Conceptual Foundations of the Balanced Scorecard

“Conceptual Foundations of the Balanced Scorecard”

David Norton and I introduced the Balanced Scorecard in a 1992 Harvard Business Review article.1 The article was based on a 1990 Nolan, Norton multi-company research project that studied performance measurement in companies whose intangible assets played a central role in value creation.2 Our interest in measurement for driving performance improvements arose from a belief articulated more than a century earlier by a prominent British scientist, Lord Kelvin:3

I often say that when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind.  

If you can not measure it, you can not improve it.  Norton and I believed that measurement was as fundamental to managers as it was for scientists. If companies were to improve the management of their intangible assets, they had to integrate the measurement of intangible assets into their management systems.  After publication of the 1992 HBR article, several companies quickly adopted the Balanced Scorecard giving us deeper and broader insights into its power and potential. During the next 15 years, as it was adopted by thousands of private, public, and nonprofit enterprises around the world, we extended and broadened the concept into a management tool for describing, communicating and implementing strategy. In this paper, I describe the roots and motivation for the original Balanced Scorecard article as well as the subsequent innovations that connected it to a larger management literature. The paper uses the following structure for organizing the origin and subsequent development of the Balanced Scorecard: 1. Balanced Scorecard for Performance Measurement 2. Strategic Objectives and Strategy Maps  3. The Strategy Management System 4. Future Opportunities

Balanced Scorecard for Performance Measurement

Figure 1 shows the original structure for the Balanced Scorecard (BSC). The BSC retains financial metrics as the ultimate outcome measures for company success, but supplements these with metrics from three additional perspectives – customer, internal process, and learning and growth – that we proposed as the drivers for creating long-term shareholder value.  

Figure 1:  Translating Vision and Strategy:  Four Perspectives

Vision and Strategy

Objectives Measures Targets Initiatives FINANCIAL

“To succeed financially, how should we appear to our shareholders?”

Objectives Measures Targets Initiatives LEARNING AND GROWTH

“To achieve our vision, how will we sustain our ability to change and improve?”

Objectives Measures Targets Initiatives CUSTOMER

“To achieve our vision, how should we appear to our customers?”

Objectives Measures Targets Initiatives INTERNAL BUSINESS PROCESS

“To satisfy our shareholders and customers, what business processes must we excel at?”

1.1. Historical Roots: 1950-1980

The Balanced Scorecard, of course, was not original for advocating that nonfinancial measures be used to motivate, measure, and evaluate company performance. In the 1950s, a General Electric corporate staff group conducted a project to develop performance measures for GE’s decentralized business units (Lewis, 1955).2 The project team recommended that divisional performance be measured by one financial and seven nonfinancial metrics.

1. Profitability (measured by residual income) 2. Market share 3. Productivity 4. Product leadership 5. Public responsibility (legal and ethical behavior, and responsibility to stakeholders including shareholders, vendors, dealers, distributors, and communities) 6. Personnel development 7. Employee attitudes 8. Balance between short-range and long-range objectives 

One can see the roots of the Balanced Scorecard in these eight objectives. The financial perspective is represented by the first GE metric, the customer perspective with the second, the process perspective with metrics 3 -5, and the learning and growth perspective with metrics 6 and 7. The 8th metric captures the essence of the Balance Scorecard, encouraging managers to achieve a proper balance between short and long-range objectives. Unfortunately, the noble goals of the 1950s GE corporate project never got ingrained into the management system and incentive structure of GE’s line business units.  In fact, despite metrics 5 and 8 in the above list, several GE units were subsequently convicted of price-fixing schemes, with their managers claiming that corporate pressure for short-term profits led them to compromise long-term objectives and their public responsibilities.

At about the same time as the GE project, Herb Simon and several colleagues at the newly-formed Graduate School of Industrial Administration, Carnegie Institute of Technology (later Carnegie-Mellon University) identified several purposes for accounting information in organizations:

Scorecard questions: “Am I doing well or badly?”

Attention-directing questions: “What problems should I look into?”

Problem-solving questions: “Of the several ways of doing the job, which is the    best?

