Performance
measurement in private sector organisation
1. Performance measurement: Performance measurement aims to establish how well something or
somebody is doing in relation to a plan. Performance measures may be divided
into two types.
• Financial performance indicators
• Non-financial performance indicators
Performance measurement aims to establish how well something
or somebody is doing in relation to a plan. The 'thing' may be a machine, a
factory, a subsidiary company or an organisation as a whole. The 'body' may be
an individual employee, a manager, or a group of people.
Performance measurement is a vital part of the planning
and control process.
1.1 Financial and non-financial performance measures: Measures
of performance may be either financial or non-financial.
(a) Financial measures are typically measures relating to
revenues, costs, profits, return on capital, asset values or cash flows. Actual
performance is often measured against a financial plan, such as a budget.
(b) Non-financial measures may relate to a number of
different aspects of performance, such as:
• Product or service quality
• Reliability
• Speed of performance
• Risk
• Flexibility
• Customer attitudes
• Innovation
• Capability
• Pollution
It may be asked why organisations in the private sector
whose primary objective is to make profits for shareholders should be
particularly concerned with non-financial aspects of performance.
The answer is quite simply that non-financial aspects of
performance are often a good indicator of future financial performance. Strong
financial performance is not achievable over the long term unless non-
financial performance is sufficiently strong to sustain the business.
Some performance measurements combine financial and
non-financial aspects of performance, especially performance that relates to
the efficiency of resource utilisation or capacity utilisation. Examples are
such measures as cost per patient day in the hospital service and cost per
tonne-mile in the transport and distribution industry.
1.2 Performance measures: The performance measures
that are used will vary between organisations. Different measures are
appropriate for different businesses. Other factors that influence the design
of a performance management system are:
(a) Measurement needs resources – people, equipment
and time to collect and analyse information. The costs and benefits of
providing resources to produce a performance indicator must be carefully
weighed up.
(b) Performance
must be measured in relation to something, otherwise measurement is
meaningless. Overall performance should be measured against the objectives of the organisation and the plans that result from those
objectives. If the organisation has no clear objectives, the first step in
performance measurement is to set them. The second is to identify the factors
that are critical to the success of those objectives.
(c) Measures
must be relevant. This means finding out what the organisation does and how
it does it so that measures reflect what actually occurs.
(d) Short- and
long-term achievement should be
measured. Short-term targets can be valuable, but exclusive use of them may
direct the organisation away from opportunities that will mean success for the
business in the long term.
(e) Measures should be fair. They should only include factors which managers can control
by their decisions, and for which they can be held responsible. Measuring controllable costs, revenues and assets may
prove controversial, however.
(f) A variety of
measures should be used. Managers may be able to find ways to distort a single
measure, but should not be able to affect a variety of measures. The balanced
scorecard (Section 6) provides a method of measuring performance from a
number of perspectives.
(g) Realistic
estimates may be required for measures to be employed. These include
estimates of financial items whose value is not certain, such as the cost of
capital, and estimates of the impact of non-financial items.
(h) Measurement needs responses, and above all managers to make decisions in the best
interests of the organisation. Managers will only respond to measures that they
find useful. The management accountant therefore needs to adopt a modern
marketing philosophy to the provision of performance measures: satisfy customer
wants, not pile 'em high and sell 'em cheap.
Once suitable performance measures have been selected they
must be monitored on a regular basis to
ensure that they are providing useful information. There is little point in an
organisation devoting considerable resources to measuring market share if an
increase in market share is not one of the organisation's objectives.
1.3 Quantitative and qualitative performance measures:
Quantitative information is information that is expressed in numbers and by
measurements. Qualitative information is not numerical, and may relate to such
issues as customer loyalty, employee morale and capability. Qualitative
information can sometimes be converted into quantitative values through tools
such as ranking scales. For example 1 = Good, 2 = Average, 3 = Poor.
(a) An example of a quantitative
performance measure is: 1,000 units were produced in 50 hours at a cost of
$15 per unit.
(b) An example of a qualitative
performance measure is 'Market research indicates a very strong and positive
consumer response to the new product.'
Qualitative measures are
by nature subjective and judgmental but they can still be
useful. They are especially valuable when they are derived from several different sources, as the likelihood of
an unreliable judgement is reduced.
Consider the statement: 'Seven out of ten customers think
our service is very reliable.'
This is a quantitative
measure of customer satisfaction (seven out of ten), as well as a qualitative measure of the perceived
performance of the service (very reliable).
2. Financial performance indicators (FPIs): Financial performance indicators analyse
return on capital, profitability, liquidity and financial risk, often in
relation to a plan or budget, or in relation to performance in preceding time
periods.
Financial indicators (or monetary measures) include:
• Profit (both gross profit and net profit)
• Revenue
• Costs
• Cash flows
• Debt and gearing
The two most common ways of using financial measures to
assess performance are:
• Comparing actual results with the budget or another
financial plan
• Comparing performance in the most recent time period with
performance in a corresponding previous time period (or analysing a trend
over time)
Financial measures may be presented as ratios, such
as gross profit margin (gross profit/sales), and return on capital employed
(net profit/capital employed).
Monetary amounts have meaning only in relation to
something else. Financial results should be compared against a benchmark
such as:
• Budgeted sales, costs and profits
• Standards in a standard costing system
• The trend over time (last year/this year, say)
• The results of other parts of the business
• The results of other businesses
• Future potential (for example, the performance of a
new business may be judged in terms of nearness to breaking even)
2.1 Profitability: In private sector organisations,
the most important financial performance indicators are measurements of profit.
