Evaluation and Control in Strategic Management Evaluation and control information consists of performance data and activity reports (gathered in Step 3 in Figure 11-1). If undesired performance results because the strategic management processes were inappropriately used, operational managers must know about it so they can correct the employee activity. Top management need not be involved. If, however, undesired performance results from the processes themselves, top managers, as well as operational managers, must know about it so they can develop new implementation programs or procedures. Evaluation and control information must be relevant to what is being monitored. One of the obstacles to effective control is the difficulty in developing appropriate measures of important activities and outputs. Measuring Performance Performance is the end result of activity. Select measures to assess performance based on the organizational unit to be appraised and the objectives to be achieved. The objectives that were established earlier in the strategy formulation part of the strategic management process (dealing with profitability, market share, and cost reduction, among others) should certainly be used to measure corporate performance once the strategies have been implemented. APPROPRIATE MEASURES Some measures, such as return on investment (ROI) and earnings per share (EPS), are appropriate for evaluating a corporation's or a division's ability to achieve a profitability objective. This type of measure, however, is inadequate for evaluating additional corporate objectives such as social responsibility or employee development. Even though profitability is a corporation's major objective, ROI and EPS can be computed only after profits are totaled for a period. It tells what happened after the factnot what is happening or what will happen. A firm, therefore, needs to develop measures that predict likely profitability. These are referred to as steering controls because they measure variables that influence future profitability. Every industry has its own set of key metrics that tend to predict profits. Airlines, for example, closely monitor cost per available seat mile (ASM). In 2002, Southwest's cost per passenger mile was 7.5, the lowest in the industry, contrasted with United's 11.5, the highest in the industry. Its low costs gave Southwest a significant competitive advantage. By 2011, Southwest's costs had risen substantially to 12.5, while United had moved to 16.6. In the meantime, Southwest had been replaced as the most lowcost airline by Spirit Airlines, whose cost per ASM in 2011 was 10.1. 1 An example of a steering control used by retail stores is the inventory turnover ratio, in which a retailer's cost of goods sold is divided by the average value of its inventories. This measure shows how hard an investment in inventory is working; the higher the ratio, the better. Not only does quicker moving inventory tie up less cash in inventories, it also reduces the risk that the goods will grow obsolete before they're solda crucial measure for computers and other technology items. For example, Office Depot increased its inventory turnover ratio from 6.9 in one year to 7.5 the next year, leading to improved annual profits.2 Another steering control is customer satisfaction. Research reveals that companies that score high on the American Customer Satisfaction Index (ACSI), a measure developed by the University of Michigan's National Research Center, have higher stock returns and better cash flows than those companies that score low on the ACSI. A change in a firm's customer satisfaction typically works its way through a firm's value chain and is eventually reflected in quarterly profits.3 Other approaches to measuring customer satisfaction include Oracle's use of the ratio of quarterly sales divided by customer service requests and the total number of hours that technicians spend on the phone solving customer problems. To help executives keep track of important steering controls, Netsuite developed dashboard software that displays critical information in easy-toread computer graphics assembled from data pulled from other corporate software programs.4 TYPES OF CONTROLS Controls can be established to focus on actual performance results (output), the activities that generate the performance (behavior), or on resources that are used in performance (input). Output controls specify what is to be accomplished by focusing on the end result of the behaviors through the use of objectives and performance targets or milestones. Behavior controls specify how something is to be done through policies, rules, standard operating procedures, and orders from a superior. Input controls emphasize resources, such as knowledge, skills, abilities, values, and motives of employees.5 Output, behavior, and input controls are not interchangeable. Output controls (such as sales quotas, specific cost-reduction or profit objectives, and surveys of customer satisfaction) are most appropriate when specific output measures have been agreed on but the cause-effect connection between activities and results is not clear. Behavior controls (such as following company procedures, making sales calls to potential customers, and getting to work on time) are most appropriate when performance results are hard to measure, but the cause-effect connection between activities and results is relatively clear. Input controls (such as number of years of education and experience) are most appropriate when output is difficult to measure and there is no clear cause-effect relationship between behavior and performance (such as in college teaching). Corporations following the strategy of conglomerate diversification tend to emphasize output controls with their divisions and subsidiaries (presumably because they are managed independently of each other), whereas, corporations following concentric diversification use all three types of controls (presumably because synergy is desired).6 Even if all three types of control are used, one or two of them may be emphasized more than another depending on the circumstances. For example, Muralidharan and Hamilton propose that as a multinational corporation moves through its stages of development, its emphasis on control should shift from being primarily output at first, to behavioral, and finally to input control.7 Examples of increasingly popular behavior controls are the ISO 9000 and 14000 Standards Series on quality and environmental assurance, developed by the International Standards Association of Geneva, Switzerland. Using the ISO 9000 Standards Series (now a family of standards with eight management principles) is a way of objectively documenting a company's high level of quality operations. The ISO 14000 Standards Series establishes how to document the company's impact on the environment. A company wanting ISO 9000 certification would document its process for product introductions, among other things. ISO 9001 would require this firm to separately document design input, design process, design output, and design verificationa large amount of work. ISO 14001 would specify how companies should establish, maintain and continually improve an environmental management system. The benefits from ISO certification are partially in cost savings, but primarily they are a signal to suppliers and buyers about the focus of the company.8For an example of how one company that is steeped in controls is using an innovative idea to improve their systems, see the Innovation Issue feature. Many corporations view ISO 9000 certification as assurance that a supplier sells quality products. Firms such as DuPont, Hewlett-Packard, and 3M have facilities registered to ISO standards. Companies in more than 60 countries, such as Canada, Mexico, Japan, the United States (including the entire U.S. auto industry), and the European Union, require ISO 9000 certification of their suppliers.9 The same is happening for ISO 14000. Both Ford and General Motors require their suppliers to follow ISO 14001. In a survey of manufacturing executives, 51% of the executives found that ISO 9000 certification