Performance of Business-Value Drivers- Valutrics
Companies that have insight into how a market and industry will evolve and then act on that insight to expand existing businesses or develop new ones can be valued highly.
The overall value that a company creates is the sum of the outcomes of innumerable business decisions taken by its managers and staff at every level, from choosing when to open the door to customers to deciding whether to acquire a new business. A company needs systems to ensure that all decisions affecting value are consistent with its short-and long-term objectives.Such performance management systems enable management to see clearly the impact of those myriad decisions on value creation.
Performance management systems typically include long-term strategic plans, short-term budgets, capital budgeting systems, performance reporting and reviews,and compensation frameworks.Successful value creation requires that all components of the performance management system be aligned with the company’s strategy, so that they encourage decisions that maximize value.
For example, if product development is important to the strategic plan, the short-term budget and capital budget must include enough spending in the current year to develop the new products, and performance reviews must evaluate progress on new products, not just short-term profits.
The success or failure of performance management depends not so much on the system—the metrics, corporate meeting calendars, scorecards, and so on—as on the rigor and honesty with which everyone engages in the process.
Do the senior management team members really understand the economics of the business units they oversee? Can they negotiate performance targets that are both challenging and achievable? Are trade-offs between the short term and the long term transparent? Are managers sufficiently rewarded for focusing on long-term value?
When performance management is working well, it helps the layers of the organization communicate frankly and effectively. It gives managers space to manage, while assuring their bosses that agreed-on levels of performance will be achieved. In many companies, communication between layers of management revolves entirely around profit targets, whether they are hit or missed.
With a good performance management system, just as much attention is paid to the long-term value-creating intent behind short-term profit targets, and people across the company are in constant dialogue about what adjustments need to be made to stay in line with long-term performance goals.
We approach performance management from both an analytical and an organizational perspective. The analytical perspective focuses first on ensuring that companies use the right metrics: as well as historical performance measures, companies need to use diagnostic metrics that help them understand and manage their ability to create value over the longer term. Second, we analyze how to set appropriate targets, giving examples of analytically sound performance measurement in action.The organizational perspective describes the mind-sets and processes needed to support effective performance management.
Identifying Value Drivers
Companies need metrics that will monitor their long-term health as well as their short-term performance. They also need to set appropriate targets in these dimensions.
If a company shows strong growth and return on invested capital (ROIC), it still needs to know whether that performance is sustainable. Comparing readings of company health indicators against meaningful targets can tell us whether a company has achieved impressive past financial results at a cost to its long-term health, perhaps crippling its ability to create value in the future.
To see the critical difference between companies’ recorded performance and their long-term health, consider the pharmaceutical industry. In the year after the patent on a drug expires, sales of that drug often decline by 50 to 75 percent or more, as generic producers lower prices and steal market share.
When a major product will be going off patent in a couple of years with no replacement on the horizon, investors know future profits will suffer. In such a case, the company could have strong current performance but a poor performance outlook reflected in a low market value, because market values reflect long-term health, not just short-term profits. To take another example, retail chains can sometimes maintain apparently impressive margins by scrimping on store refurbishment and brand building, to the detriment of their future competitive strength.
We can gain insight into a company’s health by examining the drivers of long-term growth and ROIC, the key drivers of value creation for all companies.
We consider two types of value drivers: key value drivers and subordinate company value drivers. The generic subordinate value drivers are broken down into short-, medium-, and long-term categories. The choice of particular value drivers,along with targets for testing and strengthening each one,should vary from company to company, reflecting each company’s different sectors and aspirations.
This is similar to “balanced scorecard” framework introduced in a 1992 Harvard Business Review article by Robert Kaplan and David Norton. Numerous nonprofit and for-profit organizations have subsequently advocated and implemented the balanced scorecard idea. Its premise is that financial performance is only one aspect of performance.As important to longterm value creation, Kaplan and Norton point out, are customer satisfaction, internal business processes, learning, and revenue growth.
Companies may choose their own set of metrics and tailor their choice to their industry and strategy. Such tailoring is critical to setting the right strategic priorities. For example, product innovation may be important to companies in one industry, while to companies in another, tight cost control and customer service may matter more, and their respective prioritization of value drivers should reflect the difference. Similarly, an individual company will have different value drivers at different points in its life cycle.
