Measuring Strategy Performance
What is Strategy Performance?
Strategy performance is the result of the implementation of that strategy. In order to assess this performance, firms must define measures based on the business objectives that the strategy is designed to achieve.
Find Appropriate Measures
The profitability of a corporate is a major objective. However, some measures can only be computed after profits are totaled for a period.
Thus, measures like return on investment (ROI), earnings per share (EPS) can only tell what happens after the fact, and not what is happening or what will happen.
Steering controls exist so that a firm can predict likely profitability in the future.
One of the metrics for steering controls is the inventory turnover ratio, in which the cost of goods sold is divided by the average value of its inventories. This measure shows how hard investment in inventory is working.
The higher the ratio, the better. Not only does quicker moving inventory tie up less cash in inventories, but it also reduces the risk that the goods will grow obsolete before they are sold.
Another metric for steering controls is customer satisfaction. Companies with higher scores on customer satisfaction usually have higher stock returns and better cash flows.
Types of Controls
Controls can be established to focus on actual performance results (output), the activities that generate the performance (behavior), or on resources that are used in performance (input).
Corporations following the strategy of conglomerate diversification tend to emphasize output controls with their divisions and subsidiaries.
Corporations following the strategy of concentric diversification use all 3 types of controls because synergy is highly desired in such situations.
Even if all 3 types of control are used, one or two of them may be emphasized more than another.
Output controls specify what is to be accomplished by focusing on the end result of the behaviors through the use of objectives and performance targets or milestones.
Output controls such as sales quotes, specific cost-reduction or profit objectives, and surveys of customer satisfaction are most appropriate when specific output measures have been agreed on but the cause-effect connection between activities and result is not clear.
Behavior controls specify how something is to be done through policies, rules, standard operating procedures, and orders from a superior.
Behavior controls such as following company procedures, making sales calls to potential customers, and getting to work on time is most appropriate when performance results are hard to measure, but the cause-effect connection between activities and results is clear.
Input controls such as the number of years of education and experience are most appropriate when output is difficult to measure and there is no clear cause-effect relationship between behavior and performance.
Input controls emphasize resources, such as knowledge, skills, abilities, values, and motives of employees.
Measures Performance of Corporate-Level Strategy
Some of these methods are (1) traditional financial measures, (2) stakeholder measures, (3) shareholder value, and (4) balanced scorecard approach.
There are many methods to evaluate the success or failure of corporate-level strategies. The current trend is toward more complicated financial measures and increasing use of non-financial measures of corporate-level strategy performance.
Method 1: Traditional Financial Measures
Return on Investment (ROI) is the most commonly used measure of corporate performance in terms of profits.
It is the result of dividing net income before taxes by the total amount invested in the company. Although ROI gives the impression of objectivity and precision, it can be easily manipulated.
Earnings per Share (EPS) involves dividing net earnings by the amount of common stock.
EPS has several deficiencies as an evaluation of past and future performance and also does not consider the time value of money.
Return on Equity (ROE) involves dividing net income by total equity.
It also has limitations because it is derived from accounting-based data.
Operating cash flow is the amount of money generated by a company before the cost of financing and taxes.
This is the company’s net income plus depreciation, depletion, amortization, interest expense, and income tax expense.
Free cash flow is the amount of money a new owner can take out of the firm without harming the business.
This is net income plus depreciation, depletion, and amortization fewer capital expenditures, and dividends.
Although cash flow may be harder to manipulate than earnings, the number can be increased by selling accounts receivable, classifying outstanding checks as accounts payable, trading securities, and capitalizing certain expenses.
Method 2: Stakeholder Measures
Each stakeholder has its own set of criteria to determine how well the corporation is performing its corporate strategy.
These criteria typically deal with the direct and indirect impacts of corporate activities on stakeholder interests.
Top management should establish one or more stakeholder measures for each stakeholder category so that it can keep track of stakeholder concerns.
Method 3: Stakeholder Value
Stakeholder value can be defined as the present value of the anticipated future stream of cash flows from the business plus the value of the company if they are liquidated.
Shareholder value analysis concentrates on cash flow as the key measure of performance. The value of a corporation is the value of its cash flows discounted back to their present value, using the business cost of capital as the discount rate.
As long as the returns from a business exceed its cost of capital, the business will create value and be worth more than the capital invested in it.
