Balanced Scorecard REPORT

I N S I G H T, E X P E R I E N C E & I D E A S F O R S T R AT E G Y - F O C U S E D O RG A N I Z AT I O N S

Article Reprint No. B0609A

Linking Operations to
Strategy and Budgeting
By David P. Norton and Philip W. Peck

HARVARD BUSINESS
SCHOOL PUBLISHING
For a complete list of Harvard Business
School Publishing newsletters:
http://newsletters.harvardbusinessonline.org
For reprint and subscription information
for Balanced Scorecard Report:
Call 800-988-0866 or 617-783-7500
http://bsr.harvardbusinessonline.org
For customized and quantity orders of reprints:
Call 617-783-7626 Fax 617-783-7658
For permission to copy or republish:
Call 617-783-7587
 Part Two of a Two-Part Series But its not enough to allocate
B A L A N C E

funding for strategy. Ideally,

Linking Operations to the budget should govern the
allocation of resources to support
Strategy and Budgeting both strategy and operations. To
By David P. Norton, President, Palladium Group, and cofounder, Balanced allocate all resources successfully,
Scorecard Collaborative; and Philip W. Peck, Director, Palladium Group we need a linkage mechanism
that connects strategy and opera-
O N

In the MayJune issue, David Norton made the case for a new tions. If a strategic investment is
expense category, STRATEX, dedicated to funding strategic successful, we need to be able
initiativesthe means by which the enterprise carries out to see its results explicitly in our
strategy. But successful strategy execution requires more financials (e.g., costs go down,
than just a separate budget for strategy; the organization revenues go up)and, in turn, in
must link both strategy and operations to the budget, and our future budgets and forecasts.
do so in a way that is transparent (thus easy to analyze and But nowadays, most organizations
lack this visibility, because there
revise) and future-focused. Causal models, driver-based plan-
is no direct link between the
ning, and adaptive tools such as rolling forecasts together investment and the operating
constitute just such an integrating mechanism that can also plan. Fortunately, new approaches
give organizations more information (the whys, not just the provide this much-needed integra-
whats), flexibility, and agilityvital capabilities in a competi- tion. As shown in the lower half
tive, fast-changing world. of Figure 1, causal models (con-
structed from key operational
The budget: we love to hate it. their use, functions that it per- activity drivers), tools such as
Former GE chief Jack Welch once forms with reasonable effective- rolling forecasts, and causal
characterized it as the bane of ness. It was not designed to analysis allow us to link all
corporate America, words that adequately make forecasts, resourcesstrategic, operational,
capture the frustration of growing explain variances, or promote a and capital spendingto the
numbers of managers. For most long-term view. It was not meant operating plan. And causal models
organizations, the annual budget for communicating strategy or for offer much more than just a means
process is a painful, distracting, target setting. And more impor- of integrating these important
months-long exercise that con- tant, it was never intended for processes. They can dramatically
sumes a tremendous amount of managing either strategy or opera- simplify and transform the tradi-
resources and so quickly becomes tions, although many organiza- tional budgeting process into an
outdated that it is often irrelevant tions attempt to do so. We dont effective instrument of planning
for decision making. Moreover, advocate, as some do, eliminating and strategy. By eliminating the
since most organizations do not financial budgeting. Lets just excruciating detail, they vastly
link the operational plans (the accept it for what it is: a neces- reduce the time and effort needed
basis for budgets) to strategy, they sary tool for managing the alloca- to create budgets. They provide
suffer chronic fiscal disconnect. tion of financial resources. To transparency to the numbers
Once the budget is approved, manage strategy and operations, and their underlying assumptions.
they spend the next twelve we must look to other systems. And they enable organizations
months reconciling results to the to become more flexible and
Like operations, strategy needs to
originaland flawednumbers. responsive to internal and external
be funded. In the MayJune BSR,
Despite the cost and complexity, events. As a result, they can help
we discussed linking strategic
the end result is so inflexible organizations execute as well as
funding requirements to the bud-
that it cant be adapted toor hone strategy.
get by creating a new category
help the organization adapt to
called STRATEX to subsidize Driver-Based Planning:
changing conditions.
