Performance Measurement System PDF

 TOPIC 2 PERFORMANCE MEASUREMENT SYSTEM PERFORMANCE MEASUREMENT SYSTEMS (PMS) Translate strategy into an integrated set of financial and non-financial measures across a range of perspectives. All are driven by the goals and strategic priorities of the organizations and provide the potentia...

 TOPIC 2 PERFORMANCE MEASUREMENT SYSTEM PERFORMANCE MEASUREMENT SYSTEMS (PMS) Translate strategy into an integrated set of financial and non-financial measures across a range of perspectives. All are driven by the goals and strategic priorities of the organizations and provide the potential to identify cause and effect relationship between a variety of measures including financial performance. Can be divided into: 1. Financial Performance Measures: ROI, RI, EVA 2. Non-Financial Measures: BSC and BM EFFECTIVE PERFORMANCE MANAGEMENT SYSTEM (PMS) Effective PM is vital in ensuring successful implementation of organisational strategies Its about monitoring organization’s effectiveness in fulfilling its own goals or the requirements of the stakeholders Successful company performs well financially as well as in term of quality, flexibility, value etc. 441 CHARACTERISTICS OF EFFECTIVE PMS Recognise Keep it controllability simple Emphasise the positive Link to Include only a strategy and few the goals of performance the measure organisation Include benchmarking CHARACTERISTICS OF EFFECTIVE PMS (cont.) Link to strategy Helps to promote goal congruence and the goals of Encouraged employee to focus their effort the organisation in the right direction Measure should be understandable and Keep it simple easy to communicate to employee Employee are responsible for achieving Recognise certain performance measure controllability Must be relate to activities and process that are under their control CHARACTERISTICS OF EFFECTIVE PMS (cont.) Emphasise the Should be express in positive rather than positive negative terms Important that performance measure Include are benchmarked to high external benchmarking standards Include only a Too many- confuse the real performance few No person should be held responsible for performance more than 5 measures. measure 1.FINANCIAL PERFORMANCE MEASURES The primary objective of a profit making organization is to maximize shareholders’ wealth Therefore, performance measure should be based on the value created by each division of the organization 13 8 1. FINANCIAL PERFORMANCE MEASURES The commonly used measures by profit making organizations in evaluating their investment centres include: Return on investment (ROI) Residual income (RI) Economic value added (EVA) 149  Return on Investment (ROI) Used to measure the financial performance of an investment centre To measure how effective each investment centre used its invested capital to generate profit (refer pg 607) profit ROI = invested capital Expanding : profit sales revenue = × sales revenue invested capital = return on sales × investment turnover  Return on Investment (ROI) Invested capital  The assets that the investment centre has available to generate profits i.e. plant, equipment and building Return on sales  The percentage of each sales dollar that remains as profit after all the expenses are covered Investment turnover  The number of sales dollars generated by every dollar of invested capital  Return on Investment (ROI)  Improving  Increase return on sales  By increasing the selling price or sales revenue, increasing sales volume or decreasing expenses  Increase investment turnover  By increasing sales revenue or reducing invested capital  Actions that are taken with the sole purpose of making these ratios more favourable in the short term may have adverse effects on performance in future years i.e. sales may be lost in the future due to adverse effect on product quality  The advantages of ROI  Widely used in practice to measure the performance of units and managers  Encourages managers to focus on both profits, and the assets required to generate those profits i.e. increase revenue and reduce cost  Promotes an understanding of the relationship between revenues, costs and assets  Can be used to evaluate the relative performance of investment centres, even when those business units are of different sizes i.e. can compare ROI of a small with large business  Limitations of ROI  It may encourage managers to focus on improving short-term financial performance, which may sometimes reduce long-term financial performance  May encourage managers to defer asset replacement, to maintain a high ROI i.e. purchase of assets would boost the size of invested capital  Discourages managers from investing in projects which are acceptable from the organisation’s point of view, but which decrease the investment centre’s ROI Minimising the behavioural problems of ROI  Use ROI as one of several performance measures that focus on both short-term and long-term performance  Consider alternative ways of measuring invested capital to minimise dysfunctional decisions  Use alternative financial measures, such as residual income or economic value added  Residual Income (RI) = = Profit – (Invested Capital × Imputed Interest Rate)  RI is an amount of an investment centre’s profit that remains after subtracting an imputed interest charge  Imputed interest charge  Based on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capital  Weighted average cost of capital (WACC) is the weighted average of the cost of funds from all sources of borrowings and equity  Advantages of Residual Income More likely to promote goal congruence, compared to ROI (refer pg 611) i.e. incentive to make investment Takes into account of the organisation’s required rate of return in measuring performance Encourages investment in projects which yield a positive residual income to the organisation  Disadvantages of Residual Income  Cannot be used to assess the relative performance of businesses that are of different sizes, unlike ROI  Formula is biased in favour of larger businesses, because it uses an absolute dollar measure unlike ROI. Evaluating performance of different sizes, ROI is preferred  Can encourage short-term orientation, as with ROI  Measuring Profit & Invested Capital How should profit and invested capital be measured for calculating ROI and RI?  