KPI Targets and the Value Gaps Tree
Mihai Ionescu - Senior Strategy Consultant, Author.
When I've got in contact fore the first time with the Kaplan-Norton BSC Framework, nearly nine years ago, I thought that I've understood how to set targets for the KPIs. But then the proof of practice showed me otherwise. When you work with a team and reach the Targets-setting point in the work-stream, you can't say 'Let's set them like this ... and take it on faith', because that's a signal that nearly everybody can set targets as they see fit, based on common sense, on benchmarking, on 'what's more important', on 'what's more urgent', on 'how well did we do last year', on 'what's doable next year', or on any similar variations that you can think of.
Don't we know better than that? Otherwise, it's no wonder that we might soon say things like 'Balanced Scorecard is too difficult', or 'Strategic Planning and reality are two different things', or anything that would allow us to blame Strategy Execution's problems on the method. In fact, the root cause may be the lack of a proper method. Strictly speaking about setting the KPIs targets, what kind of 'method' might we be talking about in the above examples?
What have KPI Targets to do with Value Gaps?
First of all, since we've mentioned the Strategy Execution, we must underline that our discussion here is not about the targets for the KPIs in operational dashboards. That's a different story. Then, let's resist the temptation of going through all sorts of wrong or half-wrong ways of setting targets for strategic KPIs. It doesn't worth the effort, because they replicate the Strategic Objectives 'magic hat' mistakes, at the KPIs level.
So, what do the KPI targets have to do with the top Value Gaps? The quick answer would be: Quite a lot!, but we have to clarify the meaning of the top Value Gaps first, before we attempt to demonstrate that.
A. The Top Value Gaps
Our top profitability aspiration is to reach break-even in two years? If our revenues last year were $2.3 million and the costs were at $2.5 million, we can do the math and determine that our profitability rate should increase by Δ = 8.7% in, two years. That's an example of profitability top Value Gap.
Is our growth aspiration to have the largest national customers base in three years? If the current market penetration is 80%, with an increase forecast of 5% per year, and our two competitors have 12 million customers each, while we have 9 million customers, we can do the math and determine that our growth top Value Gap is Δ = 41% of the current number of customers, a gap that we have to close over the next three years.
But let's take a simplified example. Assume that our Strategy involves a how-to-win Strategic Choice of increasing the customer intimacy, for better understanding our customers' Jobs-to-Be-Done (the context) and for offering them a more competitive (and, hopefully, unique) Way-of-Doing Value Proposition (the content). The success will come only when our content fits the context of the exact place and time when the customer needs it (where place means much more than just physical location).
Why this Strategic Choice? For instance, because our business came under increasing competitive fire from new entrants with cheaper or easier to use substitute products, or with more innovative customer communication channels, and the result is that we've started to loose more and more of our valuable customers. Moreover, an increasing number of our customers are using digital technology (smartphones & tablets, social networking, cloud-based applications, etc.), but we don't, at least not as part of our customer relationship interface.
At the same time, our main strategic goal may be to double our business over the next three years (Δ = 100%), in a profitable way, by relying mainly on the value generated by our existing customers, although some growth would also be expected to come from new customers. So, based on our analysis, the Value Gaps may be Δ1 = 70% growth in revenue from existing customers and Δ2 = 30% revenue growth from new customers.
We don't know if the revenue growth split will turn out, three years later, to be different than 70%-30% (as long as the 100% is achieved), however we don't have any other choice but to build our Strategy on such hypothesis (based on any possible analysis that we can perform), since our strategic focus and resources allocation's breakdown will have to be based on such initial forward-looking assumptions. Why? Because we have to deliberately focus on some things and not on others, otherwise, we don't have a Strategy. In this simplified example, we'll focus more on growing the revenue from existing customers than on acquiring new ones, based on our comparative outcomes & feasibility analysis (it might be the other way around in other examples).
