What are The Balanced Scorecard & EVA(r)

Over the past several years, many organizations have become more and more disenchanted with their performance measures. Business leaders are finding that as organizations move away from traditional mechanistic structures in favor of more flexible organic ones, age-old performance measures simply do not provide the information needed to manage in the 90's. Global competition is driving fast paced changes in both business strategy and structure. Continuing the use of traditional measures when environment and structure have undergone radical change often causes a multitude of undesirable effects. In the ultra-competitive 90's traditional measures are seen as:

• Reactive and slow to respond
• Internally focused as opposed to stakeholder focused
• Activity or output based as opposed to outcome based
• Likely to cause sub-optimization due to fracturing of functional units

Modern management theories center around ways to achieve strategic alignment. That is, setting up a performance management system which propels all units within an organization to move in a concerted direction toward the fulfillment of that organization's business strategies. This is more easily said than done, given the fact that business climates, markets and windows of opportunity can change at a dizzying pace. What is needed is a hierarchical structure which defines strategies and then somehow translates those into performance measures that are meaningful to a wide array of stakeholders with very different perspectives (i.e. customers, shareholders, senior executives, mid-level executives, process owners, front line managers, suppliers, etc.).

The solution is to implement a comprehensive four-tiered performance management approach which involves first setting business strategies via Vision, Mission, Objectives and Goals. This is followed by three levels of performance measures which are designed to track the organization's progress toward achieving the strategies. Each successive level involves more detailed performance measures. At the Organizational Level Economic Value Added measures such as EVA, ROIC, and MOI are used to quantify the value that has been created or destroyed from ongoing operations. These are used because there is a direct correlation between long-term Share Price and EVA. EVA performance measures provide an organization-wide leading indicator especially useful for executives and investors. Additional details are provided below.

The third tier of the performance management system involves Process Performance measures. Since value is added horizontally across an organization, it is only fitting that performance measures be aligned along processes, as opposed to the traditional functional alignment. A move from vertical to horizontal alignment involves a significant paradigm shift in the leaders of the organization. A very useful approach was described by Professor Robert S. Kaplan of the Harvard Business School (see below). Finally, the fourth tier involves Job Performance Drivers or Value Drivers which take the strategic direction and deploy it out to the front lines of the organization. Value Drivers are those measurements at an activity or job level which have a predictable impact on process measures. Managers at all levels are involved in spanning the four tiers in ways that are meaningful and drive constructive decision making across the organization. This ensure seamless strategic alignment from the CEO down to the front line manager.

A well designed Four Tiered Performance Measurement System using the Balanced Scorecard and Economic Value Added will accomplish many objectives including:

• Establishing cause and effect interrelationships between organizational variables so that optimization of resources and profits can occur
• Locating system constraints which inhibit higher levels of organizational performance from occurring
• Maintaining a proactive look ahead posture
• Reinforcing ever-changing business strategies and priorities
• Fostering creativity, innovation and organizational learning

Economic Value Added or EVA (EVA is a trademark of Stern Stewart Company) allows an organization to identify the amount of value that was created or destroyed over and above the risk-adjusted rate of return required by an investor. Economic Value Added is defined as the Net Operating Profit After Taxes less the quantity, Average Capital multiplied by Risk-Adjusted Cost of Capital. EVA uses standard accounting data to relate operational performance to shareholder value, thereby linking two critical stakeholder sets. EVA is a proactive measure of organizational performance based on cash flow analysis. This allows managers to identify drivers within the organization which create value. Benefits of Economic Value Added include:

• Allows an organization to link current events to future performance
• Provides a good operational measurement of an organization's success
• Forms a solid compensation / reward framework
• Provides a common framework for portfolio management

The Balanced Scorecard was the title of a landmark article in the Harvard Business Review in the first issue of 1992. Wherein its primary author, Professor Robert S. Kaplan of the Harvard Business School, discussed the use of a comprehensive, but finite number of system-wide performance measures to guide organizations. Kaplan likens leading an organization to flying an airplane in that they are both complex tasks requiring a certain amount of information to be successful. A pilot guides an airplane based on integrating the feedback from a handful of instruments (i.e. airspeed, altitude, fuel, bearing, etc.). Kaplan hypothesizes using the same approach to business management, stating that too few indicators can increase risk due to blind spots; while too many measures can create confusion and sluggish response to changes in market conditions.

Kaplan argues that the benefits of using The Balanced Scorecard include:

• Minimizing information overload by forcing focus on what's critical
• Guarding against sub-optimization by forcing leaders to look at the "big picture"

Traditional performance measurements were derived from a control perspective. Managers defined what specific actions they wanted employees to take, then measured whether or not they were performing those actions. The Balanced Scorecard approach forces a system perspective grounded in the company's strategic plans. It places business strategy at the center (not control) by establishing goals and then assuming that employees will do what's smart to achieve them. Kaplan's approach to implement the Balanced Scorecard involves four fronts (these are analogous to the gauges in the cockpit of an airplane):

• Financial Perspective (How do we look to shareholders?): Indicate whether a company's strategy, implementation, and execution are contributing to bottom-line improvement. Typical goals in this area have to do with profitability, growth, and shareholder value.
• Customer Perspective (How do our customers see us?): Concerns fall into five categories -- time, quality , performance, service, and cost.
• Internal Business Perspective (What must we excel at?): Focusing internally on those critical operations that enable you to satisfy your customers. Should stem from the business processes that have the greatest impact on customer satisfaction -- factors that affect cycle-time, quality, employee skills, and productivity. Also should look at core competencies and critical technologies needed to ensure continued market leadership and specify measures for each.
• Innovation and Learning Perspective (Can we continue to improve and create value?): A company's ability to innovate, improve, and learn correlates directly to the company's value. Only through the ability to launch new products, create more value for customers, and improve operating efficiencies continually can a company penetrate new markets and increase revenues and margins.

