A Smarter Way To Run a Business

Operating a company in todays business environment is tough. Managers need all the help they can get. This article offers much-needed assistance by demonstrating how two management tools can help a company cut costs, boost profits and, at the same time, remain focused on its strategic business targets.

The tools are activity-based management (ABM) and performance measurement. When used together, they can help a company identify and set priorities for cost-improvement opportunities. And, equally important, managers can do this without losing sight of the companys overall business and marketing strategiesa typical shortcoming of conventional cost-improvement programs.

To accomplish these goals, the ABM tools link multiple measurements about an organization with what amounts to a fast-reacting, integrated feedback loop. To illustrate what the tools do and how they do it, this article follows managers of a fictitious company through the steps of the process. But before getting into those steps, some background about the tools is necessary.

STAYING IN BALANCE

A balanced performance measurement system (often referred to as a balanced scorecard) is a set of quantifiable business measurements derived from an organizations strategies, goals and objectives. Taken together, they communicate the direction an organization must take to meet its strategic goals. As a bonus, the scorecard helps managers take the steps needed to reach the goals. The key phrase in the definition is “set of measurements.” If the process focused on only one or two measurements, its likely the wrong corporate behavior would be encouraged. For example, if managers tracked only cash flow, the company eventually might stop investing in long-term assets and market opportunities. Therefore, the goal is to put together a set of areas to be measured that are linked to corporate strategy. Further, those areas must be in balance. To understand the notion of “balance,” consider the following examples:

Financial and nonfinancial. Most traditional performance measurement systems focus only on financial areas, such as net income and sales. They fail to track nonfinancial measures, such as the number of new products introduced or defects in manufactured goods. But when managers consider both financial and nonfinancial considerations, and aim to keep them in balance, the result is a more comprehensive picture of how the business is functioning—generating what in ABM lingo is called a balanced scoreboard.

Process and result. A process measure provides an indication of how well a process is working. For example, the measure would track production output, defects in the product, customer complaints, machine downtime or missed shipments. Such measures are important because they provide managers with the business insights they need to be more predictive, and that, in turn, prompts them to seek out opportunities and to take the initiative in solving any problems those measurements may uncover. A result measure, on the other hand, looks at the consequence at the end of a process. For example, it would track a processs return on investment. Once again, to be useful, the two should be in balance.

Stakeholders. When determining what to measure, its important to limit the choices to those that make a real difference to the organizations key stakeholders. And that includes not only shareholders but also customers, suppliers and employees. For example, managers traditionally tend to measure only what is important to the most visible stakeholderthe shareholderwhile, in fact, customers, suppliers and employees also must be considered.

External focus. Its also important to measure what the outside world thinks of the company. That can be measured by market share, customer satisfaction and the companys stock price.

All these measures must be tied to the companys business strategies so, when considered together, they become a barometer of how well those goals are being met.

We need one more definition before getting to an example of how the balanced scorecard is created. ABM is a technique for determining the true cost of a product or process. The exercise requires identifying the many factors (called drivers) that eventually affect the cost of a productfor example, manufacturing setup time, design complexity and error correction. Traditional costing focuses too narrowly on direct labor and material costs. While the immediate goal of ABM is to develop an underlying rationale for setting prices, a frequent result of going through an ABM exercise is an improvement in the business processes being measured.

THE PROCESS IN ACTION

Now, lets see how a typical company, XYZ Co., would create a performance measurement system.

XYZ Co. makes specialized machines. Its a fast-growing business, with 3,000 employees in 18 plants in four countries. The company manufactures and services 500 different products, sells to seven major markets and buys from more than 1,000 suppliers—clearly, a complex operation. When new competitors entered the market, industry prices softened, putting a squeeze on the companys profit margins. As a result, XYZs managers decided to launch a major cost-reduction campaign using the following steps:

Step 1—Strategy. They began by identifying XYZs business strategy. Once the managers agreed on their strategy, they identified the measures that were important. Next, they listed what they currently measured, concluding that they were tracking too many items.

Step 2—Designing measures. The managers then considered all their major business processes—from designing products to distribution. Since many diverse functions were involved across many departments, it was decided to recruit a cross-functional team, which agreed to track a potential set of measurements. For example, to assess the efficiency of XYZs distribution channels—which was critical to the success of the companys strategy—required measurements of inventory turns, fill rate and cost of excess capacity. The measurements were then plotted, based on their characteristics of process vs. results and financial vs. nonfinancial. That chart, in effect, became the companys initial performance measurement scorecard.

Step 3—Planning and implementation. Once the managers knew what to measure, they focused on how to collect the necessary information. The plan they adopted included steps for merging, consolidating and sharing information throughout the company. Also, a process “owner” (the person responsible for a particular process) was identified; that person was expected to chart each measure for his or her process on an ongoing basis. Each chart had a graph, a goal and a commentary on how and why that measure exceeded the goals or, if it lagged, what remedial steps would be taken. The charts, in effect, became a business barometer.

Step 4—Continual improvement. As the managers reacted to each change, they adjusted their strategy accordingly, which required continual review of the measurement process and the measurements to be dropped or added. Management recognized the process had to be dynamic, with constant feedback to fine-tune the plan.