B. The Strategic Gaps
Now, let's move one notch down from these top Value Gaps and the customer intimacy Strategic Choice that will drive our intended way of closing these gaps. Let's talk about the required Capabilities. One way of gaining a better understanding of our customers' Jobs-to-Be-Done is by using the digital technologies that would allow us to identify with more clarity their interests and the reasons behind them (some of which might not have been known to us before).
Since we relied so far mainly on arms-length interaction with our customers, this involves the development of some digital platforms that we've never used. But if we don't deal with such a missing (but required) capability, our customer intimacy Strategic Choice would not be adequately supported and it may remain just an unfulfilled desire.
So, what is the mastery of digital technology platforms for us? A Strategic Gap, or more precisely, a Strategic Coherence Gap (related to the coherence between our Strategic Choices and the Capabilities required to support them). It's something that we don't posses today (at least, not at the level or in the configuration required) and that we have to build, acquire, redesign or reconfigure.
But what's the connection between A and B? Well, it should better be a connection, otherwise we won't know how much of the new capability is required for helping us close those top Value Gaps. Should we attempt to become top experts in digital technology platforms, mastering it better than our competitors, for instance? That's unlikely, because we would probably over-stretch our existing Capabilities System, by trying to quickly become top experts at something that we've never did before. Many companies have failed when they've tried to do something like this, gambling too much with their Right to Win.
OK, but again, how much of this new capability would be enough (the sufficient requisition level) for supporting our customer intimacy Strategic Choice? Out of many possible answers (more or less subjective), only one may be fully correlated with our top Value Gaps. The Value Gaps Tree is what will help us find the right answer.
The Value Gaps breakdown
Colloquially known as the Targets Tree, the Value Gaps Tree allows us to build the hypothesis chain that started from the upper links of the top Value Gaps (Δ = Δ1 + Δ2). It allows us to define the causal contribution of closing each Strategic Gap to closing the top value gaps. This is not a descriptive process, it's a prescriptive one, aimed at focusing our efforts, in a quantifiable manner, on what we believe to be the necessary changes required for achieve our top goals, considering our Strategic Choices.
You might wonder what are W3-1 and W3-2 in the above diagram. Since we've only identified so far only one Strategic Gap, closing the Δ1 and Δ2 top Value Gaps relies only on it (100%). So, W3-1 and W3-2 are Contributory Weights. OK, that explains W3-1 (defined due to the coherence between our Strategic Choice and the supporting Capability required), but what about W3-2? Well, we suspect that mastering the digital technology platforms will also help us, at some extent, close Δ2, as well. One more question: Will we focus on closing only one Strategic Gap? Obviously, not.
So, let's address that! Consider that our analysis has shown that we must also be more proactive in communicating with our customers, especially the existing ones, irrespective of what channels or technology we'll use. Will that help us increase the intimacy with our customers (our Strategic Choice)? Yes, it will, at some extent. Does it sound like another required Capability (proactive customer communication), with an associated Strategic Gap?
In the case of this new Strategic Gap, we have the same big question: How much more proactive must we be in our customer communication, considering our Δ1 and Δ2 top Value Gaps that we want to close, over the next three years? Should our customers find a message from us in their inbox every week? Should we ask them about the experience of buying or using our products every month (consider that we might have done that only once a year or every two years, until now)? So, how large is this proactive customer communication Strategic Gap that we need to close? If we illustrate both Strategic Gaps, the diagram will look like this:
Now, we have a different kind of problem. Since we have more than one Strategic Gap, we don't know how much will each of them contribute to closing our top Value Gaps. As the W4-1 and W4-2 have appeared in our model, we have to use another set of hypothesis, more specifically, about the Contributory Weights of each Strategic Gap, in relation to the top Value Gaps that they are helping us to close.
Whatever analysis we might use to support these new hypothesis, we'll find out that there is no right-wrong answer here. But don't leave it to the gut feeling of a few people. Without any doubt, the Strategy Dialogue will help us a lot here, as for any other Strategy Hypothesis that we have to use during our model's construction.