portfolios of strategic initiatives Making the Causal Connection
In fairness, much of the frustra- defined by the strategy manage-
tion comes from what budgeting ment process. This simple addi- A relatively new approach,
doesnt doand was never tion to the traditional chart of driver-based planning, has already
intended to do. The financial accounts represents a revolution- shown promise as a way of over-
budget was meant to provide a ary change in the way organiza- coming many of the limitations
rational way to allocate financial tions manage. (See top half of of traditional budgeting. Driver-
resources and ensure control of Figure 1 on the following page.) based planning uses operational

Copyright 2006 by Harvard Business School Publishing Corporation. All rights reserved. 3
Linking Operations, Strategy, and Budgeting (continued)
driver models to predict financial
results. These models are essen-
tially equations that represent
the mathematical relationships
between key operational drivers
(e.g., call volume, response rates,
machine utilization, sales conver-
sion ratios, brand awareness)
and financial outcomes. The
models are created by determining
the cause-and-effect relationships
among drivers, business activities,
resource requirements, and finan-
cial outcomes. While such rela-
tionships have always been the
basis for budgeting, they are
typically not represented in a
formal, systematicand transpar-
entway. Organizations such as
CVS (the drugstore chain), EMC
(the information management and
storage company), and American
Express have successfully used
driver-based models to improve
their planning and forecasting
capabilities. With the increased
adoption and continued refine-
ment of the Balanced Scorecard,
organizations have experienced
the benefits of identifying, map-
ping, and continually revisiting
the cause-and-effect relationships
in their key strategic performance
dimensions (scorecard perspec-
tives). Applying the principles
of causal models to operational
and financial planningand
establishing the linkages between
operations and strategycan offer
equally significant benefits.
Figure 2 contrasts the traditional
budget architecture with that of
the causal model approach. The
traditional budget provides only
financial information in a hierar-
chical chart of accounts format.
Using the example of a companys
call center, labor expenses appear
as a single line item, wedged in
among other elements of costs
of goods sold. A causal model,
by focusing on the drivers of
performance, enables the call
center to better plan and manage
labor expenses and becomes the
basis for determining the financial
4 Balanced Scorecard Report SeptemberOctober 2006
Figure 1. Linking the Budget to Strategy and Operations
STRATEGY
Strategy
Themes
Cause-and-effect
Objectives
STRATEGY LOOP analysis
Balanced Scorecard
Strategic initiative portfolios
(by theme)
Stratex
Budget
Opex Capex
(ope
Initia
tives 1. Activity drivers and causal models
ratin
g im
pact
) Operating Plan
2. Rolling forecasts OPERATIONS LOOP 3. Causal analysis
Res
our
ces Performance
OPERATIONS
Results
Cause-and-effect relationships provide the foundation for linking strategy and
operations throughout the entire management cyclefrom planning to review to
revised actionand enable continuous learning.
budget for the centers labor per month. The call center man-
expenses. The figure shows the ager assumes a 75-call-per-day
cause-and-effect relationships of capacity for each agent and deter-
the driver-based causal model: the mines how much extra staffing
marketing group of this company is required to compensate for
produces a series of advertisements employee absence and activities
(a driver) that results in a volume such as training (20%)factors
of inbound inquiry calls (an activ- that together will determine the
ity). These calls require phone number of agents needed. By
agents and staffing hours (resource multiplying the number of agents
requirements), which generate call required by the assumed cost per
center labor expenses (financial agent ($2,500), the manager arrives
outcomes). at his monthly labor expense.
Figure 3 juxtaposes the output Using driver-based models as the
of a traditional budget with the basis for operational planning
explicit assumptions and causal and financial forecasting provides
relationships of a driver model. In numerous benefits. By focusing
the former, labor expenses for call on the underlying drivers of
center operations appear as one performance, the business model
number. None of the assumptions is deconstructed and made trans-
underlying the final expense figure parent. In fact, the act of develop-
are visible or tracked systemically; ing a driver-based model can
thus, they arent available for actually help establish a common
review, discussion, or subsequent language for talking about the
analysis. In contrast, the driver business: leaders are forced to
model consists of a series of achieve consensus on which
equations that derive the final drivers are important, how financial
labor expense figure, equations statement line items are derived
that mathematically represent the from these drivers, and who
causal relationships illustrated in should be accountable. With the
Figure 2. Assumptions are explicit underlying assumptions visible,
for all components of the model. managers cant hide behind the
In this example, advertising and numbers. In addition, driver-
promotional activities are expected based planning facilitates scenario
to generate 200,000 inbound calls building and what if analysis.
