20

Strategy,
Balanced
Scorecards and
Incentive Systems

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Learning Objective 1
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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.
20-4

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 Business and

learning and production Customer Financial
Lead Lead Lead
growth process value performance
efficiency

Leading indicators
20-5

Using Leading and Lagging Indicators

in Balanced Scorecards
Lagging indicators are measures of the final
outcomes of earlier management plans and
their execution.

Organizational Business and

learning and production Customer Financial
Lead Lead Lead
growth process value performance
efficiency
20-6

Communicating Strategy to
Employees
Many employees do not understand the impacts
of their activities on customer value and
profitability because their jobs are narrowly
defined or they do not interact directly with
customers. Communicating leading indicators in
a balanced scorecard can make the effects of
employees’ actions more visible.
20-7

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 Faster Increased More Better

employee Leads to loan Leads to customer Leads to loyal Leads to financial
training processing satisfaction customers results
20-8

A Balanced Scorecard’s Strategic

Performance Measures
Financial performance
How should we appear to
our shareholders?

Customer performance Vision Business and production

How should we appear to and process performance
At what business practices
our customers Strategy must we excel?

Learning and growth performance

How should we sustain our ability
to change and improve?
20-9

Learning Objective 2
20-10

Implementation of a Balanced
Scorecard
1. Organizational learning and growth
a) Employee training and education.
b) Employee satisfaction.
Organizational
learning and Business
growth and
Customer
1. Employee training Lead production Lead
value
2. Employee satisfaction process
3. Employee turnover

Lead
efficiency
4. Innovativeness
5. Opportunities for
improvement Financial
performance
20-11

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
20-12

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

20-13

Business and Production Process

Efficiency
Business and
production
process efficiency
Organizational 1. New service development
Customer
learning and Lead 2. Employee productivity and Lead
value
growth error rates
3. Service costs

Lead
4. Process improvements
5. Supplier relations
Financial
performance
20-14

Customer Value

Customer value
1. Customer satisfaction
Organizational Business and
2. Customer retention and
learning and Lead production process Lead
loyalty
growth efficiency
3. Market share
4. Customer risk

Lead
Financial
performance
 Evaluation of Measures of Customer
20-15

Value
Customer satisfaction survey – scale 1 to 5

4.5

3.5

2.5

1.5

0.5

0
Services meet Service superior to Employees respond Employees give Employees superior
customer needs competitors' service to special requests prompt service to competitors'
20-16

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 Business and
Customer
learning and Lead production process Lead
value
growth efficiency

Lead
Financial performance
1. New interest margin
2. Revenue growth
3. Customer profitability
4. Overall return on assets
20-17

Learning Objective 3
20-18

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. Choosing and validating measures
2. Training and interpretation activities
3. Managing many measures at once
20-19

Learning Objective 4
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How One Organization (a Bank)

Implemented a Balanced Scorecard
 The bank’s cost management team led the
implementation effort.
 The team drafted an initial sketch based on
the bank’s strategy and processes.
 Then employees from all over the bank took
part in designing the scorecard.
 After a year of interaction with other
employees, the team unveiled the scorecard.
 See previous slides for the measures chosen.
20-21

Learning Objective 5
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Fundamental Principles of Incentive

Systems
Pay for performance means that at least
some portion of a manager’s income is not
guaranteed but depends on measure(s) of
organizational performance.

An effective incentive system should motivate

employees to achieve the organization’s goals and
objectives and reward them if they do.
20-23
Role for Theories of Incentives and
Behavior Theory and Practice
Most individuals are motivated by
self-interest.
Organizations get the behavior they
reward.
Effort follows rewards.
Difficult but attainable goals
motivate best.
Fairness is a basis for sustained
motivation.
Manipulation undermines fairness
and effort.
Different rewards can motivate
effort.
Incentive systems involve trade-offs. Minimizing the overall costs of
Guideline
Performance-based rewards must
be greater than alternative rewards
from nonperformance.
Performance measures and related
rewards must reflect organizational
goals.
Employees must believe that their
efforts influence performance.
Impossible goals are de-motivators,
and so are easy goals. Make goals
difficult but not impossible.
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.
aligning goals and monitoring
behavior is a goal of incentive
system design.
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Learning Objective 6
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Features of Performance-Based
Incentive Systems
1. Absolute or 3. Financial or 5. Current or
relative nonfinancial deferred
performance? performance? rewards?

Performance-based
management incentive
system

2. Formula-based 4. Narrow or broad 6. Salary, bonus

or subjective responsibility of or stock
performance? performance? 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
individual’s performance to that of others.
20-27

Formula-Based or Subjective
Performance
 A performance evaluation formula computes
rewards earned for specific achievements.
 Subjective performance evaluation uses non-
quantified 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
Adding nonfinancial measures to the incentive system
 Gets managers to focus on the leading indicators of
profit
 Gives recognition of the time lags between
nonfinancial and financial performance
20-29

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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Current or Deferred Rewards

 Rewards can be given now, based on current
performance (immediate cash bonus when
residual income increases in this period).
 These rewards are closely linked with a manager’s
present efforts and the organization’s present
performance.
 The performance criteria can be subjected to
manipulation.
 Or rewards can be given later if sustained
performance is desired (cash or stock rewards
payable at the end of several years).
 They encourage managers to stay for a while.
 They help managers focus on the long term (as
long as it is not too remote).
20-31

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 – the most liquid and immediate

2. Stock awards – usually not redeemable right away
3. Stock appreciation rights – confer a bonus to
employees based on increases in stock price for a
predetermined number of shares
4. Stock options – give an individual the right to
purchase a number of shares at a specified price over
a specified time period
20-32

Learning Objective 7
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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
ultimately it is difficult to mandate integrity or
ethical behavior.
20-34

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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Learning Objective 8
20-36
Theories of Incentives and Behavior
Expectancy theory (from
applied psychology)
 People are motivated to
act in ways that they
expect to provide them
with desired rewards and
to prevent the penalties
they wish to avoid.
 So incentive plans must:
 Provide the proper
rewards and penalties
 Make it likely that the
desired behaviors will
lead to those rewards or
penalties
Agency theory (from
financial economics)
 An employee contracts
with an employer to
perform certain work, and
the employer wants to be
sure that the work is duly
and well performed.
 So incentive plans must:
 Motivate the employee
to work
 Align the employee’s
goals with the
employer’s
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End of Chapter 20