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Resource Capacity Planning in the Strategy Execution System By Robert S. Kaplan
At the heart of Robert Kaplan and David Norton’s six-stage management model is “Linking strategy to operations,” the place where strategy gets executed. Resource capacity planning represents one of the two big opportunities for linking strategy to operations. (See Figure 1, p. 3.) Drawing on Time-Driven Activity-Based Costing, a recent advance in his landmark costing model, Kaplan presents here a straightforward, step-by-step approach to resource planning— one that requires no negotiation, obviates the need for multiple iterations, and eliminates politics from the budgeting process. Using the abundant data now captured through various enterprise systems, this approach gives managers the information they need to authorize only the resources necessary to fulfill the growth and profitability goals of the company’s strategic plan. Regular readers of Balanced Scorecard Report are familiar with the concept of StratEx, the authorized spending for a company’s strategic initiatives and projects. But such strategic spending typically accounts for less than 10% of overall corporate spending. The remaining 90%-plus supplies the resources for the company to produce and deliver products and services to customers and to perform corporate support functions. Traditionally, budgeting for the company’s employees, equipment, technology, and facilities has been labor intensive, highly political, and fraught with guesswork and imprecision. Now companies can use an analytic approach to estimate the spending on the resource capacity that is required to achieve the sales forecasts in their strategic plan. By resources, we mean not only the tangible resources—the equipment, facilities, and technology—required for producing and delivering products and services and for serving customers, but also the human resources needed—the employees involved in sales, production, distribution, and customer service. This analytic approach consists of four linked steps: 1. Derive the sales forecasts for future periods from the strategic plan. 2. Translate the sales forecasts into a detailed sales and operating plan. 3. Enter the sales and operating plan, as well as projected process efficiencies, into a Time-Driven Activity-Based Costing (Time-Driven ABC) model that forecasts demand for resource capacity. (We’ll define Time-Driven ABC later.) 4. Derive dynamic forecasts (budgets) for operational and capital spending. The four steps also produce pro forma financial profitability reports by product, customer, channel, and region. Continued on next page
INSIDE THIS ISSUE Case File..............................7 How Benchmarks, Best Practices, and Incentives Energized PSE&G’s Culture and Performance When New Jersey–based Public Service Electric & Gas embarked on its strategic transformation in 2002, executives recognized that change required a 360-degree approach. Creative, inspired leadership transformed the century-old utility into a performance-driven, customeroriented enterprise (and 2007 BSC Hall of Fame winner).
Executive Insight ..........................10 Picking “the Right Hill”: How PSEG (and PSE&G) Executives Are Leading Change In the 1990s, the BSC helped Ralph Izzo build PSE&G’s new appliance services division into a competitive organization. So when Izzo became president in 2002, he turned to the scorecard as his preferred instrument of change. Today he’s spreading the message as CEO and chairman of parent Public Service Enterprise Group. Izzo and current PSE&G president Ralph LaRossa reveal their thoughts on the makeover.
Strategy Management Officer....12 Rebalance Your Initiative Portfolio to Manage Risk and Maximize Performance Initiatives don’t exist in a vacuum. Managing them well requires that you manage them not merely as individual projects, but in the aggregate, as a portfolio. And like an investment portfolio, an initiative portfolio must be periodically rebalanced to ensure you’re maintaining your targeted risk levels and performance. Learn how—with examples from high-performing organizations.
Management Synergies ..............15 Turning Strategic Risk into Growth Opportunities Your moment of maximum risk is also your moment of maximum opportunity. So says new-business-development adviser Adrian Slywotzsky. The author of the 2007 book, The Upside: Seven Strategies for Turning Big Threats into Growth Breakthroughs discusses the four major types of strategic risks that can represent record-breaking growth opportunities for your organization.
Balanced Scorecard Report
Key Terms Sales and operating plan (S&OP): The monthly forecast of sales and operations; includes a detailed sales forecast, a resource capacity plan, and budgets for operating expenses and capital expenditures. Most S&OPs have a 12- to 18month horizon that provides a tactical, near-term view of performance. The S&OP thus provides a link between the strategy planning and management system and the operational management system. Annual operating plan (AOP): Another term for the budget; includes discretionary spending. OpEx: Operating expenses budget; the locus of most resource costs (personnel). CapEx: Capital expenses budget; includes equipment resource costs. StratEx: Strategic expenses, a relatively new category recommended by Kaplan and Norton, used to finance initiatives, projects, and process improvements; segregated from OpEx to ensure strategic projects are not compromised or cut in periods of budget cutting.
Step 1: Derive the Sales Forecasts for Future Periods Accurate revenue forecasting is a key capability for creating an integrated planning, resource allocation, and budgeting process. All strategic plans involve forecasts of future sales. While many companies forecast sales as part of preparing their annual operating plan and budget, a number of companies have in recent years abandoned the rigidity of the annual budget to reforecast sales at least quarterly, with the forecast period going beyond the current fiscal year to incorporate the next five or six quarters—an output known as the rolling forecast.1 The sales forecast drives the sales and operating plan developed in the next step.
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Step 2: Translate the Sales Forecasts into a Detailed Sales and Operating Plan In the next step, managers translate the aggregate sales forecast they created in Step 1 into a detailed sales and operating plan. In a manufacturing company, the sales and operating plan would specify the quantity of each product that will be produced and shipped, plus the number of sales orders, purchase orders, production runs, shipments, and deliveries that must be processed. For a financial services organization, the detailed sales plan would include the quantity of transactions that customers have with the institution; for a bank, the transaction count would be the number of deposits, cash withdrawals, mortgage and loan payments, new accounts opened, new credit cards issued, and the like. This level of detail is necessary because the operational implications of $10 million in sales coming from 100 orders of $100,000 each are far different from generating the same $10 million in sales from 100,000 orders averaging $100 each. The latter plan requires the company to process three orders of magnitude (103) more transactions, which creates a much more complex and costly operating environment. Technology can play a helpful role here. Companies with wellfunctioning enterprise resource planning (ERP) systems have a historical record of product and customer mix and transaction patterns that they can draw on for forecasting. For example, to reach the forecast level of sales in each product and service line, the company could assume the same distribution of order size and frequency it experienced in the past, but increase the quantities by the assumed percentage rise in sales. From this simple extrapolation, the company’s
Balanced Scorecard Report Editorial Advisers Robert S. Kaplan Professor, Harvard Business School David P. Norton Director and Founder, Palladium Group, Inc. Publishers Robert L. Howie Jr. Managing Director, Palladium Group, Inc. Edward D. Crowley General Manager, Newsletters, Harvard Business Publishing Executive Editor Randall H. Russell VP/Research Director, Palladium Group, Inc. Editor Janice Koch Balanced Scorecard Collaborative/Palladium Group, Inc. Circulation Manager Bruce Rhodes Newsletters, Harvard Business Publishing Design Robert B. Levers Levers Advertising & Design Letters and Reader Feedback Please send your comments and ideas to
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[email protected] Copyright © 2008 by Harvard Business Publishing Corporation. Quotation is not permitted. Material may not be reproduced in whole or in part in any form whatsoever without permission from the publisher. To order back issues or reprints of articles, please call 800.668.6705. Outside the U.S., call 617.783.7474. Harvard Business Publishing is a not-for-profit, wholly owned subsidiary of Harvard University. The mission of Harvard Business Publishing is to improve the practice of management and its impact on a changing world. We collaborate to create products and services in the media that best serve our customers—individuals and organizations that believe in the power of ideas. Palladium Group, Inc. helps its clients achieve an execution premium by linking strategy and operations and enabling mission-critical links with timely, robust data. Balanced Scorecard Collaborative (BSCol) is Palladium’s education and training division. Our products and services in strategy, finance, and IT consulting, conferences, technology, training, research, publications, and communities are delivered globally from offices worldwide. BSCol also manages the Balanced Scorecard Hall of Fame for Executing Strategy™ program. To learn more, visit www.thepalladiumgroup.com, or call 781.259.3737.
