Performance Measurements and Budgets

Question 1

Why are performance measurements important?

Answer 1

Things can be very deceiving (think Theranos), If you have actual numbers, you can see the truth.

Question 2

What is a pitfall of performance measurements?

Answer 2

What you measure is what you get

Question 3

What is the rational perspective on performance measurements?

Answer 3

Unintended effects and flawed measurements.

• Think; a teacher is measured on how much students enjoy the teaching but that means that should just bring in croissant and have fun in class

Question 4

What is management myopia? And how is it fixed?

Answer 4

Focusing on one thing (or few things) and loosing focus on the bigger picture and long track.

Question 5

What are the 6 criteria for performance measures? (IMPORTANT FOR EXAMS)

Answer 5

1) Congruence with organizational objectives i.e. long term value maximization

2) Controllability. The manager’s or employee’s ability to affect the measure

3) Timeliness: The lag between managers action and the measurement/feedback

4) Accuracy and Precision. Low variance or noise in the measurement

5) Understandability. What the measure is/how it is calculated and how can they influence it

6) Cost effectiveness. Cost implementing vs. benefits

Question 6

What is a pitfall of an individual performance measure?

Answer 6

It tends to involve tradeoffs among the 6 criteria.

Question 7

What is the most important of the 6 performance measures?

Answer 7

Congruence can be crucial, as you often move towards/improves on what you’re measured on, meaning they must align with company values.

BUT, it can be hard to directly link certain KPIs to the overall long term goal and values (think Social Media KPIs in a pharma company. A good SoMe strategy doesn’t necessarily create the best diabetes treatment for patients)

Question 8

What are KPIs?

Answer 8

Key Performance Indicators

Question 9

Mention a market measurement easily available for most people

Answer 9

Stock values – timely, valuable (objective and precise), understandable and cost effective

Question 10

What are some problems with stock values as a performance measurement?

Answer 10

• Availability (not all companies are listed)
• Controllable only for top management & macroeconomic factors
• Controllability: Expectations are important
• Short term problems with congruence – markets are not perfect – overshooting (the hysteric stock market). However, in the long run they are congruent.

Question 11

What is EBIT?

Answer 11

Earnings before interest and tax – a measure that makes it easy to compare across firms as taxes and interest can vary.

Question 12

Mention the two (three ish) types of accounting performance measures

Answer 12

1) Residual measures
2) Ratio measures
3) Specialized ratio measurements developed by finance firms

Question 13

What are some ratio measures?

Answer 13

Return on investment (ROI), P/E (Price / Earnings)

Question 14

What are residual measures?

Answer 14

Net income, EBIT

Numbers left after deduction relevant numbers

Question 15

What are the strengths and weaknesses of accounting performance measures?

Answer 15

Strengths: Timely, cost effective, relatively accurate and understandable (though problems in understanding how to influence measures)

Weaknesses: Congruence is low (lag indicators, profit dependent on measurement method, are conservative disregards investments in intangible assets, ignores cost of equity and capital risk.

Controllability depends on measure (macroeconomic influence like inflation)

Question 16

What is the EVA?

Answer 16

Economic Value Added (Net Profit minus Cost of Capital)

Question 17

What is the weakness of EVA?

Answer 17

Lag indicator (takes time to show), transaction oriented, conservative, incoherent with market valuation.

Question 18

Can you combine different performance measures?

Answer 18

Yes! And you probably should

Question 19

What is the balanced scorecard?

Answer 19

Addresses a serious deficiency in traditional management systems: their inability to link a company’s long-term strategy with short term actions. A combination of Measures.

Looks at Financial, Customer, Learning and Growth, and Internal Business Process and considers these in relation to Vision and Strategy.

Question 20

What are the benefits of BSC (balanced score card)?

Answer 20

+ helps close gap between strategy and its implementation
+ doesn’t only rely on short-term measures as indicator for performance
+ links long-term strategic objectives with short-term actions

Question 21

What are the benefits of combining measures?

Answer 21

• Potentially high congruence and a better measurement system because of potential ability to reflect complete value creation
• Accuracy, timeliness and controllability vary depending on the chosen metrics
• Usually expensive, i.e. potentially not cost effective
• Are build (BSC) based on hypotheses which may be wrong (e.g. Sears found no relationship between empowerment and personal growth and customer measures)
• The use of many measures makes them ineffective motivators – should account to 5-10 % of base salary

Question 22

What is information asymmetry?

Answer 22

That people in an organization don’t know the same stuff/have the same information.

Question 23

What is EBITDA?

Answer 23

Earnings Before Interest Taxes Depreciation and Amortization

Question 24

What is opportunity cost?

Answer 24

The cost of the next best option (what the value of a certain opportunity is)

Question 25

What is turnover?

Answer 25

How much you sell, how many items you get out the door.

Question 26

What is a problem with budgets?

Answer 26

That you maximize own benefits as an individual and create budgets that are not necessarily true.

It creates another problem, once you start lying, the barrier is broken and it spreads.

Question 27

What is gaming?

