FINANCIAL PERFORMANCE MEASURES

What are performance measures? How are they used? What are their problems?

Use to measure and reflect performance of the division or work unit

Used diagnostically to detect performance issues and take routine
Corrective actions to get back on track in line with expectations, there is
no alteration of strategy
The type of PMs used and its associated target can lead to
Unintended consequences:
. Negative behavioral effect
. Put individuals under pressure for Prime Ministers used and associated
target
PMs problems related to goal congruence:
When performance is purely measured on divisional level
. Encourage the manager to act in the best interest of their own division and not the
company
. Not goal congruence
Solution: use a bonus split: 75(division perf) 25(corp
perf) to encourage decision making at division level
that is good for firm
When a PM is used in isolation
. Performance perspective: reflect division performance
. Behavioral effect perspective: Encourage ST focus on
meeting target thanLTbenefit, discourage goal congruence,
encourage dysfunctional decision making

What determines the suitability of the PMs:

1. Linked to strategy
Consistent with value creation
3. Structure change, responsibility centre change, PM change
4. Does PM encourage goal congruence decision – the behavioural effect of
PM
5. At what level is performance measured? – individual, division/unit, organization
If performance is measured purely at the divisional level, it leads to greater goal congruence.
problem
Reflect managerial control and accountability
7. Be relatively objective, timely and responsive

What are the different responsibility centers and their performance?

measure?

Cost centres: manufacturing, supporting, discretionary cost

Cost budget and variance compared to benchmark

Efficiency measures

Revenue centres: sales

Revenue budget and variance compared to sales target

 Net operating income

Profit centres: Retail sales outlet

Profit plan and variances

Net profit margin

Investment centres:

ROI, RI, EVA = measure returns on investments (profitability performance

of the division/ co)

What are the Financial PMs to measure profitability?

1. ROI = NOI / Total asset

a. Measure returns on investment in percentage
b. Problem:
i. When used in isolation, linked to reward system and on
annual basis
ii. Encourages short term focus on meeting targets than long term
benefit, encourage dysfunctional decision making and
discourage goal congruence
Through:
1. Cost cutting R&D, training, staff
Defer asset replacement
3. Not investing in projects due to negative short-term impact on
ROI when it is overall good for the company in the long term
term
c. Solution:
i. Use a comprehensive set of measurements to measure
performance, balance scorecard that is well balanced with
ST/LT measures, F & NF measures
ii. Use alternative FM: RI, EVA
iii. Longer assessment period: 3 years >annually
iv. Manager service history
v. Redefine components of ROI
vi. Create a goal congruence environment
2. RI = NOI - (cap charge X total asset)
a. Measures profit left over after charging for asset utilization
b. Measure return on investment in dollar terms
c. Adds value to the firm
d. Offers a different behavioral effect as compared to ROI
3. EVA = (NPAT + R&D) - (capital charge X asset + R&D - CL)
a. Measure return on investment in dollar terms adjusted for economic
factors
b. Reflect shareholders’ value
c. Worries about economic profit and asset
d. Add values to the company
e. Limitations:
i. Still has a short term focus on decision making
ii. Based on past performance
iii. Reduce to a single FM used in isolation
iv. Just an alternative FM that is better at the organizational level
 v. Offers a different behavioral effect compared to ROI and
RI

The performance perspective & behavioral effect of PMs

Performance P: All reflect the profitability performance of the division or

work unit
different for each PM
The manager has a short-term focus on meeting targets rather than on long-term goals.

benefit > dysfunctional decision making: may not pursue project

because of ST impact on ROI
The manager pursues the project because it has a positive short-term impact on the return on investment.

value to the firm

oEVA: manager pursues project because of positive short-term impact on EVA,
adds value to the firm
Why the different behavioral effect?
oROI: preocupaciones sobre el ROI existente, si el ROI es más bajo hará
dysfunctional decision
oRI: worries about profit left over, existing ROI doesn’t matter, less
likely to make dysfunctional decision although ROI is lower because
the project still adds value to the company
oEVA: worries about economic profits, existing ROI doesn’t matter,
less likely to make dysfunctional decisions although ROI is low but
projects still add value to the firm and bring in economic profits
Different PMs have different emphasis thus leading to different
behavioral effect

How to use performance measures diagnostically?

