Module 4 Learning Summary:

Measuring and Monitoring Performance

Key Takeaways
• Businesses can implement strategy as plans by using diagnostic control systems
that allow them to measure and monitor performance.
• Examples of diagnostic control systems include:
♦ Performance scorecards
♦ Expense center budgets
♦ Project monitoring systems
♦ Brand revenue/market share monitoring systems
♦ Human resource systems
♦ Standard cost-accounting systems.
• Well-designed diagnostic control systems allow managers to put much of the
work of performance measurement on “autopilot,” freeing up their scarce time
and attention and alerting them only to deviations from expected performance.
• To implement “management by exception” effectively, a business needs to
develop a set of clearly defined, pre-set performance goals, which provide a
benchmark by which to identify those deviations. They must communicate these
goals clearly to front-line employees.
• It has never been easier or more cost efficient to collect information, but
businesses must ensure that their diagnostic control systems are reporting the
information that matters most.

Profit Plans

• Profit plans are one of the primary diagnostic control systems managers use to
execute strategy. They summarize the anticipated revenue inflows and expense
outflows for a specified accounting period—typically one year—and are produced
in the form of an income statement.
♦ To create a profit plan, there are three questions managers should ask:
1. Will the business’s strategy make enough profit to cover costs and
reinvest in the business going forward?
2. Does the business generate enough cash to remain solvent
through the year?
3. Does the business create sufficient financial returns for investors?

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 ♦ To answer these questions, managers analyze three wheels—the Profit
Wheel, the Cash Wheel, and the Return on Equity, or ROE, Wheel.

The Profit Wheel

Sales of goods and services minus operating expenses generate profits.

These profits are reinvested in assets, which are used to produce new
goods and services that generate more sales.

sales

operating PROFIT investment

expenses WHEEL in assets

profits

This module covers three steps that managers must work through to
complete their Profit Wheel analysis:

1. Estimate the level of future sales they expect for the business.
2. Forecast operating expenses, including both variable and non-
variable costs.
3. Calculate expected profit (the residual economic value after paying
interest expense and income taxes).

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 The Cash Wheel

The Cash Wheel tracks the flow of cash through a business over
time. Sales (as generated by the Profit Wheel) lead to accounts
receivable, which reflect purchases from customers for products or
services that are made on account, meaning that payment may not be
received for thirty or sixty days. After a set period, these accounts
receivable become operating cash, which the business can use to
manufacture or purchase new products for inventory or to create new
services. These products and services are then sold to customers, and the
cycle starts again.

operating
cash

accounts CASH inventory

receivable WHEEL

sales

• To confront cash flow challenges effectively, businesses must think carefully

about where cash is most needed and why. For example, if your strategy
requires consistently high levels of inventory to set yourself apart from
competitors, you will need much more operating cash on hand to finance those
purchases from suppliers.
• You should estimate cash flow on a frequent basis. The aim is to free up cash
and get it moving through the cash wheel as quickly as possible. Leaving cash
tied up in accounts receivable longer than necessary or holding excessive levels
of inventory forces businesses to be more dependent on external sources of
financing, and this inefficiency will quickly eat into your operating profits.

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 The ROE Wheel

The ROE Wheel examines a business’s profit in relation to the size of the asset
base used to generate it (i.e., the business’s level of
asset utilization). Businesses with high profits will have more resources to invest
in new opportunities. They can pay higher dividends to their investors.
Shareholders will then be more willing to continue investing in the business. The
business can use these funds to increase its asset utilization (e.g., by optimizing
the supply chain to speed up inventory turnover). The wheel comes full circle as
higher levels of asset utilization generate higher profits.

profits

asset ROE stockholders’

utilization WHEEL equity

return on
equity

• Large companies with many business units can analyze their total asset base
to determine the amount of capital that each individual business employs. They
can then calculate how effectively managers are employing that capital by
looking at the amount of profit that business unit produced. This ratio calculation
is known as return on capital employed (ROCE) or return on invested capital
(ROIC).

𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

𝑅𝑅𝑂𝑂𝑂𝑂𝑂𝑂 = ×
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒

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 • This table outlines some actions that can improve or reduce ROE.

