6640 06102014 Summary Performance Measurement and Control Systems for Implementing Strategy

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Robert Simons - Performance Measurement and Control Systems for Implementing Strategy

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Performance Measurement & Control Systems for implementing Strategy Robert Simons (2000)

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Part 1: Foundations for implementing Strategy Chapter 1: Organizational Tensions to be managed Managers rely on performance measurement and control systems to set direction, make strategic decisions and achieve desired goals. Performance measurement and control systems are formal, information based routines and procedures managers use to maintain or alter patterns in organizational activities. 1. The purpose of performance measurement and control systems is to convey information 2. Represent formal routines and procedures 3. Are designed to be used by managers 4. Are used by managers to maintain or alter patterns in organizational activities Profit planning systems Accounting systems collect information about the transactions of business Internal control systems – The set of procedures that dictate how and by whom information should be recorded and verified. Provides the checks and balances that ensure that assets are safeguarded and the information collected and processed by the accounting system is accurate. Profit plan is a summary of future financial inflows and outflows for a specified future accounting period. Profit plans are supported by planning systems – recurring procedures to routinely disseminate planning assumptions, gather market information, provide details about relevant analysis and prompt managers to estimate resource needs and performance goals and milestones. Performance measurement systems Business strategy refers to how a company creates value for customers and differentiate itself from competitors in the marketplace Business goals are the measurable aspirations that managers set for a business. Goals are determined by the reference to business strategy. Performance measurement systems assist managers in tracking the implementation of business strategy by comparing actual results against strategic goals and objectives. Two questions should be answered by designers of PM systems: 1. What type of information should be collected at which frequency? 2. How should the information be used? Five major tensions in implementing PM and control systems:


1. 2. 3. 4.

Balancing profit, growth and control Balancing short-‐term results against long term capabilities and growth opportunities Balancing performance expectations of different constituencies Balancing opportunities and attention a. Return on management (ROM) = amount of productive organizational energy released / amount of management time and attention invested 5. Balancing the motives of human behaviour Chapter 2: Basics for successful strategy Corporate strategy defines the way that the company attempts to maximize the value of the resources it controls. Business strategy, by contrast, is concerned with how to compete in defined product markets. PM and control systems are important for the successful implementation of both. Five forces that determine the degree and nature of competition: 1. 2. 3. 4. 5.

Customers Suppliers Substitute products New entrants Competitive rivalry

Items on the firms balance sheet Asset is a resource, owned or controlled by the entity that will yield future economic benefits. Current assets include cash, marketable securities, accounts receivable, inventory and prepaid expenses. Productive assets are used to produce goods and services for customers A resource is more broadly defined as a strength of the business embodied in the tangible or intangible assets that are tied semi permanently to the firm. Distinctive internal capabilities: 1. Functional skills 2. Market skills 3. Embedded resources Four p’s of strategy: 1. 2. 3. 4.

Strategy as perspective As position As plan As patterns of actions


Mission refers to the broad purpose or reason that a business exists. Good missions inspire and provide sense of direction for the future Chapter 3: Organizing performance Organizational structure are the basic building blocks of the organization, the grouping of the people into work units and the working relationships among these group that collectively comprise a business. Two reasons to impose structure: 1. To facilitate work flows 2. To focus attention A work unit represents a group of individuals who utilize the firm’s resources and are accountable for performance. Two types: 1. Engaged in similar work process and 2. Focused on a specific market. Accountability defines (1) the output that a work unit is expected to produce and (2) the performance standards that managers and employees of that unit are expected to meet. Market focus are found in three basic configurations: 1. Units clustered by products 2. Units clustered by customer 3. Units clustered by geography Clustering units by function or market brings different benefits and costs. Managers cluster units by function when the benefits of specialization are greater then the benefits of market responsiveness. Span of control indicates how many (and which) subordinates and functions report to each manager in the organization. But span of control does not tell us what they are accountable for. Span of accountability describes the range of performance measures and evaluates a manager’s achievements. Cost centre accountability: managers of cost centres are only accountable for their unit’s level of spending. Profit centre accountable: Broader span of accountability. Not only accountable for costs but also for revenues and, often, for assets as well. Three structural design levers to organize business: 1. Work units 2. Span of control 3. Span of accountability These design levers have the purpose to influence the Span of attention: refers to the domain of activities that are within a manager’s field of view. Within centralized firms