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September–October 2008
planners would modify the distribution to reflect planned changes in sales and ordering patterns. If the company has raised the minimum order size, then planners would eliminate small orders and increase the frequency of larger orders, especially around the new minimum. This is not an exact process. To reflect the inherent uncertainty in forecasting a detailed ordering, production, and delivery schedule, managers should embrace scenario planning and develop optimistic, realistic (most likely), and pessimistic forecasts. Much of the planning data are already in electronic form, enabling planners to run multiple scenarios quickly and inexpensively. The output of this second step is a sales and operating forecast (or forecasts) sufficiently detailed to translate into resource requirements. Step 3: Entering Sales and Operating Data into a Time-Driven ABC Model This step represents the main innovation in linking a strategic plan to an operating plan. It requires that a company have a Time-Driven ABC costing model in operation. Time-Driven ABC
is a new costing approach that is faster, simpler, and more flexible than traditional activity-based costing.2 Time-Driven ABC assigns costs to products, services, and customers based on two fundamental parameters: 1. The cost of supplying resource capacity in each operating department and process. Managers estimate this cost by dividing the costs of resources supplied to the department by its practical capacity (measured typically by the time available each period for productive work). 2. The capacity (time) required from each department or process to handle the product or customer transaction. Before embarking on this step, a company should already have built a Time-Driven ABC model to measure and manage the profitability of its products, services, and customers. The company can now realize a major additional benefit of its Time-Driven ABC model by forecasting the needed resource capacity to deliver on the strategic plan. The company must supply sufficient resources to generate the sales orders, receive the sales orders, produce
the products and services, and deliver them to customers. The Time-Driven ABC model estimates the total demand for each type of resource capacity by multiplying the quantity of transactions in the operating plan by the time needed to complete each transaction. It then divides the amount of time demanded for each resource type by the hours supplied by each unit of that resource for the estimated period (generally a calendar quarter). The result is the estimate of the quantity of each type of resource required to produce and deliver on the sales forecast. Figure 2 (next page) shows an estimate of resource demands by transactions and products for Towerton Financial, a financial services firm. For stock trading, for example, Towerton estimates brokers’ monthly time used in minutes: 5 minutes for each trading transaction + 60 minutes per each new account opened + 20 minutes per meeting with existing customers or 5(275,000) + 60(595) + 20(3,570) equals 1,482,100 minutes, or 24,702 hours
Figure 1. Linking Strategy to Operations: The Strategy Execution Process
STRATEGY EXECUTION PROCESS
OBJECTIVE
BARRIERS
REPRESENTATIVE ACTIVITIES
1. Improve key processes (What business process changes does the strategy require?)
Ensure that the changes required by the strategic themes are translated to changes in operational processes
No alignment between strategic priorities and quality and continuous improvement programs
• Total quality management • Business process improvement • Key success factors • KPIs/dashboards
2. Develop the resource capacity plan (How do we link strategy to operating plans and budgets?)
Ensure that resource capacity, operational plans, and budgets reflect the directions and needs of the strategy
Forecasts, budgets, and operating plans developed independently of strategic plan
• Rolling forecasts • Activity-based costing • Resource planning • Budgeting (OpEx/CapEx) • Pro forma financials
In Kaplan and Norton’s six-step management model, linking strategy to operations consists of two broad areas of activity: business process improvement and resource capacity planning (resource management).
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Figure 2. Determining the Resources Needed to Hit Sales Targets: Towerton Financial Example
STOCK TRADING
MUTUAL FUND TRADING
INVESTMENT MANAGEMENT
FINANCIAL PLANNING
$3,644,000
$2,031,000
$113,000
$169,000
275,000
49,000
2,600
—
595
255
40
90
Number of calls to customer service center
47,600
11,475
600
480
Number of meetings servicing existing accounts
3,570
765
200
400
Forecasted monthly sales (Target) Number of transactions Number of new accounts opened
To meet its $5.9 million/month sales target, Towerton Financial decomposed the target into subtargets for each product line (stock trading, mutual fund trading, etc.). Each subtarget was then broken down by the volume and mix of transactions that would be executed by the company’s resource units (people and technology).
Since sales and operating plans involve considerable uncertainty, the analyst should explore a variety of possible scenarios, not just a single forecast, to provide a sense of the range of resources required to meet a likely range of outcomes. After examining the resource requirements under diverse assumptions, the company can authorize the level of resource supply to be carried into the next period, as shown in Figure 3. Because each resource unit has a known cost per period, the decision about the level of resource supply automatically
Resource demand is never uniform throughout a given period, and some demand may take longer to process than the average amount—such as hiring employees with the special skills needed to market a new product. To avoid queuing and delays, some buffer amount of resource capacity may be desirable.
In this example, Towerton used a one-period-ahead forecast to generate a resource demand model for the next period. Typically, companies that reforecast quarterly create rolling forecasts that extend up to five or six quarters into When demand for future resources is expected the future. The to decrease, the company can start to plan planning group can replicate the ways to shed capacity so that it will not be resource capacity burdened with significant excess capacity in planning step future quarters. for each quarter’s forecast: translate each quarter’s leads to an authorized or budgetforecast into a detailed sales and ed level of spending on each operating plan, update the Timeresource category, as calculated Driven ABC model for expected 3 in the next step. efficiency improvements in that In general, companies should quarter, and run the structural supply somewhat more capacity Time-Driven ABC model to prethan that forecast by the deterdict resource demand for that ministic Time-Driven ABC model. quarter.
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In this way, the company can see in advance where resource shortfalls may occur in future periods. It can take near-term steps to acquire and train personnel so that they become available as needed in future periods. The company can also start the capital acquisition process to ensure that adequate levels of physical capacity—plant or office space, production and distribution equipment, servers and bandwidth—also come online as needed to meet future sales and operating projections. Conversely, suppose that the TimeDriven ABC had forecast a substantial drop in future demand for resources. The reduced demand could arise from productivity and process improvements, changes in operating policies (such as higher minimum-order sizes or account balances), or anticipated declines in sales. When demand for future resources is expected to decrease, the company can start to plan ways to shed capacity so that it will not be burdened with significant excess capacity in future quarters. This is the process by which almost all organizational costs
September–October 2008
become, as economists say, “variable in the long run.” Most costs don’t go away by themselves. Costs vary downward only when managers take explicit actions to reduce the supply of resources by ceasing to issue paychecks and starting to sell equipment and facilities that are no longer needed to support current and future operations. In fact, there are very few fixed costs; just lazy managers. By acting on the information from the Time-Driven ABC resource forecasting model, managers get a head start on adjusting resource supply to future needs. Step 4: Develop the Operating and Capital Expenditures Forecast Once managers have agreed on the level of resource supply for future periods, the financial implications can be calculated simply and quickly. At the end of Step 3, the company has estimated the quantity of each type of resource it has agreed (or expects) to supply in a future period. From its first step in building a TimeDriven ABC model, the company has calculated the cost of supplying each unit of resource. In Towerton Financial’s case, each of its 230 resource “units” (i.e., brokers) costs $6,800 per month, for a
total of $1.5 million per month. The planners should adjust the resource unit costs for any anticipated price changes, such as employees’ salary increases, changes in occupancy, or changes in computing costs. In this way, the cost and spending forecasts will reflect future expectations rather than historical actuals. Once the company has entered the estimated cost of each resource unit, it multiplies this value by the quantity of each type of resource to be supplied during the forecasting periods. This multiplication yields the forecast (budgeted) cost of supplying the quantity of each resource type. Resource costs are, in effect, the line items in the budget. But rather than the budget for line items coming from an extensive iterative and negotiated process, item by item, it arrives from a simple cross-multiplication process—multiplying the quantity authorized for each resource type by the resource’s cost per unit. The result is a budget that has been derived quickly and analytically from the sales and operating plan, rather than being imposed by fiat or through negotiations whose outcomes often depend more on power than on logic.
