PERFORMANCE MEASUREMENT AND
VALUE BASED MANAGEMENT
Part II of a series on Value Based Management


Introduction

In the article on Value Based Management (VBM) in the December 1999 edition of Focus Magazine, we described a broad framework of tools.  The purpose of VBM is to create a holistic measurement and management mechanism that is designed to facilitate improved organization performance.  In VBM, as we describe it, we embrace methodologies such as strategy development, Balanced Scorecard, Activity Based Costing, process management and best practices, all of which involve significant measurement efforts. This article will focus on measurement as a key management methodology with which to drive organization performance within the context of VBM.

Value Based Management is a term that is being popularized by consultants and management journals.  Even Dilbert [1] referenced VBM in a recent cartoon.  To many people in Europe, and to a lesser degree in North America, VBM relates to deployment of the logic of Economic Value Added (can’t use the acronym because Stern Stewart copy- righted it), Shareholder Value Added (SVA) or Market Value Added (MVA).  All of these determine the relative value of earnings to the cost of money. In each case, SVA, MVA and Economic Value Added are a measurement.  In other words, when defined this way, VBM is about the focusing of managers’ energy to apply organization efforts towards maximizing financial performance.  Furthermore, these financial measures are applicable only to commercial, for-profit organizations.  Other financial measures are more appropriate for government and not-for-profit organizations.


[1] Dilbert, The Comic Zone, created by Scott Adams.  1998 United Feature Syndicate, Inc


Financial analysis is very important to the development of adequate measurement systems. Revenue growth and optimal cost represent the primary operational drivers of financial value creation.  Dupont analysis can be used to decompose the primary drivers into their component parts:

Revenue Growth - New Revenue Sources
- Increased Profitability from Existing Clients

Optimal Cost - Lowest Cost
 - Increased Asset Use

It is critical that disciplined and complete measurement information be available to address value creation and profitability by product and customer, as well as in aggregate for the entire organization. Solid financial and profitability analysis is an important first step in deploying VBM. It becomes the basis of operational and non-financial measures and decisions, such as number of employees to hire and facilities to build. If the outcome of value creation is improved financial performance, then the management component of VBM relates to the mechanisms used by managers to facilitate value creation. Managers are responsible for each of the drivers of value.  They are required to make decisions based on the information available to them.

In the VBM methodology,  management undertakes a series of analytical and planning steps for all significant aspects of the organization. These begin with identification of key stakeholders and an understanding of their needs, coupled with strategy development to create a clear understanding of critical success factors and goals for the organization. Value in this case is defined by the needs of key stakeholders, prioritized by strategy. Management also undertakes analysis of operational and economic performance, in order to gain a clear understanding of their current position. These analyses establish the foundation on which to base change initiatives and to create plans and forecasts of future operations.  Goals are described in terms of measures, their current performance, desired performance and a vector for their accomplishment. Performance measurement, therefore, is a fundamental aspect of VBM.

The Only Reason For Measures Is To Influence Human Behavior

Performance measurement is generally acknowledged to be critical to the successful operation of any organization.  Goals are defined by expected results and described in terms of measures.  Measures establish a vehicle for communication with which managers describe expectations to each other and subordinates in precise and understandable terms. Measures and numbers represent the language of business.  Using this language, people agree on what performance is expected of them, and then they adjust their behavior sufficiently to ensure achievement of the desired results.  Indeed, the only purpose for measuring something is to influence human behavior. Therefore, to maximize performance, there must be a clear articulation of expectations (which are detailed with measures and goals) and then actual results are compared to ensure the desired outcomes are accomplished. In the event that results do not match expectations, actions are taken to bring performance in line.

Measures Must Direct Actions

The emphasis in measurement should be on new conditions, future state and desired performance.  There is an old saying “when you don’t know where you are going, any direction will do”.  The inverse perspective being that people must know their destination and be provided with directions and navigational aids to facilitate accomplishment of their goal.  Measures deployment involves detailed planning and analysis of how the organization and its entire workforce must behave in order to achieve their objectives, complete with milestones and feedback mechanisms.  Those who are expected to accomplish them should receive plans, goals and measures in a manner, which is understandable.

