CHAPTER 1: PERFORMANCE MEASUREMENT AS PART OF THE OVERALL MANAGEMENT FRAMEWORK

• Theory of Scientific Management (1885–1920)

• Theory of Administration (1920–1950)
• Human Relations Movement/Neoclassical Management (1930–1950)
• Behavioral Management Theory (1950–present)
• Theory of Quantitative Management (1950–present)
• Strategic Management Theory (1970–present) and its modern manifestations such as
Total Quality Management, Competitive Advantage Strategy, a concept of Customer
Relationship Management
and Consumer-Oriented Management, etc. (2000–present)

1. Theory of Scientific Management: Frederick Taylor’s

The key elements in the theory of Rational Management were Standardization,

Rationalization, Specialization, and Intensification of Work.

Effective management and issues of high productivity in commerce and business

organizations only became a subject of serious studies at the beginning of the 20th
century after
the publication of F. Taylor’s ‘Principles of Scientific Management’. Since that
time, efficiency and performance in management have become an independent area of
research
and a recognized science.
Frederick Taylor accurately defined poor administration and inefficient or ill-
directed management as a national loss. He advocated for training the workforce and
developing
a good cooperation in the production process. That alone already represented a
significant improvement over the outdated human relations of the time.

Henry Ford introduced a modified concept of scientific management, which included a

systematic approach towards personnel management, with the idea of shared
responsibilities
between workers and managers in providing a workflow of high quality and efficiency
for the organization.

Taylor’s and Ford’s theories laid the foundation for the development of concepts of
how to organize large-scale machine production, which in turn determined frameworks
for a
model of coordination of modern enterprises.

Max Weber introduced a concept of an ‘ideal’ model of bureaucratic organization

focused on the administrative hierarchy and specialization of labor. Weber
postulated that western
civilization was shifting from ‘wertrational’ (or value oriented) thinking,
affective action (action derived from emotions) and traditional action (action
derived from past precedence)
to technocratic thinking.
According to Max Weber, western civilization was changing in order to seek
technically optimized results at the expense of emotional or humanistic value.

2. Theory of Administration: Henry Fayol, Lyndal F. Urwick, J. D. Mooney, A. C.

Railey, and Alfred P. Sloan

Between 1920 and 1950, a rational approach in management focusing on the production
cycle was slowly replaced by a ‘classical’ approach, or what is well-known today as
administrative
management, relating to the issues of improved governance and administration at the
level of the organization as a whole and gives priority to the concept of
‘efficiency’ in relation to the
function of the organization as a whole unit.

Administrative Management emphasized the main five principles of organizational

management, which were put by Fayol as follows:‘Plan’, ‘Organize’, ‘Command’,
‘Coordinate’, and ‘Control’.
Planning is the act of anticipating the future and acting accordingly. Organization
is the development of the institution’s resources, both material and human.
Commanding is concerned with keeping the institution’s actions and processes
running. Co-ordination indicates the alignment and harmonization of the groups’
efforts.
Finally, control implies that the above activities were performed in accordance
with appropriate rules and procedures.

H. Fayol proposed fourteen principles of administration to go hand in hand with

management’s five primary roles. These principles are as follows:

1. Specialisation/division of labor 2. Authority with responsibility 3. Discipline

4. Unity of command 5. Unity of direction 6. Subordination of individual interest
to the greater interest
7. Remuneration of staff 8. Centralisation 9. Scalar chain/line of authority 10.
Order 11. Equity 12. Stability of tenure 13. Initiative 14. “Esprit de corps”

3. The Human Relations Movement: Mary Parker Follett and George Elton Mayo

A new direction in management-the neoclassical management (the theory behind the

human relations movement which replaced the classical administration)-emerged in
the 1930s.
This theory adopted the achievement of sociology and psychology and used them as
tools. Within the framework of this approach, business institutions were viewed as
social structures,
for which it is necessary to apply knowledge of the organizational culture,
different types of motivation, and behavioral functions of the staff.

They first called attention to the fact that instead of considering the production
process and people involved in it to be components to be controlled, it is vital to
focus on the
interpersonal relationships within the organization.

The theory of the human relations movement studied human behavior from the
production point of view i.e. what benifits worker performance. This approach
focuses on the
relationships between performance and social and psychological conditions as
critical management elements.

4. Behavioral Management Theory:

The theory of behavioral management postulates that a close interaction exists

between the internal capacity and personal needs of employees and organizational
efficiency and
related production growth, making management of employees a key task required to
achieve a high level of performance.

Chris Argyris and Douglas M. McGregor argued that the bureaucratic form of
management is largely incompatible with the individual needs of the employees, &
that rigid hierarchy might cause
inefficient relations within an organization when representatives of a higher level
of an association (management level) consider subordinates (the lower level staff)
to be irresponsible.
These relations create structures which promote an unhealthy one-sided dependence
and lead to the basic needs of the workforce being unmet.
This can in turn lead to conditions that foster reduced interest of employees in
their work and the development of anti-organizational activities such as strikes.

Another well-known psychologist Ralph Stogdill formulated the theory of individual

behavior and group achievements. With the publication of his first article on
leadership,
‘Personal Factors Associated with Leadership: A Survey of the Literature’, Stogdill
became a pre-eminent opinion leader in management research.

L. Porter found a correlation between different approaches in management and the

size of the organization that also acknowledged differences between the structure
of the organization and
different positions held by individuals.

The theories of the human relations movement and behavioral management then became
the theoretical basis for the development of a new concept of ‘Informal
Organization’
Chester Barnard, James G. March, and Herbert A. Simon laid the foundations of the
‘informal organization’ concept which focused on understanding how decisions come
to pass among individuals
groups, organizations, companies, and society.

5. The Theory of Quantitative Management: Alfred D. Chandler (Jr.), Thomas G.

Burns, G.M. Stalker, Joan Woodward, Paul R. Lawrence, and Jay W. Lorsch

In the early 1950s, a quantitative approach appeared alongside the development of

the behavioral approach in effective management.
The motivation for this was the rapid development of mathematics and IT, which
greatly contributed to the wide application of quantitative methods in
administration.
The period of the early 1960s was characterized by a more drastic transition from a
static to a dynamic management model, which took changes in the internal and
external environment of the
organization into account. During this period, a more systematic approach to
management was enacted.

The organization was considered to be a complex hierarchical and multi-component

system which is inextricably linked with the outside world.
Key factors for success of a business venture were thought to reside in both the
external environment (from which it obtains resources, including information) and
the internal environment.

The Strategic Management Theory: Lawrence and Lorsch

The pivotal idea at that time was that the organization is constantly adapting to
the external environment and changing its internal structures at the same time.
However, the causes for internal changes in the organization should be considered
with regard to the external environment.
The theory of management in the decade was mainly focused on studying the
relationships between external environments,types of organizational structures, and
forms of governance.

According to this theory, evaluating the performance of the organization was

necessary to strengthen the influence of the environment on organizations and their
performance efficiency.
as well as address social and ethical factors and the interests of different
stakeholders and groups involved in organizational development.
This evaluation can not only be conducted from the standpoint of social and
economic effectiveness, but also has to consider the issue of how the approach of
the organization meets the
individual and group values of the employees, stakeholders, and the whole society.

Management concepts of the 1990s advocated for the following three principles:
1. Alteration of the role and the value of manufacturing (i.e. material,
production, andservice provision) due to the increasing influence of science and
technology, including the growing
role of quality for competitive advantage
2. More attention given to organizational culture and democratic corporative
governance with focus on behavioral and social aspects of management
3. Usage of the ‘product-market’ model for measuring the organizational performance

The beginning of the 21st century revealed different concepts within the framework
of strategic management. Those are total quality management and the idea of
customer relationship management.
We will discuss the concept of total quality management in the context of
performance measurement in more detail, but, in short, its basic principles
include:
• Continuous improvement of productivity and performance
• A fact-based approach towards and involvement of employees in the decision making
process
• A customer-oriented focus
• Leadership and a mutually beneficial relationship with suppliers, which goes hand
in hand with the creation of strategic targets for effective organizational
development and establishing
a competitive advantage over time.

Customer relationship management (CRM) is a customer-oriented management strategy

for organizations which already have certain regular customers.
Development of a management strategy using the CRM method includes the following
elements:
• Strategic Management
• Opportunity Management
• Strategy for Marketing Management
• Documentation Management

The concept of CRM is a process approach which can be divided into two parts:
‘front-office’ (client-facing part of the organization) and ‘back-office’
(part of the organization dedicated to tasks that support the business itself).
In this model, the front-office tends to sub#divide performance activity into
marketing management and customer services, while the back-office divides
performance activity into optimizing
effectiveness of sales and processing, logistics, monitoring financial flows, and
other types of business performance.

Performance Management:
Performance management can be described as the management of the performance of an
organization or an individual.
While this definition is not precise, it does acknowledge the breadth of
performance management and points to some of the difficulties in defining its
scope, activities, and practices.
It shows that performance management is concerned with managing the performance
capacity of a whole organization and is often a multidisciplinary approach in its
application.

The theories describing the evolution of performance management most clearly are
performance measurement (since it has the most identifiable body of literature) and
the ‘balanced scorecard’
(which in the eyes of many people is synonymous with performance measurement).
Performance management includes a variety of activities, including the planning and
execution of actions required to ensure that performance objectives are achieved.

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CHAPTER 2: MEASURING FINANCIAL PERFORMANCE

Why Performance Measurement is Important?

For Business, the running score are data such as profits, gains and losses, or the
market share. However, analyzing costs or other specific measures alone means
little.
The context and position in relation to competitors#the ‘national league’ to draw
on the football example-is equally important for the organization’s strategy

The following statements, often used in the context of performance measurement,

stress the importance of identifying the right metrics for a business:
• You cannot manage what you cannot measure.
• What gets measured gets done.
• Measurement influences behavior.

The extent to which financial information must be disclosed is dependent upon the
public or private character of the company, its size, and whether the company is
listed on a stock exchange
or not. Performance measures focusing on financial aspects can be divided into two
main types:
1. Measures based on Accounting Data
2. Market-based Measures derived from Stock or Other Financial Market Values

Accounting-Based Performance Measures:

Traditional accounting-based performance measures are characterized as being
financially-based, internally-focused, retrospective, and more concerned with local
departmental performance
rather than with the overall performance of the business. The validity of these
measures has been extensively examined and the main focus has been on profitabilty
measures.
The search for and interest in profitability measures is in line with neoclassical
economists and classical management, which ultimately sees the legitimate objective
of any private organization as maximizing profits.

The minimum accounting-based financial information for any business is compiled in

the form of periodic financial statements which consist of a balance sheet and a
profit and loss statement
The financial statement is a public document which is targeted at the main user
groups which include:
• Investors/Shareholders • Employees • Lenders • Suppliers • Customers • Government
• The Public

The various user groups have different interests in the business and consequently
apply a series of accounting ratios to interpret and appraise financial performance
based on their
information needs. From a high-level perspective such performance comparisons and
analysis may include:
1. Comparison of current year’s results with the previous year to identify trends
and performance drivers within the organization.
2. The current year’s results in comparison with the results of companies in the
same line of business, in order to establish whether the organization is performing
better or worse than its
competitors.
3. Current performance against a standard or benchmark of performance.
4. Comparisons of one segment or division of a business with others, so as to
establish Which parts of the business are achieving their goals.
Financial performance indicators included in the financial statement can be
presented in the form of ratios and cover a number of concepts.

