Most firms base their higher managerial-level results controls on accounting measures of performance; that is, accounting profits and returns and their components (revenues, costs, assets, and liabilities). Accounting measures have some significant advantages over all other measurement alternatives. In particular, they provide a useful summary of the results of the many actions that managers take. It must be recognized, though, that even the best accounting measures are not perfect; they are only surrogate indicators of changes in firm value.
Measuring the right things The ideal performance management system is one that energizes the people in an organization to focus effort on improving things that really matter - one that gives people the information and freedom that they need to realize their potential within their own roles and that aligns their contribution with the success of the enterprise. Many systems fail to achieve this ideal. One of the root causes of failure is over-complexity - it is the death knell of a performance management system. Detail can swamp useful information, paralyzing decision making. The effort of collecting the data can outweigh the benefit of having the information. This scenario guarantees disenchantment for staff and a system that atrophies from underuse. Systems fall prey to over-complexity because organizations themselves are complex. Except in the most streamlined, most tightly engineered organizations, many levels of management interact across functions in the pursuit of &quot;what has to be done&quot; (WHTBD). Responsibility for WHTBD is too often diffuse and a typical reaction to this is a system which measures minutiae and further obscures the underlying reasons for good or bad performance.
Measure what matters This is easy to say but difficult to do. One way to check for yourself where to focus your measurement effort is to plot what you, your team or your organization actually do on a value matrix similar to the one in figure 1. The activities in the top right box - highly valued both by customers and stakeholders or shareholders - are the ones to measures, to focus on, to (with apologies to North American readers) beaver away at. If your analysis shows much of your current effort to be focused in the dog box, - no value to anyone - you’re not alone. Experience shows some senior managers spend up to an amazing 80% of their energy on &quot;corporate hygiene&quot; - the activities that keep an organization ticking but don’t contribute to its prime functions. Identifying this is the first step in doing something about it. This matrix also tells you what sort of measures to apply: o Focus on measures which will help you work hard to improve value from both the customer’s perspective and the shareholder’s perspective, e.g. process: new product development, measure: time to market. o Concentrate on generating more value for the shareholder, don’t let the process become a white elephant, gobbling your resources but not contributing value to you. e.g. process: customer service, measure: customer retention. o Keep these processes lean, don’t let them proliferate. e.g. process: treasury management, measure: cost of service vs. value created. o Make sure that you don’t waste any effort, outsource, let someone else walk the dog for you. e.g. process: pensions administration, measure: who cares as long as it gets done?
Keep it simple The second guiding principle has three elements. The measuring system should be: • simple to operate • simple to understand • simple to action For a system to be simple to operate, data collection must be easy, distribution must be timely, and the information should be easy to manipulate. Make sure that information demands are matched by ability to deliver. Simple needs can be easily met by low technology, manual systems. Complex needs have to be supported by systems investment: don’t get stuck in a situation where you force your front line staff to spend significant time gathering and manipulating data - this takes minds of WHTBD: if salesmen spend too much time on call reporting, they have less time for making calls. For a system to be simple to understand, information must be clearly presented and there must be as little of it as possible. Clear presentation can take many forms. Perhaps the most elegant is to compare your actual performance against what you were expecting - your forecast - indexed as 100. Good performance will always give you a Figure 1. Concentrate on what really matters number greater than 100, and bad performance less than 100. What could be simpler? Volume of information can be kept under control by having cascades of measures at different levels in an enterprise. This balances the need for actionable information at all levels with the absolute imperative never to overload anyone. The check questions is &quot;will the person receiving this information do anything with it themselves?&quot;. If the answer is yes, make sure they get it. Without it, they will never be able to take action. In practice, guarantees that a measurement system will be simple to action go beyond the gifts of the measurement system alone. This is determined by an organization’s modus operandi, management style, appraisal and reward system, etc. For example, two health service managers are told to cut costs by 5/5. One works hard and achieves the goal. The other decides that the target is too difficult and overspends. The achiever is told to work even harder to save more next yea; the budget buster is given more money. Message, forget the targets, chaos equals cash. However, the measurement system itself must observe two key principles to help make it actionable. The first is give people the information they need, don’t expect people to meet or exceed your expectations if they don’t know what is important and how they’re doing. The second is make sure the information sends the right message. For example, a manager of a tissue paper factory who has a production target expressed in tons will make you the heaviest tissue paper you ever blew your nose with. This is great for his bonus and bad for your business. He needs quality targets too or he will continue to work to perverse incentives and produce perverse results. These simple guidelines explain the principles of measuring the right things. It is difficult to do, but it is absolutely vital if you are to achieve the holy grail of performance managers - a performance managem
It is possible to measure accounting profits in short time periods. Because accounting rules exist, different people assigned to measure the profit of an entity for any given period will arrive at approximately the same number. Second, compared with other quantities that can be measured and objectively on a timely basis, such as cash flows, shipments, or sales, accounting measures are relatively congruent with the organizational goal of profit maximization. Accounting profits provide an advantage over cash flows because accounting accruals are designed to provide a better matching of cash inflows and cash outflows. Third, accounting measures can usually be largely controlled by the managers whose performances are being evaluated. The profit performance of a middle-level entity (division) is almost certainly more controllable by, and therefore more indicative of the performance of a, middle-level general manager than is the change in the company’s stock price. Fourth, accounting measures are understandable. Finally, accounting measures of performance are inexpensive.
