PERFORMANCE MEASUREMENT & CONTROL SYSTEMS FOR | IMPLEMENTING STRATEGY Text & Cases ' Robert Simons Harvard Business School, Boston Robert S. Kaplan Harvard Business School, Boston Prentice Hall Upper Saddle River, New Jetsey 07458CHAPTER 1 Organizational Tensions to be Managed [maz ha 3a ee of a small clothing chain in suburban Boston. You started with one small store and a novel idea: to offer cheap but fashionable clothing, along with a selection of decorative merchandise, to college students who attend Boston's many universities By focusing on the college market and staying in tone with youthful fashion and lifestyle changes, you have saccessfully built up a company with six stores. Your busi- ness now employs more than 100 employees. Innovation—focusing on the local youth market—differentiates your merchandise from the big department stores in the area. ‘The key to success is your employees —young and in tune with the college clientele. ‘They experiment continually with new products and fashion fads and recommend changes in merchandising mix. ‘However, as the company has grown larger, unanticipated problems have surface Profitability among the six stores has been uneven. Two of the units are especially prof- itable, but it is not clear what causes them to be more profitable than the others. Another store seems to consistently underperform, Moreover, if you are not always in a store, you suspect that sloppy financial controls may be eroding profits Other issues have absorbed a lot of your time. You worry about missing the next fad, In one store, employees began experimenting with nontraditional products such as ‘vegetarian foods. Some of the new products sold briskly, but overall store sales de- clined. You are considering expanding into New York state, but you worry about how much to invest in new facilities and inventory. As the business becomes larger and more dispersed, you wonder how to set direction and ensure common goals for the business. ‘The strength of your business has been in letting employees suggest new products to meet their focal customers’ needs. They know their customers best. On the other hand, some of their ideas have been failures. As the number of stores increases —-especially in other states —-greater geographical distance will make it harder for you to communicate your vision for the business and to get information to allow you to manage the business effectively To resolve these issues, effective managers rely on performance measurement and contral systems 1 set direction, make strategic decisions, and achieve desired goals. Setting direction and achieving desired goals 1s relatively easy for a sinall busi hess in which all employees work together in one location. Informal discussions and 3CHAPTER! ORCANIZATIONAL TENSIONS TO BE MANAGED 5 2. Performance measurement and control systems represent formal rowtines and proce dures Information is written down or entered into computer systems and captured in standard formats, either on paper documents or in computer-based systems. The fecording, analyzing, and distributing of ths information is embedded inthe rhythm of the organization, and is often based on predetermined practices and at preset mes in the business eyce. 3. The performance measurement and control systems that we study in this book are de Signed specially to be used by managers. Organizations create masive amounts of information, not al of whichis diretly relevant to manages in their day-to-day werk 'A profit statement for a division or data on customer satisfaction is part of a manager's ‘Control system; information reccived by shipping clerks to allow them to pick mer~ ‘chandise from inventory for specific customers i not, 4. Managers use performance measurement and conteol systems fo maintain or alter pol, tems it organisational activities, Desirable paters of activity may rela to efficiency tind errocctree processing, such as yield rates in a manufacturing process. In other in- ‘tances they may relate to patters of ongoing creativity and innovation in products oF internal processes, such as the percentage of sles from new products or year-over-Year ‘improvement in provessing speed. ‘We can think of performance measurement and control systems in a business in such the same way that we think of controls in a car. The steering, accelerator, and brakes allow the driver to control direction and speed; instrumentation on the dashboard provides eritial information about actual speed and carly warning about potentat prob Teme with the cat's Key operating systems. Like a racing car operating at top speed, high-performance organizations need excellent performance measurement and control systems to allow inanagers fo operate their organizations to their highest potential. in the next section, we introduce profit planning systems. These systems are the foundation for performance measurement and control in all high-performing businesses, and we will refer to them repeatedly throughout the book Profit Planning Systems SBvery business seeks to make a profit, For a business to survive and prosper over time, the inflow of resources must exceed the outflow. Revenue from goods and services pro- Wied to costomers must be greater than the expenditures needed to manufacture and supply those goods and services on an ongoing basis. ‘Accounting systeins collect information about the transactions of a business. Ac- counts (such as the T accounts that you studied in financial accounting classes) are ulti- mately summarized in financial statements such as balance sheets, income statemen!s. wind cash flow statements. Internal control systems—the set of procedures that dictate how and by whom information should be recorded and verified — provide the checks find balances to ensure that assets are safeguarded and the information collected and processed by the accounting system is accurate ‘ccounting systems report actual, or historical, data. In addition to understanding how a business has performed in pst accounting periods, however, managers mnust plan how mucih profit the business will (or needs to) make in future accounting periods. profit plan is a sunmary of fatze financial infos and outflows for a specified fours ecounting period, I is usually prepared in the familiar format of an income statementCHAPTER! ORGANIZATIONAL TENSIONS TO BE MANAGED 7 Employees are constantly reminded of how to keep the store's costs to