These concepts can be grouped as follows:

• Profitability • Liquidity • Utilization • Financial Structure • Investment
Shareholder Ratios

Accounting-Based Performance Measures/ Traditional Performance Measures:

• Return on Equity (ROE): Calculates the earnings over a shareholder’s equity. It

measures a corporation’s profitability by revealing how much profit a company
generates with the money
shareholders have invested.
ROE = Net Income/ Shareholder Equity

• Return on Assets (ROA): This is an indicator of how profitable a company is

relative to its total assets. ROA gives an idea as to how efficient management is
at using its assets to
generate earnings. This ratio is calculated by dividing a company’s annual
earnings by its total assets.
ROA = Net Income/ Average total Assets

• Return on Investment (ROI): Represents the after-tax return which owners are
receiving on their investment and should be compared with alternative forms of
investment.
ROI = Gain from investment−Cost of investment/ Cost of investment

• Earning per Share (EPS): The portion of a company’s profit allocated to weighted
outstanding shares. EPS serves as an indicator of a company’s profitability.
EPS = Profit/ Weighted Average Common Share

• Dividend Payout Ratio: Calculates the percentage of earnings paid to shareholders

in dividends in a specific period.
A stable dividend payout ratio indicates a solid dividend policy by the company’s
board of directors.
Dividend Payout Ratio = Dividends/ Net income for the same period

• Cash Flow: There are different definitions for cash flows and different types of
cash flows (e.g. free cash flow, operational cash flows, etc.).
For practical purposes earnings plus depreciations can be used as a simple
approximation.
Cash Flows = Earnings + Depreciation

ROE Drawbacks and How to Keep Investors Happy:

ROE can obscure a lot of potential problems. If investors are not careful, it can
divert attention from business fundamentals.
Organizations can resort to financial strategies & therefore artificially maintain
a healthy ROE temporarily while hiding deteriorating performance in business
fundamentals.
Growing debt leverage and stock buybacks, funded through accumulated cash, can help
to maintain a company’s ROE even if operational profitability is eroding.
Mounting competitive pressure combined with artificially low interest rates,
characteristic of the last decades, creates a potent incentive to engage in these
strategies in order to keep
investors happy.

ROA:
These issues with ROE led some companies to pick a different bottom-line metric for
corporate financial performance.
This is return on assets (ROA) which receives far less attention from executives
and investors alike when seeking to analyze long-term profitability trends across
all public organizations.
Return on Assets avoids the potential distortions created by financial strategies
such as those mentioned above.

At the same time, ROA is a better metric of financial performance than income
statement profitability measures such as return on sales. ROA explicitly considers
the assets used to
support business activities. It determines whether the organization is able to
generate an adequate return on these assets, rather than simply showing robust
return on sales.
Asset#heavy business organizations need a higher level of net income to support the
business, whereas asset-light organizations can generate a very healthy return on
assets on thin margins.

In addition to the Above Mentioned ‘Traditional’ Accounting-Based Performance

Measures (in particular ROE and ROA), other key financial performance indicators
are used and monitored widely.

• Stock turnover-days: Reflects the number of times inventory is sold or used in a

time period. The lower the ratio, the quicker the stock is sold.
Inventory Turnover = Cost of Goods Sold/ Average Inventory
This ratio can be used to calculate the average days it takes to sell the
inventory: Average days to sell the inventory = 365 Days/ Inventory Turnover Ratio

• Receivables Turnover Ratio: Reflect average length of time from sale to cash
collection.
The lower the ratio, the quicker an account is paid. From a cash flow
perspective, it is important to keep the time lag to a minimum.
Accounts Receivable Turnover = Net Credit Sales/ Average Accounts Receivable
The average days to collect receivables can be calculated as: Average Collection
Period = 365/ Accounts Receivable Turnover

• Current Assets/Liability ratio: Indicates the extent to which current assets

cover current liabilities and is a way to measure the ability to meet short-term
obligations.
The rough rule of thumb is a ratio of 2:1. That is for every €1 of liabilities
(within 12 months), there should be at least €2 in current assets to meet such
liabilities.
Current Ratio = Current Assets/ Current Liabilities

• Debt/Equity Ratio: This is a way to measure the extent to which a business relies
on external borrowings to fund its ongoing operations.
The higher the ratio, the more heavily debt financing is used. In order to
provide a reliable measure, assets should be valued at market value.
Debt/Equity Ratio = Total Liabilities/ Shareholders Equity

• Interest Coverage Ratio: Provides a way to measure the ability of the business to
meet its interest commitments through profits and is linked to the debt/equity
ratio.
Therough rule of thumb used by banks is a ratio of 3:1. That is earnings before
interest and taxes (EBIT) exceeding interest expense threefold.
Interest Coverage Ratio = EBIT/ Interest Expense

• Gross Profit Margin: An indication of the profitability of the business and a

reflection of control over cost of goods sold (COGS) and pricing policies.
This ratio should be com#pared to prior periods and to any available industry
data.
Gross Profit Margin = Revenue−COGS/ Revenue

• Breakeven Sales: Reflects the sales which need to be generated in order to cover
expenses. In other words, this is the level of activity at which neither profit nor
losses are
incurred, or where total costs equate with total revenue. This is a very
important ratio which every business should monitor on a monthly basis.

Profit and Loss Budget:

In addition to these metrics which are mainly based on historical annual totals,
one of the key financial performance indicators an organization should prepare on a
monthly basis is
a profit and loss budget for at least a 12-month period. It is vitally important to
assess the impact that these projections have on the future cash flow of the
business.
Budgets should be compared to actual results and variances acted upon on a timely
basis. The following table shows an example of a profit and loss budget

Weaknesses of Accounting Based Financial Measures:

Excepting this budget, all of the different accounting-based financial measures are
retro#spective and depict the company’s performance over the past year or several
previous years.
This is one of the most criticized aspects of accounting-based performance
meas#ures: they only reflect a company’s former achievements which are not always
indicative of future developments.
These measures show the results of the business after eventshave occurred and as
such are ‘lagging’ indicators. In addition, accounting-based meas#ures have further
weakness.
Since some accounting rules are not static and leave room for interpretation,
accounting measures can be misleading, if they have been ‘massaged’ or ‘window
dressed’ in such a way that they
do not provide a true reflection of the company’s results. Especially when it comes
to the comparison of performance figures between com#panies from different
countries,
accounting-based measures reveal another weakness. Accounting principles (e.g. US-
GAAP and IFRS) can differ significantly from country to country with respect to
goodwill, taxation,
valuation of inventories, and capitalization of losses. This inevitably leads to
different performance figures. As a result, it could be possi#ble that the same
company reports a loss based
on one country’s accounting principles and a gain based on another set of
accounting principles.

To overcome the weaknesses of accounting-based measures, there is a need for more

frequent reporting periods and to gather more essential data as well as making use
of other
financial and non-financial indicators.
Market-Based Performance Measures:

Market-based measures of financial performance are completely different from

accounting-based metrics.
While accounting-based performance measures focus on the companies past
performance, market-based measures reflect the present value of future streams of
income.
These figures fluctuate daily and incorporate internal as well as external factors
& developments in the valuation.

A central concept of market-based performance figures is market capitalization,

which is defined as the total market value of all shares of a company.
The current market capitalization can be calculated by multiplying the number of
shares of a company with the current price per share on the stock market.
If the market capitalization plus the market value of debt (i.e. total market value
of a company) is higher than the capital contributed by investors (both equity and
debt),
the management of the company has created value and this additional value is called
market value added (MVA).
It is simply calculated as the difference between the company’s market
capitalization and the shareholders’ equity plus debt.
The shareholders’ equity is made up of the share capital and any retained profits
of the organization.

Traditional Market-Based Performance Measures:

• Price-to-book ratio (P/B ratio): This ratio is used to compare a stock’s market
value with its book value.
It is calculated by dividing the current market capitalization by the latest
quarter‘s book value of the shareholders’ equity.
P/B Ratio = Market Capitalization/ Total Assets−Liabilities

• Price-to-earnings ratio (P/E ratio): A Valuation ratio of a company’s market

capitaliza#tion to its earnings. P/E Ratio = Market Capitalization/Earnings
Alternatively, this ratio can also be calculated as the current share price
divided by the per-share earnings (EPS). The P/E ratio is sometimes referred to as
the ‘multiple’,
because it shows how much investors are willing to pay per dollar of earnings.
If a company were for example trading at a multiple (P/E) of 20, the
interpretation is that an investor is willing to pay €20 for €1 of current
earnings.

• Dividend yield: This figure shows how much a company pays out in dividends each
year relative to its share price.
In the absence of any capital gains, the dividend yield is the return on
investment for a stock.
Dividend Yield = Annual Dividends Per Share/ Price Per Share

In general, high measures indicate well-performing companies. But this is not

always the case and depends very much on the circumstances and on the sector a
company is operat#ing in.
For example, a high P/E suggests that investors are expecting higher earnings
growth in the future compared to companies with a lower P/E and it can be a sign of
the quality of
the management. However, it also might reflect the poor quality of present
performance. Usually, it is better to consider market-based performance measures in
relation to the
entire stock market (national or international), against an industry average, or a
subset of organizations in a particular industry. The comparison with the company’s
industry is also
referred to as peer group analysis.

• Net present value (NPV): This metric calculates the difference between the
present value of cash inflows and cash outflows (Ct) over a period of time (t). It
is primarily used
in capital budgeting to analyze the profitability of a specific investment or
project and is sensitive to the reliability of future cash inflows that an
investment or project will yield
and the expected rate of return (r).
NPV = r ∑ t − 1 Ct/ (1 + r) t − CO

If the net present value of a potential project or investment is positive, it

should be accep#ted. On the other hand, if the net present value is negative, the
project should be rejected
because it does not create value for the organization.

• Internal rate of return (IRR): The internal rate of return is often used in
capital budgeting. It is the exact interest rate (r) which makes the net present
value (NPV) of all
cash flows from a particular project equal to zero. Generally speaking, the higher
a project’s or an investment’s internal rate of return, the more desirable it is to
undertake the
project or investment. In this context, the IRR can be used to prioritize several
potential projects a company is considering. Assuming all other factors are equal
among the various project
The project with the highest internal rate of return would probably be considered
the best and undertaken first. Seen from a different angle, IRR can be viewed as
the rate of growth
a project is expected to generate. Although, in many cases, the actual rate of
return that a given project or investment ends up generating, will often differ
from its estimated IRR.
However, it can be expected that a project with a substantially higher IRR value
than other available options would still provide a much better chance of strong
growth.

Current Trends and Drivers for Performance Measures:

Organizations are trying to improve their management of the cost-effectiveness
ratio, deepen relationships with customers and enhance product mix and pricing
decisions.
These and other factors are causing organizations to re-examine and improve the
ways in which they measure and recount business performance.
The following key areas of performance management are emphasized and marked as
central trends which are emerging across the business world:

• Reviewing and Enhancing Organizational Management Profitability and the

Methodologies of recounting them
• Emphasizing the use of business-unit key performance indicators
• Refining Customer- and channel-profitability measurement and analytics
• Improving Alignment of the components of the performance management process
• Improving Systems support and automation of the performance management process
• Improving Data quality and consistency
As these trends and needs indicate, traditional performance measures are not able
to cover all of these requirements

The Economic Value Added (EVA) Metric:

The concept of Economic Value Added (EVA) expands this approach and additionally
builds on the residual income concept.
Residual income measures how much profit reamains for investment in the business or
distribution to the owners after subtracting expected returns on investment.
It is generally defined as the accounting profit minus a charge for capital used to
generate returns: Residual Income = Profit − Capital Charge
It is expected that a positive residual income should help to increase the total
market value of an organization because a positive residual income indicates that a
company is
accumulating profits at a greater rate then it needs to accummulate in order to
satisty the providers of capital.
Consequently, the residual income concept has shifted focus from a total profit
perspective to a ‘net’ profit view that takes into account expected capital
returns.