increased their international competitiveness. Other executives noted that it signaled their commitment to quality and gave them a strategic advantage over noncertified competitors.10 INNOVATION issue: REUSE OF ELECTRIC VEHICLE BATTERIES No industry is more concerned about established procedures and minimizing fluctuations in their business model than the electric utility industry. Beyond storms that bring down the power grid, the biggest issue is dealing with fluctuations in power demand. Backup generators, purchasing power from other utilities, and keeping excess power available has been used for decades. However, the wide-scale introduction of solar arrays has added a whole new wrinkle to the issue in the industry. While solar arrays work quite well when the sun is shining, even modest cloud cover can cause large fluctuations in output. Duke Energy in partnership with General Motors and ABB (the huge power technology company) is now exploring the reuse of electric vehicle batteries to smooth out fluctuations in the power grid. Not only would the system be good for the environment, but it would provide an innovative solution to a known problem in the industry. A typical electric vehicle battery weighs more than 700 pounds and has 70% or more of its useful life left when it is no longer usable in an electric vehicle. General Motors estimates that it will have 500,000 vehicles with battery packs on the road by 2017, meaning that there is a huge recycling/reuse/waste issue that will have to be dealt with shortly. Duke sees battery systems (EV battery packs that are linked together in a series) as a means for smoothing out sudden swings in output from solar arrays, thus helping the whole grid work more smoothly. The solar arrays could be used to provide power (when the sun is shining) to the grid, as well as to the recharging of battery systems. The system was demonstrated in San Francisco in 2012 and will be tested in undisclosed locations before being utilized on any scale. SOURCES: M. Ramsey, \"Ford Reveals How Much Electric Car Batteries Cost,\" The Wall Street Journal (April 17, 2012),http://blogs.wsj.com/drivers-seat/2012/04/17/fordreveals-how-much-electric-car-batteries-cost/; B. Henderson, \"Duke to Test Uses for EV Batteries,\" The Charlotte Observer (November 16, 2012), pg. 2B. Since its ISO 14000 certification, SWD Inc. has become a showplace for environmental awareness. According to SWD's Delawder, ISO 14000 certification improves environmental awareness among employees, reduces risks of violating regulations, and improves the firm's image among customers and the local community.11 Another example of a behavior control is a company's monitoring of employee phone calls and PCs to ensure that employees are behaving according to company guidelines. In a study by the American Management Association, nearly two-thirds of U.S. companies actively monitored their workers' Web site visits in order to prevent inappropriate surfing while 65% use software to block connections to Web sites deemed off limits for employees. 43% of companies monitor e-mail, and 28% of employers have fired workers for e-mail misuse. (For example, Xerox fired 40 employees for visiting pornographic Web sites.12) ACTIVITY-BASED COSTING Activity-based costing (ABC) is a recently developed accounting method for allocating indirect and fixed costs to individual products or product lines based on the value-added activities going into that product.13 This accounting method is thus very useful in doing a value-chain analysis of a firm's activities for making outsourcing decisions. Traditional cost accounting, in contrast, focuses on valuing a company's inventory for financial reporting purposes. To obtain a unit's cost, cost accountants typically add direct labor to the cost of materials. Then they compute overhead from rent to R&D expenses, based on the number of direct labor hours it takes to make a product. To obtain unit cost, they divide the total by the number of items made during the period under consideration. Traditional cost accounting is useful when direct labor accounts for most of total costs and a company produces just a few products requiring the same processes. This may have been true of companies during the early part of the twentieth century, but it is no longer relevant today, when overhead may account for as much as 70% of manufacturing costs. According to Bob Van Der Linde, CEO of a contract manufacturing services firm in San Diego, California: \"Overhead is 80% to 90% in our industry, so allocation errors lead to pricing errors, which could easily bankrupt the company.\"14 The appropriate allocation of indirect costs and overhead has thus become crucial for decision making. The traditional volume-based cost-driven system systematically understates the cost per unit of products with low sales volumes and products with a high degree of complexity. Similarly, it overstates the cost per unit of products with high sales volumes and a low degree of complexity.15 When Chrysler used ABC, it discovered that the true cost of some of the parts used in making cars was 30 times what the company had previously estimated.16 ABC accounting allows accountants to charge costs more accurately than the traditional method because it allocates overhead far more precisely. For example, imagine a production line in a pen factory where black pens are made in high volume and blue pens in low volume. Assume that it takes eight hours to retool (reprogram the machinery) to shift production from one kind of pen to the other. The total costs include supplies (the same for both pens), the direct labor of the line workers, and factory overhead. In this instance, a very significant part of the overhead cost is the cost of reprogramming the machinery to switch from one pen to another. If the company produces 10 times as many black pens as blue pens, 10 times the cost of the reprogramming expenses will be allocated to the black pens as to the blue pens under traditional cost accounting methods. This approach underestimates, however, the true cost of making the blue pens. ABC accounting, in contrast, first breaks down pen manufacturing into its activities. It is then very easy to see that it is the activity of changing pens that triggers the cost of retooling. The ABC accountant calculates an average cost of setting up the machinery and charges it against each batch of pens that requires retooling, regardless of the size of the run. Thus a product carries only those costs for the overhead it actually consumes. Management is now able to discover that its blue pens cost almost twice as much as do the black pens. Unless the company is able to charge a higher price for its blue pens, it cannot make a profit on these pens. Unless there is a strategic reason why it must offer blue pens (such as a key customer who must have a small number of blue pens with every large order of black pens or a marketing trend away from black to blue pens), the company will earn significantly greater profits if it completely stops making blue pens.17 ENTERPRISE RISK MANAGEMENT Enterprise Risk Management (ERM) is a corporatewide, integrated process for managing the uncertainties that could negatively or positively influence the achievement of the corporation's objectives. In the past, managing risk was done in a fragmented manner within functions or business units. Individuals would manage process risk, safety risk, and insurance, financial, and other assorted risks. As a result of this fragmented approach, companies would take huge risks in some areas of the business while over-managing substantially smaller risks in other areas. ERM is being adopted because of the increasing amount of environmental uncertainty that can affect an entire corporation. As a result, the position Chief Risk Officer is one of the fastest growing executive positions in U.S. corporations.18 Microsoft uses scenario analysis to identify key business risks. According to Microsoft's treasurer, Brent Callinicos, \"The scenarios are really what we're trying to protect against.