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1998 International System Dynamics C onference
Balanced Strategies for Balanced Scorecards:
The Role of System Dynamics in supporting Balanced
Score Cards and Value Based Management"
Eric Wolstenholme,
Professor of Business L earning, Leeds Business School and Director
COGNITUS
Abstract
This paper will describe the potential of system dynamics models to support
balanced score card and value based management initiatives in business.
Balanced scorecards are being used by an increasingly large range of
companies to develop performance measurement thinking outside the pure
finance area. They have created an awareness of the need for companies to
balance measures of financial performance with measures of internal processes,
customers and human resources. In particular, to recognise the intangible assets
of a company such as intellectual capital and competency.
These methods represent a first step in holistic thinking by recognising the
existence and importance of the full breath of operational aspects of business
and the idea of measuring future potential. Additionally, users of the approach
are increasingly recognising another systems concept - that such performance
measures are interdependent.
In systems terms, performance measurement is an important, but limited
application of systems thinking representing only one aspect of the feedback
cycle. System dynamics has an important role to play in extending this trend in
performance measurements to a full systems approach.
This paper will describe the way in which system dynamics is being used to
support the design, testing and use of balanced score cards, involving value
based measurements, centered on the use of models to relate today’s investment
and strategy decisions to tomorrow’s scorecards.
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The paper will also comment on this work as an excellent example of the way
in which the use of system dynamics in business can be rapidly accelerated by
integrating it into current semi-systemic management initiatives.
Introduction - New Wave Management Thinking
Many managers are recognising that there is an urgent need to gain better
perspectives of the operations and performance of their companies and
numerous ideas to facilitate improved understanding of complex organisations
are being developed. Traditional business school disciplines are being rewritten
and re-grouped into a new wave of management thinking. Recently defined
topics include: strategic management, total quality management, business
process re engineering, value based management, knowledge management,
balanced score cards, intellectual capital, competence management, brand
management, change management, financial engineering and business learning.
Whilst being very welcome these recent approaches to management are
severely lacking in tools and techniques to aid their development and
implementation and are being pursued independently in many organisations.
The common thread of all these approaches is that they try to take a new
perspective on organisational activities and, whilst no one approach captures
the whole management picture, each tries to link important elements of
management across organisations and to emphasise a future perspective. In
other words each, to differing degrees, takes a step towards a systems view of
management. Additionally, each recognises in its own way the concept of
value. Value is an elusive term in management, but is increasingly being
defined as future shareholder value and is being established as a key, global
performance indicator of success.
This paper will focus on the role of system dynamics in support of balanced
scorecards and value based management and also on the role of these methods
in promoting system dynamics.
Balanced Scorecards and Value Based Management
Origins
The concept of balanced scorecards arose as a result of the disappointing
results arising from many well intended initiatives associated with TQM, JIT,
ABC and BPR. The missing link (Kaplan and Norton, 1994) was the fact that
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these initiatives were often not measured against financial performance and
economic indicators, nor linked to the strategy of organisations. Breakthroughs
in performance require major change and that includes changes in the
measurement and measurement systems used by organisations. More
importantly is the idea that competitive, technological and capability-driven
futures cannot be accomplished merely by monitoring and controlling financial
measures of past performance, but need to be linked to visions and perceptions
of the future. This is the link with value based management.
Value based management is a method of exploring ways of measuring and
improving the performance of a company in terms of future free cash flow
across all its sectors (Dauphinais and Price, 1998; Price Waterhouse Cost
Management Team, 1997).
A number of methodologies are being developed for balanced score card. These
are supported by heavy data mining exercises and by system integration
implementations. Most implementations generally aim to derive and apply
measures in four, balanced categories. These are internal processes, customers,
learning/growth and finance. When value based management is linked with
balanced scorecards, future value becomes a key performance measure (See
Figure 1).
There are two significant concepts associated with balanced scorecards and
value based management which create a link with system thinking and
dynamics. These are the idea of thinking about the whole organisation, not just
one aspect of it and the idea of thinking of the future. These will be discussed
further in turn.
