Chapter 15 The Essentials of Control

Costs

Controls can cost the organization in several areas, including (1) financial, (2) damage to culture and reputation, (3) decreased responsiveness, and (4) botched implementation. An example of financial cost is the fact that organizations are often required to perform and report the results of a financial audit. These audits are typically undertaken by external accounting firms, which charge a substantial fee for their services; the auditor may be a large firm like Accenture or KPMG, or a smaller local accounting office. Such audits are a way for banks, investors, and other key stakeholders to understand how financially fit the organization is. Thus, if an organization needs to borrow money from banks or has investors, it can only obtain these benefits if it incurs the monetary and staffing costs of the financial audit.

Controls also can have costs in terms of organization culture and reputation. While you can imagine that organizations might want to keep track of employee behavior, or otherwise put forms of strict monitoring in place, these efforts can have undesirable cultural consequences in the form of reduced employee loyalty, greater turnover, or damage to the organization’s external reputation. Management researchers such as the late London Business School professor Sumantra Ghoshal have criticized theory that focuses on the economic aspects of man (i.e., assumes that individuals are always opportunistic). According to Ghoshal, “A theory that assumes that managers cannot be relied upon by shareholders can make managers less reliable.”Ghoshal S., & Moran, P. (1996). Bad for practice: A critique of the transaction cost theory. Academy of Management Review. 21(1), 13–47. Such theory, he warned, would become a self-fulfilling prophecy.

Less theoretical are practical examples such as Hewlett-Packard’s (HP) indictment on charges of spying on its own board of directors. In a letter to HP’s board, director Tom Perkins said his accounts were “hacked” and attached a letter from AT&T explaining how the breach occurred. Records of calls made from Perkins’s home phone were obtained simply with his home phone number and the last four digits of his Social Security number. His long-distance account records were obtained when someone called AT&T and pretended to be Perkins, according to the letter from AT&T.Retrieved January 30, 2009, from http://i.n.com.com/pdf/ne/2006/perkins_letter.pdf HP Chairman Patricia Dunn defended this rather extreme form of control as legal, but the amount of damage to the firm’s reputation from these charges led the firm to discontinue the practice. It also prompted the resignation of several directors and corporate officers.Retrieved January 30, 2009, from http://news.zdnet.com/2100-9595_22-149452.html

The third potential cost of having controls is that they can afford less organizational flexibility and responsiveness. Typically, controls are put in place to prevent problems, but controls can also create problems. For instance, the Federal Emergency Management Agency (FEMA) is responsible for helping people and business cope with the consequences of natural disasters, such as hurricanes. After Hurricane Katrina devastated communities along the U.S. Gulf Coast in 2005, FEMA found that it could not provide prompt relief to the hurricane victims because of the many levels of financial controls that it had in place.U.S. Government Printing Office. (2006, February 15). Executive summary. Select Bipartisan Committee to Investigate the Preparation for and Response to Hurricane Katrina.

The fourth area of cost, botched implementation, may seem obvious, but it is more common than you might think (or than managers might hope). Sometimes the controls are just poorly understood, so that their launch creates significant unintended, negative consequences. For example, when Hershey Foods put a new computer-based control system in place in 1999, there were so many problems with its installation that it was not able to fulfill a large percentage of its Halloween season chocolate sales that year. It did finally get the controls in working order, but the downtime created huge costs for the company in terms of inefficiencies and lost sales.Retrieved January 30, 2009, from Hershey profits for 4Q 1999 down 11% due to SAP implementation problem. http://www.greenspun.com/bboard/q-and-a-fetch-msg.tcl?msg_id=002SUM Some added controls may also interfere with others. For instance, a new quality control system may improve product performance but also delay product deliveries to customers.

Benefits

Although organizational controls come at some cost, most controls are valid and valuable management tools. When they are well designed and implemented, they provide at least five possible areas of benefits, including (1) improved cost and productivity control, (2) improved quality control, (3) opportunity recognition, (4) better ability to manage uncertainty and complexity, and (5) better ability to decentralize decision making. Let’s look at each one of these benefits in turn.