Economic Value Added (EVA) measures the difference between the pre-strategy and post-strategy values for the business.
It is after-tax operating income minus the total annual cost of capital. EVA has become an extremely popular shareholder value method of measuring corporate performance and may be on its way to replacing ROI as the standard performance measure.
Management can improve the company or business unit EVA by (1) earning more profit without using more capital, (2) using less capital, and (3) investing capital in high-return projects.
Market Value Added (MVA) measures the difference between the market value of a corporation and the capital contributed by shareholders and lenders.
Like net present value, it measures the stock market estimate of the net present value of the firm’s past and expected capital investment project.
MVA is essentially the present value of future EVA.
Method 4: Balanced Scorecard
A Balanced Scorecard for a firm is simply a listing of all key objectives to work toward, along with an associated time dimension of when each objective is to be accomplished, as well as a primary responsibility or contact person, department, or division for each objective.
A Balanced Scorecard is an approach that includes both non-financial as well as financial measures. An effective Balanced Scorecard contains a carefully chosen combination of non-financial and financial objectives tailored to the company’s business.
Balanced Scorecard derives its name from the perceived need of firms to balance financial measures that are oftentimes used exclusively in strategy evaluation and control with non-financial measures such as product quality and customer service.
The overall aim of the Balanced Scorecard is to balance shareholder value with customer value and operational objectives.
The basic tenet of the Balanced Scorecard is that firms should establish objectives and evaluate strategies on items other than financial measures. Financial measures and ratios are vitally important. However, of equal importance are factors such as customer service, employee morale, product quality, pollution abatement, business ethics, social responsibility, community involvement, and other such items.
These factors can vary by organization, but such items, along with financial measures, comprise the essence of a Balanced Scorecard. It combines financial measures that tell the results of actions already taken with operational measures on customer satisfaction, internal processes, and the corporation’s innovation and improvement activities, which are the drivers of future financial performance.
These sets of factors interrelate and some even conflict. Customers want a low price and high service, which may conflict with shareholders’ desire for a high return on their investment.
Thus, steering controls are combined with output controls.
The Balanced Scorecard analysis requires that firms seek answers to the following questions and utilize that information to adequately and more effectively evaluate strategies being implemented.
They are: (1) How well is the firm appearing to shareholders? (2) How well is the firm continually improving and creating value along with measures such as innovation, technological leadership, product quality, operational process efficiencies, and so on? (3) How well is the firm sustaining and even improving upon its core competencies and competitive advantages? and (4) How satisfied are the firm’s customers?
Each goal in each area is then assigned one or more measures, as well as a target and an initiative. These measures can be thought of as key performance measures, which are essential for achieving a desired strategic option.
A company could include cash flow, quarterly sales growth, and ROE as measures for success in the financial area. It could also include market share, customer satisfaction, and the percentage of new sales coming from new products as measures for success in the customer area. It could include cycle time and unit cost as measures under the internal business area. It could include time to develop next-generation products under the innovation and learning area.
The most popular non-financial measures are customer satisfaction, customer service, product quality, market share, productivity, service quality, and core competencies.
In using the Balanced Scorecard, firms should tailor the system to suit its situation, not just adopt it as a cookbook approach. When a Balanced Scorecard complements corporate strategy, it improves performance. Using the method in a mechanistic fashion without any link to strategy hinders performance and may even decrease it.
The basic form of a Balanced Scorecard may differ for different organizations.
The Balanced Scorecard approach to strategy evaluation aims to balance long-term with short-term concerns, to balance financial with non-financial concerns, and to balance internal with external concerns.
The Balanced Scorecard would be constructed differently, that is, adapted, to particular firms in various industries with the underlying theme or thrust being the same, which is to evaluate the firm’s strategies based upon both key quantitative and qualitative measures.
The Balanced Scorecard concept is consistent with the notions of continuous improvement in management (CIM) and total quality management (TQM).
Measure Performance of Divisions and Functions
If a corporation is composed of SBUs or divisions, it will use many of the same performance measures such as ROI or EVA to assess overall corporate performance. To the extent that it can isolate specific functional units, the corporation may develop responsibility centers.
Typical functional measures are market share and sales per employee, unit costs and percentage of defects, percentage of sales from new products and number of patents, and turnover and job satisfaction.