managers have a narrow span of attention. In decentralized firms managers have a wide span of attention. Chapter 4: Using information for performance measurement and control One of the primary purposes of performance measurement and control is to allow fact-‐ based management: management that moves from intuition and hunches to analysis based on hard data and facts. In terms of implementing strategy the information is of two types: 1. Information about progress in the achievement of goals 2. Information about emerging threats and opportunities. Both types provide useful feedback which is essential for conducting and update SWOT analysis based on changing competitive dynamics and internal capabilities. Organizational process model All organizational processes can be decomposed into: input – process – output. To gain control over this process the following things are needed: 1. A standard or benchmark which to compare actual performance 2. A feedback channel to allow information on variances to be communicated and acted upon. Managers must focus their performance measurement and control activities on either the transformation process itself or the outputs being produced. In order to make a choise the following four criteria must be considered: 1. 2. 3. 4.

Technical feasibility of monitoring and measurement Understanding cause and effect Cost Desired level of innovation

Total Quality Management (TQM) is a approach that represents the standardization and streamlining of key operating processes to ensure high levels of quality and/or low defect rates. Five categories of information purposes: 1. 2. 3. 4.

Decision making Control Signalling Education and learning 5. External communication


Part 2: Creating performance measurement systems

Chapter 5: Building a plan A budget refers to the resource plans of any organizational unit that either generates or consumes resources. Objectives of creating profit plans and budget: 1. To translate the strategy of the business into a detailed plan to create value 2. To evaluate whether sufficient resources are available to implement the intended strategy 3. To create foundation to link economic goals with leading indicators of strategy implementation. To build a profit plan managers need to answer three questions: 1. Does the organization’s strategy create economic value? 2. Does the organization have enough cash to fund the strategy and remain solvent throughout the year? 3. Does the organization create enough value to attract the financial resources that it needs to fund long-‐term investment in new assets? Three wheels of profit planning To answer the above questions and design a profit plan, three distinct analysis must be performed. There are three cycles that managers must analyse to build a profit plan: the profit wheel, the cash wheel and the ROE wheel. The foundation of profit planning is built upon assumptions about how the future will look.


The profit wheel: Value creation is measured by profit. The profit plan summarizes the expected revenue inflows and expense outflows for a specified future accounting period. Five steps for creating a profit plan using the profit wheel as illustrated above: 1. 2. 3. 4. 5.

Estimate the levels of sales Forecast operating expenses Calculate expected profit Price the investment in New Assets Close the profit wheel and test key assumptions

The cash wheel: Before a profit plan can be accepted as feasible, managers must forecast whether the company will have enough cash to operate (cash wheel) and whether the return to invenstors is sufficiently attractive (ROE wheel). The cash wheel illustrates the operating cash flow cycle of a business: sales of products and services to customers generate accounts receivable, which are eventually turned into cash; this cash is used to produce inventory, which in turn can be used to generate more sales.


Forecasting cash needs is important for all businesses because companies have limited cash reserves and borrowing capacity. The most intuitive way to estimate cash requirements is to forecast the cash inflows and cash outflows for each specific time period. Operating cash needed during a period = cash received from customers -‐ cash paid to suppliers and operating expenses. (direct cash flow method). To estimate cash needs over longer periods of time companies generally use the indirect method: 1. 2. 3. 4.

Estimate net cash flows from operations Estimate cash needed to fund growth in operating assets Price the acquisition and divestiture of long-‐term assets Estimate financing needs and interest payments.