A company ought of course to be profitable, and there are
obvious checks on profitability.
(a) Whether the company has made a profit or a loss on its
ordinary activities
(b) By how much this year's profit or loss is bigger or
smaller than last year's profit or loss
It is probably better to consider separately the profits or
losses on exceptional items if there are any. Such gains or losses should not
be expected to occur again, unlike profits or losses on normal trading.
Another profit figure that should be calculated is PBIT:
profit before interest and tax. This is the amount of profit which the
company earned before having to pay interest to the providers of loan
capital. PBIT is often the same as 'operating profit'.
PBIT = profit on ordinary activities before taxation +
interest charges on long-term loan capital
PBIT is also often Gross profit – Other operating costs.
2.1.1 Sales margin (gross profit margin): Sales margin is turnover less cost of
sales. It is also called gross profit. Look at the following examples.
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(a)
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XYZ Printing Company
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$'000
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Turnover
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89,844
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|
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Cost of sales
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(60,769)
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|
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Gross profit
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29,075
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Distribution expenses
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(1,523)
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|
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Administrative expenses
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(13,300)
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|
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Goodwill amortisation
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(212)
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|
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Operating profit (15.6%)
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14,040
|
Cost of sales consists of direct material
cost, such as paper, and direct labour. Distribution and administrative
expenses include depreciation. Sales margin = 32%
(29,075/89,844).
(b) Fairway Transport, a bus company
|
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$m
|
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Turnover
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1,534.3
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Cost
of sales
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1,282.6
|
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Gross profit
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251.7
|
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Net operating expenses
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133.8
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Operating profit (7.6%)
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117.9
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(1) Sales margin as a measure is not really any use in comparing companies in different industries.
Cost structures differ with the nature of business operations.
(2) Comparisons with
similar companies in the same industry may be of interest. If an
organisation has a lower sales margin than a similar business, this suggests
problems in controlling costs.
(3) Trends in
profit margin are also of interest. A falling sales margin suggests an
organisation has not been able to pass on input price rises to customers.
(4) A comparison of actual profit with budgeted profit would
also be of interest, but this information is not always available to the person
who is analysing financial performance.
In short, the value of gross profit margin as a measure of
performance depends on the cost
structure of the industry and the uses
to which it is put.
2.1.2 Net profit margin: For the purpose of the exam,
net profit margin is either profit before interest and tax/sales or operating
profit/sales, depending on the information you are given for analysis.
As with gross profit margin, net profit margin only has meaning
when compared with performance in the previous period(s) or performance of
similar companies in the same industry.
2.1.3 Cost/sales ratios: When there is a significant
change in the net profit ratio from one year to the next, it may be useful to
identify the main cause of the change. For example, if the net profit ratio
falls from 8% in one year to 2% in the next year, the fall in the net profit
ratio is likely to be due to a fall in the gross profit margin, or an increase
in:
(a) The ratio of sales and distribution costs to sales
(b) The ratio of administrative costs to sales
(c) The ratio of another cost to sales, such as R&D
costs
A significant increase in the ratio of costs to sales (with
a corresponding fall in profit margin) would need to be investigated.
Earnings per share (EPS): EPS is a measure that
relates profitability to the shareholder. It is the profit after tax (and any
preference dividend) divided by the number of shares in issue.
EPS is widely used as a measure
of a company's performance, especially in comparing results over a period of several years. A company must be able to sustain its earnings in
order to pay dividends and reinvest in the business so as to achieve future
growth. Investors also look for growth
in the EPS from one year to the next.
Earnings per share
(EPS) is defined as the profit attributable to each equity (ordinary)
share.
EPS on its own does
not really tell us anything. It must be seen in context.
(a) EPS is used for comparing the results of a company over time. Is its EPS growing? What is
the rate of growth? Is the rate of growth increasing or decreasing?
(b) EPS should not be used blindly to compare the earnings
of one company with another. For example, if A plc has an EPS of 12c for its
10,000,000 10c shares and B plc has an EPS of 24c for its 50,000,000 25c
shares, we must take account of the numbers of shares. When earnings are used to compare one company's
shares with another, this is done using the P/E ratio or perhaps
the earnings yield.
(c) If EPS is to be a reliable basis for
comparing results, it must be
calculated consistently. The EPS of
one company must be directly comparable with the EPS of others, and the EPS of
a company in one year must be directly comparable with its published EPS figures
for previous years. Changes in the share capital of a company during the course
of a year cause problems of comparability.
(d) EPS is a figure based on past data, and it is
easily manipulated by changes in accounting policies and by mergers or acquisitions.
The use of the measure in
calculating management bonuses makes it particularly liable to manipulation. The attention given to EPS as a performance
measure by City analysts is arguably disproportionate to its true worth.
Investors should be more concerned with future earnings, but of
course estimates of these are more difficult to reach than the readily
available figure.
2.1.5 Profitability
and return: the return on capital employed (ROCE): It is impossible to assess profits or profit growth properly without
relating them to the amount of funds (capital) employed in making the profits.
An important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage
of the amount of capital employed.
Return on Capital
Employed =
Capital employed = Shareholders' funds plus 'payables: amounts falling due after more than one year' plus any long-term
provisions for liabilities.
= Total assets less
current liabilities.
What does a company's ROCE tell us? What should we be looking for?
There are three comparisons that can be made.
