Performance Management Systems Overview

Intelligence

• Intelligence is the ability to connect knowledge.
• The highest form of intelligence is connecting all known knowledge with the Most Intelligent (God).

Performance Measurement System (PMS)

• PMS translates strategy into financial and non-financial measures across multiple perspectives.
• PMS is driven by organizational goals and strategic priorities.
• It identifies cause-and-effect relationships between various measures, including financial performance.
• PMS can be divided into financial and non-financial measures.

Effective Performance Management System (PMS)

• Effective PMS is crucial for successful organizational strategy implementation.
• PMS monitors organizational effectiveness in meeting goals and stakeholder requirements.
• Successful companies perform well financially and in terms of quality, flexibility, and value.

Characteristics of Effective PMS

• Keep it simple: Include only a few performance measures.
• Emphasize the positive: Express measures in positive terms.
• Recognize controllability: Employees are accountable for the measures under their control.
• Link to strategy: Connect measures to organizational goals.
• Include benchmarking: Compare performance against high external standards.

Financial Performance Measures

• The primary objective of a profit-making organization is to maximize shareholder wealth.
• Performance measures should be based on the value created by each organizational division.
• Commonly used measures: ROI, RI, and EVA.

Return on Investment (ROI)

• ROI measures the financial performance of an investment center.
• It calculates how effectively an investment center used its capital to generate profit.
• ROI = profit / invested capital
• Expanding on the formula: ROI = (profit/sales revenue) * (sales revenue/invested capital) = return on sales * investment turnover.

Return on Investment (ROI) – components

• Invested capital: The assets (plant, equipment, and buildings) available to generate profits for the investment center.
• Return on sales: The percentage of each sales dollar that remains as profit after expenses.
• Investment turnover: The number of sales dollars generated by every dollar of invested capital.

Return on Investment (ROI) – improving

• Increase return on sales: Increase selling prices, profits, sales volumes, or reduce expenses.
• Increase investment turnover: Increase sales revenue or reduce invested capital.

Return on Investment (ROI) – advantages

• Widely used to measure the performance of units and managers.
• Encourages focusing on generating profits given the assets required.
• Promotes an understanding of the relationship between revenues, costs, and assets.
• Can evaluate relative performance, even for business units of different sizes.

Return on Investment (ROI) – limitations

• Encourage short-term financial performance, sometimes at the expense of long-term performance
• Potentially encourage managers to defer asset replacement to maintain high ROI.
• Discourage investments in projects that would decrease the investment center's ROI.

Minimizing ROI behavioral problems

• Use ROI as one measure among others to focus on both short-term and long-term performance.
• Consider alternative ways to measure invested capital to prevent dysfunctional decisions
• Use alternative financial measures (like RI or EVA) to evaluate performance.

Residual Income (RI)

• RI is an investment center's profit remaining after subtracting an imputed interest charge.
• Imputed interest charge is based on the required rate of return expected.
• It depends on the organization's cost of capital (WACC).
• WACC is the average cost of funds from borrowing and equity.

Residual Income (RI) – advantages

• More likely to promote goal congruence compared to ROI.
• Considers the organization's required rate of return in measuring performance.
• Encourages investment in projects yielding positive residual income.

Residual Income (RI) – disadvantages

• Cannot assess the relative performance of different-sized businesses efficiently.
• Biased towards larger businesses due to its absolute dollar measure.
• Can potentially encourage short-term orientation.

Measuring Profit & Invested Capital

• Invested capital can be defined as total assets, total productive assets, or total assets minus current liabilities.

Asset Measurement

• Acquisition cost, carrying amount, or market value can be used.
• Advantages of carrying amount: Consistency with balance sheets (prepared for external purposes) and consistent with profit definitions.
• Advantages of acquisition cost: Choice of depreciation method is arbitrary, and carrying amount isn't reliable for ROI and RI.
• Depreciation can sometimes deter new equipment investment.