In addition, top management will require periodic statistical reports summarizing data on key measures such as the number of new customer contracts, the volume of received orders, or productivity figures.
Responsibility Centers
Responsibility centers are used to isolate a unit so that it can be evaluated separately from the rest of the corporation.
Each center, therefore, has its own budget and is evaluated on its use of budgeted resources. The center uses resources to produce a service or a product. The types of centers are determined by the way the corporation control system measures these resources and services or products.
There are 5 major types of responsibility centers: (1) standard cost centers, (2) revenue centers, (3) expense centers, (4) profit centers, and (5) investment centers.
Most corporations tend to use a combination of cost, expense, and revenue centers. In these corporations, total profitability is integrated at the corporate level.
Multidivisional corporations with one dominating product line generally use a combination of cost, expense, revenue, and profit centers.
One problem with using responsibility centers is that the separation needed to measure and evaluate a division’s performance can diminish the level of cooperation among divisions that is needed to attain synergy for the corporation.
Center 1: Standard Cost Center
This is primarily used for manufacturing facilities. Standard costs are computed for each operation based on historical data. In evaluation, its total standard costs are multiplied by the units produced. The result is the expected cost of production, which is then compared to the actual cost of production.
Center 2: Revenue Center
Production is measured without consideration of resource costs. The center is judged in terms of effectiveness rather than efficiency. The effectiveness of a sales region can be determined by comparing its actual sales to its projected or previous years’ sales. Profits are not considered because sales departments have very limited influence over the cost of the products they sell.
Center 3: Expense Center
Resources are measured in dollars, without consideration for service or product costs. Budgets will have been prepared for engineered expenses and for discretionary expenses. Typical expense centers are administrative, service, and research departments. They cost money but only indirectly contribute to revenues.
Center 4: Profit Center
Performance is measured in terms of the difference between revenues and expenditures.
This type of center is typically established whenever an organizational unit has control over both its resources and its products or services. By having such centers, a company can be organized into divisions of separate product lines. Management of each division is in charge to keep profits at a satisfactory level.
Some organizational units can be considered profit centers, for evaluation purposes. A manufacturing department can be converted from a standard cost center into a profit center. It is allowed to charge a transfer price for each product it sells to the sales department. The difference between the manufacturing cost per unit and the agreed-upon transfer price is the unit’s profits.
Transfer pricing is used in vertically integrated corporations and can work well when a price can be easily determined for a designated amount of product. When a price cannot be set easily, the relative bargaining power of the centers, rather than strategic considerations, tends to influence the agreed-upon price.
The top management has an obligation to make sure that these political considerations do not overwhelm the strategic ones. Otherwise, profit for each center will be biased and provide poor information for strategic divisions at both the corporate and divisional levels.
Center 5: Investment Center
The performance of this type of center is measured in terms of the difference between its resources and its services or products.
Because divisions in large manufacturing corporations use significant assets to make their products, their asset base should be factored into their performance evaluation, thus they can be evaluated on the ground of efficiency. The most widely used measure of investment center performance is ROI.
Benchmarking
Benchmarking involves openly learning how others do something better than one’s own company so that the company not only can imitate but perhaps even improve on its techniques.
Benchmarking generally involves the 6 following steps.
Step 1: Identify the area or process to be examined. It should be an activity that has the potential to determine a business unit’s competitive advantage.
Step 2: Find behavioral and output measures of the area or process and obtain measurements.
Step 3: Select an accessible set of competitors and best-in-class companies against which to benchmark.
Step 4: Calculate the differences between the company’s performance measurements and those of the best-in-class and determine why the differences exist.
Step 5: Develop tactical programs for closing performance gaps.
Step 6: Implement the programs and then compare the resulting new measurements with those of the best-in-class companies.
Evaluation of Top Management
The board should evaluate top management not only on the typical output-oriented quantitative measures but also on behavioral measures.
The board is concerned primarily with overall corporate profitability as measured quantitatively by ROI, ROE, EPS, and shareholder value.
The absence of short-run profitability contributes to the firing of any CEO. The board, however, is also concerned with other factors. CEO’s ability to establish strategic direction, build a management team, and provide leadership is more critical in the long run than are a few quantitative measures.
The specific items that a board uses to evaluate its top management should be derived from the objectives that both the board and top management agreed on earlier.