The process described here is exactly analogous to material resource planning (MRP) systems introduced for manufacturing companies in the 1980s. MRP systems took detailed forecasts of the production of each product and “exploded” them up to give a total demand calculation for materials and component parts during the production period. Purchasing and logistics people then had a sound basis for ordering and scheduling the delivery of material inputs to meet the planned production schedule. The resource capacity planning process, described in Steps 1 through 4, extends the MRP model to forecast all resource capacity demand, not just materials. It explodes the detailed sales and operating plans into the total demand calculation for all resources: employees, equipment, facilities, and distribution. Forecasting Discretionary Spending Before concluding the budgeting process, the company needs one additional set of estimates: forecasts of the level of discretionary spending on items such as research and development, advertising and promotion, training, and, of course, strategic
Figure 3. Calculating the Quantity of Resources Required to Implement the Next Period’s Operating Plan at Towerton Financial
RESOURCE CATEGORY
TOTAL HOURS DEMANDED
AVAILABLE HOURS/MONTH PER RESOURCE UNIT
RESOURCE UNITS REQUIRED
RESOURCE UNITS SUPPLIED
CAPACITY UTILIZATION
29,295*
130
225.3
230
98%
Account managers
793
130
6.1
7
87%
Financial planners
1,500
130
11.5
12
96%
Principals
3,118
130
24.0
25
96%
Customer service reps
5,282
140
37.7
40
94%
Brokers
* Stock trading = 24,702 (as calculated on p. 3) + 4,593 hours required for mutual fund trading = 29,295 hours.
Demand by transaction and product as calculated in Figure 2 becomes the basis for the estimate of people resources required for the subsequent period.
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initiatives. The forecast spending on these discretionary items does not bear a tight causal relationship with sales and operating levels, and therefore requires a parallel calculation along with the quarterly update of revenues. Determining the spending on such discretionary items remains a judgment call by experienced executives, and not a decision that can be automated through an analytic model. Calculate Profitability by Product, Customer, Channel, and Region In addition to the total level of expected spending for the forecast period, the Time-Driven ABC model supplies, essentially for free, the detailed profit-and-loss statement (P&L) for each product, customer, and region. After all, the total demand for resource supply and resource spending has been estimated by aggregating the resource demands for each product, customer, channel, and
translate high-level sales forecasts into detailed sales and operating plans that specify the volume and mix of individual products and services sold, produced, and delivered, and the quantity and mix of customer-based transactions. In the third step, the detailed sales and operating plans are translated, through a TimeDriven ABC model, into estimates of demand for capacity of the company’s primary resources. Based on forecasted demand for resource capacity, managers determine the quantity of each type of resource that will be supplied in upcoming periods. In Step 4, planners translate the authorized level of resource supply into budgeted operating and capital expenses for the upcoming periods and estimate pro forma P&Ls.
This series of logical and tightly linked steps provides a mechanism for translating strategic sales growth targets into detailed plans for authorizing resource capacity Determining the spending on certain as well as forecasts of operatdiscretionary items remains a judgment ing profitability call by experienced executives, and by products, not a decision that can be automated customers, and regions. through an analytic model.
region—in fact, for each transaction. By going back to the detailed sales and operating plan, the model automatically attributes the supply and cost of each resource type to the transaction, product, or customer that triggered the demand. From Strategic Intent to Detailed Plan Companies translate their strategic intent into detailed operating plans through a disciplined, integrated four-step process. This process starts with quarterly sales forecasts for the next several periods. In the next step, planners
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In this way, Time-Driven ABC serves to connect strategy with operational decisions and financial plans. And the insights gained from creating and using the Time-Driven ABC model can also help the organization develop operational driver models that serve as the foundation for developing financial plans. I The editors wish to thank Michael Contrada, Senior Executive Vice President, and Philip Peck, Vice President and Finance Practice Leader, of Palladium Group for their valuable input. 1. The rolling forecast is discussed in the context of traditional and newer approaches to budgeting in “Why Budgeting Fails: One Management System Is Not Enough,” BSR September–October 2004 (Reprint #B0409C). It is also described in cases on Borealis, the European plastics manufacturer: “Beyond Budgeting: Pathways to the Emerging Model,” BSR May–June 2000 (Reprint #B0005B),
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• What’s your performance management philosophy? David Norton analyzes leading methodologies and approaches and how organizations use them in combination to drive their management system. • Managing in partnership: how the BSC and strategy maps helped the entities within a major North American port system to work together to improve operations and boost collective performance • The art of change management— the principles underlying behavior and attitudes toward change, and how to use them to advance your organizational programs • Performance analysis that clicks: how to write effective, actionable analysis • Chris Zook on finding your next growth engine
and “New Tools for a Corporate Culture: The Budget-less Revolution,” BSR January–February 2002 (Reprint #B0201C). See also “Linking Strategic Planning and the Rolling Financial Forecast at Millipore,” BSR May–June 2007 (Reprint #B0705D) and “Statoil: Scorecard Success—the Second Time Around,” BSR January–February 2008 (Reprint #B0801B), which discusses the oil giant’s approach to “blowing up the budget” to link budgeting more effectively to strategy execution. Finally, an indepth Case File on Luxfer Gas Cylinders describes the company’s many mechanisms for integrating planning, budgeting, and strategy execution; see “Luxfer Gas Cylinders: Mastering the Strategy– Operations Linkage,” in BSR May–June 2008 (Reprint #B0805B). 2. The main reference for Time-Driven ABC is R. S. Kaplan and S. R. Anderson, Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits (Harvard Business School Press, 2007). In Activity-Based Costing, the resource expenses assigned to an activity are determined through interviews, time logs, and direct observation of the time (amount or percentage) people actually spend on various component activities. For example, the cost of warehousing goods is derived from its component activities: receiving, inspection, put-away, picking, packing, and shipping. Activity cost driver rates are calculated by dividing by the outputs of each activity. ABC proved difficult to scale, a problem that Time-Driven ABC overcomes. 3. A more detailed illustration of this procedure can be found in R. S. Kaplan and D. P. Norton, “Plan Operations: Sales Forecasts, Resource Capacity, and Dynamic Budgets,” Chapter 7, The Execution Premium (Harvard Business Press, 2008); and in R. S. Kaplan and S. R. Anderson, “What-if Analysis and Activity-Based Budgeting: Forecasting Resource Demands,” Chapter 5, Time-Driven Activity-Based Costing.
