Using Performance Architecture to Create Economic Value

· Management accountants structure their financial systems according to the constructs of personal training and experiences as reinforced by GAAP standards. GAAP standards do not necessarily express the needs and desires of other stakeholders in the context of the entire organization.

· The performance of the financial team must be grounded in the context of the performance architecture of the entire organization. Processes and activities at all levels of the organization are aligned according to this architecture.

· Analysis of processes and activities is an essential management ingredient to establish and maintain a vital, successful performance architecture. Cost managers must be part of the cross-functional teams that conduct organizational analyses on a cyclical basis.

Management perspectives vary from personal to professional to organizational, and each perspective carries its own structured set of management constructs based on the individual employee’s learning and experience. The GAAP standards are one of the most important personal and professional constructs of the management accountant. The management accountant will feel this established construct significantly challenged by the emerging value creation construct as organizations look for a strategic partnership with their financial professionals. More and more, financial information needs to be tightly integrated with all processes within the organization. One of the best ways to integrate organizational, professional and personal constructs is by managing performance architecture. Performance architecture is a way to see and manage the organization where all employee perspectives and constructs can be integrated into a manageable unity. The financial professional is an important leader in performance architecture management.

People don’t know what they don’t know. During the fifteen years since CAM-I research in Cost Management Systems (CMS) became prominent, extensive work has been done to popularize new measurement and management methodologies to drive organizations to increasingly higher levels of productivity. Many times, organizations attempt to simultaneously implement a number of different performance improvement initiatives without recognizing that the methodologies they deploy are often simply measure different attributes of a single measurable – activities and processes – or the similar attributes of a variety of measurables – quality, time, cost, capacity or risk – all premised on a different perspective[i].

The “Fish Tank Syndrome” is a business analogy that acknowledges multiple perspectives. Each person or group of people within the organization actually sees the business differently. No amount of encouragement from management will moves employees from their primary, local perspective. To overcome distortion created by the local perspective, people need a mechanism to facilitate a common understanding.

The success of any measurement methodology is a function of many variables, the most significant being the ability to comprehend, integrate and extend beyond the constructs associated with the local professional and personal perspectives that each person has learned to use habitually. This methodology requires a series of analytic mechanisms with which to integrate apparently disparate perspectives into a cohesive framework that aligns strategic intent and coordinates the way in which people perform activities. The structural design of these analytic mechanisms is literally a performance architecture. Performance architecture builds on the construct of the Balanced Scorecard and leads to a holistic and integrated measurement and management framework.

The management of organization performance is influenced by a fundamental human desire to create plans and predict outcomes of things to come. Personal Construct Theory of psychologist George Kelly provides insight on how human beings view our environment (see exhibit 1). Human beings evaluate the environment based on personal psychological constructs of perception and understanding from the context of experience, training, and peer group practices. These constructs represent the mental model by which we observe and compare the business dimensions that we are responsible for improving.

GAAP is a pertinent example of a financial construct that affects the personal constructs of all management accountant professionals. As the foundation of accounting, GAAP is the basis for the determination of accounting profit. Yet, in the last 15 years since the inception of economic profit, there has been a shift towards longer-term measures as the basis for evaluating corporate performance. At a CAM-I work group session in the mid 80’s, significant discussion focused on the subject of how to shift business and stock market emphasis from short term quarterly and annual earnings performance to a longer term perspective. Consequently, constructive thinking by academicians like Peter Drucker led to a new focus on a value creation construct. Alfred Rappaport observed, “Earnings is just an opinion. Cash is a fact.[ii]” Economic profit and a number of other similar new measures make corrections to accounting earnings in order to represent current cash value of earnings to share holders. This has led to the creation of Value-Based Management to provide a compelling logic with which to link the drivers of value to business and operational actions.

Another key change in financial analytic techniques has been the development of activity-based costing (ABC), which directly counters the GAAP construct that “cost should be allocated fairly to products.” If done properly, ABC provides operational and financial managers the opportunity to create a measurement system that captures measurement dimensions of resources consumed, capacity, cost, and driver quantities at the points of confluence. At this point, activities as defined by ABC and the understanding of actions, tasks, events and processes can be understood in the context of each other.

Accounting firms often recommend that their clients implement “fully attributed ABC” in which any costs that cannot be assigned on the basis of activities to products should be allocated on “some reasonable basis.” This is a classic example of an evolving construct used as an excuse for not undertaking a deliberately designed ABC analysis in which activities are identified to a material level of detail, correct activity drivers and cost objects identified.

ABC design does not finish with cost assignment. A fundamental concern of any organization must be to understand how operational decisions influence financial performance. Another style of implementation is “Operational ABC,” a non-GAAP form outside the requirements of accounting reporting. Operational ABC is simply the same basic analysis as the simpler version, but it is performed with greater discipline closer to the evolving value-based construct. The level of materiality of activities defined is lower and the analysis tends to be in greater detail. Because support and business-sustaining activities are first identified and then assigned to more appropriate cost objects, the difference in product costing results may be substantially different from the results of simple “GAAP-style ABC” implementation.

