APM – Chapter 3: Strategic performance measurement
Strategic performance measurement
Key Points to Highlight in Chapter 3
Objective of Strategic Performance Measurement:
- Purpose: Monitor progress towards strategic goals.
- Focus: Long-term strategic objectives and goals.
- Outcome: Informed decision-making, strategic alignment.
Characteristics of Effective Strategic Performance Measures:
- Relevance: Aligned with strategic objectives.
- Timeliness: Provide timely and actionable insights.
- External Factors: Reflect both internal and external influences.
- Complexity: May not always be easily measurable.
Purpose of Strategy Map:
- Visualization: Represents strategic objectives and relationships.
- Communication: Communicates strategy to stakeholders.
- Alignment: Aligns activities with strategic goals.
Balanced Scorecard Approach:
- Focus: Incorporates both financial and non-financial measures.
- Perspectives: Financial, customer, internal processes, learning and growth.
- Benefits: Comprehensive assessment, strategic alignment.
Role of Benchmarking:
- Purpose: Identify best practices and areas for improvement.
- Comparison: Against industry peers or best-in-class competitors.
- Insights: Inform performance improvement efforts.
Advantages of Leading Indicators:
- Predictive: Help forecast future performance outcomes.
- Proactive: Enable early identification of trends and risks.
- Forward-looking: Focus on future performance.
Non-Financial Indicators:
- Focus: Assess innovation, adaptability, customer satisfaction.
- Complement: Financial indicators for a holistic view.
- Insights: Provide insights into organizational effectiveness.
Linking Individual Goals to Strategic Objectives:
- Alignment: Ensure every employee contributes to strategic goals.
- Accountability: Hold individuals accountable for strategic outcomes.
- Motivation: Increase employee engagement and performance.
Customer Perspective:
- Focus: Delivery of value to customers.
- Indicators: Customer satisfaction, loyalty, retention.
- Competitive Advantage: Enhance competitiveness in the marketplace.
Continuous Improvement through Feedback:
- Purpose: Provide feedback on performance and areas for improvement.
- Adaptation: Adjust strategies and initiatives based on performance insights.
- Iterative Process: Drive continuous improvement over time.
Operational Indicators:
- Focus: Assess internal process efficiency and effectiveness.
- Improvement: Identify opportunities to streamline processes.
- Productivity: Improve overall organizational performance.
Strategic Planning Support:
- Insights: Provide insights into progress towards strategic goals.
- Adjustment: Inform strategic planning and decision-making.
- Alignment: Ensure strategic initiatives are aligned with objectives.
Rolling Forecast Approach:
- Flexibility: Adapt plans to changing circumstances and market conditions.
- Agility: Adjust resource allocations more frequently.
- Responsiveness: Improve adaptability and responsiveness to changes.
Contribution to Risk Management:
- Identification: Identify and assess risks to strategic objectives.
- Mitigation: Proactively manage risks to enhance resilience.
- Adaptation: Adjust strategies to mitigate emerging risks.
Innovation and Adaptability Evaluation:
- Non-Financial Indicators: Assess organization’s ability to innovate and adapt.
- Competitive Advantage: Drive long-term success and competitiveness.
- Market Responsiveness: Enhance ability to respond to changing market conditions.
Setting Performance Targets:
- Motivation: Motivate and focus efforts on achieving strategic objectives.
- Alignment: Align individual and organizational goals.
- Accountability: Hold individuals accountable for performance outcomes.
Communication and Transparency:
- Openness: Share performance information openly with stakeholders.
- Trust: Build trust and confidence among stakeholders.
- Collaboration: Foster collaboration and alignment towards strategic objectives.
Financial Health Assessment:
- Indicators: Profitability, liquidity, solvency.
- Viability: Assess organization’s ability to sustain growth.
- Investor Confidence: Influence investor decisions and perceptions.
Contribution to Strategic Decision-Making:
- Insights: Provide insights into progress towards strategic goals.
- Informed Decisions: Inform strategic planning and decision-making.
- Adjustment: Adapt strategies to achieve strategic objectives.
Advantage of Strategic Performance Measurement Framework:
- Comprehensiveness: Provides a balanced view of performance.
- Alignment: Aligns measures with strategic objectives.
- Guidance: Offers structure for performance assessment and improvement.
Topic 1. Strategic Performance Measures in the Private Sector
A) Why Shareholders’ Benefits are Primary in Financial Performance
Financial performance measurement in the private sector primarily focuses on shareholder value because shareholders are the owners who take on the risk of the business. They expect a return on their investment, which can come in the form of dividends, share price appreciation, or both. Maximizing shareholder value ensures investors receive an adequate return for the risks they bear. This focus aligns with the primary objective of most private sector businesses, which is to generate profit for its owners.
B) Different Measures of Performance
i) Gross Profit and Operating Profit:
- Gross Profit:
Revenue minus the cost of goods sold (COGS). It indicates the initial profitability after accounting for direct production costs.
- Operating Profit:
Gross profit minus operating expenses. It represents the profit earned from core business activities before considering non-operating items like interest and taxes.
ii) Return on Capital Employed (ROCE):
ROCE measures the profitability of a company relative to the capital employed (debt and equity). A higher ROCE indicates better utilization of capital to generate profits.
Formula: ROCE = Operating Profit / Capital Employed
iii) Return on Investment (ROI):
Similar to ROCE, ROI measures the return on invested capital. However, ROI can use different definitions of investment, such as total assets or shareholders’ equity.
iv) Earnings Per Share (EPS):
EPS represents the portion of profit attributable to each outstanding share. It’s a key metric for investors to assess a company’s profitability per share.