Reprint #B0809A
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September–October 2008
How Benchmarks, Best Practices, and Incentives Energized PSE&G’s Culture and Performance By Anne Field, Contributing Writer
How do you shift from a fire-engine-response mentality to one of continuous improvement? For Public Service Electric & Gas, the 105-year-old New Jersey–based utility, this was no small feat. Prior success with the BSC convinced then-new president Ralph Izzo to adopt the BSC companywide. Welldefined performance drivers and measures, a deep benchmarking effort, and a well-rounded program of incentives, initiatives, and reviews have won PSE&G across-the-board breakthrough results—and a place in the BSC Hall of Fame. It’s one of the largest investorowned utilities in the nation, delivering gas and electricity to New Jersey’s six largest cities, as well as approximately 300 suburban and rural communities— serving about 5.5 million residents. In fact, the Newark-based Public Service Electric and Gas Company (PSE&G) serves a total area of roughly 2,600 square miles that is home to dozens of major corporations and some of the nation’s wealthiest communities. The $7.6 billion company, a subsidiary of Public Service Enterprise Group (PSEG), also has a safety and reliability record that is among the highest of any U.S. utility. Back in 1999, however, the company faced a new world brought about by deregulation. Now, both residential and commercial customers would be able to choose among different power suppliers. When Ralph Izzo became president of the utility in 2002 (he is now PSEG’s chairman and CEO), he was determined not just to maintain, but to improve, performance. Deregulation, however, meant that the business could no longer rely on favorable regulatory treatment to help with earnings performance. To succeed in the new competitive environment—and offer top-level services
at the lowest cost possible— Izzo decided that PS&G had to focus on operational excellence to meet earnings targets.
success in streamlining operations, boosting productivity, and launching the company’s own appliance brand convinced Izzo to expand the BSC methodology throughout the entire company. Here was a system that could unify the organization around common strategic goals. “Until you begin to put on a single sheet of paper all the things you need to measure, you can’t talk about interrelationships,” says Izzo. “If you tackle metrics as if they were isolated hills, you will always be in the position of making progress on one front and losing position on another.” Initial scorecard development was launched by a team of vice presidents and directors, who analyzed the company’s financial statements to identify drivers of success “from the standpoint of different stakeholders—employees, customers, shareholders,” Izzo notes. But when the team came
Accomplishing that goal, Izzo figured, would be impossible without a new, disciplined approach to measuring and tracking performance. For one thing, the activities of most of the utility’s 6,100 “If you tackle metrics as if they were employees, who isolated hills, you will always be in the were represented position of making progress on one front by four unions, needed to be and losing position on another.” better coordinated with its busiup with more than 500 drivers, ness areas. Also, Izzo had them drill down more to improve accountability, deeply to agree on about 30 performance results had to be priority ones. reported consistently across the company. What’s more, Izzo After that, a working group made needed to institute a major up of managers from each business cultural change: replacing the area was formed to develop measold management mindset, ures based on these priority drivers which focused on successfully and to create a standard set of handling emergencies, with a metrics for the entire organization. new approach that would drive The working group defined the continuous improvement in the strategy and developed a pictorial company’s day-to-day activities. business model—an illustrated strategy map that depicted the Developing Drivers cause-and-effect relationships of Not long before, as the vice people, process, customer, and president of the company’s financial performance in a manner appliance service business, Izzo that all company stakeholders had introduced the Balanced could understand at first glance. Scorecard. The unit’s subsequent The group also established a
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BSC team to handle monthly reporting and disseminate best practices. To clearly define accountability for results, specific business areas were assigned direct responsibility for implementing specific parts of the strategy. By the end of 2002, the team had produced the company’s first strategy map, and by January 2003, it had completed the company’s first corporate-level scorecard. Soon afterward, scorecards were cascaded to business and supporting units. Departmentlevel scorecards were created, which further depicted the linkage of day-to-day results to strategy. Incentives Lead to a New Understanding Management knew, however, that for the new system to succeed, the entire workforce—including union members and leaders—would have to embrace the concept. In 2003, PSE&G introduced a shared savings program for the unionized workforce, which provided a bonus for meeting between six and ten key targets for each operating unit. The underlying
support, in addition to holding monthly meetings with the unionized workforce. While the ostensible reason for these gatherings was to discuss performance and how closely the workforce was achieving its targets, the conversations quickly became even more substantive. “We realized that with an incentive payment program, a healthy discussion of why we were measuring certain things and how to make them better would naturally follow,” says Izzo. For example, by understanding underlying measures, employees were able to gain insights for the first time into the real causes of certain problems. And instead of speculating about why customers weren’t satisfied with repair services, workers could look at consumer satisfaction metrics and see the reasons for those complaints.
In addition, Izzo’s team also made sure the new compensation system rewarded behaviors that led to day-to-day improvement, rather than the reactive, emergencytype response that had previously been celebrated. Ultimately, the The upshot, says Izzo, is that “the basic performance incentive plan incentive metrics are the same for everyone, ensured that including the president, and, for the most individual and part, all employees are working towards the group goals at all levels of the same end.” organization would be directly measures, drawn from three of related to a product or service the four BSC areas—people, custhat in turn was aligned with busitomer, and operations—included ness strategy. The upshot, says meter-reading errors, timely Izzo, is that “the basic incentive response to customer service metrics are the same for everycalls, and employee engagement one, including the president, survey results. (Compensation for and, for the most part, all employnonunion employees was also ees are working towards the linked to achieving certain goals). same end.” Equally important, Izzo established Infusing Benchmarking quarterly meetings with union into Planning leaders and executive councils to keep them abreast of strategic In an unusual move, Izzo also performance and to sustain their embedded benchmarking data
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into everything from strategy reviews to the budgeting process, providing an efficient way to promote best practices used at other organizations and improve results. All review meetings now include external benchmarking data. At an annual review for top managers, for example, metrics used by top-performing utilities are discussed if they differ from those employed at PSE&G. For service reliability, the company uses numerous benchmarks, including leak reports per mile and leak response rate, to compare its performance with that of six leading national utilities. As for the planning process, all metrics across all four quadrants of the BSC (people, operations, customer, and financial) must meet annual targets. But the process for setting targets includes more than just the usual historical trends data. It also includes current benchmarking performance in either the top decile or top quartile and projected three- to five-year benchmarks, along with other company-specific data. Through this process, the business planning group and individual business areas arrive independently at a proposed target and then jointly present it to the president for review. Before the budget cycle begins, the business planning group also collects and publishes benchmarking data, allowing the leadership team to include initiatives in its plans. The plans also include the implementation of best practices to close performance gaps, which helps the company move closer to achieving its objectives. For example, for a health and wellness and safety initiative, the company adopted seven criteria, including adding a health and wellness metric on its BSC to underscore the connection between health and wellness and safety. It also created a utility-level director of health and safety position.
