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The performance measurement and reward system: Critical to strategic management
To help implement long-term strategy, a performance measurement and rewards system must be in tune with the organization’s structure and culture and must link performance measurement, rewards, and strategic priorities.
The Performance Measurement and Reward System: Critical to Strategic Management Paul J. Stonich
n 0
n many companies, considerable emphasis has been put on combining strategy formulation and resource allocation to improve strategic implementation. Unfortunately, such efforts have not been wholly effective because the necessary performance measurement and reward system that completes the cycle is often missing. Although management has traditionally used the measurement and reward process to influence employees’ activities, the measurement process rarely reflects the organization’s strategic needs. Alfred Rappaport, a professor at Northwestern University’s J. L. Kellogg Graduate School of
American
Organizational Management
Dynamics, Associations.
Management underscored the problem in a recent issue of Business Week: “Many executive compensation systems are just pay-delivery systems linked to what executives think are strategic objectives, like earnings-pershare growth and return on investment, but which are not.” What is needed is a mechanism to encourage managers to behave in ways that are truly in the firm’s long-term interest. This mechanism should monitor and recognize corporate progress toward strategic objectives and demonstrate senior management’s interest and investment in attaining strategic
Winter 1984. 0 1984, Periodicals Llivision, All rights reserved. 0090-2616/84/0016-0045/$02.00/O
45
Paul J. Stonich charge of the
is senior
vice-president in of Management
Chicagooffice
Analysis Center, Inc He earned his undergraduate degree from Denison University and his M.B.A. from the University of Chicago. He has written two books, Zero-Based Planning and Budgeting(Dow Jones-Irwin, 1977) and Implementing Strategy: Making It Happen (Baflinger-Harfax, 1982). His articles have appeared in ManagementReview, Strategic Management Journal, Managerial Planning, Journal of Business Strategy, Today’s Manager, Financial Executive, Public Telecommunications Review, and Educational Broadcasting Review.
46
goals that are in the company’s best longterm interest. The reward system and the performance measurement on which it is based form that mechanism. Consequently, rewards and the measurement framework should be designed as an integral part of the entire strategic management process. One company provides a good example of how overlooking the power of measurement and reward systems can hamper an otherwise sound program. Over the last three years, this multibillion-dollar, diversified manufacturer installed a strategicplanning process and training program that succeeded in getting managers to think in more strategic terms. The company also regrouped its business units more logically and became more formal in reallocating its corporate resources. In short, management made excellent progress.
Unfortunately, the results have not yet fully paid off. The sticking point is the short-term orientation of the measurement and reward systems. Because division net profits still serve as the primary measure of performance, it is understandable that managers are reluctant to take strategic actions. Long-term actions will tend to hurt their units’ near-term performance and therefore reduce their personal compensation. Aligning the performance measurement and reward system with a corporation’s strategy is not in itself enough, however. The system must also be either consistent with, or specifically designed to help modify, certain of the firm’s internal characteristics. While reward systems have long been acknowledged as motivators of managerial performance, they are frequently overlooked as tools to better align strategy with the firm’s internal characteristics. Used alone or out of context, measurement and reward systems cannot influence managerial behavior strongly enough to make strategy happen. The interaction of a number of key variables needs to be carefully orchestrated, along with measurements and rewards to achieve success. Figure 1 shows how these interactions take place. (See box on pages 54 and 55 for details of basic concepts and a model for implementing strategy.) Management can and should make careful decisions about all the interrelated variables. For example, a large midwestern bank spent one year- and hundreds of thousands of dollars - developing a strategy based solely on market needs and economic facts. Although the resulting strategy looked good on the surface, the bank’s top management was uncomfortable with it. “This strategy simply doesn’t fit our culture, our people, or our way of doing things,” said the executive vice-president. And he was right. While elegant, the strategy simply could not be imple-
Figure 1 INTERACTION
0
OF KEY VARIABLES
IN STRATEGY
Strategy
I)
mented in that particular bank without significant behavioral changes. No amount of overhauling measurements and rewards could change that fact. The lesson is simple, yet essential: Measurement and reward processes are only part of the equation. To achieve intended results, the whole set of interrelated variables must be carefully managed by top management to effect changes that work in concert, not in conflict. Sending one message through an explicit strategy statement and a conflicting one through the measurement or reward system can only cause confusion and frustrate positive results. Key questions to keep in mind when examining the effectiveness of a particular approach include the following: How does the system fit with strategy, organizational structure, human resources, culture, and other management processes? Are performance measurement criteria explicitly tied to the rewards structure? Does the system provide incentives to accomplish the organization’s long-term strategies and its short-term objectives? In short, does the approach under consideration encourage or discourage the behavior necessary to successfully execute the corporate strategy? In the following sections we will
consider the three sets of relationships that are particularly important to the design of an effective measurement and reward process. The first relationship is that between measurement and the organization structure. Because structure is typically out of step with strategy, the measurement and reward systems must reflect that gap and close it. Next we will discuss the relationship between measurement on the one hand and the corporate culture and subcultures on the other. A reward process that causes behavior dramatically different from what is “culturally acceptable” may well result in frustrated managers and “climate” problems. Finally, we will look at the explicit links between measurement, rewards, and strategic priorities.
l
l
l
MEASUREMENT
LINKED
ORGANIZATION
STRUCTURE
TO
A most important yet frequently overlooked relationship is that between the company’s formal organization and the measurement process. The size, nature, and diversity of a corporations business impact organization structure and, in turn, the performance measurement and reward system. However, executives responsible for compensation pro-
47
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grams have been unable or unwilling to recognize these factors in the past because of the technical difficulty of collecting relevant performance data or because of their desire to keep things simple through uniform approaches and procedures. Techniques are now available to tailor the measurement and reward processes to varying organizational forms, Before considering appropriate measurement and reward systems, we should understand the four major types of organization structure: centralized function, division, holding company, and matrix. The centralized function organization is made up of specialized units-marketing, sales, production, engineering, research and development, personnel, finance, and administration-each with a single manager at the top and a single chain of command reporting to each functional head; the specialization that develops in this structure is most effective when the company sells a single product or a very few products. A division structure emphasizes a decentralized organization based on product or market groupings; division structure often mirrors the definitions of the business, with each division having its own dedicated functional resources. A holding company is a collection of separate businesses-designated as divisions or subsidiaries-held together by a financial control system; corporate staffs are kept small and do not get involved in division operations, with the exception of financial performance decisions. Matrix structure is characterized by two types of managers: (1) a matrix manager in charge of either a function or a product and (2) a “two-boss” manager, responsible for a defined work package, who reports both to a functional manager and to a product manager. The matrix structure is generally used by businesses involving multiple products or families of products. The relation between structures and measurement systems can be explained
by placing them on two parallel continuums as shown in Figure 2. At one extreme, companies following a centralized, often functional, organizational philosophy frequently use functional measurements for performance. At the other extreme, decentralized companies such as holding companies frequently use return on equity as the primary method of performance measurement. The use of profit-center measurement is frequently aligned with divisional organization. This alignment is not automatically desirable; too often, companies adopt profit-center measurement even though they are not using a decentralized, divisional type of organizational format. This alignment will be dysfunctional if managers are not given the authority and control needed to influence the parameters being measured. Thus in a functional organization, with its centralized decision making, rewarding managers on the basis of profit measures over which they lack control cannot effectively motivate them. The diamonds in Figure 2 mark changes in the position of a large moneycenter bank as it worked to align its organization philosophy, measurement methodology, and business strategy. During the 1970s the bank followed a traditional approach to organization and measurement by using divisions and return on assets as its primary focus. As commercial banking evolved as a result of high inflation rates and increased internationalization of the banking business, the bank introduced a number of changes in its organization and measurement system to improve its alignment with its environment. To recognize the dual nature of many aspects of the banking business, matrix organization was introduced. For example, funds management within branches was placed in a matrix reporting both to the local branch manager and to a centralized funds management organization. International commercial banking was also matrixed, with some loan officers
Figure 2 DIVISIONAL
MEASUREMENT Organizational
I
OPTIONS
Philosophy
+--0
Centralized iFwct;onolj
I
fMotrixJ
Decentralized fHoJdrng CamponyJ
fD,vrsionol)
Measurement
Options
+*------0 I Functional
$
Contrtbution
Profit
Return on Assets
Return on Equ,ty
Earlier position of the bank. Revised position of the bank.