ROE wheel: Businesses that earn the most profit will be better off: they have more resources to invest in future opportunities, they will be able to pay higher dividends to investors, their stock price will be higher and their cost of debt will be lower. The single most important measure for investors is the Return on Investment (ROI), which is a ratio measure of the profit output of the business as a percentage of financial investment inputs. If we adopt the perspective of managers then the appropriate internal measure for return on investment is Return on Equity (ROE). To calculate the ROE wheel: 1. Calculate the overall return on equity ROE = Net income / Shareholder equity. 2. Estimate the asset utilization 3. Compare the project ROE with industry benchmarks and investor expectations Managers must use the three wheels to evaluate the economics and internal consistency of each of these strategies. Chapter 6: Evaluating Strategic profit performance To analyse profit performance, the three conditions enumerated in chapter 4 must be present: 1. Ability to measure outputs 2. Existence of a predetermined standard of performance 3. Ability to use variance information as feedback to adjust inputs and/or process.


Strategic profitability analysis is a tool to evaluate the success of a business in generating profit from implementing its strategy. The first step in profitability analysis is to isolate significant deviations from expectations using variance analysis. Once simple profit variances have been calculated the business strategy must be tested and validated. Strategic profitability comprises two components as defined in the following formula: Strategic profitability = profit (loss) from competitive effectiveness + profit (loss) from operating efficiencies. Competitive effectiveness can be determined via market share variance analysis or revenue variances. Operating effectiveness can be determined by calculating no variable costs. Profit plans can be used for performance evaluation: the comparison between expected and actual performance serves to inform managers about the effort that subordinates have put into achieving goals described in the profit plan. Chapter 7: Designing asset allocation systems An asset allocation system is the set of formal routines and procedures designed to process and evaluate requests to acquire new assets. They provide a number of benefits: 1. They provide a framework and set of categories into which asset proposals can be grouped 2. They include analytical tools that can be tailored to different types of assets 3. They provide guidelines that help managers throughout the organization to understand how their proposals relate to the strategy of the business. There are no GAAP (generally accepted accounting principles for designing asset allocation systems. Senior managers typically specify limits on the types of capital expenditures that will be approved. Asset allocation procedures should specify a process by which proposals are evaluated and approved. These procedures typically set out: 1. The analyses needed to document a request 2. The process by which proposals will be gathered and reviewed by top managers 3. A time frame each year during which managers will consider formal requests for new assets. Spending limits, defined according to managerial position and span of accountability, are a common way of limiting discretion. Assets by category:


1. Assets to meet safety/health/regulatory needs 2. Assets to enhance operating efficiencies and/or increase revenue 3. Assets to enhance competitive effectiveness Chapter 8: Linking performance to markets All businesses produce products or services to sell to third-‐party customers. In some instances however, business units sell their products or services to other divisions or business units within the same firm. A transfer price is an internally set transaction price to account for the transfer of goods or services between divisions of the same firm. Transfer prices are used to value and coordinate the work flows of interdependent organization units that are each held accountable for financial performance. Two ways for setting transfer prices: 1. Transfer prices using market data, equal prices as market prices 2. Transfer prices using internal cost data. The success of any corporate strategy is reflected in corporate performance, which refers to the firm’s level of achievement in creating value for market constituents. Ultimately corporate performance is determined by the achievement of business goals across the different business units of a firm. They key constituents of value creation form a corporate performance perspective are: 1. Customers 2. Suppliers 3. Owners and creditors. Chapter 9: Building a balanced scorecard The balanced scorecard communicates multiple, linked objectives that companies must achieve to compete based on their intangible capabilities and innovation. Managers can build a balanced scorecard using the following steps: 1. Develop goals and measures for critical financial performance variables a. The indicate whether the implementation of plans or initiatives is contributing to profit improvement. 2. Develop goals and measures for critical customer performance variables a. Customer satisfaction, customer retention, customer loyalty. 3. Develop goals and measures for critical internal process performance variables. a. Identify the critical internal processes for which the organization must excel in implementing its strategy (innovation, operation, post sales service process). 4. Develop goals and measures for critical learning and growth performance variables. a. People, systems and organizational procedures. 5. Use the balances scorecard for communicating strategy


The four perspectives of the balanced scorecard permit a balance (1) between short and long-‐term objectives (2) between external measures – for shareholders and customers – and internal measures for critical business processes, innovation and learning and growth (3) between desired outcomes and performance drivers of those outcomes and (4) between hard objective measures and softer, more subjective measures. The balanced scorecard is a complement, not a supplement, for an organization’s other performance measurement and control systems.

