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The development of new financial and non-financial performance measurement models

By referring to the current robust global competition with the improvement in production technology and capability, a wide fluctuation of exchange rates and the price, Johnson & Kaplan (1987) had then referred it as the huge challenge for organizations. By exploring further into the MAS in the past 150 years, confidently declared that with the modern information technology, they could develop a better opportunity, a more accurate, timely, and more effective MAS. Meanwhile, Lev and Zarowin (1999) discovered that financial information has not been very useful in the past 20 years. They argued that financial information could not provide significant information on the operating activities changes of a firm. J&K had also explained about the new developed systems for process controls and cost management, and the performance measurement systems for the future, after improvements in the MAS.

Therefore, this paper helps identifies the development of new financial and non-financial performance measurement models from the 1990s to the present day. By reviewing the book, “Relevance lost: The Rise and Fall of Management Accounting” (1991), written by Johnson and Kaplan (J&K), they criticise “managing by the numbers” which they see as a consequence of (over) emphasis on financial performance measures, especially return on investment (ROI). They had criticise the over reliance on these short-term financial performance measures and call for to increase the emphasis on improving financial measures and non-financial measures. Further in this paper, criticism and opinion which tag along views as well, from scholars and researches on the thesis of J&K will be speak about too. Different types of models and management accounting system will be introduced and the reliableness of those models was discussed later in this paper. Those models were juxtapose too.

2. Financial Indicator

2.1. Return On Investment (ROI)

Return on Investment (ROI) was used as a measurement tool of a firm’s profitability towards the investment that investors had invested into the project. In other words, ROI helps measures how a firm effectively generate profit; the higher the ROI, the better. Hence, this has led to a huge range of argument later on. Johnson and Kaplan (1987) argued that ROI covers up behavioral implications and may influence the decision making of a firm. J&K (1987) critique that business schools had detached the original meaning of ROI after the establishment of it, which helps the decision making of the organization. Hence, most researchers believe that if a manager’s performance is measured with ROI as benchmarking tool, there is a highly possibility that managers will tend to manipulate the profit figure in order to obtain higher payout. On the other hand, if ROI was used to judge the investment center performance, divisional managers will not engage themselves in the investment unless it could help increase the ROI of their center. However, this was further argued that rather only discuss about the managerial discourse in divisionalized company, firm should also consider that the concept of ROI could be related to wider financial accounting information of ratio analysis. Llwellyn and Milne (2007)

Though with all the arguments from researches, ROI still proves its reliableness with some success stories on how does it changes the company profit and management making decision. One of it was the Kubota Tractor Corp, after they saw a ROI in less than 6 months. Besides, Kubota also managed to improve customer satisfaction and also reached a near perfect line delivery rate.

After reconsidering all the weaknesses, researches tend to formulate alternatives models to overcome ROI weaknesses, and few of the famous one are, Economic Value Added and Residual Income.

2.2. Residual Income

Ohlson (1995) proposed that firms’ value can be determine by 3 different measurements – residual income, book value and related information.

Residual Income could be define as the difference of the profit of the project/business by pursuing the other alternative business decision (Carlo Alberto Magni , 2008). The differences were also called as the opportunity cost to the business as the alternative choice of business may be the better one. The concept of Residual Income (RI) was developed based on in the counterfactual feature of opportunity cost, by Marshall (1980), who believed was inspired by Hamilton (1777). This was soon restructure it throughout decades started by Carsberg (1966), Leakes (1921), Sloan (1929), Goetzmann and Garstka (1999), Preinreich (1936, 1937, 1938), Edey (1957), and lastly Peccati (1989,1990) generalized the standard RI approach, and adapting RI into equity and debt component.

