Effective Performance Measures of Corporate Control

The primary purpose of strategic management is to maximize the firm’s performance in the long-run. In financial terms, this means maximizing the enterprise value of the firm by maximizing the net present value of the stream of profits (cash flows) over the long-run. Enterprise value is equal to shareholder value plus the value of the firm’s debt. Most companies consider enterprise value and shareholder value equivalent when making managerial decisions. To improve or maximize performance, it is imperative to measure and control it. To improve or maximize performance through strategic management’s performance management system, strategic goals are translated into performance targets, and then performance results are monitored, evaluated, and controlled against the targets. To become successful, performance targets must be clear and consistent with long-term goals and linked to the firm’s strategy.

However, the strategic management system is an ambidextrous system because it uses a dual planning system (strategic and implementation planning): medium and long-term planning focuses on periods of two to three years, and five years or more respectively, and short-term planning focuses on one to two years period. In this manner, most large companies, including multinationals use strategic management as a dual evaluation and control system: a strategic or strategic planning control system focuses on medium and long-term, and a financial planning control system focuses on improving short-term performance. The strategic control system uses three out of four basic elements (environmental scanning, strategy formulation, and evaluation and control) of the strategic management model (environmental scanning, strategic planning, implementation, and evaluation and control), and the financial control system uses two elements (strategy implementation and evaluation and control) of the model. These two control systems are discussed below in more detail.

Financial Planning or Short-Term Control

The purpose of financial planning control is to assess how a firm’s current strategy is doing with respect to the financial performance of the firm. The next step is to identify the sources of unsatisfactory performance. If the financial performance is unsatisfactory, corrective action is taken to bring back the performance under control. Return on Invested Capital (ROIC), which is both a long- and short-term measure, can be disaggregated into components to identify the short-term drivers of performance. We can use the Du Pont identity to disaggregate ROIC into return on sales and capital turnover. These two measures can be further disaggregated to identify additional performance measures such as cost of goods sold (COGS) to sales ratio, selling, general and administrative (SG&A) expense to sales ratio, depreciation to sales ratio and fixed asset turnover ratio, sales to receivables ratio and net working capital (NWC) turnover ratio. These ratios can be used to judge if performance is improving or degrading over time, for benchmarking and comparing performance with respect to competitors.

Recent Performance can Guide Future Performance

By analyzing the firm’s current or recent past performance, we can provide useful feedback into strategy formulation that can guide the firm to achieve its future performance targets. If we can identify the causes of unsatisfactory performance, then corrective actions can be taken to improve both strategic (medium-to long-term) and operational (short-term) performance. If the performance degradation is substantial, then the firm needs to focus more on the short-term. For example, the current COVID-19 pandemic has brought numerous companies in the airlines, hospitality, and cruise industries to the brink of bankruptcy. Therefore, these companies should concentrate more on improving short-term performance and less on long-term strategy, as the survival of these businesses from this pandemic is crucial.

Short-Termism  

Most company executives, when they design their corporate control system, they emphasize one control system, either strategic planning or financial control of performance targets. The financial control type companies with corporate headquarters emphasize short-term control and rigorously monitor short-term performance against specific targets, but limit their involvement in formulating long-term business strategies, leaving this responsibility to business unit managers. Over time, the impact of this is that company headquarters increasingly use financial control to manage their business units. Additionally, executives do not realize the importance of long-term evaluation and do not have time to do long-term analysis. The outcome of the 2008 financial crisis was that it distrusted short-term value maximization and increasingly emphasized long-term control over short-term control.

Controlling Short-Term Key Success Factors

Described under the heading “Controlling Key Success Factors” below.