The EVA model expands the residual income concept further and tries to measure the
difference between the revenue made during a period and the costs of all resources
valued in
economic terms consumed in the same period. Discounting the stream of all the
expected future improvements in EVA helps to explain the difference between the
total market value
of an organization and its debt plus equity capital. In other words, the market
value added (MVA) is the present value of all future EVA.

The main idea of EVA and how it differs from traditional approaches. The two main
differences are:
• Inclusion of capital costs: One of the key features of the EVA model is that it
brings balance sheets and therefore cash flow variables into the profit and loss
account by charging the
organization’s cost of capital as a percentage of the assets employed in the
business before the bottom-line profit is calculated.
• Post-tax profits: Another main feature of EVA is its focus on post-tax profits
rather than operational profit. This incentivizes management to actively take this
part into consideration
when managing the profit and loss account. Althoug this sounds like a simple
modification, for the practical implemention the tax issues add a significant layer
of complexity to the EVA
model. The resulting number is usually called net profit after tax (NOPAT).
• Interest is not deducted: In order to avoid double accounting interest, paid for
capital is not deducted from the revenues but it is included in the capital charge
for both equity
and debt (net working capital).

Calculating the Economic Value Added and Other Related Measures:

Earnings before interest and taxes (EBIT), as well as the net operating profit
after taxes (NOPAT), are two important measures on the way to EVA calculation.
However, there are other related figures worth mentioning in the context of EVA
since they are commonly used. These figures provide an additional and somewhat more
precise ‘route’ to arrive
at the EVA and highlight the dependence on, yet difference from accounting-based
measures. To explore the relationships between various non-traditional measures,
one should commence by
defining a concept of earnings before extraordinary items (EBEI) and then discuss
all the additional components required to calculate the measures which lead to the
EVA.

An organization’s EBEI could be defined as follows: EBEIt = CFOt + Accrualt

Where:
• EBEIt: is the earnings before extraordinary items and tax for period t,
• CFOt: is the net cash from operating activities, and
• Accrual stands for the total operating accruals of the organization: The
difference between EBEI and the net operating profit after tax (NOPAT) is that
NOPAT
does not take the after-tax interest expense into account, while EBEI does.
Therefore:
NOPATt − ATIntt = EBEIt
Where:
• ATIntt: is the interest expense after provision for tax.
While EBEI makes provision for the cost of debt by subtracting the interest
expense, resid#ual income (RI) is calculated by deducting the cost of the total
(i.e. debt and equity) capital.
RIt = NOPATt − c * · ICt − 1
Where
• c* is the organization’s estimated weighted average cost of capital (WACC) after
tax, and
• ICt–1is the amount of capital invested in the organization at the beginning of
the period.

Organizations which achieve positive RI values are able to generate profits in

excess of their total cost of capital and consequently shareholder value should be
created. Negative
RI values are an indication that insufficient profits are generated, and as a
result, share#holder value could be destroyed.
Finally, EVA is calculated in a similar way as RI. The major difference between the
two measures relates to a number of adjustments to NOPAT and IC. These adjustments
are
included in the calculation of EVA.
EVAt = NOPATt + AcctAdjop; t − c * · ICt − 1 + AcctAdjc; t
Where
• AcctAdjop;t is adjustments to remove the accounting distortions from operating
profit, and
• AcctAdjc;t is adjustments to remove the accounting distortions from invested
capital.

Alternative Value-Based Financial Performance Measures:

In addition to the EVA concept, a number of value-based financial performance

measures have been developed in an attempt to guide management actions towards
achieving the
maximization of shareholder value and ensure that all activities generate positive
net present values. All of these value-based measures attempt to include an
organization’s
cost of capital and to adjust financial statement information in order to remove
some of the accounting distortions contained in traditional financial performance
measures.

These value-based management approaches also attempt to overcome some of the

problems associated with traditional measures.
Accounting distortions contained in the finan#cial statements are being removed

Cash value added (CVA):

Cash value added (CVA) is another well-known performance measure and serves as an
alternative to economic value added. Cash value added is considered to be another
form
of residual income. This measure calculates the difference between an
organizations’ operating cash flow and a capital charge based on the gross amount
of invested capital.
One of the major differences between CVA and EVA is that depreciations and accruals
are added when calculating the operating cash flow values in CVA. Furthermore,
accumulated
depreciation is included in the invested capital amount when the gross invested
capital is determined. The calculation of CVA is less complex than the calculation
of EVA since no
accounting adjustments are required. Since depreciation is added back during the
calculation of the CVA, the measure is not influenced by an organization’s
depreciation policy.
This characteristic of CVA can be seen as an advantage over EVA where different
depreciation policies can result in large variations in the value of the measure.

Cash flow return on investment (CFROI): has been presented by its proponents as an
improvement over some of the other traditional and value-based measures.
It is calculated by considering the inflation-adjusted investment in assets, the
inflation-adjusted cash flow generated by employing these assets in the
organization, and determines
the yield generated over the estimated lifetime of the assets.

The calculation of CFROI is based on basic discounted cash flow principles. The
four inputs required to calculate the measure are as follows:
• The Average life of the depreciating assets.
• The Total amount of assets (includes both depreciating as well as non-
depreciating assets) adjusted for inflation.
• The Inflation-adjusted cash flows generated by the assets over their lifetime.
• The Final Inflation-adjusted residual value of the non-depreciating assets at the
end of the asset lifetime.

The company’s cash flow return on investment (CFROI) value is calculated as the
discount rate which would ensure that the present value of all the future cash
flows (i.e. the equal
annual inflation-adjusted gross cash flows, as well as the terminal non-
depreciating assets amount), is equal to the initial investment (i.e. total non-
depreciating and depreciating
assets). As such, the CFROI may be viewed as a return on investment (ROI). However,
it is not calculated for individual projects, but rather for the firm as a whole.

Basic Shared Elements of Value-Based Management:

In addition to the main conceptual foundations that value-based performance
measures share, some common operational elements can be identified.
This includes the organization’s management, which can be thought of as a three-
stage-process:
• Gain understanding of value creation in each business
• Transform the company to align it with the ultimate goal of shareholder value
maximization
• Communicate results internally and externally

It is understood that value creation is the central theme of value-based management

and shareholder value is created when future cash flows with a positive net present
value
exceed expectations. From a management perspective, the main focus is on value
drivers which ultimately increase shareholder value. In many cases these drivers
are thought of in
financial terms. All aspects and activities of the organization need to be brought
in line with shareholder value maximization.

After an initial analysis, phase actions must be untertaken to create and preserve
share#holder value and allign the company with its overall goal. This is clearly
the management
component of the value-based management process. For the practical implementation
of this process, several techniques such as portfolio management and competitive
advantage frameworks are
used. In many cases, specific reward and compensation plans are also developed to
back this process.

A traditional managerial bonus plan awards a target bonus for meeting expectations.
These expectations can be linked to share price or any other metric. The size of
the bonus to be earned
by exceeding expectations is capped. The cap controls costs, but it provides no
incentive to improve performance above a certain level. Sub-par performance is
punished by reducing the bonus
with no further disincentive once the bonus bottoms out at zero. A value-based
bonus plan can also include a target bonus plus a fixed percentage of excess value
added improvement
(since value-based metrics are measured in currency and can be positive or
negative). The fixed percentage component results in an uncapped bonus level on the
upside or the downside.

Although such a bonus model has advantages over traditional measures, it still has
three major limitations:
• The bonus plan can backfire if the corporate or national culture spurns strong
wealth incentives. Older managers near retirement may see strong wealth leverage as
too risky.
• In highly cyclical industries, it is difficult to create strong wealth leverage
while avoiding large negative bonus bank balances in downtimes. This can only be
achieved by setting
compensation above market levels which results in a high cost to shareholders.
• In start-up companies or emerging markets, EVA is not the best performance
metric.

Communication is the third and last step in value-based management. While specific
to various aspects of internal and external communication, good, clear
communication is sort of a holistic
approach which especially stresses the question of how everybody in the company can
contribute to the overall goal of the organization. Comminication efforts outside
the company need to be
very well coordinated and are part of the value realiza#tion process. Good and
clear communication to the financial markets is crucial. In addition to these
practical and more operational
steps, value-based management is generally embedded in an ethical framework for
achievement in business. As such, this management system balances individual values
with economic values.

Three notions of value according to value-based management are:

• A foundation of shared ethical values-starting with a belief in the intrinsic
value of each person (each employee, customer, and supplier).
• success in the marketplace based on delivering maximum value (higher quality at
lower prices) to the customer.
• rewards based on the value people contribute to the organization; as individuals
and as a team, as employees and as owners

Basic value-based management compensation and reward systems might include:

• monthly, bimonthly, or quarterly bonuses linked to each worker’s profit centre
within the company
• annual, corporate-wide performance bonuses based on formulas tying each worker’s
contributions to overall organizational profits
• a structured, profit-based program of shared ownership (i.e. annual ESOP
contribu#tions) supplemented by cash dividend payouts to reinforce ownership
awareness Value based management is
designed to ‘institutionalize’ shared responsibility and shared risks as well as
shared rewards within the organization’s ongoing structures and pro#cesses.

The key management areas affected by the value based management transforma#tion
process include:
• Corporate Values and vision • Leadership Style and skills • Corporate Governance
• ‘Open Book’ Management • Operations (policies and procedures) • Communications
and information sharing
• Training and Education • Payment and Rewards • Grievances and Adjudication •
Collective Bargaining with labor unions • Employee Shareholder education and
participation • Future planning

Experiences from a growing number of organizations indicate that the more people’s
self interests are unified within a management system which is reflecting the
principles of
value-based management, the greater customer and employee satisfaction will be.
This can lead to a flow of increased cost savings, increased sales, and increased
profits.
The success of value-based management comes when each person, from top manage#ment
down to lowest staffing levels, feels that they own and benefit from the process
and
can share the results as members of one team.

Pros and Cons of the Economic Value Added Model:

Pros:
Considered alongside similar value-based measures metrics, the EVA metric can
overcome some significant shortcomings of other approaches such as:
• Traditional income measures, including net income and earnings per share, can be
easily manipulated and they do not account for the cost of equity.
• Market-based measures, including market value added (MVA), excess return, and
future growth value (FGV) can only be calculated for publicly-traded entities.
• Cash flow measures, including cash flow from operations (CFO) and cash flow
return on investment (CFROI) include neither the cost of equity nor the cost of
debt.

Paying managers for performance is a backward-looking practice, since the capital

markets assign value on a forward-looking basis.
Therefore, organizations which pay their managers for past performance may
unwittingly pay to undermine value creation.

