By Curtis D. Frye

Developing a budget often entails months of work, a fair amount of negotiating savvy, and reliance on past performance to justify present budget requests. Difficulties arise when executives determine budgets by using only a few financial measures, such as corporate profitability and stock price. As a result, budgets often don't help managers execute a company's goals in areas not governed by finances, such as customer satisfaction, process efficiency, innovation, and employee retention. Executives require a better-defined system upon which to base their budgeting decisions.

One way to improve the budgeting process is to use the balanced scorecard, a performance management method developed in the 1990s by Harvard professor Robert Kaplan and management consultant David Norton. The balanced scorecard identifies and measures key performance indicators (KPIs), which are statements that define a measurable action and align not only with a company's financial performance but also with all of the company's goals. When you link KPIs to specific budget requests, you can identify how money is allocated to achieve company goals.

What are balanced scorecards?

Balanced scorecards measure company performance in four broad areas, which are known as perspectives: customer, internal business process, learning and growth, and finance. Company executives and managers link each perspective with one or more KPIs. These action statements help managers across an organization translate corporate strategy into tangible objectives and measurements.

The following table summarizes the four perspectives of a balanced scorecard, along with examples of key performance indicators.

Creating effective KPIs

What makes an effective KPI? David Parmenter of Waymark Solutions, a performance-management company, observes that to be effective, KPIs must be:

• Measured daily or continuously.
• Acted upon by the CEO and the senior management team.
• Well understood by the staff, who also know how to take effective corrective actions.
• Assigned to a responsible individual or team that can be held accountable for failures.
• Relevant to the company's core critical success factors and balanced scorecard perspectives.
• Catalysts for improved performance; that is, when a KPI trends positive, the improvement causes improvements in other measured areas.

The final point is vital to implementing balanced scorecards effectively. Consider a company with a KPI requiring that 98% of payments to vendors be processed within seven days of receiving a valid invoice. Unscrupulous employees in the payment department could reject a percentage of valid invoices to reduce their workload and make the KPI target easier to reach. The department meets the goal of the KPI, but it decreases customer satisfaction because of the invoice "mistakes." To solve this problem, the company should have a KPI requiring a high level of customer satisfaction for the payment department. Using customer satisfaction ensures that the department doesn't meet the payment-processing KPI through artificial means.

Types of KPIs

But how do you decide what to measure? It all depends on your organization's strategy. In their 1996 book The Balanced Scorecard  (Harvard Business Press), Robert Kaplan and David Norton distinguish two types of performance measures:

• Diagnostic measures   These measures evaluate whether the organization is working within acceptable operating parameters. Diagnostic measures include such factors as cash on hand, burn rate for project budgets, department staffing levels, and available warehouse space.
• Strategic measures   These measures gauge how effectively the organization competes within its environment. Examples of strategic measures include increasing corporate cash on hand by 15% at the end of the next fiscal year or reducing warehouse space by 20% by using just-in-time delivery practices.

Cascading KPIs

Implementing balanced scorecards correctly requires high-level executives to take a hard look at their business processes to determine which activities add value and which don't. In turn, managers at all levels need to measure the processes they control to ensure that their groups are working toward the company's strategic goals.

In Balanced Scorecard Step-by-Step (John Wiley and Sons, 2002), management consultant Paul R. Niven describes how cascading balanced scorecards can align KPIs from top to bottom within an organization. Niven recommends that after top-level executives in an organization create a master balanced scorecard, each business unit creates its own balanced scorecard. Business unit managers make sure that each KPI they use in their balanced scorecard relates to a measure or goal on the higher-level scorecard.

Niven stresses this point: If a KPI on a lower-level balance scorecard doesn't help the organization meet an overall goal, the lower-level KPI isn't appropriate and needs to be refined or removed.

Developing budgets by using KPIs

One of the fundamental assumptions of a balanced scorecard system is that managers must relate all of their budget requests to measures on the scorecard. For example, employees in a state government organization that is charged with reducing drug abuse could use cascading KPIs to justify their budget requests in terms of the organization's overall goals.

A sample budget request, including the organization's overall KPIs and a business unit's KPIs, appears in the following table.

This balanced scorecard reflects a government organization, but the corporate budgeting process is similar. Corporate managers should be required to show how their requests map to specific KPIs. If the company has cascaded the balanced scorecards correctly at all levels of the company, it will be easy to determine how each request helps the company meet its overarching strategic objectives.

Creating effective KPIs that measure company performance is one of the most important tasks that managers can do this year to create success in future years. And linking KPIs to budget requests ensures that managers allocate money to activities that relate directly to a company's strategic goals.

About the author   Curtis D. Frye is an industry analyst and author of Microsoft Office Excel 2003 Step by Step and several other books from Microsoft Learning.