indicators can contribute to employees improved motivation and commitment. At a commercial bank the following sequence may be effective.
Increased employee training Faster loan processing Increased customer satisfaction More Better loyal Leads to financial customers results

Leads to

Leads to

Leads to

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A Balanced Scorecards Strategic Performance Measures


Financial performance
How should we appear to our shareholders?

Customer performance
How should be appear to our customers

Vision and Strategy

Business and production process performance


At what business practices must we excel?

Learning and growth performance


How should we sustain our ability to change and improve?
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Implementation of a Balanced Scorecard


1.

Organizational Learning and Growth


a) Employee Training and Education. b) Employee Satisfaction.

Organization learning and growth

1. Employee training.
2. Employee satisfaction. 3. Employee turnover. 4. Innovativeness. 5. Opportunities for improvement.

Lead

Business and production process efficiency

Lead

Customer value Lead

Financial performance
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Evaluation of Measures of Organizational Learning and Growth


Consider the information in this table:

Incremental profit = Total benefits Total costs Break-even profit = 0 = 9X - $240,000 9X = $240,000

Break-even benefit level, X = $26,667 per year


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Evaluation of Measures of Organizational Learning and Growth


Information in this table considers the time value of money

Break-even profit = .909X + .826(2X) + .751(3X) + .683(2X) + .621(X) 1.000($80,000) - .909($80,000) - .826($80,000) Break-even benefit level, X = $32,170 per year rounded
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Business and Production Processes Efficiency


Business and Production Process Efficiency 1. New service development. 2. Employee productivity and Lead error rates. 3. Service costs. 4. Process improvements. 5. Supplier relations.

Organizational learning and Lead growth

Customer value Lead Financial performance

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Customer Value
Customer Value 1. Customer satisfaction. 2. Customer retention and loyalty. 3. Market share. 4. Customer risk. Lead

Organizational learning and Lead growth

Business and production process Lead efficiency

Financial performance

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Evaluation of Measures of Customer Value


Customer satisfaction survey scale 1 to 5
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0
Services meet customer needs
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Service superior to Employees respond competitors' service to special requests

Employees give prompt service

Employees superior to competitors'


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Financial Performance
Financial measures of performance tend to be the most objective measures because most organizations have dedicated significant resources to ensure the validity of their financial performance measures.
Organizational learning and Lead growth Business and production process Lead efficiency Customer value Lead

Financial Performance 1. New interest margin. 2. Revenue growth. 3. Customer profitability. 4. Overall return on assets.
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Benefits and Costs of a Balanced Scorecard


Benefits of a balanced scorecard
1. Encourages all employees to consider the impacts of their decisions on profitability. 2. Appears to work in various types of organizations.

Costs of a balanced scorecard


1. Measurement costs. 2. Education costs. 3. Use costs.
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Fundamental Principles of Incentive Systems


Pay for performance means that at least some portion of a managers income is not guaranteed but depends on measure(s) of organizational performance.
An effective incentive system should motivate employees to achieve the organizations goals and objectives and reward them if they do.

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A Role for Theories of Incentives and Behavior


Theory and Practice Most individuals are motivated by self-interest

Guideline Performance-based rewards must be greater than alternative rewards from nonperformance Organizations get the behavior they Performance measures and related reward rewards must reflect organizational goals Effort follows rewards Employees must believe that their efforts influence performance Difficult but attainable goals Impossible goals are de-motivators, motivate best and so are easy goals. Make goals difficult but not impossible Fairness is a basis for sustained motivation Manipulation undermines fairness and effort Different rewards can motivate effort Rewards must be linked to desired performance in a fair manner Performance measures must be observable and verifiable Rewards must meet market conditions, and rewards must be available Incentive systems involve trade-offs Minimizing the overall costs of aligning goals and monitoring behavior is a goal of incentive The McGraw-Hill Companies, Inc. 2006 system design

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Features of Performance Based Incentive Systems


1. Absolute or relative performance? 3. Financial or nonfinancial performance? 5. Current or deferred rewards?

Performance-based management incentive system


2. Formula-based or subjective performance? 4. Narrow or broad responsibility of performance? 6. Salary or bonus rewards?

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Absolute or Relative Performance

Absolute performance evaluation compares individual performance to set objectives or expectations. Relative performance evaluation compares an individuals performance to that of others.

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Formula-Based or Subjective Performance


A performance evaluation formula computes rewards earned for specific achievements. Subjective performance evaluation uses nonquantified criteria not captured by formulas.
Evaluation Group

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Financial or Nonfinancial Performance


Financial performance reflects the achievement of financial goals, such as . . .

Cost control. Revenue growth. Earnings. Residual income. Gets managers to focus on the leading indicators of profit. Gives recognition of the time lags between nonfinancial and financial performance.
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Adding nonfinancial measures to the incentive system,

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Narrow or Broad Responsibility of Performance


Incentives work best when individuals see a strong link between their actions and performance results. Many companies reward division managers for both business-unit and companywide performance.

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Salary, Bonus, or Stock Rewards


Some companies stress salary while others stress performance-based compensation. Some common performance-based compensation plans include:
1. Cash bonuses. 2. Stock awards. 3. Stock appreciations rights confers a bonus to employees based on increases in stock price for a predetermined number of shares. 4. Stock options gives an individual the right to purchase a number of shares at a specified price over a specified time period.
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Ethical Aspects of Incentives and Compensation


A mismatch of executive pay and firm performance has been widely observed in many types of organizations. In some cases, the mismatch is the result of poorly designed incentive systems that generate high rewards even when stockholders lose money.

It is likely that regulatory actions will more closely align executive pay and performance, but it ultimately it is difficult to mandate integrity or ethical behavior.

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Incentive Plans in Nonprofit Organizations


Despite differences between for-profit and nonprofit organizations, nonprofit organizations increasingly use features of executive incentive plans developed in the private sector.

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End of Chapter 20

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