OK, so assuming that we've done all that, our work resulted in this:
We've taken each top Value Gap (Δ1 and Δ2), broken down from the top goal, and assessed their reliance on closing the two Strategic Gaps identified. That has lead to a 80%-20% contribution breakdown, for Δ1, and 40%-60% for Δ2 (the Contributory Weights W3-1, W4-1 and W3-2, W4-2)
We have cascaded the top Value Gaps (Δ1 and Δ2) to the Δ3 and Δ4 value gaps, than we have chosen the highest resulting value, in each case. Please note that the value gap Δ3 would have been be equal to 12% (30% x 40%), if it would have been contributing only to closing Δ2, but the contributory requirement from Δ1, has lead to its value of 56% (70% x 80%)
Although the top Value Gap Δ1 would have required Δ4 to be only 14% (70% x 20%), the contributory requirement from Δ2 has lead to the value of 18% (30% x 60%). This means that we might overshoot the closing of Δ1 by 4% (18% - 14%) and the same goes for closing Δ2, which we might overshoot by 44% (56% - 12%). Should we redo the math and reconsider the breakdown of 70%-30% of Δ1 and Δ2? Well, if we take that approach, we'll bring havoc to our chain of hypothesis, so don't do it, event if tempted to. You'll have the chance to review the model periodically (during the quarterly Model Review Meetings), while progressing through the execution cycle, and update the hypothesis employed (including those referring to the Contributory Weights), if the outcome data will indicate that such update is required. But not sooner than that!
Another observation (maybe not so intuitive): Don't try to re-construct the top Value Gaps Δ1 and Δ2 by bottom-up aggregating the weighted Δ3 and Δ4, because if you'll do it in Excel you'll get 'circular reference error'. I'm sure that you can easily understand why doing it doesn't make sense :)
If you are not fully convinced on how this goes, or in case you might say that the sum of Δ3 + Δ4 = 74% is less than the sum of Δ1 + Δ2 = 100%, please note that the effects of closing the Strategic Gaps are cumulative and cross-supporting in closing the top Value Gaps Δ1 and Δ2. Then take a look at the following simplified scenarios and see if you are more comfortable with the way the value gaps have been calculated for the Strategic Gaps.
Scenario (a): in case the top Value Gap Δ2 wouldn't have existed:
Scenario (b): in case the top Value Gap Δ1 wouldn't have existed:
Compare the scenarios (a) and (b) with the complete version and try to interpret the meaning of the differences in the resulting Δ3 and Δ4 values gaps, considering the specifics of our example case.
The Strategic Objectives Value Gaps
Let's jump to the next level, as the initially-invoked KPI Targets are still further down the road. One more intermediary step is required now: the value gaps of the Strategic Objectives, objectives that we should [better] define based on our Strategic Gaps. If not familiar with this, it's recommendable to read The Strategic Objectives 'magic hat' (Where do our Strategic Objectives come from).
Two things will help us here. First, the practice shows that we cannot communicate a Strategic Plan (Strategy Maps, Scorecards, Alignment, etc.) based on Strategic Gaps. They remain an important foundation of our model, but we cannot work directly with them, further on. There are several reasons, but I'll mention only two:
There are a lot of Strategic Gaps that we need to close. In practical cases, it's not at all unusual to identify 40-70 of them, or sometimes even more. Especially if the Strategic Dialogue has been used (highly recommendable!) and the Strategic Gaps have been put forward by people from various organizational functions, each of them reflecting the function-specific view of the capabilities required to support the Strategic Choices that define our Strategy. Imagine what would happen if instead of a Strategy Map with 15-25 Strategic Objectives we would use a Strategic Gaps Map, illustrating 40-70 Strategic Gaps!
Compared to the Strategic Objectives, the Strategic Gaps cannot communicate our Strategy equally intuitive, powerful and motivating. They specify what gaps do we have to close (both positioning gaps and coherence gaps), in order to fulfill our Strategy, but the Strategic Objectives are a much better communication vector than the Strategic Gaps
What do we do with the Strategic Gaps? We wrap them into Strategic Objectives! This means that each Strategic Objective will have behind it one, but usually more, Strategic Gaps. When will the Strategic Gaps be closed? When the Strategic Objectives that include them will be achieved! This is something easy to understand in practice.
