Examining Contingency Approach and Performance Measures

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A performance measurement is used to evaluate the performance of organization and managers. Because of technology improvement, the performance measurement systems can now encompass and support speedier access to, more detailed information, on a wider range of activities than ever before. On top of data, contemporary information systems now include vast stocks of meta-data. (Gandy and Chapman 1997) (Ahrens and Chapman 2006) However, a lot of organizations fail to think through the relationship between performance management system design and organizational activity.

Contingency Approach

The origin of the contingency approach lies in organizational theory and in the work of Burns and Stalker (1961), Perrow (1970), Lawrence and Lorsch (1961) and Thompson (1967),

(Chenhall 2003) (Langfield-Smith, 2006)

Burns and Stalker (1961) were the first to publish findings that showed the impact of environmental uncertainty on the internal structures of the firm. Their work- The management of Innovation- is based on a study of UK firms. On the basis of this empirical material, Burns and Stalker defined two different categories of divergent systems of management practice: "mechanistic system" and "organic system" The mechanistic system was particularly appropriate for firms operating in stable conditions. This stability made it possible to break down and co-ordinate activities through centralized decision-making with a vertical flow of information. (Nilsson & Rapp, 2005)

The theories of Burns and Stalker were further developed by Lawrence and Lorsch (1967). The authors studied six organizations in the business of developing, marketing and producing plastics material, two in the consumer food industry and two in the container industry. The findings showed that high performing organizations adapted their integration devices to the environment and its characteristics. Another important finding was that within a company different styles of organization could be present. Still another significant contribution to the literature treating the influence of the environment on firm organization is Organizations in Action by Thompson. Unlike the two works previously mentioned, Thompson's approach was primarily deductive. Even in the introduction to the book, he argues that companies are open systems which are affected by uncertainty related to technologies and environment. (Nilsson & Rapp, 2005)

Contingency approaches see organizations changing their performance measures over time to fit their changing circumstances in an attempt to maintain effective operations (Donaldson 2001). In the management accounting research, several contingencies have been found, including: business strategy, company structure, technology and external environment. The following paper will explain each of the element and exam the relationship between these contingency factors and performance measurement.

Business Strategy:

Strategy is a long-term plan that to accomplish company's goals and targets. An organization should begin its strategy formulation with a mission statement. The mission statement should clearly state what the organization wants to accomplish and express how the company exceptionally achieves its targeted customers' needs. Strategy links an organization's mission to its actual activities. It should ensure the "effective and efficient resources allocations are made, an overall riding culture is developed and organizational direction is enhanced" (Koch, 1994)

Building-holding-harvesting approach was introduced by Gupta and Govindarajan. It defined that company chooses different strategy across its life cycle - build, hold or harvest stage. The main purpose to use different strategies are: to mark market share growth or to maximize short-term profit. In the build stage, company emphases on developing market share although it decreases short term profit. In the harvest stage, companies focus on maximizing short term earning and improve cash flow instead of enlarging market share. A hold strategy is applied to sustain market share and also attain reasonable profitability. (Gupta and Govindarajan, 1985)

In addition, Porter (1985) named two sustainable competitive advantages: cost leaser and differentiation to meet the needs of targeted customers. Firms that engage in both of the strategies but fail to use any of them is "stuck in the middle". Usually, these firms are much less profitable then competitors that possess one of the strategy. Cost leadership is the most apparent generic strategy. Company strive to become low-cost provider by pursuing economies of scale, advanced technology, privileged access to raw materials. If the company can achieve cost leadership, they are able to charge low prices through cost efficiencies and make above average profitability. Wal-Mart does extremely well at cost leadership by using its extensive information systems to control its huge customer group located around the world.

Differentiation is a competitive strategy providing its products or services that is unique in its industry from competitors. Differentiation includes providing higher products quality, faster delivery system or using different marketing approach, such as changing brand image and product appearance. The organizations that can achieve differentiation are able to change premium from customers and become above average performer in the industry. (Porter 1985)

Therefore, firms that use cost leadership should emphasize on constricted cost control or performance measurement. The focus on the performance measurement should be how efficient the manufacturing and delivery process is to minimize overhead costs and transaction costs.

