CHAPTER 11 Corporate Performance, Governance, and Business Ethics SYNOPSIS OF CHAPTER Chapter 11 introduces concepts related to strategy implementation. The first section addresses the causes of poor performance, which occurs in some firms in every industry. Causes of poor performance include poor management, high costs, inadequate differentiation, overexpansion, shifts in demand, and organizational inertia. The chapter then suggests ways that firms can improve poor performance, such as changing leadership, changing strategy, or changing the organization. The chapter then describes the ways in which various stakeholder groups make contributions to, and receive benefits from, the organization, and how stakeholder support leads to high organizational performance. Managers don’t always act in the best interests of stakeholders, and this chapter uses agency theory to explain this difficulty and to suggest ways to overcome it. Next, corporate governance is presented, including boards of directors, compensation for principals, independently audited financial statements, the threat of corporate takeover, strategic control systems, and incentive systems. Each of these governance mechanisms is described in detail, and the costs and benefits of each are provided. The final topic of the chapter is ethics. Business ethics are defined and described. Then, suggestions are given to help improve an organization’s ethical performance. TEACHING OBJECTIVES 1. Introduce concepts about strategy implementation. 2. Describe reasons for poor performance and suggest ways to improve poor performance. 3. Identify important stakeholder groups, show how they contribute to and benefit from the firm, and describe how stakeholders affect corporate profitability. 4. Familiarize students with agency theory, and use it to explain why a misalignment of interests exists at every level of the organization. 5. Present information about various corporate governance mechanisms. 6. Define and describe business ethics, and show how managers can improve a firm’s ethical performance. OPENING CASE: THE FALL OF ENRON Enron was one of the world’s largest energy traders in 2000; by 2001, it was bankrupt. Enron fell so rapidly because it held $27 billion in hidden debt, with most investors and regulators completely unaware of the firm’s true financial position. The partnerships were set up in compliance with regulations, but they were a way of boosting Enron’s apparent profitability for the enrichment of a few corrupt executives. These top managers reaped millions from the sale of their Enron stock, then abruptly left the firm. It seems clear that a few managers were deliberately misleading investors. And the company’s independent auditor, Arthur Andersen came under suspicion for its role in the debacle and has also declared bankruptcy. More than one employee attempted to “blow the whistle” on the suspect transactions, but Enron management took no action. The outcome? Thousands of lost jobs, billions of dollars in lost shareholder wealth. Copyright © Houghton Mifflin Company. All rights reserved. 132 Chapter 11: Corporate Performance, Governance, and Business Ethics Teaching Note: The Enron case highlights the importance of good strategic control and other corporate governance mechanisms. Enron’s board, its auditors, and its bankers have all been held partially responsible for the mess. However, poor ethics seems to be at the heart of it all. Management was apparently committing deliberate fraud, although a legal outcome for the case may be years away. This is a tale of governance and ethics gone horribly wrong and provides a sobering note for students as they approach the topics in this chapter. LECTURE OUTLINE I. II. Overview A. This chapter examines the issues and factors that can prevent a company’s strategies from being implemented in a way that will lead to superior profitability, along with strategies for raising performance. B. Corporate governance and business ethics are two tools that can be used to ensure that managers act in the best interests of stakeholders. The Causes of Poor Performance A. Virtually every industry contains some firms, and in some industries, many firms, that are not profitable—that is, whose returns do not exceed their cost of capital. B. There are six causes of persistent poor performance that are found in many organizations. When organizations are declining, typically they are experiencing several of these factors simultaneously. 1. Poor management is a cause of persistent poor performance, and it covers a variety of problems, from neglect to outright incompetence. a. Poor managers are too dominant, autocratic, or overly-ambitious. b. Another characteristic of poor managers is trying to do too much by themselves, rather than delegating appropriately. c. Other characteristics include the lack of a succession plan, failure by the board of directors, or a lack of strong middle managers. d. Poor managers sometimes execute strategies that are designed to enrich themselves, rather than the firm’s shareholders. 2. Another hallmark of poorly-performing organizations is a high cost structure, which is often due to low labor or capital productivity. a. Low labor productivity stems from union work restrictions, lack of investments in laborsaving technology, or lack of employee incentives. b. Low capital productivity is caused by failure to fully use the company’s fixed assets, such as occurs when a firm has low economies of scale or holds too much inventory. c. Low productivity is usually tied to deeper problems, such as lack of accountability for financial returns. 