Performance Measurement

Performance measurement is main part of performance management as

“management is a process of getting things done by others” and “what gets
measured gets done”.

While selecting performance measures following factors should be considered:

1. Measurement needs resources – The costs and benefits of providing

resources to produce a performance indicator must be carefully weighed up.
2. Performance must be measured in relation to something (i.e. against
objectives)
3. Measures must be relevant- they show you something about the system
or person that you need to know.
4. Measures should be fair- should include only those factors that managers
could control
5. Measures should be easy to understand
6. Measures should be reliable
7. Measures should be based on accessible data

Key terms

Key Performance Indicator (KPI) KPI can be defined as providing the most
important performance information that enables organizations or their stakeholders
to understand whether the organization is on track or not.

Critical Success Factor (CSF) it is something the achievement of which is

necessary for the success of the company. (E.g. profitability, liquidity)

Performance indicators are of two types

 Financial performance indicators

 Non-financial performance indicators

Financial performance indicators

Financial performance indicators show how well a division or organization has

performed from financial perspective like

 Profitability
 Liquidity etc
 Utilization
 Financial structure
 Investment – shareholder ratios

Advantages OF Financial Performance Indicators

1. It simplifies the financial statements.

2. It helps in comparing companies of different size with each other.
Performance Management Performance Measurement

3. It helps in trend analysis which involves comparing a single company over

a period.
4. It highlights important information in simple form quickly. A user can judge
a company by just looking at few numbers instead of reading the whole
financial statements.
Problems with financial performance indicators

1. Ratios deal mainly in numbers – they don’t address issues like product
quality, customer service, employee morale and so on (though those
factors play an important role in financial performance)
2. Financial performance indicators focus on short term performance
3. Few of the financial performance indicators are based on accounting
profit, which is subject to manipulation
4. Financial performance indicators are based on historic information,
which is not always a true indicator of future performance
5. Financial performance indicators focus on very few variables as the deal in
information that can be expressed in monetary terms

Non-Financial Performance indicators

Following are few things that non-financial performance indicators would show:

 Defects
 Equipment failures
 Warranty claims
 returns
 stock outs
 lateness
 absenteeism
Advantages of NFPIs
 They are closely linked with long term performance
 NFPIs can usefully be applied to employees and product/service quality
 Performance can be accessed from any aspect of the business as there is
no reliance on financial information
 They give better idea of future performance
 NFPIs also help in TQM

NFPIs should cover following areas

1. Competitiveness
2. Productivity
3. Quality of service
4. Customer satisfaction
5. Quality of staff experience
6. Innovation

1. Competitiveness:

 Sales growth by product or service

 size of customer base
 market share by product
 service or customer group
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2. Productivity:

 Capacity utilization of facilities and personnel

 Average number of Units produced per day or per man-day
average setting up time for new production run
3. Quality of service:

 Number of Units rejected in manufacturing

 Number of Units failing in service

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.

 Number of visits by representatives to customer premises

 Number of new accounts gained or lost
 Number of repeat customer orders received

4. Customer satisfaction

 Market research information on customer preferences and customer

satisfaction with specific product features
 Number of defective units supplied to customers as a percentage of
total units supplied
 Number of customer complaints as a percentage of total sales volume
 Percentage of products which fail early or excessively
 On-time delivery rate
 Average time to deal with customer queries
 New customer accounts opened
 Repeat business from existing customers

5. Quality of staff experience

 Days absence per week
 Staff turnover rate
 Number of new qualifications/courses completed by staff
 Number of new staff skills certified
 Expressed job satisfaction
 Qualification levels of newly recruited staff.

6. Innovation
 Number of new products or services brought to market
 Proportion of Sales relating to new products
 Technical lead relative to competitors
 lead time to bring new products to market

Following are the reasons for short-termism:

1. Postponing or abandoning capital expenditure projects, which would

eventually contribute to growth and profits, in order to protect short term
cash flow and profits

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2. Cutting R&D expenditure to save operating costs, and so reducing the

prospects for future product development
3. Reducing quality control, to save operating costs (but also adversely
affecting reputation and goodwill)
4. Reducing the level of customer service, to save operating costs (but
sacrificing goodwill)
5. Cutting training costs or recruitment (so the company might be faced
with skills shortages)

Ways to encourage long term view:

 Performance measurement should be based on both long term and
short term objectives
 Link managers’ performance with share price

Financial Perspective Customer perspective

Goals (CSFs) Measures (KPIs) Goals Measures (KPIs)
(CSFs)
Profitability Net profit margin New Percentage of sales
products from new product
Succeed Monthly sales growth Responsive On-time delivery
supply
Liquidity Current ratio Customer- Number of
partnership cooperative
engineering efforts