Answer 27

People are taught to lie in these pervasive budgeting system because if they tell the truth they often get punished and if they lie they get rewarded.

Once taught to lie in this system, people generally cannot help but extend that behaviour to all sorts of other relationships in the organisation”

Question 28

What is the two problems with gaming budgets?

Answer 28

• Employees do not reveal information about their true expectations
• Employees game the realisation of budgets

Question 29

How can you game a budget?

Answer 29

• Shift costs or income/payment. Shift income from early next year into this or do costs now that are in next year because you’re not going to hit a target.
• This murk up the performance measurement of other parts of the company (does this marketing campaign work, now we can’t see it because the cost has increase for example).

Question 30

What are the problems with linear compensation models?

Answer 30

• External factors can influence the budget
• Retention would probably be bad as the work/life balance is bad
• We are knowledge workers, hard to see “how many boxes we produce”
• We see this at waiters in the states, they are paid by tips so have to be incredibly nice, horrible safety in the job!

Question 31

What is a budget?

Answer 31

A budget is a management’s forecast of revenues, expenses or profits in a future time period.

Question 32

What can budget show/do?

Answer 32

1) Knowledge: Budgets communicate key planning assumptions such as product prices, unit sales and input prices.
2) Partition Decision Rights: Budgets can set guidelines on resources available for each segment. Gives mandate and reduced bottlenecks.
3) Performance Evaluation: Department’s actual performance is compared to what was budgeted.

Question 33

Organizational architecture consists of which elements?

Answer 33

1) Assignment of decision-making authority: Who gets to make what decisions?
2) Performance evaluation: How is the performance of business units and employees values?
3) Compensation structure: How are employees rewarded?

These all need to be aligned like a three-legged chair, otherwise it is not stable.

Question 34

What is the ratcheting effect? (VERY IMPORTANT for the exam!)

Answer 34

Basing the next years standard off performance on this year’s actual performance. Favorable budget variances lead to larger increases than unfavorable variances leads to decreases.

You can only go up. You can produce 100 this year, so next year you can do 110 next year and 120 the year after etc. OR a big order this year can upwards adjust a budget which is not realistic next year.

Question 35

What are disadvantages of the ratchetting effect? (See slide)

Answer 35

– Performance targets usually adjusted upward
– Employees reduce output to avoid being held to higher standards in the future

Question 36

What are possible solutions to the ratcheting effect? And are they problematic?

Answer 36

– Eliminate budget targets (no growth)
– Estimate next year’s sales (hard)
– More frequent job rotation (can be difficult and unwanted to implement)
* Summary: While the ratchet effect creates dysfunctional behavior, the alternatives might produce even greater problems.

Question 37

Mention four types of budget types

Answer 37

1) Bottom up (participative) and top down
2) Short-term vs. long-term
3) Zero based vs. Incremental budgets
4) Flexible vs. Static

Question 38

What is a line-item budget?

Answer 38

Having budgets for your item lines (like a blue and red pencil). Authorizing managers to spend only up to the specified amount on each line item.

• Advantage: Easily to control and look at
• Disadvantage: Growth in one line cannot help the other so it isolates the capital from each.

Question 39

What are budget lapses?

Answer 39

Unspent funds are not carried over to the next period

o Advantage: You spent the money given to the budget for the development of your projects.
o Disadvantage: You game this, by spending a lot of money towards the end of the fiscal year on unnecessary things.

Question 40

Are budgets always static?

Answer 40

No, you can have:
- Static or flexible budgets

• Static: Does not vary with volume
  o Hard to quantify in knowledge work that isn’t production oriented.
• Flexible: Varies with volume
  o Increase in budget due to increased volume is maybe unnecessary (maybe we don’t need to produce 50 million pens if we only sell 10 million)

Question 41

What kind of compensation models are there? Advantages and disadvantages

Answer 41

Linear vs. nonlinear compensation plans

Question 42

What is a stage-gate model?

Answer 42

A way to handle moving from a development/idea to a finished product.

Defining different stages and gates between the stages to ensure a proper movement forward where you narrow down the project.

At each gate, you decide whether to move forward or not.

Question 43

What does Sethi and Iqbal study?

Answer 43

The relationship between ”rigorous” use of stage models and learning.

Rigor is defined as tightness of controls, uniformity and objectivity of controls and frequency of controls

Question 44

How does the rigorous use of stage-gate models relate to performance measurements?

Answer 44

Rigorous use of stage gate models leads to learning failure and increased inflexibility in product development

Question 45

Overall, a the more strict (tight control at each stage, objective review criteria, high frequency of stages etc.) a stage-gate model the more it leads to?

Answer 45

Project inflexibility and learning failure - particularly with technological turbulence and with novel products.

Question 46

What is gate conditionality?

Answer 46

The possibility of meeting criteria at later gate

Question 47

How does gate conditionality affect gate-stage models in product development?

Answer 47

Gate conditionality does not reduce inflexibility.

Question 48

What is zero based budgeting?

Answer 48

That you have to justify all expenses for each new period. (Really time consuming).