2  See also, General Electric (A), HBS Case Study

Simon and his colleagues explored the role for financial and nonfinancial information to inform these three questions. This study was perhaps the first to introduce the term “scorecard” into the performance management discussion.  Peter Drucker introduced management by objectives in his classic 1954 book, The Practice of Management. Drucker argued that all employees should have personal performance objectives that aligned strongly to the company strategy:

Each manager, from the “big boss” down to the production foreman or the chief clerk, needs clearly spelled-out objectives. These objectives should lay out what performance the man’s [sic] own managerial unit is supposed to produce. They should lay out what contribution he and his unit are expected to make to help other units obtain their objectives. […] These objectives should always derive from the goals of the business enterprise. […] [M]anagers must understand that business results depend on a balance of efforts and results in a number of areas. […] Every manager should responsibly participate in the development of the objectives of the higher unit of which his is a part. […] He must know and understand the ultimate business goals, what is expected of him and why, what he will be measured against and how (Drucker 1954, pp. 126-9). 

Despite Drucker’s insights and urgings, however, management by objectives in the next half- century mostly became a somewhat bureaucratic exercise, administered by the human resources department, based on local goal-setting that was operational and tactical, and rarely informed by business-level strategies and objectives. Companies at Drucker’s time and for many years thereafter lacked a clear way of describing and communicating top-level strategy in a way that middle managers and front-line employees could understand and internalize.

In the mid-1960s, Robert Anthony, building upon the decade-earlier research by Simon et al, and on another article by Simon on programmed versus nonprogrammed decisions, proposed a comprehensive framework for planning and control systems. Anthony identified three different types of systems: strategic planning, management control, and operational control. Strategic planning was defined as: 

the process of deciding upon objectives, on changes in these objectives, on the resources used to attain these objectives, and on the policies that are to govern the acquisition, use, and disposition of these resources (Anthony 1965, p.16). 

Foreshadowing the subsequent development of strategy maps, Anthony claimed that strategic planning depends “on an estimate of a cause-and-effect relationship between a course of action and a desired outcome,” but concluded that, because of the difficulty of predicting such a relationship, “strategic planning is an art, not a science.” Further, Anthony noted that strategic planning is not accompanied by what we would today call strategic control, “Although strategic revision is important, top management spends relatively little time in this activity.” Anthony also believed that information for strategic planning usually had a financial emphasis. 

Anthony’s second category, management control, concerned “the process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organization’s objectives” (Anthony 1965, p. 17). He observed that management control systems, with rare exceptions, have an underlying financial structure; that is, plans and results are expressed in monetary units … the only common denominator by means of which the heterogeneous elements of outputs and inputs can be combined and compared. He acknowledged, however, 

Although management control systems have financial underpinnings, it does not follow that money is the only basis of measurement, or even that it is the most important basis. Other quantitative measurements, such as […] market share, yields, productivity measures, tonnage of output, and so on, are useful. (Anthony 1965, p. 42) 

Anthony described the third category, operational or task control, as “the process of assuring that specific tasks are carried out effectively and efficiently.” He stated that information for operational control was mostly nonmonetary, though some information could be denominated in monetary terms (presumably, frequent variance reports on labor, machine, and materials quantity and cost variances).

 Thus the roots of management planning and control systems encompassing both financial and nonfinancial measurement can be seen in these early writings of Simon, Drucker, and Anthony. Despite the advocacy of these scholars, however, the primary management system for most companies, until the 1990s, used financial information almost exclusively and relied heavily on budgets to maintain focus on short-term performance.

1.2. Japanese Management Movement: 1975-1990

During the 1970s and 1980s, innovations in quality and just-in-time production by Japanese companies challenged the Western leadership in many important industries. Several authors argued that Western companies’ narrow focus on short-term financial performance contributed to their complacency and slow response to the Japanese threat.  Johnson and Kaplan (1987) reviewed the history of management accounting and concluded that US corporations had become obsessed with short-term financial measures and had failed to adapt their management accounting and control systems to the operational improvements from successful implementation of total quality and short-cycle-time management.  

A Harvard Business School project on Council on Competitiveness (Porter, 1992) echoed these critiques when it identified the following systematic differences between investments made by US corporations versus those made in Japan and Germany:

The US system is less supportive of investment overall because of its sensitivity to current returns … combined with corporate goals that stress current stock price over long-term corporate value. 

The US system favors those forms of investment for which returns are most readily measurable. … This explains why the United States underinvests, on average, in intangible assets [N.B., product and process innovation, employee skills, customer satisfaction] where returns are more difficult to measure.  

The US system favors acquisitions, which involve assets that can be easily valued over internal development projects that are more difficult to value. (Porter, 1992, p. 72-73). 

