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The article, "Coming Up Short", by Christopher Ittner and David Larcker is about the use of non-financial performance measures by companies. Recently, there have been more and more companies using these to positively affect profitability. There can be a great benefit if these measures are used correctly; however, many companies are not realizing these benefits. First, this paper will discuss the advantages and disadvantages to using non-financial performance measures. Next, it will go through an example of an industry that currently uses these measures. Lastly, this paper will discuss how this topic relates to the course of Cost Management Accounting.
Non-financial measures are a relatively new idea for measuring performance and future profits. To start with, this paper will go over the background of non-financial measures. This will be followed by a discussion of advantages and disadvantages. Next, an example will be given of an industry that is required to use non-financial measures. Finally, this paper will discuss how non-financial performance measures relate to the course.
Non-financial measures are measures that use non-monetary units, like the number of dissatisfied customers or the number of on-time deliveries. These can be important to a company because it can affect their strategy and bottom line. This stems from the "belief that social, environmental, ethical, and geopolitical factors materially impact the ability of a company to perform favorably" (Non-Financial Performance Measurements Article). The use of non-financial performance measures are not required for companies as of yet, so there is a great deal of variation in how companies measure and report (Non-Financial Performance Measurements Article). Also, not all corporate activity is money; some things are non-monetary in value (Shaw).
Likewise, analysts that use non-financial information more than financial information tend to create the more accurate forecasts. Indeed, investors' decisions are influenced greatly by non-financial performance information, about 1/3. These non-financial performance measures can include the "perceptions of a company's strategic vision and the company's ability to execute against it, the credibility of management, the prospects of innovations in the pipeline, the ability to attract talented people, and so on." (Low, Siesfeld).
Additionally, the article, "Coming Up Short", by Christopher Ittner and David Larcker discusses the four main reasons why companies are not receiving the benefits of non-financial performance measures. These reasons are:
Not linking the measures to strategy,
Not validating that the links are correct,
Not setting the right performance targets, and
Not measuring the data correctly.
Any one of these problems can cause the non-financial measures to be inaccurate and a waste of time, money and resources to the company. Therefore, it is very important to do this the right way. To counteract these problems, Ittner and Larcker give six ways for companies to get the job done right. The six steps are as follows:
Develop a causal model (also known as a strategy map),
Pull together the data that already exists in the databases,
Turn the data into information by using correlations, multiple regressions, or qualitative analyses,
Continually go back and refine the model for changes in the environment,
Base the actions taken on the findings of the data, and
Assess the outcomes of the measures to see if they were actually helpful.
To begin, there are four main advantages to non-financial performance measures over financial measurements. First, the non-financial measures are better for looking at the organization's long-term strategies rather than the financial measures that focus on short-term or annual strategies. If companies were to include these non-financial measures into their strategy and communicate the objectives to the managers, with some incentives, it would be simpler to address the long-term strategies that are important to the company (Non-Financial Performance Measures: What Works and What Doesn't).
Second, non-financial measures include the "intangible assets" that financial measures do not include on the balance sheet ("hard assets"). Intangible assets are things like intellectual capital and customer loyalty. These can be difficult to quantify; however, one study shows that measures like innovation, management capability, employee relations, brand value and quality account for a large portion of the company's value to customers (Non-Financial Performance Measures: What Works and What Doesn't).
Third, non-financial measures can be better at indicating the future financial performance of a company. As stated earlier, financial measure are not as good at capturing the long-term performance of a firm. Under US GAAP, Research and Development expenditures and marketing costs are to be charged in the period they are incurred and this reduces the profits immediately, instead of spreading this over a period of time. However, non-financial measures would show that successful research could improve future profits (Non-Financial Performance Measures: What Works and What Doesn't).
Fourth, non-financial measures may improve managers' performance by providing improved evaluations of their actions. Managers need to know how their actions affect the success of the company (Non-Financial Performance Measures: What Works and What Doesn't).
To compare, there are five main disadvantages to non-financial performance measures. First, time and costs are a problem. In some cases, the costs can outweigh the benefits of using the non-financial performance measures, so there needs to be a greater benefit than cost to make these measures worthwhile. Also, the development of the correct measures is very time consuming and expensive. Sometimes, the time could be better spent elsewhere (Non-Financial Performance Measures: What Works and What Doesn't).
Second, non-financial data is measured in many ways; there are always different ways to do things and every company and company type is different. Evaluations can be difficult because the things being measured are measured in different ways (time, percentage, quantity) (Non-Financial Performance Measures: What Works and What Doesn't). In addition, the value of using the non-financial performance measures may differ across industries because of the "differences in production functions, competitive environments, agency conflicts, management control systems and the potential manipulability of such measures" (Srinivasan, et. al.).
Third, non-financial measures have a lack of causal links. Most companies do not go in-depth to figure out whether or not the relationship between the measures and objectives is correct. This creates two problems in evaluating performance. One, incorrect measures focus on the wrong objectives, and two, improvements cannot be linked to the outcomes later on. This can cause difficulties in accurately making decisions or measuring success (Non-Financial Performance Measures: What Works and What Doesn't).
Fourth, non-financial measures have a lack of statistical reliability. Meaning, it is difficult to know whether or not the measure is actually measuring what it is supposed to measure, or just getting lucky through random error. Moreover, customer satisfaction surveys generally have very few people answer and have very few questions to answer. This creates poor statistical reliability because there are simple questions and answers for a complex area (Non-Financial Performance Measures: What Works and What Doesn't).
Fifth, there tends to be too many non-financial performance measures put into place. This can cause "measurement disintegration," which is when there are too many measures and it dilutes the effect of the measurement process. In other words, managers try to measure too much and end up gaining little in the important areas (Non-Financial Performance Measures: What Works and What Doesn't).
An example of a company that uses non-financial performance measures is the airline industry; they are required by the DOT to disclose of some of these measures. The DOT publishes certain statistics on 10 of the major US carriers. These statistics include mishandled baggage, on-time arrivals, and customer complaints. Airlines are companies that are very customer satisfaction oriented and so would be more likely to use non-financial measures whether or not required. The airlines have to use long-term decision making and so financial measures may not be able to capture all of the important features. Also, airlines have a lot of capital to account for, like purchasing a plane (a long-term decision). Many of the things that airlines do financially are over multiple decades. Additionally, the market for airlines is based mainly on the customers' decision of which airline to use. This is usually based on price, availability, customer service and satisfaction, the DOT statistics, etc. (Srinivasan, et al).
Relation to Course
In conclusion, non-financial performance measures are relatively new. This paper went over the background of these measures as well as the advantages and disadvantages. It ended with an example of an industry that is required to report non-financial performance measures.