Identifying Metrics with Strategic Business Impact
Step one: Understand the difference between financial and managerial accounting
- By Richard MacLean
- Apr 01, 2005
Everyone wants metrics: first it was the regulatory agencies; now it is a myriad of stakeholders, watchdogs, and investment analysts. As companies struggle to satisfy these external demands, they may be overlooking the true indicators of future competitive performance. A robust metric set consists of not just what stakeholders want but what is needed to run the business profitably. Identifying the right metrics requires a strategic plan and a set of performance indicators that monitors progress against the plan. Here are some suggestions on how to go about this.
Initially a trickle in 2000 but currently at the flood stage, corporate watchdogs and investment analysts are requesting various metrics on corporate social responsibility. What is the right metric set to respond to all of these demands? This is a question that I am frequently asked. But, it is the wrong question. The strategic question should be, "How can I best manage for competitive advantage and what metrics should I use to track progress?" To understand why, we first need to examine the difference between financial and managerial accounting.
Financial accounting keeps the books straight for the government regulatory agencies, such as the U.S. Securities and Exchange Commission (SEC), and reports the business results in standard formats for shareholders and investment analysts. Managerial accounting is all about running the business for profit and growth. An investor may be keenly interested in current profits, but the plant manager frets over the reject rate for widget production. No one at the SEC demands that metrics for widget rejections be kept but, ultimately, it is a good indicator of whether the business is doing well or headed for the sewer.
Of course, all these metrics interrelate in one fashion or another. However, the key point is that management uses a separate set of metrics, generally not externally reported, to keep the business on track. In many respects, these are the really important metrics -- the confidential ones -- that predict how well a business will do in the future. The essence of this public/private metric set was captured by the "balanced scorecard" popularized by Kaplan and Norton. What these authors recognized is that an obsessive focus on narrow endpoints, such as quarterly profits, is not a sufficiently robust indicator to run a business over the long haul. This fact was brought into dramatic focus with companies such as Enron, which looked great to investment analysts right up until the meltdown.
The first environmental, health, and safety (EHS) metrics grew directly out of regulatory agency monitoring and reporting requirements. Environmental metrics were all about emissions, reportable spills, fines, inspections, and notices of violation. Safety and health metrics grew out of the OSHA log, exposure limits, or insurance tracking needs (e.g., worker compensation). The recent demand for corporate responsibility disclosure resulted from externally driven issues (e.g., the child labor practices of Nike's subcontractors). In other words, it has been all about "financial accounting" metrics (i.e., reporting what stakeholders want or require).
The first corporate environmental reports were prompted by the seemingly endless stream of bad news about companies behaving callously toward the environment in the 1980s. These reports gradually were expanded to include health, safety, and community issues. By the late 1990s, the Global Reporting Initiative and other corporate reporting guidelines were used to urge companies to further expand their reporting to include social responsibility metrics. It is this universe of stakeholders asking for information and companies wanting to tell their story in a positive light that drives so much of the attention on metrics and reporting today.
But, what about the metrics that are needed to run the business competitively -- you know, the "management accounting" metrics? Therein lies the big disconnect that has profound implications at several levels. At its most obvious level, EHS professionals can become so myopically focused on the usual suspects e.g., emissions, notices of violation, fines, lost time injury rates (LTIR), reportable spills, etc. that they completely overlook the essential metrics for running a profitable business. External stakeholders are interested in the "bottom line" -- the equivalent of profit and loss (P&L), return on investment (ROI), and the myriad of other financial metrics. To them, metrics are about outcomes and impacts; they may have little interest in or understanding of the internal workings of corporations. Do you use child labor? What are the emissions? Show me the results!
But at a more profound level, business managers (who are some really bright individuals) quickly figure out that if this environmental, health, safety, and social responsibility (EHS & SR) metric set is the primary indicator of what is significant, they easily can conclude that this stuff will have no material impact on the business. Sure, they might glance at them from time to time. Sure, they want to achieve excellence, do well and protect employees and the environment. But what is the strategic business value? The implied or expressed marching orders are: "Keep this under control and in compliance at a minimum cost."
Before you go totally ballistic over that last paragraph, ask yourself this: How many companies went bankrupt because their LTIR was a little out of whack or their Toxic Release Inventory (TRI) numbers were not the greatest? On the other hand, how many companies went bankrupt because they wound up using (and abusing) the wrong raw material? (Hint: Think asbestos.) Yet, how many companies have metrics that track the robustness of their raw material's due diligence practices? (Hint: Think of the primary justification for the European Union's proposed regulatory framework for chemicals, called REACH, which stands for Registration, Evaluation, and Authorization of Chemicals.)