reporting both to the local branch management and to a centralized world corporation management group. This shift in organization paralleled the banks strategic decisions to emphasize its services to large global corporations and to improve its control of the funding or treasury side of the bank. The move toward matrix organization was in effect a move toward more centralized control of the banks activities. Paralleling this change in organization, the bank changed its measurement system to reduce dependence on return on assets by setting up a contribution form of measurement. The bank also double-counted the contribution coming from those operations operating in a matrix, thereby further reducing the bottom-line orientation previously in use. The purpose of this measurement change was to reinforce the cooperation required by the more centralized form of organization in effect. In this example, measurement philosophy was directly aligned with organization philosophy to implement the strategy intended by the bank. Measurement philosophy provides a creative opportunity that can be used either to complement or to counterbalance a com-
pany’s organizational changes to implement strategic direction. Strategy implementation can involve dealing with a misalignment of organizational philosophy and measurement philosophy. For example, a company may be driven toward decentralization by the need to spread its operations across a broad geographical area. The independence created by physical separation frequently creates a drive for decentralized structure and complementary measurement methods. However, if an organization seeks to maintain a firmwide approach to products or services, striving for overall efficiency and effectiveness as opposed to automatically opting for decentralized responsiveness, a purposeful mismatch of organization and measurement philosophies may accomplish the desired results. For instance, a large consulting firm operating in over twenty offices around the world chooses to use a single profit center for measuring performance in the firm. In spite of the fact that, in terms of structure, each of its offices is accorded a degree of independence approaching that of divisions, this consulting firm does not measure profit at the office level. Rather, it uses such functional forms of measurement as overhead control, salary control, firmwide utilization and productivity measures, and revenue measures. The firm deliberately does not bring these functional measures together to create a profit calculation for each office in the organization. This mismatch between organizational and measurement philosophies is explicitly designed to recognize the realities of geography through organization form, and to offset this reality with a measurement philosophy that requires a firmwide view. In this way, the firm is able to maintain consistency in practice across the firm, to force individual offices to work together toward the common good of the firm, and to strive for firmwide benefits and economies that would inevita-
49
bly be lost by a measurement system that was as decentralized as the firms structure.
MEASUREMENTAND THE IMPACT OF CORPORATECULTURE
50
Over the long term an organization’s culture or guiding beliefs can be shaped by the effective use of measurement and reward. Indeed, much of any organization’s current culture can be specifically attributed to past reward policies. Profit-center measurement and the resulting well-known “profit centeritis” may have served a useful purpose at a point in many companies’ history, but now such an orientation can form a major roadblock to achieving the cross-organizational cooperation necessary for many contemporary strategies. However, the more important issue at this point is the impact of inconsistencies between measurement and reward on the one hand and culture on the other during the short term. One multibillion-dollar industrial firm had a history of being a highly political, nondemanding organization. A new chief executive officer was brought in and, within five years, had introduced formal strategic planning, resource allocation at a strategic level, and a sophisticated personal objective-setting process that was linked to the business-planning process and the compensation system. Managers were held accountable for strategic goals that reasonably reflected strategic direction. Still, there was some room for individual negotiation around the measured results that took some of the teeth out of the measurement and reward process. When the budget was tightly integrated into the process, a significant climate problem arose. The disciplined, resultsoriented behavior demanded by the management process was at variance with the “way things are done” and managers could not “escape” the system by saying “I don’t
have enough resources to meet my objectives.” In subsequent years the linkages were relaxed, allowing more flexibility in the system. The company has become a premier competitor in its industry and the climate problems have diminished as “the way things are” have approached the way management wanted them eight years ago.
MATCHING MEASUREMENT/REWARDSYSTEMS WITH STRATEGICGOALS The previous sections described how the conceptual design of the measurement process can be made consistent with a company’s organization structure and culture and yet be supportive of the philosophy and strategy driving the organization. That is not enough, however. It is important to tailor the details of the measurement and reward process to the company’s specific strategy and situation. Toward this end, several approaches are available to help match measurements/ rewards with explicit strategic goals and timeframes; these approaches include (1) weighted factor, (2) long-term evaluation, (3) strategic funds, and (4) combined approaches. The Weighted-Factor Approach The weighting of performance measurements reflects the generally accepted idea that funds should be invested in strategic business units (SBUs) with high growth opportunity. Conversely, where it has been deemed that there is little opportunity for growth, cash flow and return on assets (ROA) measures are weighted more heavily. This weighted-factor approach can be fine-tuned to reflect each individual strategy by using such additional points as target market share, productivity levels, product quality measures, product development measures, and personnel development measures. These measurements form the basis for determining appropriate rewards.
Figure 3
A
WEIGHTED-FACTOR
APPROACH
ACHIEVEMENT
TO REWARDING
OF STRATEGIC
Strategic Business Unit Category
GOALS
Factor
Weight
High Growth
Return on Assets Cash Flow Strategic-Funds Programs Market-Share Increase
10% 0% 45% 45% 100%
Medium Growth
Return on Assets
25% 25% 25% 25% 100%
Cash Flow
Strategic-Funds Programs Market-Share Increase
Low Growth
Return on Assets Cash Flow
Strategic-Funds Programs Market-Share Increase
50% 50% 0% 0% 100%
A large manufacturing company recently completed a rigorous planning process that went far beyond that which most companies attempt. In an effort to tie long-term strategy to operations, an executive committee identified programs having long-term benefits and funded those programs on a priority basis. However, the expected surge of managerial enthusiasm in support of the future-oriented programs failed to appear. The reason for the absence of enthusiasm was ultimately uncovered: The reward system continued to reinforce attainment of short-term goals. The company’s approach for bridging this strategy-results gulf was creative. After categorizing each of its strategic business units as “high growth,” “medium growth:’ or “maintenance,” it developed a measurement system unique to the desired strategy and growth for each unit. The new
weighted-factor approach measured the performance of each unit against the strategic goals of that unit. High-growth SBUs were measured in terms of market share, sales growth, cash-flow potential, and progress of several future-oriented strategic projects. Low-growth SBUs were measured in terms of their cash-generating ability. Just one year after initiating the new measurement and reward system, management behavior began to change. There wa:s a noticeable increase in enthusiasm for the strategy formulation, planning, and programming processes resulting in better implementation. The weighted-factor approach used by the manufacturing company described above called for dieveloping a measurement system that fit the behavior required of each SBU to achieve its strategic goals. Figure 3 illustrates how performance measurement factors such as ROA, cash flow, strategic-funds
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Figure 4 STRATEGIC
BUSINESS
(illustrating
UNIT
Sales Cost of sales Gross margin Operating (general and administrative Operating (return on sales) Strategic funds Pre-tax profit
and increases in market share were weighted according to the importance of each factor in achieving the SBU’s desired performance.