Management Actions Increasing Management Actions Decreasing

ROE ROE

• Improving profit margins by either • On-shoring business activities that

raising prices or lowering costs previously occurred offshore
• Increasing asset turnover by where tax rates are lower
holding less inventory or selling • Retaining excess cash on the
inventory more quickly balance sheet
• Improving financial leverage by • Holding non-productive assets as
increasing the asset base funded an option to hedge against
by debt changes in the competitive
• Selling non-productive assets market
• Tightening credit terms to collect • Extending credit payment terms to
accounts receivable more quickly late-paying customers

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Putting the Wheels Together

• While nearly all businesses measure profit variables, fewer measure cash flow
variables or return on equity variables. The most successful businesses capture
variables from all three wheels in their diagnostic control systems.

operating
cash

accounts CASH inventory

receivable WHEEL

sales

operating PROFIT investment

expenses WHEEL in assets

profits

asset ROE stockholders’

utilization WHEEL equity

return on
equity

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 This table outlines some of the variables related to each of the wheels.

Wheel Relevant Variables

Profit Wheel • Sales revenue

• Operating expenses
• Net income
• Investment in assets

Cash Wheel • Accounts receivable

• Operating cash
• Inventory

ROE Wheel • Balance sheet assets

• Return on capital
• Asset utilization

Balanced Scorecards and Strategy Maps

• Some businesses only measure financial performance. However, this approach

overlooks other key dimensions of value creation. For example, profit plans do not
capture the effects of intangible assets such as research capabilities, brand loyalty,
and customer relationships.
• The balanced scorecard combines the traditional financial perspective with
additional perspectives that help businesses measure all the activities that are
essential to creating value. It typically includes four perspectives:

Perspective Description Relevant Variables

(non-comprehensive
list)

Financial Perspective Ensures that plans and Revenue, gross

processes lead to desired profit, operating margin,
levels of economic value cash flow
creation. Financial measures
are derived from profit wheel
analyses and captured in
traditional financial accounting
systems.

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 Customer Perspective Defines how a business’s Net promoter score,
products and services are seen repeat purchases
by customers in its target
market. This perspective
includes the business’s product
attributes, brand image, and
reputation. Are they the most
trusted brand? The most
innovative? The best value?
Customer measures should be
designed to reflect the desired
market position by focusing on
metrics such as quality,
delivery speed, and customer
service experience.
Internal Business Identifies critical functional Innovation, quality,
Process Perspective practices related to innovation, supplier risk mitigation
operations, marketing and
sales, and engineering that
create value for customers. It is
typically broken down into the
following processes: operations
management, customer
management, innovation,
regulatory, and social.
Measures are developed for
each of these processes.
Learning and Growth Details how intangible human Diversity and talent,
Perspective capital and infrastructure employee training
resources can be utilized to
meet company goals. It
typically considers the role of
human capital (people, talents,
and knowledge required to
meet goals); information capital
(the databases, networks, and
IT systems needed to support
long-term growth); and
organization capital (leadership
capabilities and cultural
alignment to business goals).
Measures are developed for
each of these processes.

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• The order of these perspectives (starting from learning and growth and moving
through internal business processes and customer perspective to the financial
perspective) reflects the precise way the perspectives typically build on each other to
create value for a business.
• Anyone who wants to use a balanced scorecard should:
1. Create a strategy map
2. Select measures based on that map.
• Here we present a strategy map for Boston Retail, which sells affordable fashion to
Boston area students. To create this strategy map, Boston Retail must define their
goals by identifying the cause-and-effect relationships across the various
perspectives. For example, one way to expand revenue opportunities (a financial
goal) is by improving the shopping experience (a customer perspective goal). Next,
they might ask, “How can we improve the shopping experience?” One way is to
ensure that key items are always in stock (process perspective goal). How can they
ensure that key items are always in stock? By installing an updated inventory
management technology system (learning and growth goal). And so forth.
♦ Importantly, goals are expressed using action verbs (“increase revenue” or
“enhance customer loyalty”). The business must clearly state what they
are striving for.

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 GROWTH LONG-TERM PRODUCTIVITY
STRATEGY SHAREHOLDER STRATEGY
VALUE

Improve Increase
FINANCIAL Expand revenue
efficiencies within inventory
PERSPECTIVE opportunities
supply chain turns

PRODUCT ATTRIBUTES RELATIONSHIP IMAGE

CUSTOMER Be first to Improve the Penetrate Increase same-store Increase brand awareness
PERSPECTIVE market with shopping the New York sales in Boston
new fashions experience market market

OPERATIONS MANAGEMENT CUSTOMER MANAGEMENT INNOVATION

PROCESS PROCESSES PROCESSES PROCESSES
PERSPECTIVE - Improve warehouse efficiency Improve ability to analyze and understand Identify new fashion trends through
- Ensure key items are always in stock new markets suppliers and store employees

HUMAN CAPI TAL Develop training program for all store employees
LEARNING
and GROWTH INFORMATION CAPITAL Install updated inventory management technology system
PERSPECTIVE
ORGANIZATION CAPITAL Create integration plan for New York staff

• The arrows are the most important part of the strategy map. They reveal cause-and-effect relationships so that everyone
in the business can understand the theory of value creation.