Soon after the exposure of Residual Income, it was proven that it could help to reduce the dysfunctional of behavioural problem which previously faced by ROI. It was believed that it could help to provide supportive information on decision making as long as its residual income is increased as its rate of return is greater than the company’s minimum rate of return, unlike ROI, as managers will not accept the project unless its returns are higher than the ROI. However, James. R. Martin argued that RI could not be relating of the size of center’s income to the size of the investment. Though the RI seems to be better than ROI, it did not mange to get high level of acceptance on their DCF approach or the ROI measure (Johnson and Kaplan, 1987). General Electric is one of the case that switched RI measures back into ROI measures after they discovered that ROI seems to be more ‘consistent’ on financial data. (Source: Johnson and Kaplan, 1987)

2. 3. Economic Value Added

Until the late 1990s, Stern Steward Co. (1997) strengthens the measurement from Ohlson and shaped EVA, which is known as a performance measurement to overcome traditional accounting items, in a way similar to residual income and to calculate the cost of capital in a proper approach.

Later on, Chung-huey Huang and Mao-Chang Wang (2008) proposed that firms valuation is mainly determine by book value, EVA and by intellectual capital. By comparing both methods of calculating residual income based on EVA and intellectual capital, C.H. Huang and M. C. Wang proposed that ‘explanatory capital’ for firms market values of residual income based on GAAP earnings are greater than the residual income based on EVA. One case from SPX (a chronic under-performer in late 1990s) saw the effect on their profit boost by nearly $27 million from year 1996 after John Blystone was hired as a CEO in 1995, when the company has low profits and a languishing share price. In their 1996 annual report, they credited the usefulness of EVA by claiming that EVA was the bone of contention of the success and had helped them improve both operating performance, the use of capital, and producing a quick financial turnaround while driving the cultural change in the meantime (S. David Young, Stephen F. O'Byrne, 2001).

To support the argument from Bontis et al, Chung-huey Huang and Mao-Chang Wang (2008) suggested investors should consider both intellectual capital and information from firms’ financial report in order to value the firms accurately. Researchers like Ben-Hsien (1998), Gerald T. Garvey and Todd T. Milbourn (2000), Chung-huey Huang and Mao-Chang Wang (2008), and Will Seal (2010) also detailed the usefulness of EVA and compared it with alternatives measurement like residual income, strategic management accounting, and abnormal economic earnings. By comparing with ROI measurement, due to the none dominant effect of RI, it helps solve over or under investment for long term assets problems; as to EVA, it helps to solve under and over investment by encouraging managers to spend more money in customer service, R&D, and employee training.

These arguments had also proved that J&K’s critique on the relevance of figures’ in financial reporting and the traditional way of accounting policies. These also strengthen their argument that firms nowadays have to consider both financial and non-financial measurements as well.

Non-Financial Indicator

3. 1. Balance scorecard

The Balance scorecard (BSC) was firstly proposed by Robert S. Kaplan and David P. Norton in 1992a. Several researches and scholars like Brown and Gibson (1972), Ragavan and Punniyamoorthy (2003), Meena Chavan (2009), extended the model by either introducing new measurement of balance scorecard. Kaplan and Norton (1993, 1996a, 1996b) reformulate and redesign it into the present form in the early 1990s, and claims that the remodeling of BSC helps to include all drivers of performance which is important to the firm with the diverse set of performance measure.

To support the usefulness of BSC, firms and businesses have to willingly adopt themselves into any benchmarking standards and process controls systems, which was believed that it could bring the business to a higher level of standards (Johnson and Kaplan, 1987). In addition, the balance scorecard could refer as a very beneficial performance measurement tool for an organization in strategic performance management, for both financial and non-financial performance. (Brewer and Speh (2000), Dye (2003), and Punniyamoorthy and Murali (2008))

In contrast, L. C. Leung et al. (2006) claims that BSC framework does not provide proper and reliable guidance to show how appropriate weight must be placed on each measure or criterion of managers, to help avoid any unsatisfactory reward given to managers. Managers in different level of management should have different way of reward but BSC does not consider this. It provides an average amount of reward to managers, and hence issue of unsatisfactory reward might occur. Other than that, BSC was discovered that it does not consider the time-dependent relationships (Kaplan and Norton (1996) and Ittner and Larcker (1998), and L. C. Leung et al. (2006)). It fails to reveal that whether the improvements made have been reflected into both the expansion of business and financial performance. Lastly, BSC does not give clear information whether firm should use objective or subjective measures in their performance appraisal as both measurements give different approach of measurement (Kaplan and Norton (1996), Ittner and Larcker (1998), and L. C. Leung et al. (2006))

Nevertheless, though the argument of weaknesses in BSC, results shows that firms in this modern era had adapted BSC in their cooperation strategy and performance measurement appraisal. This proves the reliability of BSC in practical. In instance, Veolia Water North America has successfully implemented BSC as their strategy to help achieve their business goals. It has helped them to measure the progress facilities and maximize resources. Courses were developed to help employees understand the terminology and best practices related to BSC as well (Sources: Balance Scorecard Institute).