a minimum to ‘ensure adequate profits in spite of low prices. Business goals are the measurable aspirations that managers set for a business. Goals are determined by reference to business strategy. Goals may be financial, for ex: ample, achieve 14% return on sales; or nonfinancial, for example, to increase market shate from 6% to 9%. The business goals for the clothing store following a fashion strat- cegy will be different than the goals of the store following the low-price strategy. AS we ‘will discus in later chapters, goals can be set for any entity thet can be held accountable for performance: individual managers, departments, divisions, and stand-alone busi- nesses. Performance measurement systems assist managers in (racking the implementa- tion of business strategy by comparing actual results against strategic goals and objec- tives, A performance measurement system typically comprises systematic methods of setting business goals together with periodic feedback reports that indicate progress against those goals. Performance goals may be either short-term or long-term. Short- term performance usually focuses on time frames of one year or less. Longer-term pet- formance goals include the ability to innovate and adapt to changing competitive dy- namics over periods of several years. Successful competitors are able to recognize or create opportunities and turn them into advantage over both the short term and long term, Performance measurement systems can play a critical role in helping managers adapt and learn, ‘Two types of decisions must be made by the designer of a performance measure- ment system. The fitst decisions are about design features: What types of information should be collected and with what frequency of feedback? Second, decisions must be made about how to use the performance measurement systems, Who should receive the data and what should they do and not do with it? How to make cach of these types of decisions will be covered in subsequent chap- ters, First, we must acknowledge briefly the inherent challenge of employing perfor ‘mance measurement and management control systems in any complex organization, BALANCING ORGANIZATIONAL TENSIONS Organizations are complex entities in which managers must balance a variety of forces. ‘There are five major tensions to be balanced in implementing performance measurement and control systems effectively: 1, Balancing Profit, Growth, and Control Managers of high-performance companies constantly seek profitable growth. To do so, they ate continually innovating. Innovation may take many forms. It may be in develop- ing new products or services, or it may appear as lew ways of doing internal tasks re- lated to order processing and manufacturing. Over time, successful innovation finds its ‘way into sustained profitability and growth. However, an excessive emphasis on profit and growth can tend to danger. Employ- ees may engage in behaviors that put the business at risk, They may misconstrue man-CHAPTER | ORGANIZATIONAL TENSIONS TO BE MANAGED 9 Tension of Profit and Growth at America Online ‘When America Online (AOL) went public in 1992, it pursued an aggressive growth strategy. AOL “rained diskettes” by direct mail to millions of computer owners, of- fering them free tials of AOL. It distributed free disks in music CDs, in boxes of Rice Chex cereal, with video rentals at Blockbuster Video, and even with meals on United Airlines. Membership soared from 155,000 in 1992 to more than 4.6 million in 1996, However, this growth came at the expense of profitability and control, Sub- scriber-acquisition costs soared to $400 per new subscriber. AOL decided to treat | these enormous marketing costs as capital expenses, amortizing them over 12 to 18 months. However, after negative publicity over its accounting practices, AOL aban doned its amortization policy and wrote off $385 million, an amount that exceeded the sum of all prior earnings. Then, when AOL changed its pricing policy from an hourly charge to a flat-rate plan its systems could not handle the explosive growth in subscriber demand, leading to well-publicized outages and breakdowns in ser- vice access. : "AOL's refocus on profitability started in 1997. Having established a well-rec- ‘ognized brand name for {ntemet access, managers slashed marketing costs. AOL'S | subscriber-acquisition costs were reduced to $90 per new subseriber and more than 3 million new subscribers were added to the system. It leveraged its scale to cut ac~ ‘ess costs by nearly 50%. AOL exploited its dominant market position by signing lucrative advertising deals with online retailers such as N2K music, 1-800-FLOW ERS, Preview Travel, and CUC International. For example, ‘Tel-Save paid AOL $100 million to become the exclusive retailer of telecommunication services on { ‘AOL. By 1998, AOL reported profits once again, It even increased monthly sub Seriber charges, a clear sign that it did not intend to sacrifice profitability for growth | inthe future Source: Adapted ftom Mare Guather, "The Internets Mr Case's Neightovbos,” 9-40, Fortune, Mach 30,1998, 2. Balancing Short-Term Results Against Long-Term Capabllities and Growth Opportunitles Businesses must deliver financial performance —not tomorrow, or the year after, but l0- day, The stock market. representing shareowners, rewards managers who can produce ceamings in the current period. However, producing earnings consistently — period after period-—is ofien difficult, especially in cyclical businesses, or when significant up-front investment is necessaty to launch a new product or invest in a new plant Managers must also manage for the long term. They must renew production facili- ties, enter new markets with new products, and invest in research and development to stay current with competitors and meet changing customer needs. Performance rneasuremtent and control systems play a critical role in managing the tension between short-term profit demands and the necessity for long-term investment inCHAPTER ORGANIZATIONAL TENSIONS TO BE MANAGED 11 to increase prices and profit margins, bat pay Tow taxes; employees may be interested in ‘salary increases and generous post-tetirement benefits. Well-designed performance nose avecent and control systems provide a fundamental way of recognizing and balancing these trade-offs, 4, Balancing Opportunities and Attention ‘Another tension in organizations telstes to having too