Part 3: Achieving profit goals and strategies

Chapter 10: Using diagnostics and interactive control To understand how to communicate and control strategy effectively, we differentiate between two different types of control systems: (1) Diagnostic control systems and (2) interactive control systems. The distinction between the two is solely the way how managers use these systems. Diagnostic control systems are used as levers to communicate critical performance variables and monitor the implementation of intended strategies. Interactive control systems are used to focus organizational attention on strategic uncertainties and provide a lever to fine-‐tune and alter strategy as competitive markets change. We define diagnostic control systems as the formal information systems that managers use to monitor organizational outcomes and correct deviations from pre-‐set standards of performance. Any informal system can be used diagnostically if it is possible to (1) set goals in advance, (2) measure outputs, (3) compute or calculate performance variances, (4) use that variance information as feedback to alter inputs and/or process to bring performance back in line with pre-‐set goals and standards. Two reasons for using systems diagnostically: 1. To implement strategy effectively – Measure critical performance variables: those factors that must be achieved or implemented successfully for the intended strategy of the business to succeed. Without diagnostic control systems managers could neither communicate nor implement strategy effectively in large complex organizations. 2. Conserve scarce management attention – Management by exception. To operate diagnostic control systems effectively managers must ensure that they devote sufficient attention to five areas: setting goals, aligning performance measures designing incentives, reviewing exception reports and following up significant exceptions. Risks in using diagnostic control systems: -‐

Measuring the wrong variables


-‐ -‐

Building slack into targets Gaming the system

Interactive control systems give managers freedom to concentrate on growing the business, enhancing profitability, and positioning products and services in rapidly changing markets. They are the formal information systems that managers use to personally involve themselves in the decision activities of subordinates. They provide the information that the boss pays a lot of attention to and are used to create an ongoing dialogue with subordinates. They are designed by how managers use these system. To focus the organization on these strategic uncertainties, managers chose one or more performance measurement and control systems and use it in a highly interactive way. Strategic uncertainties are the emerging threats and opportunities that could invalidate the assumptions upon which the current business strategy is based. By focussing on strategic uncertainties managers can use the interactive control process to guide the search for new opportunities, stimulate experimentation and rapid response, and maintain control over what could otherwise be a chaotic process. An interactive control system is not a unique type of control system: any control system can be used interactively by senior managers if it meets certain requirements: 1. The information contained in an interactive control system must be simple to understand 2. Interactive control systems must provide information about strategic uncertainties 3. Interactive control systems must be used by managers at multiple levels of the organization 4. Interactive control systems must generate new action plans. Factors that influence the choice of system to which managers devote their attention: 1. 2. 3. 4.

Technical dependence Regulation Complexity of value creation Ease of tactical response

Managers choose to use only one system interactively for three reasons: (1) economic, (2) cognitive and (3) strategic. Incentives for interactive control systems must be designed to reward an individual’s innovative effort and contribution. This can only be done by subjective assessment. Subjective rewards yield three outcomes that help organizational learning: 1. Reward contribution and effort provides incentives for employees to make their effort visible to their superiors 2. Rewarding contribution and effort, rather than result, reduces information biasing that is a constant concern in diagnostic control systems


3. Rewarding contribution subjectively demands that superiors have the ability to calibrate the efforts of subordinates accurately.


