Performance Measurement System (PMS)

1. Performance Measurement System (PMS) • PMS is established to identify responsibility, evaluate performance and reward individual employees. • Typically performance measures are financial-oriented. • Annual budget • Variance report (actual vs. budget) • Performance evaluation of employee

2. Financial Measures • Profit measures: • Short-run operating margin • Controllable contribution • Divisional segment profit margin • Divisional profit • Productivity Measures: Labour yield; material yield & equipment yield. • Return on Investment • Economic Value (residual Income) measure

3. Decentralization • Why do companies decentralise their operations? • Faster and better decision-making • More efficient use of management time at HQ • Opportunity for training and motivation effect • Decentralised units are organised as: • Cost or expense centre • Revenue centre • Profit centre • Investment centre

4. Decentralization • Problems in performance evaluation of decentralized units that interact closely with one another: • How to ensure goal congruence? • How to split common revenues? • How to determine transfer prices?

5. Decentralization • Transfer pricing: • Using market prices (existence of a competitive market). • Using cost (activity-based costs or long-term marginal costs) –no external market exists. • Negotiated Market-based price (Not perfectly competitive market). • Full cost (traditional cost recovery) • Dual-rate for transfer prices

6. Deficiencies of Traditional PMS Deficiencies of traditional performance measures Short-term oriented In-ward looking Past-focused & might be irrelevant Lack operational measures Unable to link to strategy for monitoring its effectiveness

7. The Balance Scorecard • To sustain their competitive advantage, business enterprises must have: • Good relationships with customers & suppliers. • Ability to innovate new products & services • Talented & motivated employees • Efficiency in producing high quality of goods & services

8. The Four Perspectives in BSC • The Financial Perspective • The Customer Perspective • The Internal Business Process Perspective • The Learning & Growth Perspective

9. Monitoring Strategy through BSC Measures • Appropriate choice and mix of outcome measures and performance drivers (diagnostic and strategic) that can monitor/evaluate effectiveness of strategy • The measures in the four perspectives must be consistent and reinforcing

10. Financial Performance Measures • ROI is a common measure of performance based on assets invested, and is particular used in enterprises with decentralized business units. • This measure, which was developed and adopted by Dupont Company in 1920s, is a function of return-on-sales and assets turnover. Profit Sales Possible to ROI = ----------- x -----------  increase profit at Sales Assets the expense of the long-term value of the business.

11. ROI Manipulation Some of the ways are: • Reduce investment base by disposing assets with lower ROI ( but › cost of capital) than the average ROI of the division. • Refuse investment in new assets that yield lower ROI ( but › cost of capital) than the division’s average ROI. • Increase production level and keeping excessive stock to lower unit cost of production to show higher profit margin.

12. Economic Value Added (Residual Income) Measure • Residual Income is computed after capital charge on each division’s assets. • The capital charge is equivalent to the risk-adjusted cost of capital (or the expected normal return on investments). • This EVA measure will encourage investment in projects or assets that yield higher return than the division’s required cost of capital, and hence in congruence with the corporate goal of maximising profits or wealth. RI = Net profit before tax – (cost of capital x capital invested)

13. EVA OR RI • Studies show higher correlations between RI and  stock prices. • In practice, general reluctance to use EVA for want of consistency between internal accounting numbers and externally reported accounting numbers and also the use of %, instead of absolute numbers for comparison with other financial measures, such as inflation rates, interest rates and profit rates of other companies.

14. Distortions By GAAP on ROI and EVA • Distortions by GAAPs: • Expensing of expenditures on intangibles (e.g., R & D, advertising, HRD) lead to understating current ROI and EVA measures and overstating them in later years. • Leasing assets instead of purchasing lowers assets base. • Inflation leads to overstatement of ROI and EVA measures because profits are measured in current prices, while assets are stated at past costs. • Depreciation charge is based on historical cost of purchase and not representing the periodic loss in present value of the asset.

15. ROI & EVA • Technical adjustments in computing ROI and EVA measures are : • Capitalizing expenditures on intangibles • Re-categorize leased assets • Adjust for price changes • Adjust depreciation amounts

16. Integration of ABC to EVA measure • Knowledge of ABC enables a business unit or an enterprise to allocate or assign costs to activities and hence to product and services. • A proper assignment of costs results in a fairer comparison of revenue and costs. • The capital charge is computed based on the assets requirements that can be directly linked or attributed to (through ABC analysis) a particular product or service. • RI (or EVA) is the residual after deducting the capital charge from operating profit.

17. Measuring Customer Relationship • Measures of Customer Perspective: • Market (targeted) & account (customer’s purchase budgets) shares • Customer retention or loyalty • Customer (new) acquisition • Customer satisfaction (complaints) • Customer profitability (by customer segment) • Attributes to enhance customer satisfaction (Time, Quality & Price) • Short lead (waiting) time • Reliability (on-time delivery) • Defect or reject rate • Service/ product warranty • Low price (ABC or VCA)

18. Measuring Internal Business Process Performance • Measures for internal process perspective: • Process time measures, e.g. cycle or throughput time reduction (elimination of non-value-added activities through BPR) • Process quality measures, e.g., reject rate, rework, waiting time and impoliteness (services sector) • Process cost measures, e.g., cheap supplies (good relationship with suppliers)

19. Learning (Innovation) & Growth Performance • Measures of Innovation: • Number of new products introduced, time from conceptualisation to market (Breakeven time by HP) • Measures of human resources/talent: • Employee satisfaction (through empowerment, recognition & support) • Employee retention (staff turnover) • Employee productivity (yield measures) • Human inventory (% of critical posts filled by qualified personnel)