The effectiveness of different approaches to a performance measurement system

Category: Accounting

Over the past 20 years, changes in technology and competitive conditions have dramatically altered the conditions of business operations. Many mangers of the companies realised that new tools for measurement performance are required. The challenge rose due to the fact that the traditional financial performance measurement did not capture all of the customers' demands (Otley, 1999). In order to overcome the limitations of financial indicators, the need arises to complement them with a monitoring of non-financial indicators such as quality, flexibility, value and so on -which, given their very nature, seem to be more appropriate, to follow operations closely and in real time, thus making it possible to carry out revisions and corrections as needed (Azofa et.al. 2003). Therefore, effective performance measurement is a vital ingredient in ensuring the successful implementation of an organisation's strategy. A performance measurement system that enables it to meet the customers' demands successfully is essential as it helps ensure that decision-making at strategic and operational level is better informed and more effective (CIMA, 2002). Hence there are several factors that a performance measurement system might need to contain in order to be in assistance of the managers to overcome their day to day management issues. It must be integrated with the overall strategy of the business, to be a system of feedback and review, to be comprehensive, and measures need to be fair and achievable (CIMA, 2002). In order to solve these issues mentioned above, academics and practitioners have oriented them toward two main approaches. The stakeholder approach and the shareholder approach. Stakeholder perspective argues that companies compete in many dimensions whose evaluation cannot be confine to narrow financial indicators (Otley, 1999). In other words, if the firms relay only on financial performance this might be not enough because nowadays companies are more oriented in establishing good employee relationship and customer satisfaction. Thus, a new non-financial measurement strategy is needed to be developed in order to meet these requirements. The main principle underlying shareholder perspectives of measurement is that the measuring and rewarding activities that create shareholder value will ultimately lead to shareholder wealth (Otley, 1999). All of these shareholders perspectives are based on value-based management programs which involve residual income metrics as a key performance measurement and compensation to the achievement (Coper, 2001).The main difference between stakeholder and shareholder dimensions performance is that stakeholder approaches involve a number of measures, both financial and non-financial, whereas shareholder approaches focus on one financial metric (Otley, 1999). In practice we can see overlaps between stakeholder and shareholder approaches to measuring and managing performance. There is a considerable amount of evidence to suggest that both of these approaches have plenty of tools for measuring the performance. This paper will focus on most popular example of each, the balanced scorecard (BSC) for the stakeholder approach and economic value added (EVA) for shareholder approach. The objectives of this paper are to evaluate the effectiveness of these different approaches, indentify the assumptions and biases inherit in these models and to review how these methods are linked to the reward system of organisations.

Balance Scorecard

Literature review

The balanced scorecard (BSC) is probably the most widely known multidimensional framework adopted by organisations in the quest for improved corporate performance (Otley, 1999). In the early 1990s the balance score card was proposed as a framework to provide a structure for related sets of organisational performance measures (Kaplan and Norton, 1996a).The idea of the creation was to overcome some imperfections in previous traditional approaches. The main purpose was to transform the vision of an organisation strategy into measurable objectives with meaning for practitioners. The main difference between BSC and the other approaches is that it links together the four perspectives measurement in casual chain (Kaplan and Norton, 1996a).It was suggested from the authors of BSC that these four areas of measurement should pay attention to innovation and learning, internal business, customer satisfaction, and financial outcomes.

The organizational learning and growth perspective involves the changes, investing in human capital and improvements which the company needs to realise if it is to make its vision come true. The internal-business-process perspective describes the business processes at which the company has to be particularly adept in order to satisfy its shareholders and customers (Davis and Albrigh, 2004). The customer perspective determines how the company wishes to be viewed by its customers and try to identify what they need and want . The financial perspective illustrates the company is doing in monetary terms where managers try to maximise the profit to satisfy the shareholders requirements. The conclusion one can be drawn from these points is that there is a positive relation between financial outcomes and both customer satisfaction and learning process. Providing this casual chain (Kaplan and Norton, 1996a) made attempt to indentify how the effectiveness and efficiency can be improved in an organisation in order to meet the final agenda, which in this case is maximising the financial performance. In addition, it thus aims to contribute to reducing the problems involved in using only financial measures for the purposes of control.

Discussion

There are a considerable amount of papers that provide arguments which focus attention on that the BSC is not fully developed and there are many areas where the system could be improved in order to be useful tool in the professional practice. In this paper the discussion will focus on to what extent the BSC is effective, whether the assumptions which underpin the theory is relevant and finally how the BSC is linked to the reward scheme in organisation.