Short-term value drivers
Short-term value drivers are the immediate drivers of historical ROIC and growth. They are typically the easiest to quantify and monitor frequently (monthly or quarterly). They are indicators of whether current growth and ROIC can be sustained, will improve, or will decline over the short term. They might include cost per unit for a manufacturing company or same-store sales growth for a retailer.
Short-term drivers fall into three categories:
1. Sales productivity metrics are the drivers of recent sales growth, such as price and quantity sold, market share, the company’s ability to charge higher prices relative to peers (or charge a premium for its product or services), sales force productivity, and for a retailer, same-store sales growth versus new-store growth.
2. Operating cost productivity metrics are typically drivers of unit costs, such as the component costs for building an automobile or delivering a package. UPS, for example, is well known for charting out the optimal delivery path of its drivers to enhance their productivity and for developing well-defined standards on how to deliver packages.
3. Capital productivity measures how well a company uses its working capital (inventories, receivables, and payables) and its property, plant, and equipment. Dell provides an example of highly productive working capital. The company revolutionized the personal computer (PC) business by building to order so it could minimize inventories. Because the company kept inventory levels so low and had few receivables to boot, it could, on occasion, operate with negative working capital.
When assessing short-term corporate performance, separate the effects of forces that are outside management’s control (both good and bad) from things management can influence. For instance, upstream oil company executives shouldn’t get much credit for higher profits that result from higher oil prices, nor should real estate executives for higher real estate prices (and the resulting higher commissions). Oil company performance should be evaluated with an emphasis on new reserves and production growth, exploration costs, and drilling costs. Real estate brokerages should be evaluated primarily on the number of sales, not whether housing prices are increasing or decreasing.
Medium-term value drivers
Medium-term value drivers look forward to indicate whether a company can maintain and improve its growth and ROIC over the next one to five years (or longer for companies, such as pharmaceutical manufacturers, that have long product cycles). These metrics may be harder to quantify than short-term measures and are more likely to be measured annually or over even longer periods.
The medium-term value drivers fall into three categories:
1. Commercial health metrics indicate whether the company can sustain or improve its current revenue growth. These metrics include the company’s product pipeline (talent and technology to bring new products to market over the medium term), brand strength (investment in brand building), and customer satisfaction. Commercial health metrics vary widely by industry. For a pharmaceutical company, the obvious priority is its product pipeline. For an online retailer, customer satisfaction and brand strength may be the most important components of medium-term commercial health.
2. Cost structure health metrics measure a company’s ability to manage its costs relative to competitors over three to five years. These metrics might include assessments of programs such as Six Sigma, a method made famous by General Electric and adopted by other companies to reduce costs continually and maintain a cost advantage relative to their competitors across most of their businesses.
3. Asset health measures how well a company maintains and develops its assets. For a hotel or restaurant chain, the average time between remodeling projects may be an important driver of health.
Long-term strategic value drivers
Metrics for gauging long-term strategic health show the ability of an enterprise to sustain its current operating activitiesandtoidentifyandexploitnewgrowthareas.Acompanymustperiodically assess and measure the threats—including new technologies, changes in customer preferences, and new ways of serving customers—that could make its current business less profitable. In assessing a company’s long-term strategic health, it can be hard to identify specific metrics; those situations require more qualitative milestones, such as progress in selecting partners for mergers or for entering a market.
Besides guarding against threats, companies must continually watch for new growth opportunities, whether in related industries or in new geographies.
Organizational health
This final element of corporate well-being measures whether the company has the people, skills, and culture to sustain and improve its performance. Diagnostics of organizational health typically measure the skills and capabilities of a company, its ability to retain its employees and keep them satisfied, its culture and values, and the depth of its management talent.
Again, what is important varies by industry. Pharmaceutical companies need deep scientific innovation capabilities but relatively few managers. Retailers need lots of trained store managers, a few great merchandisers, and in most cases, store staff with a customer service orientation.
Benefits of Understanding Business Value Drivers
Clarity about a business’s value drivers has several advantages. First, if managers know the relative impact of their company’s value drivers on long-term value creation, they can make explicit trade-offs between pursuing a critical driver and allowing performance against a less critical driver to deteriorate. This is particularly helpful for choosing between activities that deliver shortterm performance and those that build the long-term health of the business.