The correlation between annual profits and stock prices are small. As the time increases, accounting profits have greater correlation with economic income or firm value but not in the short run. How long depends pm what caused the economic income change and what type of accounting measurement rules are being used.
Businesses are being besieged by new measurements. Many of the performance measures developed during the Industrial age were able to capture how well an organization performed. Today, with technology and information systems implementation and a vastly changed business structure, many of these measures are inappropriate or inadequate to tell the stockholders and the organization whether they are in the right direction. Until recently, companies such as GE, DuPont, GE and others, success was measured through efficient allocation of financial capital. Summary financial measures such as ROE, ROA and profit margins. However, these measures are increasingly becoming insufficient to portray the true picture about a firm. For example, PPG industries, uses a form of business array to increase the information content of its financial statements. For each of its major businesses (coatings, resins, glass, and chemicals), it includes annual sales and operating earnings. It then describes each of the business areas in terms of worldwide size, annual growth rate, major products and uses, global competitors, and PPG’s competitive position in the global market. We often read in the news or on the TV that such and such companies are fast-growing, most profitable, and large revenue generators and such and such companies are least profitable, low revenue generators, etc. But if you attempt to compare these companies and why some do better and some do worse, you will not learn much because these companies are not comparable. With the wide variations in accounting practices, differences in asset base and cost of capital, even the profit numbers are not comparable. Let me give you an example. If you compare Bethlehem Steel (steel producer) with Colgate Palmolive (produces consumer goods), their 1989 profits were quite close. Return on sales places them side by side. However, Bethlehem steel requires 50% more capital than Palmolive to manage and if we compare them on the basis of return on capital, Bethlehem will be fare below Colgate.Because of these difficulties, London Business School came out with a OVA or output-based added value analysis. It takes the profit a firm makes, adjusts it for accounting differences and subtracts its capital charge. The reminder is added value for shareholders. There are other measures such EVA or economic value added analysis. Before we find about some of these new measures, let us first examine why traditional performance measures are becoming inappropriate for an IT age.
Cross-functions: IT age competitive advantages come from specialization of functional skills: in manufacturing, purchasing, distribution, marketing and technology. The organization operates with integrated business processes that cut across traditional business functions. Combines functional expertise with speed, efficiency, and quality of integrated business processes. Links to customers and suppliers: Industrial age companies worked with customers and suppliers through arm’s length transactions. Today, organizations integrate supply, production, and delivery processes so that operations are triggered by customer orders, not by production plans that push products and services through the value chain. Every organization within the value chain benefits. Customer segmentation: Industrial age offered low-cost and standardized products and services. Today, organization must learn to customize products and services to its diverse customer segments, without paying the usual cost penalty for high variety, low-volume operations. Global Scale: IT age companies compete against the best in the world. The organization must combine the efficiencies and competitive honing of global operations with marketing sensitivity to local customers. Innovation: Product life cycles shrink. Continuous improvement and product capabilities are a must for survival. Knowledge workers; Industrial age separated employees into managers and engineers and workers who produced products and delivered the services. Today, all organizations and their employees must contribute value by what they know and by the information they can provide. Investing, in, managing, and exploiting the knowledge of every employee have become critical to the success of information age companies.
If the organization tracks the right set of leading indicators and gives them proper importance weightings then profits do not really have to be measured (for results control purposes). The profits will inevitably follow. Empirical evidence, particularly focused on customer satisfaction, appears to support the premise that some non-financial measures are significantly associated with future financial performance and contain additional information not reflected in past financial measures.
For example, when analysts and other evaluators report that the products and services sold by VCB are profitable and add the VCB firm value, they are reporting lag indicators. Remember: Lag indicators of financial performance are important and because financial performance is sometimes too late does not mean that you can ignore them or even nor measure them. Such an action would be unwise and could lead to greater difficulties in an increasingly competitive environment.