much of one thing and to litle of aenthee What do managers today have too much of? The answer is “opportunity.” Think ‘of all the things that any modern business might choose to do: new products, new St Sices, branching into other industries, striking aliances, and opening global markets Conder MCT Communications Corporation, started by a young Harvard M.B.A. in {968 to compete with AT&T's monopoly in long-distance telephone communications MCI's managers recognized many untapped opportunities to create value for customers, and they have ereated many opportunities themselves. Today, MCI has entered ito & Jong-teem alliance with Microsoft Corporation to develop an array of on-line and Inter sone ices. MCI is also collaborating with News Corporation to deliver satellite elevi- ‘yon using high-powered orbital satlites. Recently, MCI agreed fo merge with World- Cam anther communications company. What isthe limite the opportanities wat MCT WorldCom might pursue? ‘To answer that question, think about what businesses have too litle of ‘The answer is management time and attention, Think of all the constraints facing & modern baste Famncil constraints, production constraints, information constraints, and technology eeaatrants, Still, the most critical constraint is management attention. If enough smart people focus thir attention ona set of problems, there arc very few opportniies that cerot be tured to advantage and very few problems that cannot be solved. However: there are only 24 hours in a day. Ye, there are so many things to do, and so many is-00 terscus on, that managers must ration ther ime and atention wisely. There is foo Hikle to go around. ‘Ths, an important issue in designing performance measurement and contro] 3S: tems is ensuring that these systems are valuable tools in leveraging scarce management ee cattention. Inthe chapters that follow, we wil be focusing on various types of aantcurement techniques and financial ratio measures such as Return on Assets (ROA) and Return on Investment (ROI). We should note, however, that we need to pay alien: tion always to how performance measurement and contcol systems can enhance Return ‘on Management (ROM), which we can define as: ‘Amount of productive orgenizational energy released? Return on Management = ——— “Amount of management time and attention invested Brfective monagers have leamed how to leverage this scarcest ofall resources: £9 this book we will staly how managers can use performance measurement and contro} (yutems to maximize their ROM by driving up the numerator (amount of productive open Semone ant Annyne Dail, How High is You Retr on Management” Harn! Business Review ‘i January = Febrsey 1998) 10-80‘CHAPTER| ORGANIZATIONAL TENSIONS TO BE MANAGED 13 personally. This is the view that is prevalent in evonomic models of organizalin Em- Ployees and managers are viewed as rational, calculating, maximizing individuals who vhke work, attempt to do the minimum thats demanded of them, and can be expected to actin opportunistic ways to enhance their own well-being at the expense ofthe orgs. nization to which they belong. To the extent these assumptions are true, performance veasurement and control systems mist be designed fo ensure that people will work hard and do what managers expect of them. ‘although these assumptions are undoubtedly tre in specific cireumstances fora) of us, they ean sometimes be too limiting. For example, they fail to explain people's sense of commitment and responsiblity to others-—why people often try to help some- see else without inducement or possibility for future payoft. They fail to explsin why people join organizations in which they think that they can make a difference, such eer eites and benevolent organizations that help the poor and indigent. They fail 10 explain the importance of deeply held convictions about values, core beliefs and reli- tion. They fail to explain the role of conscience in personal decisions. They fil 10 «x plain the sense of pride and accomplishment that is often a sufficient reward for 8 job well done. “To design a performance measurement and contro systems effectively, therefore managers need @ more holistic and rounded view of human nature, In this book, we tnake the following assumptions about the nature of human activity in organizations oP- erating in modern economies." 1 People in organizations want to comtibue 1 an organization of which they hase from someone else) + abayerean switch to alternative suppliers with ite cost {In many industries, distribution access is prerequisite for success, Products are sold to wholesalers who warehouse and deliver products to retail stores; retailers in fum sell te product to customers This is tre in the brewing industry, for example, where Miller Breweries sells beer in large quantity to regional wholesalers. Sales representa, tives who are smployees of the wholesaler visit retail establishments (restaurants and Tiquor stores) on a weekly basis to deliver product, stock shelves, and take orders for Inter delivery, Without these distributors, the nature of Miller's competitive position would be severely damaged. In industries such as this, access to efficient distribution ‘hannels that facilitate the low of goods and services from the producer to the end con- sumer is an extremely valuable resource. Tike everything else in our modern world, electronic media has changed dramat- cally the nature of customer relationships. Its now commonplace to electronically fink producers, distributors, and customers so that orders can be instantly wansmited for Payer to seller, with real-time updating of purchase orders, ventory records, and hip- mont dates. These electronic linkages can be extremely valuable intangible resources providing competitive advantage. THE 4 Ps OF STRATEGY Look back at Figure 2-2. Our SWOT analysis has now considered the strengths, weak esses, opportunites, and threats created by the interplay of competitive market dynary- iss and firm-specific resources and capabilities, This isthe background or content fr he formation and implementation of business strategy. Next, to formulate and implement strategy effectively, we must understand the design implications of each ofthe four cas, ading boxes shown in Figure 22. Understanding these different views of strategy wil be ecsentel to the performance measurement and control techniques developed later. In the remainder ofthis chapter, we