In contrast, organizations with differentiation strategy should use a performance measurement system to foster creativity and innovation. Non-financial measures to evaluate the research and development ability, engineering skills, marketing capabilities and customers satisfactions are necessary.

Company Structure

Company's structure is about to combine different levels, different members of an organization or different tasks of the group to ensure the objects or tasks are took place. The president could not possibly do all the company's strategy and works alone. Other people must carry a large share of the management load. The way to share work load is an organizational structure.

The organizational structure reflects the distribution of power and accountability. A good structure can make sure the work is efficient, individuals are motivated, information flow is smooth and control system is properly.

Decentralization means the "delegation of decision-making authority throughout an organization by allowing managers at various operating levels to make key decisions relating to their area of responsibility" (Garrison, Chesley & Carroll, 1993) In management accounting research, structure is considered the extent to which decentralization of authority leads to differentiating activities around profit centers. Centralized firms often have difficulty diversifying operations because top management might lack the necessary and critical industry-specific knowledge. If higher-level management insists on maintaining all authority, then the people who deal directly with the issues are not making the decisions. On the other hand, in the decentralized firms, the authority for decision making is distributed to different personnel. In today's competitive environment, implementation of a decentralized organizational structure is cost beneficial. For decentralization to work effectively, employees may be "empowered" by giving the authority and responsibility to make their own decisions about their work. (Mallouk, Spraakman, Raiborn, Raiborn, Barfield and Kinney, 2007)

Roberts (1990) review strategic adjustment in a big decentralized organization. The high level of decentralization encouraged competition between profit center managers and distanced the head office managers from the changes in market conditions that affected those profit centers. Accounting information was prevailing power in determining managers' activities and connections and made an image of success (Langfield-Smith, 2006).

Companies' structure has important implication for the design of performance measure. For example, a firm may decide to structure into different market and regions. Then, managers may be assigned high or low decision-making autonomy and there may be different degrees of interdependencies between those business units. As the organization increases in size and business become more remote and independent, performance measurement needs to provide assurance to head office management that operations are under control. The performance measurement also needs to need to encourage managers and employees to follow the correct behaviors through proper reporting structure.

Cyert and March (1963) argued that managers are narrow-minded, in their perceptions and responsibilities and tend not to research beyond familiar territory to find solutions to problems. So structure and systems can constrain managers in their search for the best solutions.

Information Technology

In the current business environment, the firm having the highest level of technology and the employees with the skill to employ that technology often finds itself one step ahead of its competitors. Companies have entered the stage of information revolution. New information technologies are becoming less and less expensive and more and more powerful. It is estimated that there is an improvement of 15 to 25 percent in the cost-to performance ration annually. (Heterick, 1993)

Technological innovations have dramatically advanced accounting and other information systems. Even in the smallest companies, accounting, customer and supplier records are computerized in Canada. Computerized record keeping reduces the error rate in recorded data and enhanced data usage for a variety of applications. For example, the time and effort dedicated to prepare financial statements, filling tax documents or preparing budges is substantially reduced when data are recorded electronically.

In addition, the trend to integrate all business systems, such as accounting, production, inventory, marketing and product design. Such systems integration provides a more accurate and complete picture of organizational operations. It also provides the ability to obtain and retain important market information and stay informed about customer requirements. Moreover, systems integration eliminates duplicate systems, allows managers to identify and respond to problems more quickly and facilitates more rapid decision making. (Garrison, Chesley & Carroll, 1993)

Over the past twenty years management control systems research has recognized the importance of technologies such as total quality management (TQM) and just in time (JIT). The objectives of JIT are to obtain materials just in time for production, to move work in process from one work center to another just in time to meet the need of the next work center, and to provide finished goods just when the customer wants them. In a JIT inventory system, a firm does not buy or make a product until a customer has demanded it. This system depends on accurate market data, since a tight linkage is required between sales and production volume. In addition, high-quality production processes are required so that defects can be avoided. JIT production promotes flexibility in production processes, short lead times, short production runs, quick setups and greatly reduced inventory levels. In other words, JIM implies that all materials should be in active use within the manufacturing process in order to avoid "unnecessary" costs. (Raiborn, barfield and kinney, 1996)