First, good controls help the organization to be efficient and effective by helping managers to control costs and productivity levels. Cost can be controlled using budgets, where managers compare actual expenses to forecasted ones. Similarly, productivity can be controlled by comparing how much each person can produce, in terms of service or products. For instance, you can imagine that the productivity of a fast-food restaurant like McDonald’s depends on the speed of its order takers and meal preparers. McDonald’s can look across all its restaurants to identify the target speed for taking an order or wrapping a burger, then measure each store’s performance on these dimensions.

Quality control is a second benefit of controls. Increasingly, quality can be quantified in terms of response time (i.e., How long did it take you to get that burger?) or accuracy (Did the burger weigh one-quarter pound?). Similarly, Toyota tracks the quality of its cars according to hundreds of quantified dimensions, including the number of defects per car. Some measures of quality are qualitative, however. For instance, Toyota also tries to gauge how “delighted” each customer is with its vehicles and dealer service. You also may be familiar with quality control through the Malcolm Baldrige National Quality Program Award. The Baldrige award is given by the president of the United States to businesses—manufacturing and service, small and large—and to education, health care, and nonprofit organizations that apply and are judged to be outstanding in seven areas: leadership; strategic planning; customer and market focus; measurement, analysis, and knowledge management; human resource focus; process management; and results.Retrieved January 30, 2009, from http://www.nist.gov/public_affairs/factsheet/baldfaqs.htm Controlling—how well the organization measures and analyzes its processes—is a key criterion for winning the award. The Baldrige award is given to organizations in a wide range of categories and industries, from education to ethics to manufacturing.

The third area by which organizations can benefit from controls is opportunity recognition. Opportunities can come from outside of the organization and typically are the result of a surprise. For instance, when Nestlé purchased the Carnation Company for its ice cream business, it had also planned to sell off Carnation’s pet food line of products. However, through its financial controls, Nestlé found that the pet food business was even more profitable than the ice cream, and kept both. Opportunities can come from inside the organization too, as would be the case if McDonald’s finds that one of its restaurants is exceptionally good at managing costs or productivity. It can then take this learned ability and transfer it to other restaurants through training and other means.

Controls also help organizations manage uncertainty and complexity. This is a fourth area of benefit from well-designed and implemented controls. Perhaps the most easily understood example of this type of benefit is how financial controls help an organization navigate economic downturns. Without budgets and productivity controls in place, the organization might not know it has lost sales or expenses are out of control until it is too late.

The fifth area of benefit in organizational control is related to decentralized decision making. Organization researchers have long argued that performance is best when those people and areas of the organization that are closest to customers and pockets of uncertainty also have the ability (i.e., the information and authority) to respond to them.Galbraith, J. R. (1974). Organization design: An information processing view. Interfaces, 4, 28–36. Galbraith believes that “the greater the uncertainty of the task, the greater the amount of information that must be processed between decision makers during the execution of the task to get a given level of performance.” Firms can reduce uncertainty through better planning and coordination, often by rules, hierarchy, or goals. Galbraith states that “the critical limiting factor of an organizational form is the ability to handle the non-routine events that cannot be anticipated or planned for.” Going back to our McDonald’s example, you can imagine that it would be hard to give a store manager information about her store’s performance and possible choices if information about performance were only compiled at the city, region, or corporate level. With store-level performance tracking (or, even better, tracking of performance by the hour within a store), McDonald’s gives store managers the information they need to respond to changes in local demand. Similarly, it equips McDonald’s to give those managers the authority to make local decisions, track that decision-making performance, and feed it back into the control and reward systems.

Proactivity

Proactivity can be defined as the monitoring of problems in a way that provides their timely prevention, rather than after the fact reaction. In management, this is known as feedforward controlThe active monitoring of problems in a way that provides their timely prevention, rather than after-the-fact reaction.; it addresses what can we do ahead of time to help our plan succeed. The essence of feedforward control is to see the problems coming in time to do something about them. For instance, feedforward controls include preventive maintenance on machinery and equipment and due diligence on investments.

Concurrent Controls

The process of monitoring and adjusting ongoing activities and processes is known as concurrent controlProcesses that entail monitoring and adjusting ongoing activities.. Such controls are not necessarily proactive, but they can prevent problems from becoming worse. For this reason, we often describe concurrent control as real-time control because it deals with the present. An example of concurrent control might be adjusting the water temperature of the water while taking a shower.