analyze strategy from these four different angles: strat py as perspective, strategy as position stategy as plan, and strategy as pallerns Of 3¢- tion. These are the four Ps of strategy” Pons, Compertive Stes 27 * id. 4-36 aie aberg. “Five Psi Sustegy:” Carma Mange Review (GH 1987), The hE ut covered i this erp. rstategy plCHAPTER? BASICS FOR SUCCESSFUL STRATEGY 29 Sony's mission is intended to ingpire employees to patriotic effort and make each em ployee proud of his or her association with the company and its values, Missions are often written down in formal documents known as mission state- iments that are circulated widely throughout a firm, A mission statement communicates Te gore values ofthe business. Some firms may adopt different names for their mission Statements such as credo, or statement of purpose, but they all serve the same objective: to communicate the larger purpose of the organization and inspire pride in participants. “obnson & Johnson's Credo is reproduced in Exhibit 2-1. Note that in both the Sony and Johnson & Johnson examples—as well as the missions of most high- performance companies—maximizing profit is not the principal reason for exsieiee Eaming profit is never a sufficient definition of a firm’s mission; higher ideals are nec essary to instill pride and motivate productive effort from employees. OF course, every Company has 10 earn profit—just as each of us needs oxygen and water fo Surin However, breathing and quenching ovr thirst are not the primary purposes by which we ‘letne our human existence. Like profit, they are necessary, but not sufficient, condi- tions for success. ‘A firms mission provides an overarching perspective to all ts activities. Rooted in business's history, its culture, and the values of its senior managers, a mission state- trent provides the guideposs that allow all employees to undcrstand how the frm re- Sponds to the opportunities tat surround it, Can you imagine Jaguar introducing 2 Jon priced entry level car to compete with Hyundai Motor Company’? OF McDonald's Corporation opening a fashionable French restaurant? Or Rolex Watch Company pio diuing cheap plastic watches? Or Swatch Group AG offering $5,000 watch? Of couse aan Te cach of these firms, an overarching perspective frames the opportunities that managers pursue and the types of decisions they make when faced with competing Choices, This perspective is the lens through which business strategy is defined goals —> measures ~ action (shown in Figure 7nd illustrates a cascading concept—from a general inspirational mission to specific ‘quantitative measures of success, AS we have discussed briefly, this hierarchy js 5D" ported by strategic plans based on a series of analytic techniques such as SWOT: How: aver this is an incomplete picture of the strategy process. Not all successful strategies are planned. Many arise spontaneously. Consider the following story: Robert Stag, president of Hamitton Bank, was addressing a group of M.B.A. students at Hiesatd Basiness School. Hamilion Bank was an important competitor in the private bank ‘ia nuusty The bank specializes in meeting the personal and corporate banking needs of ‘wealthy individuals who ovsned their own businesses. ‘A student raised her hand and asked, “ME. Stage, you've told us that your private banking steategy is new. Where did it come from? Whose idea was it?" Stage responded, “Denise that’s an excellent question. You probably think that 9 group of sae Hamilton's executive committee —got together and worked i out based on market Spportuites and an assessment of our own capabilities, Butt didn't happen ike (ht ceiained to you, our earlier stegy was much broader .. . and not very suecesia)- We Fall schedaled a seaes of performance ceview mectings with key managers around the county heads of major morkels. Eaeh came tothe meeting to review their profit plans for the coming yee and discuss year-to-date performance ‘What surprised us was 1y managers dseribed profitable niches they had veh cattang to wealthy business cxeners in theis local countries, During the meetings “ee staied o question how much ofthis type of business we had around the world. No one tux! a clue, So we eommessionedt a study to find outCHAPTER? ASICS FOR SUCCESSFUL STRATEGY 35 the owners, volume in this category grew steadily. In time, a decision was made by the fownerfpresident to specialize inthe collegefashion niche and eliminate othet product Yines. Replicating this formula, the business prospered and additional stores were opened, Professor Henry Mintaberg describes how this can happen in other unpredictable ways: Cut in the field salesman visits a customer, The product isn't quite right. and together they work on some modifications. The salesman returns to his company and puts the Changes through: ftr two or three more rounds, they Finally get ight. A new product Emergent Strategy at 3M Innovation is the driving force in 3M’s strategy. In 1997, 30% of sales camme from prociets less than four yeas old, up from 26% in 1994, However, innovation by is erate, cannot be planned in advance. Over the years, 3M has ereated a unique cul ture and set of processes that promote its prolific inventiveness, ‘All 3M employees are trained in risk-taking, and all scientists are expected (0 devote 15% of their time to projects outside of their current responsibilities. If a project fails to win approval within a business unit, scientists routinely find funding Sutside of theit own organization. 3M is determined to follow where its scientists fand customers lead them. 3M scientists work closely with major-customer teams 0 aukdess expressed requirements and to identify and solve vnartieulated needs. 9M Dwomotes erose-frilization of knowledge and ideas by frequent job changes. For Example, when the “Post-It Note” product was being launched, 3M temporarily as Signed the Post-It note product manager to develop a new fly-fishing line "IM pursues a corporate program of investing in emerging technologies with limited current commercial application but with the potential for changing the basis of competition in an industry. In 1961, for example, 3M developed a technology Galled “microreplication” for covering surfaces with millions of precisely made Structures such as cubes or spheres. By 1981, microreplication was used in one Stnall 3M bsiness for making lenses for lighting systems, but many more business tunits were experimenting with this technology for new applications. Recognizing its broader applicability, 3M made substantial investments in the technology. Mi Croteplication is now responsible for more than $1 billion in sales, with explosive growth predicted. Being a patient investor isnot without its risks. For example, 3M continued 10 ‘vest in innovation in its magneticstorage business while the technology followed Steep downward cost curves that quickly tured the high-tech product into a com tnodity, In 1994, 3M wrote off $600 million, laid off thousands of workers, and spun off operations related to this investment “Gone Aap fom Thomas A Stevat."3A Fights Back rane, Feb $199,942. 