Internal business perspective Innovation and learning

perspective
Technology Vs competition Technology Time to develop next
capability leadership generation of
products
Manufacturin Processing time Manufacturi Process time to
g excellence ng maturity
learning
Design Silicon efficiency Time to New product
market introduction vs
competition
Balance scorecard

Benefits of the balanced scorecard:

 It provide external as well as internal information
 It focuses both on financial as well as non-financial performance

Problems with the balanced scorecard:

 Balanced scorecard focuses a lot on key performance indicators, the
selection of which becomes difficult at times
 Intense performance measurement means intense information
 Intense information leads to “information overload”
 Conflict between measures

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The building block model

Fitzgerald and Moon adopted a framework for performance evaluation
of service organizations which they named as “building block
model”. They suggested that the performance measurement in
service organization should be based on three building blocks:

Dimensions
CSF’s

Standards Rewards
KFPI’s

The dimensions could better be illustrated through following table:

Performance Measure
Dimension
Competitive Market share
performance Increase in Sales
 (market leader) retention rate for customers
Conversion of queries into sales
Financial Be profitable
performance Enhance Liquidity position
Capital structure
Quality of Reliability
service quick Response to customer orders
Number of complaints
Flexibility The different types of work done by the employees ( to
assess the flexibility of work force)
The speed in responding to customer requests ( to assess
the flexibility of response to customer requests)
Resource Productivity/efficiency ( wastage rates, idle time rates etc
utilization )
Innovation Number of new services offered each year
Proportion of revenue earned from new services to
revenue earned from old services

Reward system
According to Fitzgerald the reward system should possess three key
characteristics
 Clarity
The employees should clearly be aware of how their performances will be
measured and how will they be rewarded
 Motivation
They should be motivated towards the achievement of targets
 Controllability

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The individuals should only be held responsible for the financial

performance they can control
Divisional performance measures
Divisionalisation

Advantages of divisionalisation

1. Divisionalisation can improve the quality of decisions as divisional managers knows better about local
conditions
2. Decision making process will be quick
3. Higher motivation
4. Top level management will have more time for strategic level decisions
5. Will lead to better use of divisional managers’ skills

Disadvantages of divisionalisation

1. It might lead to dysfunctional decision making

2. Control may be lost

Responsibility accounting

The process of dividing an organization into areas of personal responsibility.

Responsibility centre could be of following three types

 Cost centre
 Revenue centre
 Profit centre
 Investment centre

3. Cost of activities that are common will be higher

Objective of Performance Measurement:

The objective is to develop performance measurement systems for divisions that

are significant investment centers in large organizations. Such systems should:

 provide information for economic decisions

 facilitate the control of division operations
 motivate managers to achieve high levels of divisional performance so as
to further the objectives of the entire organization
 serve as a basis for evaluating the performance of divisional managers.
 

Measurements must match the type of divisions. 

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Type of Description Typical measures

division

Cost  Division incurs cost but has no  Total cost

center revenue stream  Cost variances
 Cost per unit and other
cost ratios
 NFPIs related to quality,
productivity, efficiency,
etc.

Profit  Division has both costs and All of the above plus:
center revenue
 Sales
 Profit
 Sales variances
 Margins
 Working capital ratios
(depending the division
concerned)
 NFPIs related to
customer satisfaction

Investme  Division has both costs and All of the above plus:
nt center revenue
 Manager does have the  ROI
authority to invest in new assets  RI
or dispose of existing ones
 
  
Traceable ROI (divisional Performance Measurement)
 

Return on investment Traceable profit

= x 100%
(ROI) Traceable assets

 Traceable profit is the revenue of the division less directly attributable

expenses
 Traceable assets are those that exit exclusively for the division
 Non-current assets might be valued at cost, net replacement cost or net
book value (NBV). The value of assets employed could be either an
average value for the period as a whole or a value as at the end of the
period. An average value for the period is preferable.

Controllable ROI (Managerial Performance Measurement)

Return on investment = Controllable x 100%

profit

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Controllable
(ROI)
assets

Controllable profit is the revenue of the division less controllable

expenses
 Controllable Assets are those assets that are under the control of the
divisional manager
Evaluation of ROI as a performance measure

ROI is a popular measure for divisional performance but has some serious
failings which must be considered when interpreting results.

Advantages

 ROI normalizes the size effect since it is a ration. This, we can compare
entities of different sizes.