(a) The change in ROCE from one year to the
next
(b) The ROCE being earned by other companies, if this
information is available
(c) A comparison of the ROCE with current market
borrowing rates
(i) What would be the cost of extra borrowing to
the company if it needed more loans, and is it earning an ROCE that suggests it
could make high enough profits to make such borrowing worthwhile?
(ii) Is the company making an ROCE which suggests
that it is making profitable use of its current borrowing?
2.1.6 Analysing profitability and return in more
detail: the secondary ratios: We may analyse the ROCE to find out why it is
high or low, or better or worse than last year. There are two factors that
contribute towards a return on capital employed, both related to turnover.
(a) Profit margin. A company might make a high or a low profit
margin on its sales. For example, a company that makes a profit of 25c per $1
of sales is making a bigger return on its turnover than another company making
a profit of only 10c per $1 of sales.
(b) Asset turnover. Asset turnover is a measure of how well the
assets of a business are being used to generate sales. For example, if two
companies each have capital employed of $100,000, and company A makes sales of
$400,000 a year whereas company B makes sales of only $200,000 a year, company
A is making a higher turnover from the same amount of assets and this will help
company A to make a higher return on capital employed than company B. Asset
turnover is expressed as 'x times' so that assets generate x times their value
in annual turnover. Here, company A's asset turnover is four times and company
B's is two times.
Profit margin and asset turnover together explain the ROCE, and if the
ROCE is the primary profitability ratio, these other two are the secondary
ratios. The relationship between the three ratios is as follows.
Profit margin × asset turnover = ROCE
It is also worth commenting on
the change in turnover from one year to the next. Strong sales growth will
usually indicate volume growth as well as turnover increases due to price
rises, and volume growth is one sign of a prosperous company.
2.2 Gearing: The assets of a
business must be financed somehow and, when a business is growing, the
additional assets must be financed by additional capital. Capital
structure refers to the way in which an organisation is financed, by a
combination of long-term capital (ordinary shares and reserves, preference
shares, debentures, bank loans, convertible bonds, and so on) and short-term
liabilities, such as a bank overdraft and trade payables.
2.2.1 Debts and financial risk: There are two main
reasons why companies should keep their debt burden under control.
(a) When a company is heavily in debt, and seems to be becoming even
more heavily so, banks and other would-be lenders are very soon likely to
refuse further borrowing and the company might well find itself in trouble.
(b) When a company is earning only a modest profit before interest and
tax, and has a heavy debt burden, there will be very little profit left over
for shareholders after the interest charges have been paid. And so, if interest
rates were to go up or the company were to borrow even more, it might soon be
incurring interest charges in excess of PBIT. This might eventually lead to the
liquidation of the company.
A high level of debt creates financial risk. Financial risk
can be seen from different points of view.
(a) The company as a whole: If a
company builds up debts that it cannot pay when they fall due, it will be
forced into liquidation.
(b) Payables: If a company cannot pay its debts, the company
will go into liquidation owing creditors money that they are unlikely to
recover in full.
(c) Ordinary shareholders: A company will not
make any distributable profits unless it is able to earn enough profit before
interest and tax to pay all its interest charges, and then tax. The lower the
profits or the higher the interest-bearing debts, the less there will be, if
there is anything at all, for shareholders.
When a company has preference shares in its capital structure, ordinary
shareholders will not get anything until the preference dividend has been paid.
2.3 Gearing ratios: Gearing ratios measure the financial risk of a company's
capital structure. Business risk can be measured by calculating a company's
operational gearing.
Financial
leverage/gearing is the use of debt finance to increase the return on equity by using
borrowed funds in such a way that the return generated is greater than the cost
of servicing the debt. If the return on borrowed funds is less than the cost of
servicing the debt, the effect of gearing is to reduce the return on equity.
Gearing measures the relationships between shareholders' capital
plus reserves, and debt. Debt is any loans which pay fixed interest and are
secured. In this exam, overdrafts do not form part of debt in a gearing ratio.
The common gearing ratios are:
Gearing =
and Gearing =
When applying the above ratios, remember to compare like with like (apply the same
gearing ratio throughout to enable accurate comparisons to be made).
A gearing ratio of over 50% indicates high gearing.
There is no absolute limit to what a gearing
ratio ought to be. Many companies are highly geared, but if a highly geared
company is increasing its gearing it is likely to have difficulty in the future
when it wants to borrow even more, unless it can also boost its shareholders'
capital, either with retained profits or with a new share issue.
2.3.1 The effect of gearing on earnings: The level of
gearing has a considerable effect on the earnings attributable to the ordinary
shareholders. A highly geared company must earn enough profit to
cover its interest charges before anything is available for equity. On the
other hand, if borrowed funds are invested in projects which provide returns in
excess of the cost of debt capital, then shareholders will enjoy increased
returns on their equity.
Gearing, however, also increases
the probability of financial failure occurring through a company's
inability to meet interest payments in poor trading circumstances.
2.3.2 Example: Gearing: Suppose that two
companies are identical in every respect except for their gearing. Both have
assets of $20,000 and both make the same operating profits (profit before
interest and tax: PBIT). The only difference between the two companies is that
Nonlever Co is all equity financed and Lever Co is partly financed by debt
capital, as follows.
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Nonlever Co
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Lever Co
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$
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$
|
|
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Assets
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20,000
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20,000
|
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10% bonds
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0
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(10,000)
|
|
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20,000
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10,000
|
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Ordinary shares
of $1
|
20,000
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10,000
|
Because Lever has $10,000 of 10% bonds it must make a profit before
interest of at least $1,000 in order to pay the interest charges. Nonlever, on
the other hand, does not have any minimum PBIT requirement because it has no
debt capital. A company, which is lower geared, is considered less risky than a higher
geared company because of the greater likelihood that its PBIT will be high
enough to cover interest charges and make a profit for equity shareholders.
