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Enhance Competitive Performance via Critical Key Performance ...


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Enhance Competitive Performance via Critical Key Performance ...

  1. 1. Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) by Zahirul Hoque Executive Summary • Measuring performance is a fundamental part of every organization, whether it is run by a private sector or a government sector. • Performance measures are used to evaluate organizational as well as managerial performance. • A key performance indicator (KPI) is a quantitative value that can be scaled and used for performance evaluation. • Organizations should use both financial and nonfinancial KPIs when measuring employee as well as firm performance. • KPIs should be aligned with business strategy, work environment, and employee incentives. • Too many KPIs should be avoided, to maximize their usage by employees in their day-to-day operations. • “It is much more difficult to measure nonperformance than performance.” Introduction Measuring performance is a fundamental part of every organization, whether it is run by a private sector or a government sector. A performance measurement system (PMS) highlights whether the organization is on track to achieve its desired goals. Performance measures are primarily used to evaluate organizational, as well as employee performance. A PMS develops key performance indicators (KPIs), or metrics, depending on the nature and activities of the organization. KPIs can serve as the cornerstone of an organization’s employee incentive schemes. KPIs are used as guidelines and incentives to facilitate the coordination of managers and business unit goals, with those of the overall corporation goals, that is, they encourage goal congruency. Through these metrics, the organization communicates how it wishes the employees to behave, and how this behavior will be judged and evaluated. Effective organizational managers rely on KPIs to set 1 direction, make strategic decisions, and achieved desired goals. It has been suggested that, in today’s competitive and global financial crisis environments, organizations need to be masters at anticipating customers’ needs, devising radical new product and service offerings, and 2 rapidly deploying new production technologies into operating and service delivery processes. For several decades, performance measurement has been used as an internal informational tool to evaluate business units’ operations, and make program and budgetary decisions. PMS and KPIs: Definitions A PMS typically comprises systematic methods of setting business goals, together with periodic feedback 3 reports that indicate progress against those goals. Within a PMS, an organization develops some key performance metrics or indicators. A KPI can be defined as “a quantitative value that can be scaled and used 4 for purposes of comparison.” There is also the view that KPIs are quantifiable performance measurements 5 used to define success factors, and measure progress toward the achievement of business goals.” The PMS literature classifies performance measures into two major groups: financial and non-financial. Financial measures may include return on investment (ROI), earnings per share (EPS), revenue (sales) growth, profit margin, etc. Non-financial measures may include customer satisfaction, employee satisfaction, production efficiency, quality, customer services, etc. Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) 1 of 7
  2. 2. Balanced Scorecard Measures In today’s competitive environment, one that encompasses fierce global competition, advancing technology, and increased customer awareness, traditional KPIs such as ROI and EPS can be inadequate for a business organization. Traditional KPIs. although they can aid in detecting weaknesses with respect to the use, or non-use of individual investment or assets, and focus management’s attention upon earning the best profit possible on the capital available, tend to avoid isolating individual business units, in that it may not be reasonable to expect the same ROI for each unit. If the unit sells its respective products in markets that differ widely, with respect to product development, competition, and customer demand, lack of agreement on the optimum rate of return might discourage managers who believe the rate is set at an unfair level. For the sake of making the current period performance measure look good, be it ROI or EPS, managers may be influenced to make decisions that are not in the best long-run interests of the firm. A major concern with traditional KPIs is that these performance metrics focus on results largely internal to the firm. During the last decade, there has been an overemphasis on the use of financial KPIs to measure firm performance. This has resulted in organizations losing sight of important indicators which measure levels of customer satisfaction, process flexibility, or adaptation in response to changing needs. A strategy which concentrates on financial criteria is too closely related to short-term profit maximization. Broader measures such as customer-based measures, product and process measures, and continual improvement and innovation measures, enable the organization to establish longer-term improvements which further effective competition. Further, the imperative for improved performance measures cannot be ignored with today’s worldwide competition and advancing technologies. Once new technologies are introduced, major organization changes are required, as the interaction between people and technology is essential to ensure business