Chapter 11: Aligning performance goals and incentives Objectives or targets incorporate measurement standards and time frames against which to gauge progress and success. Goals and objectives can only be made actionable when measurement is attached to any set of aspirations. Performance goals denote a desired level of accomplishment against which actual results can be measured. Measures will communicate a different set of priorities and allow subordinates to infer the strategic direction that top managers wish to follow. Critical performance variables are critical to the successful implementation of the strategy. Factors that must be achieved or implemented successfully for the intended strategy of the business to succeed. To ensure that performance goals are achieved managers must design measures for desired outcomes. A measure is a quantitative value that can be scaled and used for purposes of comparison. In order to determine if a measure is suitable to support a performance goals, it must be subjected to three tests: 1. Does it align with strategy? 2. Can it be measured effectively? 3. Is the measure linked to value? A rule of thumb: effective managers provide focus and impact by insisting that individuals be accountable for no more performance measures than they can recall from memory: all things in live are configured in sevens. As part of the goals setting process, managers must choose the target or desired level of achievement. To set performance goals effectively, managers need to know which firms are the standard for the most effective utilization of resources. Then, they must calibrate their own efforts against this ‘best of class’ yardstick Motivation by performance goals: 1. Goals should be challenging but not unrealistic 2. Employees should participate in goals setting until a certain level Performance goals are important for planning and coordination to ensure (1) adequate levels of resources, (2) workflow coordination among interdependent units. (3) Performance goals also act as early warning signals for managers when operation begin to run off track. (4) They also serve as post evaluation of accomplishment mechanism. Managers can enhance intrinsic motivation in a variety of ways: 1. They can emphasize the positive ideals and beliefs of the business so that employees want to contribute to the overall mission.


2. The can assure attention to gaol achievement through a formal incentive. That is a reward or payment that is expected to motivate performance (bonus pool, allocation formula) 3. Types and mix of incentives (gifts, prizes, awards of company stock). Chapter 12: Identifying strategic risk Strategic risks is an unexpected event or set of conditions that significantly reduces the ability of managers to implement their intended business strategy. There are three basic sources of strategic risk that potentially affect every business: 1. Operations risk, results from the consequences of a breakdown in a core operating, manufacturing or processing ability. Often triggered by employee errors. 2. Asset impairment risk, an asset becomes impaired if it loses a significant portion of its current value because of a reduction in the likelihood of receiving those future cash flows. a. Financial impairment, results from decline in market value b. Impairment of intellectual property rights, unauthorised use of intellectual property by competitors c. Physical impairment 3. Competitive risk, results from change in the competitive environment that could impair the business’s ability to successfully create value and differentiate its products or services. Franchise risk is not a source of risk, instead it is a consequence of excessive risk in any of the three basic risk dimensions. It occurs when the value of the entire business erodes due to a loss in confidence by critical constituents. Many of the pitfalls of risk management can be avoided if early warning systems are in place to warn managers of impending problems. Three main causes of risk: Risk due to growth, risk due to culture, risk due to information management. The risk exposure calculator analyses the pressure points inside a business that can cause strategic risk to blow up into a crisis.


One special case: misrepresentation due to fraud can occur when three conditions exist simultaneously: 1. Pressure, 2. Opportunity and 3. Rationalization Chapter 13: Managing strategic risk Much of the risks that are described are caused by the management’s use of aggressive performance goals and incentives to get the organization up to speed, just like a driver who steps hard on the gas pedal. Strategic risks are managed primarily by communicating effective boundaries-‐ both business conduct and strategic – and installing good internal control systems. Core values are the beliefs that define basic principles, purpose and direction. They are needed to inspire commitment and stimulate engagement in the right type of activities. Belief systems are the explicit set of organizational definitions that senior managers communicate formally and reinforce systematically to provide basic values, purpose and direction for the organization. Basic ways for controlling human behaviour: 1 telling them what to do. 2 Hold people accountable for outcomes. Managers must go one step beyond missions and inspirational beliefs: they must install brakes by clearly communicate to all employees the behaviour and opportunities that are off-‐limit. To implement strategy successfully managers inspire their employees to maximize


