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BE353 - Performance Measurement & Business Control > Lecture 4: Performance Management > Flashcards

Lecture 4: Performance Management Flashcards

1
Q

When is it time for performance management (evaluating whether it works)?

A

When:
- The structure of the company is in place.
- Responsibilities are assigned to the company’s managers.
- Transfer pricing methods are chosen and implemented.

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2
Q

What are the 3 basic components of the performance management process?

A
  • Define the important measures.
  • Set targets for the measures to be able to judge whether actual performance has been good or bad (standards).
  • Reward people in the company for their behavior.
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3
Q

What are two ways managers tend to think about measures?

A
  • What gets measured gets done
  • If everything is measured, nothing gets done
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4
Q

What are some examples of financial measures?

A

Sales, EBITDA, cash flow, variable costs, fixed costs, contribution margins, EPS, ROCE, ROE

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5
Q

What are some examples of non-financial measures?

A

Customer satisfaction, churn rate, employee satisfaction, productivity, delivery precision, sick days, training days, % with formal qualification

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6
Q

A decision must be made about which measures to…

A
  • Follow-up regularly
  • Include in a performance report
  • Use as basis for performance evaluation
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7
Q

What do we want the structure of our performance report to look like?

A

Structure all financial measures together, and all non-financial measures together to be able to gain an understanding of both parts. Makes it easier to see if we are under/over performing in specific area

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8
Q

What are the two types of performance measures (NOT fin/non-fin!)?

A
  1. Lagging measures
    - Historical: focus on what has happened.
    - Examples: Financial measures such as ROCE.
  2. Leading measures
    - Relates to the means to reach future profitability.
    - Indications for the future.
    - Examples: non-financial measures such as on-time delivery, number of development projects, reductions in CO2 emissions.
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9
Q

What are Johansson & Östman’s criteria for choosing measures?

A
  1. Representational criteria
  • How well a measure captures individual events or units in a striking manner.
  • Congruence between the measure and the business significance of events.
  1. Measurement systems criteria
  • The quality of how the data for the measure is captured, transformed and used.
  • Verifiable, reasonable degree of certainty, lack of personal bias.
  • Comparability.
  • Resources needed for measurement.
  1. User criteria
  • How well the measure is adopted to the attributes and prerequisites of users/subordinates/those being measured.
  • Acceptance
  • Simplicity
  • Understanding
  • Controllability
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10
Q

What are Likierman’s criteria for choosing measures?

A

Measures can have varying time frames and target different parts of the business.

Horizon 1: Current business
- Cover actions relevant to defending and developing core businesses
- Financial and non-financial metrics

Horizon 2: Emerging business
- Cover actions taken to build emerging business
- Financial and non-financial metrics often linked to sales, marketing and R&D efforts

Horizon 3: New business
- Cover actions to create opportunities for new business
- Non-financial measures often linked to R&D and sustainability, e.g. do we reach pre-established milestones?

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11
Q

What are targets?

A

The basis/standard against which actual performance is compared

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12
Q

What different types of targets are there?

A

Predetermined targets:
- Negotiated (e.g. budget)
- Continuous improvements
- Model-based (theoretical)

Internal or external benchmarking:
- Targets derived from the performance of other responsibility centers or of other companies/units in the same industry.

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13
Q

What critique is there of budgets as evaluation targets?

A
  • Time-consuming and costly to put together
  • Updated too infrequently and outdated quickly
  • Constrain responsiveness and flexibility, often a barrier to change
  • Focus on cost reduction and not on value creation
  • May lead to “gaming” and perverse behaviors (too challenging → short-term focus)
  • Often a “Santa Claus or handbrake”-effect at the end of the year (spending the excess or not spending at all)
  • Strengthen vertical command and control (contradicting decentralized decision-making)
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14
Q

What is benchmarking?

