Strategy Communication and Measurement Systems

Abstract

Organizations often face the challenge of communicating their strategies to local decision makers. The difficulty presents itself in finding a way to measure performance which meaningfully conveys how to implement the organization's strategy at local levels. I show that organizations solve this communication problem by combining performance measures in such a way that performance gains come closest to mimicking value-added as defined by the organization's strategy. I further show how organizations rebalance performance measures in response to changes in their strategies. Applications to the design of performance metrics, gaming, and divisional performance evaluation are considered. The paper also suggests several empirical ways to evaluate the practical importance of the communication role of measurement systems.

Performance measures communicate objectives to local decision makers which often do not perfectly represent the true strategy, or goal, of the organization (Baker, 1992). For example, performance measures often induce unintended behaviors such as gaming (Lawler, 1990 and Courty and Marschke, 1997). This, however, only partially illustrates what I mean by imperfect performance measures. More generally, performance measures rarely perfectly represent contributions to the firm's value.5 Because of this lack of perfect and universal proxy organizations must constantly adjust their measurement systems so that it is aligned with their strategies.

Organizations typically measure performance on several dimensions and balance each of these dimensions. For example, depending on the objective that is communicated, measures of short-term financial performance such as return on capital employed or project profitability are sometimes combined with measures of less tangible assets such as market share, customer satisfaction index, or even employee commitment. This balance between different performance measures is explicit when agents are offered formal performance metrics or scorecards and implicit when agents are informally communicated the emphasis put on each measure.

Often performance measurement systems are coupled with incentive systems which reward performance either financially or through other decisions (e.g. promotion, training). Surprisingly, the fraction of the agent’s compensation paid as a financial award is usually low, although it varies widely across compensation systems (Baker, Jensen and Murphy, 1988). This observation suggests two distinct concepts of weights in performance measure: (a) the relative weights determine the emphasis put on each performance measure; (b) the absolute weights determine how high performers are rewarded and/or low performers punished. These two concepts correspond to the distinction between performance measurement systems and performance incentive systems, which plays a key role in this paper. Most of this paper will study how performance measures are chosen and how they are balanced (the relative weights on performance measures). Toward the end of the paper, I will take into account the incentive dimension of some performance measurement systems (the absolute weights on performance measures).

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