processes become more and more effective, and, therefore, performance measures which focus only on financial criteria will not reflect the new technological and competitive environments. New performance measures, if devised strategically, will profoundly influence business performance. Thus, more attention also needs to be placed on generating suitable non-financial performance measures to be a successful competitor, given today’s global financial crisis. Significant attention is now being given by academics and managers to building a more extensive and linked set of measures for appraising and directing corporate and divisional performance, influenced largely by Kaplan and Norton’s notion of the “balanced scorecard”. The balanced scorecard approach focuses on both financial and non-financial measures. The financial measures indicate if improvements in financial performance resulted from sacrificing investments in new products, or on-time delivery. The balanced scorecard includes financial measures that tell the results of actions already taken. Kaplan and Norton suggest that financial measures should not be eliminated altogether, because a well-designed financial performance measurement system can actually enhance, rather than inhibit an organization’s management program. The balanced scorecard supplements the financial measures with operational measures on customer satisfaction, internal processes, and the firm’s innovation and improvement activities. Kaplan and Norton’s balanced scorecard comprises the following four dimensions: • Financial—applying appropriate financial performance measures to ascertain whether the company is profitable. • Customer—assessing customer satisfaction (the customer perspective). In a competitive market, customers must be content, or market share will drop. Customers care about price, faster and reliable deliveries, design, quality, and level of services. • Internal business processes—tracking inter-organizational indicators to determine whether the business units are efficiently using resources, and ascertaining competitive performance in developing “next generation” products. • Learning and growth dimension—this measures such things as training and development, information systems, employee satisfaction, employee productivity, etc. Kaplan and Norton suggest that the use of the balanced scorecard may motivate breakthrough improvements in critical activity areas such as products, processes, customers, and market developments. They further suggest that, while traditional financial measures report on what happened in the last period without indicating how managers can improve performance in the next, the balanced scorecard functions as the cornerstone of a company’s current and future success. Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) 2 of 7
  3. 3. Table 1 provides examples of widely used KPIs within a PMS in a manufacturing setting. Table 1. KPIs in a PMS within a manufacturing setting Perspective KPIs Financial Operating income Sales growth Return on investment Earnings per share Customer Market share Customer response time On-time delivery Number of customer complaints Number of warranty claims Customer satisfaction survey Sales return due to poor quality Internal business processes Material efficiency variance Labor efficiency Ratio of good output to total output at each production process Rate of material scrap loss Number of new patents Number of new product launches Employee learning and growth Employee satisfaction survey Employee education and training Employee health and safety Case Study 6 Aligning KPIs and Strategy Omega is a water utility company that provides five core services to its customers, namely bulk water supply, water purification, reticulation of water and wastewater treatment, and wastewater disposal. On average, Omega provides services to more than 157,000 residential properties. In July 2003, Omega introduced a multidimensional PMS to improve accountability, and to communicate to organizational members the objectives and targets of the entity. As shown in Table 2, Omega developed a total of 33 KPIs for each of its six major activities. Table 2 shows this new KPI system, which, consistent with the balanced scorecard, combines a series of non-financial and financial KPIs. According to Omega’s senior management, one of the advantages of adopting a multidimensional PMS is that it gives a better indication to employees of the long-term organizational priorities. It also helps to communicate any crisis to all of Omega’s divisions, which was important to ensure that any impact is minimized. Each KPI is tailored, not to a division but to one of the five major activities of Omega, consistent with its attempts to become more outcome-focused. For instance, the percentage of lost working days or absentees is aimed at measuring Omega’s ability to be a chosen employer. Similarly, the return on net operating assets is a new KPI, which is used to measure the commercial sustainability of Omega. In setting the KPIs, Omega employees suggested that it was common when the information was available to benchmark against other water entities, to ensure that the divisions are providing a service at a similar standard as their private and public counterparts, so that they are not seen to be performing poorly when the contractual period ends. Some of Omega’s subdivisions also suggested that this had put the division under pressure to improve its performance. Table 2. KPIs of Omega Major strategic focus KPIs Customer focus % Customer satisfaction % Compliance with verbal service-request response times Number of water supply interruptions per 1,000 properties Number of planned water supply interruptions per 1,000 properties Number of unplanned water supply interruptions per 1,000 properties % of water and wastewater service interruptions within 5 hours Number of customer complaints per 1,000 properties Number of water quality complaints per 1,000 properties Number of odor complaints per 1,000 Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) 3 of 7