September–October 2008
Benchmarking is also important to process improvement efforts, which have been integrated into all business areas. All these efforts are linked to strategy, with the mandate that they directly impact one or more scorecard metrics. But a key part of these activities involves incorporating industry benchmarking data into their development. To gather this data, managers make site visits to and conference calls with leading companies to observe best practices in the field. PSE&G also participates in yearly best-practice-sharing sessions that bring together companies from inside and outside the industry. In addition, for the past 15 years, the company has been the sole sponsor of the Gas and Electric Utility Peer Panel, a group of some two dozen organizations. The panel develops two major benchmarking studies for both the electric and gas delivery industries. In 2007, a third panel was launched to support the company’s customer operations group. Each year, the studies collect performance results on the employee, customer, operations, and financial aspects of the business. Strategy Reviews and Initiative Management Strategy reviews take place among several levels of management. The president meets bimonthly and quarterly with his direct reports, and quarterly with union presidents and their top council members, as well as with senior management. Vice presidents and division heads also conduct monthly and quarterly reviews. Current president Ralph La Rossa also meets with his leadership team every month to discuss BSC results and determine their overall impact on strategic performance. Every quarter he meets separately with each vice president and his or her direct reports to discuss
the status of specific initiatives. Leaders look for performance gaps, identify the most appropriate initiatives to close those gaps, and establish teams to oversee the initiatives. The company’s top 100 leaders (including union leaders) gather each quarter for a business outlook meeting. BSC results are shared with the board of directors every month, and regularly referred to in communications with state regulators, shareholders, and investors. Surpassing Goals, Next Steps
Coastal America Special Recognition Award, in honor of the company’s work on a wetlands restoration project in New Jersey and an initiative to restore aquatic habitats on the Delaware shore. Taking the lead from its BSC success at PSE&G, parent PSEG is extending the BSC approach to the power and services sides of the business, as well as to its support areas. Just as important as these results has been the transformation of the company culture—reflected in a new, even higher level of partnership with the company’s unions, as well as a shared understanding between employees and management that each individual’s performance affects overall results. Case in point: one of the company’s auto mechanic employees recently asked PSE&G President LaRossa, “Why am I
Perhaps not surprisingly, these efforts have resulted in breakthrough results. First, there’s the company’s record in three key areas—safety, reliability, and cost. The OSHA accident severity rate, a measure of the amount of time an employee is absent due to injury, declined to 8.48% in 2006, from 36.21% just four years earlier. The electric outage Just as important as PS&G’s results has been duration rate, which measures the transformation of the company culture— the average reflected in a new, even higher level of length of time partnership with the company’s unions, a customer is out of service, as well as a shared understanding between decreased to 66 employees and management. minutes in 2006, from 101 minutes in 2002. Cost driving to Edison (from the commeasures in the company’s competitive appliance service business pany’s Newark headquarters) to have helped bolster that division’s hear your road-show talk, when profitability—yet another example I see you here every day?” (The drive, LaRossa explains, takes of PSE&G’s justified belief in two hours roundtrip.) Added the power of measures to drive the mechanic, “Let’s save time. outcomes. We’ll stay here.” As Izzo observes, In recognition of its achievements, “The BSC has focused all levels the company has won many of the organization to work in awards, including the prestigious a partnership, unified around a PA Consulting National Reliability- well-articulated and understood One Award for the best electric strategy for success. All our reliability service in the nation employees now understand for both 2005 and 2006, as well that what they do and how well as the National Employee Safety they do it, on a day-by-day basis, Award for the safest utility in contributes to the overall success 2006. In 2007, the White House of the company.” I Council on Environmental Quality Reprint #B0809B presented the company with the 9
I N S I G H T
Picking “the Right Hill”: How PSEG (and PSE&G) Executives Are Leading Change
E X E C U T I V E
Balanced Scorecard Report
By Anne Field, Contributing Writer, and Janice Koch, Editor
As a mature industry, the utility business is marked by a distinct, traditional corporate culture. Often, an us-versusthem attitude prevails between the blue-collar (and heavily unionized) workforce and white-collar employees. Historically, utilities have focused on day-to-day operations and solving emergencies. Public Service Electric & Gas’s BSC-based transformation and its progressive-minded leaders have changed all that, introducing a data-driven, customer-oriented, strategy focus that emphasizes performance in all quarters. We recently talked to Ralph Izzo, chairman and CEO of parent Public Service Enterprise Group (who implemented the BSC as president of PSE&G) and Ralph LaRossa, current president of PSE&G, about the many dimensions and challenges of strategic transformation, from winning buy-in to effecting cultural change. BSR: Can you give us a picture of managing PSE&G before and after introducing the Balanced Scorecard? Ralph LaRossa: Over the last 20 years, we were a company that looked to celebrate the “saving catch.” Resolving emergency situations were the behaviors that were celebrated in the organization, not behaviors in management style that could drive continuous improvement or line of sight to daily operating activities. So when a storm would come through or we’d have a gas leak, we’d focus on performance in those situations, not on people who turned in strong performance day in and day out. What’s changed? We’re still proud of the work we do on an emergency basis, but we’re now able to measure and report back on day-to-day activities and celebrate successes in those activities. The process has also allowed us to pick the right “hill.” Going for hill A may lay waste to hills X, Y, and Z. But if you pick the right hill, you can see improvements across all the measures. For example,
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we’re currently expanding our workforce in field locations, focusing on reliability initiatives that will produce financial results, add employees, and help customers have a better perception of our activities. We picked a hill that would provide benefits all around. BSR: Tell us about the different phases of your scorecard development effort. Ralph Izzo: In the first phase, we spent a lot of time on defining success from the standpoint of different stakeholders. For our shareholders, it might be one factor related to income, and something else related to cost. For our customers, it would include never being interrupted and receiving an accurate bill. While this initial series of dialogues resulted in an absurd number of measures, we whittled these down and were able to get alignment around what was important. In the second phase, we worked on how to use the scorecard. Not only did we change the behaviors we rewarded from our fire-engine response to day-to-day improve-
ment, but the nature of the discussion has changed. In the past, personnel would often resort to analyzing performance by anecdote. Now, the discussion has changed from one that’s experiential to one that’s more data-driven: “Let’s take a look at the reason behind customer complaints.” In the third phase, we’re still evolving in our use of measures and the BSC. We haven’t nailed the process to my satisfaction. BSR: How did you win buy-in? Izzo: That was a challenge. We won buy-in at the senior level by giving managers the ability to participate in the process. For others the project looked like just another report card. We had to demonstrate that we were really interested in making life better for our stakeholders. I can remember giving a speech countless times— I’d hold up the scorecard, wave it, and say, “If we think we can manage using only this…I can get my third-grader to replace every one of us. If all we’re going to do is look at the numbers and say, ‘Jill is doing a great job, give her a raise; Jack is doing a crummy job, fire him,’ then we won’t understand the challenge behind those numbers, the mitigating circumstances.” We had to make it OK to underperform, provided that people learned from it and tried to do better. That’s a bit of a fine line, because it’s not enough for someone to keep saying, “I’ll do better next time” and then not really try. BSR: Did having a workforce of both blue-collar and whitecollar employees create any special challenges? LaRossa: This effort is not just blue-collar driven; it’s white-collar driven, too. Improving performance is not just a matter of how quickly we’re turning a wrench or climbing a pole. But involving white-collar employees is not as easy.