TQM is defined as "a structural system for creating organization-wide participation in planning and implementing a continuous improvement process that exceeds the expectations of the customers or clients." (Coate, 1990) TQM is to achieve the goal of continuous improvement through customer focus, process improvement and total organizational involvement. All members of a company striving for total quality management must view the objective of continuous improvement as a routine part of the work environment: it must become a way of life. Improvements should be expected rather than viewed as unusually. As targets are met, new ones should be established. (Raiborn, barfield and kinney, 1996)

Technology represents contingencies for companies because it generates complex and uncertainty. These contingencies present challenges for the design of performance measures since highly formalized financial performance measures could not satisfy the companies' need. Therefore, flexible and open performance measures are required to consist with the continuous improvement and the commitment to change.

External Environment

Environment contains uncertainty that cannot be directly controlled by an organization's management. For example, under the globalization environment, companies involve a changeover in market focus from completion among national or local suppliers to competition among international suppliers. Globalization has not only created marketing opportunities for goods and services, it has also created new vendor sources for production inputs. Therefore, a variety of factors may influence the company's performance. These factors are stability of government and guarantees against expropriation or nationalization; levels of interest rates, inflation, taxes and possible currency restriction and availability of resources such as materials, labor and utilities.

Also, companies have to be aware the legal and ethical standards differences. Laws represent codified rules for a society and violation of laws may be subject to both civil and criminal penalties. Laws are not constant and change over societies. In addition, product and environmental liability are two important legal considerations. Companies in the food and health-related products industries are increasingly being held accountable when their products adversely affect consumers. Similarly, manufacturing and extraction operations are particularly capable of harming the environment. Two large multinational business was bankrupted because of product or environmental liability: Manville, a producer of asbestos and A. H. Robbins, producer of the Dalkon shield birth control device. (Raiborn, barfield and kinney, 1996)

Therefore, evaluating the performances of managers and employees become very difficult because their performance will rely on the things that they have little control. The performance measure should be focus on whether the management is able to design proper contingent approaches to minimize risks and seize opportunities when environmental changes occur.

Performance Measurement

"A performance measurement system provides economic feedback to managers and operators about process efficiency and effectiveness." (Kaplan and Cooper, 1998) Performance measurement, control and evaluation systems in large and small organizations were often considered alongside the impact of computers, which were, at this time, beginning to make inroads into commercial organizations, opening up possibilities for previously unimagined volumes of data processing (Dearden 1966). Because of technology improvement, the management accounting and performance measurement systems can now encompass and support speedier access to, more detailed information, on a wider range of activities than ever before. On top of data, contemporary information systems now include vast stocks of meta-data. (Gandy and Chapman 1997) (Ahrens and Chapman 2006) Over the last ten years, there are a lot of innovations in the performance measurement.

Performance measurements should be selected to be consistent with organizational goals and objectives and to drive managers toward designated achievements. Also, performance measurement systems should be used to support management to perform in the best attention of organization and its subunits. Establishing a performance-reward linkage assures that managers will be rewarded in line with the quality of their organizational and subunit decisions and for their contribution to achieving the organizational mission. Because higher performance equates to a larger reward, the performance measurement system requires specified performance measuring sticks and provide measurement information to the appropriate individuals for evaluation purpose. Furthermore, well-designed performance measurement system should provide a sound foundation for the budgeting process. It may highlight any activities in the budgeting process that provide no tangible benefits so that these activities can be reduced or eliminated and then reduce the time needed for budge preparation. Well designed performance measurement systems help identify the factors that cause costs and performance to be incurred so that more useful simulations of alternative scenarios can be made. Performance measurement system also has reporting elements, providing information to persons in evaluative roles. Performance reports are useful only to the extent that the actual performance can be compared to a meaningful baseline of expected performance. (Mallouk, Spraakman, Raiborn, Raiborn, Barfield and Kinney, 2007)

Financial Performance Measurements

To evaluate high level managerial performance, the type of responsibility center must be considered. If the manager is responsible for only one monetary item, performance measurements are limited to those relevant to that single monetary measure. In contrast, managers of profit and investment centers are in charge of their centers' revenues and profits. Thus, a variety of financial methods have been developed to evaluate performance.

