Performance Measurement
“Not everything that can be counted
counts, and not everything that counts
can be counted”
Albert Einstein
1
Importance of Performance
Measurement

What gets measured gets improved

Focuses attention on the items measured

Poorly designed measures can result in
misguided decisions
2
Traditional Performance Measures

External focus

Profitability

Net income

Return on assets

Etc.

Market share

Stock price

Etc.
3
Traditional Performance Measures

Internal focus

Budget to actual comparisons

Comparisons to targets

Standard costing variances

Etc.
4
Traditional, Absorption, GAAP
Income Statement
Sales
(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
5
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
6
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
7
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
8
Criticisms of Traditional Measures

Lack of relevance

Many measures are interesting, but not useful


Measures may be poorly designed or collected


Market share, revenue, etc.
Customer satisfaction, employee morale, etc.
Goals are arbitrarily determined, beyond the
ability of the system
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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
17
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
18
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
19
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
20
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
21
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
22
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
23
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
24
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)


Non-controllable fixed costs (directly related)


Controllable by manager in the short-run
Controllable by manager in the long-run
Untraceable costs (not traceable to the SBU)
25
Evaluation of Strategic Business
Units (SBUs)

Contribution income statement
Division A
Revenue
Variable costs
Contribution margin
Controllable fixed costs
Controllable margin
Non-controllable fixed costs
Contribution by SBU
Untraceable costs
Operating income
Company
$ 2,000
1,100
$
900
650
$
250
100
$
150
80
$
70
Division A
$ 1,400
900
$
500
400
$
100
75
$
25
Division B
$
600
200
$
400
250
$
150
25
$
125
Product 1
$
900
500
$
400
280
$
120
40
$
80
Not
Product 2 traceable
$
500
400
$
100
90 $
30
$
10 $
(30)
30
5
$
(20) $
(35)
26
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
27
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
28
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
29
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?
30
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?
31
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?
32
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
33