September–October 2008
Izzo: Now we have the ability to say, “OK, our unit costs for construction work are going down. So wrench time is being performed more efficiently. But our reliability measures aren’t showing the same improvement. So is the white-collar group doing its job? Are we putting our dollars in the right spot? BSR: While the development process was labor intensive and difficult, it also contributed to changing the culture. Can you elaborate? LaRossa: In general, there’s a concern that when people start to measure themselves, you’ve got to ensure accuracy to the nth decimal. There’s really no software package that can meld all the numbers in one place. But over time, we saw that people were using the numbers to drive conversations, not just to develop the BSC. We also gained a tremendous amount of credibility within the utility. We’ve expanded our credibility with customers, as a result of the awards we’ve won; with regulators because they see the outcomes and the numbers; and internally, with our board, which has given us additional resources. As for employees, they see added jobs and activities that are going to result in their benefiting from shared savings. People are seeing the bigger picture. The BSC is not an end-all, but it’s a means to move the business forward. We’re now extending the BSC and measurement process to the power generation and support service side of PSEG. BSR: What motivated you to undertake your extensive benchmarking efforts? What effect have they had on how you run the business? Izzo: Benchmarking is so powerful in helping you learn from others—not only the good things they’ve done but also
their mistakes. We benchmarked our safety programs against companies outside of the industry. From those lessons we got the idea that, as a way to get employees to practice safety on the job, we should get them to do it at home. Our reasoning was that if they have a healthy lifestyle, they’ll be safety conscious on the job. So we began offering regular cholesterol screenings, giving employees $100 if they answered a set of questions about whether they smoke, drink too much, wear a seatbelt, and so on. We let them work out in the company gym for $15 a month—all because we want our employees to have a safety mentality; so that whether they are faced with 4 kilovolts or 400 kilovolts, they’ll be thinking about safety. And that fire-engine response we spoke about? It’s no longer used to manage operational performance; it’s now part of our commitment to employee safety—coming to the aid of an injured employee as quickly as possible. BSR: How are you using the opportunity to influence (based on your success with the BSC)? Izzo: The BSC is critical to achieving operational excellence. That becomes a huge credibility builder for us. It enables me to speak publicly about what we think should happen in the policy arena on issues that are forwardlooking. Absent the BSC, it’s also hard for me to build credibility about the importance of such things as nuclear energy and reliability. BSR: You’ve indicated that you want to use the BSC throughout PSEG. Where are you in this expansion effort? Izzo: We’re at different levels of implementation. For instance, in our nuclear operation, the effort there will be one of using a common vocabulary. They don’t
think in terms of the customer; their focus is nuclear safety. But in terms of getting buy-in from the nuclear group, it will be a walk in the park. Oddly enough, in our other businesses, like fossil fuel plants, where the attitude is, “I was born in this plant, I know where the duct tape is; I know how to do this,” we will be more challenged to implement the scorecard. Our support organizations will be the most challenging. Everybody likes to raise eyebrows when we don’t restore power fast enough. But there’s an impact when a press release isn’t correct, or when IT people don’t have systems up and running when needed, so a field repairman can’t dial in remotely. Part of that is the difficulty in coming up with measures for support functions; part of it is the nature of support functions: they don’t have direct contact with the customer. To cascade the scorecard throughout the corporation, we took our BSC model used in the utility division. But this time I couldn’t lead a team and cascade—the organization is too big for that. So Ralph LaRossa and I divvied it up among the executive officers— senior managers who report to me—and said, “Choose your definition of what’s important: how you’d describe a successful gas-fired plant or a successful legal or HR organization. You come up with the measures. Here’s what you need to do with it, how to communicate it. Make sure your definitions are squared away, and ensure you’re top quartile.” I T O
L E A R N
M O R E
Visit www.pseg.com to learn more about the company’s programs and progress. See PSE&G’s profile in the Balanced Scorecard Hall of Fame Report 2008, available at www.harvardbusiness.org. Reprint #B0809C
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O F F I C E R
ment in a particular strategic theme at the expense of other themes, and simply helps avoid projects that are too risky.
By Peter LaCasse, Initiative Management Practice Leader, Palladium Group, Inc.
The Web division of a large retail bank defined its five-year strategy in terms of four strategic themes: Market Share Growth/Business Development (sales), Market Protection/Maintaining Customers (Web channel use), Process Efficiency, and Organizational Learning. Division leaders wanted to focus on expanding the Web as a sales channel without losing ground in the other areas. After developing strategic objectives and aligning existing projects with the themes, leaders learned that they were spending most of their discretionary dollars on retaining customers and driving Web channel use—to the detriment of the other themes.
S T R AT E G Y
Rebalance Your Initiative Portfolio to Manage Risk and Maximize Performance
M A N A G E M E N T
Balanced Scorecard Report
You’ve instituted a systematic approach to initiative management—identifying ideas, evaluating and prioritizing them, planning and approving their implementation, and managing them. You’ve even implemented a health check to ensure initiatives are on track—and if not, to diagnose why not. But are you treating your initiatives as a portfolio of initiatives? Here, Peter LaCasse explains the importance of tracking the impact initiatives have on each other, and shows you how to manage the portfolio to balance aggregate risk and maximize performance. Most client leadership teams we work with make the same mistake: they don’t devote sufficient attention to initiatives— developing, selecting, and managing them. As competition intensifies across every industry and the speed of change accelerates, organizations must redouble their efforts to develop new products and revenue sources, protect existing ones, boost process efficiencies, and invest in the skills and capabilities that will keep them competitive. Initiatives that help augment organizational value warrant management’s attention. But organizations cannot simply allocate funding for projects and hope for the best. They need to create shared accountability for these investments, take the time to manage the initiative portfolio, and ensure these investments are aligned with enterprise strategy. Disciplined initiative portfolio management is vital to sound leadership decision making that will maximize the organization’s return on investment.1 Unlike project management, which involves keeping individual projects on track, initiative portfolio management enables organizations to enhance the value of their entire discretionary expenditure. The concept of initiative portfolio
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management is borrowed from sound investment practice. A good financial adviser ensures that each client has a balanced portfolio, with an appropriate mix of investments in stocks, bonds, money markets, and other asset classes. In choosing this mix, the adviser considers many factors, such as the client’s date of retirement, future income needs, and risk tolerance, among others. On an ongoing basis, as things change, the adviser tweaks the mix. For example, if stocks represent 40% of a client’s portfolio but quarterly returns from them exceed that percentage, he’ll need to rebalance the stock allocation to maintain the portfolio’s original risk levels.2 Initiative portfolio management should follow this portfolio balancing approach, where each project is evaluated in the context of the total portfolio. Unfortunately, this is not common practice. Most organizations select initiatives independently of one another, with little regard for their impact on other efforts. The business case for each initiative should be reviewed in the larger business context, to consider its impact on other initiatives. This prevents overweighting investments to short-term results that risk mortgaging the organization’s future, prevents overweighting invest-
A Case Example
However, as they pushed for more projects geared toward sales growth, the leaders did not overlook the other elements of a balanced portfolio. To balance the portfolio’s risk profile, they maintained a healthy investment in retaining their current customer base in case the new product ideas failed to catch hold in the marketplace. They also made sure that the returns from their projects aligned to their short-, mediumand long-term (division) targets. In the short run, they felt the impact of freeing up 20% of their discretionary spending and an even greater percentage of their employees’ time that could be applied to projects more closely aligned to the strategy. For example, they invested in building the capability to sell products that they had never before sold on the Internet, rather than on enhancements to online checking and savings account services. We can’t emphasize enough the importance of building initiative portfolios that align with the
September–October 2008
organizational strategy. Doing so can be tricky; companies can falter at any step along the way. For example, despite developing viable strategic themes to help regain market share and industry predominance, an educational testing company ended up lumping all its initiatives into financial objectives (revenue growth, revenue protection, and cost savings). This not only undermined the strategic differentiation executives had worked hard to clarify, but it also created confusion, muddling the discussion of project performance and analysis. The company lost time and had to go back to the drawing board to ensure the appropriate balance of initiatives throughout its seven strategic themes. Once an enterprise establishes portfolio categories based on its strategic themes, each business unit should use the portfolios to organize its discretionary spending. When units present their project portfolios to enterprise leaders, leaders can more readily assess how well the portfolios are balanced against enterprise strategy. In reviewing the portfolios collectively, enterprise leaders can ensure that each division is doing its part to support the enterprise strategy.