\"19 The scenarios were the possibility of an earthquake in the Seattle region and a major downturn in the stock market. The process of rating risks involves three steps: 1. Identify the risks using scenario analysis or brainstorming or by performing risk self-assessments. 2. Rank the risks, using some scale of impact and likelihood. 3. Measure the risks, using some agreed-upon standard. Some companies are using value at risk, or VAR (effect of unlikely events in normal markets), and stress testing (effect of plausible events in abnormal markets) methodologies to measure the potential impact of the financial risks they face. DuPont uses earnings at risk (EAR) measuring tools to measure the effect of risk on reported earnings. It can then manage risk to a specified earnings level based on the company's \"risk appetite.\" With this integrated view, DuPont can view how risks affect the likelihood of achieving certain earnings targets.20 Research has shown that companies with integrative risk management capabilities achieve superior economic performance.21 PRIMARY MEASURES OF CORPORATE PERFORMANCE The days when simple financial measures such as ROI or EPS were used alone to assess overall corporate performance are coming to an end. Analysts now recommend a broad range of methods to evaluate the success or failure of a strategy. Some of these methods are stakeholder measures, shareholder value, and the balanced scorecard approach. Even though each of these methods has supporters as well as detractors, the current trend is clearly toward more complicated financial measures and an increasing use of non-financial measures of corporate performance. For example, research indicates that companies pursuing strategies founded on innovation and new product development now tend to favor non-financial over financial measures.22 Traditional Financial Measures The most commonly used measure of corporate performance (in terms of profits) is return on investment (ROI). It is simply the result of dividing net income before taxes by the total amount invested in the company (typically measured by total assets). Although using ROI has several advantages, it also has several distinct limitationsROI gives the impression of objectivity and precision, it can be easily manipulated. Earnings per share (EPS), which involves dividing net earnings by the amount of common stock, also has several deficiencies as an evaluation of past and future performance. First, because alternative accounting principles are available, EPS can have several different but equally acceptable values, depending on the principle selected for its computation. Second, because EPS is based on accrual income, the conversion of income to cash can be near term or delayed. Therefore, EPS does not consider the time value of money. Return on equity (ROE), which involves dividing net income by total equity, also has limitations because it is also derived from accounting-based data. In addition, EPS and ROE are often unrelated to a company's stock price. Operating cash flow, the amount of money generated by a company before the cost of financing and taxes, is a broad measure of a company's funds. This is the company's net income plus depreciation, depletion, amortization, interest expense, and income tax expense.23 Some takeover specialists look at a much narrower free cash flow: the amount of money a new owner can take out of the firm without harming the business. This is net income plus depreciation, depletion, and amortization less capital expenditures and dividends. The free cash flow ratio is very useful in evaluating the stability of an entrepreneurial venture.24 Although cash flow may be harder to manipulate than earnings, the number can be increased by selling accounts receivable, classifying outstanding checks as accounts payable, trading securities, and capitalizing certain expenses, such as direct-response advertising.25 Because of these and other limitations, ROI, EPS, ROE, and operating cash flow are not by themselves adequate measures of corporate performance. At the same time, these traditional financial measures are very appropriate when used with complementary financial and non-financial measures. For example, some non-financial performance measures used by Internet business ventures are stickiness (length of Web site visit), eyeballs (number of people who visit a Web site), and mindshare (brand awareness). Mergers and acquisitions may be priced on multiples of MUUs (monthly unique users) or even on registered users. Shareholder Value Because of the belief that accounting-based numbers such as ROI, ROE, and EPS are not reliable indicators of a corporation's economic value, many corporations are using shareholder value as a better measure of corporate performance and strategic management effectiveness. Shareholder value can be defined as the present value of the anticipated future stream of cash flows from the business plus the value of the company if liquidated. Arguing that the purpose of a company is to increase shareholder wealth, shareholder value analysis concentrates on cash flow as the key measure of performance. The value of a corporation is thus the value of its cash flows discounted back to their present value, using the business's cost of capital as the discount rate. As long as the returns from a business exceed its cost of capital, the business will create value and be worth more than the capital invested in it. For example, Deere and Company charges each business unit a cost of capital of 1% of assets a month. Each business unit is required to earn a shareholder value-added profit margin of 20%, on average, over the business cycle. Financial rewards are linked to this measure.26 The New York consulting firm Stern Stewart & Company devised and popularized two shareholder value measures: economic value added (EVA) and market value added (MVA). A basic tenet of EVA and MVA is that businesses should not invest in projects unless they can generate a profit above the cost of capital. Stern Stewart argues that a deficiency of traditional accounting-based measures is that they assume the cost of capital to be zero.27 Well-known companies, such as Coca-Cola, General Electric, AT&T, Whirlpool, Quaker Oats, Eli Lilly, Georgia-Pacific, Polaroid, Sprint, Toyota, and Tenneco have adopted MVA and/or EVA as the best yardstick for corporate performance. Economic value added (EVA) has become an extremely popular shareholder value method of measuring corporate and divisional performance and may be on its way to replacing ROI as the standard performance measure. EVA measures the difference between the prestrategy and post-strategy values for the business. Simply put, EVA is aftertax operating income minus the total annual cost of capital. The formula to measure EVA is: EVA = after-tax operating income - (investment in assets weighted average cost of capital)28 The cost of capital combines the cost of debt and equity. The annual cost of borrowed capital is the interest charged by the firm's banks and bondholders. To calculate the cost of equity, assume that shareholders generally earn about 6% more on stocks than on government bonds. If longterm treasury bills are selling at 2.5%, the firm's cost of equity should be 8.5%more if the firm is in a risky industry. A corporation's overall cost of capital is the weighted-average cost of the firm's debt and equity capital. The investment in assets is the total amount of capital invested in the business, including buildings, machines, computers, and investments in R&D and training (allocating costs annually over their useful life). Because the typical balance sheet understates the investment made in a company, Stern Stewart has identified more than 160 possible adjustments, before EVA is calculated.29 Multiply the firm's total investment in assets by the weighted-average cost of capital. Subtract that figure from after-tax operating income. If the difference is positive, the strategy (and the management employing it) is generating value for the shareholders. If it is negative, the strategy is destroying shareholder value.30 Roberto Goizueta, past-CEO of Coca-Cola, explained, \"We raise capital to make concentrate, and sell it at an operating profit. Then we pay the cost of that capital. Shareholders pocket the difference.