PERFORMANCE MEASURES and the
QUEST FOR THE HOLY GRAIL
Borrowing and expanding upon an image used by Dr. Robert Kaplan and David Norton in The Balanced Scorecard(1), management teams have often functioned in a manner similar to that of the flight crew on a commercial airplane. There is a General Manager, President, or Owner who functions as the pilot. He establishes the flight plan, ensures that everyone has the appropriate equipment to do his or her job, and is responsible for navigating the plane from origin to destination successfully. He relies on a team of other professionals to help him fulfill his mission. One of the key people he relies on is the accountant who functions as a navigator and provides information about speed, altitude, direction, air traffic, etc. to which the pilot reacts.
(1) Kaplan and Norton; The Balanced Scorecard; Harvard Business
School Press, 1996
In the world of air travel this relationship works quite well, because
the navigator has ever-adapting technology and is responsible solely to the pilot. In the
business world however, the accountant is responsible to a diverse range of stakeholders
including, but not limited to, the management team, shareholders, regulators, vendors,
customers and employees. Furthermore, the "technology" that the accountant uses
to generate his or her information has not evolved significantly from the early days of
the industrial revolution.
The information generated by today's financial accounting systems is primarily focused on
the needs of external users of financial information. External users have a vital need for
timely, accurate, and relevant information, and it is important that there be a common
framework, such as generally accepted accounting principals (GAAP) within which to
evaluate the information. However the information generated to meet external needs is not
sufficient or appropriate for internal management.
Management accounting addresses some of these internal needs. However, management
accounting principles are largely an extension of financial accounting concepts, and are
premised on an industrial production environment.
Historically, the financial reporting system has served as the key measurement system.
Although managers developed measures to manage their own domain, those measures have
always been intrinsically linked to the financial system, which served as the final
measure of success. As managers became aware of their need for better information, they
naturally looked for a single answer to replace the financial reporting measures.
This can be an increasingly frustrating quest, as managers try to balance the diverse
needs of different stakeholders, and trade-off between long-term benefits and short-term
costs. There are a number of approaches to solving these measurement issues and a few
leading methodologies have gained widespread acceptance. In spite of the desire for a
single, elegant solution to an organization's performance measurement needs, there does
not appear to be any single, best answer. Managers must understand the core elements of
the leading approaches, and apply them intelligently to their unique business situations.
There is no holy grail that will provide managers with all the answers to every question
through the magic of technology or otherwise.
This series will explore the evolution of performance measurement, and examine the
strengths and weaknesses of today's leading methods, specifically Economic Value Added
(EVAŽ), Balanced Scorecard (BSC), Activity Based Cost Management (ABC) and Theory of
Constraints (TOC). Furthermore, the series will look at the situations that lend
themselves to application of these tools. This first installment will examine the
evolution of current accounting and measurement practices in order to understand where
that evolution has stalled and fails to support management decisions.
Traditional Financial Information
Financial Accounting
The objective of financial statements is to communicate information that is useful to investors, members, contributors, creditors and other users in making their resource allocation decisions and/or assessing management stewardship. Consequently, financial statements provide information about:
a) an entity's economic resources, obligations and equity/ net
assets;
b) changes in an entity's economic resources, obligations and equity / net assets; and
c) the economic performance of the entity.
Qualitative characteristics define and describe the attributes of information provided in financial statements that make that information useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability.(2)
(2) CICA Handbook, Canadian Institute of Chartered Accountants, Section 1000.15 and 1000.18
The first published description of double entry bookkeeping was written
by Luca Pacioli, in Venice, Italy, in 1494. The nature of accounting has remained
essentially unchanged since that time, although it has evolved in response to the massive
changes in the business environment.
The focus of financial accounting continues to be the external user of financial
information to support investment decisions. Any usefulness of the information for
management purposes is purely coincidental. In fact, in North America, the United States
Securities and Exchange Commission (SEC) continues to be a leader in influencing the
development of accounting standards. The recommendations published by the Federal
Accounting Standards Board (FASB) are often in response to queries raised by the SEC.
Management Accounting
Management accounting can be described as the process of identifying, measuring, accumulating, analyzing, and communicating financial information, which is used by management to plan, evaluate and control an organization. Management accounting is also responsible for the appropriate use of, and accountability for the resources of the firm.(3)
(3) Srikanth, M., and Umble, M., Synchronous Management Profit-based Manufacturing for the 21st Century
Management accounting seeks to interpret the actions and decisions of an
organization in financial terms. Many critics have argued that the financial focus of
traditional management information leads to decision making with exceptionally short time
horizons. In order to maximize current profits and return on investment, companies have
over-invested in short-term assets and under-invested in long-term assets and
technologies. These decisions have impaired the long-term viability of the firm.
