Performance Measurement

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PERFORMANCE, COMPENSATION, AND THE BALANCED SCORECARD*

Christopher D. Ittner, David F. Larcker, and Marshall W. Meyer The Wharton School The University of Pennsylvania November 1, 1997

*This research was funded by the Citicorp Behavioral Sciences Research Council, whose support is gratefully acknowledged. © 1997, Christopher D. Ittner, David F. Larcker, and Marshall W. Meyer

PERFORMANCE, COMPENSATION, AND THE BALANCED SCORECARD

A growing number of firms are replacing their financially-based performance measurement and compensation systems with a "balanced scorecard" incorporating multiple financial and nonfinancial indicators. Proponents of the balanced scorecard concept contend that this approach provides a powerful means for translating a firm's vision and strategy into a tool that effectively communicates strategic intent and motivates performance against established strategic goals (Kaplan and Norton, 1996). However, the balanced scorecard literature provides little discussion of the scorecard's role in compensation decisions, despite the fact that the majority of adopters use the scorecard for this purpose (Towers Perrin, 1996). The limited discussion of performance evaluation and compensation issues raises a number of questions regarding how the multiple performance measures and their relative weights are chosen to ensure "balance" in the compensation plan, the appropriate role of subjective versus formula-driven performance evaluations, the choice of qualitative versus quantitative performance measures, and the extent to which managers' understanding of strategic objectives and managerial actions vary with different forms of scorecard-based incentive plans. These questions are all the more interesting because, in the past, firms have sought to simplify performance measures by adopting multiunit organizational designs, decentralizing operational decisions to individual business units, and holding business units accountable mainly for bottom-line financial results. This study provides exploratory evidence on these issues based on a field study of the U.S. retail banking operations of “Global Financial Services” (GFS), a leading international financial services provider. Prior to the 1990s, GFS had had, according to a senior executive, "a thirty-year 2

obsession with decentralization." Business units were held accountable for earnings and "not a lot of other measures." Within its U.S. retail banking operations, performance was measured and branch managers were compensated inconsistently. Beginning in 1993, GFS implemented a formula-based system for compensating retail branch managers throughout the U.S. The system initially rewarded profitability and growth once customer satisfaction and operational audit hurdles had been achieved, but it changed rapidly during the three years it was in use. It was replaced in the Western region in the second quarter of 1995 and elsewhere in the U.S. in the first quarter of 1996 by a "balanced scorecard" system. The "balanced scorecard" contained six categories of financial and non-financial performance measures, some of which were qualitative, and was intended for use at all levels of the organization, not just branch managers. Unlike the formula-based program, the "balanced scorecard" used subjective weightings to aggregate the various scorecard measures when determining overall performance evaluations and bonus awards. We examine whether managers' understanding of strategic goals and compensation determinants differed under the two systems, and investigate whether the balanced scorecard met the objectives of generating closer links between strategic goals and compensation, improvements in non-financial strategic "drivers," and, ultimately, improved financial performance. The remainder of the paper is organized as follows. The next section provides an overview of the balanced scorecard concept and related research on the use of multiple performance measures and...
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