2.3.3 Operating gearing: Financial risk, as
we have seen, can be measured by financial gearing. Business risk refers to the risk
of making only low profits, or even losses, due to the nature of the
business that the company is involved in. One way of measuring business risk is
by calculating a company's operating gearing or 'operational
gearing'.
Operating gearing or leverage =
If contribution is high but PBIT is low, fixed costs will be high, and only just
covered by contribution.
Business risk,
as measured by operating gearing, will be high. If contribution is not
much bigger than PBIT, fixed costs will be low, and fairly easily covered.
Business risk, as measured by operating gearing, will be low.
2.4 Liquidity and
cash flow: A company can be
profitable but at the same time get into cash flow problems. Liquidity ratios (current
and quick) and working capital turnover ratios give some idea
of a company's liquidity and ability to generate cash from its business
operations.
Profitability is of
course an important aspect of a company's performance, and debt or gearing is
another. Neither, however, addresses directly the key issue of liquidity. A
company needs liquid assets so that it can meet its debts when they fall due.
Liquidity is
the amount of cash a company can obtain quickly to settle its debts (and
possibly to meet other unforeseen demands for cash payments too).
2.4.1 Liquid assets: Liquid
funds include:
(a) Cash
(b) Short-term
investments for which there is a ready market, such as investments in shares of
other companies (NB not subsidiaries or associates)
(c) Fixed-term
deposits with a bank or building society, for example six-month deposits with a
bank
(d) Trade
receivables
(e) Bills of
exchange receivable
Some assets are more
liquid than others: Inventories of
goods are fairly liquid in some businesses. Inventories of finished production
goods might be sold quickly, and a supermarket will hold consumer goods for
resale that could well be sold for cash very soon. Raw materials and components
in a manufacturing company have to be used to make a finished product before
they can be sold to realise cash, and so they are less liquid than finished
goods. Just how liquid they are depends on the speed of inventory turnover and
the length of the production cycle.
Non-current assets
are not liquid assets: A company
can sell off non-current assets, but unless they are no longer needed, or are
worn out and about to be replaced, they are necessary to continue the company's
operations. Selling non-current assets is certainly not a solution to a
company's cash needs, and so although there may be an occasional non-current
asset item which is about to be sold off, probably because it is going to be
replaced, it is safe to disregard non-current assets when measuring a company's
liquidity.
In summary, liquid assets are current asset items that
will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are all current assets or all current assets with the exception of inventories.
The main source of
liquid assets for a trading company is sales. A company can obtain cash from sources other than sales, such as the
issue of shares for cash, a new loan or the sale of non-current assets.
However, a company cannot rely on these at all times and, in general, obtaining
liquid funds depends on making sales and profits.
2.4.2 The current
ratio: The current ratio is the standard test of liquidity.
Current ratio =
A company should have enough current assets that give a promise of
'cash to come' in order to meet its commitments to pay its current liabilities.
Obviously, a ratio in excess of 1 should be expected. In practice, a
ratio comfortably in excess of 1 should be expected, but what is 'comfortable'
varies between different types of business.
Companies are
not able to convert all their current assets into cash very quickly. In particular,
some manufacturing companies might hold large quantities of raw material
inventories, which must be used in production to create finished goods.
Finished goods might be warehoused for a long time, or sold on lengthy credit.
In such businesses, where inventory turnover is slow, most inventories are not
very liquid assets, because the cash cycle is so long. For these reasons, we
calculate an additional liquidity ratio, known as the quick ratio or acid test
ratio.
2.4.3 The quick ratio:
Quick ratio or acid test ratio =
This ratio should
ideally be at least 1 for companies with a slow inventory turnover. For companies with a fast inventory turnover, a quick ratio can be less than 1 without suggesting that the company is in cash flow difficulties.
Do not forget the
other side of the coin. The current ratio and the quick ratio can be bigger
than they should be. A company that has large volumes of inventories and
receivables might be overinvesting in working capital, and so tying up more
funds in the business than it needs to. This would suggest poor management of
receivables or inventories by the company.
2.4.4 The accounts
receivable payment period
Accounts receivable
days or accounts receivable payment period =
× 365 days
This is a rough measure of the average length
of time it takes for a company's accounts receivable to pay what they owe.
The trade accounts
receivable are not the total figure for accounts receivable in the
balance sheet, which includes prepayments and non-trade accounts receivable.
The trade accounts receivable figure will be itemised in an analysis of the
total accounts receivable, in a note to the accounts.
The estimate of
accounts receivable days is only approximate.
(a) The balance
sheet value of accounts receivable might be abnormally high or low
compared with the 'normal' level the company usually has. This may apply
especially to smaller companies, where the size of year-end accounts receivable
may largely depend on whether a few customers or even a single large customer
pay just before or just after the year-end.
(b) Turnover in the
income statement excludes sales tax, but the accounts receivable figure in the
balance sheet includes sales tax. We are not strictly comparing like with like.
2.4.4 The inventory
turnover period
Inventory days =
This indicates the
average number of days that items of inventory are held for. As with the
average accounts receivable collection period, this is only an approximate
figure, but one which should be reliable enough for finding changes over time.
