Behavioural implications of performance measurement systems. Flashcards
What is the problem of goal alignment?
- Objective of MC is to align objectives of the firm and employees. Objective of the firm is to maximise shareholder wealth. Employees are not motivated by this in the same way
- Employees hold more risk than shareholders, as shareholders can diversify through portfolio theory
- If there was goal alignment, MCS would not be needed
- How to measure performance to ensure alignment?
Common performance measurement systems to achieve goal alignment?
- Market-based measures of performance
- Accounting measures of performance
- Return on investment and residual income measures
- Combination of measures
Market Based Measures of Performance
- Measures that are direct reflections of shareholder value (e.g. share price, dividend growth and return to shareholders). Setting measures to this can be negative (crisis).
- highly congruent with objective but the question whether shareholder value is short term returns or long term growth.
- Easy for top management who have more influence than lower levels, controllability.
- Perfect market hypothesis holds rational perfect information to see through manipulative behaviour, not always the case.
- Assumes all shareholders of homogenous, some will want long term some will want small shareholders. Day traders.
- Can be found on a timely basis (daily) but performance takes a while to affect the share price
- Precise, accurate, objective and understandable
- Lack controllability, only top managers can impact. Doesn’t say much about the performance of grass root employees, leading to demotivation
- Windfall gains also impact, monetary policies, political climate, macroeconomic environment
- Markets can also overreact to news, e.g. Share price Microsoft fell when announced deal with Yahoo
- Behavioural displacement of managers opportunism, realising info that they know the market will positively overreact too
Accounting Measures of Performance
- Measures based on various concepts of accounting profits (profit before or after tax, contribution margin measure).
- Profits can be controlled by more employees, can be timely, monthly reporting, understandable
- Profit is still an imperfect proxy for stock valuation
- accounting profit does not = economic income, transaction orientated vs no. patent is not transaction but is economic value
- accounting choices also impact, first in last out etc.
- conservatism, treating losses differently to gains
- profit is cost of borrowed capital does not consider cost of equity capital (which is more expensive), therefore overstating profit
- backward looking, economic value forward
- myopia always, short term profit ignoring investments (underinvestment, myers 1977). short term revenues, reducing employee satisfaction, quality which are all economic values
- IBM 2014 restructuring in the US, to hit earnings targets?
Return on Investment and Residual Income measures
- Accounting measures in relation to invested capital (e.g. Return on net or total assets, residual income/ economic value added).
- ROI is the ratio of accounting profits earning by division divided by the investment tied up in the division. Trade off between revenue and costs. % better than financial value.
- More congruent than accounting costs
- myopia, behavioural displacement, suboptimisation, misleading signals
- RI as a solution to ROI. Divisions given equal incentives to invest, removes possibility of increasing equity leverage by debt financing. Does not address distortions
- EVA, economic added value.
Combination of Measures
•Combination of financial and non-financial performance measures that provide leading as well as lagging indicators of performance Kaplan and Norton. (E.g. Balance Scorecards) future combined with the past.
depending on how well relationships between leading and lagging indicators reflect drivers of Shareholder value. If they are it is a good fit!
• If FPI designed well cause and effect relationships, optimal metrics strong!
• Jensen, Balance scorecards tend to be confusing, diverting attention between too many objectives.
• BSC in a corporate setting, too much ambiguity. • • • Kaplan and Norton, BSC core argument to overcome short termism and historical focus.
How congruent are various types of measures with the objective of maximising shareholder value?
• Market based measures of performance:
highly congruent with objective but the question whether shareholder value is short term returns or long term growth.
Easy for top management who have more influence than lower levels, controllability.
Perfect market hypothesis holds rational perfect information to see through manipulative behaviour, not always the case.
Assumes all shareholders of homogenous, some will want long term some will want small shareholders. Day traders.
• Accounting measures of performance:
less congruent.
Accounting profits are manipulated in ways which distort notions of economic profit (conservatism, depreciation, asset valuation rules).
Also ignore returns on investments and the “true” cost of capital.
Accounting regulations provide flexibility. Perfect market hypothesis held would be able to see it, but it does not.
• Return on investment and residual income measures: more congruent than accounting profits.
Returns on investment taken into account.
