Performance Measurement

Performance Measurement “Not everything that can be counted counts, and not everything that counts can be counted” Albert Einstein

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

Traditional Performance Measures • External focus • Profitability • Net income • Return on assets • Etc. • Market share • Stock price • Etc.

Traditional Performance Measures • Internal focus • Budget to actual comparisons • Comparisons to targets • Standard costing variances • Etc.

Sales (Cost of goods sold) Gross profit/margin (Operating expenses) Operating income + Other revenue (Other expenses) Income before taxes (Income taxes) Net Income Traditional, Absorption, GAAPIncome Statement Product - Mfg DM, DL, OH Period - SGA R&D Distribution Interest, dividends, rent Rent

Challenges • Period costs are not associated with product or service (SGA R&D Distribution) • R&D Expensed --- not allocated over life of product/service • Able to manipulate net income by manipulating inventory levels • Encourages maximum production even if demand does not exist

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

Criticisms of Traditional Measures • Cost accounting is a poor source of managerial information • Designed to allocate costs, not to control them • Purpose is to value inventory for financial statement purposes • Historical, short-term focus • Standard costing promotes working to keep people busy

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

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

Criticisms of Traditional Measures • Promote detrimental outcomes • Short-term thinking • Local optimization • Manipulation of operations or measures • “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

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

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

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

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

Effective Performance Measurement Systems • Initiative must start at the top • Senior management has overview, power to implement the system • Lower levels must have goals that support higher levels • “Top down” system prevents local optimization while emphasizing overall optimization

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 • Complexity may lead employees to ignore the system

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 • Should compensation be tied to the measures? • Powerful motivator • Employees must have some control over the measures

Effective Performance Measurement Systems • Must look beyond the entity • External groups can provide useful information • Measures should be benchmarked • Other departments or divisions • Other entities

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

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

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

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

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

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)

Evaluation of Strategic Business Units (SBUs) • Contribution income statement

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

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

Analysts’ “Top 10” List • Ernst and Young study of financial analysts’ use of non-financial measures • Improves earnings forecasts • 35% of a company’s valuation is attributable to non-financial information

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 management’s vision create future value?

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 company’s brand?

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?

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? • R&D budget as a percent of sales, profits and cash flow

Performance Measurement