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• To track employees’ success hitting the goals defined on the strategy map,
managers must design measures—quantitative values that they can scale and use
for purposes of comparison—and set targets—specific levels of performance and
timeframes against which to gauge progress. These measures and targets, together
with the goals on the strategy map, comprise the balanced scorecard for an
organization. The inclusion of the strategy map on the balanced scorecard tells
employees where the measures on the balanced scorecard come from and why they
are the right measures for the business.
• Here are some of the goals that Boston Retail has defined on their strategy map,
along with the specific measures and targets they could develop for each:
Strategy Map Goal Measure Target
Perspective
Financial Expand revenue Total revenue Reach 150%
Perspective opportunities growth revenue growth
within five years

Customer Improve shopping Volume growth per Grow per-store

Perspective experience store volume by 15%
annually

Process Identify and % of revenue from Ensure 30%

Perspective execute new new items annual revenue
trends from new items

Learning and Develop in-store Employee surveys Achieve 90%

Growth training program satisfaction level in
Perspective one year

• To set these measures and targets effectively, businesses should identify which
firms in their industry set the standards for the most effective use of resources and
calibrate their own efforts accordingly (e.g., by commissioning or consulting a study
of similar firms that excel at a particular goal and identifying their levels of efficiency
and effectiveness with various indicators). This process is called benchmarking.

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• Here, we present a simplified version of the strategy map for Boston Retail alongside their balanced scorecard.

Strategy Map Balanced Scorecard

MARKETING DEPARTMENT OBJECTIVES MEASURE TARGET

FINANCIAL Expand revenue

- Total Revenue Growth - Reach 150% revenue growth within 5 years
PERSPECTIVE opportunities

Penetrate the Increase - Market share - Achieve 12% growth in market share within 3 years
New York same-store
market sales - Number of new stores - Open 3 new stores annually
CUSTOMER - Volume growth per store - Grow per-store volume by 15% annually
PERSPECTIVE Increase Improve - Customer satisfaction rating - Reach satisfaction ratings over 90% within 6 months
brand shopping
awareness experience - Mystery shopper score - Reach mystery shopper scores over 92% within 6 months

PROCESS Identify and - Ensure 30% of annual sales from new items
- % of sales from new items
execute
PERSPECTIVE new brands - % of sales from markdowns - Keep annual sales from markdowns at less than 15%

LEARNING Integrate Develop - Dollar sales per transaction - Increase dollar sales per transaction by 20% within 9 months
and GROWTH New York in-store training - Employee surveys - Achieve 90% satisfaction level in one year
PERSPECTIVE staff program - Employee retention rates - Increase employee retention by 50% within 18 months

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 ♦ Having too many variables on the balanced scorecard can prevent you
from focusing on the things that are most important. An individual
manager should be held accountable for no more than seven measures,
plus or minus two—the amount that most people can easily remember.
The rest can and should be delegated. (This advice is based on the article
"The Magic Number Seven, Plus or Minus Two" by psychologist George
Miller.)
♦ To pinpoint the dimensions of performance measurement where
managers should devote greater time and attention, managers should
identify critical performance variables—factors that would cause their
strategy to fail if they were not achieved or implemented successfully.

Designing Effective Measures

• When designing measures, there are three tests you should apply to see how
effective your selected measures will be in tracking progress to key goals.
♦ Test #1: Does the measure align with strategy?
 A person who examines the measures on the balanced scorecard
should be able to infer the business’s strategy from it.
♦ Test #2: Is the measure objective, complete, and responsive?
 If a measure is objective, it can be independently verified—multiple
people could look at the same set of data and draw the same
conclusion (e.g., sales revenue, operating expenses). Subjective
measures (e.g., ratings of an employee’s professionalism or leadership
capabilities) work well only when there's a high degree of trust between
employees and managers.
 A measure is complete when it captures the full range of behavior
needed to achieve a goal. Problems can arise when measures are
incomplete and employees can influence them. For example, if the
goal is to encourage salespeople to increase revenue with important
customers, the number of sales calls they make each week would be
an incomplete measure, because the salespeople may choose to visit
easy-to-reach customers instead of those with the highest revenue
potential. They will be able to hit their targets without bringing in any
substantial new business. In this example, a more complete measure
would be the amount of new revenue they generate, which would
motivate employees to focus on customers with the highest potential.
 Finally, the measure should be responsive to the action of a manager,
meaning they can directly influence it. Return on equity and stock price

