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

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Performance Measurement

“Not everything that can be counted counts, and not everything that counts can be counted”

Albert Einstein

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Importance of Performance Measurement

What gets measured gets improved

Focuses attention on the items measured

Poorly designed measures can result in misguided decisions

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Traditional Performance Measures

External focus

Profitability Net income

Return on assets

Etc.

Market share

Stock price

Etc.

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Traditional Performance Measures

Internal focus

Budget to actual comparisons

Comparisons to targets

Standard costing variances

Etc.

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Traditional, Absorption, GAAPIncome StatementSales(Cost of goods sold)Gross profit/margin(Operating expenses)Operating income+ Other revenue(Other expenses)Income before taxes(Income taxes)Net Income

Product - Mfg DM, DL, OH

Period - SGA R&D Distribution

Interest, dividends, rent

Rent

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

Complexity may lead employees to ignore the 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

Should compensation be tied to the measures?

Powerful motivator

Employees must have some control over the measures

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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

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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

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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)

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Evaluation of Strategic Business Units (SBUs)

Contribution income statement

NotCompany Division A Division B Product 1 Product 2 traceable

Revenue 2,000$ 1,400$ 600$ 900$ 500$ Variable costs 1,100 900 200 500 400 Contribution margin 900$ 500$ 400$ 400$ 100$ Controllable fixed costs 650 400 250 280 90 30$ Controllable margin 250$ 100$ 150$ 120$ 10$ (30)$ Non-controllable fixed costs 100 75 25 40 30 5 Contribution by SBU 150$ 25$ 125$ 80$ (20)$ (35)$

Untraceable costs 80 Operating income 70$

Division A

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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

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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

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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

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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 management’s 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 company’s 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?

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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