Rethinking Strategy.

The volatile business environment of the last three decades has forced companies to rethink the way that they organize their activities to meet new challenges.

The need to respond to intensified global competition, to satisfy more demanding markets, and to cope with rapid change are some of the biggest challenges facing organizations today. These needs have led to the dismantling of traditional hierarchies to a flatter triangle, with empowerment of the lower levels and the formation of multifunctional teams to better coordinate activities and minimize communication bottlenecks.

While our thinking on how companies are organized has changed, one key aspect of management has not: the need to set objectives and measure results remains a cornerstone of the management control process. The old adage "if you want it to happen, you've got to be able to measure it" remains valid. Consequently, numerous ways of measuring and judging performance are in common use.

During the volatile 1970s and early 1980s, many companies abandoned long-term strategy to focus on surviving, by being able to adapt rapidly to change. However, since the late 1980s, as the pattern of change has become dearer, companies have had to return to developing strategies to improve performance and take advantage of the changes in the competitive environment. This has raised the question of how to measure the effectiveness of any strategy -- an area where conventional performance measurement methodologies have serious shortcomings and new thinking is required.

Let's first examine these conventional performance measurement processes and their limitations in measuring strategic performance.

Shareholder value

This has become the primary measure of management performance despite the fact that it is virtually useless in this regard and in fact, even damaging. Here, management performance is measured almost entirely by the current market price of the stock, hence its "value" to the shareholder. The interests of the shareholder and management have been wedded by the practice of granting management generous stock options, which often results in their giving priority to the stock price. The company then becomes managed for its share price.

As a measurement of performance, shareholder value has several major deficiencies. First, it focuses almost entirely in the short term -- in fact, on quarterly results. The stock market rewards the consistent growth of earnings per share but punishes, often severely, companies missing the quarterly earnings expectations of the investment analysts. Management attention is therefore diverted to the short-term results and expenditures and investments of a strategic nature, which would have long-term benefits, are often sacrificed to maintain this quarter's earnings per share. Shareholder value thus limits strategic initiatives.

The second limitation of shareholder value as a measurement of management performance is the fact that the share price is influenced by other factors which have nothing to do with management performance. Between the beginning of 1996 and the end of 1999, the Standard and Poors 500 stock index rose by 111%, which would indicate that management performance has been superb. However, during this same period, the Standard and Poors 500 trailing price/earnings (p/e) ratio rose from 17.5 to 30.1 or 72%. Therefore, while the major portion of the increase in stock prices during this interval was due to a change in the market's perception of the value of stocks in general, and had little to do with management performance, management was nevertheless rewarded through a major increase in the value of their options. In other words, a gigantic free ride for even mediocre management. This suggests that the exercise price of options should be adjusted for market p/e level changes to eliminate this variable, and make share pr ice a fairer, though still flawed, measure of management performance.

However, what the market growth, it can also take away. Stock options though have become so engrained that timid boards of directors have often been bullied by management to reprice options at a lower level when the share price has fallen. So much for performance measurement and rewards based on shareholder value.

The budget

The ability to "make" budget is probably the most widely used measurement of management performance. Budget preparation each year takes a great deal of management time and effort, and is generally a negotiated process in which the performance targets have a margin of safety and rarely reflect the full potential of the business. CEOs are usual willing to accept this limitation so long as the budget promises safe, predictable increases in earnings. While the budget is a necessary planning device, it too tends to have a short-term focus, particularly if management has its eye on the stock price.

However, more damaging is the rigidity that budgets tend to impose on management thinking. Lets take the case of a common situation in which an operating division is falling behind budget in sales and earnings because of unexpected, adverse market conditions. The conventional management response would be to cut costs by downsizing in an attempt to offset the sales decline, and thereby limiting its ability to respond when the market recovers. A strategic thinking manager would consider increasing the marketing effort and advertising to boost sales, which could be effective because competitors are likely to be curtailing such costs.

Few managers, however, would have the courage to take the strategic course even if it strengthened the company's market position in the long term. If it failed, the manager would be seen as being guilty of two sins: that of failing to meet the sales budget and that of incurring higher costs. On the other hand, the conventional manager may have failed to meet the sales budget, but would not be judged too harshly because of the offsetting effort to make the bottom line by reducing costs. In addition to the problem created by its short-term focus, the budget therefore tends to discourage bolder strategic action. It can thus become the enemy of strategy.