  4. 4. properties % of meters installed within 14 days from date of payment Chosen employer % lost working days Training expenditure versus total operating expenditure (%) Environmental sustainability % tests meeting WWTP EPA license criteria Quantity of treated water supplied per property, not seasonally adjusted Number of uncontained wastewater spills % of wastewater spilt per wastewater treated % effluent reused Commercial sustainability Combined operating costs per property % expended of revenue-funded capital expenditure Water and wastewater renewals expenditure as a percentage of current replacement cost of system assets % unaccounted water Operating profit Return on turnover (net profit after tax/sales) Return on net operating assets (EBIT/total net assets) Debt-equity ratio (total interest-bearing debt/total equity) Total financial distribution to council (as a % of post-tax profits) Quality water service provision % tests meeting NHMRC (1996) bacteria criteria % tests meeting NHMRC (1996) chemical criteria Water main breaks per 100km of water main Sewer chokes per 100km of wastewater main Wastewater main (gravity and pressure) breaks per 100km of main Accountability % Compliance with wastewater spillage procedure (ensures spillages are properly reported and remedied) Maintenance of ISO 9000 and 14000 third-party certification Conclusion An English-born American communications executive, who was president and CEO of ITT, suggests that, “the best way to inspire people to superior performance is to convince them by everything you do and by 7 your everyday attitude that you are wholeheartedly supporting them.” This short article suggests that measuring performance is important for all businesses. However, it is much more difficult to develop KPIs for each area of performance within the organization which can be measured effectively. Effective KPIs are those that enhance business performance in all areas of businesses—financial and non-financial. Harold Green remarks: “Performance stands out like a ton of diamonds. Non-performance can always be explained away.” KPIs need to be developed to fit to the business process flow, and focus attention on the critical success factors of the business. Making It Happen Developing KPIs is a critical decision-making process for any organization. Effective KPIs are those that help the organization to achieve its desired outcomes. Performance indicators must advocate the firm’s internal and external environment. However, for many firms the difficulty is that there are too many KPIs, ones that are outmoded, and that are not harmonious. KPIs should observe changes in the market environment, determine and assess progress towards business strategies and goals, and affirm achievement of performance goals. This is elaborated in turn. Robert Simon at Harvard University developed three tests to assess whether a measure or metric is suitable to support a performance goal. 1. Does the KPI align with business strategy? 2. Can it measured effectively (that is, metrics should be objective, complete and responsive)? Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) 4 of 7
  5. 5. 3. Is the measure linked to economic value? 8 According to Robert Simon (2000, p.239): “To be effective as communication devices, managers must use measures to focus attention. As you all know, what gets measured gets managed.” Linking KPIs to Business Strategy and Competitive Environments Strategy plays an important role in the choice of KPIs, and effective KPIs must be able to assess the organization’s progress on strategic priorities. Business strategy has been broadly conceptualized as a continuum spectrum between two extreme orientations: at one extreme, prospector or differentiator firms; and at the other end, defender or cost-leader firms. However, some business units may stand between both 9 defenders and prospectors, which are often refereed to as “analyzers.” As defender or cost leaders focus on searching for new ways to reduce production and distribution costs, to cut marketing expenses, and to improve product quality, short-term, retrospective financial and efficiency indices (for example, cost control, internal business processes, quality and efficiency, operating profit, cash flow from operations, return on investment, etc) are relatively informative KPIs of performance. In contrast, as prospectors or differentiators compete in a broad product market domain by introducing new products and developing new markets, KPIs for focuses such as these would necessarily come from knowing what the customer wants, the level of staff involvement in creativity, and the ability of the organization to produce and market new products. Hence, a greater usage of non-financial KPIs (for example, new product development, market share, and customer satisfaction), as opposed to short-term financial indicators, would be prominent in this type of firm. Analyzer strategies combine both defender and prospector strategies. As a result, an analyzer firm’s organizational problem is how to accommodate both stable and dynamic areas of operations. The first concentrates on being efficient, and the second concentrates on watching its competitors closely, so as to