Cons:
It can be said that EVA as a single period measure does not address the problem of
the time period over which profits are to be maximized and it does not provide a
strong
enough incentive to avoid ‘short-termism’. An additional critique stems from the
fact that EVA is still tied to accounting derived figures such as the capital
charge being based on the
economic book value and thus strategic and market based aspects are neglected. A
final drawback of EVA is the financial focus of the model. It fails to consider the
industry
and competitive context in which each organization operates and it does not give
clear direction on how businesses can create sustainable value from a strategic
long-term view.
The performance measures, in particular the balanced scorecard, tackles these
issues.
Additionally, it is worth mentioning that implementing EVA is a complex and very
much company-specific process. Its practical application goes beyond pure account
and financial measures.

Companies are more likely to benefit from economic value added (EVA) if they adopt
the following characteristics:
• The corporate structure consists of relatively autonomous business units, rather
than one large unit or a matrix organization with substantially shared resources.
• Strong managerial wealth incentives are tied to business unit performance, rather
than to corporate-wide goals or the discretion of the compensation committee.
• The CEO is an enthusiastic advocate. They go along with something that they fully
understand and support. Economic value added implementation should begin at the
top.
• Business unit heads are personally involved with the well-being of the
organization and are thus motivated by long-term incentives.

Ultimately, it can be said that EVA-based management is a customer-focused system

built upon shared principles and core values. It is designed to instill an
ownership culture in an
organization. Following on from the market-oriented theory of economic justice,
this management system is triggered by ‘authentic leaders’ who actively seek to
empower others; it
is developed and sustained from the bottom up.
`
Traditional Profit Calculation:
Revenues – Operational costs = Earnings before interest and taxes (EBIT) – Interest
= Earnings before taxes – Taxes = Profit after taxes

EVA-Based Profit Calculation:

Revenues – Operational costs = Earnings before interest and taxes (EBIT) – Taxes =
Net operating profit and taxes (NOPAT) – Capital charge = Economic value added
(EVA)
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CHAPTER 3: DRIVERS OF OPERATIONAL PERFORMANCE

What are the Specific BUISNESS PRESSURES that Drive Operational Performance Goals:
• Improve Executive Visibility: to operational drivers: There is no doubt that
organizations can do better than just an entry-level of maturity.
Companies are successful when operational data is applied within a time frame,
since that can affect performance improvement.

• Replace ‘Intuitive’ Decisions with ‘Fact-Based’ Decisions: However, some studies

have revealed that many operational decisions are still based on the so-called
‘gut-feel’ approach,
since there is no immediate and relevant information after the occurrence of
business events.

• Gain an Understanding of operational performance drivers: There are many

operational ‘moving parts’ within the organization.
Operational managers are increasingly demanding visibility into day-to-day
metrics in order to align operational business activity with corporate objectives.
This means they must gather, track, analyze, & act upon operational performance
drivers which can change multiple times throughout the business day or week.

The Five Operations Performance Objectives:

In order to help structure the different performance relevant aspects in the
context of operational activities, five operations performance objectives are
usually utilized:
• Quality • Dependability • Speed • Cost • Flexibility

Quality: includes a number of other dimensions, such as how well a product performs
additional features next to its primary functions, how reliable and technically
durable it is,
how easy it is to service the product, how the look and feel of the product is
perceived by the cus#tomers, and how the value for money viewpoint is.

Dependability: can mean the adherence to a plan or set schedule, but may also refer
to the delivery performance. The question of whether the products are delivered in
full and always on time). It can also include the general ability to meet promises.

Speed: can refer to the time taken to generate quotes, the time to answer quotes,
the frequency with which deliveries can be made, the time to manufacture a
product, or the time to develop and invent a new product.

Cost: includes manufacturing cost, value added, selling price, running cost,
service cost, profit.

Flexibility: There are various definitions for what it is supposed to include. It

can be distinguished between range flexibility and response flexibility.
Range flexibility focuses on the ability to cope with a wide range of requirements.
Response flexibility on the other hand means the ability to adapt to changes
quickly. In addition to these two general characteristics of flexibility,

There are two additional points which add to the complexity and multidimensional
nature of operational performance measures. The first point is that the five
operations perform#ance objectives
trade off with one another, but the extent of these trade-offs depends very much on
context-specific characteristics and timing.
Like a big jigsaw puzzle, the "Challenge for Operations Managers" is to decide on
which of the five objectives they wish to focus their main attention to and how
changing this dimension will
affect the other dimensions.

Analysis of Performance Drivers:

Analysis of Performance Drivers will generally include:

• A Leading Indicator: or early warning system which reports existing situations
will lead to a poor result if not addressed accordingly.
For example, Customer Satisfaction is as a leading indicator for Customer
Retention.

• Value Genration (KPI Components): A performance metric which is associated with a

preceding step in a value stream. For example,
if the key performance indicator is on-time-in-full shipments then a performance
driver may be manufacturing lead time which impacts the flexibility to respond to
customer orders.

• KPI (KPI Metric): A metric which directly contributes to a key performance

indicator. This metric could well be a helpful component when calculating the key
performance indicator.
For example, a gross margin key performance indicator could be calculated in the
following way: sales units multiplied by list price, minus discounts and minus
cost-of-good-sold.
This calculation is based on the fact that each of these components contributes
to gross margin and is also one of its drivers:
 Gross Margin = Sales Units· Price Per Unit −
Discounts+Cost‐of‐Good‐Sold

The following graph shows how leading indicators and operational KPIs can be linked
with performance metics:
Performance metrics measure aspects of the business process or value stream which
directly affect results or outcomes.

The Creation, Management, and Continuous review of a performance measurement system

(PMS) can be a difficult process, particularly when large, complex data volumes are
combined with
rapidly changing business dynamics. For example, projects often involve the
integration of data from disparate sources. Furthermore, complex calculations to
derive accurate indicators,
as well as a host of infrastructure requirements, are needed to deliver the
information in a meaningful format (e.g. reports/dashboards, scorecards, alerts,
etc.) and
via an effective medium (e.g. desktop PC, website, remote access, email, PDAs,
mobile devices, etc.)

This drive towards deeper insight is an internally-focused pressure which directly

addresses the next most pressing business concern-replacing ‘intuitive’ decisions
with ‘fact-based’ decisions.
In order to accomplish this, organizations clearly must have a firm grip on the
actual operational performance drivers as well as the definition and calculation of
operational performance
measures which will inevitably produce the desired insight and transparency.

There are four key performance metrics which are often used to determine excellent
performance:

• Customer Satisfaction: Reflecting annual changes in customer satisfaction. It

usually measures the percentage of total customers, whose reported experience with
a company,
its products, or its services exceeded specified goals.
• Customer Issue Resolution Capability: Reflecting the aver#age time in which
customer issues are resolved. This data also needs to reflect the per#formance
throughout an entire year.
• Conversion of Inquiries to Sales Leads: Reflecting annual changes in the rate at
which inquiries are converted to leads. Usually, it is calculated as percentage of
sales leads per inquiries.
• Sales Forecast-to-plan Performance: Reflecting annual changes in the accuracy of
sales forecast-to-plan measurement.

This strategy is of utmost importance and happens to be a prime concern of

executives when addressing their operational performance initiatives.

Process: As business dynamics change, performance management systems must also be

realigned.
This can be done by regularly employing a method for identifying, incorporating,
and reviewing the performance management system and framework with relation to
opera#tional performance.

Organizations:
In addition to having a process for updating the performance management system
related to operational performance, organizational aspects are relevant as well.
This also includes adopting a process in which the Key Performance Indicators
suitable for the respective organization are defined.
Monitoring Key Performance Indicators will look into the following aspects:

Knowledge Management:

To establish a set of operational key performance indicators and a performance-

driven culture, clear and effective corporate communication is required.
Information about
industry-wide performance will help to guide the performance thresholds which
should be pursued. Gathering this information should be based on peer and
competitor performance.
Any performance measurement capability should be accompanied by an internal
training program which helps all stakeholders to understand and participate in the
program.

Performance Management:
It is not enough to simply define key performance indicators and track them over
time. They also need to be clearly communicated throughout the organization in
order to enable all levels of
staff to understand how the indicators relate to performance goals of the group,
the company, and how this performance compares to that of competitors’.

A focus of operational performance metrics across a variety of operational business

areas might include:
• Customer Performance: This includes metrics for customer satisfaction, customer
issue resolution speed, customer issue resolution accuracy, and customer retention
rate.
• Service Performance: This includes metrics for service, such as first-call
resolution rates, renewal rates, service level agreement-compliance rates, delivery
performance to customers.
• Sales Operations: This includes metrics for new accounts, meetings secured,
conversion of enquiries to leads, and calls completed per hour, shift, and day.
• Sales Plan: This includes metrics for price-to-purchase order
accuracy, purchase order fulfillment ratio, quantity earned and total closed
contracts

Technologies:
Technical ability, or the lack of it among users, naturally pushes the job of
report generation to the IT department. This does not only lead to additional costs
in terms of IT resource
utilization, but also drives up the headcount required to meet the increasing
demand for reports and the requests for analytical views.
Automation of data integration, report generation, and alerting can improve the
speed and ease with which information can be collected and delivered to end-users.

Operational performance management capabilities depend on technological disciplines

including:
• Data Management, Data Integration, and Data Cleansing.
• Data Modelling and Development of business rules.
• Scorecarding with an eye toward easy access and making information available to a
variety of technical and non-technical business stakeholders.
• Automated Alerting to enable stakeholders to learn about performance changes
while they occur.

At the top list of priorities should be ‘ease of use for end-users’ and
‘integration capabilities with other applications’.
To achieve excellent quality performance, organizations must prioritize the areas
of the business which will benefit most from operational performance management
initiatives.
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CHAPTER 4: CUSTOMER PROFITABILITY ANALYSIS, LIFETIME VALUE, AND BENCHMARKING

Measuring the Improvements in quality and the Profits from different Customers or
Customer Groups require performance measurement techniques:

Customer Profitability Analysis:

A customer profitability analysis is an evaluation process which focuses on

assigning costs and revenues to segments of the customer base, instead of assigning
revenues and costs to the
actual products or the units or departments which compose the corporate structure
of the producer.
Many businesses use a customer profitability analysis as a means of streamlining
processes in order to provide the highest degree of efficiency and return while
generating the lowest degree
of cost.

Goals of CPA
Forward Looking: Right Decisions about Current and Potential Customers
Backward Looking: Identify what was actually working to increse profitability with
cusromers (Learning)
Operational: Analyze resource allocation

Increased customer costs can result from services such as:

• Smaller order quantities • More frequent deliveries • Producing a greater number
of products • Requirement to hold inventory • Increasing necessity for post-sales
support

A customer profitability analysis can help to identify factors which could have a
negative impact on the future of the company.
For example, most customer profitability analysis templates allow for determining
what percentage of revenue is generated from a given customer or group of
customers.
There are cases when analysis makes it clear that the company is depending on two
or three large customers to generate half or more of its business volume.
In such a case, steps are taken to diversify and expand the client base, often by
attracting more small- to mid-sized customers.
A proper customer profitability analysis will also look closely at how much of the
compny’s resources are dedicated to producing goods and services for specific
clients.

Determination of Process, Activity and Customer-Specific Costs:

These factors include cost sales, customer service, warranty department etc. Each
of these specific costs is relevant for all customers.
It is crucial importance to identify and understand these costs as well as the
major activities included and the key cost drivers.
These costs can be benchmarked internally and externally and best practices can be
identified and implemented.
As a result, costs cannot only be better assigned to customers, but opportunities
to reduce or redirect them can be identified in order to decrease the total cost to
serve the customer.