A
  • Strong trend internationally
  • Every part of the company is judged on how well its performance compares with its internal and/or external peers, given the economic conditions prevailing at the time
  • Employees will not know whether they have succeeded until the period is over, highly motivating
  • No predetermined targets needed, on-demand allocation of resources
  • Business units become smaller, more numerous and more entrepreneurial
  • Potential problem: hard to find data for external benchmarking (but: many companies have not even tried)
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15
Q

What is the Handelsbanken way?

A

Abandoned the budget in the 1970s and does not do any budgets or forecasts at all. Their management control system features:

  • Benchmarking. Instead of comparing the outcome with a budget or predetermined target, they compare performance with past performance and competitors’ performance.
  • Planning. Plans like activity plans, but without absolute targets.
  • Decentralization. Branches are the closest to customers and should hence be the ones making strategic decisions about which direction to take in order to meet customer needs.
  • Management compensation. No individual performance-based bonuses. Instead a profit-sharing system where each employee gets an equal share of the profit placed in a retirement pension fund.
  • Culture. Corporate culture of decentralization and strong cost consciousness. Shows through low staff turnover.
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16
Q

What signs show success of Handelsbanken?

A
  • Universal bank (10,000 employees)
  • Consistently higher ROE
  • Consistently better customer satisfaction
  • Consistently lowest cost-income ratio
  • Among the best employer ratings
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17
Q

What are the principles of Handelsbanken?

A
  • Customer responsiveness
  • Freedom and capability to act
  • Transparency
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18
Q

What internal and external benchmarking levels does Handelsbanken have?

A
  • Branch-to-branch (internal): cost-income, profit/employee, total profit
  • Region-to-region (internal): ROE
  • Bank-to-bank (external): ROE
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19
Q

Performance evaluation is important for…

A
  • getting managers and employees to behave in the best interest of the organization
  • getting managers and employees motivated
  • getting managers and employees to enjoy work and really do their best

However, this is often not enough: there is a need for incentive systems
- Positive and negative incentives (focus on positive incentives)

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20
Q

What are the two theories about incentive systems?

A
  • Agency theory
  • Motivation crowding theory
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21
Q

What is the basis for agency theory (short)?

A

Built on Economics.

The economic man:
- Driven by self-interest
- Utility maximizer
- Ignores intrinsic motivation

22
Q

What is the basis for motivation crowding theory (short)?

A

Built on Psychology & Sociology.

Extrinsic and intrinsic motivation
- The task might be motivating in itself
- Fulfilling the task might be satisfying in itself
- Routine vs. non-routine tasks

23
Q

What is agency theory?

A

The principal delegates decision-making authority to the agent.

  • Self-interested individuals with a primary interest of financial gain.

The principal cannot continuously observe the agent → asymmetric information.

  • The agent will exploit the asymmetrical information, i.e. use private information to shirk from responsibility and duty, hide actions, manipulate signals.

Motivation derives solely from an agent’s self-interest. Implications for design of incentive systems:

  • Builds on the fact that the agent is utility maximizing
  • Align agent’s self-interest with principal’s interest (monitoring/incentive contracting)
24
Q

What is motivation crowding theory?

A

Extrinsic motivation:

  • Including the satisfaction from what you will get if you reach the goal
  • Satisfy needs indirectly
  • Relates to external needs
  • Driven by factors such as money, status, promotion, power

Intrinsic motivation:

  • Including the satisfaction of doing something or of reaching the goal
  • Satisfy needs directly
  • Relates to internal needs
  • Driven by factors such as interest, involvement, challenge, joy, pride
25
Q

What is the crowding-out effect?

A

Total motivation = intrinsic + extrinsic motivation.

Extrinsic and intrinsic motivation are dependent on one another → possible tradeoffs; increasing one type might reduce the other.

Crowding-out effect: an activity that is carried out for its own sake (intrinsic) can be undermined or even corrupted by external (extrinsic) intervention.
- Adding external rewards → reduce total motivation
- Total motivation might increase if external rewards is removed

26
Q

What are some implications of the crowding-out effect?