A lengthening
inventory turnover period indicates:
(a) A slowdown in trading; or
(b) A build-up in inventory levels, perhaps suggesting that the investment in
inventories is becoming excessive.
If we add together
the inventory days and the accounts receivable days, this should give us an
indication of how soon inventory is convertible into cash, thereby giving a
further indication of the company's
liquidity.
2.4.4 The accounts
payable payment period
Accounts payable payment period=
The accounts
payable payment period often helps to assess a company's liquidity; an increase
in accounts payable days is often a sign of lack of long-term finance or poor
management of current assets, resulting in the use of extended credit from
suppliers, increased bank overdraft, and so on.
All the ratios
calculated above will vary by industry;
hence comparisons of ratios
calculated with other similar companies in the same industry are important.
3. Non-financial performance indicators (NFPIs): Changes
in cost structures, the competitive environment and the manufacturing
environment have led to an increased use
of non-financial performance indicators (NFPIs). Non-financial performance
indicators can also be a very useful guide to future financial performance. There
has been a growing emphasis on NFPIs for a number of reasons.
(a) Concentration on
too few variables: If performance measurement systems focus entirely on
those items which can be expressed in monetary terms, managers will concentrate
on only those variables and ignore other important variables that cannot be
expressed in monetary terms.
(b) Lack of
information on quality: Traditional responsibility accounting systems fail
to provide information on the quality or importance of operations.
(c) Changes in cost
structures. Modern technology requires massive investment and product life
cycles have become shorter. A greater proportion of costs are sunk and a large
proportion of costs are planned, engineered or designed into a product/service
before production/delivery. At the time the product/service is
produced/delivered, it is therefore too late to control costs.
(d) Changes in
competitive environment. Financial measures do not convey the full picture
of a company's performance, especially in a modern business environment.
(e) Changes in
manufacturing environment. New manufacturing techniques and technologies
focus on minimising throughput times, inventory levels and set-up times.
However, managers can reduce the costs for which they are responsible by
increasing inventory levels through maximising output. If a performance
measurement system focuses principally on costs, managers may concentrate on
cost reduction and ignore other important strategic manufacturing goals.
(f) NFPIs are a
better indicator of future prospects. Financial performance indicators tend
to focus on the short term. They can give a positive impression of what is
happening now but problems may be looming. For example, falling quality will
ultimately damage profitability.
Unlike traditional variance reports, NFPIs can be provided quickly for managers, per shift, daily
or even hourly as required. They are likely to be easy to calculate, and easier
for non-financial managers to understand
and therefore to use effectively.
3.1 Which NFPIs should be measured?
The most useful NFPIs for measuring aspects of operational
performance will vary between different types of business and different
business circumstances. While with financial performance measures it is
possible to list the most commonly used measures or ratios, this is not so easy
with NFPIs.
Given an exam question in which you are asked to comment on
non-financial aspects of performance of an organisation, you will need to use
your judgement and try to identify the most suitable measures for the
organisation in the question.
As a general guide, NFPIs may be measurements of the
following aspects of performance.
(a) Quality of
production: wastage rates or percentage of rejects in production
(b) Speed or efficiency, such as output per hour:
average time taken per unit of activity
(c) Delivery:
average time between taking an order and delivery to the customer
(d) Reliability: percentage
of calls answered within a given target time; number of equipment failures or
amount of 'down time'
(e) Customer
satisfaction: number of complaints
(f) Innovation:
number of new products developed and launched on to the market
With non-financial indicators, anything can be measured and compared if it is meaningful to do so. The measures should be tailored to the circumstances of the business.
3.2 NFPIs in relation to employees: NFPIs can
usefully be applied to employees and
product/service quality.
One of the many criticisms of traditional accounting
performance measurement systems is that they do not measure the skills, morale and training of the workforce,
which can be as valuable to an
organisation as its tangible assets. For example, if employees have not
been trained in the manufacturing practices required to achieve the objectives
of the new manufacturing environment, an organisation is unlikely to be
successful.
Employee attitudes and morale can be measured by surveying employees. Education and
skills levels, promotion and training, absenteeism and labour turnover for the
employees for which each manager is responsible can also be monitored.
3.3 Performance measurement in a TQM environment: Total Quality Management is a highly
significant trend in modern business thinking. As TQM embraces every activity of a business, performance measures
cannot be confined to the production process but must also cover the work of
sales and distribution departments and administration departments, the efforts
of external suppliers and the reaction of external customers.
In many cases the measures used will be non-financial ones.
They may be divided into three types.
(a) Measuring the
quality of incoming supplies. Quality control should include procedures for
acceptance and inspection of goods inwards and measurement of rejects.
(b) Monitoring work
done as it proceeds. 'In-process' controls include statistical process
controls and random sampling, and measures such as the amount of scrap and
reworking in relation to good production. Measurements can be made by product,
by worker or work team, by machine or machine type, by department, or whatever
is appropriate.
(c) Measuring
customer satisfaction. This may be monitored in the form of letters of
complaint, returned goods, penalty discounts, claims under guarantee, or
requests for visits by service engineers. Some companies adopt a more proactive
approach to monitoring customer satisfaction by surveying their customers on a
regular basis. They use the feedback to obtain an index of customer
satisfaction which is used to identify quality problems before they affect
profits.
3.4 Quality of service: Service quality is measured
principally by qualitative measures, as you might expect, although
quantitative measures are used by some businesses.
(a) If it were able to obtain the information, a retailer
might use the number of lost customers in a period as an indicator of service
quality.
(b) Lawyers use the proportion of time spent with clients.
