Business
Management Issue
External
financial reporting and internal operational control represent two fundamentally
different functions. The former is guided by GAAP, tax laws, and the needs
of stockholders and are lagging performance indicators. Operational control,
on the other hand, is a leading performance indicator, and is guided by
business strategy, and how well customer expectations are met. Satisfying
these two needs are related but measured differently.
Reporting
that is focused only on investor results can have a counterproductive
impact on the longer term performance of the company (e.g., a focus solely
on short-term financial metrics may force decisions that impede company
agility to capture new market share). However, completely severing the
tie between external financial numbers and day to day operating metrics
is a mistake.
Art
Schneiderman, pioneer of the balanced scorecard concepts at Analog Devices,
claims that there is not and can not be a quantitative linkage between
non-financial and expected financial results - but there is a soft link.
Empirical research supports his claim. Several longitudinal studies verified
the lead-lag relationship at a point in time. For example, companies that
achieve fast cycle times later reported triple the revenue growth and
double the profits over industry average competitors. However, given the
many complex interactions between parts of the organization and the external
environment, a quantified linkage is a stretch.
Architecture
Impacts
Companies
need a business reporting architecture that ensures that the right information
is provided at the right time. As opposed to quantifying the lead-lag
relationship, focus should be on getting the lead information to decision-makers
to take appropriate action that will get desired lag results.
The
reporting architecture should direct behavior, evaluate performance against
preset goals, and provide information for adjusting the goals themselves
through a feedback process. In many cost accounting-based performance
measurement systems, this loop is not complete. Accounting variances,
rather than serving to update non-financial goals (i.e., efficiency standards),
are merely used to create adjusting entries for the general ledger. The
underlying assumption, of course, is that the standards are right and
operating reality is wrong. This assumption is at odds, for example, with
the goals of just-in-time manufacturing.
Whether
for an individual operation or the whole department, non-financial measures
such as on-time delivery, quality, cycle time and waste provide a complete
control loop. See the figure below.
Loop 1: Focusing in on the workgroup (or department) level, targets
are set (e.g., reduction of waste or cycle time, improvement in quality),
action takes place, and results are charted. Based on the results, process
adjustments are made to keep the system on track. These measures are timely,
and close to the point of action. Feedback can be used to accurately adjust
current activities. This is the definition of a complete control loop.
Loop
2: The core business process level (e.g. new product introduction,
order fulfillment and post sales service) actually consists of a double
set of controls: operating and financial. The operating controls are used
to evaluate how departments and teams work together in meeting core process
objectives.
Financial reporting completes the control loop used at this level, translating
the operating data into summary data for top management. For example,
as improvements in cycle time are made at the department level, this information
is passed up to the core process in a second performance feedback loop.
Adjustments are made to inventory to satisfy external financial reporting
needs and the information is fed back into the goal setting process (i.e.,
the goals are set more aggressively). The "time span" of decision-making
at this level is longer and executives should resist micro-managing and
leave that to the responsible workgroup.
Managers
at the core process level need only enough feedback to know when a problem
exists that is going to affect total period performance so that they can
put in place appropriate programs to improve performance.
Loop
3: Moving up the organization, the level of detail decreases markedly,
as does the definition, and realities, of the timeliness and frequency
of reporting cycles. For example, core process performance (e.g., # of
new products, time to market in new product introduction) is passed up
to the business unit level to evaluate how well strategies have been executed.
The
operating measures (and exceptions) provide a signal that financial and
marketing objectives may not be reached. The financial control loop verifies
this, after the fact. Here the market share and financial performance
of the business unit is reflected in the unit's profit and loss numbers,
asset turns, and revenues. Again, the financial results are translated
back into operational imperatives in the business system level. For example,
if asset return objectives for the business unit were not met, new programs
would be developed or emphasis added to the cycle time measures in the
business system to help improve financial performance.
Loop
4: The final feedback loop provides feedback on the corporate vision
itself. Top management receives information over time on how effectively
strategies have been executed and resources deployed. Total corporate
performance is compared to expectations. Markets and competitive tactics
are evaluated and adjusted as necessary.
In
summary, the information architecture should support whatever type of
reporting upper management wants. The detail is there, ready to be passed
up through the reporting hierarchy on demand. Each level has its own tightly
defined control loop as well as the means to access information from lower
levels through the integrated system. For example, if there is an increase
in product defects in loop 1, it will indicate future financial problems
and pinpoint whether the problem is related to execution (loop 1), process
design fault (loop 2) or strategy issue (loops 3 & 4).
Business
Management Response
Balanced
scorecard projects are predicated on the assumption that employee measures
on commitment and capability will lead to desired organizational capabilities
such as new product time-to-market, which in turn lead to customer results
in terms of quality, delivery, and price. These measures are the independent
variables at the core process level that drive the investor or financial/market
results at the business unit or corporate level (i.e., the dependent variables).
This assumption needs be taken on faith or 'fuzzy logic.' In other words,
companies need to focus on the non-financial indicators at all levels
because they represent in Schneiderman's words, 'the collective wisdom
of the organization that they will improve the odds of success'.
In
the case of Analog Devices, the leadership team focused on attracting
and retaining great designers, provided high visibility to new product
volume and time-to-market indicators, and paid attention to customer metrics
as well as the quality system to continuously improve them. Over the years,
these efforts have helped Analog improve production throughput rates (which
delayed the need for adding capacity) and accelerated new product development
- especially in the communications market (wireless applications and high
speed internet access).