Introduction such as customer satisfaction, innovation and quality

Introduction

 

Traditionally,
in answering the question ‘is your company doing well?’ company management would
solely be focused on financial performance based on historic trends and other
financial (quantitative) measures Fitzgerald, 2007. However, our everchanging
society has caused a need for variations to the way businesses measure
performance. In the early 2000s, a survey of US companies found that the
majority of them were unsatisfied with their performance indicators as too much
emphasis was given to financial measures, with not enough emphasis given to
other indicators such as customer satisfaction, innovation and quality Wharton
School, 2000. In the same year, businesses started turning more to
non-financial (qualitative) performance indicators as opposed to the
traditional measures Bhimani et al, 2015. The reason for this shift in
approach is primarily due to the increased expectations of stakeholders and
their needs for value-driven delivery by creating, preserving and increasing the
value of the business CIMA, 2000. However, this approach to measuring
financial performance can be seen as being unfavourable to the shareholders of
organisations when compared to EVA (Economic Value Added) and other quantitative
performance measures. In this assignment I will critically assess the different
kinds of performance measures available to organisations, which are linked more
directly to the needs of shareholders and the reasons why.

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Agency Conflict

 

Owing
to their differing needs, an agency conflict can arise between of the
management of a company and its shareholders which can result in different
performance measures being preferred by each party. The preferred measures
would be those which assist the interests of each party, as there is an
underlying presumption that parties continually act in ways which maximise their
own interests Moyer et al, 2018. Accordingly, management are more concerned
with the long-term sustainability of the company rather than short-term
profitability, which in turn retains their own job security Moyer et al, 2018.
They do, however, have to “walk a fine line between supervising and maintaining
the current resources they have to work with and the constant push for
profitability” from the shareholders Lewis, n.d. who are only interested in their
own personal wealth maximisation Moyer et al, 2018; as such the shareholders
would be reluctant for money to be spent on any expenses they deem to be unnecessary.

 

 

Qualitative Performance Measures

 

Indicators
which are based purely on financial performance are typically short-sighted, focusing
primarily on annual (or even shorter-term) performance. This creates an
environment “where short-term earnings become more valuable than the factors
that cause them” Akers, 2017, leading to longer-term strategic goals being sacrificed
at the expense of short-term profitability Wharton School, 2000. This results
in purely financial indicators not capturing the longer-term benefits of any
decisions made in the present – for example, any investments in made into
research and development ideas must be expensed in the period they are incurred
thus reducing profits, however, successful innovation coming as a result of the
research can lead to an increase in future profits Wharton School, 2000.

This
approach would therefore be more beneficial to the management of a company than
its shareholders due to their need for long-term sustainability over short-term
profitability Moyer et al, 2018.

 

Opponents
of the traditional financial indicators argue that successful businesses are in
fact driven by customer loyalty and intellectual capital Wharton School,
2000. Investing in customer satisfaction “encourages long-term financial
success by increasing levels of customer loyalty” Akers, 2017 as well as
attracting new ones, resulting in more transactions and increased profits down
the line Wharton School, 2000.  

Again,
this approach would be more beneficial to the management of a company than its
shareholders due to their need for long-term sustainability over short-term
profitability Moyer et al, 2018.

However,
a study which looked at how non-financial indicators affected the stock market
prices of US companies found that management capability, innovation and brand
value comprised a significant amount of a company’s worth. Therefore, by ignoring
these indicators management may make detrimental business decisions Wharton
School, 2000. Interestingly, this approach would also see a benefit to the
company shareholders as well as management due to their need to maximise their
own personal wealth Moyer et al, 2018.

 

The
benefits of implementing a system that monitors both financial and
non-financial data on a large scale can be outweighed by both its cost and the
amount of time spent analysing the data Wharton School, 2000. In contrast to
financial indicators, there are various ways in which non-financial indicators
can be measured due to the fact that they are not all denominated in the same
way. This makes assessing the performance of non-financial indicators more
challenging, and with businesses struggling to choose how to rank the
indicators the amount of time needed to be spent analysing data can increase
dramatically – for example, one bank saw a jump from one to six days in the
time needed for area directors to evaluate the performance of the quarter after
undertaking such changes to how financial performance is measured Wharton
School, 2000. Well-intentioned performance indicators can also descend into
purely administrative exercises which often offer no help with meeting
strategic goals. An example of an organisation which was affected in this way
is Florida Power and Light, which was the first US corporation to win the
Deming Prize for quality improvement. However, the employees felt that the
business was far too heavily orientated on reporting and presenting a
ridiculous number of indicators, therefore wasting time which should be used
serving customers. As a result, the number of indicators (and hence the number
of reports and presentations surrounding them) heavily reduced. This was a case
of measurement disintegration, where too many indicators dilute the outcome of
the performance measurement Wharton School, 2000.