Cash Flow

Cash Flow theory was developed by A. Rappaport in 1986. The cash flow statement reports and analyses transactions that have affected the cash account of the firm during the period under review. It is of critical importance for valuations which focus directly on the future cash flows of the business. An additional advantage of the cash flow statement is that it largely avoids the effects of discretionary accounting policies; this makes it more comparable across companies and can sometimes be more useful than the income statement. The cash flow statement analyses all transactions that go through the firm's bank account and classifies them into three categories: Operational Cash Flow, Investment Cash Flow and Financial Cash Flow. (Bertonche and Knight, 2001) Inadequate cash flow may indicate poor decision making on the part of the entity's manger.

Return on Investment (ROI)

ROI is a ratio about revenue produced from an organization divided by the investment used to generate that revenue. The ROI formula can be used to evaluate individual investment centers, as well as to make intracompany, intercompany and industry comparisons, if managers making these comparisons are aware of and allow for any differences in the entities' characteristics and accounting methods. Reducing costs is usually the firs t approach managers take when facing a declining return on sales. Reducing unnecessary investment often involves selling or writing off unused or unproductive assets. ROI can also be present as profit margin multiply by asset turnover. (Palepu and Healy 2008)

Economic Value Added (EVA)

EVA was introduced by Stewart, G. B. in 1991 to align the interests of common shareholders and managers more directly. EVA is a calculation of the profit generated above the cost of capital. The capital applied in EVA is about the capital invested in the organization instead of asset's fair market value or book value. EVA = After-tax income - (Cost of capital % X Capital invested). (Stewart, 1991)

Financial Performance Measurements and Contingency Approach

Wallace (1998) found that financial performance measures changed managers' behavior in utilizing assets more intensively, decreased new investments and increased payout to shareholders through share repurchases.

Financial performance measurement has to fit the business strategy. Firms in the growth stage, where they are developing markets and position themselves in a relatively complex environments, which have high degrees of uncertainty. Some asset investment values are difficult to measure or assign to investment centers, such as research and development are not capitalized. Also, financial performance measurements are short-term performance measures. For the business in the growth stage, financial measurements punish managers who currently invest in assets that do not generate returns until future periods. Ittner and Larcker (1998) note that in the cyclical industries economic value measures may regularly be negative, even when managers have taken appropriate actions.

Organizational structure also influence the extent to which financial performance measure can be used effectively throughout the organization. If economic value measures are to be used at the level of operational managers, those mangers will require authority over decisions related to the value-drivers that enhance the organization's economic value. Even if managers do have the authority to take decisions to improve economic value, it has been claimed that employees outside corporate headquarters do not understand how their actions affect economic value measures, despite extensive training. (Ittner and Larcker 1998) (Chenhall, 2006)

Non-Financial Performance Measures

Although financial measures offer essential implications of performance, they are not able to solve various new concerns under the new economical environment. A company must focus on performing well in activities such as customer service, product development, manufacturing, marketing and delivery.