Effectiveness

To be effective, BSC measures should be accurate, objective, and verifiable. Otherwise, measures will not reflect performance and may be manipulated, or managers could in good faith achieve good measured performance but cause the organization harm (Davis and Albrigh, 2004). If managers can achieve good measured performance by cheating the BSC, then the system quickly will lose credibility and desired motivational effect. Furthermore, the set of BSC measures should completely describe the organisation's vital performance variables, but should be limited in number to keep the measurement system precise and administratively simple (Malina and Seltho, 2001). An exhaustive set of performance measures may accurately reflect the complexity of the organisation's tasks, but too many measures may be distracting, confusing, and cost a lot of money to administer (Malina and Seltho, 2001). This indicates that poorly designed and implemented features of the BSC can do harm to the communication and control of strategy (Malina and Seltho, 2001).

The Implementation of BSC meets a serial of practical issues as well. First, organisations are focused to build an operational tool rather than following the concept of BSC (Happer, Scapenns and Northcott, 2007). Second, performance measurement and evaluation will always be partly subjective and to some extent depend on intuition of the top management, because both past results and the impact of future opportunities should form part of the performance picture (Happer et. al, 2007). It is unclear what weight has to be attached to each measure and for that reason many managers try to adjust these weights which in many cases might lead to biases. Third, there is no proof whether the BSC when it is implemented to organisation strategy and structure provides the information which managers will need for their evaluation. Moreover, BSC does not guarantee better financial performance compared to the other tools which can be used in an organisation. These arguments above lead one to believe that, the BSC should be adjusted for every company in order to be implemented successfully and provide effectiveness by improving the financial performance of the company.

Assumptions

In the theoretical framework of the BSC Kaplan and Norton imply the assumption that there is a cause-and-effect relationship which allows the measurements in non-financial areas to be used to predict future financial performance. Second assumption is that the BSC is a strategic control tool.

In a paper, (Nørreklit, 2000) suggest some problems in the assumptions of cause-and-effect relationship. First, there is a problem with the time lag and the time dimensions where the effect of the measures will affect the BSC at different point in time, because different areas of measurement required different time scale. Second, measuring the effect of the activities seems very difficult. Third, the directions of causality are not always clear, and the linkages between the different perspectives may be non-linear. Moreover, instead of a cause-and-effect relationship, the relationship between the areas is more likely to be one of interdependence. Finally, there is no empirical evidence whether this cause-and-effect relationship works in practice. Conclusion one can be drawn from these arguments that despite the fact that BSC is far more superior instrument for performance measurement it requires time and empirical evidence to underpin the theory of Kaplan and Norton. It is obvious that the model has plenty of limitations which have to overcome in order to be in assistance for the managers.

(Nørreklit, 2000) considers the issue regarding the relationship between the external and internal stakeholder stakeholders and the environment where the rooting problem within the relationship between management and organisation appear. Furthermore, due to its top-down management strategy orientation, the balanced scorecard will primarily create external commitment. Therefore, the main goal of the balanced scorecard is to communicate strategy to all parts of the organization. All of this might imply that, the balanced scorecard can be seen as not so valid strategic management tool, mainly because it does not ensure any organizational rooting, but also because it has problems ensuring environmental rooting (Nørreklit, 2000).

Balance scorecard and reward system

A commonly cited management axiom is "What you measure is what you get." This axiom works in practice because performance measures are linked to any of a number of incentives, both extrinsic and intrinsic, that employees value or penalties that they wish to avoid (Merchant, 2006).The measures, then, play valuable motivational, or decision influencing, roles (Doms, Dunne, and Troske, 1997). Kaplan and Norton (1996) imply that the final linkage from strategy to day-to day operations occurs when companies try to link personal reward schemes to balance scorecard. They argue that there are some benefits of connecting the reward system; such as employees' attention on strategic priorities and greater motivation for achieving the company goals. This might suggest that, when organisations tie financial rewards to performance, performance management systems could be slightly more effective. Moreover, performance management system is likely to be taken very seriously by the employees; this might lead to improving the work quality of the employees.

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EVA

Literature review

Economic value added ( EVA) is designed to provide a single value-based measure that can be used to evaluate business strategies, value acquisitions, evaluate investment projects, and set managerial performance targets, measure performance and pay bonuses (Otley, 1999). Value based management is in fact a return to economic values in assessing the performance of the firm and places the concerns of shareholders above others (CIMA, 2002). As is well known, most measures of financial performance, such as profit or return on investment, suffer from inherent defects that may cause dysfunctional decision-making on the part of managers (Otley, 1999). EVA, which is defined as accounting profit less a charge for capital employed, is claimed to be less problematic in this respect (Otley, 1999). The major inadequacies of traditional metrics mentioned in the literature are that the traditional accounting methods are not adequate for strategic decision (Kaplan and Norton 1992). Moreover, they are too historical and backward looking (Ittner and Larcker, (1998a) and do not link the non- financial measures to financial numbers. Additional drawbacks are that the traditional approaches do not consider the intangible assets (Bukowitz and Perrash, 1997) and these metrics cannot aggregate from operational to strategic level (Frigo and Krumwiede, 2000). In response of the above Stewart (the creator of EVA) contends that this measure of performance is superior to other metrics because it requires managers to take a longer-term planning horizon and gives managers clearer signals as to how to increase shareholder value (Lovata and Costigan 2002).