Traditional Profitability = Revenue - Product Cost - Administrative Cost

= Operating Profit
Customer Profitability = Revenue - Product Cost - Customer Cost - Asset
opportunity Cost = Customer Profit

Customer Lifetime Value:

For many years organizations focused primarily on acquiring new customers, without
taking into consideration how many purchases an individual customer made.
Acquiring a large number of customers who only purchase once is not an optimal
strategy. Instead, businesses should concentrate on identifying how much each
customer contributes to the
overall profit and performance of the organization. The customer lifetime value
tries to provide this information by measuring the worth of a customer to the
company.
With this information businesses can rank order their customers and formulate
different strategies.

In other words, customer lifetime value helps organizations to treat customers

differently based on their overall contribution to the company’s returns.
As a result, customer lifetime value addresses the following issues:
• Helps companies to understand how much they can invest in retaining a customer
while still achieving a positive (ROI).
• It can optimally allocate its limited resources to maximize returns.
• Provides an incentive for managers to place greater emphasis on customer service
and long-term customer satisfaction.

Customer lifetime value model can generally be classified in three basic

categories:
• Retention Rate • Revenue • Costs

Retention Rate:
It refers to the possibility that an individual customer remains loyal to a
particular supplier and keeps yielding expected revenue, as well as costs, within a
fixed period of time.

Revenue:
The second component revenue can be divided into four sub-categories:
• Autonomous revenue • Up-selling revenue • Cross-selling revenue • Referral
activities of existing customers

*The autonomous revenue represents factors which are not directly influenced by the
organization or only affected by standard marketing measures such as TV
advertising.

*Up-selling revenue: Additional selling of the same product as a consequence of

increased purchase frequency and intensity in long-life relationships.
Up-selling revenue also emerges from a price effect which is created by selling
higher-priced substitutes of the same category to loyal, long-term customers who
are less price-sensitive.

*Cross selling revenues: Defined as the selling of complementary products or

product categories which have not been bought from the vendor such as selling life
insurance to an automobile insurance customer.

Costs:
The principle methods for predicting customer costs are those which are commonly
applied in product-related accounting.

*Acquisition Cost: Customer specific calculation and assignment is based on the

acquisition procedure used (e.g. direct marketing vs. mass marketing through
advertising)
*Marketing costs:
Marketing costs represent costs of customer retention and development. This type
of costs comprise all marketing measures aimed at the improvement of customer
profitability
Promotional expendituresand costs for soliciting, mailing catalogues or sending
personalized greeting cards belong to this category.

The following graph illustrates the main phases of the customer lifetime cycle and
depicts how it relates to the different costs and revenue which occur:

Customer Lifetime Phases: Acquisition Phase, Customer Retention Phase,Smooth

Recovery or phased loss: X Axis= Time, Y Axis= Turnover

An appropriate calculation of customer lifetime value has to consider all elements

included in customer value, as well as all sorts of indirect monetary
contributions, such as
Information, Cooperation and Innovation Value.

Calculating Customer Lifetime Value:

The customer lifetime value can be calculated in five steps:

• The first component is the gross contribution margin, defined as the difference
between recurring revenues minus recurring costs.
• Gross contribution margin minus marketing costs results in the net margin.
• If the net margin is constant over time, it can be multiplied by the number of
purchases which are expected within a given time frame resulting in the accumulated
margin.
• The gross profit or accumulated margin needs to be corrected by any acquisition
costs which usually only occur in the first period.
• Finally, the results per period need to be discounted to calculate the net
present value of the profit per period and the cumulative net present value over
all periods.
This results in the customer lifetime value. As mentioned earlier, the discount
rate is usually estimated by the weighted average capital costs (WACC).
However, there may be rea#sons to use a different factor as a discount rate.

Recurring Cost - Marketing Cost = Net Margin

Net Margin * Expected Number of Purchases = Accumulated Margin
Accumulated Margin - Acquisition Cost = Customer Life Time Value

Case Study on Customer Lifetime Value:

To illustrate the customer lifetime value calculation we conclude this unit with a
simple case study.
The company Brand New Limited plans to extend its services to a new cus#tomer
segment based in the following data:
• The planning horizon is three years. It is expected to gain 20,000 new customers
with the service provided.
• The expected retention rate for the first year is 60 %. For the following two
years it is expected that the retention rate will increase to 65 % and then to 70
%.
• Moreover, it is expected that the customers make 1.8 orders on average in the
first year. This is expected to increase to 2.6 in year two and 3.6 in year three.
• The average order size in year one is $2,980. In year two it is expected that
this increase to $5,589 and in year three to $9,106.
• The direct costs are available as a percentage of the average costs. They are 70
% in year one, 65 % in year two and 63 % in year three.
• To win the new customers, the average acquisition costs for marketing and other
activi#ties per customer are $630.
• The weighted average capital costs (WACC) for the first year are 13.0 %. However,
based on a market study it is expected that capital costs will significantly
increase after year one.
In year two, costs are estimated to be 34.5 % and for year three 36.3 %.

The following table shows the calculation of the customer lifetime value based on
the above information and following the steps of customer lifetime value
calculation

Benchmarking:
This is an important tool not only in customer analysis, but also performance
measurement and business improvement in general. Benchmarking has established its
position as a tool to improve an organization’s performance and competitiveness
in the business world. Recently, the process of benchmarking has extended from only
looking at large companies to also include small businesses as well as the public
sector.
Therefore, It is clear that the central essence of benchmarking is learning how to
improve activities, processes, and management.

Benchmarking is practiced and understood as an integrated matrix or system with two

dimensions:
• What is to be compared to what?
• What the comparison is being made against?

What is important is that in the benchmarking matrix each possible combination

should be evaluated according to its relevance and subdivided into three
categories: High, Medium, and Low

Performance Benchmarking can be defined as a comparison of performance measures for

the purpose of determining how well the company is doing compared to others.
Process benchmarking concerns methods and processes aiming at improving the
operation processes of organizations.
The basis of comparison using the benchmarking approach is the organization itself
(internal benchmarking), competitors, industry, or technology (functional
benchmarking) and,
Finally, best practices irrespective of the specific industry (generic
benchmarking).

The process of benchmarking research generates five different comparison targets:

• Performance • Technology • Process • Competence • Strategy

Benchmarking experts apply Two main types: ‘Informal’ and ‘Formal’ benchmarking.
Informal benchmarking is a type of benchmarking that is unconsciously practiced by
people at work or in their private life. People constantly compare themselves to
others and
learn from their behavior and practices-whether it is how to use a software
program, how to cook a better meal, or improve their performance in a favorite
sport.

In the context of organizations, Informal Benchmarking can be derived from the

following:
• Talking to colleagues and learning from their experience (coffee breaks and team
meet#ings are a great place to network and learn from others)
• Consulting with experts (e.g. business consultants who have experience in
implement#ing a particular process or activity in many business environments)
• Networking with other people from different organizations during conferences,
semiars and Internet forums
• Online databases/websites and publications which share benchmarking information
provide quick and easy ways to learn about the best practices and benchmarks

As far as Formal types of benchmarking are concerned, there are Two Types:
Performance & Best Practice Benchmarking.

Performance Benchmarking: Involves comparing the performance levels of

organizations for a specific process.
This information can then be used to identify opportunities for improvement and
setting performance targets.
Performance levels of other organizations are normally called benchmarks and the
ideal benchmark is one that originates from an organization recognized as being a
leader in the related area.
Performance benchmarking may involve the comparison of financial measures or non-
financial measures.

Best Practice Benchmarking: Best practice benchmarking involves the whole process
of identifying, capturing, analyzing, and implementing best practices.
Where organizations search for and study organizations which are high performers in
particular areas of interest. The focus lies on the actual processes within
those businesses rather than just the associated performance levels. This
information is usually gathered through some mutually beneficial agreement which
follows a benchmarking code of
conduct. Knowledge gained through the study is evaluated and where feasible and
appropriate, these processes are adapted and incorporated into the organization.

Key Obstacles encountered during the process of benchmarking. These include:

• Finding Suitable Partners • Difficulties in Comparing Data • Resource Constraints
(time, finance, and expertise) • Staff Resistance

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CHAPTER 5: INTELLECTUAL CAPITAL MEASUREMENT AND MANAGEMENT

One of the most valuable assets companies have today is intellectual capital which
is comprised of the intangible assets of skill, knowledge, and information.
The market value of leading companies is far higher than their value of tangible
assets.
This is especially the case forbig technology companies such as Microsoft, Intel,
Apple, and Samsung or companies with a strong brand name such as Coca-Cola.
Since there is still no acceptable way of measuring intellectual capital. This of
course makes performance measurement difficult as it is a challenge to track
changes in IC over time.

# Importance and Challenges of Intellectual Capital Measurement:

Intellectual capital can be defined as intellectual resources which have been
‘formalized, captured and leveraged’ to create assets of higher value.
For a long time, businesses have acknowledged the importance of managing these
intangible assets.
The development of brands, stakeholder relationships, reputation, and the culture
of an organization are viewed as sustainable sources for providing growth and
gains.

Early attempts to measure intellectual capital (IC) focused on accounting and

financial perspectives of an association.
Intellectual capital, however, has a stronger focus on intellectual material such
as knowledge, information, intellectual property, and experience which can be used
to create wealth.
These intangible assets are difficult to measure since they include a large number
of organizational and individual variables.
By means of a comparison with tangible assets, the following table summarizes some
of the challenges in measuring intangible assets.

Refer Page No: 78 for : Comparison of Tangible and Intangible Assets Table:
Tangible Assets: Required for Business Operations
• Readily visible • Rigorously quantified • Part of the balance sheet • Investment
produces known returns • Can be easily duplicated
• Depreciates with use • Has finite application • Best managed with ‘scarcity’
mentality • Best leveraged through control • Can be accumulated

Intangible Assets: Key to Competitive Advantage in the Knowledge Era:

• Invisible • Difficult to quantify • Not tracked through accounting practices •
Assessment based on assumptions • Cannot be bought or imitated • Appreciates with
purposeful use
• Multiple applications without reducing value • Best managed with ‘abundance’
mentality • Best leveraged through alignment • Dynamic: short shelf-life when not
in use

Simple financial measures fail to recognize the complex nature of Intangible

Assets.
In order to structure the scope and to reduce the complexity of measurement,
intellectual capital can be classified as: Human Capital, Organizational Capital,
and Customer Capital.

Human Capital: refers to the accumulated value of investments in employee training,

competence, and future development.
This term also focuses on the value of what the individual can produce and how to
achieve it; thus, human capital encompasses individual value in an economic sense.
Human capital can further be broken down into the Employees Skills/Strength ,
Relationship Ability, and Values.

Organizational Capital: is the supportive infrastructure which enables human

capital to function.
In structural terms, that classification can be split into Organizational Capital,
Process Capital, and Innovation Capital.
Organizational Capital includes the philosophy of a business and systems for
increasing the organization’s capability to achieve its goals.
The Process Cpital might include the techniques, procedures, and programs which
implement and enhance the delivery of goods and services.
Innovation Capital includes intellectual properties and intangible assets.
An organization’s policies and procedures, as well as customized software
applications, r&d programs, training courses, and patents are examples of
organizational/innovation capital.

