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Aligning Compensation

Aligning Compensation with the Balanced Scorecard

For most people, money is a powerful motivator. As a simple test, give somebody two tasks that require equal effort and allow them to decide which task to complete. Tell that person that if they complete task A you will thank them, but that if they complete task B you will give them a sum of money. Which task do you think most people will choose to tackle?

The Arguments for Making the Link

With regard to the Balanced Scorecard, using money, especially through incentive-compensation interventions, is seen by many as a key lever for hardwiring the efforts of employees to scorecard objectives. Indeed, scorecard creators Drs Robert Kaplan and David Norton recognize the critical importance of the link by making incentive-compensation, or ‘balanced paychecks’ a sub-component of the Making Strategy Everyone’s Everyday Job principle of the strategy-focused organization.  They write:  (1)

“Incentive compensation is a powerful lever to gain people’s attention to company and business unit objectives. When all individuals understand how their pay is linked to achieving strategic objectives…strategy truly becomes everyone’s everyday job.”

And there are many advisors in the scorecard world that would agree on the absolute necessity of the compensation/scorecard link.  Yet, there are perhaps equal numbers that are less certain of the efficacy of the link. Indeed, there is perhaps no other aspect of the Balanced Scorecard management system that divides opinion as sharply as compensation.

The Arguments against Making the Link

In the book: Mastering Business in Asia: Succeeding with the Balanced Scorecard, Nigel Penny, CEO of the Singapore-based consultancy ClaritasAsia, and previously Vice President, Asia-Pacific for the Balanced Scorecard Collaborative, says that on the face of it the incentive-compensation link makes good sense. However, he argues that when you look more closely at the effectiveness of the connection the common wisdom that ‘money motivates’ breaks down, He provides this illustration(2):

“(Let’s assume) a typical distribution of performance where there may be 20% of high achievers, 10% of low achievers and a 70% bandwidth of good/average performers. Let’s assume that the poor performers get nothing, then we may pay 15% bonus to our stars, with our average to good performers getting an average of say, 7-8%. For an average salary of about $50,000 the average bonus differential between our stars and our solid middle-of the road guys would equate to just $3,500.”

As a consequence Penny poses two questions:

1. “If I were an average performer, would the once-a-year difference of $3,500 be enough to induce me to go all out to become a star performer next year?  Probably not.”

2. “If I’m one of the poor performers, will any of this induce me to change my ways? Again I think not.”

Penny also makes the important observation that the overall financial result of the organization typically determines the size of the pool for the bonus distribution. “In a bad to poor year, this inevitably means a zero bonus pool irrespective of the activities of individual employees.”
Somewhat surprisingly, in their latest book Alignment, Kaplan and Norton appear to endorse this view that bonuses should not be paid when financial results are weak.  “…paying bonuses when financial performance is poor is probably not a good idea even if customer, process, and employee performance are excellent….bonuses must be paid in cash and such payments may not be desirable when the company is hemorrhaging cash during times of financial distress.” (3)

Many might legitimately argue that not paying bonuses when non-financial performance is excellent yet financial results are poor will do little to enhance the reputation of the Balanced Scorecard and will go some distance to discrediting claims by senior management that non-financial performance drivers are equally worthy of attention as financial outcomes.

Clearly, receiving a bonus only when financials are good will encourage many to hit their financial targets even if this damages long term performance. This is often the case as incentive compensation is generally linked to the annual budget. It is therefore very difficult to compensate employees for performance to the Balanced Scorecard (with a longer-term performance horizon) in organizations that are still driven by conventional annual cycles and numbers.

Case example: Cigna Property and Casualty

It should also be noted that there is a paucity of best practice case studies in aligning incentive-compensation to the Balanced Scorecard. Perhaps the most celebrated is the work of Cigna Property & Casualty (P&C), one of the early poster boys of the scorecard movement.

Cigna devised a performance share plan comprising ‘phantom’ shares that were assigned a standard valuation of $10. At the start of each financial year, each employee was allocated a number of these shares depending on their personal responsibilities. The performance of P&C during the year determined the final value of the shares. Simultaneously, each individual could earn additional shares during the year based on their own performance.

For examples, consider an individual who was awarded 50 $10 shares at the start of the financial year. If the business unit of P&C that they worked for performed poorly against scorecard objectives, then at the end of the year the unit’s share value may have been $5.
However, if at the same time the individual performed well, they may have earned 100 additional shares. Their bonus would then be the final share price ($5) multiplied by the total number of individual shares (150). This would equal a bonus of $750. Conversely, if the unit performed well and received a share rating of $14, but that same individual had accumulated just 10 extra shares their bonus would be $850. However, if the individual had acquired 150 shares and the unit’s share price was $14, the bonus would be $2100.
It should be noted that the Cigna P&C example is now 10 years old.

Case Example: The Gold Colin Group

As a further, more recent, example, in 2001 the Asia-based animal and fish food provider and wheat distributor The Gold Coin Group allocated a substantial part of management’s compensation to Balanced Scorecard results.

Throughout the group, the split between fixed and variable pay was standard according to management level. For example, group directors received 50% fixed and 50% variable pay. However, in order to drive home the message that improving customer-facing performance had to be a priority, performance to the customer perspective was worth 45% of the variable pay, with financial and internal perspectives both worth 20% and learning and growth 15%.

Did this work? In the first two years of scorecard rollout, from a customer perspective the group enjoyed a 30% improvement in customer retention and a 30% increase in customer acquisitions. Customer complaints dropped by 40% and deliver lead times fell by 50%. And from a financial perspective the group achieved an average annual increase of EBITDA (earnings before interest, tax, depreciation and amortization) of 25% and over the same period the Group increased profits by 50%.

Conclusion

At some point in the scorecard journey most organizations will consider the incentive-compensation link. Some will be ambitious and attempt to fully, and equally, align all financial and non-financial objectives to incentive-compensation. Others will be much less ambitious and make the largest part of the bonus based on performance to the annual budget, while taking into account a few non-financial metrics. Others will decide not to make the link at all. 

Whatever approach is preferred, there is little doubt that, as demonstrated by the dearth of best-practice stories, the incentive-compensation link is proving the least popular, and certainly most challenging, of Kaplan and Norton’s principles of the strategy-focused organization.

References

  •   The Strategy-Focused Organization: How balanced scorecard companies thrive in the new business environment.  Robert S. Kaplan and David P. Norton, Harvard Business School Press, 2001. 
  •   Mastering Business in Asia: Succeeding with the Balanced Scorecard. James Creelman and Naresh Makhijani, John Wiley & Sons, 2005. 
  •   Alignment: Using the balanced scorecard to create corporate synergies. Robert S. Kaplan and David P. Norton, Harvard Business School Press, 2006.