Return on investment

The "return" usually consists of net earnings. The "investment" can take many forms, including assets employed, capital employed or equity. The limitations of ROI arise when "investment" is in the form of intangible assets such as intellectual capital rather than in the traditional fixed assets. Thus, outlays on R & D, marketing to establishing brand preference, or training and maintaining a skilled, creative labour force -- which have long-term benefits and are the keys to success for many companies -- are treated as expenses to the detriment of current earnings rather than being amortized, as are fixed assets. The accounting profession has been struggling with this problem but to date has not come up with any solution. Reliance on ROI can be misleading when a high rate of return is provided by low investment, as would be the case if the business was using old, written down machinery. New equipment may be more productive and might provide better quality, which could lead to future higher earnings, but a mana ger would be reluctant to re-equip because of the immediate adverse impact on ROI.

Discounted rates of return

The discounted cash flow rate of return (DCF) is a common way of evaluating investment alternatives and many companies require that any investment meet a specified minimum rate of return. The method is sound in that it recognizes the time value of money. However, it has limitations in its use in the strategic context because the rate of return calculation is highly sensitive to time, with returns provided by the investment in the early years carrying a high weight. The rate of return is sharply lower if the returns are of a longer-term nature. This would be the case for an investment in a factory to produce a new product when the utilization of capacity necessary to provide a significant contribution to earnings would not be achieved for say three to four years. Also, capital expenditures, for which the justification is based on such non-economic criteria as improving quality to keep customers, would have trouble showing the required rate of return.

Economic value added

This is the current craze in the performance measurement field and has been adopted by most major companies. It has been shown that there is a correlation between high economic value added (EVA) and a high stock price. The basic formula is simple: EVA is the after tax operating profit minus the total cost of capital. The cost of capital includes interest on debt plus a return on shareholders' equity. The EVA calculation provides a measurement of the real profitability of the business with a dollar figure rather than a percentage of some other variable, which management seeks to maximize. However, there are estimations required -- such as for the appropriate rate of return -- to be applied to equity, which depend on the risks inherent in the industry.

Overall, EVA deserves its current popularity as a method of measuring management performance. Charging for the use of capital imposes discipline in its use, inhibiting the use of EVA to pump up earnings per share. For example, it encourages close control of inventories and penalizes such relatively common practices as loading up the distribution pipeline to meet the sales budget. This assumes, of course, that management is not so focused on earnings per share and shareholder value as to ignore it.

There is no one way to satisfactorily measure the performance of a company and thereby the performance of its management. All of the single measurements have flaws. Further, conventional performance measurements have serious limitations in measuring strategic performance -- to the extent that they can actually inhibit strategic action.

The solution to this problem does not lie in abandoning the established methodologies. They are too well entrenched and if their respective limitations are recognized, they serve a useful purpose if used in appropriate combinations. Since strategic action usually provides its results over the longer term, the primary requirement is to instill a longer-term perspective into the performance review process by applying some supplementary measurements. These include:

1. Establishing definitive realistic long-term strategic objectives.

2. Integrating the budgeting and long-range planning processes.

3. Modifying the methods of measuring current performance to take in the long-term perspective.

4. Establishing interim non-financial performance measurements to track strategic progress.

Establishing strategic objectives

This may sound simplistic because without objectives there is no basis of reference for measuring performance. While companies are aggressive in measuring current performance, they are often vague in setting out longer-term expectations. The inhibiting factors may include the absence of a clear strategy, uncertainty due to a changing competitive environment, or merely reluctance to undertake a difficult task. Strategic objectives may be broadly based, such as by benchmarking against the leading performer in the industry. It is important to benchmark within the industry to recognize the economic fundamentals of the industry structure, and thus to avoid the risk of creating demoralizing unrealistic objectives. In any event, there must be a well-defined strategy to meet objectives.