Common use:
1. Set a range of target
2. Measure actual performance
3. Compare the two
4. Use variance to diagnose the performance issue
5. Take routine corrective actions to get performance back on track in
line with expectation/ strategy
If variation is within target range, managers will not be alerted.
If variation exceeds target range, managers will be alerted to take actions.
to improve performance but will not guarantee a change in strategy
PMs are used diagnostically to implement strategy effectively & conserve
manager’s attention
NON-FINANCIAL PMS & BSC

What is traditional Finance PMs?

Return on Investment
Good measure to reflect profitability performance of the division/ manager

Limitations of Financial PMs:

Lag indicators = result based, doesn’t provide info on emerging problems

and warning signals
Focus on the past = doesn’t identify causes of business performance
ST oriented – annual metrics
Unhelpful at operational level
Bank teller performance measured using organization's EVA, distance
between EVA performance and bank teller activities are too far
apart
oFMs is not a suitable measure at the operational level

We need a more comprehensive set of PMs to measure business performance

What is NF PMs

Leading indicators = the management and monitoring of NF PM leads to

improvement in other measures and outcomes
oLarge to track employee engagement index because it is a leading
indicator about organizational performance, if employee feels less
Engage, over time it would negatively affect performance.
Monitoring and improving customer satisfaction index leads to an increase in
profit
Monitor and improve market share lead to increase in profit
They are enablers = provide information about organizational activities
Can be developed in many areas: qualitative, productivity,
competitiveness
performance
Can be qualitative or quantitative
Quantitative: customer satisfaction can be 4.2
Qualitative: customers seem to be happy when they leave the store

Limitations of NF PMs

Difficult to choose the right NF PMs to use

2. Difficult to choose a NF PM that reflects the performance of the div or mgr
(mgr span of control), managerial control and accountability
Difficult to measure or quantify
 The more measures used, the more conflict we have if there is no
integration of measures

What is BSC and why do we use it?

It is a comprehensive set of ST/LTPMs and F&NF PMs.

Measured across 4 perspectives: Financial, customers, Internal business
processes, Legal and regulatory
It creates a set of measures that is linked and explains the cause and
effect relationship within an organization between the different measures
and performance
Improving customer satisfaction improves sales
Improving knowledge of workforce, improve revenue
It overcomes limitations of using FPM in isolation

Financial perspective

EVA
Net profit per barrel
Total manufacturing cost per barrel
Net growth in revenue, net growth in ROI, NPM

Customer perspective

   Customer satisfaction index

   Market share

Internal business process

Cycle time (time to produce a box of beer)

Load schedule
Waste per total production

Learning and growth perspective

Employee engagement index

LT injury free rate
Training hours per employee per year
Hours of community work involved

Limitations of BSC

Difficult to get the right balance of F&NF M

Does the measure reflect the performance of the manager and division?
managerial control and accountability
Does the measure reflect the strategic objective
Is the measure suitable at the different levels within the organization?
The measure suitable for the plant may not be suitable for the co
Difficult to link the strategies and measures to an incentive plan
Common measure bias – tends to be biased towards financial perspective
measures so what is the point of the rest?
REWARD SYSTEM and how to DEVELOP REWARD SYSTEM FROM BSC

What factors affect the reward system

Agency issue:
Senior executives may not act in the best interest of the shareholders.
not goal congruence unless the incentive plan is structured in a
way that encourages them to act in the best interest of SH

Evaluation of reward system

1. Who is it for? CEO > senior manager? divisional manager

2. How is it rewarded?
a. Fix pay component – fixed annual remuneration
b. Pay-for-performance component – ST /LT incentive plan
3. What reward mix?
ST perspective use cash
LTperspective use equity
Use equity to overcome the agency problem, if the manager holds.
more equity causes them to think and act in shareholders' interest
-
Downside: tempted to increase personal wealth by
altering account number to maintain or increase share
price
4. What PMs to use? ST/LT? F/NF?
a. Fixed annual remuneration:
Based on the scope of the role and individual performance
b. Short-term incentive plan:
Offer cash incentive
Performance assessed against scorecard measures
c. Long-term incentive plan:
Offer equity incentive: shares and rights awarded with
vesting share criteria
Performance assessed against 3 years financial target
d. PM used link to strategy, consistent with value creation, objective,
timely & responsive, reflect managerial control and responsibility
5. The weightage for managers on different incentive plans changes as we go down.
the organization:
CEO has more compensation linked to long-term performance
Manager has more compensation linked to short-term performance
6. Uses relative performance evaluation:
a. Performance relative to a peer group or benchmark
b. Total SH return vs S&P/ASX 100 index

Reward system that is structured around a bonus pool

Annual shared bonus pool shared among a group of managers

Consideration:
Size of bonus pool
 How is it distributed?
In what form?