Feedback Controls

Finally, feedback controlsProcesses that involve the gathering of information about a completed activity, evaluating that information, and taking steps to improve the similar activities in the future. involve gathering information about a completed activity, evaluating that information, and taking steps to improve the similar activities in the future. This is the least proactive of controls and is generally a basis for reactions. Feedback controls permit managers to use information on past performance to bring future performance in line with planned objectives.

Control as a Feedback Loop

In this latter sense, all these types of control function as a feedback mechanism to help leaders and managers make adjustments in the strategy, as perhaps is reflected by changes in the planning, organizing, and leading components. This feedback loop is characterized in the following figure.

Figure 15.4 Controls as Part of a Feedback Loop

Why might it be helpful for you to think of controls as part of a feedback loop in the P-O-L-C process? Well, if you are the entrepreneur who is writing the business plan for a completely new business, then you would likely start with the planning component and work your way to controlling—that is, spell out how you are going to tell whether the new venture is on track. However, more often, you will be stepping into an organization that is already operating, and this means that a plan is already in place. With the plan in place, it may be then up to you to figure out the organizing, leading, or control challenges facing the organization.

Outcome and Behavioral Controls

Controls also differ depending on what is monitored, outcomes or behaviors. Outcome controlsProcesses that are generally preferable when just one or two performance measures (say, return on investment or return on assets) are good gauges of a business’s health. are generally preferable when just one or two performance measures (say, return on investment or return on assets) are good gauges of a business’s health. Outcome controls are effective when there’s little external interference between managerial decision making on the one hand and business performance on the other. It also helps if little or no coordination with other business units exists.

Behavioral controlsThe direct evaluation of managerial and employee decision making, not of the results of managerial decisions. involve the direct evaluation of managerial and employee decision making, not of the results of managerial decisions. Behavioral controls tie rewards to a broader range of criteria, such as those identified in the Balanced Scorecard. Behavioral controls and commensurate rewards are typically more appropriate when there are many external and internal factors that can affect the relationship between a manager’s decisions and organizational performance. They’re also appropriate when managers must coordinate resources and capabilities across different business units.

Financial and Nonfinancial Controls

Finally, across the different types of controls in terms of level of proactivity and outcome versus behavioral, it is important to recognize that controls can take on one of two predominant forms: financial and nonfinancial controls. Financial controlThe management of a firm’s costs and expenses to control them in relation to budgeted amounts. involves the management of a firm’s costs and expenses to control them in relation to budgeted amounts. Thus, management determines which aspects of its financial condition, such as assets, sales, or profitability, are most important, tries to forecast them through budgets, and then compares actual performance to budgeted performance. At a strategic level, total sales and indicators of profitability would be relevant strategic controls.

Without effective financial controls, the firm’s performance can deteriorate. PSINet, for example, grew rapidly into a global network providing Internet services to 100,000 business accounts in 27 countries. However, expensive debt instruments such as junk bonds were used to fuel the firm’s rapid expansion. According to a member of the firm’s board of directors, PSINet spent most of its borrowed money “without the financial controls that should have been in place.”Woolley, S. (2001, May). Digital hubris. Forbes, 66–70. With a capital structure unable to support its rapidly growing and financially uncontrolled operations, PSINet and 24 of its U.S. subsidiaries eventually filed for bankruptcy.Retrieved January 30, 2009, from PSINet announces NASDAQ delisting. (2001, June 1). http://www.psinet.com While we often think of financial controls as a form of outcome control, they can also be used as a behavioral control. For instance, if managers must request approval for expenditures over a budgeted amount, then the financial control also provides a behavioral control mechanism as well.

Increasing numbers of organizations have been measuring customer loyalty, referrals, employee satisfaction, and other such performance areas that are not financial. In contrast to financial controls, nonfinancial controlsProcesses that track aspects of the organization that aren’t immediately financial in nature but are expected to lead to positive financial performance outcomes. track aspects of the organization that aren’t immediately financial in nature but are expected to lead to positive performance outcomes. The theory behind such nonfinancial controls is that they should provide managers with a glimpse of the organization’s progress well before financial outcomes can be measured.Ittner, C., & Larcker, D. F. (2003, November). Coming up short on nonfinancial performance measurement. Harvard Business Review, 2–8. And this theory does have some practical support. For instance, GE has found that highly satisfied customers are the best predictor of future sales in many of its businesses, so it regularly tracks customer satisfaction.

