MODERN TOOLS FOR PERFORMANCE MEASUREMENTS

Modern Tools for Performance Measurements

Amirsaleh Azadinamin
Doctorate of Finance Candidate

Swiss Management Center (SMC) University

December 11, 2011

Electronic copy available at: http://ssrn.com/abstract=2017435

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS Abstract This paper looks upon new methods, standards, and performance measurements that are required of companies in todays competitive market environment. Older and traditional methods seem to fail in measuring performance with the market structure that currently rules the market. The essence of these measurements are being modifies and they are being pushed to go from accounting-based toward a rather economic-oriented framework. New economic-based measures, such as economic value added (EVA), are replacing the more traditional measures such as earning-per-share. Activity-based costing (ABC), the Balanced Scorecard, and Economic Value Added (EVA) are the three frameworks discussed throughout this paper as the new measures.

Electronic copy available at: http://ssrn.com/abstract=2017435

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS The Need to Adapt to the Current Environment In an attempt to keep up with the competitive mood of todays business environment, many organizations have been pushed to adapt new standards, including some new performance measurements. In face of todays complex and competitive business environment, many traditional performance measurements need to be modified or changed for a company to remain competitive. It is worth mentioning that this change in the business environment has created the need for a new way to render these measurements. The changing environment has also caused organizations to re-examine their traditional evaluation measures, as well as the design of management compensation packages. These changes modified the essence of measurements, pushing them to go from accounting-based toward an economic-oriented framework. New economic-based measures, such as economic value added (EVA), are replacing the more traditional measures such as earning-per-share. Shinder and McDowell (1999) discuss some of the new measures that are becoming increasingly popular in the process of improving corporate measurements. Activity-based costing (ABC), the Balanced Scorecard, and Economic Value Added (EVA) are the three frameworks discussed throughout this paper. Activity Based Costing Shinder and McDowell (1999) describe activity-based costing (ABC) as a method where deficiencies and shortcomings of the traditional system are presented, and solutions using new measurements are offered. The traditional system solely considers the direct operational cost mentioned in the financial statements, like labor and machinery, but fails to consider other forms of expenses that company bears, for instance a cost resulting from a time delay in receiving inventory.

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS ABC systems have been around since the mid-1980s. When implemented properly, they can provide managers with more accurate product-cost data that can be used to make more informed decisions about process improvements, pricing, and managing customer relationships. The overall goal of an ABC system is to allocate indirect (support) costs in such a way that the resulting cost information reflects more accurately the resource demands/resource consumption of an organizations cost objects (products, services, and customers). (Stout & Propri, 2011, p. 2) New system takes into account elements that were traditionally never fully or even partially implemented. Activity-based costing not only considers the cost of doing a task, but it also considers the cost of not doing a task. For instance, the costs of waiting for inventory or machine downtime are the sort of costs that do not show on financial statements. Having information about those specific activities, managers can lower the actual cost of doing business, which is why activity-based costing is a more efficient system. Activity-based costing can be specifically beneficial in service sector, where there is no product per se, and the actual product is servicing the customer. Drucker (1995) explains the reasoning behind this as the following: Service companies cannot start with the cost of individual operations, as manufacturing companies have done with traditional cost accounting. They must start with the assumption that there is only one cost: that of the total system. And it is a fixed cost over given any time periodthe cost per customer in any major area of banking is a fixed cost. Thus it is the yield per customer both the volume of services a customer uses and the mix of those services that determines cost and profitability. (p. 56) ABC is a system that illuminates not only the cost of products, but also for each service or customer by analyzing each activity that goes into the production process or servicing a

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS customer. ABC recognizes all activities and their share in producing direct or indirect costs associated with them. While this new system is crucial in maximizing the efficiency of business and profit, implications from applying these measures are more essential. So, cost information alone, regardless of how accurate it is, is insufficient to maximize value (Shinder & McDowell, 2011, p. 2). The information is vital in helping managers improve performance when in interaction with other performance measures. This will lead the discussion into the next topic, the Balanced Scorecard. The Balanced Scorecard The balanced scorecard considers many financial and nonfinancial measures to provide a broader view of the business. The balanced scorecard has been scholarly and practically recognized as an effective toll of performance measurement. It is a comprehensive measure for multidimensional organizational excellence (Ahmad, et al., 2010, p. 99). Accounting standards and the related data cannot be trusted in showing the whole picture, and other indicators may have to be taken into consideration to understand the health of the business. Indicators like process efficiency, safety, customer satisfaction, or employee morale are great indicators to predict the future or make predications about the going concern of the business (Shinder & McDowell, 2011). For instance, a construction company with very attractive and healthy financial statements but lacks considerations for safety issues would be very likely to discontinue operations in the future due to unbearable damage caused by the lack of concern for safety. Lacking concern for safety issues could impede operations for various reasons, whether it is the cancelation of construction permit by the concerned authorities, or it is by numerous injured employees suing the company. The offered example provides a vivid picture on why accounting