Discussion

Effectiveness

In theory adoption of EVA should improve the performance of organisations basically because the model has been seen from many academics and managers as an improved version of the previous financial methods. There are many papers that support the EVA model increase the shareholder value (Pettit, 2000; Stern et al., 1995; Stewart, 1991). Despite all the positive rhetoric surrounding EVA, there is no empirical evidence that after the adoption of EVA the companies provide better results. (Wallace, 1997) observes that firms adopting residual income compensation plans do not present statistically significant abnormal returns over the market portfolio.

It has been argue that the EVA concept extends the traditional residual income measure by adjusting the financial performance. Adjustments are made to the operating profit in order to replace historical accounting data (Otley, 1999). However, these adjustments rime many difficult for practitioners and in many cases lead to personal interpretation of which measures should be adjusted. Furthermore, there is a general belief that managers do not and cannot understand the complex measures that are associated with EVA and the model can be quite expensive, requiring considerable assistance from consultants and much management development and training time (Merchant, 2006). Although EVA is criticised a lot for that it is not so different from the traditional measures, and adjustments have to be made in order the model to differentiate from the other models, there is an agreement among the academics that EVA provides a better understanding of the value creation capabilities of the organisation. In this way management pay more attention on value adding activities. EVA also permits a management incentive system to be integrated to the company strategy

Above discussion might suggest that EVA model can be seen from many scholars as one of the most accurate approach which underpins the shareholder approach. Despite the fact that the model is far more upgraded and developed than other models such as ROI ROCE and RI there is still room for development. Not only is it requires a great number of adjustment in order to work but in many cases the model does not provide accurate information. Moreover, the model is likely to be manipulated by the manager with intention to provide reasonable results which might satisfy the organisations' shareholders.

Assumption

Two key claims have been made about using EVA as a performance measure:

Eva is a better predictor of stock market returns that traditional accounting earnings.

A performance measurement and reward scheme based on EVA will provide higher rates of return for shareholders than conventional rewards systems based on earnings per share and other popular financial measures (Hopper et al. 2007).

The results from the (Wallace, 1997) study reviled that EVA does not dominates earnings in its association with stock returns and EVA contributes slightly to the information already available to market participants in net income.One suggested reason for that findings was that the model relay only on public available data (Merchant, 2006). Moreover, (Wallace, 1997) research pointed out that there is no benefit for medium sized firm of using EVA.

The Wallace (1997) study demonstrated that companies adopting EVA and RI in compensation schemes tended to generate higher levels of residual income than control companies by improving operating efficiency, disposing of selected assets, and repurchasing more shares. All this actions are consistent with shareholder wealth creation.

From these studies the conclusion could be that the first assumption which implies that EVA is better predictor of stock returns does not stand. However, the second assumption can be seen as a relevant for the model and indeed EVA provide higher level residual income and improve the efficiency in the organisation..

EVA and reward system

Basically, the performance measures selected for management compensation contracts are those measures that best motivate management to maximize the shareholder value (Wallace, 1997). However, in many organisations there is an agency problem between the managers and shareholders. Second, there is another problem which occurs when managers have to decide their investment decisions. Many mangers for example, might turn down positive NPV projects due to the fact that the projects expected payoffs occur in the later stages of the project and this is not beneficial for the mangers (Wallace, 1997). This might suggest that despite the fact that EVA is one of the best tools which can be attached to the reward system of an organisation it is not perfect and can be manipulated.

Conclusion

This paper has provided discussion regarding the two main models of performance measurement system. The two models have been discussed as a part of the shareholder and stakeholder perspectives. The paper finds some limitations in both models. First, it has been implied that to be effective the BSC approach has to be adjusted to the organisation need and structure. Second, there are many implementation issues which the model has to overcome in order to be a reliable tool for performance measurement. Third, the assumptions that Kaplan and Norton provided can be argued and disproved. According to the EVA approach as in BSC there is a need to adjustments. Moreover, the paper argued that the model is too difficult to be understood by the managers and on top of that it is expensive. Despite the fact that the BSC and EVA can be seen as the most appropriate models for performance measurement, they should be developed and improved in order to become more reliable implements which will help managers in their work.