Assets

Current assetsAssets that are cash or can be readily converted to cash in the short term, such as accounts receivable or inventory. are those assets that are cash or can be readily converted to cash in the short term, such as accounts receivable or inventory. In the balance sheet shown for Success-R-Us, the current assets are cash, petty cash, accounts receivable, inventory, and supplies.

Some business people define current assets as those the business expects to use or consume within the coming fiscal year. Thus, a business’s noncurrent assets would be those that have a useful life of more than one year. These include fixed assets and intangible assets.

Fixed assetsAssets that are not easily converted to cash in the short term; that is, they are assets that only change over the long term. Land, buildings, equipment, vehicles, furniture, and fixtures are some examples of fixed assets. are those assets that are not easily converted to cash in the short term; that is, they are assets that only change over the long term. Land, buildings, equipment, vehicles, furniture, and fixtures are some examples of fixed assets. In the balance sheet for Success-R-Us, the fixed assets shown are furniture and fixtures and equipment. These fixed assets are shown as less accumulated depreciation.

Intangible assets (net)An asset that cannot be physically touched, or is not physical in nature. may also be shown on a balance sheet. These may be goodwill, trademarks, patents, licenses, copyrights, formulas, and franchises. In this instance, net means the value of intangible assets minus amortization.

Liabilities

Current liabilitiesLiabilities coming due in the short term, usually the coming year. are those coming due in the short term, usually the coming year. These are accounts payable; employment, income and sales taxes; salaries payable; federal and state unemployment insurance; and the current year’s portion of multiyear debt. A comparison of the company’s current assets and its current liabilities reveals its working capital. Many managers use an accounts receivable aging report and a current inventory listing as tools to help them in management of the current asset structure.

Long-term debtLiabilities may be bank notes or loans made to purchase the business's fixed asset structure. Long-term debt/liabilities come due in a time period of more than one year., or liabilities, may be bank notes or loans made to purchase the business’s fixed asset structure. Long-term debt/liabilities come due in a period of more than one year. The portion of a bank note that is not payable in the coming year is long-term debt/liability.

For example, Success-R-Us’s owner may take out a bank note to buy land and a building. If the land is valued at $50,000 and the building is valued at $50,000, the business’s total fixed assets are $100,000. If $20,000 is made as a down payment and $80,000 is financed with a bank note for 15 years, the $80,000 is the long-term debt.

Owner’s Equity

Owner’s equity refers to the amount of money the owner has invested in the firm. This amount is determined by subtracting current liabilities and long-term debt from total assets. The remaining capital/owner’s equity is what the owner would have left in the event of liquidation, or the dollar amount of the total assets that the owner can claim after all creditors are paid.”

Sales or Revenue

The sales or revenue portion of the income statement is where the retail price of the product is expressed in terms of dollars times the number of units sold. This can be product units or service units. Sales can be expressed in one category as total sales or can be broken out into more than one type of sales category: car sales, part sales, and service sales, for instance. In our Success-R-Us example, the company sold 20,000 books at a retail price of $25 each, for total revenues of $500,000. Because Success-R-Us sells all of its books on credit (i.e., you can charge them on your credit card), the company does not collect cash for these sales until the end of the month, or whenever the credit card company settles up with Success-R-Us.

Cost of Goods Sold/Cost of Sales

The cost of goods sold/sales portion of the income statement shows the cost of products purchased for resale, or the direct labor cost (service person wages) for service businesses. Cost of goods sold/sales also may include additional categories, such as freight charges cost or subcontract labor costs. These costs also may be expressed in one category as total cost of goods sold/sales or can be broken out to match the sales categories: car purchases, parts, purchases, and service salaries, for example.

Breaking out sales and cost of goods sold/sales into separate categories can have an advantage over combining all sales and costs into one category. When you break out sales, you can see how much each product you have sold costs and the gross profit for each product. This type of analysis enables you to make inventory and sales decisions about each product individually.