 It can be broken down into secondary ratios for more detailed analysis like
 Asset turnover ratio
 Net profit margin

 Changes in ROI will lead to changes in EPS, i.e. increase in shareholders’

fund

 It is widely used and accepted.

Disadvantages

 It may lead to dysfunctional decision making, e.g. a division with a current

ROI of 30% would not wish to accept a project offering an ROI of 25%, as
this would dilute its current figure.
 There is no incentive for a division to expand to the point where the
marginal return on investment equals the cost of capital.
 It may encourage the manipulation of profit and CE figures to improve
results.

Residual income (RI)

RI = Accounting profit - Notional interest on capital

Evaluation of RI as a performance measure

Compared to using ROI as a measure of performance, RI has several advantages
and disadvantages:
 
Advantages

 Changes in ROI will lead to changes in EPS, i.e. increase in shareholders’

fund

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 It encourages investment centre managers to make new investments if

they add to RI. A new investment might add to RI but reduce ROl In such a
situation; measuring performance by RI would reduce the probability of
dysfunctional behavior.
 Residual income focuses on the level of income earned in excess of the
cost of capital some writers believe managers are primarily interested in
magnitudes, not rates of return
 Making a specific charge for interest helps to make investment centre
managers more aware of the cost of the assets under their control

Disadvantages.

 It does not relate the size of a division’s profit to the assets employed in
order to obtain that profit.
 Unlike ROI it gives absolute figure rather than relative figure. Which makes
it difficult to compare divisions with different sizes.
 It is based on accounting measures of profit and CE which may be subject
to manipulation.

Transfer pricing
Objectives of the transfer pricing system
 Goal congruence
The decisions made by each profit centre manager should be consistent
with the objectives of the organization as a whole. A common feature of
exam questions is that a transfer price is set that does result in sub-
optimal behavior.
 
 Performance measurement
The performance of each division should be capable of being assessed and
a good transfer price would enable each centre to be evaluated on the
basis of profit.
 
 Autonomy
The system used to set transfer prices should seek to maintain the
autonomy of profit centre managers. If autonomy is maintained, managers
tend to be more highly motivated but sub-optimal decisions may be made.
 

 Minimizing the global tax liability

When a divisionalized company operates entirely within one tax regime
the transfer pricing policy will have a minimal impact on the corporate tax
bill. However multinational companies can and do use their transfer
pricing policies to move profits around the world and thereby minimize
their global tax liabilities.

 
 Recording the movement of goods and services.
In practice, an extremely important function of the transfer pricing system
is simply to assist in recording the movement of goods and services.

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 A fair allocation of profits between divisions.

Most of the advantages claimed for divisionalization are behavioral.
Insofar as transfer pricing has a material effect on divisional profit it is
essential that managers perceive the allocation of corporate profit as
being fair if the motivational benefits are to be retained.

Types of transfer of transfer pricing

Theoretical transfer pricing

The general rule is to set at marginal cost plus opportunity cost. This general rule
has certain implications.
 When there is a perfectly competitive market for the intermediate product
the transfer price should be set at market price. The market price
represents marginal cost + opportunity cost.
 When there is surplus capacity in the producing division transfer price
should be set at marginal cost as there is no opportunity cost.
 When there are production constraints in the producing division the
transfer price should be set at marginal cost + the opportunity cost of
using resources to produce for the internal market rather than the next
best alternative.

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Practical transfer pricing

In the real word transfer prices are set using the following techniques:

 Market prices.
 Production cost (either variable or full, possibly with a mark-up).
 Negotiation.
 Arbitrary pricing
 Dual transfer pricing

Market Prices
If there is a market price available then this is often seen as the optimum
transfer price as all managers concerned with it view it as fair. However, there
are many situations when it would be difficult to agree a market price. Problems:

 There may be no intermediate market price (product not in market).

 The market price might not be independent (controlled).
 Difficulty in agreeing a source of market prices (variable factors like place,
timing, quality and size).
 The need to adjust prices for different volumes (bulk purchases).
 Published prices may be fictitious (list price vs. actual price).

Cost based transfer prices

If there is no market price then the transfer price is based on cost. It is generally
argued that any transfer price based on cost should be based on standard cost
rather than actual cost. A transfer cost based on actual cost would give the
transferring division no incentive to control costs as any cost overrun could
simply be passed to the buying division.

Negotiation/Arbitrary Price

A negotiated transfer price may be used even though competitive outside

market exists. It is felt that the setting of the price by negotiation between
buying and selling divisions allow unit managers the greatest degree of authority
and control over the profit of their units. A serious problem encountered with this
method is that negotiation can not only become time consuming but can also
require frequent re-examination and revision of prices.