Staff
members would be forced to take time away from their actual job in order to
deal with the administrative burden with no valuable output at the end of the
process. Consequently, more money would need to be spent on hiring more
employees to pick up the work existing staff members can no longer do due to
the administrative pressures. These costs would be on top of the already large
initial set up costs for such indicators, which primarily occur due to the data
needed feeding in from various systems which are frequently incompatible
Wharton School, 2000.

If
this were the case then the implementation of non-financial performance
indicators would not realise a benefit to either the company’s management or
its shareholders. Any resulting cash flow issues could affect both the
long-term sustainability of the company as well as the short-term profitability.
Furthermore, this would be compounded with the already high set up costs, thus
seeing less money heading towards the shareholders and all for no overall
purpose Moyer et al, 2018.

 

 

Quantitative Performance
Measures

 

An
example quantitative performance measures is EVA (Economic Value Added). It was
developed by Stern Stewart and Co., with a Partner inside the company arguing
that for a great number of management decisions it is superior to other performance
measures Bhimani et al, 2015. The thinking behind EVA was to create a measure
that links shareholder wealth directly to the performance of the company, incorporating
the value added in the period into the performance measurement Kaplan Financial,
2012. As the EVA measure was created specifically in order to encompass
shareholder wealth, the maximisation of this shareholder wealth is crucial. The
EVA measure works by taking the ‘net operating profit after tax’ figure and
deducting the ‘economic value of capital employed’ figure multiplied by the
‘weighted average cost of capital (WACC)’ Kaplan Financial, 2012. This seems
fairly straightforward in principle, however, there are a number of adjustments
which need to be made to the figures of profit and capital taken from the
financial statements as they “do not give the true picture and that the
accounting figures need to be adjusted to show the true underlying performance”
in terms of cash flows Kaplan Financial, 2012. These adjustments are useful
as they remove the effect of any accounting policies from the calculations
meaning that shareholders are able to compare the multiple investments they may
hold with each other.

 

 

Conclusion

 

Unlike
the vast majority of qualitative performance measures, the quantitative EVA
measure was created specifically in order to encompass shareholder wealth and
its maximisation Kaplan Financial, 2012. Consequently, in the eyes of the
shareholders the EVA measure is seen as the superior method for management to
base their decisions off of Bhimani et al, 2015. However, purely quantitative
measures are unlikely to completely capture all the dimensions of business
performance needed for management to assess the long-term sustainability of how
the company currently operates. The qualitative performance measures looked at
as part of this assignment primarily benefitted the company’s management rather
than the shareholders, so due to the aforementioned agency conflict a
middle-ground will need to be identified in order for both sides to be satisfied.
Therefore, quantitative performance measures (including the EVA measure) should
be used by management, however they must be supplemented with qualitative
performance measures Wharton School, 2000.

 

 

 

Reference List

 

Akers, H., 2017. What Are the Disadvantages and Advantages of Performance
Measures? Leaf Group online
Available at: Accessed 28 December 2017.

 

Bhimani, A., Horngren, C. T., Datar, S.M. and Rajan, M.,
2015. Management and Cost Accounting,
Sixth Edition. Harlow: Pearson Education Limited.

 

CIMA,
2000. Official Terminology.  London: Chartered Institute of Management
Accountants.

 

Fitzgerald,
L., 2007. Performance measurement. In: T. Hopper, D. Northcott and R. Scapens,
eds.  Issues
in Management Accounting, Third Edition. London: FT Prentice Hall. Ch.11.

 

Kaplan Financial, 2012. Economic Value
Added (EVA). Kaplan Financial online Available at: Accessed 28 December 2017.

 

Lewis, J., 200?. A Manager’s Goals vs. a Shareholder’s Goals. Hearst Newspapers online Available at:
Accessed 28 December 2017.

 

Moyer, R. C., McGuigan, J. R. and Rao, R.P., 2018. Contemporary Financial Management, Fourteenth
Edition. Boston:
Cengage Learning.

 

Wharton
School, 2000. Non-financial Performance Measures: What Works and What Doesn’t. Wharton School of the University of
Pennsylvania online Available at: Accessed 28
December 2017.