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Performance Measurement

Performance measurement systems are an integral part of the management control

Management control is a process through which management ensures that resources are
obtained and used effectively and efficiently in accomplishing the organization's goals.
To be most effective, performance measures should be tied to the strategic objectives of
the organization.
Two key principles of Performance Measurement
o Measurement of Performance.
o Compensation based on Measured Performance.

Why Measure Performance?

Objectives for profit organizations:
Measure changes to stakeholders wealth; put in simple terms, the value of a firm.
Reward an employee for contributing to increase in firm value
Issue: How would a firm measure an individuals contribution to value creation and what purpose
does it serve?
The Value Concept
(Results Control)
The Performance Measurement concept indicates that employees can increase the value of the
firm by
Increasing the size of a firms future cash flows,
By accelerating the receipt of those cash flows, or
By making them more certain or less risky.
Measure the Right Things
An ideal performance management system is one that energizes the people in an organization to
focus effort on
Improving things that really matter
One that gives people the information and freedom that they need to realize
Their potential within their own roles and that aligns their contribution with the success
of the enterprise.
Performance Measurement: Theories of Incentives and Behavior
Expectancy Theory (from Applied Psychology)
People are motivated to act in ways that
they expect to provide them with desired
rewards and to prevent the penalties they
wish to avoid.
So incentive plans must:
o Provide the proper rewards and
o Make it likely that the desired
behaviors will lead to those
rewards or penalties.

Agency Theory (from Financial Economics)

An employee contracts with an
employer to perform certain work, and
the employer wants to be sure that the
work is duly and well performed.
So incentive plans must:
o Motivate the employee to work.
o Align the employees goals with
the employers.

Effective Performance Measurement System:

Theory & Practice
Most Individuals are motivated by self-interest.
Organization gets the behaviors they reward.
Effort follows Reward.
Difficult but attainable goals motivate best.
Fairness is basis for sustained motivation.
Manipulation undermines fairness & effort.
Different Rewards can motivate effort.
Incentive system involves trade-offs.

Performance Based Reward must be greater
than alternative reward from Non-Performance.
Performance Measure & Related Rewards must
reflect Organizational goals.
Employee must believe that their effort
influence Performance.
Impossible goals are de-motivators, & so are
easy goals. Make goals difficult but not
Reward must be link to desired Performance in
fair manner.
Performance Measures must be observable &
Reward must meet market conditions & reward
must be available.
Minimizing the overall costs of aligning goals
& monitoring behavior is a goal of incentive
system design.

Uses of Performance Measurement


Decision Making
Attention Focus
Compensation income is not guaranteed but dependent on performance
Translating and implementing strategy.

Dysfunctional Outcomes of Performance Measurement

Fundamentals problems exist in performance measurement if the unintended behavior is

Designers of incentive plan can be surprised to find that these systems create unintended
o Credit Lending
o Enron performance measured by stock price and revenue recognition.

What makes an Effective Performance Measurement System?

Effective Performance Measurement System

Given the goals of the company which alternative incentive will motivate the desired
Unlikely a single measure or even several measures will effectively assess performance.
o Assesses progress toward organizational goals and objectives - promote intended
o Includes critical success factors
o A mix of financial and non-financial multiple measures
o Congruent with reward systems pay performance link
o Participatory and easy to understand by employees


Absolute vs. relative evaluation

Various types of compensation (e.g. salary, bonuses, options)

Effective Performance Measurement System

Feed back provided.

Include both short and long term measures.
Employees in appropriate jobs & appropriate performance expectations.
Attainable performance levels.
Measures are observable (objective vs. subjective).
Responsibility and control is considered (overall vs. divisional).
Limit ability to manage/manipulate outcome measures.

What are some Traditional Measures of Performance?

Traditional Performance Measures

Some monetary measurement of income is used by virtually all businesses to assess

Financial measures do not address issues of competitive reality.
1. Cash flow
2. Return on Investment
3. Residual Income
4. Economic Value Added

Why are Traditional Performance Measures inadequate?

Problems with Traditional Measures
1. Overly aggregate
2. Not Timely
3. Backward looking
4. Promote dysfunctional behavior in the short term.
5. Not one measure or type of measure can realistically capture performance.
What are non-Traditional Performance Measures?
Non-financial Performance Measures

Traditional financial measures are easy to measure but inadequate.

Non-financial measures are being used increasingly instead of traditional systems.
Focus on the leading indicators of profit.
Recognition of the time lags between non-financial and financial performance.
Non financial performance measures create shareholder wealth.
Non financial measures better predict future cash flows
A large scope of non-financial performance measures relates to critical success factors.
Intellectual capital becoming the basis of competitive advantage
What gets measured gets done.
Customer service is an important measure.

Why are non-financial measures not well utilized in performance measurement?

Non-Financial Measure - Current Practice

Importance-measurement gap
Measurement-use gap
Susceptible to measurement problems
Difficult to measure effectively (accuracy, ambiguity, timeliness)

Lead-lag relationship.