Traditional management accounting focuses on cost management. Using a framework that was
established during the early industrial age, the emphasis is placed on the management of
"direct costs", which is defined as materials and direct labour. Indirect costs
that relate to production or delivery of goods and services are applied on an arbitrary
basis to all products, in ways that assigns each product its "fair" portion of
cost. Usually this means applying the overhead as a percentage of direct labour or some
other algorithm. The logic behind this approach is premised on two critical assumptions:
1. All cost must be attributed to products
2. Overhead costs are not material
As we move away from a production driven economy that relied heavily on direct labour
towards a service driven economy (Exhibit 1), both of these assumptions begin to collapse.
EXHIBIT 1
David Rombough
In spite of the evident shortcomings and limitations of traditional accounting systems, financial accounting still serves a critical role in communicating the results of decisions and transactions to shareholders and debt holders. These users require a common framework against which to evaluate corporate performance. Generally accepted accounting principals will continue to provide a key role in how financial information is gathered and reported to external users.
In addition, the legacy information systems developed to support traditional financial reporting requirements often serve as the starting point for more advanced performance management systems. In order to generate traditional financial information, companies have been required to gather information regarding labor productivity, material usage and scrap, machine costs and utilization, and operating expenses. This information regarding how organizations choose to spend and consume resources is crucial for any performance management system.
The Quest for Solutions
As noted earlier, there has been a growing acknowledgment that traditional performance management and cost systems are not providing timely, accurate, and relevant management information. As a result, a number of different performance measurement systems have touted themselves as the key to focusing management on the key levers of success including:
Economic Value AddedŽ (EVAŽ)
Activity Based Management (ABM)
Theory of Constraints (TOC)
Balanced Scorecard (BSC)
Some of these initiatives not only tout their own benefits, but also
exploit the shortcomings of other systems. Each system has its own inherent shortcomings,
and in certain circumstances will lead to poor decisions if used in the wrong context, for
example:
- TOC or ABC alone can lead to sub-optimal product mix or
capital investment decisions
- A balanced scorecard may have unforeseen consequences if
people do not understand the context of the measures or if performance controls are not in
place.
- EVAŽ Also referred to as Economic Profit) may be difficult to communicate to divisional managers as they may only have control of certain element of the equation.
In spite of their individual limitations, used together, these four
initiatives can provide a comprehensive view of the company. There is a no performance
measurement "holy grail", and no one measure against which an organization can
monitor the implementation of strategy and the relative success or failure of that
strategy. These are in fact all linked and complementary systems with interdependence
between each system.
The inclusion of TOC in this group may be surprising to some. Many consider TOC be an
operational management approach. However, TOC is implicitly important to a discussion of
performance measurement due to the fact that it encourages organizations to focus on
maximizing throughput. In so doing it focuses measurement systems on throughput and
constraints.
As we will discover in future installments of this series, all of these methodologies are
intrinsically linked. The goal of most organizations is to make money. This money is
ultimately returned to the investors in the form of debt payments, dividends or share
redemption. In order to attract capital, the company must execute a strategy to generate
the greatest cash returns to these investors. Therefore economic profit is the ultimate
measure of the organization's success or failure. Economic profit is, however, a result of
managing the activities of the organization in different "balanced" dimensions.
Therefore, there is a requirement to understand and align the activities of the
organization with the strategic direction. These activities must be managed to maximize
the economic profit of the enterprise, while addressing the needs of diverse stakeholders
and ensuring long-term returns in addition to short-term performance.
While each of these approaches has strengths and followers who will attest to the wonders
that the application of these tools can reap for an organization, each has limitations,
and in fact must be integrated with elements of other methodologies to succeed.
Furthermore, if any of these methodologies is implemented in isolation, or implemented
poorly, there can be unexpected and potentially damaging results for the enterprise.
In the next issue, we will examine the trade-offs between Activity Based Cost Management
and Theory of Constraints. We will examine the impact on long-term planning and product
mix decisions in particular.
In the third installment, EVAŽ and Balanced Scorecard will be compared as ways of
monitoring, measuring and influencing organizational performance.
Article to an up-coming issue