To be fair, outcome indicators such as LTIR can be of key strategic importance to a corporation. For example, Volvo would be in a head-on collision if a product boycott were initiated because its cars -- advertised as the world's safest -- were produced in factories with the worst industry safety records. The stakeholders may track the LTIR, a lagging indicator, but what should Volvo's management be tracking? They need to be aware of the management accounting metrics such as safe behavior observations, training programs, safety awareness, safety employee suggestions/input, and other leading indicators. As the driver says, "I don't steer the car by looking out the back window."
The preceding illustration is an obvious example, but for most companies the question of significance is a lot more ambiguous. Few companies tie their raison d'être into a social responsibility metric. Yet most are sensitive to product boycotts or other factors in the EHS & SR universe. For example, some companies have contractual requirements that are linked to specific performance parameters (e.g., compliance, ISO 14001 certification, etc.). These must be met or the business is impacted materially. Business management can readily understand the significance of missing the mark on these performance parameters. But, again, there generally is not this degree of clarity over the metrics that matter.
The nearly universal approach to establishing a metric set is to: (1) gather the usual regulatory-focused metrics; (2) add a few more by reviewing non-governmental organizations (NGO) reporting guidelines such as those issued by the Global Reporting Initiative (GRI), and finally, (3) benchmark with others in the sector to gain reassurance that the set chosen is "right." Often the overall process is driven by the need to issue the annual report. This approach may be common, but EHS & SR professionals who use this method may put their company at a competitive disadvantage or even worse.
Blind adherence to any reporting or metric framework is of little value to either stakeholders or company managers. "When using the GRI Guidelines, most companies ignore one of the GRI's key expectations: that, in addition to standard metrics, each business should develop and track a unique set of indicators that reflects what is material to the company's long-term success," says Kathee Rebernak, principal of PenPower Communications LLC.1 This omission, says Rebernak, most likely reflects some combination of three sentiments:
(1) Reluctance on the part of senior management to invest in developing a strategic approach to EHS & SR issues -- one that regards EHS & SR activities as value-creating opportunities;
(2) Fear that, by omitting certain indicators of dubious relevance to its business, the company will incur the wrath of stakeholders seeking comprehensive (and potentially pointless) reportage; and
(3) Misinterpretation of the GRI Guidelines themselves, which state that, "Given the unique relationship of each organization to the economic, environmental, and social systems within which it operates ... GRI encourages reporting organizations to consult with stakeholders and develop an appropriate shortlist of integrated performance indicators to include in their reports."
By displaying to business management a metric set that really does not strategically matter, EHS & SR professionals, at a minimum, marginalize their potential contribution to the business. Defining the metric set should come at the end of a deliberate strategic process. The successful companies are the ones that can spot the potential issues (or opportunities) and gain control over them long before they either erupt or lose their competitive significance.
To arrive at a robust set of metrics that examines both strategic issues and opportunities, one needs to link EHS & SR emerging issues to the long-term business goals. By emerging issues, I'm not referring to the hot buttons such as child labor issues. Such issues are on everyone's radar scope and, hence, have transitioned to a "financial accounting" metric (i.e., a metric that must be monitored and controlled by everyone). To put it crassly, it is another cost of doing business ethically.
This process of defining emerging issues, defining and mapping EHS & SR strategy and linking this strategy to business goals is something with which executive management can readily identify. After all, this process is essentially what other functional areas do. The preceding description is a bit cryptic so an actual case study may be illustrative.
Case study: Schering-Plough
In general, the EHS & SR management systems within the health care industry have been at the leading edge of innovative programs, including those involving corporate disclosure. For example, companies such as Baxter International, Bristol-Myers Squibb, and Novo Nordisk have ranked high within surveys of the top global reporters.2 It is easy to understand why this sector excels: public trust in the brand is paramount.
Schering-Plough is an $8.3 billion dollar global health care company providing leading prescription (e.g., Vytorin, Zetia, Peg-Intron, Clarinex, Remicade), consumer (e.g., Claritin, Afrin, Dr. Scholl's, Coppertone), and animal health products. In many respects, the methodology of its management system is not remarkable, following the general outline of ISO 14001 -- with one notable exception. The planning step is not the all-too-common project planning process, but a detailed management process carefully linked to the strategic planning process for the corporation.
The EHS strategic planning process starts with the Corporate Environmental and Safety Council (CESC), which provides key input on the overall business goals and vision for EHS. The council is made up of ten members from the business executive team (vice president or higher), chaired by one of the business executives, and supported by the vice president, Global Safety and Environmental Affairs (GSEA).