But before we do that, we have to analyze the time required to close the Strategic Gaps identified and estimate their expected effects along our three-year Strategic Horizon, leading to the multi-annual breakdown of the top Value Gaps.
Why do we have to do that? Because the Strategic Gaps may take more than one year to close, therefore some of them will be multi-annual, (and we don't have the resources to start closing all of them at the same time). That's why the multi-annual high-level (summarized) Strategic Plan is assembled using the Strategic Gaps, not the Strategic Objectives. The Strategic Objectives belong to each cycle (e.g. year) Strategic Plan (having the Strategy Maps, Scorecards and Initiatives that you know).
That's what we work with, in every cycle/year Strategic Plan: Strategic Objectives and only a partial set of the multi-annual Strategic Gaps (and partial proportions of some of them). We might also find the same Strategic Objectives (some of them) in consecutive cycles/years Strategic Plans, but that is the exception, not the rule. For more on this, check the last part of the article The Strategic Objectives 'magic hat' (Where do Strategic Objectives come from).
In order to accommodate the Strategic Objectives, we've reshuffled at some extent our example and added more complexity to it. We've applied the same breakdown logic, but this time to Strategic Objectives, not to Strategic Gaps.
You can see that we've considered Strategic Objectives from two perspectives: Financial and Customers. Although the names of C1 and C2 don't really follow the default naming typology (verb + adjective + noun), this is often encountered in practical BSC implementations
Notice the Strategic Gaps that are behind each Strategic Objective. It is normal to have more of them and the cases when there is only one Strategic Gap behind a Strategic Objective are rather exceptional, in practice
You might have noticed that something new appeared here: Scaling Factors (SF), used for answering an important question. For example, "By how much do we have to improve our customer communication proactivity, in order to get 1% growth in our customer acquisition rate?". Same as the classic Price Flexibility case: "By how much [%] do we have to lower our price point, in order to get a X% increase in sales?". It's another set of hypothesis, but this time we can use analytics and historical (or benchmark) data to get some better estimates
Finally, if you understood the logic for Value Gaps breakdown that we've used in the Strategic Gaps part, you'll be able to quickly understand the formulas used here. For instance, ΔC2 = ΔF2 x 60% x 3.0 = 9%
In order to avoid too much complexity in one shot, we have purposely left out the Modelling Correction Coefficient (MCC) that you might have spotted in the Causality Matrix section of the article Matrices in Strategy Execution.
We won't extend the example, for simplicity reasons, to more objectives, especially from the driving perspectives (Internal and L&G), but the same value gaps calculation logic that works between F1, F2, C1 and C2, will work between the driving and driven objectives throughout the entire Strategy Map.
However, there is a caveat, which will be presented in a following article (Value Gaps and Strategic Causality), related to objectives' Causality Dependency, an important factor of Value Gaps' propagation throughout the Strategy Map, along the cause-effect relationships between the objectives.
But for now, let's move on our Value Gaps discussion to the KPIs level.
The KPI Value Gaps
Once we've calculated the Value Gaps Tree for the Strategic Objectives, we can move to the value gaps and the targets for the KPIs, which are measuring (or anticipating) the achievement of each objective. This is where it got the Targets Tree nick-name.
Let's take the example of the Strategic Objective C1. Profiled Digital Customers Communication, or, if you like the standard naming typology, 'Develop the Profiled Digital Customers Communication' (verb + adjective + noun).
This is where the Targets Tree reaches the tips of its branches, as we have to determine the value gaps of each of our KPIs, both Lag and Lead ones. To help make the case for the Lead KPIs, we have also illustrated the Strategic Initiatives that will help us achieve this objective.