Method 1: Chairman-CEO Feedback Instrument
Modern companies evaluate their CEO using questionnaires focusing on 4 key areas: (1) company performance, (2) leadership of the organization, (3) team-building and management succession, and (4) leadership of external constituencies.
Method 2: Management Audit
This is very useful to the board of directors in evaluating management’s handling of various corporate activities. Management audits have been developed to evaluate activities such as corporate social responsibility, functional areas such as the marketing department, and divisions such as the international division. These can be helpful if the board has selected functional areas or activities for improvement.
Method 3: Strategic Audit
This provides a checklist of questions, by area or issue, that enables a systematic analysis of various corporate functions and activities to be made. It is extremely useful as a diagnostic tool to pinpoint corporate-wide problem areas and to highlight organizational strengths and weaknesses.
A strategic audit can help determine why a certain area is creating problems for a corporation and help generate solutions to the problem. It can be very useful in evaluating the performance of top management.
Strategic Incentive Management
The board of directors should develop an incentive program that rewards desired performance and achieve synergy between the needs of the corporation as a whole and the needs of the employees as individuals.
This reduces the likelihood of principal-agent problems.
In many firms, performance is affected by compensation policies.
Companies using different strategies tend to adopt different payment policies. The growth strategy emphasizes bonuses and other incentives over salary and benefit. Stability strategy has the reverse emphasis. SBU managers having long-term performance elements in their compensation program favor a long-term perspective and thus greater investments in R&D, capital equipment, and employee training.
Incentive plans should be linked in some way to corporate and divisional strategy
The following 3 approaches are tailored to help match measurements and rewards with explicit strategic objectives.
Approach 1: Weighted Factors
This method is appropriate for measuring and rewarding the performance of top SBU managers and group-level executives when performance factors and their importance vary from one SBU to another.
Using portfolio analysis, one corporation’s measurements might contain some variations.
The performance of high-performing (star) SBUs is measured equally in terms of ROI, cash flow, market share, and progress on several future-oriented strategic projects.
The performance of low growth, but strong (cash cow) SBUs, in contrast, is measured in terms of ROI, market share, and cash generation.
The performance of developing (question marks) SBUs is measured in terms of development and market share growth with no weight on ROI or cash flow.
Approach 2: Long-Term Evaluation
This method compensates managers for achieving objectives set over a multi-year period.
An executive is promised some company stock in amounts to be based on long-term performance. The typical emphasis on stock prices makes this approach more applicable to top management than to business unit managers.
Approach 3: Strategic Fund
This method encourages executives to look at developmental expenses as being different from expenses required for current operations.
It is, therefore, possible to distinguish between expense dollars consumed in the generation of current revenues and those invested in the future of a business. Therefore, a manager can be evaluated on both a short- and a long-term basis and has an incentive to invest strategic funds in the future.
The board of directors and top management must be careful to develop a compensation plan that achieves the appropriate objectives.
An effective way to achieve the desired strategic results through a reward system is to combine the three approaches: (1) segregate strategic funds from short-term funds, (2) develop a weighted-factor chart for each SBU, and (3) measure performance on the pretax profit, the weighted factors, and the long-term evaluation of the SBUs’ and the corporation’s performance.
Problems in Measuring Performance
The very act of monitoring and measuring performance can cause side effects that interfere with overall corporate performance. Among the most frequent negative side effects are a (1) short-term orientation and (2) goal displacement.
Short-Term Orientation
Top executives tend to analyze neither the long-term implications of present operations on the strategy they have adopted nor the operational impact of a strategy on the corporate mission.
Long-run evaluations may not be conducted because executives (1) don’t realize their importance, (2) believe that short-run considerations are more important than long-run considerations, (3) aren’t personally evaluated on a long-term basis, or (4) don’t have the time to make a long-run analysis.
Many accounting-based measures, such as EPS and ROI, encourage a short-term orientation in which managers consider only current tactical or operational issues and ignore long-term strategic ones. Because growth in EPS is an important driver of near-term stock price, top managers are biased against investments that might reduce short-term EPS.
One of the limitations of ROI as a performance measure is its short-term nature. In theory, ROI is not limited to the short run, but in practice, it is often difficult to use this measure to realize long-term benefits for a company. Because managers can often manipulate both the earnings and investment, the resulting ROI can be meaningless.
