Third-generation strategies can't thrive in second-generation organizations with first-generation management. Sumantra Ghoshal, who was a professor of strategic management at the London Business School, made this point years ago — yet the lag he saw in the evolution of management is still institutionalized in most businesses' performance management practices. In fact, the gap between the modern business model and the way we try to manage it grows every day.

In many industries, customers can directly access systems within the companies they do business with. Think of Internet banking or online check-in for air travel. Processes like these save the organization money, while ensuring high data quality. They also strengthen the value proposition for many customers. Some companies combine this model of customer self-service with mass customization so that every transaction is tailored to the buyer's specific needs. New car orders include seemingly endless choices on options. Most PCs are built to order. Amazon.com produces personalized home pages, and Build-A-Bear Workshop allows children to make their own teddy bear.

The classical value chain, as depicted in section A of exhibit 1 has reversed directions. Section B of the exhibit shows the reality of many businesses' relationships with their customers today. Customers are effectively running the organization's processes. They choose which contact channel is used, and they take advantage of that channel at whatever moment is most convenient for them. There is no longer any difference between the front office and the back office; systems are integrated and transparent to the customer. Doing business is a process of continuous interaction and collaboration.

At the same time, many organizations are outsourcing activities such as accounting, IT, logistics, manufacturing, call centers, and even R&D. Some do so to save costs, but increasingly companies are outsourcing to gain access to new markets, faster time to market, or specialized skills. A modern organization's true value chain usually looks like section C of exhibit 1. Many physical products never even touch the organization. For example, most Nike shoes never see the inside of a Nike facility, and most Philips TV sets are not even touched by a Philips employee. The flow of information is what connects all the elements.

For some businesses, even innovation is no longer a core competency. There are countless examples of organizations collaborating with external stakeholders to create competitive differentiation. Consider a marketing department that asks customers to submit homemade commercials to YouTube or an organization that includes, as part of the product it sells, technology that it has licensed from an external business partner. Frequently new products or services are created through the collaboration of multiple distinct companies. Collaboration between Nike and Apple resulted in Nike+ shoes; Douwe Egberts and Philips jointly developed the Senseo coffee maker; and Adidas and Goodyear worked together on sports shoes with special soles. Sometimes even competing companies come together to offer a joint service; airline loyalty programs oneworld, SkyTeam, and Star Alliance are examples.

Despite the high level of interconnectivity among businesses today, our business intelligence (BI) and performance management processes remain hierarchical in nature. We “roll up” financials and “drill down” budgets. We “cascade” scorecards throughout the organization. Budgeting, Economic Value Added (EVA), and the Balanced Scorecard — to name just a few performance management methodologies — focus primarily on meeting the needs of shareholders, even though optimizing results for a single category of stakeholders doesn't necessarily optimize the company's results for everyone involved in the value-creation process. Nor does that approach take into account how a range of stakeholders contribute to the organization's performance.

Many decisions that significantly impact business performance are made outside the organization's walls. Insurance policies are often sold via associated banks or intermediaries; these organizations drive the insurer's sales. Likewise, customer service is often outsourced to contractors, who have a large impact on customer satisfaction. And the challenge of improving process efficiency to drive margins spans the complete value chain. Performance management initiatives that concentrate on performance within the corporate entity, based on an old-fashioned notion of the organization, usually come up short.

Management of Performance Across a Network

When a business operates in a network of closely interrelated, though legally distinct, organizations, it cannot pay attention only to its internal operations. Its performance management initiatives should focus on the impact that all of its various stakeholders have on the organization's results. Instead of asking “How can we optimize our performance for one group of stakeholders?” leaders of a performance management improvement effort should consider the question “What do our stakeholders contribute to our success?” However, this question can be asked only if the organization also considers the opposite question: “What do we contribute to the success of our stakeholders?”

To effectively guide decision-making within a modern, networked business, performance management must be applied between organizations and among parts of the same organization. Companies need to monitor their success within the context of their performance network. They need to understand the nature of the relationships between the organization and its many stakeholders; they need to work on their transparency; they need to develop new performance indicators; and their performance management efforts must focus on building trust, instead of just control.

Nature of the relationship

Relationships between organizations are not all the same, although all are important. Some relationships are very transactional, such as managing the cafeteria or logistics. Other business relationships add more value, and require more advanced management, because they support the core competencies of the firm or lead to innovation through co-creation of products or services. Within a performance network, companies may have three different types of relationships with other businesses: trans-actional relationships, added-value relationships, and joint-value relationships. They must implement different strategies as they manage relationships of the different types.