3. Companies whose products lack adequate differentiation will suffer from low performance. a. Poor product quality or lack of attractive product attributes contributes to lack of differentiation. b. Lack of differentiation can usually be traced to deeper problems, such as a failure to implement cross-functional product development teams or failure to implement quality improvement processes. 4. Another contributor to poor performance is overexpansion, which occurs when a company tries to move into too many diversified industries too quickly. a. Overexpansion often results when an autocratic CEO tries an empire-building strategy, with poorly conceived diversification leading to disappointing results. b. Overexpansion also tends to raise a company’s debt burden rapidly, and that may be untenable, particularly if economic conditions decline. 5. Poor performance arises when industries experience a structural shift, that is, a shift in demand that is permanent, often brought on by technological, economic, or social changes. a. These shifts revolutionize industry dynamics and threaten existing firms (although they also create opportunities for new entrants). b. Structural shifts are difficult to predict and the entrance of new competitors creates significant upheaval for existing firms. 6. Organizational inertia also plays a role in poor performance, because it slows the firm’s response to changes and problems. Copyright © Houghton Mifflin Company. All rights reserved. Chapter 11: Corporate Performance, Governance, and Business Ethics a. III. IV. 133 The existing distribution of power within a firm causes individual managers to resist change, leading to organizational inertia. b. Deeply-held values and norms can provide benefits to the firm, but they can also be very hard to change, contributing to inertia. c. Managers’ preconceptions about their firm’s business model may go unchallenged, creating an inability to see the need for change, and thus leading to inertia. Strategic Change: Improving Performance A. Most companies that are attempting to improve performance change leadership. 1. The old leaders are seen as contributing to the problems, whereas new leaders from outside the company will bring in fresh perspectives and ideas, overcoming preconceptions. 2. The new leaders must be able to make difficult decisions, motivate and listen to others, and delegate when appropriate. B. Changing strategy is another common tactic to improve performance. 1. Strategy must first be evaluated and redefined, if necessary. For a single-business firm, redefining the strategy means changes in the generic business-level strategy. For diversified firms, it means re-evaluating and balancing the firm’s portfolio of businesses. 2. Next, a firm must divest or liquidate any assets that do not contribute to the new strategy. The resulting cash can be used to improve the remaining operations. 3. Then a firm should focus attention on improving efficiency, quality, innovation, and responsiveness to customers. (This was described in detail in Chapter 4.) This will involve activities such as laying off excess employees, reengineering processes, and introducing total quality management programs. 4. Acquisitions can also be used to improve performance, if the acquired company strengthens the firm’s competitive position in its core operations. C. Firms can also improve performance through a change in the organization. 1. The first step in organizational change is to “unfreeze” the company, that is, to shock the employees in such a way that they understand and agree with the necessity for change. a. Reorganizations or plant closings are often used as a way to signal the need for change to employees. b. The commitment of senior managers—as evidenced by both their words and their actions—facilitates lower-level employees making the change. 2. After the organization is shocked into unfreezing, it can be moved into its desired state. a. Moving the organization requires actions, such as redesigning processes, reorganizing the structure, reassigning responsibilities, new control and reward systems, firing people who refuse to change, and so on. b. The changes must be substantial, in order to have an important impact on performance, and they must be rapid, to ensure success. 3. Refreezing, or making the new way of doing business the firm’s established practice, follows movement. a. Management education programs, hiring individuals whose values support the new state of the organization, and implementing consistent control and reward systems are all part of refreezing. b. Senior leaders must be consistent in their words and actions throughout the entire change and refreezing period. Also, they must be patient because changing an organization’s values and culture takes time. Stakeholders and Corporate Performance A. Stakeholders are individuals or groups with an interest, or stake, in a firm. Internal stakeholders include stockholders and employees at all levels. External stakeholders are all other groups, and typically include customers, suppliers, creditors, governments at all levels, unions, local communities, and the general public. Show Transparency 67 Figure 11.1: Stakeholders and the Enterprise Copyright © Houghton Mifflin Company. All rights reserved. 134 Chapter 11: Corporate Performance, Governance, and Business Ethics B. Stakeholders are in a reciprocal relationship with the firm, providing the organization with resources and expecting some benefit in return. 