A

When intrinsic motivation is weak (work is boring and insignificant) external motivation might be very important.

  • The motivation for unqualified, repetitive and simple work might benefit from external (monetary) rewards.

When intrinsic motivation is strong (work is interesting, important, fun, challenging) one should be cautious with external rewards.

  • The motivation for qualified, varied and complicated work might not benefit from external (monetary) rewards.
27
Q

What are the different roles of compensation?

A
  • Fulfill the obligation to pay managers and employees.
  • Attract managers and employees
  • Keep managers and employees
  • Credit/recognition
  • Encourage effort
  • Inspiration
  • Goal congruence
  • Flexible remuneration (pay more in good years)
28
Q

What different types of incentives and motivators are there?

A
  • The basic salary
  • Short-term financial incentives (bonuses)
  • Stock options
  • Intrinsic incentives (power, titles, vacation, fun tasks, independence)
29
Q

What are some critiques against agency theory?

A
  • The basic assumptions are wrong. Humans may not always be perfectly rational or act out of self-interest.
  • It does not promote ethical behavior.
30
Q

What are some critiques against motivation crowding theory?

A
  • Not in line with managers’ experience (where bonus systems is a powerful tool).
  • The findings from experiments are not relevant in practice. People from different cultures, social groups, ages, academic fields?
31
Q

What does agency theory and motivating crowding theory say about different types of tasks?

A
  • If the task is simple, repetitive and boring: both theories promote extrinsic rewards (or make the work more interesting).
  • If the task is changing and challenging: MCT promotes intrinsic motivation.
32
Q

What important dimensions should be considered when designing incentive systems?

A
  1. Types of incentives.
  2. Group vs. individual performance (free-rider problem?)
  3. How to allocate incentives?
    - Monetary: literature says everybody should take part
    - Proportional to salary or same to everyone?
  4. Size of bonus relative to salary?
33
Q

What is Handelsbanken’s Oktagonen?

A
  • A part of the profit is allocated to a foundation owned by the employees
  • After a certain time, each employee can take their share or let it stay in the foundation
  • The same allocation to everyone
  • Purpose to design a fair and long-term incentive system for all employees based on the bank’s ROE.
  • The ROE is compared to the average of the competing banks’ ROE
  • If better, ⅓ of the “surplus” is allocated to the foundation
  • Full share worth 5 million SEK (2005)
  • Allocation all years but one
34
Q

Why and what types of caps can we put on bonuses?

A

The relation between reward and performance is linear, but only within certain limits.

  • Lower cutoff: to avoid paying a bonus for bad performance.
  • Upper cutoff: to avoid short-term behavior and total compensation that is too large.
35
Q

What is the purpose of bonus banks?

A

To mitigate short-term behavior

36
Q

What are five traps of performance measurement?

A
  1. Measuring against yourself. May be better than plan, but beating the competition?
  2. Looking back. Beating last year’s numbers is not the point; are the decisions you are making now are going to help you in the coming months. Leading rather than lagging.
  3. Putting your faith in numbers. –> Low-quality data. Anonymity in data collection is important. Don’t use the measures others use, find the right ones.
  4. Gaming your metrics. Trying to manipulate their numbers. Manage by a metric –> invite managers to manipulate it. Someone who has learned how to optimize a metric without actually having to perform will often do that. Diversifying metrics helps: harder to game several at once.
  5. Sticking to your numbers too long. Easy to spot the need for change after things have gone wrong, but to evaluate your measures before they fall, you need to be precise about what you want to assess through which metrics.
37
Q

What are some pitfalls when using financial measures?

A
  • What profit should we use?
  • Should we use ROI or RI for investment centers?
38
Q

Why is it inadequate to rely solely on financial measures?