These trade-offs are material: increasing investment for the long term will cause short-term returns to decline, as management expenses some of the costs, such as R&D or advertising, in the year they occur rather than the year the investments achieve their benefits. Other costs are capitalized but will not earn a return before the project is commissioned, so they too will suppress overall returns in the short term. Understanding the long-term benefits of sacrificing short-term earnings in this way should help corporate boards to support managers in making investments that build a business’s long-term capability to create value.
Clarity about value drivers also enables the management team to prioritize actions so that activities expected to create substantially more value take precedence over others. Setting priorities encourages focus and often adds more to value than efforts to improve on multiple dimensions simultaneously. Without an explicit discussion of priorities and trade-offs, different members of the management team could interpret and execute the business strategy in numerous ways.
In general, distinctive planning and performance management systems promote a common language and understanding of value drivers that shape the way top management and employees think about creating value at each level of the organization. For example, in a pharmaceutical company, distinctive performance management would encourage discussion and coordinated action across the organization about specific steps to increase the speed of product launches and so accelerate value creation.
Setting Effective Targets
To make best use of their understanding of key value drivers and safeguard their company’s future health, managers need to agree what reading they are targeting on each one. Targets need to be both challenging and realistic enough to be owned by the managers responsible for meeting them.
Businesses can identify realistic opportunities and targets by studying world-class competitors’ performance on a particular value metric or milestone and comparing it with their own potential, or looking at the performance of high-performing firms from a different but similar sector. For instance, a petroleum company might benchmark product availability in its service station shops against a grocery retailer’s equivalents. This is in part how lean manufacturing approaches developed by automakers have been successfully transplanted into many other industries, including retailing and services.
Businesses can also learn from internal benchmarks taken from comparable operations in different businesses controlled by the same parent. These may be less challenging than external benchmarks, as they do not necessarily involve looking at world-class players. However, internal benchmarks deliver several benefits. The data are likely to be more readily available, since sharing the information poses no competitive or antitrust problems. Also, unearthing the causes of differences in performance is much easier, as the unit heads can visit the benchmark unit. Finally, these comparisons facilitate peer review.
Most performance targets are a single point, but a range can be more helpful. General Electric, for example, sets base and stretch targets. The base target is set by top management based on prior-year performance and the competitive environment. The company expects managers to meet the base target under any circumstance; those who do not meet it rarely last long.
The stretch target is a statement of the aspiration for the business and is developed by the management team responsible for delivery. Those who meet their stretch targets are rewarded, but those who miss them are seldom penalized.
Using base and stretch targets makes a performance management system much more complex, but it allows the managers of the business units to communicate what they dream of delivering (and what it would take for them to achieve that goal) without committing them to delivery.
The Right Metrics in Action
Choosing the right performance metrics can give new insights into how a company might improve its performance in the future. The greatest value creation would come from three areas: accelerating the rate of release of new products from 0.5 to 0.8 per year, reducing from six years to four the time it takes for a new drug to reach 80 percent of peak sales, and cutting cost of goods sold from 26 percent to 23 percent of sales. Some of the value drivers (such as new-drug development) are long-term, whereas others (such as reducing cost of goods sold) have a shorter-term focus.
Similarly, focusing on the right performance metrics can help reveal what may be driving underperformance. A consumer goods company we know illustrates the importance of having a tailored set of key value metrics. For several years, a business unit showed consistent double-digit growth in economic profit. Since the financial results were consistently strong—infact,the strongest across all the business units—corporate managers were pleased and did not ask many questions of the business unit. One year, the unit’s economic profit unexpectedly began to decline. Corporate management began digging deeper into the unit’s results and discoveredthat forthe precedingthree years the unit had been increasing its profit by raising prices and cutting back on product promotion. That created the conditions for competitors to take away market share. The unit’s strong short-term performance was coming at the expense of its long-term health. The company changed the unit’s management team, but lower profits continued for several years as the unit recovered its position with consumers.
A well-defined and appropriately selected set of key value drivers ought to allow management to articulate how the organization’s strategy creates value.
If it is impossible to represent some component of the strategy using the key value drivers, or if some key value driver does not serve as a building block in the strategy, then managers should reexamine the value trees. Similarly, managers must regularly revisit the targets they set for each value driver. As their business environment changes, so will the limits of what they can achieve.