The CESC, together with input from others in executive management, formulated the long-term strategy of where the business wants to be vis-à-vis EHS and ensures its alignment with the company vision, "To earn trust, every day." Nine broad-based, strategic objectives were formulated for the 2005-2007 planning cycle. Gus Moffitt, vice president, GSEA, worked with his staff to develop the specific tactical plans to achieve the goals. The strategic plan then was evaluated by the Environmental, Health, and Safety Leadership Council consisting of senior EHS managers from the business units and corporate, plus external subject-matter experts (including yours truly).
Our job was to test the strategic plan to determine if it could deliver the objectives as required by the business. First, we developed two scenarios: a most probable case and a worst-case scenario. The EHS strategy then was mapped using the recently developed business tool "Strategy Maps" by Kaplan and Norton.3
The exercise conclusively verified that the initial plan, as envisioned, would easily handle the issues likely to occur over its five-year horizon. It also revealed that the plan may not be sufficiently robust enough to counter certain low-probability, but high-impact issues. The evaluation brought to light that the key performance indicators initially selected did not contain certain process-monitoring metrics that could be used to monitor the progress of identifying and handling the most significant business impacts. Corrective action steps then were discussed and implemented to make the plan more dynamic and to identify the metrics that have real significance to the business.
Predicting the future
This description is purposely vague because it covers the strategic stuff; the details are confidential.4 Much of this analysis effort revolved around testing Schering-Plough's plan against future outcomes. While it may be possible to predict tomorrow's weather, predicting very specific issues and events five or ten years from now is impossible. So are planning efforts such as this one bogus? Not at all.
One cannot ever know the details, but it is possible to examine the current forces in play, possible future drivers and key markers to look for along the way. This is the essence of scenario development, but a detailed discussion of the techniques is beyond the scope of this article. What I can offer is an example that may serve to illustrate the principles.
You may have noticed that nearly every alcoholic beverage ad now contains some warning about "responsible drinking" or some such message. Why? There is no major, ongoing litigation against the alcoholic beverage industry. Is this some sort of feel good, social responsibility gesture? Not at all.
This industry understands full well that it could be another target for a series of class-action lawsuits just like the tobacco industry. Management may not know when and from what direction these attacks may come, but if they had continued in the same advertising mode as in past decades, they most likely would be under one or more deep pocket raids that could have a material impact on their industry. In other words, these attacks are a likely future scenario and the industry is essentially "inoculating itself" by taking defensive actions.
The metrics that matter in this instance are those that track these responsible drinking programs. The leader in this area, Anheuser-Busch Companies, devoted two pages to the subject of responsible drinking in its most recent Environmental, Health, & Safety Report.5 What is significant about Anheuser-Busch is that it was one of the first companies in that industry to begin this effort back in 1982. Again, the competitive advantage is gained by being an early predictor of how future events will unfold and then linking the EHS & SR strategic plan and key performance indicators that track progress with the business plan.
I sometimes get the impression that EHS & SR professionals are searching endlessly for the "right" metric set. Some day there may be such a set for "financial accounting" purposes. Several European Union countries already have mandated certain EHS & SR performance metrics be reported in a company's annual financial report. One Report™ (first announced in April 2004) could, I suppose, grow into a widely used set of metrics.6
But what do these predominantly lagging performance indicators have to do with running a business competitively? A single, universally reported set would facilitate comparisons among similar businesses. Company-to-company comparisons would initiate societal and peer pressure to improve the numbers akin to the aftermath of the release of the first TRI numbers. But as long as these metrics are tracked and performance is "kept under control," these metrics may have little material impact (or interest to executive management).
There is, however, a spectrum of leading indicators that may track issues material to many companies. These have been largely overlooked in the rush to get the usual suspects reported to external stakeholders. This "managerial accounting" set is derived from the strategic planning process and tracks issues or opportunities that may be on the horizon. It takes a focused effort to determine what these may be for your company, but the effort may yield results that provide a truer identification of the potential contribution of EHS & SR to long-term business success.
1. PenPower Communications supports corporations in writing EHS&SR reports, www.penpowercommunications.com.
2. See, for example, United Nations Global Environmental Programme and SustainAbility's series on reporting, The Global Reporters, 2000 and 2002.
3. R. Kaplan and D. Norton, Strategy Maps -- Converting Intangible Assets into Tangible Outcomes, Harvard Business School Press, Boston, 2004.
4. Schering-Plough 2003 Safety, Health, and Environment Report. (The author reviewed the draft of this article with the company prior to publication.)
5. Available at www.abehsreport.com/docs/ABI-EHS_site_2004.pdf, accessed 1/25/05.
6. Available at www.one-report.com, last visited 1/25/05.
This article originally appeared in the 04/01/2005 issue of Environmental Protection.