Performance Measurement

1
Performance Measurement

• Not everything that can be counted counts, and
  not everything that counts can be counted
• Albert Einstein

2
Importance of Performance Measurement

• What gets measured gets improved
• Focuses attention on the items measured
• Poorly designed measures can result in misguided
  decisions

3
Traditional Sources of Performance Measures

• Financial statements
• Designed for reporting purposes, not guidance
• Historical, short-term focus
• Follow arbitrary rules
• Ignores non-financial information
• Much useful information is not reported
• Easy to manipulate through operating decisions

4
Traditional Sources of Performance Measures

• Examples
• Profitability
• Net income
• Return on assets
• Financial position
• Debt position
• Stock price

5
Traditional Sources of Performance Measures

• Cost / managerial accounting
• Primary purpose is to value inventory for
  financial statement purposes
• Designed to allocate costs, not to control them
• Historical, short-term focus
• Provide information for managerial decisions

6
Traditional Sources of Performance Measures

• Examples
• Standard costing and related variances
• Comparisons of actual results to budgets or
  targets
• Market share

7
Criticisms of Traditional Measures

• Lack of relevance
• Many measures are interesting, but not useful
• Market share, revenue, etc.
• Trends may be useful
• Measures may be poorly designed or collected
• Customer satisfaction, employee morale, etc.
• Goals are arbitrarily determined, beyond the
  ability of the system

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Criticisms of Traditional Measures

• Lack of vision
• Short-term focus impedes decisions with long lead
  times or long-term payoffs
• Focus on what is currently being done, not what
  should be done
• Fail to consider the overall organization

9
Criticisms of Traditional Measures

• Promote detrimental outcomes
• Short-term thinking
• Local optimization
• Manipulation of operations or measures
• Well-intentioned but detrimental actions
• The numbers these systems generate often fail to
  support the investments in new technologies and
  markets that are essential for successful
  performance in global markets Eccles, p.
  28

10
Signs of an Ineffective Performance Measurement
System

• Performance is acceptable on all dimensions
  except profit
• Measures are not aligned with strategy
• Measures do not reflect critical success factors
• Competitive price, but customers do not buy
• Functionality or quality may be more important to
  the customers

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Signs of an Ineffective Performance Measurement
System

• No one notices if the measures are not produced
• Not using them anyway
• Irrelevant
• Redundant
• Questionable
• Managers debate the meaning of the measures
• Measures are confusing

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Signs of an Ineffective Performance Measurement
System

• Share price is lethargic despite solid financial
  performance
• Measures are backward looking
• Share price reflects future expectations
• The market expects that current performance will
  not continue

13
Signs of an Ineffective Performance Measurement
System

• Have not changed the measures or targets in a
  long time
• Obsolete, easily met, do not foster change
• Corporate strategy has changed
• Measures become irrelevant

14
Effective Performance Measurement Systems

• Initiative must start at the top
• Senior management has overview, power to
  implement the system
• Goals of lower levels determined by needs of
  higher levels
• Top down system prevents local optimization
  while emphasizing overall optimization

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Effective Performance Measurement Systems

• Must be balanced
• Financial and non-financial measures
• Leading and lagging measures
• Must be relatively simple
• Limit measures to critical success factors
• Too many measures lead to confusion, redundancy,
  wasted effort, irrelevance
• Employees may ignore or subvert complex system

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Effective Performance Measurement Systems

• Must promote intended behavior
• Employees actions must be aimed at improving the
  organization, not meeting arbitrary goals
• Poor measures promote dysfunctional behavior
• Employees must understand why something is being
  measured
• Should provide guidance, not just feedback

17
Effective Performance Measurement Systems

• Performance-based compensation
• Powerful motivator
• Who participates?
• General guidelines
• Must promote intended behavior
• Long-term or short-term goals?
• Employee must understand the performance/pay link
• Employee must have some control over the measures
• Must be significant enough to motivate
• Pay for ideas?

