Managing Oil and Gas Companies-II Performance Management Vital In Implementing New Strategies

David Kruzner
Ernst & Young LLP
San Francisco

Rob Trollinger
Ernst & Young LLP
Irving, Tex.

• Essentials of Performance Management [17910 bytes]

As companies concentrate on core competencies, shift to demand-pull production, and try to leverage their clout in selected regions for market dominance, performance of key operations has become paramount.

Managing performance is thus widely-and correctly-regarded as crucial to the successful implementation of the industry's newly defined strategic goals. The good news for company leaders is that none of their competitors has managed to put a process for managing performance fully in place. The bad news is that their company hasn't either.

Why is this so? In theory, performance management is a simple, straightforward proposition. It means deploying a comprehensive, strategy-linked framework for measuring performance across the entire enterprise and then using the results of these measurements to serve two critical managerial functions.

First, performance measurement is the means for making informed, knowledge-based decisions about important business issues such as minimizing operational costs, manufacturing the right mix of products, identifying the most profitable distribution channels, and optimizing the utilization of assets. Second-and in the long run more importantly-measuring performance is a means for identifying and addressing areas where a company needs to make the kinds of organizational and process improvements that can develop, sustain, and amplify competitive advantage over the long haul.

The reason that no company as yet has managed to effectively deploy a comprehensive framework is equally simple and straightforward. Making the changes that make it possible is a painful task whose arduous nature is rooted in the real-world complexity of the downstream oil and gas and chemical business segments.

For integrated energy companies, performance management can maximize value along the supply chain only if they manage it as if it were a single, seamlessly operating business. At most of them, however, each link of the chain tends to operate as a stand-alone business and separate profit center. Similarly, the manufacturing units of large chemical companies tend to operate as independent fiefdoms. Because they differ in their practices, product mix, and market position, creating the system of standardized metrics needed to compare and optimize operations across the enterprise confronts a welter of difficulties.

Nonetheless, the tools and techniques of performance management exist and have proven their worth. Experiences at a variety of companies, both within and outside the oil and gas and chemical business segments, demonstrate that progress towards comprehensive performance management is possible, with quantifiable benefits and results. Competitive advantage will be enjoyed by those companies that advance further and faster down this path.

A major's success

One of the major integrated corporations has succeeded in using the tools of performance management to streamline operations and maximize value along its supply chain.

Like many refiners and marketers of petroleum products, the company was realizing unacceptably low returns on assets due to poor refining margins and increasing competition at the retail site. Adding to its woes, environmental regulation-in particular compliance with the Clean Air Act Amendments of 1990-required the company to increase capital outlays dramatically.

The company considered responding to these pressures in the traditional way: increasing margins by cutting costs and selling off assets that were underperforming. Based on its experience, however, it realized the limitations of this approach.

Cost-cutting, viewed in isolation, is a crude tool for increasing margins, frequently offering only one-time improvements to the bottom line while hobbling long-term growth. Effective margin management required the company to get a handle on the revenue side of the margin equation as well as the cost side. Only then could the company determine which products and distribution channels promised the greatest profits and best commercial opportunities.

Effective margin management required that the company know two things: the margins of its products relative to each other and the available channels of trade and the value contributed by each link in the supply chain to those product margins. Because of the way relations along the supply chain were structured, this kind of decision-driving, actionable information was not reliably available. The company suffered from a knowledge gap.

Running from the purchase of crude supply and feedstocks by the refinery to the marketing and sales of intermediate and final products to customers, its supply chain operated in a manner typical of integrated oil companies. Each segment of the supply chain was concerned to show a profit (if it was a profit center) or zero costs (if it was a cost center). Managers along the supply chain negotiated transfer prices in order to achieve these results, basing them on historical precedents rather than market realities.

Under these conditions, there was simply no way to know the true value and profitability of a specific distribution channel and the contribution value of the assets which supported that channel.

Decision support system

To close the knowledge gap, the company constructed a decision support system to measure the true economic value of its distribution channels. Employing a variety of tools, including a variant of activity-based costing, it analyzed product pricing, product mix, distribution costs, alternative supply arrangements, customer segmentation, asset utilization, and the other factors that contributed to its margins.

The company was thus able to cut through the layers of transfer pricing and measure the cost of manufacturing a specific product and distributing it through a particular channel. In effect, it eliminated profit centers between segments of the supply chain and measured the refining, distribution, and marketing process as an integrated value chain.

This put the company in a position to understand what it did best and to take appropriate action, concentrating on its strengths and withdrawing from markets and activities where it was weak.

Measurement provided the requisite knowledge. But measuring by itself was not enough to drive the company toward pursuing its best commercial opportunities. What was critical was the use of these measurements as the basis for a compensation scheme designed to motivate employees at various locations on the value chain to move in this direction.

The new compensation scheme rewards employees based on their contribution to organizational results as a whole. By taking a holistic approach to the measurement and rewards system, the company provides its people with an incentive to work together as teams across multiple business lines. Team accomplishments are noted and rewarded.

