Development of financial and non-financial performance models

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This essay is to analyze and evaluate the developments of new financial and non-financial performance measurement models from the 1990s to the present day, with analyses from different academic articles, giving case studies showing the overall use of financial and non-financial performance measurement systems.

Background

Johnson & Kaplan mention that the return on Investment measure model is over emphasis on financial performance measure. They criticise the over reliance on short-term financial performance measures and suggest that the performance measure systems should emphasising towards long-term measures of performance instead of only short term profit. Further, non financial performance indicators are as important as financial measures. They can highlight various particular areas for company performance such as marketing and quality control and manufacturing etc. Also they proposed that should increased emphasis on financial and non-financial measures.

Return on investment is a popular financial measure model developed in early 20th century. It has been widely used for measuring project performance . The method is straight forward and allows managers to measure how efficient they used the property of the company to make profits. However ROI is not perfect. There is still some majority drawbacks which led to new performance measure methods arise such as residual income. Residual income is another performance model developed after ROI. I will compare them and analyze which model is better.

Return on investment, Residual Income Economic Value Added

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Residual income (RI) equal the net operating income less the required rate of return times cost of capital. The company's goal is to have positive and increase residual income. The higher the residual income, the more value of the investment. Theoretically ROI is the same; the higher the ROI the better. However it is not true in reality. John (1970, p.127) has stated that '' each division is expected to earn an ROI objective, a division manger will not be likely to propose a capital investment unless it is expected to earn a return at least as high as his objective''. It means manager will not make investments even it is profitable because of the lower ROI. It will causes the company lose opportunity to maximise company profit. In contrast residual income is more straight forward. In this case the manager who used residual income model is likely to accept any investment which the net operating income is above the required rate of return, in order to maximise the residual income. The manager who used residual income will tend to make better decisions concerning investment projects than manager who used ROI. Another problem which John (1970, p.125) mentioned that ''manager may increase his return on investment in the short run by reducing costs, by increasing sales volume or prices, or by reducing his investment base''. Those ideas can boost the ROI in short term but may harm company in long term. For example cutback the research and development funding. It will cause a future damage to the company such as delay or cancel new products enter the market which may makes the company become less competitive and damage the company profits in the future. However residual income is not perfect too, there is a major drawback which is cannot be used to compare the performance of divisions of different sizes. Keith (1970, p.330) mentioned that '' unless the relationship between the cost of capital and division income is made explicit, as in residual income, it is difficult to compare two divisions''. Assume a firm had A and B divisions; A had $1,000,000 average operating asset, generate $120,000 net operating income and $20000 residual income. B had 250,000 average operating asset, generate $40000 net operating income and $15000 residual income. Both of them have the same require rate of return @10%. Division A's performance had higher residual income probably because of its size rather than the quality of management. In contrast division B used only a quarter of division A's amount operating assets to generate slightly lower residual income. As an example, comparing divisions performance should not based on residual income only, should also look at the operating assets it used and the operating income. In 1982, there is an improved version of residual income is called economic value added. They are very similar but EVA is calculated based on net operating profit after tax (NOPAT). It is used to calculated the income after tax and cost of capital. It mainly relies on accepted (GAAP) accounting principles. Therefore, some adjustments are needed such as training costs for employee should be capitalized and amortized over the perceived period of future benefits, in order to prevent any possible distortions of income and investments. Compared to residual income, it has the similar functions, benefits and limitations that compared to ROI which explained above. But there are two major limitations which ROI, RI and EVA have come across. The first problem is they are over emphasis on short term measurement. Peter, Gyan and Clayton (1999, p.8) argued that '' EVA overemphasizes the need to generate immediate results'' This problem also exist with ROI and residual income, as Johnson and Kaplan mentioned the over emphasis on financial performance measures. The second limitation is over reliance on historical data. Fletcher and Smith (2004, p.3)argue that ''EVA over reliance on historical, financial measures such as profit margin, asset turn over, cost of money and the level of capital invested in the firm. Recent research has shown that these financial oriented measures are not necessary indicative of future performance '' Although the article have not mentioned ROI and residual income but they do have the same problem which is measuring performance based on historical data. Johnson and Kaplan mentioned that financial measures need to be improved and move away from short-term towards long term measures.

Balance scorecard and other non-financial performance measure systems

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Balance scorecard (BSC) is an strategic performance management tool developed in early 1990s by Robert Kaplan and David Norton. It has been used to support managers to have a fast but comprehensive view of the business. It allowed managers to manage and evaluate the business from four perspectives; How do customers see us? (customers perspective), what must we excel at? (internal business perspective), Can we continue to improve and create value? (innovation and learning perspective) and How do we look to shareholders?(financial perspective) quote from (Kaplan and Norton 1992, p.172) The major benefit of balance scorecard is it take cares financial and non-financial measure which traditional financial measure system don't cover. The customer perspective is about the satisfaction of customers. The internal business perspective is about what business processes need to excel at in order to satisfy customers and shareholders. Innovation and learning perspective is about how company sustain the ability to change and improve in order to meet their vision. Financial perspective is about how should the company appear to the shareholders in order to succeed financially. Compare to the traditional financial measures, balance scorecard provide long-term strategy in order to improve long-term decision making which traditional financial measures don't. It can increase the consistency between manager's behavior and the company's goal that the managers who used ROI may only focus on maximize ROI. Also there are some potential benefits of using balance scorecard; Varma and Deshmukh (2009, p.14) stated that '' A good measurement system must measure parameters affecting all its stakeholders. The BSC tries to do this by measuring performance across different perspectives: financial perspective affects shareholders, customer perspective affects external customers, business processes affect shareholders and customers, innovation and learning affects employees and may even affect customers.'' It allows manager to know who will be affected in the certain perspective in order to set up suitable goals for particular perspective. Also they stated that ''Another benefits is it increase the staffs' communication and understanding of the company's strategy because the goals and measures are clearly stated (Debusk and Crabtree, Does the Balance Scorecard improve performance). However, balance scorecard have several limitations should be considered; Varma and Deshmukh (2009, p.14) mentioned '' It does not allow benchmarking results against those of an industry group or competitor''. It is a major limitation that prevent comparison between firms and seriously affect the flexibility of the model for performance measure.

