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Dec 06, 2000

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In an article on Oct. 16, 2000, in the Financial

Times’ Mastering Management series,
Wharton accounting professors Christopher
Ittner and David Larcker suggest that
financial data have limitations as a measure
of company performance. The two note that
other measures, such as quality, may be
better at forecasting, but can be difficult to
implement. Below is the text of their article.

Choosing performance measures is a

challenge. Performance measurement
systems play a key role in developing
strategy, evaluating the achievement of
organizational objectives and compensating
managers. Yet many managers feel
traditional financially oriented systems no
longer work adequately. A recent survey of
U.S. financial services companies found most
were not satisfied with their measurement
systems. They believed there was too much
emphasis on financial measures such as
earnings and accounting returns and little
emphasis on drivers of value such as
customer and employee satisfaction,
innovation and quality.

In response, companies are implementing

new performance measurement systems. A
third of financial services companies, for
example, made a major change in their
performance measurement system during
the past two years and 39% plan a major
change within two years.

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Inadequacies in financial performance

measures have led to innovations ranging
from non-financial indicators of “intangible
assets” and “intellectual capital” to
“balanced scorecards” of integrated financial
and non-financial measures. This article
discusses the advantages and disadvantages
of non-financial performance measures and
offers suggestions for implementation.

Advantages

Non-financial measures offer four clear

advantages over measurement systems based
on financial data. First of these is a closer link
to long-term organizational strategies.
Financial evaluation systems generally focus
on annual or short-term performance
against accounting yardsticks. They do not
deal with progress relative to customer
requirements or competitors, nor other non-
financial objectives that may be important in
achieving profitability, competitive strength
and longer-term strategic goals. For
example, new product development or
expanding organizational capabilities may be
important strategic goals, but may hinder
short-term accounting performance.

By supplementing accounting measures with

non-financial data about strategic
performance and implementation of
strategic plans, companies can communicate
objectives and provide incentives for
managers to address long-term strategy.

Second, critics of traditional measures argue

that drivers of success in many industries are
“intangible assets” such as intellectual
capital and customer loyalty, rather than the
“hard assets” allowed on to balance sheets.
Although it is difficult to quantify intangible
assets in financial terms, non-financial data
can provide indirect, quantitative indicators
of a firm’s intangible assets.

One study examined the ability of non-

financial indicators of “intangible assets” to
explain differences in US companies’ stock
market values. It found that measures related
to innovation, management capability,
employee relations, quality and brand value
explained a significant proportion of a
company’s value, even allowing for
accounting assets and liabilities. By
excluding these intangible assets, financially
oriented measurement can encourage
managers to make poor, even harmful,
decisions.

Third, non-financial measures can be better

indicators of future financial performance.
Even when the ultimate goal is maximizing
financial performance, current financial
measures may not capture long-term
benefits from decisions made now. Consider,
for example, investments in research and
development or customer satisfaction
programs. Under U.S. accounting rules,
research and development expenditures and
marketing costs must be charged for in the
period they are incurred, so reducing profits.
But successful research improves future
profits if it can be brought to market.

Similarly, investments in customer

satisfaction can improve subsequent
economic performance by increasing
revenues and loyalty of existing customers,
attracting new customers and reducing
transaction costs. Non-financial data can
provide the missing link between these
beneficial activities and financial results by
providing forward-looking information on
accounting or stock performance. For
example, interim research results or
customer indices may offer an indication of
future cash flows that would not be captured
otherwise.

Finally, the choice of measures should be

based on providing information about
managerial actions and the level of “noise”
in the measures. Noise refers to changes in
the performance measure that are beyond the
control of the manager or organization,
ranging from changes in the economy to luck
(good or bad). Managers must be aware of
how much success is due to their actions or
they will not have the signals they need to
maximize their effect on performance.
Because many non-financial measures are
less susceptible to external noise than
accounting measures, their use may improve
managers’ performance by providing more
precise evaluation of their actions. This also
lowers the risk imposed on managers when
determining pay.

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Disadvantages

Although there are many advantages to non-

financial performance measures, they are not
without drawbacks. Research has identified
five primary limitations. Time and cost has
been a problem for some companies. They
have found the costs of a system that tracks a
large number of financial and non-financial
measures can be greater than its benefits.
Development can consume considerable time
and expense, not least of which is selling the
system to skeptical employees who have
learned to operate under existing rules. A
greater number of diverse performance
measures frequently requires significant
investment in information systems to draw
information from multiple (and often
incompatible) databases.

Evaluating performance using multiple

measures that can conflict in the short term
can also be time-consuming. One bank that
adopted a performance evaluation system
using multiple accounting and non-financial
measures saw the time required for area
directors to evaluate branch managers
increase from less than one day per quarter
to six days.

Bureaucracies can cause the measurement

process to degenerate into mechanistic
exercises that add little to reaching strategic
goals. For example, shortly after becoming
the first US company to win Japan’s
prestigious Deming Prize for quality
improvement, Florida Power and Light found
that employees believed the company’s
quality improvement process placed too
much emphasis on reporting, presenting and
discussing a myriad of quality indicators.
They felt this deprived them of time that
could be better spent serving customers. The
company responded by eliminating most
quality reviews, reducing the number of
indicators tracked and minimizing reports
and meetings.

The second drawback is that, unlike

accounting measures, non-financial data are
measured in many ways, there is no common
denominator. Evaluating performance or
making trade-offs between attributes is
difficult when some are denominated in time,
some in quantities or percentages and some
in arbitrary ways.