Under the new scheme, individuals began to assume additional risk to accomplish more-profitable results since they would share in the fruits of this effort. The scheme has resulted in the company's realizing $25-40 million/year in additional profits.

Cross-purposes

The new compensation scheme was critical because, under the former system, the various segments along the supply chain were driven by different motives, which sometimes put them at cross-purposes. Marketing, for instance, wanted to maximize supply to avoid running short of product, while product suppliers wanted to minimize it to lower working capital.

The company's solution was to require marketing and supply to work together and be jointly responsible to the same boss for setting appropriate inventories. As a result, it was able to reduce working capital by as much as $50 million. What prevented the company from realizing even larger savings was its inability, in this case, to develop compensation incentives to bolster the collaboration. The trade-offs between product supply and inventory management would have required compensation changes that were simply too dramatic for the company to implement at that stage in its business transformation efforts.

The company met with more success at the other end of the supply chain: supply of crude to refineries. An issue arose as refinery managers began responding to the new compensation incentives by trying to maximize their throughput in defiance of traditional reliability criteria. The drive toward maximization led them to recognize that a crude slate drawn from a limited number of supply sources was to their advantage.

But there was an obstacle to realizing this advantage. Crude traders traditionally purchased crude from multiple sources in order to get the best prices for the appropriate slate of crude.

A moment of truth arrived when crude traders finally realized that they could also benefit more from the new compensation scheme by acceding to the wishes of the refiners. While they would show smaller profits by limiting their sourcing of crude, this decrease in profits would be more than offset by the bonuses they would receive for contributing to overall company profitability by helping refiners achieve greater throughput.

Asset optimization

A knowledge gap also bedeviled the issue of asset optimization. While it was clear that some assets were weak performers, the company lacked the requisite information for deciding whether it made more sense, say, to sell a terminal facility, lease its unutilized capacity to a competitor, or continue to operate it below capacity in order to protect a strategic market advantage.

Following implementation of the new measurement system, which eliminated layers of transfer pricing and rigid cost allocations not reflective of market variations, the company was able to make a more realistic analysis of the performance of individual assets. With this knowledge, it was able to assess the trade-offs between maximizing the value of retail assets and maximizing assets further upstream.

In many cases, this meant challenging the old paradigm of protecting regional markets from competitors at all costs. Marketers and commercial staffs were ideologically opposed to allowing competitors to sublet terminal facilities, for instance, in regions where the company had market strength.

The analytical capabilities afforded by the company's new measurement system, however, enabled it to take a more sophisticated view. Where analysis disclosed that a terminal was not strategic to its market position, it formed joint ventures with its competitors to share the costs of these facilities.

The company's experience is typical of companies that set out to tackle performance management in a comprehensive fashion. In the first stage, the company seeks to understand its performance problems by undertaking a holistic review and analysis of the economics of the supply chain. Once that is done, a number of performance weaknesses and inefficiencies quickly become apparent, enabling the company to take immediate corrective actions.

The next stage is more challenging and ambitious: using new knowledge-harvesting capabilities to systematically determine what products to produce, what assets to deploy, and what processes to change for long-term competitive advantage.

Petrochemical productivity

Other companies have made significant strides toward creating a comprehensive performance management system, including a petrochemical company that has been a long-time leader in the integrated chemical products market. This company identified a need to enhance its competitiveness when it discovered that its productivity increases were only average for the industry.

Looking at its options, the company made a strategic bet that a major business transformation to attain operational excellence in manufacturing would be the means to winning back its commanding position among customers.

Basically a manufacturer of integrated chemical products, the company faced a major obstacle in advancing its business transformation goals: Its manufacturing facilities around the globe each measured performance, interpreted the measured results, and reported the information differently.

A multimonth review of its current processes, practices, and technical abilities identified improvement opportunities, based on leading industry practices, representing hundreds of millions in savings annually. These savings were founded in the implementation of improved processes and the efficiencies that were expected to result. Impressive as this was, such improvements could not lay the basis for achieving and sustaining operational excellence.

Creating a common, enterprise-wide performance management system was a condition for transforming the business. It involved acquiring the capability to measure performance against strategic goals, use the results to identify and address areas of improvement, and monitor on an ongoing basis how much progress was actually being made.

To achieve this, the company assembled a series of cross-functional teams, including a performance management team. Team members were carefully selected for their skills and competencies as well as to ensure functional coverage. The team members were considered experts in the manufacturing processes and thus responsible for identifying the critical success factors (CSFs) of these processes. The CSFs were then used to determine the leverage points for measuring the overall success of the entire manufacturing process.

The purpose of the performance management team was to work closely with each of the other teams to establish cascading measures from the enterprise to the process level. The enterprise and competency measures would be used for monitoring higher level manufacturing performance and its alignment with the corporate performance measures of the parent company that encompass organization-wide strategies and objectives. The process measures would be used for manufacturing performance in the field.

The entire system would be used for highlighting performance gaps, tracking initiatives against targeted performance, and evaluating the strategy. More importantly, the system would allow the company to sustain its thrust toward ever-greater operational excellence.