18
Effective Performance Measurement Systems

• Must look beyond the entity
• External groups can provide useful information
• Include measures of value chain performance?
• Measures should be benchmarked
• Other departments or divisions
• Other entities

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Output or Input-Related Methods

• Output-related (engineered-cost) method
• Used when
• Costs are largely variable and controllable
• Well-defined operations
• Measurable outputs
• Focus is on evaluation of the efficient use of
  resources at the end of the period
• Cost per unit of output or activity

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Output or Input-Related Methods

• Input-related (discretionary-cost) method
• Used when
• Costs are largely fixed and not controllable
• Operations are complex and not well defined
• Outputs are difficult to measure
• Focus is on planning the cost
• Little or no evaluation at the end of the period

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Evaluation of Strategic Business Units (SBUs)

• Cost SBU
• Manufacturing or support operations
• Does not generate revenue
• Focus is on cost control
• Type of costs determine whether engineered or
  discretionary method (or both) is used
• Fixed costs that are not controllable in the
  short-run should not be included in short-term
  evaluation
• May be considered for long-term evaluation

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Evaluation of Strategic Business Units (SBUs)

• Revenue SBU
• Focus is on the selling function
• Revenue generating operation
• Focus is on revenue generation
• Revenue per order, per salesperson, impact of
  price cuts or promotions on revenue, etc.
• Related costs (order getting, order filling) may
  be evaluated with the engineered- or
  discretionary-cost methods as appropriate

23
Evaluation of Strategic Business Units (SBUs)

• Profit SBU
• Combines cost and revenue activities in a single
  SBU
• Provides for coordination among various functions
  (production, marketing, etc.)
• Motivates managers to consider the marketability
  of internal products or services to outsiders, or
  to consider outsourcing
• Motivates managers to develop new profit streams
  from their products or services

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Evaluation of Strategic Business Units (SBUs)

• Financial evaluation of profit SBUs uses a
  contribution income statement
• Costs arranged by their relation to the SBU
• Variable (directly related)
• Controllable fixed costs (directly related)
• Controllable by manager in the short-run
• Non-controllable fixed costs (directly related)
• Controllable by manager in the long-run
• Untraceable costs (not traceable to the SBU)

25
Evaluation of Strategic Business Units (SBUs)

• Contribution income statement

26
Non-financial Performance Measures

• Useful
• Not everything can be measured in monetary terms
• Customer service
• Goal attainment
• Innovation
• Employee involvement
• Frequently difficult to measure
• Rough measures or trends may be better than
  nothing

27
Non-financial Performance Measures

• Many companies believe they could be useful, but
  do not measure them
• Difficult to measure
• Resistance to change
• Even when measured, they may not be used
• Suspicious about the validity of measures
• Resistance to change

28
Analysts Top 10 List

• Ernst and Young study of financial analysts use
  of non-financial measures
• Improves earnings forecasts
• 35 of a companys valuation is attributable to
  non-financial information

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Analysts Top 10 List

• The Top 10
• Ability of the company to execute its strategy
• Credibility of management
• Does the company do what it says it will do?
• The quality of the strategy
• Will managements vision create future value?

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Analysts Top 10 List

• Innovativeness
• How readily does the company adapt to changing
  technologies and markets?
• Ability to attract and retain talented people
• Market position
• How quickly can the company realize sales,
  profits and cash flow from products introduced in
  the prior three years?
• How strong is the companys brand?

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Analysts Top 10 List

• Management experience
• What skills and experiences does the management
  team bring to the organization?
• What is their success rate in similar situations?
• Executive compensation
• Are compensation policies aligned with strategy?
• How many executives have their pay tied to value
  creation?

32
Analysts Top 10 List

• Quality of major processes
• How well does the company execute its strategy?
• Does it have plans and processes that enable it
  to adapt to changing market conditions?
• Research leadership
• How well does the management understand the link
  between creating knowledge and using it?
• RD budget as a percent of sales, profits and
  cash flow