Dual transfer pricing

The buying and selling divisions may differ in the purpose a transfer price is to
serve. For example, a buying division may rely on a transfer price in make or buy
or in determining a final product’s sales price based on an awareness of total
differential cost. A selling division may use a transfer price to measure its
divisional performance and accordingly would argue against any price that would
not provide a divisional profit. In such circumstances, a company may find it
useful to adopt a dual transfer pricing approach in which the:

1. Selling division uses a market-based, negotiated or arbitrary

transfer price in computing its revenue from intra-company sales.

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2. Variable costs of the producing division are transferred to the

buying division, together with an equitable portion of the fixed cost.
3. Total of the divisional profits will be greater than for the company as
a whole, and the profit assigned to the selling division would be
eliminated in preparing company-wide financial statements.

Limits of transfer price

There are different situation that divisions might be facing when setting transfer
prices

 Where external markets exist for both supplying and receiving

division

 Minimum – the price at which the supplying division can sell the
component in external market
 Maximum – the price at which the receiving division can buy the
component from external market

 Where external market exist for supplying division only

 The Minimum transfer price will be the price at which supplying

division sells the
 component in the external market

 Where external market exists for receiving division only

 The maximum transfer price will be the price at which the receiving
division purchases component from external market

 Where no external markets exist for any division

the transfer price should be set after negotiation between the divisions

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PERFORMANCE MEASUREMENT
IN
NOT-FOR PROFIT ORGANIZATION

Where organizations do not exist for profit, performance measurement based on

profit will be of least importance. A best example in the situation would be of a
local government which does not exist for profit rather its core objective is to
provide civil services like provisions roads, water and sewerage facilities etc. In
such organizations the best way of performance measurement would be a value
for money analysis. The concept of three E’s.

 Economy
 Efficiency
 Effectiveness

Economy
The operations will be called as economical if the resources used for such
operations are obtained at minimum cost possible. That is selecting a supplier
that offers minimum prices, hiring labor at lower rate, etc.

Efficiency
The performance will be termed as efficient as maximum output is given for the
minimum resources being input. For example reducing the wastage level,
reducing time taken for producing a unit etc.

Effective
Operation might be economical and efficient but still will not be called effective if
it does not achieve its objectives. For example a local government might start a
signal free corridor with the objective to ensure a soft flow of traffic.

The project will not be called

 effective if it does not ensure required flow of traffic

 efficient if it is completed after utilizing more resources than required
 economical if the resources used are obtained for higher prices than it
could have been obtained for

More general objectives for not-for-profit organisations include:

 Surplus maximisation (equivalent to profit maximisation)

 Revenue maximisation (as for a commercial business)
 Usage maximization
 Full/partial cost recovery (minimising subsidy)
 Budget maximisation (maximising what is offered)
 Producer satisfaction maximisation (satisfying the wants of staff and
volunteers)
 Client satisfaction maximisation (the police generating the support of the
public)

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Problems with performance measurement of not-for-profit

organisations

 Multiple objectives
 Measuring outputs
 Lack of profit measure
 Lack of profit measure (identification of cost unit)
 Financial constraints
 Political, social and legal considerations
 Unlike commercial organisations, public sector organisations are
subject to strong political influences. Local authorities, for example,
have to carry out central government's policies as well as their own
(possibly conflicting) policies.
 The public may have higher expectations of public sector
organisations than commercial organisations. A decision to close a
local hospital in an effort to save costs, for example, is likely to be
less acceptable to the public than the closure of a factory for the
same reason.
 The performance indicators of public sector organisations are
subject to far more onerous legal requirements than those of
private sector organizations

Solutions to above problems

 Inputs: Performance can be judged in terms of inputs

 Judgement: performance can judged by “experts”
 Comparisons: performance can be compared with the performance of
similar type of organization
 Value for money: the three E’s (discussed above)

Perform/ances should be measured considering the expectations of different

types of stake holders:

Types of stake holders

 Internal stakeholders (employees, management)

 connected stakeholders (shareholders, customers, suppliers, financiers)
 External stakeholders (the community, government, pressure groups)

No organization operates in isolation, its performance is affected by external

factors which must be taken into account before measuring performances

External factors:

 Economic growth
 Inflation
 Interest rates
 Exchange rates
 Government fiscal policy

Problems associated with reward schemes

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 Might lead to encourage dysfunctional behavior

 Reward scheme based on long term targets may not motivate
 Individualization may be enhanced at the expense of teamwork
 Undervalue intrinsic reward

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