Performance Measurement and Management I: Behavioural implications of performance measurement systems Flashcards
1
Q
What is the problem of goal alignment?
A
- Recall the definition of management control as the process of ensuring that employees behaviour is aligned with organisation goals (ensuring goal congruence)
- In for profit firms this is typically translated in terms of ensuring that employee behaviours contribute to the over-riding objective of maximising the wealth of owners (shareholder value).
- Shareholder value is focusing on longer term not making windfall gains or short term stock gains a long term commitment and assets tied into the organisation. In perfect capital market settings investors are able to form better diversified portfolios even out fluctuations M&M. Shareholders are more risk neutral than employees due to risk diversification.
- SHV: long term value growth and dividend growth
- If there were no conflicts of interests we wouldn’t need a MCS at all.
- How do we measure and reward employee performance to ensure that this objective is being met?
2
Q
Common performance measurement systems to achieve goal alignment?
A
- 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)
- Accounting measures of performance: measures based on various concepts of accounting profits (profit before or after tax, contribution margin measure)
- 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). EVA 1980’s shareholder value movement, up to GFC criticised.
- 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. Time new products to market etc, new opportunities.
3
Q
How congruent are various types of measures with the objective of maximising shareholder value?
A
- 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 SHV. 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 to many objectives. BSC in a corporate setting, too much ambiguity. Kaplan and Norton, BSC core argument to overcome short termism and historical focus.
4
Q
What are the 6 relevant measurement properties?
A
- 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.
5
Q
What properties do various measures have?
A
- 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?
6
Q
What are the behavioural consequences often embedded in financial performance measures?
A
- Investment and operating myopia
- Sub-optimisation
- Misleading performance signals causing behavioural displacement
7
Q
What is investment and operating myopia?
A
- “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.
8
Q
What is investment and operating myopia?
How can the myopia problem be addressed?
A
- 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.
9
Q
What is sub-optimisation?
A
- 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.
10
Q
What is the difference between ROI and RI?
A
- ROI = Profit/ Assets
- RI = profits – (corporate capital charge x assets ) (SEE EXAMPLE IN SLIDES)
- Corporate capital charge TC debt TC equity (dividends + long term growth)
- 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.
11
Q
What is the difference between ROI and RI?
What is economic value added?
A
- 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, unlimited incentives (punishment) plans and promoting objective target setting to avoid gaming and manipulation. Make managers think like a shareholder! Needed high independence.
12
Q
Misleading performance signals and behavioural displacement
A
- ROI measures can provide misleading performance signals as a result of overstatements of returns that are not “real”. Different centres have old and new assets. Returns increase merely because of time. SEE numerical example. Assets are heading towards end of lifetime more depreciation lower net book value! Assets are the denominator for ROI! (Less division of profit!). The signals are better for the firms which are not making in new assets, entrepreneurial ideas etc. short term myopia.
- Time passes, asset value decreases, ROI increases with all else stable. This could signal good performance! Upward sloping
- Signals sent: that it is efficient to retain assets beyond their optimal lifetime. Corporate managers might over-allocate resources to sub-units with older assets as they appear to be more profitable or have a higher level of return. Powerful disincentive to invest in new and especially fixed assets.
- Errors in performance evaluation of sub-unit managers. Causing problems of unfairness. “management by numbers”
- RI will not solve this, goes off asset base, penalises those with highest book value of assets!
13
Q
What is the controllability principle?
A
- Managers of responsibility centres should only be held accountable and be rewarded for financial performance metrics which they can control (or at least influence).
- The controllability principle is closely associated with the notion of responsibility accounting, but also applies to any performance evaluation and incentive scheme.
- Assumes perfect matching of financial responsibilities and decentralization.
- Numerous studies show that many organizations do not apply the controllability principle (by design or default).
14
Q
Why do organizations fail to implement the controllability principle?
A
- Group based reward systems (profit sharing schemes) in order to avoid means end inversion and silo thinking. Beneficial in order to ensure overall goal congruence deliberate breach.
- Deformed reasons?
15
Q
How can the controllability principle be applied?
A
• Ex ante methods (before the event)(protect managers from uncontrollable events):
1. Buy insurance – protecting against uncontrollable events such as floods, fires and damages. (Acts of nature/ Natural disasters). Problem is that some risks cannot insure or high insurance premiums cost benefit trade off.
2. Ensuring responsibility centres and financial targets mainly include controllable items are matched with adequate decentralization.
• Ex post methods (after the event) (results with targets)
1. Variance analysis
2. Flexible performance standards, revised after set during accounting period if they are uncontrollable variances.
3. Relative performance evaluation (rankings and league tables): assumes similar responsibility centres face the same types of risk, in built controllability factors as comparison leaders to residual. Automatically neutralised due to level playing field. Magnitude is assumed to be the same, is it?
4. Subjective adjustments in performance evaluation. Major one off events, hurricane in one area! One off very subjective adjustments to avoid penalties for something which managers cannot control.