1. Each stakeholder group has a unique relationship with the firm. a. Stockholders provide funds and expect returns. b. Creditors provide funds and expect repayment and interest. c. Employees provide labor, skills, and ideas, and expect income, job satisfaction and security, and good working conditions. d. Customers provide sales revenues and expect products that provide value for money. e. Suppliers provide inputs and expect revenues and dependable buyers. f. Governments provide regulation and expect companies to adhere to the rules. g. Unions provide productive employees and expect income and other benefits for their members. h. Local communities provide local infrastructure and expect companies to behave as responsible citizens. i. The general public provides national infrastructure and expects the company to improve their quality of life. 2. Companies that neglect to satisfy the needs of one or more important stakeholder groups will find that the stakeholders withdraw their support, damaging the firm. STRATEGY IN ACTION 11.1: BILL AGEE AT MORRISON KNUDSEN Bill Agee was a manager with a troubled history—accounting overstatements made while he was chief financial officer at papermaker Boise Cascade, promoting a female colleague with whom he was having an affair while CEO of defense contractor Bendix. Agee became CEO of construction contractor Morrison Knudson (MK) in 1988, with a plan to update the firm’s assets and to pursue new contracts aggressively. The plan seemed to be working, but trouble signs soon appeared. Aggressive bidding led to low profits on large construction jobs, and most of the firm’s earnings came from risky securities trading. Employees became disgruntled over Agee’s selfpromoting style, firing of long-time top managers, and high compensation and perquisites. Finally, an anonymous letter to MK’s board of directors led to a full investigation. When financial mismanagement was revealed, Agee was ousted. Shareholder lawsuits caused MK to make a $63 million settlement, and Agee was required to return some of his severance pay and pension benefits. Teaching Note: Agee’s tenure at MK was a study in how to offend stakeholders. He was unable to effectively lead employees, and stockholders were displeased with MK’s poor performance, blaming him. C. D. A company cannot fully satisfy all of its stakeholders at the same time. To understand stakeholder needs and to develop effective strategies for satisfying those needs, companies use stakeholder impact analysis. 1. To begin a stakeholder impact analysis, a company must first identify stakeholder groups, along with their interests and concerns. 2. Next, a company must identify the claims that each stakeholder group is likely to make on the organization. 3. Then, a company must decide the relative importance of each stakeholder group, from the company’s perspective. 4. This process will result in an identification of some critical strategic challenges. 5. Based on this process, most firms identify the three most important stakeholder groups as customers, employees, and stockholders. Among stakeholders, stockholders’ position is unique because the stockholders are the legal owners of the firm as well as the providers of funds. Their unique position leads to an emphasis on satisfying the needs of this key stakeholder group. 1. The money provided by stockholders is called risk capital, because the stockholders are making a risky investment in the firm with no guarantee of returns or even the preservation of their original investment. 2. Because of their willingness to assume risk, managers are obliged to reward stockholders by pursuing strategies that maximize returns to them. 3. When employees become stockholders too, for example through employee stock ownership plans (ESOPs), the importance of maximizing stockholder return grows. Copyright © Houghton Mifflin Company. All rights reserved. Chapter 11: Corporate Performance, Governance, and Business Ethics E. 135 Companies can satisfy stakeholder claims by increasing profitability. 1. Managers can best serve the interests of stockholders (the most important group of stakeholders) by increasing profitability. a. Stockholders receive returns as dividends and as appreciation in share value. b. Increasing profitability (that can be measured by ROIC) tends to both increase the funds available for dividends and to drive up the value of the stock. 2. Profitability satisfies the claims of several other stakeholder groups, in addition to stockholders. a. Higher profits generate more funds for paying high salaries and offering more benefits to employees. b. Higher profits generate more funds for satisfying debt obligations to creditors. c. Higher profits generate more funds for philanthropic activities, which benefit local communities and the general public. 