Customer Capital: is considered to be the combined value of relationships with

Customers, Suppliers, Industry Associations, and Markets.
Customer capital refers to aspects such as Trust and Understanding, and the
Strength as well as the Loyalty of Customer Relations.
Customer satisfaction, repeat business, financial well-being, and price sensitivity
may be used as Indicators of customer capital.

# A key Reason for Measuring Intellectual Capital is to recognize ‘hidden’

(potential) assets and strategically develop them to achieve organizational goals.
The advantages of intellectual capital measurement include the following factors:
• Identification and mapping of intangible assets.
• Recognition of knowledge flow patterns within the organization.
• Prioritization of critical knowledge issues.
• Acceleration of learning patterns within the organization.
• Best practice identification and convey across the organization by presenting a
strong business case for the best practice.
• Constant monitoring of asset value and finding ways to increase it.
• Increased understanding of how knowledge creates interrelationships.
• Understanding social networks within an organization and identifying agents which
drive their change.
• Increase in innovation.
• Increase in collaborative activities and a knowledge sharing culture as a result
of increased awareness of the benefits of knowledge management.
• Increased identification of employees with the organization and subsequently
increased motivation to achieve organizational objectives.
• Creating a performance-oriented culture.

# What are the Approaches of Managing and Measuring Intellectual Capital:

The first phase of this process typically starts with reviewing the vision,
mission, and other important strategic initiatives of the business.
As an outcome of this first step, the management usually realizes how important
intangible assets are and seeks to monitor and manage them in a productive way.
That results in creating a separate function and assigning the responsibility to
the human resources executive division.
The next step usually includes the definition and monitoring of measures which
represent important areas related to intellectual capital issues.
This includes routine reporting, analysis, and commentary about identified issues.

A final step is developing benchmarks is indicating where the desired measure

should be and initiating actions to make improvements where needed.
Both monitoring and benchmarking result in identification with and the need for
specific intellectual capital projects.
The next figure summarizes the different phases of monitoring and managing
intellectual capital.

# There are several groups of methods of measuring the intellectual capital, which
can be used in order to evaluate intangible assets:
• Direct Intellectual Capital Methods: These methods estimate the dollar value of
intangible assets by identifying its various components.
Once these components are identified, they can be evaluated, either individually
or as an aggregated coefficient.
There are a number of different individual methods which fall into this category.
One example is the total value creation (TVC).

• Market Capitalization Methods: These methods are based on ‘market comparables’

and try to calculate the difference between a company’s market capitalization and
its
stockholders equity as the value of its intellectual capital or intangible
assets.
The value of Intellectual Capital is assessed as the difference between the stock
market value and the book value of the company.

• Return on Assets Methods:

The ROA is defined as the average pre-tax earnings of a company divided by the
average tangible assets. This figure can be compared with the industry average of a
company.
The difference can then be multiplied by the company’s average tangible assets to
calculate an average annual earning from intangibles.
Dividing the above-average earnings by the company’s weighted average cost of
capital (WACC) provides an estimate for the value of the company’s intangibleassets
or IC.
Another method which can be grouped into this category is the economic value
added. Changes in economic value added allow an indication of whether a business
was able to produce IC or not.

• Scorecard Methods: This is a very broad category which tries to identify various
components of intangible assets or intellectual capital. It uses various
indicators, indices
and generates a scorecard, which usually is a score value not necessarily related
to a dollar value. Probably the most prominent approach which belongs to this
category is
the balanced scorecard concept. It tries to combine different performance
perspectives including intangible aspects.

# Advantages and Disadvantages which are connected with different ways to tackle
the intellectual capital measurement phenomenon:
Perceptual Measures, Process Measures, Financial Measures and Other measures
including Social Measures

Refer Page No: 83

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CHAPTER 6: PERFORMANCE MEASUREMENT CONCEPTS

Performance measurement outlines a process by which businesses set up criteria for

determining the quality of their activities based on organizational goals.
It involves establishing a simple but effective system for identifying whether
organizations meet their objectives or not.

However, the analysis of different approaches to measure performance has shown that
numerous factors make performance measurement a complicated process. Sometimes it
is unclear what to measure.
In addition, the intangibility of some measuring parameters, particularly non-
financial ones, is a complicating factor as these measures may be subject to
manipulation.
This can greatly complicate and distort performance measurement. And, finally, once
certain measures have been defined, they need to be combined with a complete view
of the organization.

Three tools will be discussed in this unit: The Balanced Scorecard, The European
Foundation for Quality Management (EFQM) model, and the Performance Prism Approach.

Objectives of Performance Measurement Systems:

Theoretically, a PMS might consist of three interrelated element:

• Individual measures which quantify the efficiency and effectiveness of actions

• A set of combined measures to assess the performance of an organization as a
whole
• A supporting infrastructure which enables an association to acquire data which is
later collected, sorted, analyzed, interpreted, and disseminated

The PMS can be the information system which is the key to the performance
management process. It also integrates all relevant information from all the other
management systems.

There are a number of reasons for managing performance. PMS can be used to:
• Formulate a Strategy in order to determine what the objectives of the
organization are and how the organization plans to achieve them
• Manage the Strategy implementation process by examining whether an intended
strategy is being put into practice as planned
• Challenge Assumptions by focusing not only on the implementation of an intended
strategy but also on making sure that its content is still valid
• Check Progress by looking at whether the expected performance results are being
achieved
• Comply with Non-negotiable parameters by making sure that the organization is
securing its survival by achieving the minimum standards needed (e.g. legal
requirements, environmental parameters, etc.)
• Communicate Direction to the rest of the employees by passing on information
about what the strategic goals are and how individuals are expected to achieve them
• Communicate with External Stakeholders
• Provide Feedback by reporting to employees how they, their group and the
organization as a whole are performing in comparison to the expected goals
• Evaluate and Reward behavior in order to focus employees’ attention on strategic
priorities and motivate them to take action and make decisions that are consistent
with organizational goals
• Benchmark the Performance of different organizations, plants, departments, teams
and individuals
• Inform Managerial decision-making processes
• Encourage Improvement and Learning

The Roles of the performance management system can be defined by three key
categories:
• Strategy: Comprises the roles of managing strategy implementation and challenging
assumptions.
• Communication: Comprises the role of checking progress, complying with the non-
negotiable parameters and the communicating direction as well as providing feedback
and benchmarking.
• Motivation: Comprises the role of evaluating and rewarding behavior and
encouraging improvement and learning.

How the Scorecard framework helps managers:

In addition to the strategic purpose of the performance management system, its

motivational purpose has also been stressed as a critical factor for its
effectiveness.
A performance management system can be used as a motivational device when it is
integrated in the compensation system. Traditionally, evaluation and reward
programs have been linked
exclusively to organizational financial measures. But more and more organizations
are using different performance management models to calculate their rewards.
The use of the scorecard framework helps managers’ judgement and also strengthens
their focus on what is important. It also helps to avoid information overload.

Performance Frameworks's Characteristics: To identify the criteria by which the

organization can assess and manage their performance:

• A set of measures which provides a ‘balanced’ picture of the organizational

activity.
That set of measures should reflect financial and non-financial measures,
internal and external measures, and efficiency and effectiveness measures.
• A framework of measures which provides a complete overview of the organization’s
performance. For example, the simplicity and intuitive logic of the balanced
scorecard has
been a major contributor to its widespread adoption, as it is easily understood
by users and applied to their organization.
• A set of performance measures which is multi-dimensional. This reflects the need
to measure all the areas of performance which are important to the organization’s
success.
• All possible measures of an organization’s performance have to be mapped onto the
applied theoretical account in order to identify where there are omissions or where
there is a need for greater focus.
• Performance measures should be integrated both across the organization’s
functions and through its hierarchy, encouraging congruence of goals and actions.
• Results need to be measured in a way that the performance measurement system can
provide data for monitoring past performance and planning future performance.

The Balanced Scorecard:

In an attempt to better align performance measures to a strategy Robert Kaplan and
David Norton developed the balanced scorecard (BSC).
It is a framework which helps to develop a set of measures which gives the
executive management a fast but comprehensive view of the business.
With a strategy-centric approach, it supports the translation of the organization’s
mission and vision into multidimensional actionable goals and objective measures.
The balanced scorecard tries to link strategic initiatives with operational
activities. It complements financial measures with operational as well internal
aspects.
Additionally, the balanced scorecard provides a basis for describing,
communicating, and managing the strategy in an explicit and consistent way.

In the centre of the balanced scorecard is the vision of the organization’s future.
This includes strategy, mission, and goals.
In order to achieve its objectives, the organization needs to satisfy shareholders
and customers and has to manage internal processes as well as innovation and
learning.
The balanced scorecard tries to give all of these four perspectives the required
attention and aims to derive critical success factors and critical measures for
each of these dimensions.

We will see that the balanced scorecard does not introduce new indicators, but
tries to combine and ‘balance’ existing performance measures:

• Financial Perspectives (or shareholder value): This perspective is supposed to

address two questions: “What needs to be done to succeed financially?” and
“How the organization needs to appear to shareholders?”. It includes strategies
for revenue growth and changes in the revenue mix or cost reduction and
productivity improve#ment.
Additionally, the balanced scorecard is a communication tool which is used to
tell how value is created for the organization.
Typical FInancial perspectives include measures such as cash flow management,
sales growth and profit#ability. Other commonly used measures in this context are
return on investment (ROI),
economic value added (EVA), and return on capital employed (ROCE).

• Customer perspective: When choosing measures for the customer perspective,

businesses need to answer two critical questions: “Who are the target customers?”
and
“What is the value proposition in serving them?” Especially the second question
on choosing an appropriate value proposition encompasses a fundamental strategic
decision:

*Operational excellence: Businesses pursuing an operational excellence strategy

focus on low price, convenience. Wall-Mart, IKEA,McDonald’s, and Ryanair provide
excellent examples.
 *Product Leadership: Product leaders push their company’s products. Constantly
innovating, they always strive to be ahead of the curve and offer the best products
in the market.
Examples of such companies include Apple, Fidelity Investments, BMW, and Pfizer.
*Customer Intimacy: Doing whatever it takes to provide solutions for unique
customer requirements defines customer-intimate businesses.
Examples of companies who pursue this type of strategy include IBM and Amazon.

• Internal perspective (or Business Process): This perspective refers to internal

busi#ness processes and identifies the key processes at which the organization must
excel in
order to add value for customers and shareholders. The internal processes have a
direct link to the customer strategy chosen.Metrics based on this perspective allow
managers to get an
idea of how well their organization is run#ning and whether its products and
services conform to customer requirements (i.e. the mission).

• Innovation and Learning perspective (or growth): This perspective includes

employee training and a corporate cultural attitude related to both individual and
corporate self#improvement.
In a knowledge worker organization, people, the only repository of knowledge, are
the main resource. Hence, measures and activities in this perspective become the
enablers of the other
three perspectives. Initiatives for improvement identified from the customer and
internal learning perspective will necessarily reveal gaps between the current
organizational
infrastructure including employee skills, information systems and culture, and
the level necessary to achieve the set goals.

Afeter evolution A balance in the number of measures was no longer considered

strictly necessary. In fact, Art Schneiderman who developed the first scorecard,
which Kaplan and Norton found
in Analog Devices, argues that balance is actually harmful and that good scorecards
will be unbalanced, containing mostly non-financial, internal, leading, short-term
measures. Page No: 93
Within the framework of the balanced scorecard, Kaplan and Norton proposed the use
ofstrategy maps (or success maps) to understand how the goals of performance affect
thetop-level objectives.