\"31Managers can improve their company's or business unit's EVA by: (1) earning more profit without using more capital, (2) using less capital, and (3) investing capital in highreturn projects. Studies have found that companies using EVA outperform their median competitor by an average of 8.43% of total return annually.32 EVA does, however, have some limitations. For one thing, it does not control for size differences across plants or divisions. As with ROI, managers can manipulate the numbers. As with ROI, EVA is an after-thefact measure and cannot be used like a steering control.33Although proponents of EVA argue that EVA (unlike return on investment, equity, or sales) has a strong relationship to stock price, other studies do not support this contention.34 Market value added (MVA) is the difference between the market value of a corporation and the capital contributed by shareholders and lenders. Like net present value, it measures the stock market's estimate of the net present value of a firm's past and expected capital investment projects. As such, MVA is the present value of future EVA.35 To calculate MVA: 1. Add all the capital that has been put into a companyfrom shareholders, bondholders, and retained earnings. 2. Reclassify certain accounting expenses, such as R&D, to reflect that they are actually investments in future earnings. This provides the firm's total capital. So far, this is the same approach taken in calculating EVA. 3. Using the current stock price, total the value of all outstanding stock, adding it to the company's debt. This is the company's market value. If the company's market value is greater than all the capital invested in it, the firm has a positive MVAmeaning that management (and the strategy it is following) has created wealth. In some cases, however, the market value of the company is actually less than the capital put into it, which means shareholder wealth is being destroyed. Microsoft, General Electric, Intel, and Coca-Cola have tended to have high MVAs in the United States, whereas General Motors and RJR Nabisco have had low ones.36 Studies have shown that EVA is a predictor of MVA. Consecutive years of positive EVA generally lead to a soaring MVA.37Research also reveals that CEO turnover is significantly correlated with MVA and EVA, whereas ROA and ROE are not. This suggests that EVA and MVA may be more appropriate measures of the market's evaluation of a firm's strategy and its management than are the traditional measures of corporate performance.38 Nevertheless, these measures consider only the financial interests of the shareholder and ignore other stakeholders, such as environmentalists and employees. Climate change is likely to lead to new regulations, technological remedies, and shifts in consumer behavior. It will thus have a significant impact on the financial performance of many corporations. To see how companies are using new techniques that are simultaneously good for the environment as well as being good for the company, see the Sustainability Issue feature. BALANCED SCORECARD APPROACH: USING KEY PERFORMANCE MEASURES Rather than evaluate a corporation using a few financial measures, Kaplan and Norton argue for a \"balanced scorecard\" that includes non-financial as well as financial measures.39 This approach is especially useful given that research indicates that non-financial assets explain 50% to 80% of a firm's value.40 The balanced scorecard combines financial measures that tell the results of actions already taken with operational measures on customer satisfaction, internal processes, and the corporation's innovation and improvement activitiesthe drivers of future financial performance. Thus steering controls are combined with output controls. In the balanced scorecard, management develops goals or objectives in each of four areas: SUSTAINABILITY issue: E- RECEIPTS More than nine million trees are cut down each year to make cash register receipts in the United States and most of those receipts are simply thrown away. A number of companies were moving toward e-receipts in the late 1990s, but the dotcom bust brought all that to a temporary end. In 2005, Apple introduced e-receipts at its stylish Apple stores and the wave began. E-receipts not only save on necessary printing and landfill waste, they also provide the customer with an electronic record of purchases (for taxes, expense reports, or gift returns). A number of national retailers now offer ereceipts, including Best Buy, Whole Foods, Nordstrom, Gap Inc. (which owns Old Navy and Banana Republic), Anthropologie, Patagonia, Sears, and Kmart. The advantage beyond cost savings for the retailer is having the customer's e-mail address for use with promotions. Some companies are using this new opportunity to provide value to the consumer. At Nordstrom's, they are looking at making e-receipts more appealing by adding a picture of the item to the receipt so a shopper can post it to a Facebook wall or remember exactly what they bought last time. According to a 2012 survey of 3900 retailers, more than 35% now offer ereceipts as an option. At Wells Fargo, 12% of their customers are choosing e-receipts for their ATM transactions. The audit trail is improved for both customer and company by providing a new level of improved control. SOURCES: W. Koch, \"Retailers Find Profits with Paperless Receipts,\" USA Today (November 3, 2012),http://www.usatoday.com/story/news/nation/2012/11/03/retailers-e-maildigital-paperless-receipts/1675069/#; S. Clifford, \"Shopper Receipts Join Paperless Age,\" The New York Times (August 7, 2011),http://www.nytimes.com/2011/08/08/technology/digital-receipts-at-storesgain-in-popularity.html?_r=0. Financial: How do we appear to shareholders? Customer: How do customers view us? Internal business perspective: What must we excel at? Innovation and learning: Can we continue to improve and create value?41 Each goal in each area (for example, avoiding bankruptcy in the financial area) is then assigned one or more measures, as well as a target and an initiative. These measures can be thought of askey performance measuresmeasures that are essential for achieving a desired strategic option.42For example, a company could include cash flow, quarterly sales growth, and ROE as measures for success in the financial area. It could include market share (competitive position goal), customer satisfaction, and percentage of new sales coming from new products (customer acceptance goal) as measures under the customer perspective. It could include cycle time and unit cost (manufacturing excellence goal) as measures under the internal business perspective. It could include time to develop nextgeneration products (technology leadership objective) under the innovation and learning perspective. A 2011 global survey by Bain & Company reported that 63% of Fortune 1000 companies in North America use a version of the balanced scorecard.43 A study of the Fortune 500 firms in the United States and the Post 300 firms in Canada revealed the most popular non-financial measures to be customer satisfaction, customer service, product quality, market share, productivity, service quality, and core competencies. New product development, corporate culture, and market growth were not far behind.44 DuPont's Engineering Polymers Division uses the balanced scorecard to align employees, business units, and shared services around a common strategy involving productivity improvements and revenue growth.45 Corporate experience with the balanced scorecard reveals that a firm should tailor the system to suit its situation, not just adopt it as a cookbook approach. When the balanced scorecard complements corporate strategy, it improves performance. Using the method in a mechanistic fashion without any link to strategy hinders performance and may even decrease it.46 Evaluating Top Management and the Board of Directors Through its strategy, audit, and compensation committees, a board of directors closely evaluates the job performance of the CEO and the top