Doi: 10. 1016/S1751-3243(07)03003-9 Conceptual Foundations of the Balanced Scorecard

Robert S. Kaplan
Volume 3
1258
markets theory from the sand early s (Fama,
1971). Economists also introduced principal–agent theory
(
Jensen-Meckling, 1976
;
Harris-Raviv, 1979
;
Holmström,
1979
;
Grossman-Hart, 1983
) to formalize the inherent con ict of interests between hired executive teams and the companies ’ dispersed shareholders (owners. The principal–agent adherents urged companies to provide more fi nancial incentives to senior executive teams, especially incentives based on fi nancial performance, the typical
“ outcome ” measure assumed in principal–agent models. Effi cient market research suggested that stock prices continually re ected all the relevant public information about companies
’ performance, and that executives compensation could be better aligned with owners ’ interests through expanded use of stock options and other equity rewards (
Jensen-Meckling, 1976
;
Fama-Jensen,
1983)
. Ina similar vein, some argued for aligning compensation to better accounting surrogates of stock market performance, especially residual income under its new name, economic value added ( Stewart, 1991 )
The s saw a huge increase in the link between executives ’ pay and incentives to fi nancial performance. For the fi nancial economists at the vanguard of this movement, the idea of senior executives paying attention to non nancial performance metrics was close to blasphemous. As Michael Jensen (2001)
, a leading fi nancial economics scholar, has stated
Balanced scorecard theory is fl awed because it presents managers with a scorecard which gives no score—that is no single-valued measure how they have performed. Thus managers evaluated with such a system … have noway to make principled or purposeful decisions. I obviously agree with Jensen that managers cannot be paid by a set of unweighted performance metrics. Ultimately, if a company wants to set bonuses based on measured performance, it must reward based on a single measure (either a stock market or accounting-based metric) or provide a weighting among the multiple measures a manager has been instructed to improve. But linking performance to pay is only one component of a comprehensive management system.
Consider an airplane where passengers contract with the pilot fora safe and on time journey. One can imagine an airplane cockpit designed by a fi nancial economist. It consists of a single instrument that displays the destination to be achieved and the desired time of arrival. Alternatively the pilot is given a more complex navigation instrument where the movement of the needle represented a weighted average of estimated time to arrival, fuel remaining, altitude, deviation from expected fl ight path and proximity to other airplanes. Few of us would feel comfortable fl ying in a plane guided only by the single instrument, even though the incentives of the pilot and the passengers fora safe, on time arrival are perfectly aligned. Incentives are important, but so also are information, communication and alignment.
1.4. Uncertainty and Multi-period Optimization
Many of the principal–agent models developed by economists and fi nance scholars are single-period, in which therms output is revealed at the end of the period and no further managerial (agent) actions are required. In these cases contracting on output, such as measured fi nancial performance, can be optimal. Alternatively, if fi nancial performance measured by end-of-period stock price or economic value added is a complete and suffi cient statistic for the value managers have created during the period, then incentive contracts based on stock prices or economic value added can also be optimal. But many of the actions that managers take during a period (such as upgrading the skills and motivation of employees, advancing products through the research and development pipeline, improving the quality of processes and enhancing trusted relationships with customers and suppliers) are not revealed to public investors, so that their implications for fi rm value cannot be incorporated into end-of-period stock prices. While managers may know the amount they spent on enhancing their intangible assets, they may also have little idea, in the short-run, about how much value they have created. And, certainly, such value increases (or decreases if the expenditures do not generate future value in excess of the amount spent) do not get incorporated into the end-of-period stock price or residual value (economic value added) metric. Dynamic programming teaches us that the optimal actions in the fi rst period of a multi-period model are far from the optimal actions in the fi nal period. Managers attempting to maximize total shareholder value over, say, a ten-year period cannot accomplish this goal by optimizing reported fi nancial performance or stock price, period-by- period. The balanced scorecard recognizes the limitations of managing to fi nancial targets alone in short-term horizons when managers are following a long-term strategy of enhancing the capabilities of their customer and supplier relationships, operating and innovation processes, human resources, information resources, and organizational climate and culture. But, because the links from process improvements and investments in intangible assets to customer and fi nancial outcomes are uncertain (recall the
fi nancial problems of several of the early excellent quality companies, the balanced scorecard also includes the outcome metrics to signal when the long-term strategy appears to be delivering the expected and desired results.

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