and implementation and impact risks. If the detailed proposal passes leadership review, the business case is finalized and a project plan is developed. The detailed business case information enables organizations to regularly evaluate their initiative portfolios. Canadian Blood Services, the nonprofit that manages Canada’s blood supply and a 2007 Balanced Scorecard Hall of Fame for Executing Strategy winner, provides a good illustration of this process. Recently, the organization’s leadership team spent three days evaluating its initiative portfolios. These portfolios were based on CBS’s strategic themes, “Safety,” “Operational Excellence,” and “Prepare for Tomorrow.” It appeared that the team had allocated its initiatives appropriately across the three themes. But when team members looked at risk and benefit levels within each theme, the portfolios now seemed off balance. For example, in the theme “Prepare for Tomorrow” (about expanding business into new areas), most of the initiatives were mediumto low-risk and of medium
Portfolio analysis should be the first step in rebalancing the
Figure 1. The Nine-Cell Grid for Evaluating Theme Portfolios PURPOSE OF INITIATIVE Change the rules
Preparing Initiatives for a Portfolio Management Approach
Win the race
Stay in the race
High
Size of circle reflects the cost of the initiative
2
Low
Medium
5 RISK
Organizations that follow the disciplined initiative management process we advocate already have on hand detailed information on each project (see footnote 1). A business case is developed when an initiative is first proposed. Initially a set of high-level assumptions within a concept document, the case is refined into a detailed proposal document once the idea is approved and/or sponsored. This document addresses the project’s goals, strategic impact, financial costs and benefits, time to implement, time-to-benefit, skills and capabilities required,
benefit. The only initiative actually designed to help the organization expand into new areas was focused on developing CBS’s (umbilical) cord blood bank capabilities. Team members recognized that the strategic theme focused on changing their business should contain initiatives that would truly transform the organization. This realization spurred conversation, leading to the idea of expanding into such areas as organ transplants and tissue bank services that could further capitalize on CBS’s process expertise. Now the team could easily see the gaps in each portfolio and develop initiative ideas to fill them. According to CEO Graham Sher, this portfolio framework “has allowed us to have the difficult conversations about which initiatives to include or eliminate,” adding that the total cost of slashed initiatives “equaled millions of dollars.” Balancing the initiative portfolio, Sher observes, has helped CBS make the link between strategy and operations explicit.
3 4
1
< 12 months
12–24 months
> 24 months
TIME-TO-BENEFIT
This grid, an aid in portfolio analysis, provides a snapshot view of an office products company’s initiative portfolio for its innovation theme. The five projects represented here run the gamut in terms of purpose (design improvements to transformational change), risk, and time-to-benefit.
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Balanced Scorecard Report
Keeping It Honest Many organizations struggle with ensuring their initiatives are justified. Overzealous managers write business case proposals that claim unrealistic benefits or underestimate costs. But there is a way to ensure business case legitimacy and prevent ill-founded initiatives from passing muster. By making leaders accountable for each business case and incorporating initiative and portfolio performance into their regular strategy performance reviews, organizations can force the bias and “fluff” from proposals. Knowing that they will be held accountable for delivering their forecasted benefits and working within their own estimated budgets, leadership team members tend to be more realistic. Embedding such accountability into the process will invariably result in more pleasant surprises than unfortunate miscalculations.
initiative portfolio, as it provides the necessary data for discussion and decision making. Leaders examine the amount invested (both financial and human resources) in each theme, the skills and capabilities required to deliver on the portfolio’s initiatives, the organizational change required, the aggregate risk within the portfolio, and the anticipated changes and benefits. These requirements are then weighed against the organization’s available budget and human resources, inventory of skills, and capacity to support change, as well as the desired level of organizational performance. Portfolio analysis is often best represented in multiple formats, including graphical and written. Figure 1 (previous page) is an example of the nine-cell grid, a graphical tool useful in evaluating theme initiative portfolios. Initiatives are classified by their purpose (“stay in the race,” “win the race,” or “change the rules”), risk level, and time-to-benefit. This example represents an office product company’s portfolio of initiatives with-
in its strategic theme of innovation. Projects 1, 3, and 4 involve enhancements to the company’s stapler, pen, and desk organizer product lines. These projects, aimed at maintaining competitiveness, are relatively low cost and designed to yield short-term results. They include adding new functionality (which will require retooling the production line), changing the packaging, and marketing to a new customer segment. Project 3 focuses on streamlining stapler design. Project 4 entails making a lower-profile desk organizer that can fit in small drawers. Project 2, a transformative initiative, involves developing an entirely new line of products, which will require creating new production capabilities, distribution partnerships, and new marketing. Project 5, geared toward gaining market share (market leadership) involves marketing an existing product in a new region (China), which will require establishing a new distribution channel as well as a marketing campaign. The overall portfolio balances the shortterm need to fend off competition and expand market share with the longer-term goal of exploring new markets and establishing new sources of revenue. Making It Stick Most investors would agree: a financial adviser who analyzes the client’s portfolio only once a year is not doing his or her job. The same goes for initiative portfolio analysis. The portfolio needs to be reviewed and updated regularly by the leadership team. Regular project reviews and progress reports will provide the necessary information. Project changes should be promptly noted and assessed for their impact on the whole portfolio. For instance, if one project’s risks rise during implementation, does the portfolio contain appropriate projects that are acting as a backup in
case the project fails? Companies that are investing in a new product area, for example, will want to maintain an existing program to keep current revenues in place. Quarterly reviews are best, but regularity is most crucial; if left only to when executives have time, the reviews will almost never happen. In practice, developing a portfolio review process takes time and effort. At first, initiative portfolio reviews often seem like regular project reviews, where leadership team members know little about parts of the business outside of their direct realm of functional responsibility. Over time, however, leaders realize the importance of understanding the entire business in making portfolio tradeoff and balancing decisions. Discussions become more substantive, and leaders take a true team approach to making project portfolio decisions. A biomanufacturing firm we have worked with provides a perfect example. The firm recently implemented the initiative project portfolio process, turning its annual strategy retreat into an initiative portfolio meeting. The leadership team shares accountability for reaching enterprise performance targets, as bonus compensation is linked to targets. They therefore concentrate on developing a project portfolio with the greatest impact on organizational performance, rather than focusing solely on their individual business units’ performance. I 1. See K. Katz and T. Manzione, “Maximize Your ‘Return on Initiatives’ with the Initiative Portfolio Review Process,” BSR May–June 2008 (Reprint #B0805C); and P. LaCasse, “Initiative Management: Putting Strategy into Action,” BSR November– December 2007 (Reprint #B0711B). 2. In other words, stock returns in a given quarter may equal 50% of total returns, not the original 40%. So when the portfolio is reinvested, the actual asset mix is now off kilter, representing a higher stock allocation—and a riskier asset mix—than intended. Many people (particularly 401(k) plan investors) overlook the need to rebalance their investment portfolio, but financial advisers will tell you that doing so, ideally every quarter, is essential for staying within predefined risk tolerances.