programs,
The Long-Term
52
Evaluation
PROFIT
segregation
Approach
This method explicitly motivates managers toward a future orientation by compensating managers for achieving set goals over a multiyear period. Long-term evaluation usually involves deferred income or incentive cornpensation, typically deferred stock awarded on the basis of attaining an earnings growth target over an extended period. Alternatively, it can be designed so that bonus payments are reinvested in the business, and growth of the reinvested bonuses is contingent on future corporate and unit performance. Currently about 15 percent of companies with sales over $500 million have long-term income programs that compensate managers with some sort of deferred stock to achieve set goals over a multiyear period. The long-term evaluation approach hopefully ties the interest of the firm’s managers to the long-term interests of the firms shareholders. The approach does, however, pose two problems. First, there is relatively little that any one manager (except for the top officers) can do to affect long-term stock price or earnings growth. Therefore, the appreach may not fully take advantage of the
AND
Loss
STATEMENT
of strategic funds) !$ 12,300,000 $
expense)
6,900,OOO 5,400,000
-3,700,000 $
or 33%
1,700,000,
- 1,000,000 $
or 13.6%
700,000,
motivating potential inherent in measurement systems. Second, unless the long-term measure is aligned with the successful implementation of all aspects of the firm’s strategy, the approach can motivate managers to slight those strategy aspects that do not maximize the measure chosen.
The Strategic-Funds
Approach
A strategic-funds approach is another way to improve the linkage between short-term and long-term goals. This approach encourages executives to consider certain developmental expenses apart from current operations. Figure 4 shows a profit and loss statement that’s somewhat different from the type that accountants require for outside reporting purposes. Note that the manager is measured on two bases. The top part of the income statement is familiar in that it shows sales, cost of sales, gross margin, operating general and administrative expenses, and operating return on sales. The unique aspect of this statement is that strategic funds, conventionally included in the operating and administrative account, are separated out below operating return
on sales. These
during the programming resources
devoted
funds
are identified
process, and are the
to future-oriented
activi-
ties. The manager is given an incentive to invest strategic
funds
in the future
and is able
to determine how much is invested in the future of the business. The statement indicates pretax profitability both before and after strategic funds are accounted for. This approach differentiates between those monies spent on future-oriented activities and those expended on current activities. Managers who follow their natural inclination to manage to the “bottom line” are able to do so if operating ROS is considered the bottom line. This approach provides a practical way for executives to plan, manage, and be evaluated on two important aspects of their jobs: maintaining optimal operating performance during the short term while positioning the business for the future. Thus current company operations need not be short-changed and, more important, future investments through strategic funds are encouraged.
ture. Progressive corporations made up of highly diverse businesses already structure their measurements this way. General Electric and Westinghouse provide two excellent examples. In these companies mature SBUs are judged on their ability to generate large profits and positive cash flows while maintaining market share. The emphasis is immediate, and financial compensation correspondingly relies on short-term incentives. But in budding, high-growth areas, GE and Westinghouse make their evaluations of SBLJs against other, usually nonfinancial criteria. These criteria include effectiveness in research and development as well as success at sniffing out new marketing opportunities. Consequently, compensation for managers of these SBUs is tied to longer-term performance.
VEHICLES
The Combined Approach An effective way to achieve the desired strategic results through a reward system is to combine the weighted-factor, long-term evaluation, and strategic-funds approaches. First, segregate future-oriented strategic funds from short-term funds, list them, and report them as in the strategic-funds approach. Second, develop a weighted-factor chart for each strategic business unit, including return on assets, cash flow, strategicfunds programs, market-share increase, and others. (Specific factors taken into account depend on the strategy of the particular business unit.) Third, measure performance on three bases: the bottom-line in the strategicfunds approach, the weighted factors, and long-term evaluation of the corporation’s and SBUs’ performances. The relative weights that can be assigned to each of these in a combined approach will vary from SBU to SBU and from company to company depending on its business environment and the organization’s cul-
FOR
REWARDS
As we have seen, the behavior of groups of managers and individual managers can be measured, and such behavior does affect the company’s performance. Managers and groups of managers can be rewarded in various ways on the basis of their performance measurement. Compensation is the most obvious and! tangible means of reward. It includes salary, bonus, benefit packages, perquisites, insurance, pension plan, stock options and grams, deferred income, and so forth. Obviously, this is a very direct reward and is a very powerful motivator in many cases. However, people’s psychological needs often go beyond pure compensation. Two other important factors need to be considered. The first is power. Power can be granted thriough promotion, organizational placement, recognition, title, or even simple visibility within the organization. For some individuals this is an extremely powerful motivator. A second factor at the disposal of management is personal development and career pathing. Education and personal
53
growth and development are rewards that can be used to motivate a desired performance. These alternative factors may become
IMPLEMENTING
more important in the less hierarchical, “atomized” organizations some business observers predict for the future.
