Many organizations can’t successfully execute business strategy because executives don’t have a clear sense of how they affect it individually. The problem often stems from ineffective goal setting systems.
In selecting performance metrics for use in goal setting and incentive plans, businesses tend to rely on bottom-line financial measures such as return on equity or cashflow per share.
These measures are generally not well-suited for individual employee goals because they are not under the direct control of employees nor is it easy to provide useful individual feedback based on organizational performance.
Establishing a clear line of sight should be an important factor in selecting measures for performance goals and incentives. Line of sight refers to an employee’s ability to see how her efforts affect the performance measure and the rewards associated with achieving objectives. Bottom-line performance measures need to be broken down into measures executives can control and rewards flow accordingly.
Value tree analysis can facilitate the development of the best individual performance measures and rewards, aligned with the business strategy.
Just as a business is the sum of many parts, so the business’s key financial measures are made up of a number of different components called “value drivers.” They are referred to as drivers because they drive the overall results. Typically the drivers can be classified into four categories:
•Revenue/cost drivers — revenues, direct and indirect expenses;
•Strategic drivers — product mix, customer mix;
•Customer/operational drivers — customer service, quality; and
•External drivers — government regulations, competitors’ actions.
The linking of these value drivers to the overall measure produces a value tree since each driver branches off from the big-picture measure.
By interviewing the executives themselves it’s possible to determine which drivers have the best line of sight. These become the performance measures for individual targets which are set using quantitative analysis.
Once the goals are set, it is important to close the loop and reinforce the executive’s achievements through pay. Value tree analysis can help to calibrate the annual or mid-term incentive plan by identifying the types of measures to use and the weighting of the measures, based on the influence of the driver on the overall measure and the ability of the individual to control it.
Take the case of the director of operations at a manufacturing company. The success of the business strategy is measured in part by return on average equity (ROE).
Breaking down this financial measure yields four possible branches:
•operating profit margin;
•total average asset turnover;
•financial leverage multiplier; and
•tax retention rate.
Line of sight will be strongest to the operating profit margin branch and more specifically for this executive, to cost of goods sold expense (an example of a revenue/cost driver). Product quality (a customer/operational driver) is another area she controls that is critical in that it impacts customer spending and indirectly operating profit margin.
Her performance goals should emphasize these drivers because the strong line of sight should translate into highly focused efforts to improve these measures. Value tree analysis can be used to calibrate the executive’s cost of goods sold expense target so that it supports achieving the ROE goal in the business plan.
To successfully engage the director of operations in the task, her bonus needs to be directly tied to the accomplishment of this objective. There may also be subjective individual performance objectives, and these should be tied back to the key drivers as well (for example, contributions to making her team more quality conscious).
Some executives may express a reluctance to use value tree analysis, arguing that they already know what the important financial measures are for their business. This may be true, but they probably are not as familiar with the operational and customer drivers that are as important as the financial drivers.
By using a systematic approach to designing executive performance management and rewards systems rather than using an intuitive approach, organizations will ensure that all of the critical elements (people, goals and rewards) are properly aligned with the business strategy.
Ming Young is an executive compensation consultant in Towers Perrin’s Toronto office. He can be reached at (416) 960-7125.
In selecting performance metrics for use in goal setting and incentive plans, businesses tend to rely on bottom-line financial measures such as return on equity or cashflow per share.
These measures are generally not well-suited for individual employee goals because they are not under the direct control of employees nor is it easy to provide useful individual feedback based on organizational performance.
Establishing a clear line of sight should be an important factor in selecting measures for performance goals and incentives. Line of sight refers to an employee’s ability to see how her efforts affect the performance measure and the rewards associated with achieving objectives. Bottom-line performance measures need to be broken down into measures executives can control and rewards flow accordingly.
Value tree analysis can facilitate the development of the best individual performance measures and rewards, aligned with the business strategy.
Just as a business is the sum of many parts, so the business’s key financial measures are made up of a number of different components called “value drivers.” They are referred to as drivers because they drive the overall results. Typically the drivers can be classified into four categories:
•Revenue/cost drivers — revenues, direct and indirect expenses;
•Strategic drivers — product mix, customer mix;
•Customer/operational drivers — customer service, quality; and
•External drivers — government regulations, competitors’ actions.
The linking of these value drivers to the overall measure produces a value tree since each driver branches off from the big-picture measure.
By interviewing the executives themselves it’s possible to determine which drivers have the best line of sight. These become the performance measures for individual targets which are set using quantitative analysis.
Once the goals are set, it is important to close the loop and reinforce the executive’s achievements through pay. Value tree analysis can help to calibrate the annual or mid-term incentive plan by identifying the types of measures to use and the weighting of the measures, based on the influence of the driver on the overall measure and the ability of the individual to control it.
Take the case of the director of operations at a manufacturing company. The success of the business strategy is measured in part by return on average equity (ROE).
Breaking down this financial measure yields four possible branches:
•operating profit margin;
•total average asset turnover;
•financial leverage multiplier; and
•tax retention rate.
Line of sight will be strongest to the operating profit margin branch and more specifically for this executive, to cost of goods sold expense (an example of a revenue/cost driver). Product quality (a customer/operational driver) is another area she controls that is critical in that it impacts customer spending and indirectly operating profit margin.
Her performance goals should emphasize these drivers because the strong line of sight should translate into highly focused efforts to improve these measures. Value tree analysis can be used to calibrate the executive’s cost of goods sold expense target so that it supports achieving the ROE goal in the business plan.
To successfully engage the director of operations in the task, her bonus needs to be directly tied to the accomplishment of this objective. There may also be subjective individual performance objectives, and these should be tied back to the key drivers as well (for example, contributions to making her team more quality conscious).
Some executives may express a reluctance to use value tree analysis, arguing that they already know what the important financial measures are for their business. This may be true, but they probably are not as familiar with the operational and customer drivers that are as important as the financial drivers.
By using a systematic approach to designing executive performance management and rewards systems rather than using an intuitive approach, organizations will ensure that all of the critical elements (people, goals and rewards) are properly aligned with the business strategy.
Ming Young is an executive compensation consultant in Towers Perrin’s Toronto office. He can be reached at (416) 960-7125.