Today, firms are expected to build long-term competitive capabilities. That means you need information on your past performance and also be able to plan for the long term future. Most firms indeed measure financial performance and non-financial improvements. However, financial performance takes the front seat and the non-financial performance measures are used mostly as tactical feedback and control of short-term operations. The new emphasis is that you use both these measures at all level of an organization and at all times. You should use the measures to not only to report to your external stockholders and regulators but also to find out how you are functioning in the areas of critical business processes, innovation, learning and growth. The advantage of BSC is that it focuses on links among business decisions and outcomes. It provides reliable feedback for management control and performance evaluation. BSC is not only an evaluation method but also a device that helps (1) strategic guidance to divisional managers and (2) describes links among lagging and leading measures of financial and non-financial performance. It is very useful for low level managers to find out whether their actions conform to company strategy.
They indicate whether the plans and initiatives are contributing to profit improvement. Do you know how to compute ROE, ROA, EPS?
Targeted segments could include both existing and potential customers. Studies have shown that businesses with satisfied, loyal customers become significantly more profitable over time. Loyal customers typically increase the amount of their purchases, cost less to serve, refer new customers to the business, and are willing to pay a price premium for products or services that they trust. Thus, a 5% increase in customer loyalty can produce profit increases from 25% to 85%. The customer perspective typically includes several core or generic measures that relate to customer loyalty. These core outcome measures include customer satisfaction, customer retention, new customer acquisition, customer profitability, and market and account share in targeted segments. See the figure.
Thus, IBP measures should be focused on the internal processes that will have the greatest impact on customer satisfaction and achieving the organization’s financial objectives. Each firm will have a unique set of processes for creating value for customers and producing superior financial results. The Internal value chain model provides a handy template that companies can use to customize for their own objectives and measures in their internal business process perspective of the scorecard.
The customer and internal business process perspectives identify the factors most critical for current and future success. However, businesses are unlikely to be able to meet their long-term targets for customers and internal processes using today’s technologies and capabilities. Intense global competition requires companies to continually improve their capabilities for delivering value to customers and shareholders The financial, customer, and internal business process objectives on the balanced scorecard will typically reveal large gaps between existing capabilities and those required to achieve targets for breakthrough performance. To close the gaps, businesses must invest in training employees, enhancing information technology and systems, and aligning organizational procedures and routines..
While traditional quality programs have focused on detecting and correcting defects, Six Sigma encompasses something broader: It provides specific methods to re-create the process itself so that defects are never produced in the first place.&quot; 1
PERFORMANCE MEASURES - Chapter 11
"We want to change the competitive landscape by being not just better than our competitors, but by taking quality to a whole new level.” – Jack Welch Performance measures should aim at the long-term and should be forward-thinking initiative designed to fundamentally change the way corporations do business. It is not a post-mortem of what happened but a step towards how we do better in the future.
Why measure performance? <ul><li>Objectives for for-profit organizations: </li></ul><ul><ul><li>Measure changes to stakeholders wealth; put in simple terms, the value of a firm. </li></ul></ul><ul><ul><li>Reward an employee for contributing to increase in firm value </li></ul></ul><ul><ul><li>Issue: How would a firm measure an individual’s </li></ul></ul><ul><ul><li>contribution to value creation and what purpose </li></ul></ul><ul><ul><li>does it serve? </li></ul></ul>
The value concept (Results control) <ul><li>The performance measurement concept indicates that employees can increase the value of the firm by </li></ul><ul><ul><li>Increasing the size of a firm’s future cash flows, </li></ul></ul><ul><ul><li>By accelerating the receipt of those cash flows, or </li></ul></ul><ul><ul><li>By making them more certain or less risky. </li></ul></ul>If you are a CEO or CFO, how would you increase the cash flows?
Measure the right things <ul><li>An ideal performance management system is one that energizes the people in an organization to focus effort on </li></ul><ul><li>Improving things that really matter – </li></ul><ul><li>One that gives people the information and freedom that they need to realize </li></ul><ul><li>Their potential within their own roles and that aligns their contribution with the success of the enterprise. </li></ul>
Then, why do performance measures fail? <ul><li>Root cause: complexity - details, details, details </li></ul><ul><li>Staff who collect data get frustrated. </li></ul><ul><li>Follow: What has to be done" (WHTBD). </li></ul>
Measure What Matters <ul><li>Easy to say but difficult to do. </li></ul><ul><li>Find out what is valued both by customers and stakeholders </li></ul><ul><li>Examples: process: new product </li></ul><ul><li>development, measure: time to market. </li></ul><ul><li>process: customer service, measure: customer retention. </li></ul><ul><li>process: treasury management, measure: cost of service vs. value created. </li></ul>
Keep it simple <ul><li>Performance Measures must be </li></ul><ul><li>• simple to operate • simple to understand </li></ul><ul><li>• simple to action </li></ul><ul><li>Ex: If a sales person spends too much time on call reporting, they have less time for making calls. </li></ul>
<ul><li>Let us now examine how real world firms measure performance and we will, later, find out whether these measures conform to the concepts we just discussed. </li></ul>
Most organization measure performance using accounting measures – Net profits, gross margin, ROA, ROE, etc.