Gross Profit

The gross profit portion of the income/P&L statement tells the difference between what you sold the product or service for and what the product or service cost you. The goal of any business is to sell enough units of product or service to be able to subtract the cost and have a high enough gross profit to cover operating expenses, plus yield a net income that is a reasonable return on investment. The key to operating a profitable business is to maximize gross profit.

If you increase the retail price of your product too much above the competition, you might lose units of sales to the competition and not yield a high enough gross profit to cover your expenses. However, if you decrease the retail price of your product too much below the competition, you might gain additional units of sales but not make enough gross profit per unit sold to cover your expenses.

While this may sound obvious, a carefully thought out pricing strategy maximizes gross profit to cover expenses and yield a positive net income. At a very basic level, this means that prices are set at a level where marginal and operating costs are covered. Beyond this, pricing should carefully be set to reflect the image you want portrayed and, if desired, promote repeat business.

Operating Expenses

The operating expense section of the income/P&L statement is a measurement of all the operating expenses of the business. There are two types of expenses, fixed and variable. Fixed expenses are those expenses that do not vary with the level of sales; thus, you will have to cover these expenses even if your sales are less than the expenses. The entrepreneur has little control over these expenses once they are set. Some examples of fixed expenses are rent (contractual agreement), interest expense (note agreement), an accounting or law firm retainer for legal services of X amount per month for 12 months, and monthly charges for electricity, phone, and Internet connections.

Variable expenses are those expenses that vary with the level of sales. Examples of variable expenses include bonuses, employee wages (hours per week worked), travel and entertainment expenses, and purchases of supplies. (Note: categorization of these may differ from business to business.) Expense control is an area where the entrepreneur can maximize net income by holding expenses to a minimum.

Net Income

The net income portion of the income/P&L statement is the bottom line. This is the measure of a firm’s ability to operate at a profit. Many factors affect the outcome of the bottom line. Level of sales, pricing strategy, inventory control, accounts receivable control, ordering procedures, marketing of the business and product, expense control, customer service, and productivity of employees are just a few of these factors. The net income should be enough to allow growth in the business through reinvestment of profits and to give the owner a reasonable return on investment.

Not Using Nonfinancial Controls

While poorly conceived and implemented nonfinancial controls are certainly a cost for organizations, such ineptness is no defense for not including them in every modern organization’s system of controls. If management were a poker game, then the ability to use nonfinancial controls would be a table stake in the game—that is, you only get to play if you have skills with them. The world is simply changing too fast, and competitors’ capabilities are evolving too quickly, such that managers who relied only on financial controls would soon find their organizations in trouble. You can help us come up with plenty of examples here, but let’s simply look at the relationship between customer satisfaction and a retail store’s sales. A dissatisfied customer is hard to get back (and may have been dissatisfied enough to leave the store before even making that first purchase)!

While interest in nonfinancial controls is exploding, it seems somewhat disappointing that they aren’t living up to the job. Why do so many companies appear to misunderstand how to set and use nonfinancial controls effectively? Let’s take a look at four additional top mistakes Ittner and Larcker identified in their research.

Not Linked to Strategy

This mistake appears to be a common one but its root cause—failure to adapt the control system to the specific strategy of the organization—is not obvious. Growth in interest in nonfinancial controls has led to widespread adoption of such systems as the Balanced Scorecard, Performance Prism, or the Intellectual Capital Navigator. However, because these systems are complex, managers tend to put them in place without tailoring them to the specific needs and characteristics of their organization.

Several things can go wrong when nonfinancial controls are not linked to the strategy. First, control systems tend to be tied to reward systems, and if managers and employees are being paid based on the achievement of certain nonstrategic, nonfinancial outcomes, then the firm’s strategy and, hence, performance, could suffer. Second, if the controls are not linked to the strategy, or the linkages are unclear, then managers do not really understand which nonfinancial controls are the most important. This leads us to the second common mistake.

Failing to Validate the Links

There are two big challenges that organizations face when trying to use nonfinancial controls. First, nonfinancial controls are indirectly related to financial performance; the relationship is like a sequence of nonfinancial outcomes that cascade down to financial performance. For instance, (1) good employee recruiting leads to (2) satisfied employees, which leads to (3) an employee base that creates value, which leads to (4) satisfied customers, which leads to (5) profitable customer buying patterns, which lead to (6) good profitability. Yikes! You can see how these six nonfinancial outcomes might lead to good financial performance, but you can also imagine that it might be challenging to identify and manage the inputs to each step.