Strengths and Weaknesses of Balanced Scorecard:

Strengths:
• Clarity of vision and strategy adopted
• Consistent monitoring of strategy
• Concentration on strategy, in the competition environment critical business
objectives
• Cross-disciplinary and hierarchy traversing communication process
• Integration of performance measures for operational objectives at an appropriate
level
• Cause/effect relationships as instrument for management

Weaknesses:
• Does not express the interests of all stakeholders
• Lack of long-term commitment and leadership for management
• Too many/few metrics, development of unattainable metrics
• Lack of employee awareness or a failure to communicate information to all
employees
• Constructed as a controlling tool rather than an improvement tool
• No relationship quantification
• Inappropriate for benchmarking
Case Study: IMP Page No: 94
Fly High Airline Inc. Balanced Scorecard and Strategy Management

Performance Prism:
Claimants or stakeholder categories which help to form a holistic view in this
context are:
• Investors (Including shareholders, banks, and other capital providers)
• Customers and Intermediaries
• Employees (Including labor unions)
• Suppliers and Partners
• Regulators
• Pressure groups, Communities, and The Media

Two theoretical schemes which link performance measures with different hierarchical
levels and foster a stakeholder view of the corporation are the performance pyramid
(or the SMART system) proposed by Cross and Lynch and the performance prism
introduced by Neely.

Performance Prism:
The performance prism suggests that measurements of stakeholder satisfaction,
stakeholder contribution, strategies, processes, and capabilities of the
organization are taken
into account when developing the company’s strategy. These new areas of
consideration can give managers a more holistic report of the company’s performance
and can allow
them to plan for wider improvements across the company. No definitive evidence on
there needs to be an equal weighting of importance in these areas of measurement.

In the performance prism, stakeholder satisfaction is the first viewpoint on

performance. Furthermore, an organization’s strategies, processes, and capabilities
have to be aligned
and integrated with one another if the organization is to be best positioned and
therefore capable of delivering real value to all of its stakeholders.

The performance prism approach helps build a stakeholder-focused measurement and

management system.
This measurement framework is built around five interrelated perspectives on
performance which pose specific key questions:
• Stakeholder Satisfaction: Who are the key stakeholders and what do they want and
need?
• Stakeholder Contribution: What is wanted and needed from the stakeholders on a
mutual basis?
• Strategies: What strategies need to be put in place to satisfy these twin sets of
wants and needs?
• Processes: What processes need to be put in place to enable the execution of the
strategies?
• Capabilities: What capabilities need to be put in place to allow the company to
operate and improve these processes?

Strengths and Weaknesses of Performance Prism:

Strengths:
• Reflects new stakeholders (such as employees, suppliers, alliance partners, or
intermediaries) who are usually neglected when forming performance measures
• Considers the stakeholders’ contribution to performance
• Ensures that the performance measures have a strong foundation

Weaknesses:
• Offers little about how the performance measures are going to be implemented
• Some measures are not effective in practice
• Short of logic among the measures, no sufficient link between the results and
drivers
• No consideration is given to the existent PMSs that companies may have in place

SMART PYRAMID:
The strategic measurement and reporting technique (SMART) pyramid facilitates the
need for the inclusion of measures which are focused internally and externally.
The purpose of this performance pyramid is to connect an organization’s strategy to
its operation levels by conveing objectives from
the top down (based on customer priorities) and transmitting measures from the
bottom up.
This framework encourages executives to pay more attention to the horizontal flows
of materials and information within the organization, i.e. the business processes.
The SMART system includes four levels of objectives which address the
organization’s
External Effectiveness (At the bottom of the left side of the pyramid) and it's
Internal Efficiency (At the bottom of the right side of the pyramid).
The development of an organiza#tion’s SMART pyramid begins with defining an overall
corporate vision at the first horizon#tal level, which is then translated into
individual business unit
objectives. The second#level business units are set short-term targets of cash flow
and profitability and long-term goals of growth and market position (e.g. market,
financial, etc.).
The third horizontal level, i.e. business operating system, bridges the gap between
top-level and day-to-day operational measures. Here, targets include customer
satisfaction, flexibility
and productivity. Finally, four key performance measures such as Quality,
Delivery, Cycle Time, and Waste are used at Departments and Work Centers on a daily
basis.

Theoretically, the main strength of the SMART pyramid is its attempt to integrate
corporate objectives with operational performance indicators.
However, this approach does not provide any practical mechanisms to identify key
performance indicators, nor does it explicitly inte-grate the concept of continuous
improvement.

Strengths: and Weaknesses of SMART Performance Pyramid

• Attempts to integrate corporate objectives with operational performance
indicators.
• Manages PM strategically.

Weaknesses:
• Does not provide any mechanism to identify key performance indicators
• Fails to specify the form of the measures
• Does not explicitly integrate the concept of continuous improvement

European Foundation for Quality Management (EFQM):

Total Quality Management (TQM):

The concept of total quality management (TQM) was developed and presented in the
1950s by a committee of Japanese theoreticians, engineers, and government
representatives who dedicated themselves to improving Japanese productivity and
performance efficiency.
This concept aggregates a process of statistical quality control with extensive
statistical training in order to improve the level of quality of Japanese
enterprises.
The success of this concept in Japan caused American companies to take note and
experiment with the adoption of TQM.
The successful results experienced by American companies such as Ford, Xerox, and
Motorola spawned a new interest in performance measurement.
In short, total quality management can be considered as a management system for a
customer-focused organization which involves all employees in continual improvement
of all
aspects of the organization. TQM uses strategy, data, and effective communication
to integrate the quality principles into the culture and activities of the
organization.

Total Quality Management is comprised of ten fundamental principles underlying

specific technique that lead to achieving excellence in performance:
1. Be customer focused: Whatever you do for quality improvement, remember that ONLY
customers determine the level of quality.
Whatever you do to foster quality improvement, training employees, integrating
quality into processes management#ONLY customers determine whether your efforts
were worthwhile or not.
2. Ensure total employee involvement: You must remove fear from the workplace,
empower employees, and provide them with the appropriate environment.
3. Process centered: A fundamental part of TQM is to focus on process improvement.
The act of implementation should be designed and targeted at the desired effect.
4. Integrated system: All employees must know the organization mission and vision.
Set up goals for the future and ensure that every department is working towards the
same result.
5. Strategic and systematic approach: An effective strategic plan must integrate
quality as a core component.
6. Continual improvement: Use analytical quality tools and creative thinking to
become more efficient and effective. Real improvements must occur frequently and
continually in order to increase customer satisfaction and loyalty.
7. Fact based decision making: Decision making must only be based on facts and
data, not on personal or situational factors.
8. Quality must be measurable: Set up a quality management system which quantifies
the results.
9. Quality is a long-term investment: Managing quality is not a quick fix, the real
results will not occur immediately. The total quality management is a long-term
investment which is designed to achieve long-term success.
10. Communication: Communication strategy, method and timeliness must be well
defined

TQM implementation approaches can be generalized in the following order:

• Train top management on TQM principles.
• Assess culture, customer satisfaction, and quality management system.
• Top management determines the core values and principles and communicates them.
• Develop a TQM master plan based on the first three steps.
• Identify and prioritize customer needs and determine products or services to meet
those needs.
• Determine the critical processes which produce customer quality products or
services.
• Create process improvement teams.
• Managers support the efforts by planning, training, and providing resources to
the team.
• Management integrates changes for improvement in daily process management. After
improvements come into effect, the process of standardization takes place.
• Evaluate progress against plan and adjust as needed.
• Provide constant employee awareness and feedback. Establish an employee
reward/recognition process.

European Foundation for Qual#ity Management (EFQM):

One of the most successful modifications of total quality management is known as
the EFQM model which was initially developed in 1988 by the European Foundation for
Quality Management (EFQM).
EFQM is the most widely-used business excellence framework in Europe with over
30,000 businesses using the excellence model to improve performance and increase
their bot#tom-line.
This model encourages organizations to move from disciplined corporate cultures to
agile ones which are better suited to the challenges of today’s global economic
environment.

The ‘European Foundation for Quality Management Excellence Model’ is based upon the
fundamental concepts of excellence described below:
• Adding value for customers: Consistently add value for customers by
understanding, anticipating and fulfilling needs as well as expectations and
opportunities.
• Creating a sustainable future: Creating positive impact on the surrounding
environment by enhancing performance.
• Developing organizational capability: Outstanding organizations enhance their
capa#bilities by effectively managing change within and beyond the organizational
boundaries.
• Harnessing creativity and innovation: Generate increased value and levels of
performance through continual improvement and systematic innovation.
• Leading with vision, inspiration, and integrity: High goals can only be achieved
by leaders who shape the future and make it happen,acting as role models for a
company’s values and ethics.
• Managing with agility: Ability to identify and respond effectively
and efficiently to opportunities and threats.
• Succeeding through the talent of people: Values people and creates a culture of
empowerment for the achievement of both organizational and personal goals.
• Sustaining outstanding results: Sustaining by outstanding results which
meet both the short and long-term needs of all their stakeholders.

The EFQM excellence model is depicted by key nine criteria-five enablers and four
results#which lay ground for a whole view of an organization and,
when used as a diagnostic tool, it allows an organization to assess its strengths
and define areas for improvement in detail across nine key areas.

Its guiding postulate is based on the belief that:

“Excellency results which include performance, customer, people and society are
achieved through policies and strategies driven by strong leadership.
Results are delivered by people, partnership, resources, and process.”
Enablers: Leadership, People, Policy & Strategy, Partnerships & Resources,
Processes
Results: People Results, Customer Results, Scoiety Results, Key Performace Results

The model criteria suggest that:

• Leaders guide development of the mission, vision, values, and ethic of

organizations. They are the role model of a culture of excellence. Leaders are
personally involved in
ensuring that the organizational management system is developed, implemented, and
continuously improved.
• Policy and strategy are based on the present and future needs as well as on the
expectations of the stakeholders. It is built upon information from performance
measurement, research,
learning, and activities related to external circumstances.
• People resources are planned, managed, and improved. An excellent organization
manages, develops, and releases the full potential of its employees at an
individual,
 team and organizational level.
• Partnership and resources are managed. An excellent organization plans and
manages external partnerships, suppliers, and internal resources in order to
support policy, strategy and
effective operation of processes.
• Processes are systematically designed, managed, and improved in order to fully
satisfy customers and stakeholders as well as to generate increasing value for
them.
• Customer, people, and society results need to be comprehensively measured and per
eption measures and performance indicators are determined and maintained.
• Key performance results are measured by the introduction of performance outcomes
with respect to the key element of organizational policy and strategy.

At the heart of the model lies the RADAR management logic, which is another set of
guiding principles.
At the highest level, RADAR logic states that:
• Results need to be determined and should be achieved as part of an organizational
strategy.
• Approaches have to be planned and developed as an integrated set of directives to
deliver the required results both now and in the future.
• Deploy the approaches in a systematic way to ensure implementation.
• Assess and refine the deployed approaches based on monitoring and analysis of the
• Results achieved and on-going learning activities.