Integrating budgeting and strategic planning

While budgeting and strategy formulation can both be considered to be "planning," many companies treat these as distinctly different processes. The preparation of the budget almost totally preoccupies management late in the fiscal year. Long range strategic planning usually takes place during a quieter period, often mid-year. Because of this separation in both time and context, the budget tends to ignore longer-term strategic issues in favour of short-term results. Some managers use this to their advantage. In the strategic planning phase, they project glowing results that impress the board of directors. However, they subsequently present cautious budgets that can be easily achieved, confident that no one will compare the two. They thereby gain a reputation for being bold strategic managers, but also ones who make budget.

The integration of budgeting and longer range strategic planning can be done by extending the budget horizon from its customary one year to three to five years. The additional years need not be in detail nor be complicated by adjustments such as for inflation, but would incorporate the expected results from current and planned strategic initiatives. This would place the current budget in a longer-range context and would put the trade-offs of current strategic expenditures versus their expected future earnings contribution into perspective. In the preparation of next year's budget, the results can be compared not only to the actual results for the past year, as is usually the case, but also to last year's expectations for the second year. The differences can be revealing as to how competition or other circumstances may have changed. This takes the budget beyond the one-year mind-set.

This is not to say that companies should return to the five-year plans based on a myriad of detailed economic assumptions (that were almost always wrong), which formed the core of the now obsolete corporate planning function through the 1960s and into the 1970s. In particular, one must be careful not to be lulled into the trap of the "hockey stick" effect, which provides sharp increases in future earnings resulting from the marginal contribution provided by sales growth, but which rarely materialize because profit margins tend to be overestimated and fixed costs underestimated.

Modifying established performance criteria

To avoid confusion, a company should use the same criteria to track both current and long range performance as much as possible. As was already pointed out, budgeting practices can be modified to consider the longer term. However, conventional performance measures can inhibit strategic initiatives. This can be overcome by modifying some of them as follows:

* If the DCF rate of return is used, investments that are intended to provide longer term or intangible benefits should be designated as "strategic" and exempted from the DCF hurtle rate. Such projects would then be judged on the basis of strategic intent, rather than on a specific rate of return expectation.

* Because EVA is relatively new, it can be calculated in such a way as to accommodate strategic expenditures. Many companies that use EVA delete expenditures that are considered strategic from costs, so as not to penalize management for these "soft" investments. These costs might include outlays for R&D, employee training, or market development, for example, which can be amortized over their estimated effective life. While there are obvious uncertainties in the decisions on amortization periods, it is in principle more accurate than the conventional accounting treatment -- which would require expensing them in the current year -- and therefore considerably less inhibiting to management contemplating expenditures for strategic purposes. While financial statements provided to outsiders must meet generally accepted accounting standards, there is no such specification for internal reports, which can be modified to meet strategic requirements.

Establishing non-financial performance objectives

One of the challenges in measuring strategic performance is that the returns in the form of higher earnings usually lag the costs of implementing the strategy. This lead time can often be several years, leaving a measurement hole if progress is being evaluated solely by earnings performance. However, non-financial performance criteria can be used to bridge this gap. This is based on identifying the elements of performance that current or planned strategies are expected to improve. Targets for these performance variables can be set and the results tracked to assess the progress being made. For example, let's take the case of a strategy intended to increase sales by increasing market share and profit margins by repositioning a product in its market. In financial terms, the full results will not show up in earnings until the sales and price gains are achieved and the non-recurring costs associated with this action level off. However, gains in market share, sales per employee, or average size of sale, for example , can provide an interim indication of progress without bringing in the cost issue. Other similar measurements can include the level of customer satisfaction, delivery and service performance, employee skills and relations, or new product availability.

The measurement of strategic performance is complicated by the fact that the target is usually moving since the implementation of strategy tends to be evolutionary. Planned intents often have to be modified to respond to conditions that are beyond the control of the company, such as those caused by changes in the industry and competitor reactions. The expected improvement in earnings usually lags structural change because of the costs and other difficulties of implementation. These make the evaluation of strategic performance difficult to do precisely. While the suggestions presented here are intended to help, in the end, there is no substitute for a CEO with a vision of where he or she wants the company to go, who can keep an eye on the big picture, and who has the courage to resist the pressure for short-term results.

Ray Suutari is the author of Business Strategy and Security Analysis (1996, Irwin Publishing, Burr Ridge, Ill.) and currently coaches CEOs on strategy formulation.