management team. The vast majority of American (91%), European (75%), and Asian (75%) boards review the CEO's performance using a formalized process.47 Objective evaluations of the CEO by the board are very important given that CEOs tend to evaluate senior management's performance significantly more positively than do other executives.48 The board is concerned primarily with overall corporate profitability as measured quantitatively by ROI, ROE, EPS, and shareholder value. The absence of short-run profitability certainly contributes to the firing of any CEO. The board, however, is also concerned with other factors. Members of the compensation committees of today's boards of directors generally agree that a CEO's ability to establish strategic direction, build a management team, and provide leadership are more critical in the long run than are a few quantitative measures. The board should evaluate top management not only on the typical output-oriented quantitative measures, but also on behavioral measuresfactors relating to its strategic management practices. According to a survey by Korn/Ferry International, the criteria used by American boards are financial (81%), ethical behavior (63%), thought leadership (58%), corporate reputation (32%), stock price performance (22%), and meeting participation (10%).49 The specific items that a board uses to evaluate its top management should be derived from the objectives that both the board and top management agreed on earlier. If better relations with the local community and improved safety practices in work areas were selected as objectives for the year (or for five years), these items should be included in the evaluation. In addition, other factors that tend to lead to profitability might be included, such as market share, product quality, or investment intensity. Performance evaluations of the overall board's performance are standard practice for 87% of directors in the Americas, 72% in Europe, and 62% in Asia.50 Evaluations of individual directors are less common. According to a PricewaterhouseCoopers survey of 1100 directors, 77% of the directors agreed that individual directors should be appraised regularly on their performance, but only 37% responded that they actually do so.51 Corporations that have successfully used board performance appraisal systems are Goldman Sachs, Boeing, Ingersoll Rand, McDonald's, Google, and Ford Motor. Chairman-CEO Feedback Instrument. An increasing number of companies are evaluating their CEO by using a 17item questionnaire developed by Ram Charon, an authority on corporate governance. The questionnaire focuses on four key areas: (1) company performance, (2) leadership of the organization, (3) team-building and management succession, and (4) leadership of external constituencies.52 After taking an hour to complete the questionnaire, the board of KeraVision Inc. used it as a basis for a lengthy discussion with the CEO, Thomas Loarie. The board criticized Loarie for \"not tempering enthusiasm with reality\" and urged Loarie to develop a clear management succession plan. The evaluation caused Loarie to more closely involve the board in setting the company's primary objectives and discussing \"where we are, where we want to go, and the operating environment.\"53 Management Audit. Management audits are very useful to boards of directors in evaluating management's handling of various corporate activities. Management audits have been developed to evaluate activities such as corporate social responsibility, functional areas like the marketing department, and divisions such as the international division. These can be helpful if the board has selected particular functional areas or activities for improvement. Strategic Audit. The strategic audit, presented in the Chapter 1 Appendix 1.A, is a type of management audit. The strategic audit provides a checklist of questions, by area or issue, that enables a systematic analysis of various corporate functions and activities to be made. It is a type of management audit and is extremely useful as a diagnostic tool to pinpoint corporatewide problem areas and to highlight organizational strengths and weaknesses.54 A strategic audit can help determine why a certain area is creating problems for a corporation and help generate solutions to the problem. As such, it can be very useful in evaluating the performance of top management. PRIMARY MEASURES OF DIVISIONAL AND FUNCTIONAL PERFORMANCE Companies use a variety of techniques to evaluate and control performance in divisions, strategic business units (SBUs), and functional areas. If a corporation is composed of SBUs or divisions, it will use many of the same performance measures (ROI or EVA, for instance) that it uses to assess overall corporate performance. To the extent that it can isolate specific functional units such as R&D, the corporation may develop responsibility centers. It will also use typical functional measures, such as market share and sales per employee (marketing), unit costs and percentage of defects (operations), percentage of sales from new products and number of patents (R&D), and turnover and job satisfaction (HRM). For example, FedEx uses Enhanced Tracker software with its COSMOS database to track the progress of its 2.5 to 3.5 million shipments daily. As a courier is completing her or his day's activities, the Enhanced Tracker asks whether the person's package count equals the Enhanced Tracker's count. If the count is off, the software helps reconcile the differences.55 During strategy formulation and implementation, top management approves a series of programs and supporting operating budgets from its business units. During evaluation and control, actual expenses are contrasted with planned expenditures, and the degree of variance is assessed. This is typically done on a monthly basis. In addition, top management will probably require periodic statistical reports summarizing data on such key factors as the number of new customer contracts, the volume of received orders, and productivity figures. RESPONSIBILITY CENTERS Control systems can be established to monitor specific functions, projects, or divisions. Budgets are one type of control system that is typically used to control the financial indicators of performance.Responsibility centers are used to isolate a unit so it can be evaluated separately from the rest of the corporation. Each responsibility center, therefore, has its own budget and is evaluated on its use of budgeted resources. It is headed by the manager responsible for the center's performance. The center uses resources (measured in terms of costs or expenses) to produce a service or a product (measured in terms of volume or revenues). There are five major types of responsibility centers. The type is determined by the way the corporation's control system measures these resources and services or products. Standard cost centers: Standard cost centers are primarily used in manufacturing facilities. Standard (or expected) costs are computed for each operation on the basis of historical data. In evaluating the center's performance, its total standard costs are multiplied by the units produced. The result is the expected cost of production, which is then compared to the actual cost of production. Revenue centers: With revenue centers, production, usually in terms of unit or dollar sales, is measured without consideration of resource costs (for example, salaries). The center is thus judged in terms of effectiveness rather than efficiency. The effectiveness of a sales region, for example, is determined by comparing its actual sales to its projected or previous year's sales. Profits are not considered because sales departments have very limited influence over the cost of the products they sell. Expense centers: Resources are measured in dollars, without consideration for service or product costs. Thus budgets will have been prepared for engineered expenses (costs that can be calculated) and for discretionary expenses (costs that can be only estimated). Typical expense centers are administrative, service, and research departments. They cost a company money, but they only indirectly contribute to revenues. Profit centers: Performance is measured in terms of the difference between revenues (which measure production) and expenditures (which measure resources). A profit centeris typically established whenever an organizational unit has control over both its resources and its products or services. By having such centers, a company can be organized into divisions of separate product lines. The manager of each division is given autonomy to the extent that he or she is able to keep profits at a satisfactory (or better) level. Some organizational units that are not usually considered potentially autonomous can, for the purpose of profit center evaluations, be made so. A manufacturing department, for example, can be converted from a standard cost center (or expense center) into a profit center; it is allowed to charge a transfer price for each product it \"sells\" to the sales department. The difference between the manufacturing cost per unit and the agreed-upon transfer price is the unit's \"profit.