9M 107 ‘Sia! Repent Chairman s Leto nl‘CHAPTER? BASICS FOR SUCCESSFUL STRATEGY 37 FIGURE 2-6 Basics for Successful Strategy Implementation ‘Strategy resources, motivate people, and measure and monitor implementation, This is SHAE) ts plan, Finally, to succeed over the longterm, managers must KEXP their eyes focused aa earmmers and competitors and their ears to the ground. They must sen and learn. ‘They must encourage employees to experiment and constantly challenge subordinates to pee ede ideas and successes so this information can be used to realign straeBY OVE tinte, This is strategy as emerging patterns of actions. Tae Memainder of this book is devoted to learning how to use petformance NOX ovement and contol systems to achieve profit goals and strstegies. To do 80. 8 intro- aan tools and teshnigues that allow managers to take charge of all the asDecls of successful strategy.Cosmetics: Sales Force Incentives (A)—26.. Duckworth Industies Inc. Incentive Compensation Programs—27. Kidder, Peaoox’ Tnstractons: ive Profits—28. ester Distr 29, Creating Eksive Profts—28, Westchestar Distributing. Inc.—28, ‘This case deerbes the evolution of en innovative, entrepreneurial frm inthe ‘Automatic Oata Processing: The EFS Decision —30. Hamilton Financial Investments: A Franchise Built 6n Trust—1, Automation Consulting } Services—32. Becton Dickinson: Designing the N Process—33. Guident Corporation ure Through Syste about how managers shoul ue controls 0 ovecome te problems ‘83. Guidant Corporation: Shaping Culture Through Systeins ee wo: yo can eluate your understanding ofthe applica gronth, and contr SOF Planning Pow morn aber oc pan fs os Bk= a eae = - =— {Long Tem Debt ‘Comme Stock Reid Barings 12 Wyoe wore Prscet of ATH Teshlagie, ow wo {okie prot and perfomnuos gle? ‘ween $1 tallion and 85 million ational pay-out rom the sae ofthe company. Qvestions: | 1, Docetne “amu” stueie focus nthe sight performance goal? + Should Seer Parmaceical pt wna contol oe hs enceprnei fm? + How would you sommaniet and cont eves and employee aon reabetnes ase” TEXHIBIT 1: Structure of the Baro-Out Payments sn GON poms CARRIES GON 192 Resse 1993 Ress 199 Rests ‘milion $l0zillon 51S mite joo S20 mon11. Growth Phase: 1990-1991 Netlgcome (Lex) (Cath and ST. avestnane (Ober Cane Assets NerPacdAues TaslAvee + ars te semey of 2 U you were President of ATH Technologies, wht weal! yo tear empigeer™FET cn aw namercons oe (eter Came Assess Tet Fixed Acete ‘Teal Aree Long Term Deb Retied Exige Headsout (eae) centre operation! Questions: 1. Row i manger at ATH Tahal, oe, chieve hl po ad perenne ee rng Ba 8 mee ies dt po and pt . 2 Lyon arth siden of ATH, what wou yo do gett hn bck ck? + How cool ep marae hive eid the seen by employees th ad th FDA in vesteatoa?, ae older ng 616% of teary if eat goal fr lacete Before Tes ya percentage of {ler were achieved tere eld be ao dona 5 boous td tere would eo femur abe EXHIBITS: Vision and Beliefs of ATH Technologies Inc. Vastor Our ultimate accountability ito our patie continually set the andar for dag ” thei evolution. The four customer measures he prop + Product Defects saber of eit hat dona: ‘dey the al umber of patente etd + Castomer Contact Eevare: somber of order srr ied by te etal auer oo ae + Backorders ral mate of ores recive fr backordered pede vided by tol mae berof order ake, + "New Product Delays: tne nuaber of months hat aew producveshancerent relate go's eet achive, sarve 1 continually improve what 1 well do By the end of 1993, every single issue ia the FDA's “Warning Lets” had bern re solved. In addon, 80% of the sles and earings goals for the 1993 “eam?” were iaet and the comespooding payment was ade. In 1994, be new bonus scheme Was implemented. The maximum boat lor customer Tam accountable we focused qulliy measures was 10%, representing @ maximam of 25% for mproveme each ofthe four customer measures desorbed above, The response of te employees ‘again impressive and they reached the maximum bons in every single dimension except backorder (Gee Rxhibit (Or success depends on my commit Serer EEE EXHIBIT 6: Bonus Scheme for 1993 and 1994 12 Way od manages ATH Techoolois ine. change hei perfomance messes? Boous Program 1993 Ram Program 1954 + Yoh Fo nae oh rots an out ee, Wan? Mat ke yi 0 cme as isk Ee a ‘ompiesee —+ Depeme rn & heSete Product Defects Cunomer Conta Ero 23. What we thesis for ATH Tehcogies going forward? How soul ters te mori and New Product Delays: Pare 7 oa Q os i: c on 1983 (Cah and ST nests Otter Cureat Asses NePacd Aves ‘oul Anes {Long Tem Dest (Corman Stock Resied Eraigs Hendon (yearend) 36487Prodet Defects Customer ContetExort Backorders ‘New Prodvet Delays 2 How shuld net ise design an use prtrmance management an contol ete ‘mentbe agen nah charge oe sadn? + Wate eral erfomaoe ever of eat going frwant? we Saha mien X 00 Connon ‘iso Rone ae on eke ert “7+ Wattles sould be measured? + low eayo ial hoo goats? + How should ancl expecaion estan communicated? ‘Over the years, J Boats had won any avards including: + "Bout of the Yu” (Sl maganine, Sailing World, Ching World—8 feet} Bout sien bat ‘iat evento: employe scons could pt basins objet ait? How wold you este at ‘tee ih a equi commaniae ad conmoled? ‘5 How would yoo messire and evaluate Scepe's decison wo pure AT Techaolgies i 19907“eg good at ive op ‘cookbooks for oatdoor cocking: new age health; o fishing ‘Accordingly, book pabishers often pl trade abead ef economies, For of a discipline, While these cial inthe seller houses that ‘Maul, te industryEXHIBIT 2 Income Statement by Baitorial Line Toot Cake formation for Children’s Book Line for Year Ended May 31, 1997 mer ry Net trade prof ss) sian s mest Nee: Pees ha ben ded prcene cont,EXWIBIT 4 Comparative 1997 Financial