Reprint #B0809D
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M A N A G E M E N T
S Y N E R G I E S
September–October 2008
Turning Strategic Risk into Growth Opportunities By Adrian Slywotzsky, Director, Oliver Wyman, and author, The Upside: Seven Strategies for Turning Big Threats into Growth Breakthroughs (Crown Business, 2007) Adapted by Anne Field, Contributing Writer, from the presentation delivered at the November 2007 Palladium/Balanced Scorecard Collaborative North American Summit
Businesses today face an environment of ever-increasing change—and risk. And no business, whether a Wal-Mart or a Dell Computer, is immune to potentially devastating threats, which can range from a sudden change in customer tastes to a technology that turns a company’s business model upside down. But such change needn’t spell disaster. In fact, claims Adrian Slywotzky (who has advised CEOs on new business development and growth for 30 years), companies can transform times of great strategic risk into record-breaking growth opportunities. About four years ago, we noticed a startling development: many large blue-chip companies were abruptly losing 60% to 70% of their market value over just a 12-month period. The culprit, it seemed, was a variety of strategic risks—external threats able to destroy even the most wellestablished company’s business. In fact, we realized that such risk has been increasing at an alarming rate over the last 15 years. What’s more, while this phenomenon has long been characteristic of the technology sector, it has moved not only to other industries, but to the bluest of the blue chips as well. Take Procter & Gamble, one of the best-run companies in the world. In the late 1990s, the company attempted a major restructuring to address slowing sales from maturing brands— and failed. The CEO was ousted, and the company lost half its market value—and spent five years recovering. There are dozens of other examples like this. Why has this been happening? For one thing, there’s the faster rate of change occurring around the world across every dimension you can think of. Globalization
has created an explosion of competitors at the low and high end. Finally, a more informed consumer has shifted power from the supplier to the customer. All these factors are likely to intensify in the future. But companies can manage such risks. Managing risk is really about managing opportunity. And your moment of maximum risk is also your moment of maximum opportunity. While the rules of business success are changing, organizations can take advantage of those changes rather than be victimized by them. What do I mean by a strategic risk? It’s any external event that can damage part or all of your business model. There are seven major kinds of strategic risk, but the most important are technological shifts, brand threats, project risk, and changing customer tastes. 1. Technological Shifts One of the most abrupt risks is a shift in technology. A company might spend two decades creating an enormous amount of value, only to lose most of it quickly when an unanticipated technological advance comes along. Think of Barnes & Noble. It built a great
bond with its customers, then watched as Amazon tore it apart. A small group of companies, including Microsoft, IBM, and Intel, have developed a successful countermeasure: when they don’t know whether a new technology will win out, they “double bet”— putting their money both on the existing approach and the new one. Often, the trigger for such a move doesn’t come from the top. Back in 1994, a Microsoft employee and new college graduate who noticed students shifting their life to the Internet emailed a warning to the CEO that although the company was about to launch Windows, the Internet would soon make the product irrelevant. The CEO listened. In 12 months there was a complete turnaround, and the company created the engine for its greatest growth for the next five to seven years. In some industries, such as telecommunications, you may need to double bet on three or four technologies at once. In that case, it’s important to figure out how to act as cheaply and efficiently as possible. For example, you will have to study customer behavior on a weekly basis to see where trends are going. The vast majority of companies, however, either don’t double bet or do so too late. Why? We often don’t see things as they are but as we are; we see through the lens of our own success. As a result, companies not only lose value, but they also miss what could have been a great growth opportunity. It took Barnes & Noble 36 months to double bet, and in that time it lost out on becoming the leader in distributing books using the customer’s preferred delivery mechanism. Other examples include Blockbuster, which waited 58 months before it double bet, losing out to Netflix; and GM, which took 84 months to double bet against Toyota’s hybrid.
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Balanced Scorecard Report
Recently, brand risk has grown exponentially, as long-standing household names have begun experiencing greater competition. Over the last six years, during one of the strongest markets we’ve had, 40% of the 100 most powerful brands in the world lost significant brand value. Ford, which had a brand value of $36 billion in 2000, lost three-quarters of it. Sony lost one-third of its $16.4 billion value. Still, a small number of companies facing tremendous brand risk reversed the situation despite the odds. Consider Samsung. In 1998, its CEO realized its brand was all about one thing: cheap TVs and microwaves. So he put a team to work to determine how to change that. He instituted cost reductions to allow for more investment in product development and advertising. He also focused on business design. Six months before rolling out new products, for example, he pulled the old cheap TVs and microwaves off the market, sending a clear signal they were not consistent with the new brand. He changed the organizational structure, putting designers above engineers. You can imagine the blood on the floor after that. He also pulled all Samsung products out of Wal-Mart. The result: Samsung’s brand value tripled from 2000 to 2006. 3. Project Risk Brand and technology risks occur every few years. But another type of threat that we live with every day is project risk. And companies’ track record here isn’t good. We are wired to be optimistic, so if a project realistically has a 10% chance of success, we think it’s 50%. Yet, if you look at the 10year success rate across industries for projects, it’s very sobering. Most projects fail. Why? There are many reasons.
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Companies often don’t allocate enough resources. The scope of the project may be unclear. People in different areas—manufacturing, marketing, and so on— may not communicate with each other adequately. Or there may just have been poor planning. With the right approach, however, projects can succeed. When Toyota decided to invest $1 billion in building a hybrid car in 1993, the chief engineer said there was a 5% chance of success. But he then pinpointed 20 things the company could do to improve the odds. It tested 80 different hybrid engine systems to identify the best three or four, along with 20 suspensions and seven kinds of styling. It found a way to assemble the product with an existing platform. And it thought about the right business model for taking it to market. For example, while Honda targeted the same moderate-income buyer of the Civic and the Accord, Toyota pinpointed affluent “green” customers willing to pay more for a hybrid car with the right styling. 4. Changing Customer Tastes Consumer tastes can change suddenly, leaving you without a market. Addressing this type of risk requires having an ongoing way of developing an up-to-theminute understanding of consumer buying habits. That’s something the CEO of Coach is a master at. Fashion accessory trends, he claims, start in Japan and then filter over to the U.S. Fifteen years ago, the company developed a system for constantly measuring customer behavior across various criteria. In the 1990s, when things started to go bad in Japan, the company learned about the situation immediately and moved quickly to turn the situation to their advantage. The company invests in ways to get more granular information on the customer than is typically garnered by other businesses.
It conducts 60,000 customer interviews each year, up from 10,000 in 2004. This research costs $5 million annually, but Coach, a $2.5 billion company, considers this cheap insurance. It has created a data culture with 10 to 15 times more customer information than its competitors. And it uses the data to generate ideas, which it then tests. Tackling Strategic Risk at Your Company Addressing the specific strategic risks your own company faces is a difficult task. Start with a simple question: What are the seven to ten biggest strategic risks that could kill your business model in the next two to four years? The answers could range from regulation to geopolitics. Make a list of two to three dozen choices and then pinpoint the major ones. Get a sense of just how big the risks are, and whether you can mitigate their impact or actually transform them into growth opportunities. Engage your colleagues in the discussion, but know that the best source of information is your customers. You can also take a broader view, looking at the risks at the business unit, functional, and individual career level. Some risks may not be significant to the company, but may be significant to you and your colleagues. Ultimately, managing strategic risk requires a different way of thinking.You’re not quite predicting the future. You’re doing something else. I’m reminded of a quote from the Greek philosopher Philostratus: “For gods perceive things in the future, ordinary people things in the present, but the wise man perceives things about to happen.” And for companies today, developing that ability has become not a luxury, but a business imperative. I Reprint #B0809E
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2. Brand Threats