Bonus plan

1. KPM: ROI
Size
3. Form: cash
4. How to distribute:
a. Bonus pool divided between different levels of managers
b. Bonus distributed to managers on the basis of the number of bonus units
awarded
i. ROI=5%, one bonus unit
ii. For each full percentage point above 5%, a further bonus unit
awarded until a cap of 6 bonus units
The monetary value of the bonus unit is found by dividing the bonus pool.
by total number of bonus units earned by all managers

Bonus plan evaluation

When bonus plan linked to performance measure

Manager wants to increase bonus by maximizing ROI, which may cause dysfunction.
decision making
Even if the manager's ROI increases, the bonus may still decrease because of other managers as well.
has an increased ROI, hence bonus distribution is limited to bonus pool
size

Use BSC to develop a bonus plan

Set targets for performance

2. Measure actual performance using a BSC
3. Compare the two and calculate the variance between actual performance
and its associated target
4. Decide the weights to assign to the different perspectives and its
measurements
a. More weights on Financial perspective
b. So award 4 points for every positive variance under the financial
perspective
c. Award 2 points for every positive variance under the rest
d. Calculate the total weighted variance points for each division
5. Use the weighted variance point on manager performance to evaluate
their performance
6. After considering the performance from the BSC and discussing it through
with the managers, the remuneration committee will decide the managers
deserve how much for performance on a scale of 1 -10 , 5 being average
and 10 being outstanding
7. The bonus pool size is decided
8. The bonus is distributed to the manager based on the number of bonuses.
unit awarded:
a. Based on the performance evaluation scale,
b. A performance rate of 5 is awarded 1 bonus unit
c. Every full percentage point above 5 is further awarded 1 bonus unit.
 d. Monetary value of bonus unit is found by dividing total bonus pool
with the total number of bonus units earned by all managers.

Problems with using BSC to develop a bonus plan

Difficult to get the right balance of F&NF M

Does the measure reflect the performance of the manager and division?
managerial control and accountability
Does the measure reflect the strategic objective?
Is the measure suitable at the different levels within the organization?
Measure suitable for the plant may not be suitable for the co
Difficult to link the strategies and measures to an incentive plan
Common measure bias – tend to be biased towards the financial perspective
measures so what is the point of the rest?
Difficult to assign weights to the different perspectives, how to know which
is more important > may lead to unintentional behavior to maximum one person
at the expense of another
Arbitrary conversion of the weighted variance points on manager performance
on to a number of the performance scale index
There may be possible inadvertent errors
Intentional bias
Collapsing the BSC into an arbitrary scale number may cause
disaggregated info on mgr’s performance lost
Even if the process is fair, the manager may not be able to see the causal link.
between the performance and bonus

How the BSC can be used as a diagnostic tool or interactive tool

. Diagnostically, specify a target range for the variances as

As long as the variance is within range, the manager will ignore it; if it's outside, it

alerts manager and routine corrective action taken in line with

existing strategy, performance issue may not warrant a
change in strategy unless a long-term trend
. Interactively analyze market trends to identify opportunities or threats.
Adjust business strategy accordingly, market share.
interactively focus firm performance relative to competitors > result
inform regular revision and adjustment of business strategy
to enhance competitive advantage
REVENUE ANALYSIS: CAUSE OF PROFIT DEVIATION FINDING OUT MORE
INFO

Use market-related data to further analyze the profit deviation

Overall profit variance due to

oCost variance
. Efficiency/ cost variance
. Non-variable cost variance
oRevenue variance
. Volume
Market size, share, product mix
. Price
Selling price
By comparing the flexible budget and the profit plan we get the variance.
for the profit deviation
We want to unpack the variance to get more information on what
causes this variance? Why are we selling more or less than
expected?
The revenue is higher or lower than expected because of volume
effect (competitive effectiveness) or price effect (operating
efficiency). Tell us more about the organization’s performance
We want to know the proportion of volume and price effect
Using the information we get, we can make better future decisions.
You can use information in a routine fashion to diagnose performance issues and
improve performance
Can use info interactively to compare performance with
competitors, develop new plans

How to unpack the deviation in profit?