Important: We have kept in this view the Strategic Gaps SG03 and SG04 that are wrapped within our objective. They prove to be an invaluable & practical support in identifying, in a systematic way:
the KPIs that we need for measuring Strategic Objective's achievement. Remember, that objective will be achieved when its Strategic Gaps will be closed
the Strategic Initiatives that will help us close the two Strategic Gaps and therefore achieve the Strategic Objective
Another important observation is related to the Lead KPIs. The fact that we have defined our Strategic Initiatives helps us a lot in further defining the Lead KPIs, as they measure the outcomes of initiatives' realization and anticipate the values that will be measured by the Lag KPIs. But both types of KPIs (with their current values) are used in calculating the current status of Strategic Objective's accomplishment, although the Lag KPIs are relevant for today's actual results, and the Lead KPIs are relevant for the anticipated evolution of objective's accomplishment.
Only by looking at the current values of both Lag and Lead KPIs can we use the Balanced Scorecard as a decision-support system, as Strategic Objectives' statuses simultaneously incorporate both the current situation AND the anticipated evolution, so we'll be able to take Corrective Actions BEFORE the final outcome results will be available!
Several observations about the way KPIs' value gaps have been determined:
First, imagine the case of our Strategic Objective having a single KPI. It's easy to understand that objective's value gap ΔC1 would be entirely transferred to its KPI. So, our KPI (e.g. C1.1) would have ΔC1.1 = ΔC1 (32%, in our example). But it is unlikely to have only one KPI per objective, in reality, with a few exceptions
As we have to use both Lag and Lead KPIs, the first step is to break down objective's value gap to its Lag KPI, on one side, and its Lead KPIs, on another. Since these two types of KPIs have their separate roles (one, in showing the current situation and the other, in anticipating objective accomplishment's evolution) we have to allocate ΔC1 to both its Lag and Lead KPIs. So, ΔC1 = ΔLag = ΔLead, if we consider that the two roles are equally relevant. So, when we'll calculate C1's status, we'll have the average of the two roles: [C1] = ( [C-Lag] + [C-Lead] ) / 2
However, that is valid only if we trust Lead KPIs' anticipation accuracy (their capability to correctly anticipate the evolution) as much as we trust Lag KPIs' view of the actual reality. Sometimes, we don't. This means that the Lag KPIs have to have a higher weight in calculating objective's status, while the Lead KPIs will have a lower weight, as their anticipation capability (of future values) is not as much trustworthy as we would like. In this case, we won't have a simple average of the two roles, but a weighted average, with higher weight for the Lag KPIs and a lower weight for the Lead KPIs
Now, let's look at the Lag KPIs. We've used three of them C1.1, C1.2 and C1.3. Probably one too many, in practice, but we are doing this for exemplification purposes. What's the difference between them and why have we broken down the ΔC1 in a different way to some of them, specifically to ΔC1.2 and ΔC1.3?
First of all, let's observe that since we have two Strategic Gaps wrapped under our Strategic Objective C1 (SG03 Use of Digital Technology Platforms and SG04 Depth of existing customers profiling), we have two separate drivers that will influence the accomplishment of the objective. And this needs to be translated to the KPIs level, in order to have a proper measurement for both drivers (the use of digital technology and the customer profiling).
This is what happens for the Lead KPIs, where C1.4 (% customer communication performed digitally) anticipates the effects of using the digital technology and C1.5 (% customers with updated digital profiles) anticipates the effects of customer profiling. But with the Lag KPIs, the situation is different.
Since the C1.2 and C1.3 measure two aspects or characteristics related to the same Strategic Gap, the worse-than-expected results measured by one of them may be compensated by the better-than-expected results measured by the other. For instance, we may have more customers digital profile details, even if they have a lower accuracy, or fewer profile details, but containing very accurate data. For this reason, the value gap translated from the Strategic Objective is shared between these two KPIs, either equally, or on a weighted basis, if we have a rationale for weighting them.
We have assumed so far that the achievement of C1's objective relies equally on closing the two Strategic Gaps that it contains. But what if it wouldn't be so? What if their participation ratio (in objective's achievement) would be 1.25 / 0.75, for example? That would, of course, propagate into the breakdown of objective's value gap to those of its KPIs (both Lag and Lead). The result would be this:
The KPI Targets
If we have reached this far, it should be downhil