Linking Operations, Strategy, and Budgeting (continued)
Figure 2. Traditional Budget vs. Driver-Based Causal Model
Traditional budget architecture
Cost of goods sold
Product cost
Labor expense
Other
The causal model focuses on all the key drivers of performancein this case, the initial input,
activity, and resource requirements that together amount to call center labor expenses.
Performance Analysis:
Understanding Cause and Effect
With its emphasis on reporting
actual results and budget-centric
variance analysis (i.e., comparing
actual results to the budget),
traditional budgeting is backward
looking. It addresses only what
happened, not why. As a result,
traditional variance analysis offers
no help in ensuring that the
organization will either repeat
or enhance its successesor
minimize its failures. A 2005
study by the IBM Institute for
Business Value shows that this
ineffectiveness is widely felt; only
42% of CFOs surveyed believe
that their finance department
measures and monitors business
performance effectively.1 In fact,
traditional planning focuses on
minimizing deviation from the
original budgetnot on under-
standing the underlying perfor-
mance drivers or on seeking
proactive measures that can boost
competitiveness and strategy
success. By encouraging close
adherence to the budget, tradi-
tional planning reinforces the
command-and-control organiza-
tional structure, rather than pro-
moting adaptability, flexibility, and
learning. Bottom-up and frontline
feedback is stifledyet another
obstacle to performance trans-
parency. The desire for control
overrides all other considerations.
To understand the whys behind
performance variances, you must
look to the operational manage-
ment system. Causal models that
Balanced Scorecard Report SeptemberOctober 2006
is significantly below the plan
estimate. These business drivers
Causal model work in concert to generate
higher-than-expected labor
# of # of # of Call expenses for the call center
agents center
advertise- inbound
and labor labor $468,750, which is 17.2% higher
ments calls
hours expenses than the estimated $400,000.
Input Business Resource Financial By making the planned and
driver activity requirements outcomes
actual driver values explicit, the
organization enables insightful dis-
cussion and analysis of the unfa-
vorable labor expense variance.
incorporate key operational drivers Using their knowledge of the dri-
used to support the financial plan- ver models and the underlying
ning process are equally valuable business, managers can now
for financial analysis. investigate the causes underlying
Figures 4 and 5 illustrate variance the unexpected call volume
analysis (the review process), increase and the poor agent
causal analysis, and action plan- productivity. Because key assump-
ning for our hypothetical call cen- tions are exposed, managers can
ter. Traditional variance analysis more readily identify incorrect
would focus on the single line assumptions and work together
item salary expense; no other to develop corrective action plans
drivers are evident. We know that spell out remedial actions,
only that salary expense is 17.2% initiative owners, and deadlines.
above plannot why. Driver- In this case, the unit head whose
based analysis, however, examines new product promotion is being
the driver value assumptions on supported by the call center can
which the original plan or forecast approve additional funding to hire
is based. We see that the number more call center agents, or HR
of inbound calls received by the can do remedial training to boost
center is substantially greater than agents capacity, or the call center
the plan estimate: 225,000 versus manager can confer with HR to
200,000, for a 12.5% variance. assess whether to replace some
Agent capacity of 66 calls per day agents with more experienced,
higher-wage personnel.
Figure 3. Traditional Budget vs. Driver Model
Traditional budget Driver model:Call center labor expense
Forecast Drivers & values
Gross sales $8,500,000 Inbound calls per month 200,000
Less: discounts & rebates 500,000
Net sales 8,000,000
Working days per month 20
Cost of goods sold
Calls per agent per day 75
Peak absence factor 20%
Product cost 1,950,000
Call center operations labor Cost per agent per month $2,500
400,000 Modeling & results
Other 50,000 Capacity per agent per month:
Gross margin 2,400,000 = (calls per day) x (working days) = 75 x 20 = 1,500
R&D 200,000 # of agents required:
Selling 200,000
General & admin 300,000
= (calls/capacity per agent) x (1 + factor) = (200K 1.5K) x 1.2 = 160
Strategic investment (Stratex) 500,000 Monthly labor expense:
Operating income $1,200,000 = (# of agents required) x (cost per agent) = 160 x $2,500 = $400,000
While the traditional budget shows call center labor expense as simply one line item
among many, the driver model reveals the full set of assumptions driving that expense,
thereby facilitating financial analysis, planning, and management.