STRATEGY:
THE
MODEL
The performance measurement and reward system has sometimes been considered incidental to and separate from a company’s business, The system is in reality a basic subelement of an organization’s management process. The management process is, in turn, one of the five key elements-strategy formulation, organization structure, human resources, corporate culture, and management processes - that drive an organization’s ability to implement strategy. Success-achievement of strategic objectives through implementation of the strategy- is brought about through a complex interaction of all these elements. Strategy Formulation Strategy formulation is fundamentally the process of deciding where a company is today and where it should be tomorrow. Its primary focus is external, though it must be balanced by assessment of internal capabilities. Questions that must be considered include these: Can enough of the needed human resources be marshaled to make the strategy work? How will existing planning, budgeting, and reward processes have to be modified to meet the strategy’s requirements? Will the strategy require full or partial reorganization? Does the proposed strategy go against the grain of current organizational values and norms of behavior? Organization
Structure
and Human
Resources
Broadly speaking, structure is the formal authority hierarchy that delineates the various roles, responsibilities, and reporting relationships within a firm. If there is a poor fit between the strategy and the structure in place, managers have two choices: Either they must develop restructuring alternatives, or they must attempt to refocus the chosen strategy to fit the existing structure. Similarly, trying to implement a strategy without people who have the requisite skills, attitudes, and training will lead to disaster. If human resources are deficient, managers must make difficult choices: Alter the strategy to fit the available human resources, develop the skills of existing staff, or hire the new people needed to bring the strategy to fruition. Corporate
Culture
Culture comprises the unofficial and usually unspoken “rules of the game” in any organization. Culture, more than any other element, subtly dictates what can and will be done. The success of the strategic planner depends on his or her ability to assess the cultural risks inherent in a chosen strategy. Management
Processes
Planning, budgeting, programming, and the measurement/reward component make up the vital “nervous system” that directs and sends signals throughout an organization and stimulates its movement toward the chosen objectives. These major management processes make up the set of tools that management has available to implement strategy. (See Figure 5.) The planning process is closely related to strategy formulation but is different in several ways. First, strategy formulation develops a specific strategy for a firm or business unit while planning
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For the reward system to work well, it must complement the measurement system and, in turn, be complementary to all of the
other elements in the strategic model presented earlier. Thus the reward system must balance the firms long- and short-term strate-
describes the current strategy to Cop management and provides the link to detail programming and budgeting. Where there are several business units, planning pulls together the strategies of those units and allows top management to develop a corporate strategy and to allocate scarce resources. Second, strategy formulation studies are done periodically when the need arises for a new strategy, while planning is done every year at the same time to communicate all current business unit strategies concurrently to management. Third, strategy formulation is typically an exhaustive analysis involving top management as well as many line and staff managers. Planning generally involves less effort and fewer people. Fourth, strategy formulation is done in reaction to and in anticipation of changes in the environment. Planning profiles those changes and their impact on the strategy. Planning, therefore, can be thought of as the communication of strategy to top management. The strategy may or may not have changed over the previous year, but the periodic nature of the process ensures that the strategy or strategies that are pursued are moving the firm in a rational way toward its overall strategic objectives. Budgeting is the mechanism used to make operational resource allocation decisions and to record them for subsequent measurement. In the budgeting process, the dollars and the people necessary to carry out all organizational tasks are decided and forecast. This is a key process in implementing strategy because it is very close to the action-the actual carrying out of the critical tasks necessary for the company to meet its strategic objectives. Without an appropriate budget it is unlikely that strategy will be implemented effectively. And budgeting is intricately interrelated to the organization structure (who budgets?), the culture (what kind of process will be accepted?), and human resources (can they prepare good budgets?). Two allocation periods or timeframes are important to the top management of a firm: the operational, or short-term, and the strategic, or long-term. The emphasis in many companies is focused on both strategy formulation and short-term budgeting. When the budget is not closely linked with strategy, resources can be allocated in a manner that stifles rather than promotes a firm’s longrange strategy. Thus, although budgeting may be highly developed and although it may provide the information required to reach decisions about day-to-day operations and to set goals that must be achieved by taking specific actions, the resulting resource allocation often is short-term oriented and not designed to explicitly move the firm toward its strategic objectives. Programming is the management process that allocates resources on a multiyear basis toward the fuIfillment of strategic goals. Programming requires the identification and analysis of strategic programs, which in turn require managers to pass judgment on the needs for each program, its risks, its fit with criteria, its chance for success, and the costs involved. Once the strategic funds programs have been approved and funded, the next phase is controlling the progress toward the initial strategic goal. This implies that the proposals have already specified a timetable, milestones, and other controllable and measurable activities. Measurement/reward systems, our interest here, involve considerations well beyond the salary and benefit packages required to attract and keep people of the caliber needed to implement an organization’s chosen strategy. Effective rewards also motivate management to take actions that move the firm toward its strategic goals. All of these elements work together to influence managerial behavior-and managerial be-
havior makes or breaks successfulimplementation of strategies.
%igure TOOLS
5
FOR IMPLEMENTING
STRATEGY
Programming Budgeting
CA /
Strategy
56
T
Implementing Strategy
\
Formulation
gies by granting both long-term and shortterm behavior incentives to managers. From an internal point of view, the reward system needs to be consistent within the business environment and within industry standards. Obviously, this means that, to be fair, rewards must be aligned along the continuum from best performance to worst. They must also be aligned within the industry to maintain a competitive position.
I
x
I
D
Change
A favorite saying of the chief operating officer of a Forfune 500 company is, “If you provide appropriate rewards, their hearts and minds will follow.” The operative phrases in his philosophy are appropriate rewards and hearts and minds will follow. We have discussed that rewards must be appropriate in matching the measurement system and the other elements in the model, as well as the realities of the firm. We’ve also dis-
cussed that it’s important to achieve a certain set of behaviors to carry out strategy.
MEASUREMENT IN
AND
REWARD
SYSTEMS:
PERSPECTIVE
Successful strategy implementation depends, in part, on a well-designed measurement and reward system. A measurement and reward system serves not only to demonstrate senior management’s interest and investment in attaining strategic goals, but also to motivate managers to make strategic business decisions. Strategy formulation, organization structure, human resources, management process, and culture are the five elements that drive an organization to implement strategy. A performance and reward system is a subelement of an organization’s management process. Successful corporate performance occurs when an appropriate strategy is implemented through the rationalization of these five key elements along with the measurement and reward system. The internal consistency of these elements is referred to as “fit.” Measurement and reward systems send powerful signals to a company’s people about their performance. Rewards should motivate people to take action that moves the firm toward its strategic goals. By necessity, the size, nature, and diversity of a business impact the type of performance measurement and reward system that should be utilized. Reward systems can be designed to motivate both short-term and long-term performance. The company that rewards exclusively on the basis of today’s bottom-line may well be hindering the achievement of its long-term strategic goals. Several approaches to reward systems work to integrate strategy with management incentives without sacrificing short-term performance: weighted factor, long-term evaluation, strategic funds,
and a combined approach that utilizes features of the other three. Some co;mpanies do a good job of developing strategy, managing culture, organizing, and developing other management processes, but do not achieve a well-implemented strategy because their measurement and reward system is not in tune. Successful implementation of strategy requires a very carefully designed measurement and reward system. If you mea.sure and reward managers on the appropriate management tasks, their “hearts and minds will follow.”
CD SELECTED
BIBLIOGRAPHY
Some additional reading on the subject dealt with in this article can be found in the following books and articles: David Kraus’s “Executive Pay: Ripe for Reform” (Harvard BusinessReview, September/ October 1980); K. R. S. Murthy’s Co~porute Strutegy and Top Executive Compensation (Harvard BusinessSchool, 1977); K. R. S. Murthy and M. S. Salter’s“Should CEO Pay Be Linked to Results?” (Harvard Business Review, March/April 1973); Alfred Rappaport’s “Executive Incentives vs. Corporate Growth” (Harvard Business Review, July/ August 1978); Howard M. Schwartz and Stanley M. Davis’s‘Matching Corporate Culture and Business Strategy” (Organizational Dynamics, Winter 1981); Paul J. Stonich’s “Using Reward to Implement
Strategy”
(Strategic
Management
]oumal,
January/March 1982); Paul J. Stonich (ed.) and the staff of Management Analysis Center In& Implemenfing Strategy: Making Strategy Happen (Bailinger, 1982); Richard F. VanciI’s “What Kind of Management Control Do You Need?” (Harvard Business Review, March/April 1973); and Richard F. Vancil’s Decentralization: Managerial Ambiguity by Design (Dow Jones-Irwin, 1978).