3.4.1 Measures of customer satisfaction: You have
probably filled in questionnaires in fast food restaurants or on
aeroplanes without realising that you were completing a customer attitude
survey for input to the organisation's management information system. Other
possible measures of customer satisfaction include:
(a) Market research information on customer preferences and
customer satisfaction with specific product features
(b) Number of defective units supplied to customers as a
percentage of total units supplied
(c) Number of customer complaints as a percentage of total
sales volume
(d) Percentage of products which fail early or excessively
(e) On-time delivery rate
(f) Average time to deal with customer queries
(g) New customer accounts opened
(h) Repeat business from existing customers
4. Short-termism and manipulation: Short-termism is when there is a bias
towards short-term rather than long-term performance. It is often due to the
fact that managers' performance is measured on short-term results.
Short-termism is
when there is a bias towards short-term rather than long-term performance.
Organisations often have to make a trade-off between
short-term and long-term objectives. Decisions which involve the sacrifice
of longer-term objectives include the following.
(a) Postponing or abandoning capital expenditure projects,
which would eventually contribute to growth and profits, in order to protect
short-term cash flow and profits
(b) Cutting R&D expenditure to save operating costs, and
so reducing the prospects for future product development
(c) Reducing quality control, to save operating costs (but
also adversely affecting reputation and goodwill)
(d) Reducing the level of customer service, to save
operating costs (but sacrificing goodwill)
(e) Cutting training costs or recruitment (so the company
might be faced with skills shortages)
Managers may also manipulate results, especially if
rewards are linked to performance. This can be achieved by changing the timing
of capital purchases, building up inventories and speeding up or delaying
payments and receipts.
4.1 Methods to encourage a long-term view: Steps that
could be taken to encourage managers to take a long-term view, so that the
'ideal' decisions are taken, include the following.
(a) Making short-term
targets realistic: If budget targets are unrealistically tough, a manager
will be forced to make trade-offs between the short and long term.
(b) Providing
sufficient management information to allow managers to see what trade-offs
they are making. Managers must be kept aware of long-term aims as well as
shorter-term (budget) targets.
(c) Evaluating
managers' performance in terms of contribution to long-term as well as
short-term objectives.
(d) Link managers'
rewards to share price. This may encourage goal congruence.
(e) Set quality-based
targets as well as financial targets. Multiple targets can be used.
5. Improving performance: Performance is measured to
assess how well or badly an organisation has performed over a given period of
time. When performance is measured, the objectives should be to:
(a) Identify aspects of performance that may be a cause for
concern
(b) Explain differences between actual performance and the
plan or expectation, or deteriorating performance over time
(c) Consider ways of taking control measures to improve
performance
In an exam question on performance measurement, it is highly
likely that you will be required to do all three of these things in your
answer.
5.1 Analyse performance: As explained previously,
performance is analysed by comparing actual results with a target (such as a
budget) or with performance in previous time periods.
The purpose of analysing performance in this way is to
identify whether there are any aspects
of performance that are worse than the target or worse than the previous year,
where there may be some cause for concern.
Where performance is more or less as expected or in line
with previous years, there should be no cause for concern, and no reason to
investigate this aspect of performance in any detail.
5.1 Identify reasons for unexpected performance or poor
performance: Having identified aspects of performance that may be a cause
for some concern, the next requirement is to consider possible reasons for
actual results, and why for example performance is worse this year than last
year.
To identify possible reasons for disappointing performance,
you may need to apply your judgement and common sense to the facts in an
examination 'case study'.
The table below gives some examples of matters that you may
need to consider, but these examples are illustrative and by no means
exhaustive.
|
Aspect of performance
|
Possible reasons
|
|
Increase in rejection rates
for faulty products
|
Using relatively inexperienced staff to do the work Using cheaper materials (to 'save money')
|
|
Increase in time
between taking a customer order and delivering the product to the
customer
|
Administrative delays in processing customer orders
|
|
Increase in frequency of machine breakdowns
|
Reduction in amount
of routine maintenance work
|
|
Customer dissatisfaction with online sales
service
|
Poor website design
|
|
Longer average time
to answer customer calls
in a call centre
|
Reduction in number of call centre staff
|
|
Declining labour productivity
|
Failure to train
staff
Increase in complexity of
the work Use of inexperienced staff
|
5.3 Improving performance: Having identified reasons
for poor performance, whether financial or non-financial, the final step is to
consider and implement methods of improving performance. Methods of improving performance should be linked to the possible
reasons for the poor performance.
The aim of corrective measures should be to tackle the
problems that are the cause of the poor performance. Illustrative control
measures are shown in the table below.
|
Aspect of performance
|
Possible reasons
|
Possible measures to improve performance
|
|
Increase in rejection rates
for faulty products
|
Using relatively inexperienced staff to do the
work
Using cheaper materials (to 'save money')
|
Hire more experienced staff Provide training
Switch back to better-quality materials
|
|
Increase in time
between taking a customer order
and delivering the product to the
customer
|
Administrative delays in processing customer orders
|
Set a maximum time limit for processing orders
and monitor performance continually
|
|
Increase in frequency of machine breakdowns
|
Reduction on amount
of routine maintenance work
|
Increase routine maintenance of machines
|
|
Customer dissatisfaction with online sales
service
|
Poor website design
|
Redesign the website. Hire web design specialists if necessary
|
|
Longer average time
to answer customer calls
in a call centre
|
Reduction in number of call centre staff
|
Employ more
staff
|
|
Declining labour productivity
|
Failure to train staff
Increase in complexity of the work
Use of inexperienced staff
|
Hire more experienced staff Provide training
Give the most
complex tasks to specialist staff
|
Some structured approaches to performance measurement have
been developed, which combine measurements of financial and non-financial
performance. Two of these are described in the next sections.