Correctly defined activities, activity drivers and cost objects coupled with proper assignment of activities and resources to objects differentiates a good ABC analysis from a poor one. Operational ABC is necessary to undertake process cost assignment and activity-based management (ABM). In fact, Operational ABC is a critical linking mechanism in the effort to create an overall measurement and management framework within the evolving perspective of the value-based construct.

The functional, structural biology in the living creatures and systems around us in nature provide a model for understanding performance architecture in terms of the appropriate linkages between the various measurement and management methods employed within an organization. A naturalist would describe the outward facing characteristics of the frog, its appearance, its capabilities, size and color. During dissection, the same naturalist would describe a variety of systems including the skin, respiratory, digestive, neural, skeletal, muscular and circulatory systems. The naturalist could further disassemble each of these major systems if greater detail were desired. For example, the circulatory system includes the heart, veins, arteries, heart and blood cells. Along the way, each level of detail is described and measured by different standards. As an analytical evaluation, dissection and examination occur at different levels, and a variety of diagnostics tools are applied at each level – a camera, a scalpel, and a scanning electron microscope.

Similarly, an organization can be analyzed first from the external perspective and then dissected in order to understand the systems or processes that are employed. The understanding of the way in which processes interact in an adaptive system is the performance architecture. A description of an organization’s external attributes reflects the perspective of the person who holds some degree of interest in it – the stakeholder. The organization may also be dissected in layers of detail to identify its component systems/processes down to lower levels of greater detail – first activities, then tasks and finally actions.

The analogy is different when it comes to the purpose of the dissection. The naturalist catalogues the unchanging anatomy of the frog; but as managers understand greater levels of organizational detail, they seek to change the way in which it functions. Organizations have to adapt to ever more rapidly changing environmental conditions in a very different way from an animal species. In an organization, the system of processes and activities interact with each other and change on a continuous and occasionally dramatic basis.

There are three primary levels of analysis in an organization’s performance architecture (see exhibit 2). Each descending level represents a further dissection. Level One, the organizational level, is the perspective of the organization as a whole in which there are missions and goals, performance measures, and strategies for improvement. Level Two, the next level down from organization, is processes. Here the sum of the performance of the processes equals the performance of the organization in total. As with the organization in aggregate, there are objectives for each process that are required for the organization to attain its goals. Characteristics of process performance are highly measurable including cycle time, errors or customer satisfaction. The decomposition of process in Level Three is basically the level of activities. The sum of the performance of activities in an individual process is equal to the performance of the process.

In ABC, the definition of an activity is highly influenced by the materiality of the amount of resources consumed. In process analysis, the documentation of events is the focus of analysis independent of the quantity of resources they consume. Measures of activity performance address attributes similar to those of total process measures but in more detail. Furthermore, cost and quantity/capacity measures are captured with ABC-defined activities whereas, quality and cycle time measures are accomplished with process defined event/activity analysis.

The three levels of performance architecture are hierarchical, and performance may be summed from the bottom through the activity level or decomposed from the top at the organization level. By undertaking an analysis of the activities that each person performs it becomes feasible to assign performance measures and goals to groups and individuals. Performance activities aligned in a common, understandable fashion contribute to the overall performance of the processes they serve and similarly support the achievement of organization performance by summing the results of process performance.

In measuring organization performance, emphasis is placed on establishing performance criteria that is required to satisfy the needs of those who judge the performance of the organization and ultimately to influence management choices on how they go about doing business. The expectations of owners and stockholders would be expressed in terms of financial performance constructs such as economic profit and risk. Customers, employees and other stakeholders each have their own specific priorities and needs in the context of any specific organizational construct. The needs and constructs of each stakeholder should be examined and prioritized in the context of strategic imperatives in order to define critical success factors and specific goals linked to particular measures. Typical measures will deal with earnings, market share, sales growth, cash flow and other drivers of economic profit coupled with high level qualitative measures such as customer satisfaction, employee satisfaction and capability / capacity related items much as described in Balanced Scorecard measures. Balance, however, in deciding what measures should be monitored is less critical than ensuring that focus is maintained on accomplishing the goals of the organization in a dynamic and holistic way.

Process analysis consists of identifying the events and the sequence in which they occur. During process analysis information is captured about sequence triggers, suppliers, inputs, fundamentals, outputs, and receiverships (i.e. customer). The primary question asked during process mapping is “and what happens next?” Process analysis is usually undertaken with a cross functional group of people who have specific, in depth knowledge about the nature of the events, their sequence and how well the process does that which it was created to do. In most organizations, processes evolved step by step over a long period of time, so it is necessary to undertake detailed analysis of processes by involving knowledgeable process participants.