The elements of approach, deployment, assessment, and review are used when
assessing ‘enabler’ criteria and the ‘results’ elements are applied to assess
‘result’ criteria

A key feature of the model is that it can be used as a diagnostic tool for self-
assessment, where organizations grade themselves against a set of detailed criteria
under each of the
nine headings. The overall score acts as a European benchmark and helps
organizations identify areas to be improved.
It is then possible to develop and implement improvement plans which deliver
sustainable growth and enhanced performance for the organization.
EFQM is not to be understood as a ‘standard’. It is a framework or a practical
diagnostic tool.

EFQM Excellence Model's - Self-Assessment:

One of the recommended strategies within the EFQM Model for improving performance
is the adoption of the process of self-assessment.
Self-assessment is a comprehensive, systematic and regular review of an
organization’s activities and results referenced against the EFQM excellence model.

It is recognized that self-assessment against all nine criteria of the EFQM

excellence model is both desirable and accepted as good management practice.
The primary objective of self-assessment is to identify an organization’s strengths
and areas for improvement and to develop action plans to improve organizational
performance.

The five key self-assessment methods are:

• Questionnaire • Matrix chart • Workshop • Pro-forma • Award simulation

There are eight generic steps for carrying out a self#assessment. These steps are
shown below:
• Develop Commitment • Plan Sef-Assesment
• Establish Teams to perform self-assesment and educate them • Communicate Self
Assesment Plans
• Conduct Self Assesment • Establish Action Plan • Implement Action Plan • Review
Progress 1-7 Steps

Although they are shown as sequential, some activities may overlap others:
• Educating and training staff to give them the knowledge and skills necessary to
fulfill their role.
• Scheduling self-assessments • Developing action plans resulting from self-
assessments.
• Planning review meetings • Embedding the self-assessment process into the regular
business planning cycle.
• Maintaining commitment to activity plans by supporting improvement activities.

Strengths: and Weaknesses of EFQM Excellence Model:

• Systematic and Non-Prescription Model • Uses self-assessment approach in order to
achieve organization excellence • Strengthens the sense of quality
• Recognizes strengths and weaknesses of an organization • Consists of criteria
hierarchy • Allows shortlist of indicators based on ‘exemplars’ of practice
• Creates conditions for comparative analysis of business processes with external
business • Feedback from results helps to improve enablers

Weaknesses:
• No focus/priorities – no links • Criteria are not specific within the company –
no possibility for differentiation.
• Is not a strategic management tool and therefore is not for the strategy
implementation. • Is not suitable for enterprise communication. • Promotes the
tendency for bureaucracy.
• Does not give guidelines how to design and conduct effective performance
measurement.
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CHAPTER 7: COMMON CHARACTERISTICS OF DIFFERENT CONCEPTS

# What is PMS and Three Pillers:

The Three Pillars of Performance Measurement: Features, Roles, and Processes.

The basic feature of performance measurement to be a system which Measures
Organizational Performance.
The role of performance measurement is to Implement Organizational Srategy.
The Information Provision is a Key area for processes of a performance measurement
system.

Thus, a Performance Measurement System is comprised of performance measures and

supports management infrastructure.
It can also be utilized for measuring performance as a role and finally includes
information provision. It serves to measure design and capture data processes.
In other words, PMS provides organizations with the information necessary to
identify strategies that offer the greatest potential for meeting the targets set
by the organization.
A performance measurement system provides managers with useful information in order
to help them to effectively fulfill their required tasks and to help the
organization identify and
develop the most feasible set of actions for successful achievement of its
objectives.
In addition, a PMS and metrics give employees a more tangible understanding of how
their daily actions contribute to the organizational goals and mission.

#Common Characteristics of Different Concepts:

Analyze two of the most successful and applicable models for business concepts:
The Balanced Scorecard and
The EFQM excellence model. Refer Page No:113 Table

The European Foundation for Quality Management (EFQM)'s Excellence Model, is a

self-assessment framework for measuring the strengths and areas for improvement of
an organisation across all of
its activities.
The term ‘excellence’ is used because the Excellence Model focuses on what an
organisation does, or could do, to provide an excellent service or product to its
customers,
service users or stakeholders.

The previous chart shows clearly that both models have much in common, in
particular using measurement approaches for the improvement of performance and
applying similar principles of
management. But despite the fact that these two models come from the same origins,
they take different routes and deliver different outcomes and benefits.
The principal difference between the two approaches is that the balanced scorecard
communicates and assesses strategic performance, whereas the excellence model
includes its various
applications, such as the self-assessment process, and focuses more on the adoption
of good practice across all management activities.
For example, the self-assessment, which is typically an annual exercise, examines
how well an organization defines and manages the process of its strategic planning.
It does this by determining whether the organization has a formally established and
appropriate process. This process is reviewed regularly and is systematically
deployed at different levels.

On the other hand, the balanced scorecard tests the validity of the strategy and
monitors the organization’s performance against its delivery on a regular and
monthly basis.
The balanced scorecard does not assess the quality of the strategic planning
process itself. The main purpose of the balanced scorecard is to ensure that the
strategy gets
implemented as well as to enable an organization to continuously learn from its
performance and adapt its strategy accordingly.
Additional comparisons of the two approaches can help to understand how they work
and, what is more interesting, how the two choose to address issues on performance
management.

#Table 13: Characteristics of Balanced Scorecard and EFQM's Excellence Model Refer
Page No: 114 Table

The excellence model and its associated self-assessment processes are assessing
best practice at the process level. In order to provide equitable comparison and a
system of benchmarking to
organizations, the assessment must be applied consistently in its structure,
criteria, approach and content. It makes it easier for an organization to situate
itself in a kind of European
top league table. In this case, a market niche or particular competitive
environments are factors that do not have any essential impact on the usefulness &
application of the model.

As for the balanced scorecard and its context specific approach to performance
management, it is obvious that it entirely depends and is based on an
organization’s positioning, challenges,
competitive context, and, of course, its strategy. Thereby the balanced scorecard
model becomes a high-level guiding framework which needs to be tailored to the
organization’s individual
circumstances. (This process needs to be repeated every time it is applied to a
different situation or framework).
Thus the key task of this framework is to lead corporate governance through a path
of logical strategic thinking, which in turn can be flexed and adapted to every
situation.

The balanced scorecard is characterized by the provision of the unique advantage,

while the excellence model gives the opportunity to build up improved performance
based on best practice.

#The next critical delimitation lies in the fact that each model takes two entirely
different approaches as starting point of comparison:

The self-assessment process gives a critical and comprehensive description of the

current processes within an organization. The excellence model and self-assessment
process
show the present-day picture very deliberately. It builds up knowledge on how an
organization accumulates, selects and embeds best practice against a acumulative
and objective
set of criteria. The assessment gives a thorough account of an organization’s
current strengths and areas for improvement and as a result provides suggestions as
to where the
organization might choose to focus some of its effort in the future.

On the other hand, The Balanced Scorecard distinguish performance objectives which
need to be achieved in order to reach the organization’s vision in two or five
years’ time.
The balanced scorecard is future-oriented. It asks the question: “Where does the
organization need to improve to achieve its three-year financial objectives?”
Attached to those objectives is a set of actions and initiatives which the
organization needs to undertake today to get the objective.
In the scorecard, the priorities for today are derived from the assumption of where
the organization needs to be tomorrow.
It then takes further analysis to determine how much effort it will take to get to
tomorrow, given the current strengths and weaknesses of the organization.

By using the EFQM's excellence model, an organization will have a good and broad
understanding of its own strengths and weaknesses at the process level. As a result
of the
assessment, an organization will have an indication as to where it may need to
improve significantly, where it performs adequately, and where it excels against
the ideal benchmark.

On the other hand, the balanced scorecard can be used to provide knowledge of where
the strategic focus is needed and which action needs to be prioritized as well as
where
resources need to be allocated to

Pitfalls in Performance Measurement and Management:

Performance measurement systems (PMS) are multi-functional in their approach and
quite difficult to implement. In many cases, efforts to implement performance
measurment systems in an
attempt to positively influence the performance of an organization end up slow down
performance or producing undesired effects.

#Certain Risks associated with Performance Measurement Systems:

•Information Overload:
Since information gathering and provision are key areas of a performance
measurement system, there are some cases in which a large amount of information
creates negative effects on an
organization. Management teams become overloaded with excessive amounts of
information which leads to ‘paralysis by analysis’.
The conclusion is to reassess measurement systems and metrics which do not
contribute to the achievement of strategic goals.

•Key Performance Indicators (KPI):

Key performance indicators, also known as KPI or key success indicators (KSI), help
an organization define and measure progress toward organizational goals.
Once an organization has analyzed its mission, identified all its stakeholders and
defined its goals, it needs to find a way to measure progress toward those goals.

KPI's can be those measurements. Examples from different sectors indicate how KPIs
can be applied:
* A business may have ‘Percentage of Income’ generated from return customers as one
of its KPI.
* A school may focus its KPI on graduation rates of its students.
* A customer service department may define ‘percentage of customer calls answered
in the first minute’ as one of its KPI and evaluate that in line with overall KPIs.
* A KPI for a social organization might be the number of clients assisted during
the year.

Whatever KPI's are selected, they must reflect the organization’s goals, they must
be critical to the success of the organization, and they must be measurable.
The goals of a particular KPI may change as the organization’s goals change or as
it gets closer to achieving a goal.

•Unreasonable Incentives:
Another obstacle lies in the creation of incentives and their application. The risk
in this case is that incentives which are linked to performance may motivate
employees only
temporarily and thus an incentive scheme will not result in any long-term
commitment to performance. It is important to state that all performance measures
must be thoroughly examined
before defining incentives for their achievement. Consider the following example. A
retail outlet may have a KPI which measures ‘stock outs’, a situation which occurs
when the outlet
cannot satisfy demand because of insufficient stock. In addition, the retail outlet
also has a KPI to keep a lean stock inventory.
If the retail outlet excels at the latter KPI (i.e. keeping a lean inventory), it
may increase the amount of ‘stock outs’ and thus delay or fail to realize the first
KPI.

•Cost of Measurement:
Every measurement activity, the implementation as well as the maintenance, creates
costs. Every additional measure potentially reduces the efficiency of the process.
In addition, all proposed measures must be examined to determine if they are
adequately contribute to the strategic intentions of the organization.
Any measures which do not that should be eliminated as they add unnecessary costs
without providing any value to the organization in return.

•Cultural Resistance:
Using too many performance measurement metrics may generate resistance from
employees who potentially feel that the amount of observation is excessive.
Employees who are instructed via using performance measurement metrics must be
equipped with appropriate information and knowledge to act on these measures
accordingly.
If, however, they are unable to do so, it may lead to employee disappointed and
reduced staff morale.

#Why Orgnizations are Failing to Implement Performance Measurement Methods :

Many organizations began to introduce new performance measurement methods and

management systems, often at considerable expenses.
However, there are obstacles which create difficulties in implementing a PMS.
Unlike the environment in which organizations operate, many initiatives to
introduce PMSs appear to be static.
There is a conflict between the fixed organization’s strategy goals and rapidly
changing business environments which might create some operational problems.
There is also the danger that organizations are constantly creating new performance
measures which are significantly different and do not correspond to already
existing measures.
However, it is necessary for all organizations to evaluate and modify their
performance measures, and hence their performance management, in order to adapt to
a rapidly changing and
highly competitive business environment.
Organizations may implement new performance measures to reflect new priorities but
fail to discard measures reflecting old priorities, resulting in uncorrelated and
inconsistent measures
and hence the loss of focus of performance management.