6. The balanced scorecard: The balanced scorecard approach to performance measurement focuses on
four different perspectives of performance, and uses both financial and
non-financial indicators to set performance targets and monitor performance.
Although business performance may be measured by a single
financial performance indicator such as ROI, profit, or cost variances, it is
often more suitable to use multiple measures of performance where each measure
reflects a different aspect of achievement. Where multiple measures are
used, several may be non- financial.
An important argument in favour of measuring non-financial
performance is that current and future financial performance depend largely on
non-financial aspects of performance. If an organisation uses a performance
measurement system for monitoring its performance, it seems appropriate that
the measurement system should be formally structured, so that:
• All relevant aspects of performance are measured.
• Targets are set for all key aspects of performance.
• Actual performance is measured against targets, rather
than compared with performance in previous years.
• Performance targets are consistent with each other.
Perhaps the most widely used structured approach to
performance targeting and measurement is the 'balanced scorecard'.
A balanced scorecard
is a performance measurement system in which:
(a) Objectives and
targets are set for four
different aspects or perspectives of performance: a financial perspective; customer perspective; internal perspective;
and innovation and learning perspective. All four perspectives are important
for the long-term success of the organisation. Three of these perspectives are
non-financial in nature.
(b) There should be
a small number of targets for
each of the four perspectives.
(c) The different targets for the four perspectives
should be consistent with each other:
the four perspectives are sometimes in conflict with each other and it is necessary
to establish an acceptable balance between the different perspectives and
targets (hence, a 'balanced' scorecard).
(e) Actual performance is measured regularly
and compared with the targets for all the perspectives.
(f) Differences
between the target and actual performance are investigated and, where
appropriate, measures are taken to improve performance.
The balanced
scorecard approach emphasises the need to provide management with a set of
information which covers all relevant areas of performance in an objective and
unbiased fashion. The information provided may be both financial and
non-financial and cover areas such as profitability, customer satisfaction,
internal efficiency and innovation.
6.1 Perspectives: The balanced scorecard focuses on four
different perspectives, as follows.
|
Perspective
|
Basic question
|
Identifying performance targets
|
|
Customer
|
What do existing and new customers
value from us?
|
Gives rise to targets that matter to customers: cost, quality, delivery, inspection, handling, and so on
|
|
Internal
|
What processes must
we excel at to achieve our financial and customer objectives?
|
Aims to improve
internal processes and decision- making
|
|
Innovation and learning
|
Can we continue to improve and create future value?
|
Considers the business's capacity to maintain its competitive position through
the acquisition of new skills and
the development of
new products
|
|
Financial
|
How do we
create value for
our shareholders?
|
Covers traditional
measures such as
growth, profitability and shareholder value but set through talking to the shareholder or shareholders directly
|
Performance targets are set once the key areas for improvement have been identified, and the
balanced scorecard is the main monthly report.
The scorecard is 'balanced',
as managers are required to think in terms of all four perspectives to
prevent improvements being made in one area at the expense of another.
Important features
of this approach are as follows.
(a) It looks at both
internal and external matters concerning the organisation.
(b) It is related to
the key elements of a company's strategy.
(c) Financial and
non-financial measures are linked together.
6.2 Example: An example of how a balanced scorecard might
appear is offered below. Arguably, there are too many performance targets here
for each of the four perspectives, but this balanced scorecard is a good
illustration of issues that may be considered as critical to the organisation's
success.
Balanced Scorecard
|
Financial
Perspective
|
Customer
Perspective
|
||
|
GOALS
|
MEASURES
|
GOALS
|
MEASURES
|
|
Survive
Succeed
Prosper
|
Cash flow
Monthly sales growth and
operating income by division
Increase market share and
ROI
|
New products
Responsive supply
Preferred supplier
Customer partnership
|
Percentage of sales from new
products
On – time delivery (defined
by
customer
Share of key accounts’
Purchases
Ranking by key account
Number of co – operative
engineering efforts
|
|
Internal
Business
Perspective
|
Innovation
and
Learning
Perspective
|
||
|
GOALS
|
MEASURES
|
GOALS
|
MEASURES
|
|
Technology
capability
Manufacturing
excellence
Design productivity
New project introduction
|
Manufacturing configuration
vs. competition
Cycle time
Unit cost
Yield
Silicon efficiency
Engineering efficiency
Actual introduction schedule
vs. plan
|
Technology
leadership
Manufacturing
learning
Product focus
Time to market
|
Time to develop next
generation of products
Process time to maturity
Percentage of products that
equal 80% sales
New product introduction vs.
competition
|
6.3 Example: Balanced
scorecard and not for profit organisations: Balanced scorecards are used most in private sector organisations, where
reward systems may be based on success in achieving targets in each of the four
perspectives. It is also possible, however, to use a balanced scorecard in not
for profit organisations.
Not for profit
organisations such as charities are likely to have significantly different
goals in comparison to profitable businesses. The following are goals that may
be relevant to a charity.
Financial perspective
• Increase income
from charitable donations
• Improve margins
Internal business
perspective
• Reduce overheads
• Claim back tax on
gift aid
Customer perspective
• Continued donor
support
• Donor involvement
in initiatives
Innovation and
learning perspective
• More projects
supported
• More fundraisers
• More money pledged
Required: Suggest some performance measures for each of
the goals outlined above.