Measuring performance attributes of processes involves understanding two perspectives. The first perspective looks at the process in aggregate to identify appropriate output measures such as customer satisfaction, process cost, output unit cost, cycle time, quality and capacity utilization. The second perspective focuses on the measures of each event as they occur within the process. Process performance goals have to be linked to the overall organizational goals as constructs; drivers of value should specify exactly what is expected of each process. For example, a sales process should specify what the value of new sales orders will be in a given period and expressed in terms of growth by product or service and market.

In activity based costing, activities are identified for each department in the organization. The primary concern when identifying the cost of activities is to correctly define real activities differentiated by proper activity drivers. It is critical that the activities be understood in the context of resources consumed to perform them. This means that the cost of salaries must be accounted for and reconcilable to the general ledger. The primary question for identifying activities in ABC is simply “What activities do you and your staff perform?” When asking this question, activity is defined as a set of tasks that have a common purpose, a common activity driver, and consume more than 5% of a person’s time.

Conduct activity analysis independent of process analysis to understand the cost of a process. Completely identify and define activities with an activity dictionary for each department. During the ABC design process, schedule a cost flow diagram session in order to refine activity definitions, agree on activity drivers, assign activities to cost objects, and identify which activities contribute to each process. In order to assign activities to processes, it is necessary to have already obtained a competent process inventory, or list of core processes. The process inventory preparation can be completed in the same period of time as the ABC activity analysis work. It is not necessary to complete process mapping work to be able to determine the cost of a process. It is only necessary to first identify the processes and then determine which activities occur within each process. This is accomplished during a cost flow diagram meeting. Armed with the output of the cost flow diagram, then the ABC team are generally in a position to calculate the cost of the activities and hence the cost of the processes. Knowing the cost of the processes will prioritize process improvement initiatives and facilitate simulation modeling and activity / process based budgeting. Costing activities and assigning them to processes yields relatively high level information.

There are many applications of the information achieved by process analysis in linking cost to non-financial performance in a clear and demonstrable fashion. An ABC system built upon the organization’s performance architecture can demonstrate which people actually perform each of the activities and which steps in the process are affected by their efforts. With the redesign of processes comes re-alignment of roles and responsibilities of people. In turn, this should influence organization design.

Managing with Performance Architecture

The integration of measurement and management systems using performance architecture has two very important implications. First, professionals in many disciplines within the organization can examine their personal constructs to determine how to blend them into the broader integrated measurement and management framework. As the global economy becomes increasingly dependant on knowledge and the speed at which change occurs it is important that we challenge our beliefs to test whether they will stand up to the rigors of a new business environment which is always emerging.

The second implication deals with implementation of an integrated measurement and management system. People often balk at the complexity of extensive analytical work. A major concern revolves around approach. Performance architecture is highly specific to each organization. Those organizations that change at very fast rates can expect limited benefits from one-time improvement projects. Rapidly changing organizations require constant awareness of measures, goals and results premised on evolving and continuous aspects of stakeholder needs, strategic goals, market conditions, technology enhancements, business changes and process and activity evolution / revolution. To address these concerns it is necessary for an organization to establish teams of people to focus on specific aspects of the work together. These teams would be cross-functional, cross-discipline and highly integrated.

Major stages of implementing performance architecture involve analysis, design, recommendations, implementation and ongoing maintenance and integration with day to day business operations. New employees have to be trained as staff turns over, consequently there is a strong need for attention to be paid to getting the people side of this right. This is work for employees. Each stage has unique skills, methodology and technology considerations. Care has to be taken to ensure that employees who participate are given the time and training to do the work and to know how the organization functions.

In today’s business environment, things move so rapidly that the processes employed and financial performance achieved is premised on decisions made in prior periods. Process design (or lack thereof) determines exactly what activities are performed, and the measurement system influences exactly how people will behave within the context of those processes. By the time a business begins to fail, it is often too late to respond effectively. The surviving competitors usually have established better processes that provide them sufficient differentiation until another organization, or technology bests them.

Performance architecture analyses create a common construct for all members of the organization. Performance architecture creates a basis of knowledge and fact through a common language for the single purpose of driving continuous, long-term change and competitive performance. The tools involved create a dynamic resource for future generations of employees to learn and understand why things operate the way they do. It will also provide a reliable basis of fact with which to form decisions on how to change the business with some degree of comfort.

In a nutshell, changing and managing organization performance is a complex affair requiring that careful thought be given to actual characteristics at all levels. Tying the pieces together requires open and analytical minds who are aware of their own personal management constructs and a willingness to let go of the status quo in favor of the opportunities that exist in a system where many individual perspectives can be combined to create the whole picture. The involvement of cost managers in the analysis of process and activities can be the glue that holds the perspectives together through many cycles of advantageous change.

[i] The Fish Tank Syndrome. Paul Sharman, Journal of Cost Management January 2001 (?)

[ii] Creating Shareholder Value. Alfred Rappaport. The Free Press 1998