3. The cause-and-effect relationship between profitability and satisfying stakeholder claims shows that profitability must be the cause, leading to the ability to satisfy. a. If the relationship works in the opposite direction, where stakeholders must first be satisfied before the firm can be profitable, the results are overly high costs and no guarantee that the firm can bear those costs. b. Once a company is profitable, then it can satisfy stakeholders. In return, satisfied stakeholders provide more generously for the firm, which leads to further increases in profitability. Thus the process is a self-reinforcing cycle. See Figure 11.2 for a graphic depiction of the process. Show Transparency 68 Figure 11.2: Relationship Between ROIC, Stakeholder Satisfaction, and Stakeholder Support 4. Not all stakeholder groups are satisfied by high profitability. a. Suppliers want to sell to a profitable company, because it will pay for what it receives. Customers want to buy from a profitable company that will exist long enough to provide customer service and additional sales. However, neither group wants the firm to profit at their expense. b. Governments expect every company to make profits only within the limits set by law. The general public expects companies to profit in a manner consistent with societal expectations. c. Every stakeholder group disapproves of the unfettered pursuit of profit, if it leads to unethical or illegal behavior. STRATEGY IN ACTION 11.2: PRICE FIXING AT SOTHEBY’S AND CHRISTIE’S Sotheby’s and Christie’s, the two largest fine art auction houses in the world, were earning low commissions in the 1990s, as sellers negotiated simultaneously with both firms for the best rates. Sotheby’s CEO, Dede Brooks, secretly met with CEO Christopher Davidge of Christie’s, to establish together a fixed, nonnegotiable rate structure. This had the effect of illegally fixing prices and reducing competition. The deal was exposed, and the auction houses paid settlements to sellers that totaled $512 million, in addition to federal fines. The conspirators, and the chairmen that were their superiors, lost their jobs and received jail time or probation from federal courts. Teaching Note: In this case, illegal price fixing led to higher commissions paid by sellers. It also might have contributed to buyers paying higher prices, as sellers tried to recover some of their additional expenses. Finally, it was not in the best interests of shareholders, because the lawsuits and fines led to lower profitability. Use this case to spark classroom discussion by asking students to examine other times when corporations acted to either protect stakeholder interests or hurt their interests by acting unethically or illegally. Examples could include Exxon’s cover-up of the Valdez oil spill, Union Carbide’s Bhopal disaster, or Johnson & Johnson’s exemplary response to Tylenol tampering. After describing the facts of the situation, ask students to indicate how the corporation’s actions either helped or hurt stakeholders. Copyright © Houghton Mifflin Company. All rights reserved. 136 V. Chapter 11: Corporate Performance, Governance, and Business Ethics Agency Theory A. Agency theory looks at the problems that can arise in a business relationship when one person delegates decision making authority to another. It offers a way to understand why managers do not always act in the best interests of stakeholders. B. An agency relationship occurs whenever one person delegates decision-making authority to another. The principal is the person delegating authority, and the agent is the person to whom the authority is delegated. C. The agency problem is that principals and agents may have different goals, and therefore, that agents may act in ways that are not in the best interests of their principals. 1. Agents may do this because of information asymmetry, that is, because the agent almost always has more information about the resources they are managing than does the principal. 2. Thus, it is difficult for the principals to measure the agent’s performance or to hold them accountable for their performance. 3. To some extent, it’s impossible for a principal to know for sure whether the agent is acting in the principal’s best interests, and so the principal must trust the agent. 4. The principals also make efforts to monitor agents, evaluate their performance, and if necessary, take corrective actions. D. The agency problem exists in corporations, as stockholders (the principals) are the company’s owners, but they delegate decision-making power to the company’s managers (the agents). 1. Managers, like other people, desire status, power, job security, and income. They can use their decision-making authority and control over corporate funds to satisfy those desires at the expense of stockholders. This is called on-the-job consumption. 2. Boards of directors typically make executive pay decisions, in order to control expenses. However, CEOs can use their influence with the board to get pay increases. The historically high level of CEO pay in the U.S. can be attributed to this cause. a. CEO pay is rapidly increasing and is at the highest level it has ever been. b. CEO pay is rising more rapidly than workers’ pay. In 1980, the average CEO earned 42 times what the average worker did; by 1990, CEO pay was 400 times greater. c. CEO compensation is increasing, including stock options or other forms of indirect payment. For most CEOs, stock options are a far bigger part of their total compensation than is their base salary. d. CEO compensation doesn’t seem to be linked to corporate profitability; many CEOs of companies that posted an overall financial loss received large increases in pay for that same period. 