Planning, analysis and objective setting processes already exist in most organizations, but often in a fragmented state.  We constantly see managers changing the way in which operations work while continuing to use existing measurement systems.  Indeed, existing measurement systems may represent a big impediment to change and productivity improvement. 

    In a recent example, Service Co., a distribution and service organization, which operates in a number of different countries had a separate profit and loss (P&L) statement for  each country.  Country managers were held accountable for profit and their bonus was calculated accordingly. At the same time competitors had developed lower cost/price solutions and were growing at the expense of Service Co.’s market share.  In response, Service Co. launched a business process re-engineering initiative, designed to create processes that crossed country boundaries. The newly designed process would eliminate duplicated activities, such as infrastructure and administration.

    Over a two year period, Service Co. deployed significant resources in developing creative solutions that would streamline their operations, improve service timeliness, quality and customer satisfaction. Cost would also reduce substantially. Leading up to implementation of the newly designed processes, Service Co. executives resisted recommendations to change the measurement systems to be more broadly focused on the overall network of countries. Specifically, they chose not to abandon country P&L’s in favor of one single management P&L for all countries combined.  (Accountants understand that statutory P&L’s versus management P&L’s need not be structured in the same way.) Country targets would focus on revenue targets rather than profits.  Country managers were asked to implement new process designs, which meant that performance in any individual country would become dependant on the efforts of cross-country/cross-functional processes, and decisions made by centrally co-ordinated managers. Managers agreed that the changes were necessary and were satisfied that they would improve long-term performance.

    Country managers were then told that profit and loss calculation by country and the compensation scheme would remain the same as in the past “because it is too difficult to change the accounting system”. Meanwhile, country managers were being asked to implement process changes that involved them losing direct control of activities that were fundamental to their ability to achieve bottom line targets.  Obviously the solution was unacceptable to them. Country managers, therefore, resisted implementation of the new processes, and delayed it to the point of abandonment.

    Consequently, circumstances overtook Service Co..  Before executives were able to recognize the need to change the measurement system, head office demanded drastic and immediate cuts in cost by reducing the number of employees.  In doing so, the reductions were made within the existing country/functional structures, and caused the existing processes to continue to operate, but with reduced staff.  Thus, the risk of significant service degradation was created. 

    Senior managers failed to recognize how human behavior was affected by the measurement system and compensation scheme . Their unwillingness or inability to change the measurement system to be more aligned with desired operations processes caused the abandonment (at least temporarily) of an alternative and viable solution.  Even though that solution may have delivered satisfactory cost reduction results, and possibly set the scene for long-term growth and success of the business.

The challenge for executives is to ensure that measurement systems facilitate human performance. Also, to make sure that all of the measurement components of the organization are designed and do work together in a single logical framework. 

Financial Vs Non-Financial Measures

Financial measurements continue to dominate business decision-making in all sectors. And with good reason, too.  The purpose of a for-profit business is to make money.  Not-for-profit organizations are either enabled or constrained by the availability of funds. Government organizations are controlled by budgets. Cost is an attribute of resources consumed, revenue comes from customers, for things they want to buy (resources for them), and profit is the difference. Money is the result of doing operational things. Its value is relative to the scarcity and demand for the things that can be bought with it.  Generally Accepted Accounting Rules (GAAP) have been created to manage the counting of money, premised on the needs of regulators, but not necessarily the needs of business managers.  The rules were created in layers, over years, based on theories and social policies, rather than science and any deep understanding of human performance systems. Indeed, some of the concepts and rules of accounting are no longer relevant. 