determine the possibility of introducing new products or services as rapidly as possible. In relation to the first area, analyzers may tend to emphasize stability, defense of the firm’s position in the market, and to earn the best profit possible. The key rationale being that too many firms are able to provide the same product at the same price, hence the incentive to increase sales, or the profit margin, is to ensure its internal processes are acting as efficiently and cost-effectively as possible. As a result, analyzers may place emphasis on short-term, financial KPIs. The second area focuses on new market opportunities by developing new brands in response to emerging environmental trends. Consequently, the level of uncertainty would be high in organizations pursuing analyzer strategy. Consistent with this strategic position, analyzers are also likely to rely more on non-financial KPIs. Thus, since analyzers operate in two combined market areas, these firms would then be more prone to incorporate a much broader range of KPIs, such as that required by the balanced scorecard. It is felt that for analyzers, four dimensions of the balanced scorecard, as outlined above, can be regarded as meeting organizational performance measurement requirements, as they provide useful insights into the firm’s performance evaluation paradox in one report. In conclusion, different types of strategy will require different types of PMS and KPIs, and an appropriate fit between PMS and strategy is likely to enhance a firm’s performance. Aligning KPIs and Incentives Are KPIs linked to employee incentives? If KPIs are not linked to employee incentive schemes they tend to be overlooked by employees and therefore they are likely to result in no desired outcomes. KPIs must be aligned with employees’ individual goals and job descriptions. As a rule of thumb, Robert Simon suggested a maximum of 10 KPIs for each individual; otherwise individuals may suffer from information overload. With a reasonable number of KPIs, at the individual level, employees use KPIs to track their performance against agreed targets. Further, when developing KPIs for individuals, financial indicators should integrate nonfinancial or operational indicators on customer satisfaction, internal processes and the firm’s innovation and improvement activities. Implementation of KPIs Organizations also need to place greater emphasis on implementation issues when designing and implementing a PMS, and relevant KPIs. A recent study in Australia identified several factors (such as top Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) 5 of 7
  6. 6. management support, adequate technology, greater employee involvement in the design stage, adequate staff training and education, and linking PMS and KPIs with other financial control models) that impact on the 10 successful implementation of a new PMS. More Info Books: • Hoque, Z. Handbook of Cost and Management Accounting. London: Spiramus, 2005. • Hoque, Z. Strategic Management Accounting: Concepts, Processes and Issues. 2nd ed. Sydney, Audtralia: Pearson Education, 2003. • Johnson, H. T., and R. S. Kaplan. Relevance Lost, the Rise and Fall of Management Accounting. Boston, MA: Harvard Business School Press, 1987. • Kaplan, R. S., and D. P. Norton. The Balanced Scorecard: Translating Strategy into Action. Boston, MA: Harvard Business School Press, 1996. • Lynch, R. L., and K. F. Cross. Measure Up! Cambridge, MA: Blackwell Publishers, 1991. • Niven, P. R. Balanced Scorecard Step by Step: Maximizing Performance and Maintaining Results. New York: Wiley, 2000. • Simon, R. Performance Measurement & Control Systems for Implementing Strategy. Upper Saddle River, NJ: Prentice Hall, 2000. Articles: • Ittner, C. D., D. F. Larcker, and M. V. Rajan. “The choice of performance measures in annual bonus contracts.” The Accounting Review 72:2 (1997): 231–255. • Kaplan, R. S., and D. P. Norton. “The balanced scorecard—Measures that drive performance.” Harvard Business Review (January–February 1992): 71–79. • Kaplan, R. S., and D. P. Norton. “Putting the balanced scorecard to work.” Harvard Business Review (September–October 1993): 134–147. • Nanni, A. J. Jr, J. R. Dixon, and T. E. Vollmann. “Integrated performance measurement: Management accounting to support the new manufacturing realities.” Journal of Management Accounting Research 4 (1992): 1–19. Websites: • Website of Better Management: • Website of the Balanced Scorecard Institute: Notes 1 Simon (2000), p.3. 2 Kaplan and Norton (1996). 3 Simon (2000), p.7. 4 Ibid., p.234. 5 See, accessed on February 11, 2009. 6 Based on Moll, J. and Z. Hoque. “New organizational forms and accounting innovation: The specifier/ provider model in the Australian public sector.” Journal of Accounting & Organizational Change 4:3 (2008): 243–269. 7 See, accessed on February 19, 2009. 8 For further details, refer to Simon (2000), pp.234–238. 9 Miles, R.E. and Snow, C.G. Organizational Strategy, Structure, and Process. New York: McGraw Hill. 10 Hoque, Z. and C. Adams. Measuring Public Sector Performance: A Study of Australian Government Departments. Melbourne: CPA Australia, 2008. Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) 6 of 7
  7. 7. See Also Best Practice • Multidimensional Performance Measurement Using the Balanced Scorecard • Navigating a Liquidity Crisis Effectively Checklists • Assessing Business Performance • Understanding Key Performance Indicators • Understanding the Balance Sheet • Using and Understanding Financial Ratios for Analysis To see this article on-line, please visit Enhance Competitive Performance via Critical Key Performance Indicators (KPIs) 7 of 7