Performance metrics give managers information about how well their company is performing now and its likely future performance. But without the right mechanisms to support managers in acting on this information, an elaborate performance measurement system is useless. Indeed, the measurements are less important than how they are used by the organization. The following ingredients may lead to more effective organizational support for corrective action.
Buy-In to Performance Management at All Levels
Companies that succeed at performance management instill a value-creating mind-set throughout the business. Their employees at all levels understand the core principles of value creation , know why it matters, and make decisions that take into account the impact on value. They achieve this understanding if their top managers consistently reinforce the importance of the value mind-set in all their communications, build the capabilities to understand value creation, and (as discussed at the end of this section) link value creation to the reward process. Midlevel managers are unlikely to buy into managing for longer-term value creation if top management regularly cuts R&D, advertising, or employee development to make short-term profit targets. Without leadership from the top, a company cannot build a successful performance management system.
Motivating Targets
Managers and staff responsible for meeting targets need to be involved in setting them, so they understand the targets’ purpose and will strive to deliver them. Consider the experience of one global consumer goods company. When the corporate technical manager ordered that all the company’s bottling lines should achieve 75 percent operating efficiency regardless of their current level, some plant operators rebelled. Operators at one U.S. plant concluded that at 53 percent utilization their plant was running as well as it had ever run, and they refused to aim for higher performance. Then the plant launched a process permitting the operators to set their own performance goals. The same U.S. plant managed to raise efficiency above the 75 percent target over a period of only 14 months.
Higher-level managers also need to be seen to embrace the whole set of targets and be able to explain their interrelation. Otherwise, the targets may simply appear as a set of arbitrary aspirations imposed from above.
Performance Reviews
In too many performance reviews, senior management does not understand enough about the business to assess whether a business unit’s performance resulted from the management team’s cleverness and hard work or simply from good or bad luck. They need to base performance reviews on facts in order to ensure honest appraisal and make corrective action effective.
The best way to record facts for performance reviews is on a scorecard incorporating the key value metrics from the value driver analysis. Managers may be tempted to think financial reports alone can serve as the basis for performance discussions. Financial results are only part of the review process, however. Key value metrics show the operating performance behind the financial results.
Corporate centers may find it convenient to impose one scorecard on all business units, but this is shortsighted. Although a single scorecard makes it easier to compare units, management forgoes the chance to understand each unit’s unique value drivers. Ideally, companies should have tailored scorecards that cascade through each business, so that each manager can monitor the key value drivers for which he or she is accountable.
Managers should use performance reviews as problem-solving sessions to determine the root causes of bad performance and how to fix them, rather than identifying who is to blame. To succeed, reviewers must first prepare thoroughly for reviews. They should then turn traditionally one-sided discussions (“boss tells, subordinate does”) into collaborative sessions. Bringing groups together for performance reviews will introduce even more wellinformed insights and perspectives, making problem solving more effective, increasing a sense of accountability, and deflecting potential sandbagging. Orchestrated with care, a performance review—even when results are below expectations—can help motivate frontline managers and employees, rather than deflating them.
Appropriate Rewards
The final element of successful performance management is giving appropriate rewards to individual managers and employees. Rewards today are typically financial and,according to some critics, have become excessive. Certainly in the late 1990s, as the long bull market extended, executives received extraordinary rewards, particularly in stock options, that had little to do with their own performance and everything to do with factors beyond their reach, such as declining interest rates. When the stock market fell, companies maintained the higher level of rewards.
Many have argued that current compensation systems remain broken because they rarely link compensation to the company’s long-term value creation. Several ideas are emerging on how better to align the two. Here are several of the proposals:
– Linking stock-based compensation to the specific performance of the company, stripping out broad macro and industry effects .
– Tying some portion of compensation for senior executives to corporate results several years after the year of the review, even if that means deferring payment of that portion until after the executive’s departure from the company.
– Linking bonuses as much to long-term company health metrics as to short-term financial results.
– Moving away from formulaic compensation to a more holistic system that incorporates performance against both quantifiable and nonquantifiable value drivers, even if it requires more judgment by the evaluator.
– Harnessing the power of nonfinancial incentives, such as career progression. Identifying and adhering to a distinctive set of values is another way that companies can attract and motivate employees who find working somewhere in tune with their beliefs to be a powerful incentive.