Some accounting academics proposed methods by which a firm’s spending to create intangible assets could be capitalized and placed as assets on the corporate Balance Sheet. During the 1970s, there was a burst of interest in human resources accounting (Flamholtz, 1974; Caplan and Landekich, 1975; Grove et al, 1977). Subsequently, Baruch Lev and his doctoral students and colleagues proposed that financial reporting could be more relevant if companies capitalized their expenditures on intangible assets or found other methods by which these assets could be placed on corporate Balance Sheets. While such a treatment is consistent with Lord Kelvin’s (and our) advocacy of measurement to improve understanding and management, none of these approaches gained traction in actual companies. Several factors led to the lack of adoption of placing values for intangible assets on corporate Balance Sheets.

First, the value from intangible assets is indirect. Assets such as knowledge and technology seldom have a direct impact on revenue and profit. Improvements in intangible assets affect financial outcomes through chains of cause-and-effect relationships involving two or three intermediate stages. For example, consider the linkages in the service management profit chain (Heskett et al, 1994; Heskett, Sasser and Schlesinger, 1997), a development done in parallel and consistent with our Balanced Scorecard approach:

 investments in employee training lead to improvements in service quality  better service quality leads to higher customer satisfaction  higher customer satisfaction leads to increased customer loyalty

 increased customer loyalty generates increased revenues and margins.  

Financial outcomes are separated causally and temporally from improving employees’ capabilities. The complex linkages make it difficult if not impossible to place a financial value on an asset such as workforce capabilities or employee morale, much less to measures changes from period to period in such a financial value.

Second, the value from intangible assets depends on organizational context and strategy. This value cannot be separated from the organizational processes that transform intangibles into customer and financial outcomes. A corporate Balance Sheet is a linear, additive model. It records each class of asset separately and calculates the total by adding up each asset’s recorded value. The value created from investing in individual intangible assets, however, is neither linear nor additive.

Senior investment bankers in a firm such as Goldman Sachs are immensely valuable because of their knowledge about complex financial products and their capabilities for managing relationships and developing trust with sophisticated customers. People with the same knowledge, experience, and capabilities, however, are nearly worthless to a financial services company such as etrade.com that emphasizes operational efficiency, low cost, and technology-based trading. The value of an intangible asset depends critically on the context – the organization, the strategy, and other complementary assets – in which the intangible asset is deployed.  Also, intangible assets seldom have value by themselves.3 Generally, they must be bundled with other intangible and tangible assets to create value. For example, a new growth- oriented sales strategy could require new knowledge about customers, new training for sales employees, new databases, new information systems, a new organization structure, and a new incentive compensation program. Investing in just one of these capabilities, or in all of them but one, could cause the new sales strategy to fail. The value does not reside in any individual intangible asset. It arises from creating the entire set of assets along with a strategy that links them together. The value-creation process is multiplicative, not additive.

Rather than attempt a solution to the measurement and management of intangible assets within the financial reporting framework, several articles and books in the 1980s recommended that companies integrate nonfinancial indicators of their operating performance into their management accounting and control systems, e.g. Howell et al. (1987), Berliner and Brimson

3  Brand names, which can be sold, are an exception.

(1991), Kaplan (1990). Some authors went further when they urged that internal reporting of financial information to managers and employees, especially those tasked with improving operations by continuous improvement of quality, process yields, and process cycle times, be abolished.

Managing with information from financial accounting systems impedes business performance today because traditional cost accounting data do not track sources of competitiveness and profitability in the global economy. Cost information, per se, does not track sources of competitive advantage such as quality, flexibility and dependability. […] Business needs information about activities, not accounting costs, to manage competitive operations and to identify profitable products (Johnson, 1980, 44-5). Essentially, these authors argued that companies should focus on improving quality, reducing cycle times, and improving companies’ responsiveness to customers’ demands. Doing these activities well, they believed, would lead naturally to improved financial performance. 

The US Government in 1987 introduced the Malcolm Baldrige National Quality Award to promote quality awareness, recognize quality achievements, and publicize successful quality strategies. The initial set of Baldrige criteria included financial metrics (profits per employee), customer-perceived quality metrics (market cycle time, late deliveries), internal process metrics (defects, total manufacturing time, order entry time, supplier defects) and employee metrics (training per employee, morale). But in the early 1990s, several studies revealed that even businesses that had received the Baldrige Award for quality excellence could encounter financial difficulties, suggesting that the link, assumed by the academic scholars quoted above, between continuous process improvement and financial success was far from automatic