Strategic or Strategic Planning Control

The typical strategic management model’s evaluation and control element use a feedback control system that is not appropriate to measure and control long-term performance. This is because the control error function is only useful in a small dimension of time (for example, in days, months, etc.) to capture the deviations from the target performance and take corrective action to bring the performance back in control if the deviations are large enough to justify correction. In addition to this long-term measurement problem, there is a tendency of management to concentrate more on short-term performance and very less on long-term strategic issues. Therefore, to perform effectively as a feedback control system, the performance targets should be monitored over the short-term only because the feedback system is inadequate to measure long-term performance, as described above. Here are few methods that a firm can use to measure and control its long-term strategic performance.

Disaggregating Corporate Goals

The long-term profitability goal can be disaggregated into short-term performance targets for implementation and then integrated back to achieve long-term profitability goal. However, just focusing on maximizing the disaggregated short-term profitability goals without correlating them quantitatively to long-term profitability is unlikely to result in achieving long-term profit maximization goal. This correlation is not possible because the short-term financial metrics are often manipulated by managers. To resolve this issue, the overall corporate goal of value maximization is disaggregated and linked to strategic and operational targets to make sure that the company is not favoring short-term financial goals at the expense of its long-term strategic goal. The most popular method to achieve this is the balanced scorecard. The balanced scorecard provides an integrated approach for balancing strategic and operational goals and integrating performance targets up from individual business units and departments to the corporate level.

Controlling Key Success Factors

Key success factors (KSFs) are those factors within an industry environment that can enhance a firm’s ability to outperform rivals. However, the firm must also have capabilities relevant to the KSFs to deliver a competitive advantage. The KSFs can be identified by analyzing the demand side of the product, competition, and direct modeling of profitability. I disaggregate the KSFs into two components: short-term or operational key success factors (OKSFs)-that are related to the demand side of the product, and strategic key success factors (SKSFs) that are related to the competition-how to survive competition or how to compete effectively. This disaggregation will allow managers to differentiate between the two success factors, set clear and measurable short-term and long-term goals, and enhance their ability to control their firms’ performance.

Controlling Short-Term Key Success Factors

OKSFs are related to the demand side of the product: in terms of what customers want and the basis upon which they choose between competing offerings. Based on this analysis, we can identify the OKSFs related to the marketing tactics. Tactics are specific short-term plans and narrower in their scope. There are seven key elements in marketing tactics, also known as the marketing mix: product, service, brand, price, incentives, communication, and distribution that a firm can monitor and control to create value and generate profitability for the firm. For example, air travelers choose airlines based on “airfare,” therefore, price is a short-term key success factor and a key element of the marketing mix. Likewise, for an “online grocery store business,” the OKSFs are speedy delivery, low prices, and convenient location.

Controlling Strategic Key Success Factors

The SKSFs are related to the supply side of the product: the competition. Here, we identify the factors that can help the firm to create company value, become profitable, and generate and sustain competitive advantage. To accomplish this, we examine the nature of competition, its scope, and its intensity. The intensity of competition determines industry profitability. High levels of competitive intensity mean lower profit margins for the entire industry. For example, to survive competition in an economic bust, an airline not only requires offering low fares but also requires financial strength and may also require a good strategic relationship with the government and regulators. SKSFs are industry-specific, due to differences in industry structures and customer preferences. For example, we can divide the potential US bicycle buyers into two market segments: high-priced enthusiasts (high quality) and low-cost economy. SKSFs in the enthusiast segment are technology, dealer relations, quality, and reputation. In the economy segment, the SKSFs are low-cost design, low-cost manufacturing, and long-term supply contracts with major retail chains.

Controlling Milestones

A firm must earn a higher rate of profit constantly over its rivals to establish a competitive advantage. And to establish a competitive advantage requires formulating and implementing strategies that exploit the firm’s strengths. To implement strategies successfully, strategy formulation (strategic planning) should be linked to operational management. This linking (or bridging) can be achieved through portfolio, program, and project management. Milestones can be introduced for specific actions or intermediate performance goals (to be achieved at specific dates) monitoring and decision making to bring reality to the strategic plan. For example, to keep its cost reduction strategy in its automotive business on track for moving its manufacturing overseas, Honeywell managers developed a series of milestones to accomplish this goal.