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The Performance Measurement and Reward System: Critical to Strategic Management Paul J. Stonich
n 0
n many companies, considerable emphasis has been put on combining strategy formulation and resource allocation to improve strategic implementation. Unfortunately, such efforts have not been wholly effective because the necessary performance measurement and reward system that completes the cycle is often missing. Although management has traditionally used the measurement and reward process to influence employees’ activities, the measurement process rarely reflects the organization’s strategic needs. Alfred Rappaport, a professor at Northwestern University’s J. L. Kellogg Graduate School of
American
Organizational Management
Dynamics, Associations.
Management underscored the problem in a recent issue of Business Week: “Many executive compensation systems are just pay-delivery systems linked to what executives think are strategic objectives, like earnings-pershare growth and return on investment, but which are not.” What is needed is a mechanism to encourage managers to behave in ways that are truly in the firm’s long-term interest. This mechanism should monitor and recognize corporate progress toward strategic objectives and demonstrate senior management’s interest and investment in attaining strategic
Winter 1984. 0 1984, Periodicals Llivision, All rights reserved. 0090-2616/84/0016-0045/$02.00/O
45
Paul J. Stonich charge of the
is senior
vice-president in of Management
Chicagooffice
Analysis Center, Inc He earned his undergraduate degree from Denison University and his M.B.A. from the University of Chicago. He has written two books, Zero-Based Planning and Budgeting(Dow Jones-Irwin, 1977) and Implementing Strategy: Making It Happen (Baflinger-Harfax, 1982). His articles have appeared in ManagementReview, Strategic Management Journal, Managerial Planning, Journal of Business Strategy, Today’s Manager, Financial Executive, Public Telecommunications Review, and Educational Broadcasting Review.
46
goals that are in the company’s best longterm interest. The reward system and the performance measurement on which it is based form that mechanism. Consequently, rewards and the measurement framework should be designed as an integral part of the entire strategic management process. One company provides a good example of how overlooking the power of measurement and reward systems can hamper an otherwise sound program. Over the last three years, this multibillion-dollar, diversified manufacturer installed a strategicplanning process and training program that succeeded in getting managers to think in more strategic terms. The company also regrouped its business units more logically and became more formal in reallocating its corporate resources. In short, management made excellent progress.
Unfortunately, the results have not yet fully paid off. The sticking point is the short-term orientation of the measurement and reward systems. Because division net profits still serve as the primary measure of performance, it is understandable that managers are reluctant to take strategic actions. Long-term actions will tend to hurt their units’ near-term performance and therefore reduce their personal compensation. Aligning the performance measurement and reward system with a corporation’s strategy is not in itself enough, however. The system must also be either consistent with, or specifically designed to help modify, certain of the firm’s internal characteristics. While reward systems have long been acknowledged as motivators of managerial performance, they are frequently overlooked as tools to better align strategy with the firm’s internal characteristics. Used alone or out of context, measurement and reward systems cannot influence managerial behavior strongly enough to make strategy happen. The interaction of a number of key variables needs to be carefully orchestrated, along with measurements and rewards to achieve success. Figure 1 shows how these interactions take place. (See box on pages 54 and 55 for details of basic concepts and a model for implementing strategy.) Management can and should make careful decisions about all the interrelated variables. For example, a large midwestern bank spent one year- and hundreds of thousands of dollars - developing a strategy based solely on market needs and economic facts. Although the resulting strategy looked good on the surface, the bank’s top management was uncomfortable with it. “This strategy simply doesn’t fit our culture, our people, or our way of doing things,” said the executive vice-president. And he was right. While elegant, the strategy simply could not be imple-
Figure 1 INTERACTION
0
OF KEY VARIABLES
IN STRATEGY
Strategy
I)
mented in that particular bank without significant behavioral changes. No amount of overhauling measurements and rewards could change that fact. The lesson is simple, yet essential: Measurement and reward processes are only part of the equation. To achieve intended results, the whole set of interrelated variables must be carefully managed by top management to effect changes that work in concert, not in conflict. Sending one message through an explicit strategy statement and a conflicting one through the measurement or reward system can only cause confusion and frustrate positive results. Key questions to keep in mind when examining the effectiveness of a particular approach include the following: How does the system fit with strategy, organizational structure, human resources, culture, and other management processes? Are performance measurement criteria explicitly tied to the rewards structure? Does the system provide incentives to accomplish the organization’s long-term strategies and its short-term objectives? In short, does the approach under consideration encourage or discourage the behavior necessary to successfully execute the corporate strategy? In the following sections we will
consider the three sets of relationships that are particularly important to the design of an effective measurement and reward process. The first relationship is that between measurement and the organization structure. Because structure is typically out of step with strategy, the measurement and reward systems must reflect that gap and close it. Next we will discuss the relationship between measurement on the one hand and the corporate culture and subcultures on the other. A reward process that causes behavior dramatically different from what is “culturally acceptable” may well result in frustrated managers and “climate” problems. Finally, we will look at the explicit links between measurement, rewards, and strategic priorities.
l
l
l
MEASUREMENT
LINKED
ORGANIZATION
STRUCTURE
TO
A most important yet frequently overlooked relationship is that between the company’s formal organization and the measurement process. The size, nature, and diversity of a corporations business impact organization structure and, in turn, the performance measurement and reward system. However, executives responsible for compensation pro-
47
48
grams have been unable or unwilling to recognize these factors in the past because of the technical difficulty of collecting relevant performance data or because of their desire to keep things simple through uniform approaches and procedures. Techniques are now available to tailor the measurement and reward processes to varying organizational forms, Before considering appropriate measurement and reward systems, we should understand the four major types of organization structure: centralized function, division, holding company, and matrix. The centralized function organization is made up of specialized units-marketing, sales, production, engineering, research and development, personnel, finance, and administration-each with a single manager at the top and a single chain of command reporting to each functional head; the specialization that develops in this structure is most effective when the company sells a single product or a very few products. A division structure emphasizes a decentralized organization based on product or market groupings; division structure often mirrors the definitions of the business, with each division having its own dedicated functional resources. A holding company is a collection of separate businesses-designated as divisions or subsidiaries-held together by a financial control system; corporate staffs are kept small and do not get involved in division operations, with the exception of financial performance decisions. Matrix structure is characterized by two types of managers: (1) a matrix manager in charge of either a function or a product and (2) a “two-boss” manager, responsible for a defined work package, who reports both to a functional manager and to a product manager. The matrix structure is generally used by businesses involving multiple products or families of products. The relation between structures and measurement systems can be explained
by placing them on two parallel continuums as shown in Figure 2. At one extreme, companies following a centralized, often functional, organizational philosophy frequently use functional measurements for performance. At the other extreme, decentralized companies such as holding companies frequently use return on equity as the primary method of performance measurement. The use of profit-center measurement is frequently aligned with divisional organization. This alignment is not automatically desirable; too often, companies adopt profit-center measurement even though they are not using a decentralized, divisional type of organizational format. This alignment will be dysfunctional if managers are not given the authority and control needed to influence the parameters being measured. Thus in a functional organization, with its centralized decision making, rewarding managers on the basis of profit measures over which they lack control cannot effectively motivate them. The diamonds in Figure 2 mark changes in the position of a large moneycenter bank as it worked to align its organization philosophy, measurement methodology, and business strategy. During the 1970s the bank followed a traditional approach to organization and measurement by using divisions and return on assets as its primary focus. As commercial banking evolved as a result of high inflation rates and increased internationalization of the banking business, the bank introduced a number of changes in its organization and measurement system to improve its alignment with its environment. To recognize the dual nature of many aspects of the banking business, matrix organization was introduced. For example, funds management within branches was placed in a matrix reporting both to the local branch manager and to a centralized funds management organization. International commercial banking was also matrixed, with some loan officers
Figure 2 DIVISIONAL
MEASUREMENT Organizational
I
OPTIONS
Philosophy
+--0
Centralized iFwct;onolj
I
fMotrixJ
Decentralized fHoJdrng CamponyJ
fD,vrsionol)
Measurement
Options
+*------0 I Functional
$
Contrtbution
Profit
Return on Assets
Return on Equ,ty
Earlier position of the bank. Revised position of the bank.