Non-financial performance measures include statistics for activities such as on-time delivery, manufacturing cycle time, set-up time, defect rate, customer satisfaction and customer returns. These measures have been used for many years by functional managers, quite often separate from their organizations' main performance measurement system. After nonfinancial measures have been chosen, managers establish acceptable performance levels by providing bases against which actual measurement data can be compared. Nonfinancial measurements directly indicate an organization's performance, such as producing and delivering quality goods and services to customers. Also, as they measure productivity activity directly, nonfinancial measures might forecast the trend of future cash flows more accurately. (Mallouk, Spraakman, Raiborn, Raiborn, Barfield and Kinney, 2007)

Non-Financial Performance Measurements and Contingency Approach

Organization's strategy, especially the key success factors that works toward strategy such as quality, customer satisfaction, manufacturing efficiency and effectiveness, technical excellence and raid response to market demands should be used to choose the no-financial performance indicators. According to the survey of Ittner and Larcker (2003) about 300 executives from more than 60 manufacturing and services companies, the major three reasons of ineffective non-financial performance measures are: measures are not linked to strategy; links to strategy are not validated and the appropriate performance targets are not set.

In many cases it seems intuitively obvious that our ambition should be maximize aspects of performance, such as customer satisfaction. Ittner and Larcker (2005) presented an analysis of the relationship between reported customer satisfaction and positive and negative product recommendation for a personal computer manufacturer. The analysis showed that scoring a 5 (highest) on satisfaction had no incremental effect over scoring a 4, but that scoring a 1 or 2 had a very strong negative effect. (Ahrens and Chapman, 2006)

The external environment is also essential to assess the appropriateness of the non-financial performance. Govindarajan and Gupta (1985) showed that non-financial measures provided enhanced performance benefits on long-term and subjective situation. In the environment with high levels of uncertainty, it is difficult to set target accurately and to measure managerial performance objectively with financial performance measures. Thus, it is suitable to use non-financial performance measures to directly measure the performance in the activities.

Integrated Performance Measure - Balanced Score Card

Financial and nonfinancial performance can be combined to provide an organizational and managerial performance. The balanced scorecard converts organization's strategy into comprehensible measures and targets. It has four perspectives. The criterion "Innovation and Learning" focuses on developing competence, supporting innovation and on keeping employees motivated and committed to the work. "Internal Business" focuses on utilizing resources and competence in the most efficient way through processes and systems. "Internal Business" is measured on short-term basis. The "Financial" criterion focuses on sales, returns on investment, cash flow, contribution and other financial measures. Finally, the criterion "customer" focuses on the external customer, market situation, customer satisfaction and customer loyalty. (Kanji, 2002)

Integrated Performance Measurements and Contingency Approach

The integrated performance measurement is intended to assist in strategic management. However, according to Chenhall (2006), balanced approach will unlikely be achievable in the complex technology environment. The organization's technology presets varying degree of complexity. Less complex technologies have routine process and well-understood tasks, while more complex situations involve tasks that are less routine, less well understood and possibly having high levels of interdependencies across the value chain. This complexity can result in more complex business modeling with a large number of causal connections between strategy and operations. Attempts to build in performance measures to mirror these models can result in a wide diversity of measures. It is possible that this could cause information overload where attempts to manage performance against the measures exceed the information processing capabilities of managers, which at the extreme could result in a decline in performance. With a highly diverse set of measures, managers much decide how they will spread their efforts over the different areas. Ideally, a balanced set of measures will indicate which decision areas should receive priority as the causal connections between performance areas will be clear. If the technology is complex and uncertain, managers will need to make judgments on this trade-offs. (Chenhall, 2006)

Company structure also influences the integrated performance measurement. Ittner and Larcker (2005) reported that measurement activity in many companies was frequently organized as the duty of discrete groups, with measurements built piecemeal over time. Set of measure were frequently comprehensive, covering diverse parts of performance, such as financial performance, customer satisfaction and employee skills. However, those measures were often difficult to integrate in a systematic analysis due to their technical design. For example, in one organization they worked with, different measures had mismatched time periods. One set of weekly statistics was based on a week ending on Saturday, and another ending on Sunday. In the context of a retail chain, in which a significant portion of activity took place over the weekend, this presented a significant problem when it came to statistically analyzing the relationship between the two measures. (Ahrens and Chapman, 2006)


The paper exams different types of performance measurements, including financial measures, non-financial measures and integrated performance measures. Using the concept of contingency approach, the business strategy, company structure, technology and external environment are important when considering the appropriateness of different performance measurements.