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 are responsive measures for a CEO, but not for lower-level employees,
who will probably not influence the stock price of the company, even if
they perform well.
♦ Test #3: Does the measure link to economic value?
 Recall the Organizational Process Model from Module 1:

THE
ORGANIZATIONAL
PROCESS MODEL

INPUTS PROCESS OUTPUTS

 The more that a measure focuses on outputs (e.g., increasing revenue

and profits), the more confident you can be that it is creating value.
The link between process and value creation can be less clear. An
example is the process of building relationships with customers; not all
new relationships will lead to increased revenue and profit. The link
from inputs to value is still less clear. For example, it’s not clear that
every dollar spent on employee training will lead to economic value.
The closer you are to outputs, the more you can use objective
measures derived from formulas to measure and reward performance.
The more that you move toward inputs, the more you need to rely on
your own judgment when evaluating performance. In these instances,
subjective measures are often more valuable.

Incentives

• To “power up” diagnostic control systems, managers must design incentives that
motivate employees to hit their targets. The most common—and important—
incentive is the cash bonus.
♦ When assigning bonuses, top managers should pay attention to three key
design decisions:
1. Decide how much money is available to distribute as incentives or other
rewards—the size of your bonus pool. Managers typically set the size of the
bonus pool as a function of business- or corporate-level financial
performance.
2. Decide whether you want to allocate payouts based on individual
performance, business performance, or corporate performance. Then

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 assign weights to each of these three categories. Generally, higher-up
managers with wide spans of control will have more weight assigned to
business performance than to individual performance. In a multi-business
company, the degree to which a business unit successfully interacts with
other business units to achieve overall company profits will likely increase
the weight given to corporate (company-wide) performance.
3. Decide how you will calibrate and pay for different levels of performance
within each of these three categories—by using a formula or by subjective
judgment. Formulas eliminate ambiguity and provide clarity for those being
measured. They help maximize return on management because they can
be updated relatively infrequently (e.g., once a year). Subjective rewards
sacrifice some of this clarity and require more time and attention to gather
the relevant information. However, they allow you to more closely tailor
rewards to the true contribution of employees in circumstances where
objective measures may give a false reading.
• To unleash the full potential of employees, however, managers should consider
additional incentives that tap into the full range of employee motivations—not only to
achieve, but also to contribute, do right, and innovate.
♦ Beyond cash, you can offer:
 Gifts and prizes
 Other non-financial incentives (e.g., positive feedback, opportunities to
grow and develop skills, public recognition for accomplishments)
 Incentives that focus attention on the long term, such as deferred cash
payments, stock options, and stock grants
o One option is to link stock options and stock grant payouts to
company performance rather than a fixed vesting period, as is
done traditionally. This can make employees even more
invested in ensuring that the company continues to do well.

Case Summary
Citibank: Performance Measurement

When the California division of Citibank introduces a new performance scorecard, the
change prompts difficult questions regarding how to evaluate and compensate a top-
performing branch manager. James McGaran has always delivered outstanding
financial performance during his long tenure at Citibank, even as he managed a branch
with notoriously difficult customers. But now the division—and its branch managers—
are being measured on a wider set of variables including customer satisfaction, control,

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strategy implementation, and people and standards. If Citibank wants to adhere to the
new system, they cannot grant James a full bonus, due to his below-par score on
customer satisfaction. Worried about the impact of losing James to a competitor, the
evaluation team deliberates over how they can best signal the importance of the new
measurement system without sacrificing a key contributor to the division’s success. This
debate, in turn, raises a larger question: If James has always delivered success for his
branch despite his low customer satisfaction rating, is customer satisfaction in fact a
critical performance variable for Citibank? Because the California division did not
choose goals for the scorecard using a strategy map, they cannot be sure. Customer
loyalty, for example, could in fact be a more critical variable.

The evaluation team ultimately decides to partially override the new performance
measurement system, assigning James McGaran a global rating of “above par” despite
his lower customer satisfaction rating but awarding him a 25% bonus, rather than the
maximum 30% bonus, to communicate the value and integrity of the new performance
scorecard.

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