By definition, accounting rules are designed to influence the behavior of business people.  Therefore, it should be incumbent on accountants to understand the implications of their concepts on organization performance.  This requires accountants to become very involved with the operations of the business, by learning to use new analytical tools, and by learning about non-financial measurement and how to apply it in order to achieve desired financial performance.

Non-financial measures relate to other perspectives or attributes of an activity or process that is to be measured, such as cycle time or cost.  For example, a customer service representative (CSR) may receive and process an order from a customer. As the CSR performs the activity, there will be a certain amount of time which elapses (cycle time), it will consume the efforts of the CSR (cost), it will be performed accurately (quality) and one or more orders will have been processed (quantity).  Each of these measurement attributes has significance within the overall context of the measurement system.

Balance and Perspectives

Operational measures are necessary for directing and monitoring the performance of all functions in any organization.  To be effective, operational measures must use concepts and language that are consistent with the functionality of the people whose behavior they are designed to influence. Each measure must be designed to accomplish a particular objective and to influence a specific individual or group of people to behave in a particular manner. Depending on the level and nature of responsibility of any single individual, they will regard an objective from a different perspective.

Measurements are representations of objects (or events).  Depending on the angle from which a person views the object, it may appear differently.  The different views from which an object is regarded are described as perspectives.  In measures, the concept of perspectives is very important.  A perspective represents the view of the object by a specific person whose interests may be quite unique. Other people will have different perspectives that may be equally valid. For example, from the perspective of owners, measurement of cash flow and return on equity are important indicators of whether their money is invested wisely, whereas an employee may view the same measures from the perspective of whether he/she could be paid more or receive better equipment and training. Therefore, when designing a measurement system it is important to be very aware of all significant perspectives and to ensure measures are created to address them. Creation of a multi-perspective measures system is understood to provide a “balanced” view of the operations of the business.

There are many perspectives in any organization.  We believe that it is useful to attempt to understand what different perspectives exist, which ones need to be monitored and which are less influential.  Different perspectives exist, depending on the relative role of the person or group of people and their relationship to the organization.  For example, owners of a privately held business may have more influence over the operation of the organization, than would the owner of a single share in a publicly traded corporation.  Other people, such as customers, employees or senior executives, each have their own needs from their particular point of view.  Depending on the level of responsibility of a person in a organization, they, too, will have differing views on what they, personally, need to measure.  For example, a department manager may be concerned with monitoring the activities of his/her subordinates.  A manager responsible for the functioning of a process will be concerned with monitoring the performance of the process in total, as well as the performance of the activities of which the process consists.  Meanwhile, senior executives will be concerned with monitoring the performance of the organization overall, to ensure that results of the combined activities and processes is to deliver the desired outcome.

Another important perspective in measures is relative to the timing of the view.  For example, when managers review the results of the most recent business period, they are looking at historical information. Measures that depict historical facts are described as be “lagging” indicators. When managers, however, examine the number of leads generated by marketing initiatives they do so to assess the potential for future revenue. Measures used to identify future performance are referred to as “leading indicators”.

VBM Framework Created a Single Multi-Perspective Measures Framework

Every few years, new measurement and management techniques emerge, they last a while and then something “new” comes along.  Looking at new techniques of the past twenty years, ranging from Total Quality Management, Cycle Time Management to Benchmarking, Activity Based Costing and Process Re-engineering, we find many common threads.  For example, all of them involve identification and measurement of processes and activities.  Other similarities relate to the analytical approach, the need to focus efforts on achievement of strategic objectives, and implementation, by having teams of people work together.  Generally, these techniques are applied as individual solutions to perceived problems, rather than as components of a complete measurement and management system.

VBM provides an integrated measurement and management framework defined by three levels of performance, in an almost mechanical structure (Figure 1).  The levels represent different depths of measurement detail, namely:

1.      Organization – describes the organization entity in a highly aggregate fashion.  Organization performance is equal to the sum of the performance of all of the processes.   Strategy is developed at the organization level. Execution of strategy is a accomplished by taking actions and performing activities.  Organization level measures include such things as ROE, Profit Margin, Customer Satisfaction and Service Level. 