reporting both to the local branch management and to a centralized world corporation management group. This shift in organization paralleled the banks strategic decisions to emphasize its services to large global corporations and to improve its control of the funding or treasury side of the bank. The move toward matrix organization was in effect a move toward more centralized control of the banks activities. Paralleling this change in organization, the bank changed its measurement system to reduce dependence on return on assets by setting up a contribution form of measurement. The bank also double-counted the contribution coming from those operations operating in a matrix, thereby further reducing the bottom-line orientation previously in use. The purpose of this measurement change was to reinforce the cooperation required by the more centralized form of organization in effect. In this example, measurement philosophy was directly aligned with organization philosophy to implement the strategy intended by the bank. Measurement philosophy provides a creative opportunity that can be used either to complement or to counterbalance a com-
pany’s organizational changes to implement strategic direction. Strategy implementation can involve dealing with a misalignment of organizational philosophy and measurement philosophy. For example, a company may be driven toward decentralization by the need to spread its operations across a broad geographical area. The independence created by physical separation frequently creates a drive for decentralized structure and complementary measurement methods. However, if an organization seeks to maintain a firmwide approach to products or services, striving for overall efficiency and effectiveness as opposed to automatically opting for decentralized responsiveness, a purposeful mismatch of organization and measurement philosophies may accomplish the desired results. For instance, a large consulting firm operating in over twenty offices around the world chooses to use a single profit center for measuring performance in the firm. In spite of the fact that, in terms of structure, each of its offices is accorded a degree of independence approaching that of divisions, this consulting firm does not measure profit at the office level. Rather, it uses such functional forms of measurement as overhead control, salary control, firmwide utilization and productivity measures, and revenue measures. The firm deliberately does not bring these functional measures together to create a profit calculation for each office in the organization. This mismatch between organizational and measurement philosophies is explicitly designed to recognize the realities of geography through organization form, and to offset this reality with a measurement philosophy that requires a firmwide view. In this way, the firm is able to maintain consistency in practice across the firm, to force individual offices to work together toward the common good of the firm, and to strive for firmwide benefits and economies that would inevita-
49
bly be lost by a measurement system that was as decentralized as the firms structure.
MEASUREMENTAND THE IMPACT OF CORPORATECULTURE
50
Over the long term an organization’s culture or guiding beliefs can be shaped by the effective use of measurement and reward. Indeed, much of any organization’s current culture can be specifically attributed to past reward policies. Profit-center measurement and the resulting well-known “profit centeritis” may have served a useful purpose at a point in many companies’ history, but now such an orientation can form a major roadblock to achieving the cross-organizational cooperation necessary for many contemporary strategies. However, the more important issue at this point is the impact of inconsistencies between measurement and reward on the one hand and culture on the other during the short term. One multibillion-dollar industrial firm had a history of being a highly political, nondemanding organization. A new chief executive officer was brought in and, within five years, had introduced formal strategic planning, resource allocation at a strategic level, and a sophisticated personal objective-setting process that was linked to the business-planning process and the compensation system. Managers were held accountable for strategic goals that reasonably reflected strategic direction. Still, there was some room for individual negotiation around the measured results that took some of the teeth out of the measurement and reward process. When the budget was tightly integrated into the process, a significant climate problem arose. The disciplined, resultsoriented behavior demanded by the management process was at variance with the “way things are done” and managers could not “escape” the system by saying “I don’t
have enough resources to meet my objectives.” In subsequent years the linkages were relaxed, allowing more flexibility in the system. The company has become a premier competitor in its industry and the climate problems have diminished as “the way things are” have approached the way management wanted them eight years ago.
MATCHING MEASUREMENT/REWARDSYSTEMS WITH STRATEGICGOALS The previous sections described how the conceptual design of the measurement process can be made consistent with a company’s organization structure and culture and yet be supportive of the philosophy and strategy driving the organization. That is not enough, however. It is important to tailor the details of the measurement and reward process to the company’s specific strategy and situation. Toward this end, several approaches are available to help match measurements/ rewards with explicit strategic goals and timeframes; these approaches include (1) weighted factor, (2) long-term evaluation, (3) strategic funds, and (4) combined approaches. The Weighted-Factor Approach The weighting of performance measurements reflects the generally accepted idea that funds should be invested in strategic business units (SBUs) with high growth opportunity. Conversely, where it has been deemed that there is little opportunity for growth, cash flow and return on assets (ROA) measures are weighted more heavily. This weighted-factor approach can be fine-tuned to reflect each individual strategy by using such additional points as target market share, productivity levels, product quality measures, product development measures, and personnel development measures. These measurements form the basis for determining appropriate rewards.
Figure 3
A
WEIGHTED-FACTOR
APPROACH
ACHIEVEMENT
TO REWARDING
OF STRATEGIC
Strategic Business Unit Category
GOALS
Factor
Weight
High Growth
Return on Assets Cash Flow Strategic-Funds Programs Market-Share Increase
10% 0% 45% 45% 100%
Medium Growth
Return on Assets
25% 25% 25% 25% 100%
Cash Flow
Strategic-Funds Programs Market-Share Increase
Low Growth
Return on Assets Cash Flow
Strategic-Funds Programs Market-Share Increase
50% 50% 0% 0% 100%
A large manufacturing company recently completed a rigorous planning process that went far beyond that which most companies attempt. In an effort to tie long-term strategy to operations, an executive committee identified programs having long-term benefits and funded those programs on a priority basis. However, the expected surge of managerial enthusiasm in support of the future-oriented programs failed to appear. The reason for the absence of enthusiasm was ultimately uncovered: The reward system continued to reinforce attainment of short-term goals. The company’s approach for bridging this strategy-results gulf was creative. After categorizing each of its strategic business units as “high growth,” “medium growth:’ or “maintenance,” it developed a measurement system unique to the desired strategy and growth for each unit. The new
weighted-factor approach measured the performance of each unit against the strategic goals of that unit. High-growth SBUs were measured in terms of market share, sales growth, cash-flow potential, and progress of several future-oriented strategic projects. Low-growth SBUs were measured in terms of their cash-generating ability. Just one year after initiating the new measurement and reward system, management behavior began to change. There wa:s a noticeable increase in enthusiasm for the strategy formulation, planning, and programming processes resulting in better implementation. The weighted-factor approach used by the manufacturing company described above called for dieveloping a measurement system that fit the behavior required of each SBU to achieve its strategic goals. Figure 3 illustrates how performance measurement factors such as ROA, cash flow, strategic-funds
51
Figure 4 STRATEGIC
BUSINESS
(illustrating
UNIT
Sales Cost of sales Gross margin Operating (general and administrative Operating (return on sales) Strategic funds Pre-tax profit
and increases in market share were weighted according to the importance of each factor in achieving the SBU’s desired performance.
