Incentives and BSC Managerial Accounting David Fender

Incentives and BSC

Managerial Accounting

David Fender

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

US humor

US humor

Let’s think about incentives

What kind of incentives do you know? What is your experience?

Forms and types of compensation

Measurement of performance versus compensation

Bonuses Based a contract Subjective bonuses

Non-monetary compensation

Promotion/ Title bump Salary increase

What is the primary

objective of a firm’s

compensation system?

“What you measure gets done!”

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

What are potentially constraining factors (other factors) that you should consider when setting compensation?

Factors when determining

compensation

Potentially constraining factors: Cost Risk to employee and employer Fairness

Equitable compensation (equity principle)

Transparency – comparability Accountability

Factors when determining

compensation

Fire

Financial performance measures have a lag

timeWhat are you likely to see earlier?

Parts not fitting of a car coming down production line

Warranty claims

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

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

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

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?

“Sensitive”

What we need are performance measures

that are

“sensitive”

to individual managerial actions.

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.

Balanced Score Card

Balanced Score Card (BSC)

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

FinancialGoals Measures

InternalGoals Measures

InnovationGoals Measures

CustomerGoals Measures

Customer Perspective:How should we look to our customers?

Innovation & Learning Perspective:How can we continue to improve and create value?

Internal Business Perspective:What must we excel at?

Financial Perspective:How should we look to our shareholders?

Balanced Scorecard (BSC)

Bob KaplanHarvard Business School

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 orientationAND

With short term and long term feedback

Balanced Scorecard (BSC)

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

The Customer Perspective

Identifies targeted customer and market segments and measures the company’s success in these segments

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:1. Innovation2. Operations3. Post-sales service

The Learning & Growth Perspective

Identifies the capabilities the organization must excel at to achieve superior internal processes that create value for customers and shareholders

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).

BSC and Strategy

We proudly announce:

Performance measures

Strategy

Why?

Measuring success requires a well defined strategy Why?

Defining a strategy gets easier with a balanced scorecard! Why?

The balanced scorecard lays out concrete actions to attain desired

outcomes.

A balanced scorecard should have measuresthat are linked together on a cause-and-effect

basis.

If we improveone performance

measure . . .

Another desiredperformance measure

will improve.

Then

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

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.

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

Source: C. Ittner, 2003 AIMA Conference*Gates, “Aligning Strategic Performance Measures and Results”

BSC and strategy in practice

Employee skills in installing options

Number ofoptions

available

Time toinstall option

Customer satisfactionwith options

Number of cars sold

Contribution per car

Profit

Learningand Growth

Internal Business Processes

Customer

Financial

The Balanced Scorecard ─ Jaguar

Employee skills in installing options

Number ofoptions

available

Time toinstall option

Customer satisfactionwith options

Number of cars sold

Contribution per car

Profit

Increase Options Time

Decreases

Strategies

Satisfaction

Increases

Increase

Skills

Results

Employee skills in installing options

Number ofoptions

available

Time toinstall option

Customer satisfactionwith options

Number of cars sold

Contribution per car

Profit

Satisfaction

Increases

ResultsCars sold

Increase

The Balanced Scorecard ─ Jaguar

Employee skills in installing options

Number ofoptions

available

Time toinstall option

Customer satisfactionwith options

Number of cars sold

Contribution per car

ProfitResult

s

TimeDecrease

s

Contribution

Increases

Satisfaction

Increases

The Balanced Scorecard ─ Jaguar

Employee skills in installing options

Number ofoptions

available

Time toinstall option

Customer satisfactionwith options

Number of cars sold

Contribution per car

ProfitResult

s

Contribution

Increases

ProfitsIncreas

eIf numberof cars sold

and contributionper car increase,

profits increase.

Cars Sold Increases

The Balanced Scorecard ─ Jaguar

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

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

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)

Take-Away

Why use incentives?

Balanced Scorecard

Group incentives