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1
Performance Measurement
“Not everything that can be counted counts, and not everything that counts can be counted”
Albert Einstein
2
Importance of Performance Measurement
What gets measured gets improved
Focuses attention on the items measured
Poorly designed measures can result in misguided decisions
3
Traditional Performance Measures
External focus
Profitability Net income
Return on assets
Etc.
Market share
Stock price
Etc.
4
Traditional Performance Measures
Internal focus
Budget to actual comparisons
Comparisons to targets
Standard costing variances
Etc.
5
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
6
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
7
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
8
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
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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
17
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
18
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
19
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
20
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
21
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
22
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
23
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
24
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
25
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)
26
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
27
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
28
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
29
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
30
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?
31
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?
32
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?
33
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