Within a transactional relationship, performance managers should focus on the way in which use of the partner organization's standard processes enables their company to sell its products and services, profitably, to as many customers as possible. Just because a relationship is transactional doesn't mean that it doesn't involve innovation. Many highly innovative organizations focus on transactional relationships. One example is the way in which Dolby Laboratories licenses its surround-sound system to consumer electronics firms.

Added-value relationships are those that improve a company's supply chain and sales distribution channels. Companies often focus on performance of their added-value relationships as they move from product selling to solution selling, adding services that complement their product. The goal in solution selling is to provide a package that becomes part of the customer's everyday life or business processes, creating a high level of customer loyalty and sustainable customer profitability. Because customers are different, solution selling often requires the solution to be adaptable to buyers' unique needs. A partner network helps make adaptation possible. Think of the numerous third parties that offer Apple iPod accessories, or consider how suppliers to a supermarket can earn preferred status by integrating with the supermarket's logistical systems. Every party in an added-value relationship has its own objectives, but goals are aligned, leading to mutual success.

In joint-value relationships, parties collaborate to create a new product or service that they could not have developed on their own. Their objectives are the same: joint success in the market. Think again of the example of Senseo, a one-touch espresso system for which Philips builds the machine, while Douwe Egberts supplies coffee pads. Each firm brings crucial skills to the product. Section D of exhibit 1 illustrates the way in which value chains merge for two companies working together in a joint-value relationship.

Transparency

In a performance network, no single CEO hands out marching orders that are then cascaded down throughout a cohesive (and hierarchical) organization. Business success is achieved through communication and collaboration. Information is an asset that a company must deploy and optimize within its relationships in the same way it uses assets like capital and materials. Collaboration is impossible without information exchange. Therefore, business partners must share information to optimize relationships, knowledge transfer, and traffic of their other assets. The efficient sharing of information in a performance network enables stakeholders to identify opportunities and bottlenecks in the network and to move from suboptimization to optimization.

Within transactional relationships, transparency consists of the exchange of operational and financial information, derived from the flow of transactions. Operational information typically comprises data on the status of transactions — for instance, tracking within logistical environments or monitoring the approval status of transactions within the back office. Financial information typically consists of invoice and payment information.

Within added-value relationships, transparency requires sharing of management information in addition to the operational information; the goal is to enable other stakeholders to better manage the relationship. Examples of information sharing in added-value relationships include the corporate strategy information that a company gives its shareholders, scorecards its gives suppliers, and sustainability reporting for the general public. However, the killer business case for transparency comes from sharing information with customers, such as a utility company's sharing of energy-use data or a benefits outsourcing firm providing information on activity within a customer's employee benefits program.

In joint-value relationships, transparency consists of a full set of management information, similar to what a company would require from its internal operations teams. These relationships involve the exchange of operational information as well, but emphasis on operations can lead to transactional behaviors. In addition to management information, transparency in a joint-value relationship consists of the free flow of certain organizational capacity. This might include exchange of capital or sharing of skills and staff, materials, or facilities. Asset sharing can be formalized within a joint venture, but that is not necessary. Managing joint-value relationships requires a voluntary and open exchange.

Reciprocity

A company should use key performance indicators (KPIs) to monitor and manage the relationships in its performance network, but these metrics must not focus myopically on optimization of the company's own, internal performance. They should be reciprocal, showing both what the stakeholder adds to the organization's performance and how the organization contributes to the stakeholder's performance. Extending the traditional stable of top-down metrics to a wider audience of stakeholders makes no sense. The Performance Prism, developed at Cranfield University in the U.K., is helpful in defining reciprocal performance indicators. Exhibit 2 identifies facets of success with each of an organization's key stakeholder groups. (See also The New Spectrum: How the Performance Prism Framework Helps in the November 2003 issue of BPM Magazine.)

Companies that revamp their KPIs in the brave new world of performance networks must develop metrics that reflect performance for their full spectrum of stakeholders. Monitoring only shareholder returns or customer satisfaction surveys no longer represents an acceptable level of performance oversight if a company's processes — or very business — is defined by diverse relationships with an array of individuals and other organizations. For each stakeholder that it deems important, a company should monitor not only what it is getting from the stakeholder (for example, the benefits listed in exhibit 2's “needs of the organization” column), but also what it is providing to the stakeholder (in the “needs of the stakeholder” column). To make sure they stay on the right track, companies need to keep their eye on what is important to stakeholders. Failure to do so leads to loss of stakeholder satisfaction; if the costs of switching to a competitor are relatively low, it also leads to stakeholder defection.