Why do organizations choose accounting data as measures of performance? <ul><li>Accounting profits and returns can be measured on a timely basis relatively precisely and objectively. </li></ul><ul><li>Because they are timely, precise, and objective, employees would react positively. </li></ul><ul><li>The short term measures keep employees on check. </li></ul>
Why accounting measures of performance are not adequate? <ul><li>Accounting measures are lagged indicators. </li></ul><ul><li>Dependent on the choice of measurement method. </li></ul>
Accounting can create management myopia <ul><li>Accounting is short term earnings or returns. </li></ul><ul><li>Why focusing on the short term is inappropriate? </li></ul><ul><li>Why would this short-term focus affect long-term relationships? </li></ul>
The Changing Business Environment <ul><li>Are historical accounting measures adequate for today’s business environment that transcend global boundaries? </li></ul>
Performance Measurements for the new era <ul><li>In the global, technology-driven, decentralized environment, measuring </li></ul><ul><li>Financial performance, while important, is not adequate. </li></ul><ul><li>Even if less than precise, other measures of performance are required. </li></ul><ul><li>These measures should be capable of measuring multiple attributes of an organization. </li></ul>
We need a balanced set of Performance Measures – We need both lead and lag indicators
Lead indicators as value drivers <ul><li>Many non-financial indicators can serve as lead indicators in certain settings. </li></ul><ul><li>Common examples are: </li></ul><ul><ul><li>Market share, backlog (book-to-bill ratio), new product introductions, new product development lead times, product quality, customer satisfaction, employee morale, personnel development, inventory turnover, bad debt ratio, or safety </li></ul></ul>
Lag Indicators <ul><li>In contrast to lead indicators, lag indicators are measures that point to earlier plans and their execution. </li></ul><ul><li>Financial performances are lag indicators. </li></ul><ul><li>Many times, financial performances are too late to affect future products and services. </li></ul><ul><li>Therefore, we need multiple measures that include both financial and non-financial measures. </li></ul>
Comprehensive Performance Measures must address <ul><li>Financial performance </li></ul><ul><li>Customer satisfaction </li></ul><ul><li>Internal business process developments and </li></ul><ul><li>Allow an organization to learn and grow. </li></ul>
Financial Performance can be measured by <ul><li>ROA ROE, EPS etc. These measure are essential to summarize the economic consequences of strategy. </li></ul>
Customer-related measures <ul><li>Managers must identify the customer and market segments in which the business desires to compete. </li></ul><ul><li>Develop measures to track the business unit’s ability to create satisfied and loyal customers. </li></ul>
Customer-based measures <ul><li>Customer Satisfaction </li></ul><ul><li>Customer Retention </li></ul><ul><li>Customer Loyalty </li></ul><ul><li>Product and Service Attributes </li></ul>Image and Reputation
Internal Business Process Measures <ul><li>Identify the critical internal processes for which the organization must excel in implementing its strategy. </li></ul><ul><li>IBP dimension enable the business unit to </li></ul><ul><ul><li>deliver the value propositions that will attract and retain customers in targeted market segments, and </li></ul></ul><ul><ul><li>satisfy shareholder expectations regarding financial returns. </li></ul></ul>
Internal Business Process Measures <ul><li>Innovation processes </li></ul><ul><li>Operation Processes </li></ul><ul><li>Quality Measures </li></ul><ul><li>Cycle Time Measures </li></ul>Cost Measures
Learning and Growth measures <ul><li>Learning and growth identifies the infrastructure an organization must build to create long-term growth and improvement. </li></ul><ul><li>Growth comes from: people, systems and organizational procedures. </li></ul>
A performance concept that combines everything that we discusses so far is Six Sigma
The Six Sigma <ul><li>Is “a business process that enables companies to increase profits dramatically by streamlining operations, improving quality , and eliminating defects or mistakes in everything a company does. “ </li></ul><ul><li>The objective is change the process so that defects are never produced in the first place. </li></ul>
The objectives of Six Sigma <ul><li>To ‘satisfy the customer ’ by changing internal performance and processes. </li></ul><ul><li>To enable better performance by better design </li></ul><ul><li>To improve the ‘quality’ of supplies and other operational processes. </li></ul><ul><li>Manage the costs </li></ul>
Six Sigma points out <ul><li>You don't know what you don't know You can't do what you don't know </li></ul><ul><li>You don't know until you measure </li></ul><ul><li>You don't measure what you don't value </li></ul><ul><li>You don't value what you don't measure </li></ul>
Difference between TQM and Six Sigma <ul><li>TQM focuses on improvement in individual operations with unrelated processes; takes many years before all operations within a given process are improved. </li></ul><ul><li>Six Sigma focuses on making improvements in all operations within a process, producing results more rapidly and effectively. </li></ul>