The second challenge is, once you’ve taken the step of identifying these linkages, to show that the linkages actually exist. However, while more companies are putting such models into place, few are collecting the information to test and validate the actual relationships in their organization. In fact, Ittner and Larcker found that less than a quarter of the firms that they surveyed actually did any formal validation of the nonfinancial model they had developed.

You can imagine the possible problems that might be created with such an unvalidated system. For one, the organization might be investing in all these steps, without any evidence of their effectiveness. Worse, some of the steps might actually lead to lower performance—unfortunately, without validation, managers just don’t know. For example, an organization might believe that better technology in a product leads to more sales. If this technology also leads to a higher-cost product, and customers are very price-sensitive, then the new technology nonfinancial control could lead to worse financial performance.

Failing to Set Appropriate Performance Targets

The third common area of weakness in the use of nonfinancial controls is somewhat related to the second. Our example with technology shows this relationship well. For instance, managers might not have validated the link between better technology and downstream customer purchasing preferences; or, technology might have been important, but only up to the point that it did not affect product price. So, while technology was a valid part of our nonfinancial controls, we also need to consider the appropriate level of technology—that is, set the right nonfinancial objective for level of technology, customer service, or whatever nonfinancial control is of interest.

You can imagine that a firm might want to set high goals, and therefore control, for such things as customer satisfaction or employee turnover. But you can probably also imagine what the costs might be of getting 100% customer satisfaction or zero employee turnover. At some point, you have to make some cost-benefit decisions unless your resources (time, money, etc.) are unlimited.

Failing to set appropriate performance targets can take on another form. In such cases, instead of setting inappropriate nonfinancial controls and related targets, the organization simply has set too many.Brown, M. G. (1996). Keeping score. New York: Productivity Press. This can happen when a new control system is put in place, but the old one is not removed. Just as often, it can occur because management has not made the hard choices about which nonfinancial controls are most important and invested in validating their usage.

Measurement Failure

We have seen so far that the first three common failings are (1) failure to tie nonfinancial controls to the strategy, (2) failure to validate the relationships between nonfinancial and financial controls, and (3) failure to set the appropriate nonfinancial control targets. The fourth failing is somewhat technical, but it also relates to validity and validation—that is, in many cases, an inappropriate measure is used to assess whether a targeted nonfinancial control is being achieved.

This can happen for a number of reasons. First, different parts of the business may assess customer satisfaction differently. This makes it very hard to evaluate consistently the relationship between customer satisfaction (a nonfinancial control) and financial performance. Second, even when a common basis for evaluation is used, the meaning may not be clear in the context of how it is measured. For example, if you created a simple survey of customer satisfaction, where you were scored on a range from 1 (satisfied) to 7 (unsatisfied), what does each individual score between 1 and 7 mean? Finally, sometimes the nonfinancial control or objective is complex. Customer or employee satisfaction, for instance, are not necessarily easily captured on a scale of 1 to 7. Now imagine trying to introduce controls for leadership ability (i.e., we know if we have strong leaders, they make good choices, which eventually lead to good financial performance) or innovativeness (i.e., cool products lead to more customer enthusiasm, which eventually leads to financial performance). Such intangibles are extremely difficult to measure and to track.

Use Nonfinancial Controls

As we mentioned earlier in this section, the delayed and historic nature of financial controls makes it risky to rely on them alone. Step back and reflect on the organization’s strategy, then pick one or several nonfinancial controls such as customer or employee satisfaction as a starting point. It is critical that you start with a conceptual model using simple boxes and arrows in terms of what nonfinancial control leads to another, and so on.

The following figure shows a working model of these relationships for a retail store that sells unique products. This leads us to our second solution.

Figure 15.7 Sample Mix of Nonfinancial and Financial Controls

Tie the Controls to the Strategy

Be sure to confirm that whichever nonfinancial controls are in place, they reflect and reinforce the unique strategy of the organization. This also should remind you that, if the strategy ever changes, you should go back and revalidate the links between the nonfinancial controls and the strategy. For instance, in our retail store example, part of the strategy is to sell unique products, which means that employees with particular work experience and education may provide better customer service than inexperienced employees. If the store changed its strategy to sell more generic products, however, it might not need such experienced or educated employees anymore.