Advertising, maintenance, and research efforts can be reduced. Estimates of pension-fund profits, unpaid receivables, and old inventory, are easy to adjust. Optimistic estimates of returned products, bad debts, and obsolete inventory inflate the present year’s sales and earnings.
Management would tend to decrease spending on research and development, advertising, maintenance, and hiring in order to meet earnings targets.
Goal Displacement
Goal displacement is the confusion of means with ends and occurs when activities originally intended to help management attain corporate objectives become ends in themselves or are adapted to meet ends other than those for which they are intended.
Two types of goal displacement are (1) behavior substitution and (2) sub-optimization.
Type 1: Behavior Substitution
Behavior substitution refers to a phenomenon when people substitute activities that do not lead to goal accomplishment for activities that do lead to goal accomplishment because the wrong activities are being rewarded.
Managers are like most people, tend to focus more of their attention on behaviors that are clearly measurable than on those that are not. Employees often receive little or no reward for engaging in hard-to-measure activities such as cooperation and initiative. However, easy-to-measure activities might have little or no relationship to the desired good performance.
Rational people, nevertheless, tend to work for the rewards that the system has to offer. Therefore, people tend to substitute behaviors that are recognized and rewarded for behaviors that are ignored, without regard to their contribution to goal accomplishment.
If the reward system emphasizes quantity while merely asking for quality and cooperation, the system is likely to produce many low-quality products and unsatisfied customers.
Type 2: Sub-optimization
Sub-optimization refers to the phenomenon of a unit optimizing its goal accomplishment to the detriment of the organization.
To the extent that a division or functional unit views itself as a separate entity, it might refuse to cooperate with other units or divisions in the same corporation if cooperation could in some way negatively affect its performance evaluation.
The competition between divisions to achieve a high ROI can result in one division’s refusal to share its new technology or work process improvements. One division’s attempt to optimize the accomplishment of its goals can cause other divisions to fall behind and thus negatively affect overall corporate performance.
Guidelines for Proper Control
Control should follow strategy.
Unless controls ensure the use of the proper strategy to achieve business objectives, there is a strong likelihood that dysfunctional side effects will completely undermine the implementation of these objectives.
If corporate culture complements and reinforces the strategic orientation of the firm, there is less need for an extensive formal control system.
There are 6 guidelines to be recommended for proper control.
Guideline 1: Control should involve only the minimum amount of information needed to give a reliable picture of events. Too much information may create confusion.
Guideline 2: Control should monitor only meaningful activities and results, regardless of measurement difficulty. If cooperation between divisions is important to corporate performance, some form of qualitative and quantitative measure should be established to monitor cooperation.
Guideline 3: Control should be timely so that corrective action can be taken before it is too late. Steering controls and controls that monitor or measure the factors influencing performance should be stressed so that advance notice of problems is given.
Guideline 4: Long-term and short-term controls should both be used. If only short-term measures are emphasized, a short-term managerial orientation is likely to happen.
Guideline 5: Control should aim at pinpointing exceptions. Only activities or results that fall outside a predetermined tolerance range should call for action.
Guideline 6: Reward for meeting or exceeding standards should be emphasized rather than punishment for failing to meet standards. Heavy punishment of failure typically results in goal displacement.
Resources
Further Reading
- Strategic performance measurement: Creating a common language to drive execution (strategyand.pwc.com)
- Strategic Performance Measurement: Benefits, Limitations and Paradoxes (sciencedirect.com)
- Performance Measurement: Connecting Strategy, Operations and Actions (reliableplant.com)
- How To Select The Right Strategic Measures (clearpointstrategy.com)
- Performance Measurement Vs. Performance Management (clearpointstrategy.com)
- Performance Measurement (referenceforbusiness.com)
- Measuring and Evaluating Strategic Performance (openstax.org)
- How to measure the success of your strategic plan (bdc.ca)
- KPIs vs Metrics – Tips & Tricks to Performance Measures (onstrategyhq.com)
Even More Reading
Related Concepts
References
- Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2016). Strategic Management: Concepts: Competitiveness and Globalization (12th ed.). Cengage Learning.
- Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2019). Strategic Management: Concepts and Cases: Competitiveness and Globalization (MindTap Course List) (13th ed.). Cengage Learning.
- Hill, C. W. L., & Jones, G. R. (2011). Essentials of Strategic Management (Available Titles CourseMate) (3rd ed.). Cengage Learning.