5
Linking Operations, Strategy, and Budgeting (continued)
Using causal models as the foun-
dation for feedback, review, and
analysis enhances the planning
and performance management
process. By focusing explicitly on
the operational drivers influencing
financial results, the dialogue
shifts away from just a financial
discussion toward a discussion
about the internal as well as
external factors influencing perfor-
mance (e.g., a new employer in
the area hiring away call center
agents). This framework establishes
the linkages needed to address
operational performance gaps,
thus supporting tactical solutions
and initiatives for improving per-
formance. This framework also
supports continuous learning;
the organization is continually
adapting and updating its
hypotheses regarding the causal
relationships of its models.
Although this new approach is
gaining momentum, the behavioral
changes it requires can be threat-
ening. Because the models are
transparent, people cant pad
numbers, conceal information,
or game the system. Theres no
clouding assumptions and numbers
through allocations, transfer pricing
mechanisms, and other planning
complexities. Driver-based models
require that managers cross
organizational boundaries to
gather input from planning
constituents throughout the
enterprise. They require a deep
Figure 4. Plan vs. Actual Variance
Driver model variable values
Inbound calls per month
Working days per month
Calls per agent per day
Capacity per agent per month
Peak absence factor
Agents required
Cost per agent per month
Salary expense
The details provided by the driver model enable managers to analyze
the whys of the labor expense variance.
6 Balanced Scorecard Report SeptemberOctober 2006
understanding of the entire value
chainincluding all the activities
and information that span the
key business processes affecting
performancein this case, from
marketing to call center to opera-
tions to finance.
Rolling Forecasts to
Capture the Learnings
In traditional planning, budgeting
is a discrete, annual event. Few
organizations update their fore-
casts, and those that do typically
do not extend them beyond
the calendar year. According to
research by the American Quality
and Productivity Center, 60% of
organizations do not update their
budgets regularly. Furthermore,
fewer than 50% of organizations
use a forecast horizon beyond
the current quarter or fiscal year.2
Even those organizations that
actually use forecasts to monitor
performance generally use them
only to see whether they are
on track to meet annual targets.
Clearly, attention to near-term
performance is important, yet an
exclusively near-term focus obvi-
ously doesnt support longer-term
strategic objectives.
Driver-based planning models
can help organizations develop
a useful, more accurate approach
to financial forecasting: the rolling
forecast. The rolling forecast,
which began to appear in the
mid-1990s, provides a continuous
Plan Actual Variance
200,000 225,000 12.5%
20 20 0%
75 66 -12.0%
1,500 1,320 -12.0%
1.2 1.1 - 8.3%
160 188 17.2%
$2,500 $2,500 0%
$400,000 $468,750 (17.2%)
away to mitigate expected short-
performance outlook beyond the
current yeargenerally five to six
quarters from the present quarter.3
As the horizon is extended, the
forecast becomes less precise,
giving mainly a directional indica-
tion of performance. Rolling
forecasts typically include less
general ledger and financial
statement line-item detail than
traditional forecasts and budgets,
instead emphasizing operational
drivers. A rolling forecast provides
the best estimate of expected
future performance for both the
near- and mid-terms; it is not to
be confused, however, with the
longer-term performance target
contained in a long-range plan
or a Balanced Scorecard.
Driver models are essential for
successful rolling forecasts, as
they provide the bridge between
operational activities and financial
outcomes. Instead of completing
a detailed, bottom-up forecast
(which closely resembles a tradi-
tional budget), the rolling forecast
built from driver models focuses
on the key operational drivers
with the greatest impact on finan-
cial performance. This structure
allows for rapid forecast cycles
that provide the flexibility and
timeliness necessary for dynamic
planning. The consistency and
standardization driver models
bring also facilitate rolling fore-
casts, since common assumptions
and driver values can be centrally
managed and administered.
Without this capability, you defeat
the purpose; the organization can
end up producing multiple tradi-
tional budgets throughout the year.