Validate the Links Between Nonfinancial and Financial Controls

As you recall, organizations often use more than one nonfinancial control with the assumption that they cascade down to bottom-line financial performance. Of course, when there are fewer nonfinancial controls, it is easier to detect relationships among them. Regardless, with information collected about the controls, management must seek to use simple statistical techniques to verify the causal relationship between one control and another, and eventually financial performance. For instance, if nonfinancial controls were functioning as assumed, you might find that when employees are more satisfied, customers are more satisfied, and when both are more satisfied, more higher-profit-margin products are sold. If such relationships can’t be proved, then managers must revisit their choice of nonfinancial controls.

Set Appropriate Performance Targets

Extending the prior example, you would want to be sure that you set employee and customer satisfaction control targets appropriately. Assuming that you validated the linkages, while it might be nice to reach 100% satisfaction levels across employees and customers, it might not be cost-effective. This does not mean that you abandon the use of such controls; instead you must determine whether 90% satisfaction (or some other number) still leads to greater product sales.

Validate the Performance Measures

Finally, make sure that what you ultimately measure fits well with the control objectives. For instance, with our retail store example, would you measure work experience by the number of years that an applicant has worked? Or would you want experience with a particular type of product or service? Similarly, with regard to education, you would want to make a choice as to measuring grade-point average, standardized test score, or major. As a reminder, this type of validation is relevant to nonfinancial and financial measures alike. For instance, if our hypothetical store’s sales are growing, but profitability is going down, then we would want to figure out why these financial controls aren’t painting the same picture. For example, it might be that we’ve hired more salespeople, who help us sell more, but that we are not selling enough to cover the additional costs of the added people’s salaries. These examples should help you see the point about using the right measure.

Define Value from the Customer’s Perspective

The first core principle in the Womack/Jones lean framework is that value must be defined and specified from the customer’s perspective. While this seems simple enough, it requires much more than high-sounding, generic statements. To be meaningful, value must be defined in terms of specific products. This means that managers must understand how each specific product meets the needs of specific customers at a specific price and at a specific time.

Describe the Value Stream for Each Product or Service

The second core principle of lean is to describe the value stream for each product or service (or, in some cases, for groups or families of similar products). The value stream is the set of activities that the business is performing to bring a finished product to a customer. It includes both direct manufacturing activities and indirect activities such as order processing, purchasing, and materials management. Developing a detailed description or map of each value stream usually reveals huge amounts of waste. It enables managers to identify which value stream activities add value to the product, which activities add no value but cannot be immediately eliminated for various reasons, and which activities create no value and can be immediately eliminated (or at least reduced substantially).

Create Flow in Each Value Stream

The third essential principle of lean is embodied in the word flow. When a value stream has been completely described as unnecessary, non-value-adding activities have been eliminated, the basic idea of flow is to arrange the remaining activities sequentially, so that products will move smoothly and continuously from one activity to the next. However, flow means more than ease of movement. Flow is the lean principle that directly challenges the traditional “batch-and-queue” model of manufacturing, where people and equipment are organized and located by function, and products (and component parts) are manufactured in large batches. Lean organizations strive to improve flow by reducing the size of production batches, and in the process, they increase flexibility and lower costs.

Produce at the Pace (Pull) of Actual Customer Demand

Producing at the pace or pull of actual customer demand is the fourth key principle of lean. One of the greatest benefits of moving from traditional batch-and-queue manufacturing to continuous flow production is that lead times fall dramatically. Reduced lead times and increased flexibility mean that lean organizations can respond to actual customer demand rather than attempt to predict in advance what that level of demand will be. This allows lean organizations to substantially lower both finished goods and work-in-process inventories.

Strive to Continuously Improve All Business Operations

The fifth core principle of lean is continuous improvement, expressed in Japanese by the word kaizenThe Japanese term for continuous improvement.. Companies that implement lean adopt the mind-set that it is always possible to improve any business activity, and they regularly conduct kaizen events throughout their organizations to improve specific processes or operations. Today, Toyota is recognized as one of the most “lean” business enterprises in the world. Even more daunting, and humbling, is the fact that Toyota is still striving to improve.