Now XYZ had a balanced set of performance measures, but it still wasnt clear which products were making money and which werent. Clearly, XYZ also had to determine which improvement effort had high payback and which didnt. For example, were the process-improvement initiatives resulting in improved profits? Which projects were improving cash flow? How were suppliers contributing to XYZs financial goals?

To answer those questions, management again turned to a cross-functional team to implement ABM. The team first looked at the manufacturing processes, where it identified each activity cost. For example, within one machine process, the key driver was setup costs and in another the driver was the movement of material. It was clear the team had to focus on both of these key cost drivers to obtain long-lasting cost reductions.

Ultimately, the managers were able to relate cost drivers and activity costs to various product lines. They discovered that with ABM they could cost products with much greater precision than before. They also discovered that certain products were not making the margins they earlier had believed, while others had much stronger margins. In reaction to this new information, a marketing team determined to open new markets for certain product lines, while a team of design engineers and production personnel set out to reduce costs in other product lines.

THE POWER OF LINKING THE TOOLS

As XYZs managers reviewed their ABM cost drivers, they began to recognize that some drivers were also performance measures. For example, the number of customer complaints could be used both to measure performance and act as a cost driver. In other cases, they discovered major drivers of costs were not being measured. For example, the number of times raw material had to be moved from warehouses to the plant and even within the plant added considerably to costs. Those moves were added as part of the inventory turns measure. Reviews of this kind are important to be sure that all key drivers are included and that the major cost drivers are linked to the companys strategy.

As a final check, the team reviewed the performance measurement system to be sure all the areas being measured, when taken as a group, were consistent with the strategy of the organization.

THE BOTTOM LINE

While this exercise is not easy, the payoff is well worth the effort. In many cases, it provides the first authentic clue to how a business is really operating on both a macro and micro level. Often such an exercise can boost profits and, in some cases, may spell the difference between survival and bankruptcy.

Eileen Morrissey, CPA, is director of advanced cost management at Allied Signal Aerospace, Torrance, California. A co-author of Implementing Activity Based Cost Management: Moving from Analysis to Action, published by the Institute of Management Accountants, she is a member of the American Institute of CPAs management accounting executive committee and the strategic performance measurement task force.
Gary Hudson is manager of advanced cost systems at Allied Signal Aerospace.

CASE STUDY

Using Workshops to Sell Finance Transformation

Thomas F. Ambery, CPA, the finance reengineering team leader at CBS, Inc., in New York City, is in the process of transforming CBSs finance departmentshe wants the finance staff to spend less time on detailed transactions and more time providing managers with value-added financial information. To accomplish this, Ambery knew he would have to spend a lot of time communicating with top management, middle management and support staffs to get them to commit to change. To ensure success, he knew that communication must be frequent, open and two-way. For Ambery and CBS, one solution was setting up workshops led by a finance tranformation team comprised of the employees whose jobs would change under a new system.

Forming the team

The first step was to create a team of open-minded individuals representing the divisions we wanted to reengineer, said Ambery. The companys chief financial officer drafted letters to divisional financial management asking for volunteers who were ambitious and had the experience and personality to communicate the goals of the finance transformation. We knew the success of this project was directly proportional to the quality of the team members and the support of the departments. The team comprised 13 members, from middle management to support staff, who were committed full-time to the companys reengineering project.

The team used benchmarking information supplied by a consulting firm to determine where CBS stood in relation to the best practices of other companies. It also used the information to develop a starting point for change and to measure the companys progress. For example, based on performance measuring benchmarking information, the team decided it would monitor not only the number of invoices but also the costs of the process and the productivity of the individuals processing the invoices.

The team then held workshops with middle management and supervisors to help team members better understand the operations of the finance departments. We wanted to know what they were doing on a day-to-day basis and to identify the practices we agreed were noteworthy enough to be incorporated in our vision of the value-added finance department, said Ambery. Most important to Ambery was that staff members were able to give the finance transformation team their own ideas on the practices that needed to change. To sell change effectively, it is best to work with the people whose ideas for change come from firsthand knowledge, said Ambery.

The team compared current processes with best practices and identified opportunities for improvement. Final recommendations were presented to a steering committee that included divisional financial managers and the CFO. We had been meeting with them individually during the entire process to inform them of the details of our vision, said Ambery. The steering committee went over the feedback obtained at the on-site meetings and the recommendations made by the reengineering team.

The team held a second round of workshops to present its ideas to the staff and get their input. During these workshops, the team would learn what issues they would face when they implemented their vision, who would resist the changes and who would embrace them. We spent a lot of time explaining to employees how the changes would help both them and the company as a whole. For example, the employees were excited about the prospect of using a new procurement card for low-dollar purchases without having to always fill out purchase requisitions, said Ambery. The card would free up the purchasing department to concentrate on the high-dollar transactions. Ambery said it was important to focus on the employees who did not have preconceived notions that the changes were either good or bad. We wanted them to understand that the quality of jobs would be far better after the changes were implemented, he said.

After the second round of workshops, the team presented the final results of both rounds of workshops to all of the divisional financial managers, the CFO and the steering committee. Ambery said he had been given a green light on a number of operational changes and that the company already was in the process of implementing them.