Thinking Across the Organisation
Thinking across the organisation means effectively thinking more broadly than
financial performance and recognising each individual operation and asset of
the organisation. There is a need to broaden out performance measurement to
include measures other than finance, particularly to cover a company’s
intangible and intellectual assets, such as such as high quality products and
services skilled employees, responsive internal processes and loyal customers.
It is very possible, for example, for a company to look good in financial terms
and yet be very poor in terms of intellectual capacity.
This spatial broadening of measurement across the corporation is effectively a
first, important step in developing a systems perspective of an organisation
which, by itself, has important possibilities. It has the potential to bring more
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recognition of non-financial parts of companies to the boardroom and, in
particular, to give greater recognition at this level to people assets. It also
forces thinking on the physics and operations perspectives of organisations in
general, rather than their financial equivalents. This, in tum, opens up the
potential for management to structure thinking about all processes in the way
they think about financial processes. That is, as balance sheet items. It is
possible to think of balance sheets composed of stocks of intellectual capital,
customers, products (and those in the pipe line).
Thinking about the F uture of the Organisation
Apart from thinking across all operations, there is a need to think about future
performance, rather than past achievements. A gain, it is possible for a company
to look historically healthy, whilst having little potential for the future. There is
therefore a need to have a shift in emphasis in time as well as in space. Future
thinking is being reflected in current work in value based management, where
performance measurement, albeit in financial terms, is being captured in the
discounted value of future free cash flow. This type of measurement provides
an interesting view of a company and, by the very nature of discounting,
applies a further systemic concept. That of weighting the short term, non-
linearly, against the long term.
Practical Problems in Applying BSC and VBM
There are a number of practical problems in using the forgoing ideas which are
only too familiar to system dynamics (Forrester, 1994; Wolstenholme 1990).
Firstly, performance measurement is only one element of a based feedback
control cycle and so how can it be possible to develop balance score cards in
isolation from developing and testing the policies and strategies which create
the measurements. Secondly, BSC and VBM thinking is only just recognising
that there are interconnections and trade offs between alternative
measurements. For example, downsizing can give excellent financial results
today, but create severe medium term shortages of, say, intellectual capital.
Thirdly, how can futures be designed without tools capable of testing the
behaviour and tradeoffs between alternative performance measures, strategies
and futures? Forthly, what types of balanced strategies are required today to
ensure balance scorecards tomorrow?
BSC, VBM and Feedback
BSC and VBM provide a natural and inviting home for applications of system
dynamics and system dynamics has long had the tools to study complete
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feedback cycles. The lever by which to connect system dynamics to BSC is
hence through building up the concept of feedback control from performance
measurement. Figure 2 shows such a cycle, which has been termed the value
cycle.
Here, the purpose of balanced measurement across all operations is seen to
provides the knowledge on which to create future strategic vision. The main
route to implementation of the vision is by the definition of strategies and
(re)investment of money to the operations, which it is hoped will eventually
create future performance, which will, in turn, be successful enough to provide
the means of reinforcing further growth. The balanced score card concept
allows a better audit of where a company is and might evolve to, but still leaves
a large gap in this cycle represented by the shaded areas in Figure 2. This is
concerned with how information today can be used to create the desired
performance of tomorrow.
Designing Balanced Policies for Balanced Scorecards
Figure 2 provides a clear role for system dynamics models to fill the gap and
allow testing of strategies across all operations, over time, allowing for the
enormously differing time factors associated with each operation. In order to
link directly with, but to extend balanced score card and value based
management thinking, models have been developed with sectors to reflect the
components of balanced score card thinking. Figure 3 shows the outline of such
a model reflecting, not only physical, but also soft processes and their inter
connectivity. Of particular interest here is the knowledge management concept
associated with the need to link individual knowledge and learning with
organisational knowledge and learning. Figure 4 shows the role of such a
model in the value cycle.