programs,
The Long-Term
52
Evaluation
PROFIT
segregation
Approach
This method explicitly motivates managers toward a future orientation by compensating managers for achieving set goals over a multiyear period. Long-term evaluation usually involves deferred income or incentive cornpensation, typically deferred stock awarded on the basis of attaining an earnings growth target over an extended period. Alternatively, it can be designed so that bonus payments are reinvested in the business, and growth of the reinvested bonuses is contingent on future corporate and unit performance. Currently about 15 percent of companies with sales over $500 million have long-term income programs that compensate managers with some sort of deferred stock to achieve set goals over a multiyear period. The long-term evaluation approach hopefully ties the interest of the firm’s managers to the long-term interests of the firms shareholders. The approach does, however, pose two problems. First, there is relatively little that any one manager (except for the top officers) can do to affect long-term stock price or earnings growth. Therefore, the appreach may not fully take advantage of the
AND
Loss
STATEMENT
of strategic funds) !$ 12,300,000 $
expense)
6,900,OOO 5,400,000
-3,700,000 $
or 33%
1,700,000,
- 1,000,000 $
or 13.6%
700,000,
motivating potential inherent in measurement systems. Second, unless the long-term measure is aligned with the successful implementation of all aspects of the firm’s strategy, the approach can motivate managers to slight those strategy aspects that do not maximize the measure chosen.
The Strategic-Funds
Approach
A strategic-funds approach is another way to improve the linkage between short-term and long-term goals. This approach encourages executives to consider certain developmental expenses apart from current operations. Figure 4 shows a profit and loss statement that’s somewhat different from the type that accountants require for outside reporting purposes. Note that the manager is measured on two bases. The top part of the income statement is familiar in that it shows sales, cost of sales, gross margin, operating general and administrative expenses, and operating return on sales. The unique aspect of this statement is that strategic funds, conventionally included in the operating and administrative account, are separated out below operating return
on sales. These
during the programming resources
devoted
funds
are identified
process, and are the
to future-oriented
activi-
ties. The manager is given an incentive to invest strategic
funds
in the future
and is able
to determine how much is invested in the future of the business. The statement indicates pretax profitability both before and after strategic funds are accounted for. This approach differentiates between those monies spent on future-oriented activities and those expended on current activities. Managers who follow their natural inclination to manage to the “bottom line” are able to do so if operating ROS is considered the bottom line. This approach provides a practical way for executives to plan, manage, and be evaluated on two important aspects of their jobs: maintaining optimal operating performance during the short term while positioning the business for the future. Thus current company operations need not be short-changed and, more important, future investments through strategic funds are encouraged.
ture. Progressive corporations made up of highly diverse businesses already structure their measurements this way. General Electric and Westinghouse provide two excellent examples. In these companies mature SBUs are judged on their ability to generate large profits and positive cash flows while maintaining market share. The emphasis is immediate, and financial compensation correspondingly relies on short-term incentives. But in budding, high-growth areas, GE and Westinghouse make their evaluations of SBLJs against other, usually nonfinancial criteria. These criteria include effectiveness in research and development as well as success at sniffing out new marketing opportunities. Consequently, compensation for managers of these SBUs is tied to longer-term performance.
VEHICLES
The Combined Approach An effective way to achieve the desired strategic results through a reward system is to combine the weighted-factor, long-term evaluation, and strategic-funds approaches. First, segregate future-oriented strategic funds from short-term funds, list them, and report them as in the strategic-funds approach. Second, develop a weighted-factor chart for each strategic business unit, including return on assets, cash flow, strategicfunds programs, market-share increase, and others. (Specific factors taken into account depend on the strategy of the particular business unit.) Third, measure performance on three bases: the bottom-line in the strategicfunds approach, the weighted factors, and long-term evaluation of the corporation’s and SBUs’ performances. The relative weights that can be assigned to each of these in a combined approach will vary from SBU to SBU and from company to company depending on its business environment and the organization’s cul-
FOR
REWARDS
As we have seen, the behavior of groups of managers and individual managers can be measured, and such behavior does affect the company’s performance. Managers and groups of managers can be rewarded in various ways on the basis of their performance measurement. Compensation is the most obvious and! tangible means of reward. It includes salary, bonus, benefit packages, perquisites, insurance, pension plan, stock options and grams, deferred income, and so forth. Obviously, this is a very direct reward and is a very powerful motivator in many cases. However, people’s psychological needs often go beyond pure compensation. Two other important factors need to be considered. The first is power. Power can be granted thriough promotion, organizational placement, recognition, title, or even simple visibility within the organization. For some individuals this is an extremely powerful motivator. A second factor at the disposal of management is personal development and career pathing. Education and personal
53
growth and development are rewards that can be used to motivate a desired performance. These alternative factors may become
IMPLEMENTING
more important in the less hierarchical, “atomized” organizations some business observers predict for the future.