By definition, rolling forecasts
support dynamic, continuous
planning in everything from
strategy refreshes and target
setting to the development of
the annual financial plan. Since
they are updated each quarter, if
performance gaps appear, man-
agement can take action right
Linking Operations, Strategy, and Budgeting (continued)
falls. Conversely, if performance
surpasses expectations, resources
can be freed up or reallocated
to pursue other projects or oppor-
tunities. Rolling forecasts thus
support both operational and
strategic management activities.
The most current rolling forecast
constitutes a critical component
of strategic performance reviews,
and the action list resulting from
the strategic performance reviews
is then incorporated into the next
iteration of the rolling forecast.
In this manner, rolling forecasts
provide a degree of visibility
and flexibility not available in the
typical planning process, allowing
quarterly business reviews to shift
from their traditional focus on
financials to a broader emphasis
on strategy, potential risks and
opportunities, and operational
improvement initiatives.
Though still fairly leading edge,
the rolling forecast is used by
organizations such as Time
Warner Telecom, Borealis (the
Danish plastics company), and
Nordea (the Scandinavian bank)
to improve planning and perfor-
mance management systems.4
Through its use, these companies
have improved their forecasting
accuracy while also dramatically
streamlining the forecasting effort.
Dynamic resource allocation and
reallocation is also much easier.
The use of driver-based approaches
is increasing, though still limited.
There are several reasons: (1)
until now, the lack of a driver-
model framework; (2) the lack of
an enabling technology such as
integrated planning applications
(using spreadsheets for driver
models and rolling forecasts is a
challenge); and (3) comfort with
the status quo. Resistance could
even be due to something far
more fundamentalthe zero toler-
ance ingrained in organizations
for not meeting original budget
numbers. Most managers feel that
targets should be adhered to;
Balanced Scorecard Report SeptemberOctober 2006
Figure 5. Variance and Causal Analysis and Corrective Action
Variance analysis with driver models
Variance analysis based on driver-based forecasts provides insight into
what happened and why.
What: Salary expense 17.2% above plan
Why: (1) Call volume 12.5% above plan
(2) Agent productivity 12% below plan
(3) More agents required
Corrective action: How do I address the performance shortfall?
Detailed causal analysis
Investigate the significant above-plan call volume variance
Timing, scope, and effectiveness of marketing programs
Other external demand drivers
Agent productivity
Training program effectiveness
Enabling tools / technology
Agent proficiency, tenure, motivation, absenteeism
Customer service metrics
Corrective action plans
Actions Owner Date
Initiate forecast improvement project around
marketing program response rates Marketing 10/1
Provide remedial training for existing agents Training 12/1
Engage placement services for new hiring HR 10/1
Complete assessment of agent talking scripts Call Center Ops 11/1
Since managers have more information to go on, variance analysis enables more robust causal
analysis, which, in turn, takes much of the guesswork out of correction action planning.
floating targets suggest a lack of tions can explicitly link operations
discipline. Some organizations to the budget and the strategy.
have found a solution to this As a result, they can transform
dilemma by revising forecasts but the budgeting process from one
keeping incentives tied to the that merely allocates financial
original budget. resources to one that optimizes
the management of resources.
Optimize Resource Management Performanceand strategy execu-
Operating plans are built around tioncan only be improved. I
processes and programs, while 1. The Agile CFO: Acting on Business Insight,
budgets are built around financial
IBM Institute for Business Value, 2005.
resources. Just as the strategy map 2. The AQPC study is cited in Tad Leahy, Can
the Budgeting Competency Gap Be Narrowed?
does with the strategic objectives Business Finance, February 2006.
of the nonfinancial perspectives, 3. For more on rolling forecasts, see Why
so causal models allow us to Budgeting Fails: One Management System Is
Not Enough, BSR SeptemberOctober 2004
link the leading indicators of the (Reprint #B0409C).
operating plan with the outcomes 4. Borealiss use of rolling forecasts is covered in
of the financial reports. By using Creating Budget-less Organizations with the
causal models such as driver-
Balanced Scorecard, BSR NovemberDecember
2000 (Reprint #B0011B). See also Integrating
based planning and techniques Planning and Performance Management at Nordea,
BSR JanuaryFebruary 2005 (Reprint #B0501B).
such as rolling forecasts, organiza-
7