1. The variance between the planned CM and the flexi budget CM indicates
that profit is higher or lower than expected.
2. This variance can be explained by 2 offsetting components: mkt size, mkt
share and product mix variance
3. Market size variance
a. Given planned market share and standard product CM, company
would have gained XX profit due to overall growth in the market, especially..
b. Fav profit caused by actual market size being different from expected
c. Why?
i. Maybe caused by the external environment like government subsidy,
cause more people to buy, or general increase in demand
4. Market share variance
a. Given act market size, loss of profit due to loss in market share
(offsetted by market share gain in the other product)
 b. UNFAV profit because market share is lower than expected
c. Why?
i. Given growth in market size, our market share is lower in
proportion. It indicates our organizational performance is not
well. Probably because of managerial performance
5. Overall, this variance analysis tells us that the favorable profit variance is
because market growth is bigger than expected because of external factors,
little to do with org performance
6. Product mix variance
a. Change in average cm x actual unit volume
b. Is due to the actual sales ratio of the product being different from expected.

Whole story

Revenue increase because

The actual market size is a lot bigger than expected because of external factors.
demand
But revenue performance is dragged by share market lower than
expected
Manager performance evaluation:
Cannot hold them responsible for changes in market size outside of
their span of control
He might look at market share.

Use this market info diagnostically,

Say the overall strategy is ok.

But the reason for lower revenue performance is due to managerial actions and
decisions
It is a routine assessment, wouldn’t cause strategy to change.

Use this interactively

Say the info tells us, the deviation may be due to a poor strategy.
Trend in poor performance indicates a problem with strategy and goals rather.
than performance, have to rethink strategy

We look at information differently

BUDGETING for expenses & PROFIT PLANNING

Profit planning

Company has some strategies

2. Gave some expectations: targets, goals
3. Ask us what they should do?
a. So we analyse the alternate course of actions
b. And the financial impact of it
For example, we drop some products because demand is not going strong.
forward, what is the financial effect
d. Question does our strategy create value? Enough value to attract sh and
lenders? Do we have enough cash to fund the strategies
4. Make a conclusion on actions that should be taken
5. And prepare budget

3 wheels of profit planning

Cash: sales > accounts receivable > operating cash > inventory
Profit: sales > operating expenses > profit > investment in assets
profit > asset utilization > ROE > Shh's eq
It highlights the connections between the different financial constructs.

Planning and budgeting for different cost centres: difficulties with

aspect of planning and budgeting

Engineered cost centres:

oProduction
We know the OP cannot plan for IP.
The relationship between OP and IP is engineered
Can easily plan for budget
Discretionary cost centres
oRND
Harder to plan because
There is not a clear and direct relationship between OP number and RND expense.
Harder to plan, need to make discretionary decision on how much
should we budget the RND expense for
Usually we use the incremental budgeting
But we can use the program budgeting to structure budgets around
projects than funding a total amount to the department
STRATEGIC CAPITAL INVESTMENT

Classification of investment

Regulatory investment:
due to regulatory compliance
Logo for lowest cost, most cost effective way
Operational investment:
Asset replacement, enhance operating efficiency, increase
capacity
Use CAPEX decision model: NPV, IRR, PP, ARR - fine provided all
relevant data are included
Strategic investment:
Investment in new technology, new markets, new products that involve change
in strategy
oEg: adquisición, fusión
Google bought YouTube for 1.6 billion as a strategic decision to diversify.
business
. But just breaking-even so why investment?
. What was the decision model that they used?

