17 Non-financial Measures (Preliminary Draft)

Before the Balanced Scorecard

The movement towards measuring human capital started with the realisation in U.S. manufacturing firms that they were being overtaken by Japanese competitors. The Japanese firms focused more on quality while the U.S. firms’ strategy was determined by stock market reactions to quarterly financial reports. U.S. firms realized they
needed to focus more on the long term and on intangible assets. This moved away the firm’s attention from short-term financial profit to its reputation with customers, knowledge about its customers and loyalty of customers create a strategic advantage for the firm. Similarly, the knowledge and skills of employees are important
and the organisational structure of the firm drive a firm’s competitiveness. These three fundamentals (customers, employees and organisational structure) determine the firm’s knowledge, its capacity to innovate and ultimately it’s capacity to create a competitive advantage over other firms.

The importance of human capital for the strategy of a firm has been stressed from the outset in this textbook because human capital is difficult to copy for competitors. Some of the case studies have illustrated the importance of human capital. For instance, the role of the R&E division in Whirlpool shows the importance of creating new
products. The metallurgists in Lehigh Steel are an example of the importance of employees’ capabilities. Finally, the relation between Virginia Mason and Owens & Minor shows the role of trust and  reputation in developing inter-firm relations.

In a first attempt to measure human capital, U.S. firms tried to value their intangible assets and report the valuation in their financial reports. This approach enables them to fulfill their duties to the stock market while also focusing on the drivers of a successful strategy. However this approach of translating intangible assets in monetary terms proved to be fraud with difficulties. First of all, to create a competitive advantage, which is difficult to copy by competitors, it does not suffice to have better skilled employees or loyal customers or the right organisational structure but all aspects should be in place. Competitive advantages are the result of a bundle of different intangibles assets (see also the Apple versus Android approach). This bundling makes it difficult to value separate intangible assets but it also makes it difficult to interpret the valuation. An example of a bundle of human capital is the Virginia Mason – Owens & Minor collaboration, which is supported by mutual trust and the specific knowledge in setting up cost pricing systems.

Second, the effect of intangible assets is not necessarily direct. Better skilled employees will not always immediately improve profit. First operations will run smoother which might lead to better and cheaper products. These products might attract more customers which eventually might lead to higher sales and higher profits. Along this path are a number of uncertainties that in the aggregate create a lot of uncertainty about the value of the skilled employees. Whirlpool R&E faced similar problems because the value of developing new knowledge is not easily related to financial performance which made it difficult to compare different R&E projects.

Introduction of non-financial measures

A new approach was necessary. Some firms decided to measure operational performance, product quality and customer performance in non-financial terms. Examples of these measures are cycle time, waste, faulty products or responsiveness to customer demands. These non-financial measures allowed to better measure the performance of the firm in the domain of customers and internal processes. However, the non-financial measures are difficult to compare with each others because they are measured in different units. If a manufacturing firm decreases cycle time at the cost of lower quality, it is difficult to decide whether that is a good evolution or a bad evolution. In the
end, the firm wants to know what the financial consequences of these changes are. If we know the financial consequences, we can make a trade off between changes in the processes. Moreover, firms also want to monitor whether improvements in the business processes such as lower cycle times are costly to implement and whether these costs are lower than the expected benefits.

This is were the first incarnation of the balanced scorecard comes in as a tool to monitor both the knowledge of the firm, its processes, its performance with customers and its financial performance. The biggest innovation of the balanced scorecard is that a limited set of measures should reflect the strategy of the firm. The initial purpose of the first incarnation of the balanced scorecard is to passively monitor the success of the firm’s strategy. The balanced scorecard informs top management about deviations from the planned strategic path so that they can intervene when necessary.