\" Transfer pricing is commonly used in vertically integrated corporations and can work well when a price can be easily determined for a designated amount of product. Even though most experts agree that market-based transfer prices are the best choice, A 2010 global survey completed by E&Y found that only 27% of companies use market price to set the transfer price.56 When a price cannot be set easily, however, the relative bargaining power of the centers, rather than strategic considerations, tends to influence the agreed-upon price. Top management has an obligation to make sure that these political considerations do not overwhelm the strategic ones. Otherwise, profit figures for each center will be biased and provide poor information for strategic decisions at both the corporate and divisional levels. Investment centers: Because many divisions in large manufacturing corporations use significant assets to make their products, their asset base should be factored into their performance evaluation. Thus it is insufficient to focus only on profits, as in the case of profit centers. An investment center's performance is measured in terms of the difference between its resources and its services or products. For example, two divisions in a corporation made identical profits, but one division owns a $3 million plant, whereas the other owns a $1 million plant. Both make the same profits, but one is obviously more efficient; the smaller plant provides the shareholders with a better return on their investment. The most widely used measure of investment center performance is ROI. Most single-business corporations, such as Buffalo Wild Wings, tend to use a combination of cost, expense, and revenue centers. In these corporations, most managers are functional specialists and manage against a budget. Total profitability is integrated at the corporate level. Multidivisional corporations with one dominating product line (such as ABInBev) that have diversified into a few businesses but that still depend on a single product line (such as beer) for most of their revenue and income, generally use a combination of cost, expense, revenue, and profit centers. Multidivisional corporations, such as General Electric, tend to emphasize investment centersalthough in various units throughout the corporation other types of responsibility centers are also used. One problem with using responsibility centers, however, is that the separation needed to measure and evaluate a division's performance can diminish the level of cooperation among divisions that is needed to attain synergy for the corporation as a whole. (This problem is discussed later in this chapter, under \"Suboptimization.\") USING BENCHMARKING TO EVALUATE PERFORMANCE According to Xerox Corporation, the company that pioneered this concept in the United States,benchmarking is \"the continual process of measuring products, services, and practices against the toughest competitors or those companies recognized as industry leaders.\"57 Benchmarking, an increasingly popular program, is based on the concept that it makes no sense to reinvent something that someone else is already using. It involves openly learning how others do something better than one's own company so that the company not only can imitate, but perhaps even improve upon its techniques. The benchmarking process usually involves the following steps: 1. Identify the area or process to be examined. It should be an activity that has the potential to determine a business unit's competitive advantage. 2. Find behavioral and output measures of the area or process and obtain measurements. 3. Select an accessible set of competitors and best-in-class companies against which to benchmark. These may very often be companies that are in completely different industries, but perform similar activities. For example, when Xerox wanted to improve its order fulfillment, it went to L.L. Bean, the successful mail order firm, to learn how it achieved excellence in this area. 4. Calculate the differences among the company's performance measurements and those of the best-in-class and determine why the differences exist. 5. Develop tactical programs for closing performance gaps. 6. Implement the programs and then compare the resulting new measurements with those of the best-in-class companies. Benchmarking has been found to produce best results in companies that are already well managed. Apparently poorer performing firms tend to be overwhelmed by the discrepancy between their performance and the benchmarkand tend to view the benchmark as too difficult to reach.58Nevertheless, a survey by Bain & Company of companies of various sizes across all U.S. industries indicated that about 65% were using benchmarking.59 Cost reductions range from 15% to 45%.60Benchmarking can also increase sales, improve goal setting, and boost employee motivation.61 The average cost of a benchmarking study is around $100,000 and involves 30 weeks of effort.62 Manco Inc., a small Cleveland-area producer of duct tape, regularly benchmarks itself against Wal-Mart, Rubbermaid, and PepsiCo to enable it to better compete with giant 3M. APQC (American Productivity & Quality Center), a Houston research group, established the Open Standards Benchmarking Collaborative database, composed of more than 1200 commonly used measures and individual benchmarks, to track the performance of core operational functions. Firms can submit their performance data to this online database to learn how they compare to top performers and industry peers (see www.apqc.org). INTERNATIONAL MEASUREMENT ISSUES The three most widely used techniques for international performance evaluation are ROI, budget analysis, and historical comparisons. In one study, 95% of the corporate officers interviewed stated that they use the same evaluation techniques for foreign and domestic operations. Rate of return was mentioned as the single most important measure.63 However, ROI can cause problems when it is applied to international operations: Because of foreign currencies, different accounting systems, different rates of inflation, different tax laws, and the use of transfer pricing, both the net income figure and the investment base may be seriously distorted.64 To deal with different accounting systems throughout the world, the London-based International Accounting Standards Board developed International Financial Reporting Standards (IFRS) to harmonize accounting practices. The Financial Accounting Standards Board (FASB) oversees the Generally Accepted Accounting Principles (GAAP) that is used in the United States. Over the past decade, these two groups have worked to merge their systems and there was hope that there would be a single set of standards by 2015. Nevertheless, enforcement and cultural interpretations of the international rules can still vary by country and may undercut what is hoped to be a uniform accounting system.65 A study of 79 MNCs revealed that international transfer pricing from one country unit to another is primarily used not to evaluate performance but to minimize taxes.66 Taxes are an