Within a transactional relationship, the purpose of reciprocity is to optimize one's own performance. Reciprocity within added-value relationships has a bigger impact on an organization's performance. To achieve reciprocity in added-value relationships, the organization needs to track its stakeholders' success. Performance indicators should point out how much money the company saved a stakeholder, how much return it generated, how much opportunity it created, or similar gauges of the relationship's results. Ultimately, the success of an added-value relationship for one partner impacts the bottom line of the other partner as well. For joint-value relationships, an organization's performance indicators should measure the same things the company is measuring to gauge its own success. Because they share objectives, all parties are looking for success in the same areas, but each organization should measure not what it has achieved for the benefit of itself or the other organization, but rather what it has achieved for advancement of the relationship.

Trust

Every successful organization is built on trust. Employees trust the company's management, and vice versa. Without a basic level of trust, a business cannot be productive. The same kind of trust — probably even more — is needed between organizations. Trust, more than control, fuels performance within any relationship (even a transactional one). In fact, too much accountability can hurt strategic relationships. An atmosphere of strong accountability does not fit well with the idea of creating trust; an atmosphere of open commitment does. A relationship that does not involve open commitment between parties can be terminated at any time because accounts can be settled easily. The costs of switching to a new partner are lower, and behavior tends to be more transactional. This is not to say that an organization should not take action to control and measure success in its relationships. But the aim of performance indicators and management processes should be to build trust, thus lowering the costs within its relationships.

Transactional relationships require contractual trust, meaning that all parties involved believe that contractual obligations will be met. Simple performance indicators reflecting the results of service delivery, as put forth in a straightforward service-level agreement, suffice. But successful added-value relationships, in which one organization relies on the processes and systems of another organization, require greater trust. They demand competence trust, which means all parties believe not only that their partners will meet contractual obligations, but also that they have the right skills, technologies, and other resources. Performance indicators reflecting the level of competence trust focus on the inputs of the service — how processes have been performing, how people have been trained, how resources have been allocated, etc. — not just on the outputs. Competence trust requires much more transparency than contractual trust.

A final level of trust, goodwill trust, develops when a party knows that its partners will represent it fairly and, when representing it, will make the same decisions it would make. This high level of trust between organizations can occur only when the parties involved share the same norms and values. Goodwill trust should be present in joint-value relationships, where organizations share intellectual property — along with resources such as capital, staff, information, and facilities — and where materials flow freely between the organizations. A joint-value relationship puts an organization in an intrinsically vulnerable situation.

The link between performance and trust is complex. Different stakeholders have different expectations for an organization. If a company's strategy is aimed at cost leadership and it is doing a good job, then its cost-related performance indicators will have excellent results. But this doesn't necessarily mean the organization is trusted. Stakeholders who measure the company based on quality, rather than cost, may give it bad grades regardless of how well it is executing its chosen strategy. Trust is earned only when the organization's strategy matches the external stakeholder's expectations. A well-known anecdote — which is not true, yet makes a great point — illustrates how customers' trust in a brand might have little to do with how the organization is actually performing. It describes two car companies that perform a similar recall on a specific line of cars. Both companies send a letter advising all owners of cars in the faulty line to report to their dealer and have their car serviced free of charge. Owners of the more prestigious brand applaud their carmaker for being diligent and quality-oriented, while response to the less-trusted manufacturer is negative; for owners who expected quality problems, the recall proves them right.

It's important to note that the relationship between performance and trust is not always symmetrical. In some services, good performance is not noticed, while bad performance leads to immediate distrust. Think of an outsourcing company that processes payroll. Its service is either considered to meet expectations but draw no kudos (100 percent accuracy), or is considered to be poor (less than 100 percent accuracy).

When developing KPIs that can enhance trust across a performance network, companies should keep in mind that financial and operational metrics are not the only factors stakeholders use to evaluate an organization's performance. Shell's image took a hit during the Brent-Spar affair of the mid-'90s. The company felt that sinking the oil platform was its most economical and environmentally friendly option, but the public disagreed. Shell's products and services were not compromised by its decision; still, the company suffered from decreased trust.

Management of Today's Businesses

All stakeholders in an organization's performance network — its business partners, shareholders, government agencies, unions, customers, and employees — are interdependent. They need one another to be successful. And the contributions of all these stakeholders are part of the organization. A company needs to optimize the performance of all stakeholders to stay profitable in the long term.

Performance management is more crucial now than it was during the boom years; accurate insight into what's working, and what's not, may mean the difference between survival and failure over the next few years. To gain accurate insight into the factors truly driving their success, many organizations need to reconsider the focus of their performance management activities. Monitoring, and responding to, factors outside the scope of traditional, introspective performance metrics may become imperative. An organization that separates its partnerships based on the nature of the relationship — then pays close attention to the transparency, reciprocity, and trust in each relationship — should find itself in a much better position for survival of the downturn, and for success once the global economy rights itself.

Frank Buytendijk is a vice president and fellow in Oracle's EPM group and a visiting fellow at Cranfield University School of Management.