Practical Problems in Applying System Dynamic
This paper so far has emphasised the needs of balanced scorecards and value
based management that system dynamics can help to fulfill. However, system
dynamics also has its own needs that balanced scorecards can fulfill. Balanced
Scorecards and Value Based Management are gaining extensive use because
they relate to and satisfy specific management needs, namely comprehensive
performance measurement and future company design. System Dynamics on
the other hand suffers from the breadth of its own systemicity and it is not easy
for managers to relate their own activities to it. By using system dynamics
within other methodologies, to support and extend them, rather than to replace
them, its benefits can be more easily unfolded (Wolstenholme, 1997).
Linking BSC and System Dynamics Methodologies in Practice
Figure 5 shows a diagram of the steps in a typical application of the balanced
scorecard methodology. The general approach is to define the overall vision
then to work through perspectives, goals, critical success factors and to move
towards defining and testing key measures within each perspective; in this case
defined as financial, customer, internal processes, development and human
resources. The steps are essentially linear and much of the process towards
choice of measures evolves subjectively. There is often a need to severely
restrict the number of measures in each perspective and to give careful thought
to overlaps.
The scope to apply a system dynamics approach lies in three areas.
The first is to use a very generic model in the visioning stage across all
perspectives, to provide some insights into the nature of the processes in each
perspective, the ways in which they are/will be operated, the time scales
required to influence measures and the interactions between perspectives. The
second is to create specific sub models within each perspective which will
support within-perspective thinking. The third is to create a specific high level
model again across all perspectives to assess the magnitude of the trade-offs in
performance measures and hence shed some light on the most significant
measures. System Dynamics models can allow insights to develop and lead to
both the definition of alternative measures that may become more important in
the future.
Conclusions
This paper suggests that system dynamics modelling has much to offer the
growing field of balanced score cards and value based management. Experience
to date has indicated the types of contribution likely to be most important,
which revolve around the ability of system dynamics to move Balanced
Scorecards and Value Based Management activities from a first step in
systemic thinking to comprehensive systemic methods. It is also suggested that
the process will provide a platform for system dynamics methods to gain
greater acceptability in mainstream management thinking.
References
Kaplan R.S. and Norton D.P., 1996, The Balanced Scorecard, HBS Press, Boston.
Daupdinais W. and Price, C., 1998, Straight from the CEO, Nicolas Brearly, London.
Price Waterhouse Cost Management Team, 1997, CFO- Architect of the Corporation's
Future. Wily, Chicester.
Forrester. J.W. (1994), Industrial Dynamics, Productivity Press, Cambridge, Mass.
Wolstenholme E. F. (1990) System Enquiry - a System Dynamics Approach, Wiley,
Chichester.
Wolstenholme E. F., (1997), The Gap between System Dynamics and current Management
Practice, 1997 System Dynamics Conference, Istanbul.
Figure 1
Balanced Scorecard
_
INNOVATION/
FINANCE PEOPLE
_
VALUE
re
CUSTOMERS
copyright
Koa
COGNITUS
Figure 2 The Value Cycle faeries
Capital — Financial COGNITUS
Investment Assets —\
he. Intellectual
__w Performance *
S)* t
SJ A Value
om Operations
Performance
Investment Measurement
wy,
* Knowledge
Strategy :
* Learning
Vision <_—
Figure 3 An Outline System Dynamics Model cpyrign
to Support a Balanced Scorecard Initiative
COGNITUS
inrandd at market
internal processes —>/ |. | >
in training trained
people ———»/jj—_> |
intangible
— i L_]
assets intellectual property ecumitiilend knowledge
—pPp —p> ——> [| —
allies and
— jij
competitors
Figure 4. A System
Dynamics model
& filling a gap in the
value cycle
> —~
>
XN seranee
Investment PA
Oe
ty
* Knowledge
* Learning
Vision _ taal
SS COGNITUS
Strategy
Figure 5. The steps involved in a balanced
scorecard methodology
Cess
v
Perspectives oeroonr | Human |
v v
Strategic Goal Focused | Clarity |
Critical
Success
Factors
Key Measures
Testing
Implement