A
  • May encourage managers to take short-term actions that may be wrong in the long run.
  • Managers may not undertake useful long-term actions to obtain short-term profits.
  • They are considered too abstract by many employees. Risks decreasing employee motivation.
39
Q

What are pitfalls when using non-financial measures?

A
  • Not validating the causal links. Prove how they affect future financial results
  • Forgetting to consider system support for data gathering
  • Not setting the right performance targets. E.g. 80% customer satisfaction may yield as much sales as 100% customer satisfaction.
40
Q

What four groups can the role of budgeting be divided into?

A
  1. Planning (resource distribution, coordination).
  2. Accountability (monitoring, motivation).
  3. Process (reflection, communication).
  4. Ritual (habit, legitimacy).
41
Q

What are the different types of budget preparation?

A
  • Top-down budgeting
  • Bottom-up budgeting
  • Interactive budgeting
42
Q

What is top-down budgeting?

A

Top management sets the budget for the lower levels. The lower levels check if the budget seems realistic. If not, they can protest, which often requires very good arguments. Top management still has the last word.

43
Q

What are benefits and drawbacks of top-down budgeting?

A

Benefits:
- Relatively fast.
- Top managers can control the end result; tactical, what they want the budget to show.

Drawbacks:
Budget participation from lower levels is very low.
- Likely greater acceptance of budget goals if they are perceived as being under personal control rather than imposed externally. → higher personal commitment to achieve the goals.
- Effective information exchanges. Lower-level managers are closest to the market which is beneficial for numbers.

44
Q

What is bottom-up budgeting?

A

Lower-level managers participate in setting the budget numbers. All managers make their own assessment of how well they think they are going to perform based on the budgeting guidelines they have received.

45
Q

What are the benefits and drawbacks of bottom-up budgeting?

A
  • More likely to generate commitment to meet the budgeted objectives.
  • May be more realistic
  • Risk that managers want to include buffers in the budget figures in order to make the goals more easily achievable.
  • Figures may not be in line with top management’s predictions or ambitions.
46
Q

What is interactive budgeting?

A

Starts like bottom-up, but is then repeated once or more until top management is content with the consolidated budget figures

47
Q

What are the benefits and drawbacks of interactive budgeting?

A
  • Can get the lower-level managers involved while ensuring that the figures are in line with top management’s intentions.
  • tends to take a long time
  • revisions may undermine commitment
  • likely to try to put in a buffer in the first round.
48
Q

What are the two types of budget evaluation?

A
  • Tight budgetary control
  • Loose budgetary control
49
Q

What is tight budgetary control?

A

Strict evaluation with little acceptance of deviations. Managers must explain why deviations occur and show plans for how to prevent them from occurring again. Outcome may be linked to some kind of reward/punishment. Often the evaluation experience is related to a certain degree of anxiety for the evaluated manager.

  • Often strengthens discipline
  • Makes people do what they are told
  • More appropriate with a low-cost strategy, and in a stable/certain environment.
50
Q

What is loose budgetary control?

A

Mutual understanding that the budget was just a guess made several months earlier without the full information available today. The budget meeting is less top-down evaluation and more of a constructive discussion regarding how the evaluated unit has performed, what can be learned from it and what improvements can be made in the future. The manager often feels more supported and strengthened.

  • Makes people willing to make decisions, take initiative and be creative.
  • More appropriate with a differentiation strategy and in a dynamic and uncertain environment.
51
Q

What does budget gaming usually refer to?

A

A wish to show budget figures that are either better or worse than you actually believe is the most likely outcome for the budgeted period. Two kinds:
- Exposure: higher revenues and/or lower costs.
- Hedging: lower revenues and/or higher costs

52
Q

What are some factors that budget gaming depend on?

A
  • Budgetary control (tight –> hedging, loose –> easier to behave tactically)
  • Profitability
  • Uncertainty (more buffers)
  • Reward system
  • Personality (risk-aversion = hedging vs. risk-willing = exposure)

BE353 - Performance Measurement & Business Control (7 decks)

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