Chapter 7 THE Balanced Scorecard A TOOL TO Implement Strategy (SOFT COPY) PDF

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CHAPTER 7THE BALANCED SCORECARD: A TOOL TO IMPLEMENT STRATEGYTHE BALANCED SCORECARDThe 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 ac...

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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 products Percentage of revenue from new

Increase the number of new products Create new applications Develop new customers and markets Adopt a new pricing strategy

Applications Percentage sources

of

revenue

from

new

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) Percentage growth of business from

Increase customer retention Number of new customers

existing customers repeating customers

Percentage

Increase customer acquisition Increase from customer customer satisfaction Increase Ratings Customer profitability customer profitability Performance Value:

Price

Decrease price

Post purchase costs

Decrease post purchase costs

Ratings

from

customer

of

surveys

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 reputation

image

and

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 Post sales Service: Increase service quality Increase service efficiency Decrease service time

First-pass yields Cost Output/input Cycle time

trends

(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 Increase capabilities

information

Employee satisfaction ratings Employee turnover percentages systems Employee productivity (revenue / employee) Hours of training Strategic job (percentage of

coverage

ratio

critical job requirements Suggestions per employee

filled)

Suggestions employee

implemented

per

Percentage of processes with real-time feedback capabilities Percentage employees

of

customer-facing

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-andeffect 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 Manufacturing conversion costs

(P8.50

-P8) x 315,000 = P157,50 (P8,100 – P8,000)X 250 = 25,000 U

Selling and customer-service costs

(P9,900 - P10,000) x 100 = 10,000 U

Design costs

(P101,000 - P100,000) x 12 = 12.000 U

Total cost effect of price-recovery component

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.