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS indicators are not sufficient to indicate the health of the business. Shinder and McDowell (1999) also shed some light on how new measures relate to the strategy of the organization: Each organization will emphasise different measures depending on their strategy. Management is, in effect, translating their strategy into objectives that can be measured. The scorecard is a collection of data that helps a manager understand performance. The measures help managers balance their focus between current and future performance. Leading variable are future performance indicators, and lagging variables are historic results. Financial variables are typically lagging variables, telling managers how they have done (p. 2). Some indicators such as the training cost, a lagging characteristic, are very efficient predictions of future business since they greatly influence the customer satisfaction and repeated business. Shinder and McDowell (1999) further explain that the balanced scorecard usually contains four categories, which include financial performance, customers, internal processes, and learning and growth, in which each category will have between two to five measures of its own. The measurements also vary based on different strategies that the company follows. Shinder and McDowell (1999) explain these measures further and how they could vary based on strategies chosen and followed by the organization: If the business strategy is to increase the market share and reduce operating cost, the measures may include market share and cost per unit. Another business may choose financial indicators that focus on price and margin, willingly forgoing market share for a high-priced niche product (p. 3). So, the objectives, measures, targets, and initiatives for each of the four categories could vary accordingly to the strategic path chosen by the business.

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS The balanced scorecard is a great tool for managers in tracking factors that affect performance. If placed in a proper framework and accurately supervised by managers, there is a fruitful purpose in following it and that is adding value to the company, which leads to the next topic, the economic value added (EVA). Economic Value Added EVA is a measure in determining the value creation in an organization. EVA illuminates the true financial performance of the business as it subtracts all costs from the accounting profit. The EVA measure was created by Stern Stewart in order to address challenges companies face in the area of financial performance by measuring profits after the expected return of shareholders is subtracted, which indicates economic profitability (Shinder & McDowell, 1999). Burksaitiene (2009) states that EVA was created by Stern Stewart consulting organization after Residual Income (RI) was refined. Burksaitiene (2009) continues that based on the meaning of economic profit, Stern Stewart & Co. developed the concept of the EVA model. The basic difference between the
notions of economic value and RI concerns the method for calculating profits and invested capital (p. 711).

Adjustments were made in traditional conventional profit measures as well as accounting methods in creating EVA, and following that path, historic accounting indicators were replaced by a measure of economic profit and real asset values. New measures also help managers reshape their priorities by monitoring value added, and ultimately control and supervise the invested capital in a more efficient manner as part of a bigger financial management system (Burksaitiene, 2009). Teker et al. (2009) emphasize that EVA concept, or Economic Profit as it is often called, will avoid problems caused by trade marking, and it will help in the creation of shareholder value as it has become recognized as the ultimate economic purpose of corporations. Various metrics are used for various purposes. As the balanced scorecard is used to illuminate

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS the objectives of a strategy-driven company, EVA is also used as a single most valuable measure, as well as a common language, to illuminate the economic value added to the business, with the difference that EVA is the single metric used to weight all managerial performance. Using EVA as a single metric will also removes all confusion as to what measures managers must look for. This also causes managers, and effectively businesses, to operate more effectively because managers come to realize that this is how success is measured. Concluding Remarks All three frameworks discussed here are new measurement techniques. It is worth mentioning that adding performance measurement techniques will not increase the performance of the business unless they are implemented by managers accordingly. Activity-based costing and economic value added will help managers understand the true cost of operation and the true profit of the business respectively. The balanced scorecard is also a great framework in raising awareness on the priorities of the company, and in leading the company to align its strategies with future performance targets. The balanced scorecard can assist organizations in creation of value, as it sets targets for leading variables. It will help managers obtain a vivid picture on how they can dedicate to creation of value in the organization. This could be solely done based on indications obtained from the balanced scorecard framework. However, the information that is extracted from these measurements is only part of the effort in reaching goals, proper implementation being the other factor. But without information, decision frameworks, and performance measures, it is rather hard for managers to act accordingly. Having proper information and developing right strategies based on those measures will provide the opportunity for motivated managers to produce great results.

MODERN TOOLS FOR PERFORMANCE MEASUREMENTS References Ahmad, Z., Ahmad, Z., Ahmad, I., & Nawaz, M. (2010). Balanced scorecard: Is it a spontaneous Performance measurement tool? Interdisciplinary Journal Of Contemporary Research In Business, 2(2), 99-107. Burksaitiene, D. (2009). Measurement of value creation: Economic value added and net present value. Economics & Management, 709-714. Drucker, P. (1995, Jan. - Feb.). The information executives truly need. Harvard Business Review, 73, 54-62. Shinder, M., & McDowell, D. (1999). ABC, the balanced scorecard and EVA. Evaluation, 1(2), 1-5. Stout, D. E., & Propri, J. M. (2011). Implementing time-driven activity-based costing at a medium-sized electronics company. Management Accounting Quarterly, 12(3), 1-11. Teker, D., Teker, S., & Snmez, M. (2011). Economic value added performances of publicly owned banks: Evidence from Turkey. International Research Journal Of Finance & Economics, (75), 133-137.