564  Strategic Management: Analytics Carefully disaggregating value drivers helps managers identify and set prior- ities for operating initiatives to improve a company’s performance. Exhibit 29.10 shows the value driver tree for a component-manufacturing company. Financial value drivers such as ROIC are cascaded to business value drivers such as gross manufacturing margin and to operating value drivers such as labor productiv- ity and manufacturing error rates. Understanding what is most critical for value creation at the operating or work-floor level is important and can be expressed in a range of potential upside and downside for ROIC. Carefully aligning various operating initiatives with the value drivers affected enables a systematic com- parison and can serve as a basis for deciding which initiatives matter most. For example, initiatives to improve employee effectiveness are linked to sales force effectiveness and thus to sales volume and earnings. Product redesign improves earnings via lowering materials, energy, and/or labor costs. The tip of every branch of a value tree is a potential value driver, so a full disaggregation would result in many value drivers and metrics, more than Exhibit 29.9  Value Driver Tree for New Geography: Bicycle Repair Company Number of customers in region Number of customers in region Value Other repair service costs Service revenues Labor costs Acquisition costs Capital charge Capital charge per shop1 Other repair service costs per revenues Service revenues Service revenues Number of shops in region Customer acquisition costs Number of customers in region Service revenues per customer Number of shops per customer Share of customers Potential customers in region Cost per mechanic hour Mechanic hours per service revenues 1 Including other indirect costs. Exhibit 29.10  Aligning Operating Initiatives and Value Drivers: Manufacturing Company ROIC (pretax) EBITA2 Invested capital Volume Gross margin per unit Other operating costs R&D costs General and administrative costs Fixed assets Net working capital Market growth Market share Sales force effectiveness Negative Positive Price per unit Materials cost per unit Energy cost per unit Labor hours per unit Manufacturing error rate Unit labor costs Maintenance and repairs Depreciation Staff costs Depreciation Personnel costs Purchased services Land Buildings Equipment Feedstock Work in progress Finished goods Receivables Payments Financial value drivers Business and operating value drivers Potential ROIC impact,1 % Value driver impact of operating initiatives Employee effectiveness Work-floor optimization Product redesign … X X X X X X X X X X X X X X X X X X X X X X 1 Potential negative and positive ROIC impact, given the likely range of outcomes for underlying value driver. 2 Earnings before interest, taxes, and amortization. 565 566  Strategic Management: Analytics could possibly be helpful for running the company. To be sure that perfor- mance management remains practical and effective, managers need to decide at this stage which drivers are the most important for value creation and then should focus on these. Setting Targets To make best use of their understanding of key value drivers and to safeguard their company’s future health, managers need to agree on objectives for each driver. These targets should be both challenging and realistic enough that managers can take responsibility for meeting them. Businesses can identify realistic opportunities and set targets by studying world-class competitors’ performance on a particular value metric or mile- stone and comparing it with their own potential. Alternatively, executives can perform a similar analysis of high-performing firms operating in a differ- ent but similar sector. For instance, a petroleum company might benchmark product availability in its service station shops against a grocery retailer’s equivalents. This is in part how lean manufacturing approaches developed by automakers have been successfully transplanted into many other industries, including retailing and services. Businesses can also learn from internal benchmarks. This may involve measuring the performance of the same operation at different time periods, or from studying comparable operations in different businesses controlled by the same parent. These measures may be less challenging than external bench- marks, as they do not necessarily involve world-class players. However, the use of internal benchmarks delivers several benefits. The data are likely to be more readily available, since sharing the information poses no competitive or antitrust problems. Also, unearthing the causes of differences in performance is much easier, as the unit heads can visit the benchmark unit. Finally, these comparisons facilitate peer review. After assessing the data, companies typically arrive at performance targets defined as single points, although ranges can be more helpful. Some com- panies set a range in terms of base and stretch targets. The base target is set by top management based on prior-year performance and the competitive environment. Managers should meet the base target under any circumstance. The stretch target is a statement of the aspiration for the business and is de- veloped by the management team responsible for delivery. Those who meet their stretch targets are rewarded, but those who miss them are seldom pe- nalized. Using base and stretch targets makes a performance management system much more complex, but it allows the managers of the business units to communicate what they aspire to deliver (and what it would take for them to achieve that goal) without committing themselves to delivery.