Data for Selected EXHIBIT § Proposed Product Mix and Profit Plan for Children's Book Line— Publishing Companies ‘Year Ending May 31, 1998 Poms aIrORN Ne PCRS PHOTO Be W -MOARCHON FCHON _HACKLISIY TOTAL wovoinos tomas sazancox —"NouEmY a ee iniallanuislontnaet - Maurer Focus Conwiany ches Saeney oan No.of Eaployeet [No.of Nw Tider ue test) [No of Tides on Back (e8) INCOME STATEMENTEA By Hagry Zv1 Daves, PHD Gorpor Coun To BD0ST THEIR RESPECTIVE AVERAGE Free Lunches and ROL A Modern Fable : SOLOMON Apri; ano Pad ROI ano ricnease THEIR ANNUAL PERFORMANCE-BASED BONUSES, TWO SENIOR MANAGERS OF A MULTIVATIONAL CONGLEMERATE TRANSFER VISIONS NETWEEN THEMSELVES BUT 1S THERE SUCH A THING 4S A FREE LUNCH? ing Conglomerate w 1s large multinational Firm with many different lines of business spread acrass the globe. The company wes organized inte divisions. As King, wos a com glomerate, each division had many’ segments ‘hat were ctally independent ofeach other. The King board of directors was meeting with the new CEO to develop a compensation scheme to reward division hheads for increasing profisbiicy Because ofthe divers: ty of produce lines and geographic locations, it was very important to find a universal yarstck that could mes- saute performance without any biases. The bostd was considering two proposals: exurn on investment (ROD And residual income (RD). ‘One senior director said, "I am on the board of a numberof other firms, and they all use ROI. In sll my years of being in business, the most prevalent petfor- ‘mance measure I have seen is ROI.” “Two international dizeeters agreed. “In ovr countries, we also use ROI extensively.” they said, Anuther duector added, “I doo’ ike RI bes of Capital. Also, ‘each year ve have wo calculate thee iftwe don't wane to spend monihs sion heads, we have to use the identical cost of capital forthe entire frm. Ie his ‘vay, we fll to reward a divi= sion head who bonows locally ata favorsble rate co finance a loea investment. By using ROI, we encoungs vision heads to search for favorable financing because icallows then to increase their ROL cing, with the die «With panimovs vote, the board vored ro use ROI to measute performance ane! to reward division heads based on the increase in their ROT from the previcus ‘year. Yean One Jill and Jack were the two most successful senir man- agers at King Conglomerate. Both were able co stceess- Fully motivate theie subordinaces and were independent heads oftheir respective divisions. Bach manager's divi sion had 24 segments, Both Jil and Jack had an investment of about $35 billion, Because King used the ROL wos ane month before the endl ofthe fseal yeay, nd method ro rewsrd managers, both senior managers eare- neither had been able to improve theit ROI fiot last Fully chose the investments to maximize: their ROL year, They knew that the CEO would be very disap Jill ad incseased her ROW annually so thac she had the pointed. Jill and Jack also knew hae they would receive highest ROL in the firm. She eared $552,166,186 09.4 ng bomus if they eonihdwut shov an inerease in their ‘investment base of $3,3%,108,100, which gave her an respective ROL RO! of 19.27%, Jack camed $194,035,1185 on an invest Jill called Jack and invited him co bench 30 they sent hase of $3,814,521,000, giving him an ROT of ‘ould besinstorm together how 10 beat lst year’ ROL 5.09%. (See Table 1.) Because Jill remembered her ceanomics professor ‘This year, however, Jill and Jock were very glum. Ie telling dhe clas, “There ism such thing, 2 a free Jack Sean Rein TO, |” Seament invesinent ROT a aA "I wesaaig— teoyenaio 1% 2 osu Ke rem enone 8 519378 Ka voge7sas 334,583 500 % u uae x smsau —w7tego a w sam7aia ks messi 9.01000 i a8 6 wastieeo 577050 % u aan 7 ssnae nessa 7% ia 2067286 ta nine torneo & | Serra Ss ae eee eae uw insem {xo naira sine ¢ m ‘9600 Ke psyco area zh : us 279569 xe an 2510 a us ism esr270 Ki a us zasm186s—ano750 ns sa80 us zaessas 1838860 10 uw sankasr spon TOO xv ue ayregen he xis bs. pase7r0 vento x9 us wna x20 2758520 wa 103,929,708 kar Seba we 195 499,98, Kin aarrgee. we 79 087,348' Kas NBD SS: Bh ry ‘ote nah % 2% Teta Total 0%line,” she graciously alfeced ta pay As they were about halfway through a magnum of Dor still hadn't snaule any headway in solving their problem, Pétigaon, both Jill and Jaek felt better, bu they Ji said, “IFT coulel just yee id of some ef my sex c tay ROL But no fice lunches. Iti not far co dhe employees ments with the lowest ROI, it would ‘hem just so ean get a bonus, As, the CEO would be set and tire unions might stike. Finally, w+ would he ba! pl hhave to make » huge severanee payout. Closing. se ‘ment is not an upcion for me.” Jack said, “IFT oul just buy a segment with sa ROT larger than 5.09%, I could raise: my ROL. Buc } would have tw ineresse my invesiment base 1 buy the segs ment. By she time I Bish paying the atorneys and avcountants, 1 would end up lowering my ROL” As they were finishing the last wo glasses of cham: ppagne, both felt afte lightheaded, Suddenly fil sai, both solve our problems. My segments Lr» L19 al hy ROT preater than $099 andl less than 19.27%, IFT cans feral chose segeents v9 yinu, my ROT il go up and. “I nave a great idea. 1 just figured aust how we 6 este RGF will eo ua vinking cleats. “Bue i" ne a, “iF a's tae, if yout ROT goes 1p aud my ROL goes up, we have a free uch, and 1 know there are no fice lunches in economics. Ler’ sleep on it. Tomorrow we'll hav nach with no champagne and took at the detailed numbers.” Jill saw thas Jack was inno shape to analyve any rhombers 50 she answered, "Okay, we will meet toror- sow, but since these ate no Free lunches, you pay tomtor row’ hunch bil The nextday at lunch, Jill explained her idea: “My ‘overall ROI is 19.27%. Therefor, all the seginents from Lt to L19 ae bringing down my average ROI. IT gee rid of any of these segments, my ROL wil go up. Your ‘overall ROI is $.09%. ‘Thus, if you take any of the seg: ments from L6 10 124, your ROI will go up." (See ansferring Segments Affects Average ROI.") would love to give you Segments L1 40 L she said, "but of course you won't rake them because chey would lower your ROL, You would lowe ta have myToble2: Jill and Jack RO! After Transfer: Year One il Jock Retain vein Segment Return Tavesinent Wr ‘S155 S15 543,00 xi ‘SNA BNL 1% za 11521700 x meen sn263600 m is sig37eaiaeto Ks tooenses 334503800 w ry uta 1.509.500 “ 57osaee 187.6480 % is