Six Sigma is a business management strategy tool developed by Bill Smith in 1986. Six Sigma seeks to improve the quality of manufacturing process by identifying and eliminate the defects (errors). If the deflects per million opportunities is 3.4 which has achieved Six Sigma. Six Sigma mainly is focus on customers satisfaction in order to increase revenue. Secondly is to improve the quality of process in order to reduce the poor quality cost. There are three key points are mentioned by English; Identify your product and service, Identify the customers for your product or service and determine what they consider important, Identify your needs to provide the product/service so that it satisfies the customer ( English 2004, p.1).

Performance prism

The performance is management framework which provide structure in order to help executives to evaluate the performance from 5 related perspectives; 1.Stakeholder Satisfaction (Who are our stakeholders and what do they want and need?), 2. Stakeholder Contribution (What do we want and need from our stakeholders?), 3.Strategies (What strategies do we need to put in place to satisfy these sets of wants and needs?), 4.Processes (What processes do we need to put in place to satisfy these sets of wants and needs?), 5.Capabilities ( What capabilities - bundles of people, practices, technology and infrastructure - do we need to put in place to allow us to operate our processes more effectively and efficiently?) (Neely, Adams and Kennerley 2002, p.4) Through the five perspective executives are available to construct a business performance model.

Comparing Balance scorecard, Six Sigma and Performance prism

Balance scorecard mainly focus on customers and shareholders' satisfaction in order to produce the goals to meet their satisfaction. However it does not include some correlated stakeholders such as business partners, competitors and suppliers etc. which Performance prism has covered. Six Sigma is mainly focus on customers satisfaction and quality improvement though in order to increase income and decrease the poor quality cost though production processes. However it ignores external business environment as balance scorecard. It can be used with balance scorecard as a part of the customer perspective solution.

Cases for Balance Scorecard and EVA

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Debusk and Crabtree stated an empirical evidence to show that the companies implementing the BSC have improved their performance. By doing this they conducted a survey for more than 1,000 firms. They set out 4 questions to clarify;

How widespread is the use of the BSC?, What industries are using the BSC?, Does adopting the BSC improve a company's operating performance and profitability?, Do organizations often tie the BSC to compensation incentives? The results of the survey shows many organization have used balance scorecard which have improved their performance. 88% of the organization gained improvement in operating performance by using balance scorecard and 66% of them reported an increase in profits. However those who have failed to use balance scorecard may be because of the failure in communication and difficulty in translating the strategy. (Debusk and Crabtree, 2006)

Empirical results for the use of EVA

Abdeen and Haight stated an empirical evidence to show that the performance of the Fortune 500 companies using EVA was better than the performance of the non-EVA users. However, the earnings per share and total return is a lot worst. These results lead to conclude that EVA will become less use for measure value creation to stockholders and that EVA will use the other traditional measures.

Conclusion

I am strongly agree with Johnson and Kaplan mentioned that the non-financial performance measure is important. It is because the non-financial measure provide long term concerns in order to help companies to make better decision and success in the future. By doing this company can follow the non-financial model's framework to set up goals and measures for the staffs to follow in order to follow the strategy. However non-financial measures are not perfect such as balance scorecard, it still has its limitations. Although balance scorecard has been adopted by many firms but there is some limitations which should be consider such as ignore external business environment. Only focus on customers and shareholders satisfaction but ignore external stakeholders such as partners and suppliers etc. Assume that if the company has not meet its business partners or suppliers need, they may stop cooperate with the company and cooperate with others. As a result the company may not be able to meet the customers' need which lead to strategy failure. The users of any financial or non-financial should beware those hidden limitations and find a way to avoid or solve the problem rather than just follow the model's framework. Also good communications is important such as clearly stated the goal and how to achieve the goal in order to make the staff to follow the strategy consistently. Although non-financial performance measures is important, but financial measure should be ignored because they can provide fast and straight forward results of financial performance such as ROI can provide information about how efficient the division has used its property to generate profit etc. However blindly focus on maximise the net figure whether is ROI, RI or EVA may harm the company benefits in the future and that's why the non-financial performance is needed in order to solve the short term concerns problem. As Johnson & Kaplan mentioned that should emphasis on improved financial and non-financial measures, and it never ends.

Overall all the financial or non-financial models are just tools to help company measure and evaluate performance. They are all have different use and limitations so the users should choose the most suitable method and use it wisely in order to make improvement in the future.