3. To increase power, status, and income, a CEO might engage in empire building, that is, buying many new businesses to increase the size of the firm through diversification. a. Empire building, which is diversifying without an appropriate reason for doing so, reduces profitability, because funds are now used to pay the debt incurred to finance growth. Show Transparency 69 Figure 11.3: The Tradeoff Between Profitability and Revenue Growth Rates b. E. Too much growth too quickly also leads organizations to pay too much for acquisition targets, further depressing profits. The agency problem also exists in the relationship between higher-level managers and their lowerlevel subordinates. For example, a subordinate may withhold information to increase his pay or job security or get more than his unit’s fair share of organizational resources. STRATEGY IN ACTION 11.3: THE AGENCY PROBLEM AND THE COLLAPSE OF BARINGS BANK Barings Bank of England, a 233-year-old institution with a venerable history, was made bankrupt in 1995 by the actions of just one employee, 27-year-old Nick Leeson, of the firm’s Singapore office. Although young, Leeson was a trusted securities trader. However, his compensation and position within the firm were both based upon the profitability of his trades, encouraging him to take very high risks in exchange for potentially high returns (or Copyright © Houghton Mifflin Company. All rights reserved. Chapter 11: Corporate Performance, Governance, and Business Ethics 137 potentially high losses). At first his moves were profitable, but when the Nikkei stock exchange became more volatile, the losses began to mount. Leeson’ reaction was to bet bigger. His colleagues believed Leeson was using funds from a client, but in fact, he had used Barings’ own money to set up a trading account. Lack of controls and monitoring allowed the charade to continue until Barings had no money left. Leeson ultimately served jail time, and several other Barings executives lost their position, but the penniless firm was sold to ING, a Dutch bank, for $1. Teaching Note: Leeson exploited the information asymmetry that existed between himself and senior managers to pursue his own interests. Ask students to describe other situations that they are aware of, either from business or their own experiences, in which the agency problem was present. Ask them to answer these questions: “What led to the problem?”, “What was the outcome?”, and “How could the situation have been handled differently so as to reduce or eliminate the problem?” VI. Governance Mechanisms A. Governance mechanisms are put in place by principals to align agents’ incentives with their own, and to monitor and control agents. B. There are four main types of governance mechanisms. 1. U.S. and U.K. firms tend to rely heavily upon corporate boards of directors, elected by stockholders, to represent the interests of the stockholders. a. Boards of directors are charged with several responsibilities. (1) Boards of directors are legally responsible for the firm’s actions and act to oversee the actions of the firm’s CEO and top managers. (2) The board makes decisions about hiring, firing and compensating top corporate executives. (3) The board ensures that the audited financial statement, which is the primary reporting tool from managers to stockholders, presents a true picture of the organization’s health. b. Boards of directors are typically composed of a mix of corporate insiders and outsiders. (1) Inside directors are senior employees of the firm and are charged with bringing information about the company to the board. However, they are employees and their interests tend to be aligned with management. (2) Outside directors are not full-time corporate employees, and they are charged with bringing objectivity to the board. Full-time professional directors hold positions on several boards and do a good job, because their professional reputations are at stake. c. Many boards perform admirably, but some, such as that of Enron, do not. (1) One criticism of boards of directors is that insiders often dominate and therefore can manipulate perceptions. (2) Another criticism of boards is that many are dominated by the CEO, particularly when the CEO is also chairman of the board. When this occurs, the CEO may choose both the inside and the outside directors, who may feel loyalty to the CEO or allow the CEO to control the agenda. d. In recent years, boards of directors have been playing a more active role in corporate governance. (1) One reason for the enhanced oversight is the lawsuits that stockholders have filed against board members. In some cases, board members must pay damages out of their own pocket. (2) Another rationale for active boards of directors is the increasing number of institutional investors, such as the managers of large pension funds, that are putting their own employees on the boards of firms whose stock they own. (3) Other trends in increased vigilance include boards calling for CEO removal and an increase in outsiders serving as chairmen. 2. Another governance is stock-based compensation for principals. If agents are working under a pay-for-performance system, then it will be in their best interests to increase profitability. a. The most common pay-for-performance grants stock options to managers, which give them the right to buy shares at a predetermined price (called the strike price) at some Copyright © Houghton Mifflin Company. All rights reserved. 