important issue for MNCs, given that corporate tax rates vary from 40% in the United States to 38% in Japan, 32% in India, 30% in Mexico, 24% in the U.K. and South Korea, 26% in Canada, 25% in China, 17% in Singapore, 10% in Albania, and 0% in Bahrain and the Cayman Islands.67 For example, the U.S. Internal Revenue Service contended in the early 1990s that many Japanese firms doing business in the United States artificially inflated the value of U.S. deliveries in order to reduce the profits and thus the taxes of their American subsidiaries.68 Parts made in a subsidiary of a Japanese MNC in a low-tax country such as Singapore could be shipped to its subsidiary in a high-tax country like the United States at such a high price that the U.S. subsidiary reports very little profit (and thus pays few taxes), while the Singapore subsidiary reports a very high profit (but also pays few taxes because of the lower tax rate). A Japanese MNC could, therefore, earn more profit worldwide by reporting less profit in high-tax countries and more profit in low-tax countries. Transfer pricing can thus be one way the parent company can reduce taxes and \"capture profits\" from a subsidiary. Other common ways of transferring profits to the parent company (often referred to as the repatriation of profits) are through dividends, royalties, and management fees.69 Among the most important barriers to international trade are the different standards for products and services. There are at least three categories of standards: safety/environmental, energy efficiency, and testing procedures. Existing standards have been drafted by such bodies as the British Standards Institute (BSI-UK) in the United Kingdom, the Japanese Industrial Standards Committee (JISC), AFNOR in France, DIN in Germany, CSA in Canada, and the American Standards Institute in the United States. These standards traditionally created entry barriers that served to fragment various industries, such as major home appliances, by country. The International Electrotechnical Commission (IEC) standards were created to harmonize standards in the European Union and eventually to serve as worldwide standards, with some national deviations to satisfy specific needs. Because the European Union (EU) was the first to harmonize the many different standards of its member countries, the EU is shaping standards for the rest of the world. In addition, the International Organization for Standardization (ISO) is preparing and publishing international standards. These standards provide a foundation for regional associations to build upon. CANENA, the Council for Harmonization of Electrotechnical Standards of the Nations of the Americas, was created in 1992 to further coordinate the harmonization of standards in North and South America. Efforts are also under way in Asia to harmonize standards.70 An important issue in international trade is counterfeiting/piracy. Firms in developing nations around the world make money by making counterfeit/pirated copies of well-known name-brand products and selling them globally as well as locally. See the Global Issue feature to learn how this is being done. Authorities in international business recommend that the control and reward systems used by a global MNC be different from those used by a multidomestic MNC.71 A MNC should use loose controls on its foreign units. The management of each geographic unit should be given considerable operational latitude, but it should be expected to meet some performance targets. Because profit and ROI measures are often unreliable in international operations, it is recommended that the MNC's top management, in this instance, emphasize budgets and non-financial measures of performance such as market share, productivity, public image, employee morale, and relations with the host country government.72 Multiple measures should be used to differentiate between the worth of the subsidiary and the performance of its management. A global MNC, however, needs tight controls over its many units. To reduce costs and gain competitive advantage, it is trying to spread the manufacturing and marketing operations of a few fairly uniform products around the world. Therefore, its key operational decisions must be centralized. Its environmental scanning must include research not only into each of the national markets in which the MNC competes but also into the \"global arena\" of the interaction between markets. Foreign units are thus evaluated more as cost centers, revenue centers, or expense centers than as investment or profit centers because MNCs operating in a global industry do not often make the entire product in the country in which it is sold. GLOBAL issue: COUNTERFEIT GOODS AND PIRATED SOFTWARE: A GLOBAL PROBLEM \"We knowthat 15% to 20% of all goods in China are counterfeit,\" states Dan Chow, a law professor at Ohio State University. This includes products from Tide detergent and Budweiser beer to Marlboro cigarettes. There is a saying in Shanghai, China: \"We can copy everything except your mother.\" Yamaha estimates that five out of every six bikes bearing its brand name are fake. Fake Cisco network routers (known as \"Chiscos\") and counterfeit Nokia mobile phones can be easily found throughout China. Procter & Gamble estimates that 15% of the soaps and detergents under its Head & Shoulders, Vidal Sassoon, Safeguard, and Tide brands in China are counterfeit, costing the company $150 million in lost sales. In Yiwu, a few hours from Shanghai, one person admitted to a 60 Minutes reporter that she could make 1000 pairs of counterfeit Nike shoes in 10 days for $4.00 a pair. According to the market research firm Automotive Resources, the profit margins on counterfeit shock absorbers can reach 80% versus only 15% for the real ones. The World Custom Organization estimates that 7% of the world's merchandise is bogus. Tens of thousands of counterfeiters are active in China. They range from factories mixing shampoo and soap in back rooms to large state-owned enterprises making copies of soft drinks and beer. Other factories make everything from car batteries to automobiles. Mobile CD factories with optical disc-mastering machines counterfeit music and software. 60 Minutes found a small factory in Donguan making fake Callaway golf clubs and bags at a rate of 500 bags per week. Factories in the southern Guangdong and Fujian provinces truck their products to a central distribution center, such as the one in Yiwu. They may also be shipped across the border into Russia, Pakistan, Vietnam, or Burma. Chinese counterfeiters have developed a global reach through their connections with organized crime. As much as 35% of software on personal computers worldwide is pirated, according to the Business Software Alliance and ISDC, a market research firm. The worldwide cost of software piracy was around $63 billion in 2011. For example, 21% of the software sold in the United States is pirated. That figure increases to 26%-30% in the European Union, 83% in Russia, Algeria, and Bolivia, to 86% in China, 87% in Indonesia, and 90% in Vietnam. SOURCES: \"Head in the Clouds,\" The Economist (July 25, 2012),http://www.economist.com/blogs/graphicdetail/2012/07/online-softwarepiracy; \"The Sincerest Form of Flattery,\" The Economist (April 7, 2007), pp. 64-65; F. Balfour, \"Fakes!