Invested capital can be define as:  Total assets - Investment centre manager is responsible for decisions about all assets  Total productive assets - Investment centre managers retain non-productive assets i.e. vacant land  Total assets less current liabilities - Investment centre is responsible for decisions about assets and manages short-term liabilities  Asset Measurement Acquisition cost, carrying amount or market value for measuring asset?  Advantages of using the carrying amount  Consistency with balance sheet that is prepared for external reporting purposes  Consistent with the definition of profit (refer pg 613)  Advantages of using acquisition cost  Choice of depreciation method is arbitrary and resulting carrying amount does not provide a reliable measure for ROI and RI  Depreciating fixed assets may provide deterrent to invest in new equipment Asset Measurement  Measuring Profit  Profit margin can be controlled by the investment centre manager  Suitable when the focus is to assess the performance of the manager  Encourages managers to focus on profit that they can influence and control  Motivational impact  Profit margin attributable to investment centre  Suitable when the focus is to assess the performance of a particular investment centre Measuring Profit  Economic Value Added (EVA)  Shareholder value - Improving the worth of the business from the shareholders’ perspective i.e. Increase profitability, share price dividends etc. Economic value added (EVA)  Measure of the value created over a single accounting period  The spread between the return generated by the business activities and the cost of capital (refer pg616)  Weighted average cost of capital (WACC)  Usually use to calculate for an entire company not for each business unit (refer pg 616)  Used in the calculation of EVA and RI  Measures of Shareholder Value  To improve EVA  Improve profitability without employing additional capital  Borrow additional funds when the profits earned are more than the cost of borrowing  Pay off debt by selling assets  Limitations of EVA  There is potential for manipulation and for taking a short-term orientation, as with ROI and RI  Issues with Financial Performance Measures  Financial measures emphasise only one perspective of performance  Conventional financial performance measures focus on the consequences, not the causes  Financial performance measures provide limited guidance for future actions  Financial performance measures may encourage actions which decrease both shareholder and customer value 27  2. NON-FINANCIAL MEASURES BALANCE SCORECARD Definition: A tool that translates organization's mission, objectives and strategies into performance measure  To implement strategy, monitor & manage performance  Focused a number of different perspectives FOUR PERSPECTIVES OF BSC: Financial Customer Internal Learning Business & Process Growth STAGES involved in the development & the use of BSC Generate report at regular intervals to monitor & 7 manage performance against targets Plan and undertake initiatives & activities across the 6 organization to implement chosen strategies Cascade specific BSC to divisions & other 5 organizational units or individual managers Develop target for each performance measures to 4 evaluate actual measure 3 Choose performance measure for each perspective 2 Develop specific objectives for each perspectives 1 Set mission, objectives & strategic priorities of the organization FOUR PERSPECTIVES OF BSC FINANCIAL PERSPECTIVE CUSTOMER PERSPECTIVE  Indicates whether strategy and  Indicates whether strategy and operations add value to operations add value to shareholders customers  Summarize financial outcomes of  Outcome measures include decision and activities customer profitability, market share and number of new  Outcome measures include cost customers. and profit measures, ROI, cash flow measures, shareholders’  Lead indicator includes on-time value measures delivery, number of defects FOUR PERSPECTIVES OF BCS INTERNAL BUSINEsS LEARNING AND GROWTH PROCESSES  Indicates the ability of internal  Indicates the strength of the business process that contribute infrastructure for innovation and to achieving customer and long-term growth financial objectives.  Focus on capabilities of  Outcomes measures include organizations to achieve superior product cost and quality, time internal processes that add based measures, and new value to customers and to product development improve shareholders’ wealth  Outcome measures concentrate on employees’ capabilities, capabilities of information system and organization climate  ITEMS IN BSC PERFORMANCE MEASURES OBJECTIVES LAG INDICATORS LEAD INDICATOR (Drivers of the outcome (based on four perspective) (Outcome measure) measure) 1. Financial  Return on equity  Sales mix  Increase return to  Economic value  Cost per product shareholder added  Increase profitability  Product profitability 2. Customers  Customer satisfaction  Number of customer  Increase customer  Market share complain satisfaction  Number of new  Number of product  Expand customer customers returns base  Number of customers  On-time delivery retained  Number of product variations available  ITEMS IN BSC PERFORMANCE MEASURES OBJECTIVES LAG INDICATORS LEAD INDICATOR (Drivers of the outcome (based on four perspective) (Outcome measure - KPI) measure - KPD) 3. Internal Business  Number of goods unit  Product defects Processes completed  Number of product  Improve product  Number of products returns quality under development  Product development  Improve production time processes  Production cycle time  Create new,  Number of machine innovative products breakdowns 4. Learning and Growth  Employee satisfaction  Improvements made  Improve employees survey to employees facilities satisfaction  Number of employees  Time spent  Develop employees’ participating in developing employee technical skill training programs programs IN PRACTICE Not all organizations use lag and lead indicators or clearly articulate causal links between all measures. Different terms may be used in companies to describe lag and lead indicators.  