138 Chapter 11: Corporate Performance, Governance, and Business Ethics 3. point in the future. Typically, the strike price is the trading price at the time the option was granted. b. However, when CEOs exercise their options several years later, their compensation increases dramatically. Some claim that stock options are too generous, especially when the strike price is set deliberately low. c. Another criticism of stock options is that issuing more shares of stock dilutes the equity of the existing stockholders. Some critics would like options to be shown on financial statements as an expense, but at this time, companies are not required to do so, although some do so voluntarily. Table 11.1 shows the significant impact that this change in accounting policy would have on several firm’s stated earnings. A third governance mechanism is the use of independently audited financial statements. a. Publicly traded companies are required to file with the Securities and Exchange Commission periodic statements that comply with Generally Accepted Accounting Principles (GAAP). b. To ensure that the statements are consistent, detailed, and accurate, companies must employ independent auditors to evaluate each statement. c. However, although most companies file accurate statements and most auditors do a careful job reviewing that information, a minority of companies have abused the system, in some cases aided by their auditors. STRATEGY IN ACTION 11.4: DID COMPUTER ASSOCIATES INFLATE REVENUES TO ENRICH MANAGERS? The share price of Computer Associates’ stock rose during the 1990s, as revenues increased. Three of the company’s top executives were looking forward to bonus compensation of over $1 billion total, if the stock price remained high over 60 days. COO Sanjay Kumar announced high earnings, the stock rose above the trigger price and remained there, and they received their bonuses. Less than one month after the bonus was awarded, Kumar announced that earnings would fall substantially. CEO Charles Wang resigned, and Kumar took on the position, but federal regulators investigated the firm. They found evidence to support their contention that the firm’s executives deliberately overstated earnings in order to achieve the bonus, and that they did so with the help of their auditors, KPMG and Ernst & Young. Stockholders claim that the value of their shares was reduced; the case is ongoing. Teaching Note: This case illustrates the hazards of inadequate or inappropriate controls, both in pay-forperformance and in reliance upon auditors’ oversight. As in the Strategy in Action 11.3 about Barings Bank, managers were encouraged by the structure of their compensation to commit acts that increased their pay, rather than acts that would further the firm’s long-term interests. Also, independent auditors failed to discover or report, or perhaps even conspired in, unethical financial reporting. For classroom discussion purposes, ask students to comment on the following statement: “A white-collar crime, such as banking fraud or ‘cooking the books,’ isn’t a serious crime because it doesn’t really hurt anyone.” (1) 4. One problem is that GAAP guidelines are loose enough that they can be manipulated by unethical managers. (2) It also appears that sometimes auditors face a conflict of interest in auditing the books of companies that also have lucrative consulting contracts. Thus, the accountants may be reluctant to blow the whistle and risk losing a client. (3) Boards of directors are supposed to be the ultimate overseers of financial statements, and apparently they are not always careful enough. Too many inside directors adds to this concern. (4) In 2002, new legislation was passed, in response to Enron and other accountingdriven debacles. The law solved some problems but not all. In addition the true problem may not be too few laws, but too little enforcement of existing laws. Yet another corporate governance mechanism is the threat of a hostile takeover. This could happen if many stockholders decide to sell the stock, causing the value of the shares to decline below the book value of its assets. An acquirer could then purchase the firm, sell the assets, and profit. This threat is called the takeover constraint. Copyright © Houghton Mifflin Company. All rights reserved. Chapter 11: Corporate Performance, Governance, and Business Ethics 139 a. 5. In the 1980s and early 1990s, hostile takeovers were executed by corporate raiders for that very reason. Raiders are individuals or corporations that buy up large blocks of shares in companies that they think are pursuing strategies that do not maximize wealth. b. Corporate raiders plan to take over and run the company themselves or to replace the top management team with better strategists. c. If raiders succeed in their takeover bid, the new strategies they institute can create millions of dollars of wealth for shareholders, including the raiders themselves. d. Even if the raiders do not succeed in the takeover, the defending company will often buy back their shares just to be rid of them, paying a premium price. This practice is called greenmail. e. The takeover constraint has not been invoked as frequently in the late 1990s and 2000s, because of changed circumstances, such as the heavy debt acquired by many firms in recent years, which makes firms less attractive as takeover targets. But takeovers tend to run in cycles, and it’s likely another cycle will come around someday. f. The takeover constraint is the last resort, used only when all other forms of corporate governance have failed. When agency relationships exist within a company, such as between supervisor and subordinate, strategic control mechanisms better align the interests of top managers and employees. a. Strategic control mechanisms are the primary mechanism of internal governance. These systems consist of the formal goal setting, measurement, and feedback systems that allow managers to evaluate the effectiveness of their firm’s strategy. b. The process requires