Measurement system

The strategic goal of attaining operational excellence required that certain measures be focused on the reliability of operations and maintenance. Following Seiichi Nakajima's overall equipment effectiveness model,¹ the company developed an algorithm that measured the efficiency of its manufacturing facilities in running products through processing, using the right inputs (i.e., materials) and with the right scheduling and planning to maximize output consistent with quality, cost, and safety guidelines.

Other measures were identified through methods including causal loops and systemic thinking techniques. These approaches increased the probability of selecting measures for the balanced scorecard that truly impact enterprise performance and provide a holistic view of manufacturing performance. The approach all but eliminated the possibility of deploying measures that would increase process level performance yet compromise the entire manufacturing system.

In order for the new measurement system to allow for the collection and reporting of the same measures in a timely, accurate, and consistent way, a common performance management format was established for the company's worldwide manufacturing processes. This common format positions the company to make efficient and effective comparison among plants, facilities, and sites and provides more-decisive management reviews.

The system design requires a roll-up of the standardized information at the plant, site, regional, and worldwide level. Central analysts at the worldwide level create the final reports and coordinate the efforts. The reports are distributed throughout the organization in order to ensure all facilities are being evaluated on a common basis.

One critical step to ensure success is to validate the measures and prove that the individual level measures are integrally linked to the organizational level measures. After the issuance of the first formal report, the very fact that plant managers were aware of the measures against which their performances would be comparatively evaluated led to new efficiencies, confirming the truism that "what gets measured gets done." Perhaps more importantly, the first report already disclosed an anomaly at one facility regarding capacity utilization, which has set off a chain of enquiries in an effort to pinpoint the sources of the problem.

Feedback, planning

The system also has a feature that is critical to sustaining competitive advantage: feedback about the differences between manufacturing performance during the financial cycle rather than at its end. With quicker access to standardized data, the company is able to identify problems faster and with greater accuracy and to generate timely, problem-solving, actionable knowledge from it.

This also provides the ability to conduct scenario "what-if" planning. The company, for instance, can explore the trade-offs in production vs. operational stability under a variety of scheduling lead time scenarios. Or it can determine the impact of reducing its product mix at a particular facility on inventory costs and operational maintenance.

The value of simulation models can be described as the "forward looking" aspect of a world class performance management system. Although its historical data are key in developing scenario plans, the true impact can be felt as economic, market, and performance scenarios that help the company better prepare for the future.

One significant impact for the company is the existence of a single, common, comprehensive measurement system across all plant and business unit organizations. Validation of the performance measures in place will identify those with the most significant impact on achieving the company's strategy. But the company now has a common interpretation of performance data that, because it derives from measures linked directly to its business process, is able to provide actionable business knowledge.

The two firms discussed here have made significant headway in attacking the thorny issues surrounding effective management of performance. They have pioneered in a field where much territory remains to be conquered.

Keys to success

For reasons both structural and historical, progress toward performance management in the energy industry has been slow and hard-won. This progress, however, is not to be disdained. "Crawl, walk, run" is a long-established principle in organizational change efforts. When a first step results in positive gains, it provides the confidence that makes succeeding steps easier to take.

Moreover, companies preparing to embark on this course can take advantage of lessons already learned by those who have preceded them. Among the most important of these lessons are:

1. Secure strong executive sponsorship. By its nature, a performance management system requires collaboration across a broad spectrum of company activities for successful implementation. Unless an adequately high level of active sponsorship is acquired for the effort, collaboration will be difficult.

2. Create strong linkages between performance measures and strategic goals. Global, enterprise-wide goals remain empty rhetoric unless they are translated into specific performance expectations. Specific performance measures lack strategic value unless they contribute to broader goals.

3. Use performance measures that cross traditional organizational boundaries. Performance measures and goals of this sort can foster cooperation between departments and business units by making them mutually dependent on each other for their own success.

4. Reinforce this cooperation with compensation and bonus schemes that reward it. Employees respond better to being mutually accountable if they receive positive benefits from cooperating effectively, and not just negative consequences if they do not.

5. Tailor performance measures to the role of each business area. Often this means using a constellation of measures rather than relying on any one measure for defining efficiency and effectiveness. Economic value added, for example, is not necessarily a good measure of performance for all areas of the business. For many support functions, like accounting and finance, measures such as reduced accounting errors and simplicity of financial reports are more relevant.

6. Focus on the information needs of the end-users rather than the technology that will be used to deliver it. Involve end-users in designing the future state vision and the kinds of information contained in the reports which are to come out of activity-based costing (ABC) and other performance management activities. An understanding of what information the end-users need and how they will use it should be the criterion for selecting the software and hardware to support the system, not the other way around.

More broadly, the experiences of companies pioneering in the field of performance management demonstrate that, once the means are at hand to make measurements demonstrably linked to strategy, a whole new realm of managerial possibilities opens up: the transformation of passive data into actionable business knowledge.

Reference

1. Nakajima, Seiichi, "TPM: Introduction to TPM, Total Productive Maintenance," 1988, pp. 12-14.

The Authors