Measuring Profit

• Profit margin can be controlled by investment center managers.
• Suitable for assessing the performance of managers who influence profit.
• Profit margin attributable to the investment center is suitable when assessing investment performance specifically.

Economic Value Added (EVA)

• Shareholder value: Enhancing business worth from a shareholder perspective. This translates to increased profitability and share price dividends.
• EVA measures value creation during an accounting period and the difference between the business return and capital cost.
• EVA depends on net operating profit after tax, capital employed, and weighted average cost of capital (WACC).
• WACC is the weighted average of the costs of equity and debt. EVA and RI often both use WACC in their calculations.

Measures of Shareholder Value

• To improve EVA: Improve profitability without additional capital, borrow more when profits exceed borrowing costs, or pay off debt by selling assets.
• Limitations of EVA: Potentially for manipulation and short-term orientation (similar to ROI and RI).

Issues with Financial Performance Measures

• Financial measures focus too narrowly on a single performance perspective.

Non-Financial Measures. Balanced Scorecards.

• A tool to translate organizational mission, objectives, and strategies into performance measurements.
• Useful for implementing strategy, monitoring, and managing performance.
• Focused on multiple perspectives (customer, internal business processes, learning and growth, financial).

Four Perspectives of BSC

• Financial: Indicators of how effectively strategies and operations produce value for shareholders
• Customer: Indicators of whether strategies add value to customers. Indicators include customer profitability, market share and number of new customers; lead indicators include on-time delivery and number of defects
• Internal Business Processes: Indicators of whether internal business processes contribute to the achievement of a company's customer and financial objectives. Includes product cost, quality, time-based measures, and new product development
• Learning and Growth: Indicators of companies' infrastructure for future innovation and growth; focus on organizational capabilities for processes, including employees' abilities as well as information systems' capabilities and organizational climate

Stages in the development and use of BSC

• Establish mission, objectives, and strategic priorities.
• Develop specific objectives for perspectives (customer, internal business process, learning and growth).
• Choose performance measures for each perspective.
• Develop performance targets for each measure.
• Cascade the balanced scorecard goals, measures, and targets to organizational units.
• Monitor and manage performance against the targets.

Definition of Benchmarking

• Benchmarking is a process of comparing the business’s products, functions, and activities against other companies to identify improvement areas and implement continuous improvements.

Reasons For Benchmarking

• Efficient way to improve, eliminating trial-and-error processes
• Speeds up improvement implementation
• Compare business practices with world-class organizations to identify best practice
• Encourages a reassessment of current practices
• Changes perspectives of executives and managers

Stages in Benchmarking

• Identify the functions (or activities) to be benchmarked.
• Choose benchmark partners (companies with similar interests and technologies, competitors, or internal units from the same company)
• Collect and analyse data from benchmark companies
• Establish benchmarks
• Develop and implement plans to implement improvements

Forms of Benchmarking

• Internal Benchmarking: Comparing units within the same company, simplest to implement but does not compare to the best practices
• Competitive Benchmarking: Comparing a company against similar competitors by identifying strengths and weaknesses, improving areas for improvement
• Industry Benchmarking: Benchmarking against other organizations in the same industry to gain insights about market practices
• Best-in-class/Process Benchmarking: Benchmarking against the best performer or industry leaders

Advantages of Using BSC

• Comprehensive view of business operations beyond just finance
• Identifies opportunities for improvement
• Provides a mechanism for better alignment and communication across the organization
• Helps improve overall performance

Disadvantages of BSC

• Cause-and-effect assumptions may be too simplistic
• Timing differences between lead and lag indicators might create complications
• Expectations for improvement might be unrealistic
• Some benchmarking activities are better suited outside an organization

Other notes

• Some organizations use KPI's (Key Performance Indicators) and KPD's (Key Performance Drivers) for lag and lead indicators, respectively.
• Different businesses may have differing definitions for internal assets.
• Some companies use similar indicators across departments while others may find custom-tailored measurements for their specific needs.