effort and innovation by: (1) creating shared beliefs and mission, (2) setting challenging goals, (3) linking incentives to accomplishment and (4) declaring certain actions off-‐limit. Three categories of internal controls: 1. Structural safeguards, are designed to ensure clear definition of authority for individuals handling assets and recording accounting transactions (i.e. segregation of duties, defined levels of authorization, physical security for valuable assets, independent audit). 2. System safeguards, are designed to ensure adequate procedures for transaction processing as well as timely management reports (i.e. accurate record keeping, restricted access, timely management reporting). 3. Staff safeguards, are designed to ensure that accounting and transaction processing staff have the right level of expertise, training and resources (i.e. rotation in key jobs, adequate expertise for accounting and control staff). Strategic boundaries implicitly define the desired market position for business. They are essential to achieve maximum performance potential but any static strategy is doomed to failure over time. The brakes must be adjusted periodically to ensure that they are properly aligned with changes in technology, industry dynamics and new ways of creating value in the market place. They are often communicated as part of a formal planning process: 1. 2. 3. 4.

Minimize the levels of financial performance Minimum sustainable competitive position Products and services that do not draw on core competencies Market positions and competitors to be avoided.



Chapter 14: levers of control for implementing strategy Control of business strategy is achieved by integrating the four levers of belief systems, boundary systems, diagnostic control systems and interactive control systems. The power of these levers in implementing strategy does not lie in how each is used alone, but rather in how they complement each other when used together. Strategy can be described as a plan, a pattern of actions, a product-‐market position, or a unique perspective. Intended strategies are the plans that managers attempt to implement in a specific product market based on analysis of competitive dynamics and current capabilities. Emergent strategies by contrast are strategies that emerge spontaneously in the organization as employees respond to unpredictable threats and opportunities through experimentation and trial and error. Realized strategies are the outcome of both streams. Diagnostic control systems are the essential management tools for transforming intended strategies into realized strategies: they focus attention on goal achievement for the business and for each individual within the business. They relate to ‘strategy as a plan’ and allow managers to measure outcomes and compare results with pre-‐set profit plans and performance goals. Interactive control systems give managers tools to influence the experimentation and opportunity-‐seeking that may result in emergent strategies. These systems relate to ‘strategy as patterns of action’. The belief systems of the organization help to inspire both intended and emergent strategies. These systems relate to ‘strategy as a pattern of actions’ and create direction and momentum to fuse intended and emergent strategies together and provide guidance and inspiration for individual opportunity-‐seeking. Boundary systems ensure that realized strategies fall within the acceptable domain of activity. Boundary systems control ‘strategy as position’, ensuring that business activities occur in defined product markets and at acceptable levels of risk. Strategic control is not achieved through new and unique performance measurement and control systems but through belief systems, boundary systems, diagnostic control systems and interactive control systems working together to control both implementation of intend strategies and the formation of emergent strategies.


The levers of control must be phased in over the life cycle of the firm to effectively balance profit, growth and control. 1. Stage 1: start-‐up: an intimate sense of purpose pervades the business: commitment is achieved by sense of enthusiasm about the new product or service. There is little need for formal control systems 2. Stage 2: rapid growth: Senior managers must decentralize decision making by creating decentralized accountability structures, such as market based profit centres. Several additional controls are now needed. Managers must create and communicate their core values using formal belief systems. Second, managers must clarify and communicate strategic boundaries. Third, accounting measures must focus not only on profitability but also on the assets used to generate those profits. 3. Stage 3: maturity: Senior managers must now learn how to rely on the opportunity-‐ seeking behaviour of subordinates for innovation and new strategic initiatives. Managers should make one or more control system interactive. The levers of control can be used to: 1. Drive strategic turnaround 2. Drive strategic renewal


3. Focus on strategic uncertainties 4. Achieving profit goals and strategies.


6640 06102014 Summary Performance Measurement and Control Systems for Implementing Strategy

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