Many companies attempt to overcome this by

rating each performance measure in terms of
its strategic importance (from, say, not
important to extremely important) and then
evaluating overall performance based on a
weighted average of the measures. Others
assign arbitrary weightings to the various
goals. One major car manufacturer, for
example, structures executive bonuses so:
40% based on warranty repairs per 100
vehicles sold; 20% on customer satisfaction
surveys; 20% on market share; and 20% on
accounting performance (pre-tax earnings).
However, like all subjective assessments,
these methods can lead to considerable error.

Lack of causal links is a third issue. Many

companies adopt non-financial measures
without articulating the relations between
the measures or verifying that they have a
bearing on accounting and stock price
performance. Unknown or unverified causal
links create two problems when evaluating
performance: incorrect measures focus
attention on the wrong objectives and
improvements cannot be linked to later
outcomes. Xerox, for example, spent millions
of dollars on customer surveys, under the
assumption that improvements in
satisfaction translated into better financial
performance. Later analysis found no such
association. As a result, Xerox shifted to a
customer loyalty measure that was found to
be a leading indicator of financial
performance.

The lack of an explicit casual model of the

relations between measures also contributes
to difficulties in evaluating their relative
importance. Without knowing the size and
timing of associations among measures,
companies find it difficult to make decisions
or measure success based on them.

Fourth on the list of problems with non-

financial measures is lack of statistical
reliability – whether a measure actually
represents what it purports to represent,
rather than random “measurement error”.
Many non-financial data such as satisfaction
measures are based on surveys with few
respondents and few questions. These
measures generally exhibit poor statistical
reliability, reducing their ability to
discriminate superior performance or predict
future financial results.

Finally, although financial measures are

unlikely to capture fully the many
dimensions of organizational performance,
implementing an evaluation system with too
many measures can lead to “measurement
disintegration”. This occurs when an
overabundance of measures dilutes the effect
of the measurement process. Managers chase
a variety of measures simultaneously, while
achieving little gain in the main drivers of
success.

Once managers have determined that the

expected benefits from non-financial data
outweigh the costs, three steps can be used to
select and implement appropriate measures.

Understand Value Drivers

The starting point is understanding a

company’s value drivers, the factors that
create stakeholder value. Once known, these
factors determine which measures contribute
to long-term success and so how to translate
corporate objectives into measures that guide
managers’ actions.

While this seems intuitive, experience

indicates that companies do a poor job
determining and articulating these drivers.
Managers tend to use one of three methods
to identify value drivers, the most common
being intuition. However, executives’
rankings of value drivers may not reflect
their true importance. For example, many
executives rate environmental performance
and quality as relatively unimportant drivers
of long-term financial performance. In
contrast, statistical analyses indicate these
dimensions are strongly associated with a
company’s market value.

A second method is to use standard

classifications such as financial, internal
business process, customer, learning and
growth categories. While these may be
appropriate, other non-financial dimensions
may be more important, depending on the
organization’s strategy, competitive
environment and objectives. Moreover, these
categories do little to help determine
weightings for each dimension.

Perhaps the most sophisticated method of

determining value drivers is statistical
analysis of the leading and lagging indicators
of financial performance. The resulting
“causal business model” can help determine
which measures predict future financial
performance and can assist in assigning
weightings to measures based on the
strength of the statistical relation.
Unfortunately, relatively few companies
develop such causal business models when
selecting their performance measures.

Review Consistencies

Most companies track hundreds, if not

thousands, of non-financial measures in
their day-to-day operations. To avoid
“reinventing the wheel”, an inventory of
current measures should be made. Once
measures have been documented, their value
for performance measurement can be
assessed. The issue at this stage is the extent
to which current measures are aligned with
the company’s strategies and value drivers.
One method for assessing this alignment is
“gap analysis”. Gap analysis requires
managers to rank performance measures on
at least two dimensions: their importance to
strategic objectives and the importance
currently placed on them.

Our survey of 148 US financial services

companies — a joint research project
sponsored by the Cap Gemini Ernst & Young
Center for Business Innovation and the
Wharton Research Program on Value
Creation in Organizations – found significant
“measurement gaps” for many non-
financial measures. For example, 72% of
companies said customer-related
performance was an extremely important
driver of long-term success, against 31% who
chose short-term financial performance.
However, the quality of short-term financial
measurement is considerably better than
measurement of customer satisfaction.
Similar disparities exist for non-financial
measures related to employee performance,
operational results, quality, alliances,
supplier relations, innovation, community
and the environment. More important, stock
market and long-term accounting
performance are both higher when these
measurement gaps are smaller.

Integrate Measures

Finally, after measures are chosen, they must

become an integral part of reporting and
performance evaluation if they are to affect
employee behavior and organizational
performance. This is not easy. Since the
choice of performance measures has a
substantial impact on employees’ careers and
pay, controversy is bound to emerge no
matter how appropriate the measures. Many
companies have failed to benefit from non-
financial performance measures through
being reluctant to take this step.

Conclusion

Although non-financial measures are

increasingly important in decision-making
and performance evaluation, companies
should not simply copy measures used by
others. The choice of measures must be
linked to factors such as corporate strategy,
value drivers, organizational objectives and
the competitive environment. In addition,
companies should remember that
performance measurement choice is a
dynamic process – measures may be
appropriate today, but the system needs to be
continually reassessed as strategies and
competitive environments evolve.

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