isosio ——2,566200 Ks 2asiaoso 499261000 % us sy77a760 48368900 ts iasss20 35727000 % a osg2s0s 824474800 0 3se24e2 13620600 1% ta 135459599 SIS36 900 e msm 284978300 a te rgos7sae 349727600 ‘9 saz 64700 m bs o4ze6azo 404578500 x00 rssi70——raa07,.00 1035 Teal Seaneusea_ s2000570500 ki 1310649 184585900 11% Ke 1083908 783200 1% x13 29300 725,100 19% Ks rag608 521n800 1% 05, 9476290 3800 15% Ki8 sseoais 37,252,500 16% KIT rozersss 60876200 im x6 28720 ——_148591,600 185 x ree 501800 38 29 2asssze 13,783,100 0% ka ‘ssie907 305,700 2% ke 2775 5400 ms Soyinents £20 «9 L7%, but of eourse f won't pive kes 4503986 18.607,200 ae ‘hem co you beeause thar would lowes my ROL Ka sasam 220800 wa “That leaves Gogmenss L& to L19, Lane «6 get sid of 6 ‘eens = 43747,600 % tera, and you want therm, Look what happens when u zis 54,007,900 os Tesnsfer them to you.” (See Table 2) 8 25129 sagen 00 a Jack looked ac the Figures carefully. “il, you are iy 66.909 9822.00 6 ‘ight. This is unbelievable. IF ake Segments L6 t0 uo nse THIS B00 0% L19, my RO! goes up from §.09% to 7.86%, and un zones0s 18075500 1% your RO! yoes up from 19.27% to 21.61%. I guess uw 9420 1499.50 me that old economies professor was wrong feral, You us 2emaee 17151200 13% just gored aut how we ean boch have a free haat! sin, 105472900, 1% ‘This ceninly calls fora celebration. The next ax zag. 1 ‘num oF Dom Périgngn is on me. nose ‘As they were enjoying the drinks, a frown crossed 5814357 Jack's face. "How are we going to convince the CEO {to approve this transfer? He's nor dumb.” Jill swiled her Cheshire ca smile, “You can leave thar co me.” anyaTable 3: CEO Analysis of Hypothetical Transfers Rot i Belore Trenstor a Transfer Lt and 2 from Jit Jack rear Trenster 23 and 126 rom Jt Jack 790% “Transfer KI and K2 trom Jack tot 13% TansfosK28 and K2t trom Jaekto il 992% JUL SELLS SEGMENT Taansrenasiiry, ‘Phe next morning, ill was busy preparing # careful ‘ceport vo she CEO thac called fora ftm-wide policy ransfer of segments beween divisions allowing, ore Jil justified che policy by using » number of arguments: 1s indifferent divisions mean 1. Similar segs company-vide dupEcarion of eusts. By combining si lar segments, it would be possible o redhice overhead 2 Incetewinpony sexment eansieis allow alivision "grow withous incurring ths substantis eosts wf seqqusing an site business, 3. Finally, becouse exch manager was rewarded fev en KOM, ne irupre ager would give up ar kez division znge would tower his or her ROL ‘Thus, ow managers would spree to. transfer only if botl believed thar the wansfor would improve both their ROL. ‘The CEO read Jit’ report carefully. He was espe ally intrigued by J's tt argument. Te wae reasonable ‘hata uansfer char did not provide a company-wide benefit was a zcro-sum move, One manager's benelit ‘was the other’ loss. Just to make sure, the CEO asked fora detailed list ofthe segment performance of both Jill and Jack “Lets see what happens if | make some hypothetical transfers.” the GEO thought to himself. "Ul look at all possible transfers for boch of their highest- and lowest- performing segments." (See Table 3) “les clear that if there are no cost savings, a twanster isa zero-sum move. Every time Jill's ROT improves, Jack’s ROI deteriorates. And every time Jack's RO] Improves, Jill's RO} deteriorates, Obviously Jill and Change in ROL ee ai eek 500% 506% ‘ 2% : + 150% : ‘ 8% ’ : Jick wil only agice 10 uansfer if they expect an Improvement in both their ROL.” Aumed with Jil report and Table 3, the CEO con- vinced the board of dizeeiors co allow segment transfers beoween divisions, ill wansferred segments L6 to L.39 r0 Jack, Boch Jil and Jack received major bonuses thet yeas for improv ing their ROL ae the en of he fiscya, an nee ilar kos se aaa ec wth an fr for enc “Lan ye yu his ia ide ch oes ath rove ox RO st ow he aid." of use fice Junch. Let's meet for lunch (che meal ison me) and sce if you can come up with another briliane idea” "Sure," suid Jill, “just remember to bringa detsiled report of your major segments.” At lunch, Jack pointed out, “Last year we transferred all the segments thar were below your average and. ince this year's Figures are identical above my average. § to last your's, what could we possibly eranafer? Jill anid Jack looked over the two report. “Lave a great idea," said il. “Because of last year's transfer, my overall ROI has now gone up co 21.61%, ‘This yean if I get rid of Segments 1.20 and L2i, smy ROI will go up. Yous overal} ROI is 726. The ROI of ‘cach ofthese segments is higher than your average ROL So if you tke Segments L20 and L21, your ROL will go up. Just ook at the numbers." (See Table 4.) Jack, "Ics amazing how you are “This is eaTable 4: Jill and Jack ROI After Transfer: Year Two Jill vack wre _Investwent AOL Segment fetum Investment co ~ SISA ‘315 545,000 1% cy or a a ce a ra ee) % a ste asizg0 a Ks Toons 34883.800 % 4 e13H ss0gtoo ae ke Sms 187,848,600 % us 10710 28,8620 ks nesses 49926100 si a 105403898 553500 ik is 9543s 328,721000 0% ws raesrste RIG Ha 0 95n28%2 136320600 ™ a 1os2a6 00 5288 wh “e zaszzaee 234070300 % Tota! SUIS Shasta Lay xs 80823 564,200 9% x10 yay 7a07,100 10% Kn vases 64585 900 nm x2 1989 988 9783200 12% x13 29386, 775,00 19% kw ‘nyg0t 165 x15, a76780 18% 16 Sseaa18 8 able to figuir out» way thar we van both improve a wom sse 2% 1 There really is suciv a thing asa fice hun ne aes san a00 3% Sure enauth, [ll an Jack engineciec the trmsfe, Kis sibs 581.400 1% and both receiver? was bases: ko 2asse20 788100 mms 2) Smee) ese 200 2% Vaan Tange Ko 3738 18354400 as Filan Jack were gluen axsin. [ewan svonah es arse 190720 \. 0% before tie end of che Fiscal your, and neither wee a Samet mzan0s0a Ae, le to improve over lst year's ROK, Jack elle Jill 6 260s x77 600 % ‘ v 2anas 3017.09 ™ “The last two years vou had this biliant idea that B 2a = saaehan0 o% allowed both of us w improve eur ROL at no case,” ; 86509, 9572100 9% he recalled, “What. fice lunch, Ler's meet for ianely 10 16am 7775300 10% {the meats on ie) and see if you can comme up with ut 2088305 19075500 m5, another beiliane ides.” uz naazo 1488500 10% ure,” said Jl, “Just remernber co bring a 2279668 17,181,300 Uetailed report of your major segments." 