Controlling Capability Development

The resources and capabilities of a firm are the sources of superior profitability and input to strategy formulation that generate a competitive advantage for the firm. However, building a new product development capability or developing a new area of business is a great management challenge because of the vast array of knowledge and expertise that must be integrated. Developing capabilities is a long-term process of development and requires a methodical approach that integrates the four principal components of capability development: processes, structure, motivation, and organization alignment. Each stage or phase of development is not only linked to a particular product or part of it but also to a set of capabilities. For example, to compete and become successful in the long-run Honda and Hyundai motor companies developed automotive capabilities over many years through sequencing of product phases. This demonstrates that long-term strategic goals can be disaggregated into sequential, concurrent, or some combination of these two phases or stages to achieve complex undertakings. Drugmakers Moderna and Pfizer successfully achieved a normally very long-term (typically several years) goal of vaccine development within 10 months, mainly using sequential and concurrent development phases. Here, the “vaccine development speed” sets an unprecedented record in the life cycle (from product introduction to commercialization) of “new drugs and biologic” development.

Accounting Ratios to Measure Long-Term Performance

Widely used long-term performance indicators that drive profitability and enterprise value are growth in profit, return on invested capital (ROIC), and cost of capital. Out of these, ROIC is the key indicator to successfully generate profits for the firm. ROIC is equivalent to return on capital employed (ROCE) and is closely related to return on assets (ROA) and return on equity (ROE), which are also important performance measures. These performance indicators can be calculated over medium- to long-term (e.g., three to five years or more) as well as short-term (e.g., quarterly, and yearly). Because accounting ratios are backward-looking and, therefore, analyzing the past has limitations in predicting the future. However, ROIC and its short-term components, in conjunction with strategy and scenario analysis, can help us to understand some of the most important factors that might affect a firm’s future success. Strategy analysis can help us to understand how the industry environment will be changing with respect to customer preferences, technology, competition, and cost structure and guide us to adapt to new circumstances.

To become successful in the long-run, every firm should be explicit about its “strategic intent,” which is an important ingredient in controlling the long-term performance of the firm. Strategic intent is an expression of some ambitious goals and objectives which the firm is trying to achieve in the medium-to long-term future. These can be expressed in terms of financial targets (ROIC, growth of sales revenue, gross margin), strategic goals (market share, new product introductions, quality), and operational performance (productivity, output). Other than financial, strategic goals and objectives are harder to explicitly define and quantify. Therefore, making progress towards these long-term intentions is normally (usually) marked by defining and meeting separate “challenges” in the path of connecting the present and the future of the firm-each challenge leading to the next.

References and Further Reading

1. R. M. Grant, Contemporary Strategy Analysis (United Kingdom: John Wiley & Sons, Ltd., 2013), Chapters 2, 3, 5, 7, 8 and 14.
2. Ashok N., “Managing Innovation through Dual Planning Systems,” A&N Strategy Consulting (June 1, 2017).
3. T. L. Wheelen, J. D. Hunger, Alan N. Hoffman, and Charles E. Bamford, Strategic Management & Business Policy (United Kingdom: Pearson Education Ltd., 2018), Chapters 7, and 12.
4. Derek F. Abell, Managing with Dual Strategies (NY: The Free Press, 1993), Chapters 4, 11 and 16.
5. T. L. Wheelen & J. D. Hunger, Strategic Management & Business Policy (NJ: Prentice Hall, 2000), Chapters 1, 3 and 5.
6. A. Chernev, Strategic marketing Management (USA: Cerebellum Press, 2014), Chapter 2.
7. MaRs Startup Toolkit, Product Development Lifecycle: New Drug Development.
8. Tim Koller, Richard Dobbs, and Bill Huyett, The Four Cornerstones of Corporate Finance (New Jersey: John Wiley & Sons, Inc., 2011), Chapter 17.
9. Richard Dobbs and Tim Koller, Measuring Long-Term Performance( McKinsey Quarterly, March 1, 2005).