“True cost” of capital considered with some residual income measures (EVA).
PL shows only interest rate, not the full cost, WACC!
• Combination of measures:
depending on how well relationships between leading and lagging indicators reflect drivers of Shareholder value. If they are it is a good fit!
If FPI designed well cause and effect relationships, optimal metrics strong!
Jensen, Balance scorecards tend to be confusing, diverting attention between too many objectives.
BSC in a corporate setting, too much ambiguity. Kaplan and Norton, BSC core argument to overcome short termism and historical focus.
What are the 6 relevant measurement properties?
- Timeliness – minimal time lag between actions and results
- Precision – non-random measures that “minimise” measurement noise
- Objectivity – measures free from judgmental bias
- Understandability – the meaning of measures as well as underlying causes are well understood
- Controllability – managers need to be able to control or at least influence the performance aspects which are being measured.
- Cost effectiveness – compilation of performance measures at reasonable administrative costs.
What properties do various measures have?
- M.B.M – generally low timeliness in share price reflections, perfect capital markets holding for accuracy? Best for objectivity and Understandability if market right, is there lots of noise? Control generally low apart from very senior management. Cost effective is high for listed companies as it is there anyways.
- A.P.M – timeliness medium, dependent on reporting period. Accuracy and Precision is medium due to manipulations and methods “earnings management”. Objectivity - medium, discretion. Understandability is high. Controllability, decentralisation, manipulation etc. Cheap.
- ROI/ RIM – depends on adjustments and managements of accounting data, how assets are evaluated, judgemental discretion. EVA can be revised 500 times.
- COMB - timely, close reflections to actions. Can be complex and hard to understand and subjective (DEPENDS ON METRICS). Kaplan and Norton 20 metrics?
What are the behavioural consequences often embedded in financial performance measures?
- Investment and operating myopia
- Sub-optimisation
- Misleading performance signals causing behavioural displacement
What is investment and operating myopia?
- “Short Termism”
- Investment myopia: cutting back on long-term investments (R&D, large capital investments) to boost short-term accounting performance. Due to conservatism bias and exclusion of intangible assets. Detrimental long term performance.
- Operating myopia: making operating decisions that boost short-term performance while sacrificing long-term benefits (e.g. pressurising staff, reducing product quality or customer service satisfaction) more difficult to detect. Making sacrifices.
- Investment and operating myopia are particularly likely with market-based, accounting, return on investment and residual income measures.
- Tendencies towards myopia often reinforced through short-term capital market pressures. May be a reason not to list companies, tesla would be made private fined for “misleading stock market”. Tensions between short term and long term
How can the myopia problem be addressed?
- Eliminate accounting items that induce myopia from incentive plans (e.g. writing off unsuccessful investments, through the use of EVA) managers less exposed to risk of investments.
- Reward performance over longer time cycles by: linking rewards to NPV and long term incentive plans rather than annual bonuses (stock options).
- Regulate investment behaviour through use of action controls (e.g. pre-action reviews, action accountability). Breaking regulations.
- Reduce pressure on managers for short-term performance (not real)
- We need short term and long term performance? We can’t just sit and wait for good performance to come to us.
What is sub-optimisation?
• Decisions that appear rational and efficient from the perspective of a particular responsibility centre are not in the larger organisations best interest
• Sub-optimisation with return on investment can occur if the historical rate of return varies across different sub-units.
Conglomerate Uni-lever products are in fast growing markets and mature markets.
What is the difference between ROI and RI?
Return on investment is a ratio between the net profit and cost of investment resulting from an investment of some resources
Residual Income is the profit actually earned to the minimum level of profit required for the business.
• RI provides more neutral incentives to invest in new projects in relation to historical levels of returns as long as these meet the target for corporate costs of capital. RI preferable with variations in return.
What is economic value added?
- EVA similar to residual income, BUT includes a range of accounting adjustments to address conservatism and myopia problems (elimination of unsuccessful investments and losses on non-operating assets).
- EVA closely linked to the international shareholder value movement and seeks to provide powerful incentives for goal alignment. Using EVA as the only (or dominant) performance measure throughout organisations, make managers think like a shareholder!
- modifications to values can be subjective and complex however