Decisions and measures at the organization level define process measures and change in activities. There is a very clear relationship or linkage between each of the levels.

2.      Process – describes groupings of related activities. Activities in a process usually occur in a number of departments, where the output of an activity becomes the input to the next activity in sequence, across the organization.   Process performance is equal to the sum of the performance of each of the activities within a process.  All organization activities fit within a process of some kind, whether it be operational, administrative or management. Process measures include process capacity, number of errors produced, and cycle time, from the beginning of the process to completion.

Processes consist of sub-processes, aided by support processes.  Support processes facilitate or enable primary processes.  Examples of support processes include

- acquisition of appropriately skilled personnel
– provision of  proper training programs
– provision of appropriate computing and communications technology
– change management/human resources management

3.      Activity – describes the work done by people or machines within the context of a department.  An activity consists of a set of tasks, which have a common activity driver.  An activity is a meaningful level of analysis for which to measure performance. At this level, it is possible to capture information in all key dimensions of time, quality, cost (resources consumed and capacity (quantity).  Because activities are performed and managed within functional departments, they provide a meaningful mechanism with which to analyze job and organization design, as well as to provide a mechanism to perform activity based budgeting.


By
Paul Sharman,
President,
Focused Management Information Inc.

Figure 1.

Because the VBM framework links all of the major analytical components together in an almost mechanistic fashion, it provides context for all measurement to be focused on strategic imperatives and the creation of value. By themselves, these mechanisms are valid and important, but outside of the context of an integrating framework, they are inadequate.  Which is why people say, “we did that and now we have moved on to the next initiative”.  With VBM, the opportunity exists to understand how all of the component mechanisms interact with each other, and to sustain these measurement and management methods together.

Balanced Scorecard

One approach to measuring performance is known as the Balanced Scorecard.  In essence, BSC reflects the logic of a hierarchical, linked, multi-perspective measures system, of the same type that has been described in this article.  In principle, therefore, it fits quite well into the VBM framework.  BSC differs, because it appears to prescribe a limited set of perspectives.

Proponents of Balanced Scorecard use the term perspectives to describe four specific views; namely Financial, Customer, Internal Process and Learning and Growth.  In their model, they have decided that these views are the most important for any organization.  Balanced Scorecard views describe the perspectives of two groups of people.  First, the financial perspective represents the views of owners / investors / lenders.  Customer perspective is self explanatory, because it represents a view of the needs of those who buy goods and services from the organization. These two perspectives represent the views of two of the potentially many stakeholders of any organization. 

Internal process represents a very different kind of view of the organization; it addresses the way in which work is performed. An internal process perspective is a dimensionally different perspective from that of the customer or financial, because it addresses the internal workings of the organization.  Process measures in themselves can be viewed from a number of angles, depending on which people (stakeholders) are affected by the performance of each specific process.  Process measures should be designed to influence the behavior of the people whose actions affect the performance of the process.  Finally, learning and growth represents the view of how the organization and its component parts need to change to accomplish a desired future state.  As with process measures, learning and growth measures are based on the needs (objectives) of the people who have influence over the organization, and should be designed to influence the behavior of people whose actions can affect the achievement of those objectives. 

Conclusion

Performance measurement is a vital mechanism for most organizations, because it is highly influential on human behavior.  Great care needs to be exercised to ensure measurements systems are designed properly.  Measurement and human behavior are not subjects in which most managers have any reasonable level of training or understanding.  As the world makes technological progress with computing and telecommunications, the margin for error has eroded considerably.  Many people sense that competition is more aggressive than it has been before, such that decisions made on one day could lead to the demise of the organization on the next.  With little room for error, managers should be aware of the logic of organization performance and the role of measures.  VBM offers an integrated approach to measurement and management, where the emphasis is on influencing people to behave in a prescribed manner.


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