Solution: The balanced scorecard for the charity may
appear as follows.
|
Financial perspective
|
Customer perspective
|
||
|
GOALS
|
MEASURES
(KPI)
|
GOALS
|
MEASURES (KPI)
|
|
Income from charitable
donations
Improved margins
|
Donations received
Lower costs and/or increased
income from all sources
|
Continued donor support
Donor involvement in
initiatives
|
Pledges given and direct
debits set up
Fundraising and charity
dinners
|
|
Internal business perspective
|
Innovation and learning
perspective
|
||
|
GOALS
|
MEASURES
|
GOALS
|
MEASURES
|
|
Reduce overheads
Claim back tax on gift aid
|
Lower overheads measured by monitoring and
accounts
Improved reclaim times for
gift aided donation
|
More projects supported
More fundraisers
More money pledged
|
Number of projects given
support
Number of fundraisers
recruited
Amount of donations promised
|
Note: KPI = Key
Performance Indicator
7. Building Block model: Fitzgerald and Moon's building blocks for dimensions, standards and rewards attempt to overcome the
problems associated with performance measurement of service businesses.
Performance measurement in service businesses has sometimes
been perceived as more difficult than in manufacturing businesses. Fitzgerald
and Moon (1996) suggested that a performance management system in a service
organisation can be analysed as a combination of three building blocks.
• Dimensions of performance
• Standards
• Rewards
|
|
Dimensions of performance
Profit Competitiveness Quality
Resource utilisation
Flexibility Innovation
|
|
|
|
Standards Ownership Achievability Equity
|
Rewards Clarity Motivation Controllability
|
||
7.1 Dimensions of performance: Dimensions of
performance are the aspects of performance that are measured. Fitzgerald and
Moon suggested that there are six aspects to performance measurement that link
performance to corporate strategy. These are shown in the diagram above.
Some performance measures that might be used for each of
these dimensions are as follows.
|
Dimension of performance
|
Possible measure
of performance
|
|
Financial performance
|
Profitability Profit growth
Gross profit
margin, net profit margin
|
|
Competitiveness
|
Growth in sales
Retention rate
for customers
Success rate in converting enquiries into sales
|
|
Service quality
|
Number of complaints
Customer satisfaction, as revealed by customer opinion surveys
|
|
Flexibility
|
Mix of different types
of work done
by employees
Speed in responding to customer requests
|
|
Resource utilisation
|
Efficiency/productivity measures
Capacity utilisation rates
|
|
Innovation
|
Number of
new services offered within the previous year or two
years
|
Fitzgerald and Moon also suggested that the dimensions of
performance should distinguish between the 'results' of actions taken in the
past and 'determinants' of future performance.
(a) Financial performance and measures of competitiveness
are performance measures that have resulted from measures taken in the past.
(b) Quality, flexibility, resource utilisation and
innovation are all aspects of performance that will determine the success (or
otherwise) of the organisation in the future.
These six dimensions are measures of competitive success
both now and in the future, and so they are appropriate for measuring the
performance of current management. Measuring performance in these dimensions
'is an attempt to address the short-termism criticism frequently levelled at
financially focused reports' (Fitzgerald).
7.2 Standards: The second part of Fitzgerald and
Moon's framework for performance measurement concerns setting the standards or
targets of performance, once the measures for the dimensions of performance have
been selected.
There are three aspects to setting standards of performance.
• Individuals need to feel that they 'own' the standards and
targets for which they will be made responsible.
• Individuals also need to feel that the targets or
standards are realistic and achievable.
• The standards and targets should be seen as 'fair' and
equitable for all the managers in the organisation.
7.3 Rewards: The third aspect of Fitzgerald and
Moon's performance measurement framework is rewards. This refers to the structure
of the rewards system, and how individuals will be rewarded for the successful
achievement of performance targets. There are three aspects to consider
in a reward system.
• The system of setting targets and rewarding individuals
for achieving the targets should be clear. Clarity will improve the motivation
to achieve the targets.
• Achievement of performance targets should be suitably
rewarded.
• Individuals should be made responsible only for aspects of
performance that they are in a position to control.
8. Target setting in qualitative areas: The balanced
scorecard and Fitzgerald and Moon's Building Block model are based on the
assumption that performance targets can be set and measured for non-financial
aspects of performance. This presumes that all key non-financial aspects of
performance can be measured and quantified.
In practice, this is not necessarily the case. Some critical
non-financial aspects of performance may be difficult to quantify, or to
quantify in a reliable way. There are several problems with qualitative non-
financial performance targets.
(a) There is often a problem with selecting a suitable
measure of performance. For example, an important objective for an organisation
may be winning and retaining customer loyalty. But how is a reliable target for
customer loyalty decided?
(i) Opinion research by a market research firm and setting a
'target score for loyalty'?
(i) The percentage of customers who make a repeat order
within x months?
Similarly, a performance objective may be to deliver a high
standard of service to a customer, but how is service quality defined? Having
defined service quality, how is it measured?
(b) By its very nature, qualitative data is not quantified.
At best, qualitative measures are converted into quantitative measures using a
subjective scoring system. When performance is not quantified, it is difficult
to target and monitor.
(c) Data collection and management information systems. An
organisation may have a well- established system for measuring quantitative
data, especially in the areas of accounting and sales statistics. It is much
less likely to have a reliable and comprehensive system for collecting data
about qualitative aspects of performance.
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