Lag = Key performance indicators (KPI)  Lead = Key performance drivers (KPD) Some organizations identify critical success factors that are considered critical to the survival of business. The number and the names of perspectives in BSC may be differ and can be customized. CAUSAL LINKAGES Economic Value Financial Added Customer Customer Satisfaction Number of product Number of customer variations available complaints Internal Business Process Number of product Number of good under development units completed Learning Employee and Growth satisfaction ADVANTAGES OF BSC DISADVANTAGES OF BSC  2. NON-FINANCIAL MEASURES BENCHMARKING Definition: Benchmarking is a process of comparing the products, functions and activities of an organization against other businesses to identify areas for improvement and to implement continuous improvement. In the past, business often assessed their progress by comparing current performance with their own past performance. However this gave no indication that they were competitive in their markets. The objective is to ascertain how the processes and the activities can be improved and to implement the best practice. REASONSFOR BENCHMARKING An efficient way to make improvements as managers can eliminate trial and error process improvements. Speeds up organization’s ability to make improvements. Compare business practices with those of world class organizations. Challenge current practices and processes. Create improved goals and practices for the organization. Change the perspective of executives and managers. STAGES IN BENCHMARKING 5 Implementing plans 4 Establishing performance goals 3 Data collection and analysis 2 Selecting benchmark partners 1 Identifying the functions or activities  1 Identifying the functions or activities Before starting a program you must choose what to compare. The activities to be benchmarked should be areas that have the potential to add real sustainable competitive advantage to your business. Important to you in terms of :  Volume (large number of transactions undertaken)  Cost (high costs based on time and FTE’s)  Values (significant in terms of revenue to you and/or benefit to the customer) Easy to measure and offering comparisons Risk inherent  Selecting benchmark 2 partners The next question would be “against whom will we benchmark?” The choice of partner will be dependent on several key factors. Requirements must be established for selecting benchmarking partners given the benchmarking objective, or for characterizing the degree of relevance that any particular company that may have as a potential benchmarking partner, not necessarily in the same industry.  3 Data collection and analysis Data collection involves  Planning the data collection  Developing an interview guide/ questionnaire  Conducting primary research (telephone survey, mall survey, individual interview)  Monitoring process performance and analyze performance gaps  Making on-site observations to clarify and verify previous observation  Conducting a post-site-visit to record observation  Preparation of a report As for analysis, it consists of two aspects  Determining the magnitude of the performance gaps between you and other companies using the benchmarking metrics identified during the proto-planning step  Identifying the process enablers that facilitated the performance improvement at the leading companies.  4 Establishing performance goals Mutually establishing and reviewing with employees the expectations that guide and motivates them toward goals and narrow the performance gap. 5 Implementing plans Involves ongoing measurement of performance and to access the performance gap. The main activities are;  Set goals to close, meet, and then exceed the performance gap  Select best practice and enablers for consideration  Modify process enablers to match the company culture and organizational structure  Develop a formal action plan for implementing improvements  Commit resources  Implement the plan – piloting where sensible FORMS OF Industry BENCHMARKING Benchmarking Internal Benchmarking Process Benchmarking Competitive Benchmarking Internal Benchmarking Involves benchmarking between business units within the same company. Simplest form of benchmarking as access to benchmarking partners is easy to establish. Does not provide the world’s best benchmark, as companies outside the business group, including competitors, may be better performers. Example : Accounting & Finance Department at Petronas Gas can be benchmark with Accounting & Finance Department at Petronas Chemical Competitive Benchmarking Involves a company identifying the strengths and weaknesses of competitors in order to assist them to prioritize areas for improvement. Objective: To catch up or surpass the competitors’ performance using continuous improvement processes. Example : Samsung vs Apple Industry Benchmarking Involves comparing performance against companies that have similar interests and technologies. As there may be technological processes that are common to the business and the benchmarking partners, performance measures and practices are directly comparable. Example : The use of Internet banking in bank sector by Maybank, CIMB, RHB, etc Best-in-class/Process Benchmarking Involves benchmarking against the best practices that occur in any industry. Difficulty ; some characteristics of best practice businesses may not be common to other companies. Performance measures may not be directly comparable with those in another company that does not have the same advantages. Example : Adopting the use of bar coding in grocery store to control and sort airport luggage A D V A N T A G E S D I S A D V A N T A G E S 53 √ JULY 2024 Q1B √ JAN 2024 Q1 √ JULY 2023 Q1 √ FEB 2023 Q1 √ JULY 2022 PART B Q1 √ FEB 2022 Q2