top managers to establish standards, create a system for periodic measurement, compare actual performance to the standards, and evaluate results. c. These steps ensure that lower-level managers, as the agent of top managers, are acting in the best interests of top managers. Show Transparency 70 Figure 11.4: A Balanced Scorecard Approach d. The balanced scorecard approach to strategic control asks top managers to evaluate performance on efficiency, quality, innovation, and responsiveness to customers, in addition to the financial information used in traditional strategic control systems. The additional information focuses on future performance, whereas financial information relates to decisions and actions that were taken in the past. (1) Measures of efficiency include production costs, raw materials costs, and number of labor hours needed to make a product. (2) Measures of quality include the reject rate, the rate of returns of defective items from customers, and the product reliability over time. (3) Measures of innovation include the number of new products introduced, the time taken to develop a product, and the revenues generated from new products. (4) Measures of responsiveness to customers include the number of repeat customers, on-time delivery rates, and level of customer service. e. Reliance on several different types of measures, rather than just financial measures, makes the balanced scorecard approach more accurate and useful to managers. 6. Another mechanism for aligning the interests of lower-level managers with that of top managers involves the use of employee incentives to motivate employees to work towards goals focused on maximizing profitability. a. Employee stock ownership plans and stock option grants can be effective tools, especially if employees at lower levels of the organization are included. b. Another approach is to tie employee compensation to the attainment of strategic goals, as is commonly done with bonus pay. VII. Ethics and Strategy A. Ethics is another important consideration as managers make and implement strategic decisions. An ethical decision is one that reasonable stakeholders would find acceptable because it aids Copyright © Houghton Mifflin Company. All rights reserved. 140 Chapter 11: Corporate Performance, Governance, and Business Ethics B. C. D. E. stakeholders, the organization, or society. An unethical decision is a decision that managers would prefer to disguise because it helps the company or an individual gain at the expense of society or other stakeholders. The purpose of business ethics is to give people tools for dealing with moral complexity. It does not help people distinguish right from wrong. Most people know the difference between right and wrong, and they act on that information in their private lives, but fail to do so in their professional lives. Business ethics emphasizes two points. First, that business decisions have an ethical component, and second, that managers must consider the ethical implications of strategic decision before choosing a course of action. An important first step is for companies to establish an organizational climate that emphasizes the importance of ethics. 1. Top managers must use their leadership position to incorporate an ethical dimension into the values they stress. 2. Ethical values must be incorporated into the company’s mission statement. 3. Ethical values must be acted on, and should affect hiring, firing, and incentive systems to reward adherence to ethical values. Another important action is to give managers a clear, consistent, systematic way to think about ethical issues. 1. The various ways to answer the question “What is ethical?” can be understood through the use of three models: the utilitarian, moral rights, and justice models. The principles of each are summarized in Table 11.2. a. The utilitarian perspective asserts that an ethical decision is one that does the most good for the most people. b. The moral rights perspective asserts that an ethical decision is one that does not violate the rights of any stakeholders. c. The justice perspective asserts that an ethical decision is one that distributes benefits and harms across stakeholder groups in a fair or impartial way. 2. Another way to decide whether a decision or behavior is ethical is to examine the three questions below. If one can answer yes to all three, then the decision or behavior is probably acceptable. a. “Does my decision fall within the accepted values or standards that typically apply in the organizational environment?” b. “Am I willing to see the decision communicated to all stakeholders affected by it—for example, by having it reported in newspapers or on television?” c. “Would the people with whom I have a significant personal relationship, such as family members, friends, or even managers in other organizations, approve of the decision?” 3. Yet another approach is to work through a four-step process. a. First, managers should identify which stakeholders are affected by the decision and in what ways, paying close attention to the possibility of violating stakeholders’ rights. b. Then the manager should judge the ethics of the proposed strategic decision using moral principles. c. Next, the firm must establish moral intent, that is, must resolve to place moral concerns ahead of any other concerns if stakeholders’ rights or moral principles have been violated. d. The final step is to implement the ethical decision or action. Copyright © Houghton Mifflin Company. All rights reserved.