3. 2. Six Sigma

Six Sigma was firstly designed by engineers in Motorola Inc in the USA in the mid-1980s and was extended in the late-1980s. Due to its representation of a high level of quality, the engineers in Motorola Inc used Six Sigma as ‘informal name for an in-house initiative for reducing defects in production processes’ (Businessballs.com). Motorola claimed that its management systems could guide the firm to focus on projects that will help improve the metrics, and by leveraging the leaders wisely, it could help manage the efforts for rapid, sustainable, and improved business results.(Source: Motorola, Inc). In 1995, General Electric’s CEO Jack Welch sees the potential of Six Sigma and implemented it into GE and by 1998; GE claimed that Six Sigma had assisted them over the generation of three-quarters of a billion dollars of cost savings. (Source: George Eckes' book, The Six Sigma Revolution.). Therefore, Six Sigma could act as a very informative tool to overcome the weaknesses of BSC regarding about the unsatisfactory reward given to managers.

3. 3. Performance Pyramid

Performance Pyramid was firstly developed by Lynch and Cross in 1991. It is known as a framework that it could view the measurement business performance with the business process hierarchically. It also makes clear idea of the difference between the interest of external and internal parties’ customer satisfaction, quality and delivery. Other than that it was also believed that it could help measures the primarily interest on the business productivity, cycle time and waste. This was later seen as a tool to help overcome the time-dependent relationships of BSC. In BSC, argument stated that BSC fails to provide significant information on translation from operational improvements into expanded business, enhanced financial performance. Apparently performance pyramid could help solve this problem by giving the possibility of revealing the cycle time and waste of the project. This information considered as very important as the product and organization’s life cycle is very critical to the management control system and strategy of the business. Therefore, performance pyramid could be considered as a method to overcome BSC’s weaknesses.

4. Conclusion

It was understand that throughout the development of management accounting, investors and firms started to see the importance of it. Investors need it as a benchmarking tool for estimating the value of the firm accurately; as firms sees it as a tool to help on their discounting procedures and generates additional profit. However, different accounting policies approaches have proven that it could affect the company in a different way, which in this case, it refers to Return on Investment, Residual Income, and Economic Value Added. ROI was design and formulate as a measurement tool of a firm’s profitability towards the investment that investors had invested into the project. Soon after the development of ROI, Johnson & Kaplan critique on the weaknesses of ROI that ROI could have behavioral consequences and was believed it could lead to a dysfunctional decision making when used as a guide to investment decisions. This was later replace it with RI, which could help minimize the behavioural consequences and decision making of the projects when the earnings are above the cost of capital. However, it does not consider the size of the center’s income to the size of the investment. Thus, EVA was developed to help overcome it and reformulate the calculation methods on the cost of capital. Thou the reliability of ‘figures’ is still consider as a very relevant and important guide for both investors and firms’ executives, but it is still better to consider non financial performance measurement for firms which could also help to improve the value of the firm as well. The non-financial performance measurement could refer to The Balance Scorecard, Six Sigma, and performance pyramid. These 3 types of measurement were referred as a very informative tool to assist on the performance measurement of the firm without considering many figures in it. After considering of both financial and non-financial performance measurement of a business, it is quite clear that thou financial performance measurement gives better satisfaction and information on value of the firm and decision making part, it is still important to take the non-financial performance measurement into account while valuation of the firms (for investors) and decision making of the firm for further expansion (for management executives) was performed. Hence, this could also support J&K’s argument on traditional accounting policies and suggested on reconsidering non-financial performance measurement as well. Therefore, this could support J&K’s critique on the over reliable-ing on financial performance measurement, and non-financial performance measurement should be taken into consideration as well.

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