Decision models used to analyze investment

CAPEX decision model

Traditional tools
oNPV – measure time value of money, is a rough estimation of
expected future CF in dollars, might not be accurate and objective
oIRR – measure time value of money in %
oPP – time taken to recover investment, used in conjunction with
others, easy to use at screening stage
oARR - link to our financials
Cost-benefit analysis
Simulation
Sensitivity analysis

Evaluating strategic investment

CAPEX might not be adequate or suitable because

The strategic issue is at the forefront
Financial tools show that it doesn’t generate positive returns.
Uncertainty in future cash flow streams
Short term benefit hard to quantify and isolate
Large outlays, long payback period, benefits that come later.
part of the CF stream is penalized by the Discounted Cash Flow
analysis
Doesn’t capture other benefits like high quality, shorter lead time,
environmental impact because they are hard to quantify
Doesn’t capture the synergies of the investment that might flow to
other parts of the business because it is hard to quantify and
show its financial effect
Ignores the moving-baseline risk, risk of not investing.
 . DCF presumed that not investing means there is a
continuation of cash flow stream. But cannot assume that,
because if we don’t invest we might fall behind our
competitors, so do not invest as it leads to declining cash flow
So other than financial tools we need to include non-financial
tools into our decision making model:
1. Alignment of proposal with strategy
2. Risk of moving-baseline
3. Reputation impact
4. Impact on employees (cultural fit), customers and marketing
5. Impact on structural cost drivers (scope, scale complexity)
a. When Virgin adds a new international line, it needs to increase
scope, scale and complexity
6. Capability and ability of managers
7. Synergies and integration with other parts of the business
8. Quality of the info supporting the proposal
9. Feasibility and cost of reversing the decision
10. Sustainability effect (environmental, social, ethical)

So types of information to include in our decision making model:

1. Financial information: NPV, IRR, PP, ARR

a. Cash flow based
b. Non-cash flow base
Non-financial information
a. Quantitative
i. Non-monetized: quantified on a scale on index not dollar
terms
ii. Monetized: in dollars
b. Qualitative
i. Judgment, intuition

Decision framework

1) What are the components of the decision making model? factors

We have 2 components
NPV, IRR, PP, ARR
Non-F: Effect on community, effect on environment, synergies &
integration with other parts of the business, strategic fit, cultural fit,
impact of changes in management, competitive effect (buy skype,
google cannot buy), employee fit, feasibility and cost of reversing
decision, alignment with strategy, reputation impact, impact on
structural cost drivers, risk of moving baseline, quality of info

Are the components qualitative or quantitative?

Financial tools are quantitative

Non-F tools can be both qualitative or quantitative:
. Strategic fit can be quantified by measuring on a scale of 1-5
. Or can be qualitative by basing it on judgement.
3) How is it accounted for in the evaluation process:

At the start: strategic fit which is about judgement

Screening process: PP
Analysis process: Financial tools that require calculation

Lecture 11: Risk management

Strategic, Operational, Financial, Legal and regulatory
What each entails and examples
How to manage these risks:
. Set conduct barrier and belief system
. Set internal control
. Market analysis?
Potential risk or risk profile:
. Strategic risk: impediment in achievement of high-level goals
aligned with and support mission
Mkt-related activity: supplier behavior, customer
change preference, availability of substitute products
market trends, consumer health concern
Competitive dynamics
Techno innovation
. Operational risk: anything that damages the company's ability to
provide product and services
Extent of formalized procedures and protocol
employees' ability to follow protocol
co ability to safeguard asset and info
ability to respond to crisis
cyber security
damage due to natural events
The production process needs to comply with strict practices.
security to prevent contamination
impact of changes in key personnel
avoid mistakes in processes
. Financial risk: exposure to & potential shortfall in liquidity
Financial crisis
Increase in input cost due to natural events
Potential reduction in CF
Risk of acquisition/foreign investment
Foreign exchange risk, hedging
Impact of acquisition of leverage and gearing levels
. Legal and regulatory: exposure to and ability to comply with applicable
and impending law and reg
Food and safety law
Lending reg
Consumer protection
Banking and finance reg
Foreign investment law
Irrigation law
Livestock law
Export law
How to manage risk:
. Set conduct boundaries through code of conducts: what
cannot do
. Set belief system
. Set internal control, structural safeguard: clear line of
hierarchy authority, system safeguard: transaction timely,
 accurately securely recorded and reported, staff safeguard:
enough training, job rotation, special assignment
. Minimize market-related strategic risk
Scan market, SWOT analysis
Attend org meeting and networking event with
competitors
. Minimize operational risk

Conduck internal system checks