What does a Balanced Scorecard model do?

A CAPI Balanced Scorecard Economic Value Added Model is a comprehensive and fully integrated financial analysis tool designed to provide the backbone and baseline for reengineering and operations improvements. This high powered management tool allows executives to see the impacts of today's decisions on tomorrow's balance sheet.

The model described in the following is designed around the organizational framework of a large utility company operating via Strategic Business Units (SBUs). Of the four SBUs, three are revenue generating and one is dedicated to cross functional overhead processes. The revenue generating SBUs are: Generation, Transmission and Distribution, while the overhead processes are grouped into Services. The CAPI EVA model is capable of calculating the following:

• Economic Value Added (EVA) for each SBU and for the Corporation < LI >Return on Invested Capital (ROIC) for each SBU and for the Corporation < LI >Measured Operating Income (MOI) for each SBU and for the Corporation < LI >Average Capital for each SBU and for the Corporation < LI >Total Revenue for each SBU -- monthly and accumulated YTD < LI >KWH System Sales -- monthly and accumulated YTD < LI >Off System Sales -- monthly and accumulated YTD < LI >By Product Sales -- monthly and accumulated YTD < LI >Physical Plant and Equipment (PP&E) Maintenance -- monthly and YTD < LI >Total Cost to Generate Power -- monthly and accumulated YTD < LI >Total Labor Costs -- monthly and accumulated YTD < LI >Cost of Sales -- monthly and accumulated YTD

How powerful is it?

This CAPI Balanced Scorecard EVA Model is extremely powerful, performing thousands of calculations each run and allowing the user access to nearly 200 variables. Information is input by the user in a number of easy to use formats including: Labeled Boxes, Sliders, Tables, and Functions (see below). The most appropriate input method is selected based on the type of information to be used by the model. Some variables maintain a constant value throughout the entire run, while others change over time. In some cases, we know the exact values of parameters, while in others we can only estimate trends within a set of upper and lower limits. The CAPI EVA Model can handle any and all of these cases and apply them to a virtually limitless number of variables. The result is a simulation which closely models the real world with all of its complexity, turbulence and randomness -- giving you the upper hand in making business decisions.

Additional examples of User Defined Input Variables using Labeled Boxes include: Value of Inventory, Value of Physical Plant and Equipment (PP&E), BTUs Per Ton of Fuel, Cost Per Outage Day, O&M Costs, and Value of Liabilities.

Additional examples of User Defined Input Variables using the Slider Control include: Emission Price, Market KWH Cost, BTUs per MW, Preventive Maintenance Investment, KWH Unit Price, System Capacity, Amount of Excess Energy that can be Sold, Market Price of Fuel Per Ton, Value of Other Income, Cost of Expenses, and Purchase Price of Energy.

Additional examples of User Defined Input Variables using Input Tables include: SBU Key Process Other Than Labor Costs (OTL), and SBU Key Process Number of Full Time Equivalents (FTE).

Additional examples of User Defined Input Variables using Input Functions include: Perspective Maintenance Investment, Total Expenses Per Month, Construction of PP&E, Number of Planned Outages, By Product Factors such as Steam Sales, Emission Allowance and Fly Ash Sales.

How does it work?

The CAPI Balanced Scorecard EVA Model is built using the Extend(tm) (Extend is a trademark of Imagine That, Inc., San Jose, CA ) Decision Support Software package in the continuous modeling mode. Extend uses a visual paradigm of icons to represent values, functions, equations, and flows of information. To deal with the complexities of modeling large scale systems, Extend allows modelers to invoke and indefinite number of hierarchical levels. Hierarchical blocks allow the modeler to bundle sub-processes or subsystems together. The CAPI EVA Model uses more than one hundred hierarchical blocks along four levels (deep) of hierarchy which correspond to the Strategic Business Unit structure. Level #1 is the Top or Corporate Level. At the this level each of the SBU and overall bottom line financials are displayed -- EVA, ROIC, and MOI. The visual display of the top level is shown at full size on the cover of this document (see also below).

This is a very complex simulation, and to facilitate ease of use, CAPI utilized numerous levels of hierarchy. By doing so, a typical user would be largely unaware of the complex structure of variables, blocks and equations underlying a CAPI model. Wherever possible, setup and interface time for the user is minimized and simplified -- we build models for decision makers, not computer scientists.

Extend+BPR is a trademark of Imagine That!, Inc., San Jose, CA. EVA is a trademark of Stern Stewart Company, NY, NY.