157,78 agare700 ‘Acluneh, Jill and Jack looked! ever the two 911505 165078700 reports, 755,00. “Ic sure looks like the game is up," Jack sti, "You would transfer any segment whose return was below your average return bit above my average requrn. This way we both improve our ROL. But now ‘we can’t do that. Your segments L to LS are all below my average ROI, 0 I don't want them. YourTable 5: Jill and Jack RO! After Transfer: Year Three vith Jack Segment tum Taveatwent A] | Segment fetur Tnvesteent or ta ‘Sioizie ato seaaezagio aH *1 SBE SROKA 07 7 Teal ‘Sioa a0 x40 ke nana 932069600 ws Ks apse 334883500 3h Ke S7osee 187648500 a ks 74320 49861000 o% Ke 19540302 32 727000 0% ” asi 13600800 m% ad nase 13408.900 8% ¥9 0m 04700 3 Kon 27 aN, 306 108% KI asses 4¢85.000 % Kr 0368 795260 12% xia vas 75,100 1% Ki 20.608 s2inta 1% KIS 9276750 53,178,600 18 KiB sseoai 97,252,600 18% x wos 6876200 m% Kia 2emyre = 4an100 10% xis 576506 381400 36. 20 2mamne 13,788,100 0% ka 5656907 26,685,700 21% | Ke saris S340 2% Key ssoygso 13607200, 2% | Kae seas E00 a a zens 43247600 u zan2a ——_xaov7s00 % jo 2Be7288 23381200 wu | 6 8538s gsi) Segments L22 co 1.25 2 all above yous avenge Eee pss 775360 “Nath 201, se you won't ip ut ss 1905500 1% Even Jill ooiced eresfallen, Bur then her over uz 1480.00 1 \whelming epiisen shave some us 17351300 194 Dom Pérignon. ‘The world always looks better alter ua us 1605.28 ue. Bs 175.3500 uw sassy sa22.s00 us sagga2 723330800 ug ‘7g 409,900 over “L 4 few glasses ofthat heavenly clinic” Save enough, as they were Finishing thee mag ug, Jil ie up *Tve got,” she exchimes “vil keep segment 1.24, and vansfr all my athe so rents ro you. My ROL will po up Fem 21.89% ta ee sae 1097 took ashe numbers Te 8 aan is teens fan le es yeni waned, 2 segments (or portfolios of segments) that are below my average RO] and above your average ROL Next year, the only way we can increase our ROL is by a) yreasing productivity” (See FigyFigure 1: Summary of Jill and Jack Performance Ror cee a i EEE deek eee Before Transtar EEE EEE EERE ee eee ‘Alter Your 1 tenster 281% 785% Ate Year? Wanster, 21.89% 88% Aker Yeor3Tansler 23.00% no 000% B is00% 000% 00% Ri Table 6: Summary of King Congiomerate Performance Division investment Fo i 3304108 100 oe Yeo: Zero Jock __341a822 000 . “tat 176% ~ si ‘20794808 $29305379.500 . Year One stack 405,406572 S155.249500 Totat $646,201.70 $9.198620,100 170% 4 vil $921,091.90 $1,451 035,500, Year two Jack 525,108,040. 731,533,200, To $846 20,570 176% it ‘i04,206880 Year Tiree ack _ 74191480, “ Toto! nas Eviogus ‘The board of directors of King Cunglomerate called in the CEO. “You know that we use ROT as our performance: mea remained steady at 11.76% (see Table three years. And you gave out maloyears when we were seagnans. What weve yout thinking? ‘The meeting turned raucous, One director yelled, “OIF wich hi hes defeated, ly the board disposed ef the 1" ‘The motion was seconded, but FO awith a gone tous severance conteat, pension plan, use af thee porate jet, vested opainns, ete). In teats, the CBO lef King Conglomerate and wos never heard fiom in the business world ays, Hasry Zvi Davis, PhD it a profecor at Baruch Cotte, City Universiey of New York, He can be reach! at Hers. Dseis@buruch cunyda vf (118) 258-1075 Solomon Appel isan assistant proftcor at Metropolitan Collegeof New York. He ca be contacted at suppelonesropelitan ely or (212) 142-1234, ret 220). Gordou Cohn, PAD., is un associate professor at Toure Col- Lege in Brostlin, NY. Contact hina gordoncobn in orm ana (718) 200.3700. Sehnowiezonents: Tie withors weald ike fo tank Tong Yinker a Stare Kaishnen for thir befpfad cammens Enpnore 1 Simpaee Pincple i Demogriphy and the Staion, February 1% ps. 32H cnon. repute in Hol Caen, “An Uncesints ee as," ie Nrae % * Harvard Business School 9-198-088 Se ew. November 7, 2000 ) ara ”) | ESC¥ moore sna a ‘ax -Cafes Monte Bianco: Building a Profit Plan f . ff i “WP are facing a decision thot may well affect the future of our company. I expect Jat eqgtf67 you has adequate information to support your aguante. 1 don’t reat fo spend AE mga ha igh entind e {Cafes Monte Bianco, had called the second mecting to delineate the facturing private brand coffees for supermarkets in Italy had saved jowever, it was not clear to him whether the company should Giacomo Salve future of the compay Cafes Monte Bilis SBugent team was all in the room vith the exception of Roberto Bianchi, R&D mateger, as in Wplombia, The rest of the team were Giovanni Calvaro, marketing director; Paolo Cantayg”manufactuline director; Dino Bastico, financial officer; and Carla Salvetti, director of strategic plat x facturer and distributor of premium coffee. 8 reputation for producing some of the Monte Bianco coffees, distributed throughout Euro ided in tie early part of the century by finest coffees on the continent. The company ha Mario Salvetti, grancifather of the curcert CROMPMarin Saivetti, after spencing scvevt! decades in South Aierica working at coffee plantationdfnad come back 19 Haly to eombine che best bean that Ihe had encountered during; his career, Quickly, Monte Bianco's coffee Levame known around Milan for its taste and high quality. Mario passed ths knowledge tguNibtunr, Ruggere, who passed it on to Gaacome, The Selves farwily had owned the comoany k voesiger \ ing aroun the world visiting edféee plantetions, learning about neve beans, anid maintaining Miselationships with coffee producers. ‘The company also had @ laboratory with five people who tri com big SEAN flavors ond tested quality standards for products niready in the market. These pegs producers end aiso traveled frequently to visit plantations, Uvery year, Giacomo spent two months tra ‘The Future of Cafes Monte Bianco Giacomo, intent on surpassing his grandfather's success and making a nant wanted to grow the business aggressively. Over the past five years, he had expanded capag building an expensive, state-of-the-art facility. The performance of Cafes Monte Bianco hag Doctoral Candidate Antonio Dévia and Professor Raber Simons prepared this case asthe bess for clas ds ‘than to illustrate either efetive or infective handling ofan administrative situation Copyright © 1998 by the President and Fellows of Harvard College. Ta order copies or request permission to reproduce materials, cll 1-600-545-7685, write Harvard Business Schoo! Publishing, Boston, MA 05163, or go to hitp:// www bsp-harvard.edu, No part of this publication may be reproduced, stored in a retrieval sytem, used in @ spreadsheet, or transmitted in any form of by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.