STRATEGY:
THE
MODEL
The performance measurement and reward system has sometimes been considered incidental to and separate from a company’s business, The system is in reality a basic subelement of an organization’s management process. The management process is, in turn, one of the five key elements-strategy formulation, organization structure, human resources, corporate culture, and management processes - that drive an organization’s ability to implement strategy. Success-achievement of strategic objectives through implementation of the strategy- is brought about through a complex interaction of all these elements. Strategy Formulation Strategy formulation is fundamentally the process of deciding where a company is today and where it should be tomorrow. Its primary focus is external, though it must be balanced by assessment of internal capabilities. Questions that must be considered include these: Can enough of the needed human resources be marshaled to make the strategy work? How will existing planning, budgeting, and reward processes have to be modified to meet the strategy’s requirements? Will the strategy require full or partial reorganization? Does the proposed strategy go against the grain of current organizational values and norms of behavior? Organization
Structure
and Human
Resources
Broadly speaking, structure is the formal authority hierarchy that delineates the various roles, responsibilities, and reporting relationships within a firm. If there is a poor fit between the strategy and the structure in place, managers have two choices: Either they must develop restructuring alternatives, or they must attempt to refocus the chosen strategy to fit the existing structure. Similarly, trying to implement a strategy without people who have the requisite skills, attitudes, and training will lead to disaster. If human resources are deficient, managers must make difficult choices: Alter the strategy to fit the available human resources, develop the skills of existing staff, or hire the new people needed to bring the strategy to fruition. Corporate
Culture
Culture comprises the unofficial and usually unspoken “rules of the game” in any organization. Culture, more than any other element, subtly dictates what can and will be done. The success of the strategic planner depends on his or her ability to assess the cultural risks inherent in a chosen strategy. Management
Processes
Planning, budgeting, programming, and the measurement/reward component make up the vital “nervous system” that directs and sends signals throughout an organization and stimulates its movement toward the chosen objectives. These major management processes make up the set of tools that management has available to implement strategy. (See Figure 5.) The planning process is closely related to strategy formulation but is different in several ways. First, strategy formulation develops a specific strategy for a firm or business unit while planning
54
For the reward system to work well, it must complement the measurement system and, in turn, be complementary to all of the
other elements in the strategic model presented earlier. Thus the reward system must balance the firms long- and short-term strate-
describes the current strategy to Cop management and provides the link to detail programming and budgeting. Where there are several business units, planning pulls together the strategies of those units and allows top management to develop a corporate strategy and to allocate scarce resources. Second, strategy formulation studies are done periodically when the need arises for a new strategy, while planning is done every year at the same time to communicate all current business unit strategies concurrently to management. Third, strategy formulation is typically an exhaustive analysis involving top management as well as many line and staff managers. Planning generally involves less effort and fewer people. Fourth, strategy formulation is done in reaction to and in anticipation of changes in the environment. Planning profiles those changes and their impact on the strategy. Planning, therefore, can be thought of as the communication of strategy to top management. The strategy may or may not have changed over the previous year, but the periodic nature of the process ensures that the strategy or strategies that are pursued are moving the firm in a rational way toward its overall strategic objectives. Budgeting is the mechanism used to make operational resource allocation decisions and to record them for subsequent measurement. In the budgeting process, the dollars and the people necessary to carry out all organizational tasks are decided and forecast. This is a key process in implementing strategy because it is very close to the action-the actual carrying out of the critical tasks necessary for the company to meet its strategic objectives. Without an appropriate budget it is unlikely that strategy will be implemented effectively. And budgeting is intricately interrelated to the organization structure (who budgets?), the culture (what kind of process will be accepted?), and human resources (can they prepare good budgets?). Two allocation periods or timeframes are important to the top management of a firm: the operational, or short-term, and the strategic, or long-term. The emphasis in many companies is focused on both strategy formulation and short-term budgeting. When the budget is not closely linked with strategy, resources can be allocated in a manner that stifles rather than promotes a firm’s longrange strategy. Thus, although budgeting may be highly developed and although it may provide the information required to reach decisions about day-to-day operations and to set goals that must be achieved by taking specific actions, the resulting resource allocation often is short-term oriented and not designed to explicitly move the firm toward its strategic objectives. Programming is the management process that allocates resources on a multiyear basis toward the fuIfillment of strategic goals. Programming requires the identification and analysis of strategic programs, which in turn require managers to pass judgment on the needs for each program, its risks, its fit with criteria, its chance for success, and the costs involved. Once the strategic funds programs have been approved and funded, the next phase is controlling the progress toward the initial strategic goal. This implies that the proposals have already specified a timetable, milestones, and other controllable and measurable activities. Measurement/reward systems, our interest here, involve considerations well beyond the salary and benefit packages required to attract and keep people of the caliber needed to implement an organization’s chosen strategy. Effective rewards also motivate management to take actions that move the firm toward its strategic goals. All of these elements work together to influence managerial behavior-and managerial be-
havior makes or breaks successfulimplementation of strategies.
%igure TOOLS
5
FOR IMPLEMENTING
STRATEGY
Programming Budgeting
CA /
Strategy
56
T
Implementing Strategy
\
Formulation
gies by granting both long-term and shortterm behavior incentives to managers. From an internal point of view, the reward system needs to be consistent within the business environment and within industry standards. Obviously, this means that, to be fair, rewards must be aligned along the continuum from best performance to worst. They must also be aligned within the industry to maintain a competitive position.
I
x
I
D
Change
A favorite saying of the chief operating officer of a Forfune 500 company is, “If you provide appropriate rewards, their hearts and minds will follow.” The operative phrases in his philosophy are appropriate rewards and hearts and minds will follow. We have discussed that rewards must be appropriate in matching the measurement system and the other elements in the model, as well as the realities of the firm. We’ve also dis-
cussed that it’s important to achieve a certain set of behaviors to carry out strategy.
MEASUREMENT IN
AND
REWARD
SYSTEMS:
PERSPECTIVE
Successful strategy implementation depends, in part, on a well-designed measurement and reward system. A measurement and reward system serves not only to demonstrate senior management’s interest and investment in attaining strategic goals, but also to motivate managers to make strategic business decisions. Strategy formulation, organization structure, human resources, management process, and culture are the five elements that drive an organization to implement strategy. A performance and reward system is a subelement of an organization’s management process. Successful corporate performance occurs when an appropriate strategy is implemented through the rationalization of these five key elements along with the measurement and reward system. The internal consistency of these elements is referred to as “fit.” Measurement and reward systems send powerful signals to a company’s people about their performance. Rewards should motivate people to take action that moves the firm toward its strategic goals. By necessity, the size, nature, and diversity of a business impact the type of performance measurement and reward system that should be utilized. Reward systems can be designed to motivate both short-term and long-term performance. The company that rewards exclusively on the basis of today’s bottom-line may well be hindering the achievement of its long-term strategic goals. Several approaches to reward systems work to integrate strategy with management incentives without sacrificing short-term performance: weighted factor, long-term evaluation, strategic funds,
and a combined approach that utilizes features of the other three. Some co;mpanies do a good job of developing strategy, managing culture, organizing, and developing other management processes, but do not achieve a well-implemented strategy because their measurement and reward system is not in tune. Successful implementation of strategy requires a very carefully designed measurement and reward system. If you mea.sure and reward managers on the appropriate management tasks, their “hearts and minds will follow.”
CD SELECTED
BIBLIOGRAPHY
Some additional reading on the subject dealt with in this article can be found in the following books and articles: David Kraus’s “Executive Pay: Ripe for Reform” (Harvard BusinessReview, September/ October 1980); K. R. S. Murthy’s Co~porute Strutegy and Top Executive Compensation (Harvard BusinessSchool, 1977); K. R. S. Murthy and M. S. Salter’s“Should CEO Pay Be Linked to Results?” (Harvard Business Review, March/April 1973); Alfred Rappaport’s “Executive Incentives vs. Corporate Growth” (Harvard Business Review, July/ August 1978); Howard M. Schwartz and Stanley M. Davis’s‘Matching Corporate Culture and Business Strategy” (Organizational Dynamics, Winter 1981); Paul J. Stonich’s “Using Reward to Implement
Strategy”
(Strategic
Management
]oumal,
January/March 1982); Paul J. Stonich (ed.) and the staff of Management Analysis Center In& Implemenfing Strategy: Making Strategy Happen (Bailinger, 1982); Richard F. VanciI’s “What Kind of Management Control Do You Need?” (Harvard Business Review, March/April 1973); and Richard F. Vancil’s Decentralization: Managerial Ambiguity by Design (Dow Jones-Irwin, 1978).
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