Incentives and BSC

1. Incentives and BSC Managerial Accounting David Fender

2. Today What? We will look at incentives – pros and cons You will learn about the Balanced Scorecard Why? Because money makes the world go round

4. US humor

5. US humor

6. Let’s think about incentives What kind of incentives do you know? What is your experience?

7. Forms and types of compensation • Measurement of performance versus compensation • Bonuses • Based a contract • Subjective bonuses • Non-monetary compensation • Promotion/ Title bump • Salary increase

8. What is the primary objective of a firm’s compensation system? “What you measure gets done!”

9. What is the primary objective of a firm’s compensation system? • To attract talented people to a company (self-selection) • To provide incentives to make people exert and appropriately allocate effort in a manner consistent with the firms goals (i.e., to achieve goal congruence). • flat salary won’t work • must tie compensation to performance • Induce communication • Direct attention

10. Factors when determining compensation • What are potentially constraining factors (other factors) that you should consider when setting compensation?

11. Factors when determining compensation Potentially constraining factors: • Cost • Risk to employee and employer • Fairness • Equitable compensation (equity principle) • Transparency – comparability • Accountability

12. Fire

13. Financial performance measures have a lag time • What are you likely to see earlier? • Parts not fitting of a car coming down production line • Warranty claims

14. Example 1: CEO Motorola • CEO changed agenda of meetings – non-financial performance measures where covered first – he left when the hardcore money numbers where covered • Why? – he wanted to set a signal that when quality is achieved the financials will follow and that employees should focus on other numbers instead of money

15. Example 2: VW • Gap between car parts is a measure for quality of production – the less the better • VW had quality problems in 80s – CEO wanted to emphasize quality and measured gaps between car parts when cars rolled of the line

16. Non-financial performance measure • Nonfinancial performance metrics (NFP): • Variables not denominated in $$ but associated with value creation • Reliability may be low (e.g. customer satisfaction) • NFP should SUPPLEMENT, not replace financial measures •  Are often leading indicators of financial performance (relevance is high) •  Are often more actionable

17. What do I mean by more actionable? What’s the difference between CEO compensation and compensation for a production line supervisor? Why aren’t high-level financial metrics good performance measures to evaluate and reward the production line supervisor?

18. “Sensitive” What we need are performance measures that are “sensitive” to individual managerial actions.

19. Additional advantage of NFP • As a manager you need to connect to people • Other people might not speak “cost accounting”. Engineers speak a different language.

20. Balanced Score Card Balanced Score Card (BSC)

21. 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 its strategy • It is called the balanced scorecard because it balances the use of financial and nonfinancial performance measures to evaluate performance

22. Financial Goals Measures Customer Internal Goals Measures Goals Measures Innovation Goals Measures Balanced Scorecard (BSC) Bob Kaplan Harvard Business School Financial Perspective: How should we look to our shareholders? Internal Business Perspective: What must we excel at? Customer Perspective: How should we look to our customers? Innovation & Learning Perspective: How can we continue to improve and create value?

23. Balanced Scorecard (BSC) • No single measure can guide and motivate the actions to drive future performance. • Need to balance short-term performance with long-term growth opportunities. • BSC combines measures with short term and long term orientation AND • With short term and long term feedback

24. The Financial Perspective • Evaluates the profitability of the strategy • Uses the most objective measures in the scorecard • The other three perspectives eventually feed back into this dimension

25. The Customer Perspective • Identifies targeted customer and market segments and measures the company’s success in these segments

26. The Internal Business Prospective • Focuses on internal operations that create value for customers that, in turn, furthers the financial perspective by increasing shareholder value • Includes three sub processes: • Innovation • Operations • Post-sales service

27. The Learning & Growth Perspective • Identifies the capabilities the organization must excel at to achieve superior internal processes that create value for customers and shareholders

28. Why useful? • It tells the story of a company’s strategy by articulating a sequence of cause-and-effect relationships. • It helps identify trade-offs • It assists in communicating the strategy to all members of the organization by translating the strategy into a coherent and linked set of measurable operational targets. • The scorecard limits the number of measures used by identifying only the most critical ones (reduces complexity).

29. BSC and Strategy We proudly announce: Performance measures Strategy

30. Why? • Measuring success requires a well defined strategy • Why? • Defining a strategy gets easier with a balanced scorecard! • Why?

31. Then A balanced scorecard should have measuresthat are linked together on a cause-and-effect basis. If we improveone performancemeasure . . . Another desiredperformance measurewill improve. The balanced scorecard lays out concrete actions to attain desired outcomes.

32. How does BSC connect to strategy? • Identify and define what your business is • Identify measures of success by with different lag times • Transform this into financial success measures

33. SM and KPI Strategy map: A strategy map is a diagram that is used to document the primary strategic goals being pursued by an organization or management team. KPI: Key Performance Indicators are quantifiable measurements, agreed to beforehand, that reflect the critical success factors of an organization.

34. BSC and strategy in practice • Theory • The choice of measures should be a function of • the organization’s strategy and its corresponding value drivers • the measure’s informativeness about the achievement of organizational objectives (and/or about managers’ actions… more on this next time) • In reality, the choice of measures is poorly linked to strategy in many companies* • 69% attempted to link measures to strategy • However, only 22% attempted to rigorously make this link *Gates, “Aligning Strategic Performance Measures and Results” Source: C. Ittner, 2003 AIMA Conference

35. Financial Customer Internal Business Processes Learningand Growth The Balanced Scorecard ─ Jaguar Profit Contribution per car Number of cars sold Customer satisfactionwith options Number ofoptions available Time toinstall option Employee skills in installing options

36. Satisfaction Increases Increase Options TimeDecreases Increase Skills Profit Contribution per car Number of cars sold Results Customer satisfactionwith options Strategies Number ofoptions available Time toinstall option Employee skills in installing options

37. Cars sold Increase Satisfaction Increases The Balanced Scorecard ─ Jaguar Profit Contribution per car Results Number of cars sold Customer satisfactionwith options Number ofoptions available Time toinstall option Employee skills in installing options

38. ContributionIncreases Satisfaction Increases TimeDecreases The Balanced Scorecard ─ Jaguar Profit Results Contribution per car Number of cars sold Customer satisfactionwith options Number ofoptions available Time toinstall option Employee skills in installing options

39. ProfitsIncrease ContributionIncreases Cars Sold Increases The Balanced Scorecard ─ Jaguar Results Profit If numberof cars soldand contributionper car increase,profits increase. Contribution per car Number of cars sold Customer satisfactionwith options Number ofoptions available Time toinstall option Employee skills in installing options

40. Human pitfalls • Common measures bias • Managers default to financial numbers • Categorization • We think of people as either good or bad • Non-negativity bias • We do not want to give negative feedback • Fundamental attribution error • We just hate to be wrong

41. Citibank • Introduced BSC with subjective performance measures in the US • Few years later abandoned subjective measures and replaced them by objective measures • Measures created perception of unfairness among employees

42. Conclusion “I had hoped to be able to document the incidence and value of innovative accounting and control systems …” “I found that changes in accounting lag far behind changes in the real production phenomena they are supposed to represent.” “Effective managerial accounting systems must reflect the value-creating activities of companies: in operations, in marketing and sales, and in product and process development…”(Kaplan, 1985)

43. Take-Away • Why use incentives? • Balanced Scorecard • Groupincentives