\" BusinessWeek (February 7, 2005), pp. 54-64; \"PC Software Piracy,\" The Economist (June 10, 2006), p. 102; \"The World's Greatest Fakes,\" 60 Minutes, CBS News (August 8, 2004); \"Business Software Piracy,\" Pocket World in Figures 2004 (London: Economist & profile Book, 2003), p. 60; D. Roberts, F. Balfour, P. Magnusson, P. Engardio, and J. Lee, \"China's Piracy Plague,\" BusinessWeek (June 5, 2000), pp. 44-48. Strategic Information Systems Before performance measures can have any impact on strategic management, they must first be communicated to the people responsible for formulating and implementing strategic plans. Strategic information systems can perform this function. They can be computer-based or manual, formal or informal. One of the key reasons given for the bankruptcy of International Harvester was the inability of the corporation's top management to precisely determine income by major class of similar products. Because of this inability, management kept trying to fix ailing businesses and was unable to respond flexibly to major changes and unexpected events. In contrast, one of the key reasons for the success of Wal-Mart has been management's use of the company's sophisticated information system to control purchasing decisions. Cash registers in WalMart retail stores transmit information hourly to computers at the company headquarters. Consequently, managers know every morning exactly how many of each item were sold the day before, how many have been sold so far in the year, and how this year's sales compare to last year's. The information system allows all reordering to be done automatically by computers, without any managerial input. It also allows the company to experiment with new products without committing to big orders in advance. In effect, the system allows the customers to decide through their purchases what gets reordered. ENTERPRISE RESOURCE PLANNING (ERP) Many corporations around the world have adopted enterprise resource planning (ERP) software. ERP unites all of a company's major business activities, from order processing to production, within a single family of software modules. The system provides instant access to critical information to everyone in the organization, from the CEO to the factory floor worker. Because of the ability of ERP software to use a common information system throughout a company's many operations around the world, it is becoming the business information systems' global standard. The major providers of this software are SAP AG, Oracle (including PeopleSoft), J. D. Edwards, Baan, and SSA Global Technologies. The German company SAP AG originated the concept with its R/3 software system. Microsoft, for example, used R/3 to replace a tangle of 33 financial tracking systems in 26 subsidiaries. Even though it cost the company $25 million and took 10 months to install, R/3 annually saves Microsoft $18 million. Coca-Cola uses the R/3 system to enable a manager in Atlanta to use her personal computer to check the latest sales of 20-ounce bottles of Coke Classic in India. Owens-Corning envisioned that its R/3 system allowed salespeople to learn what was available at any plant or warehouse and to quickly assemble orders for customers. ERP may not fit every company, however. The system is extremely complicated and demands a high level of standardization throughout a corporation. Its demanding nature often forces companies to change the way they do business. There are three reasons ERP could fail: (1) insufficient tailoring of the software to fit the company, (2) inadequate training, and (3) insufficient implementation support.73 Over the two-year period of installing R/3, Owens-Corning had to completely overhaul its operations. Because R/3 was incompatible with Apple's very organic corporate culture, the company was able to apply it only to its order management and financial operations, but not to manufacturing. Other companies that had difficulty installing and using ERP are Whirlpool, Hershey Foods, Volkswagen, and Stanley Works. At Whirlpool, SAP's software led to missed and delayed shipments, causing The Home Depot to cancel its agreement for selling Whirlpool products.74 One survey found that 65% of executives believed that ERP had a moderate chance of hurting their business because of implementation problems. Nevertheless, the payoff from ERP software can be worth the effort. In an industry where one company implements ERP ahead of its competitors, it can be used to gain some competitive advantage, streamline operations, and help manage a lean manufacturing system.75 RADIO FREQUENCY IDENTIFICATION (RFID) Radio frequency identification (RFID) is an electronic tagging technology used in a number of companies to improve supply-chain efficiency. By tagging containers and items with tiny chips, companies use the tags as wireless barcodes to track inventory more efficiently. Both Wal-Mart and the U.S. Department of Defense began requiring their largest suppliers to incorporate RFID tags in their goods in 2003. After trying to implement RFID for the past decade, the UK-based supermarket chain Tesco postponed their full implementation of RFID technology in late 2012. Tesco had planned to deploy RFID tags and readers in 1400 stores and in its distribution centers by the middle of 2012. However, it had installed RFID tags in only 40 stores and one depot before it brought the program to a halt.76 Nevertheless, some suppliers and retailers of expensive consumer products view the cost of the tag as worthwhile because it reduces losses from counterfeiting and theft. RFID technology is currently in wide use as wireless commuter passes for toll roads, tunnels, and bridges. Even though RFID standards may vary among companies, individual firms like Audi, Sony, and Dole Food use the tags to track goods within their own factories and warehouses.77 According to Dan Mullen of AIM Global, \"RFID will go through a process similar to what happened in barcode technology 20 years ago. . . . As companies implement the technology deeper within their operations, the return on investment will grow and applications will expand.\"78 DIVISIONAL AND FUNCTIONAL IS SUPPORT At the divisional or SBU level of a corporation, the information system should be used to support, reinforce, or enlarge its business-level strategy through its decision support system. An SBU pursuing a strategy of overall cost leadership could use its information system to reduce costs either by improving labor productivity or improving the use of other resources such as inventory or machinery. Kaiser Health has 37 hospitals, 15,857 physicians, and 9 million plus members all tied together in a single system that has made for better health services and an increased ability to reduce problems in the system. An internal study of heart attacks among 46,000 patients in Northern California who were 30 years and older showed a decline of 24 percent. Kaiser has also reduced mortality rates by 40% since 2008 for its hospital patients who contract sepsis, a dangerous infectious disease.79 Another SBU, in contrast, might want to pursue a differentiation strategy. It could use its information system to add uniqueness to the product or service and contribute to quality, service, or image through the functional areas. FedEx wanted to use superior service to gain a competitive advantage. It invested significantly in several types of information systems to measure and track the performance of its delivery service. Together, these information systems gave FedEx the fastest error-response time in the overnight delivery business. Problems in Measuring Performance The measurement of performance is a crucial part of evaluation and control. The lack of quantifiable objectives or performance standards and the inability of the information system to provide timely and valid information are two obvious control problems. According to Meg Whitman, former CEO of eBay, \"If you can't measure it, you can't control it.\" That's why eBay has a multitude of measures, from total revenues and profits to take rate, the ratio of revenues to the value of goods traded on the site.80 Without objective and timely measurements, it would be extremely difficult to make operational, let alone strategic, decisions. Nevertheless, the use of timely, quantifiable standards does not guarantee good performance. The very act of monitoring and measuring performance can cause side effects that interfere with overall corporate performance. Among the most frequent negative side effects are a short-term orientation and goal displacement. SHORT-TERM ORIENTATION Top executives report that in many situations, they analyze neither the longterm implications of present operations on the strategy they have adopted nor the operational impact of a strategy on the corporate mission. Longterm evaluations may not be conducted because executives (1) don't realize their importance, (2) believe that short-term considerations are more