Formula: EPS = Net Profit / Number of Outstanding Shares
v) Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA):
EBITDA removes the impact of financing decisions, tax regimes, and accounting choices on profitability. It helps compare companies across different industries and capital structures.
vi) Residual Income (RI):
RI measures the amount of profit exceeding a minimum required return on capital employed. It reflects the value created by management decisions after considering the cost of capital.
Formula: RI = Operating Profit – (Cost of Capital x Capital Employed)
vii) Net Present Value (NPV):
NPV considers the time value of money and helps assess the profitability of long-term investments. A positive NPV indicates a project is expected to generate value.
viii) Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR):
IRR is the discount rate that makes the NPV of a project equal to zero. It represents the project’s inherent profitability. MIRR considers the cost of capital for reinvesting cash flows, providing a more refined measure.
ix) Economic Value Added (EVA™):
EVA™ is a performance measure that considers the cost of capital and focuses on the economic profit generated by a company. It reflects the value created for shareholders after accounting for all capital costs.
Formula: EVA™ = Net Operating Profit After Tax (NOPAT) – (Cost of Capital x Capital Employed)
C) Importance of Liquidity and Gearing
While profitability is crucial, liquidity and gearing (debt-to-equity ratio) are equally important. Liquidity ensures the company has sufficient cash flow to meet short-term obligations. A healthy gearing ratio indicates a balance between debt and equity financing. Focusing solely on profitability without considering liquidity and gearing can lead to financial distress.
D) Short-Run vs. Long-Run Performance
Short-Run Performance: Focuses on immediate financial results and operational efficiency. Metrics like gross profit margin and inventory turnover are important. Short-run management issues include cost control, working capital management, and meeting sales targets.
Long-Run Performance: Focuses on the company’s sustainability and long-term growth. Metrics like ROCE, ROI, and customer satisfaction are relevant. Long-run management issues include strategic planning, investment decisions, and building competitive advantage.
E) Appropriate Benchmarks
Benchmarks are reference points used to compare a company’s performance against competitors or industry averages. Choosing appropriate benchmarks is vital. Here are some factors to consider:
- Industry sector and size
- Geographic location
- Business model and strategic goals
Topic 2. Divisional Performance and Transfer Pricing Issues
A) Divisional Performance Measures
- ROI: Measures the return on investment for a division, similar to the company level.
- RI: Assesses the value created by a division after considering its capital employed and cost of capital.
- EVA™: Evaluates the economic profit generated by a division
B) Separate Measures for Managerial and Divisional Performance
Divisions are often headed by managers who are evaluated based on divisional performance. However, it’s crucial to distinguish between:
- Managerial Performance: How effectively divisional managers utilize resources to achieve targets set by the company.
- Divisional Performance: The overall profitability and contribution of the division to the company, considering factors beyond managerial control (e.g., market conditions).
C) Need for Transfer Pricing and Design Criteria
Transfer pricing is the price at which goods or services are transferred between divisions within the same company. It’s necessary when:
- Divisions are semi-autonomous and responsible for their own profitability.
- There’s no external market price for the transferred goods or services.
Transfer Pricing Design Criteria:
- Fairness: The transfer price should be fair to both buying and selling divisions, motivating them to make efficient decisions.
- Goal Congruence: The transfer pricing system should encourage divisions to act in the best interests of the company as a whole.
- Minimizing Distortion: The transfer price shouldn’t distort divisional performance measures.
- Administrative Ease: The system should be easy to administer and avoid unnecessary complexity.
D) Alternative Transfer Pricing Bases
- Market Price: The transfer price is set at the prevailing market price for similar goods or services. (Most desirable but not always available)
- Cost-Plus: The transfer price is based on the full cost of production plus a mark-up for profit. (Simple but can discourage efficiency)
- Variable Cost Plus: The transfer price is based on the variable cost of production plus a mark-up. (Encourages efficiency but may not recover all fixed costs)
- Negotiated Price: Divisions negotiate a transfer price that is mutually agreeable. (Can be time-consuming but fosters collaboration)
E) Transfer Pricing in Multinational Companies
Transfer pricing in multinational companies (MNCs) requires additional considerations:
- Tax Minimization: Companies may try to manipulate transfer prices to minimize taxes in high-tax countries.
- Currency Fluctuations: Fluctuations can impact the profitability of divisions involved in international transfers.
- Transfer Pricing Regulations: MNCs need to comply with regulations in different countries to avoid penalties.
Topic 3. Strategic Performance Measures in Not-for-Profit Organizations
A) Diversity in Objectives
Not-for-profit organizations have diverse objectives depending on their mission. Here are some examples:
- Charities: Focus on social impact and maximizing donations used for their cause.
- Hospitals: Aim to provide quality healthcare services while managing costs effectively.
- Educational Institutions: Strive to deliver quality education and achieve student success.
B) Measuring Outputs in Non-Monetary Terms
Measuring performance in non-profit organizations can be challenging as outputs may not be easily quantifiable in monetary terms. Here are some approaches:
- Activity Measures: Counting the number of people served, programs delivered, etc.
- Outcome Measures: Assessing the impact of services on beneficiaries (e.g., improved health outcomes, educational attainment)
- Client Satisfaction Surveys: Gathering feedback on the quality and effectiveness of services.
C) Benchmarking in the Public Sector
Benchmarking is used to compare public sector performance against similar organizations. League tables are a common form of benchmarking. However, it can have unintended consequences:
- Focus on Short-Term Gains: Organizations may prioritize meeting league table targets over long-term strategic objectives.
- Gaming the System: Organizations may manipulate data or focus on narrow metrics to improve their ranking.
- Reduced Client Focus: Overemphasis on league tables can divert attention from meeting individual client needs.
D) Politics and Targets in Public Service
The combination of political pressure and the desire to measure performance can lead to undesirable service outcomes:
- Target Obsession: Overemphasis on meeting unrealistic targets can compromise service quality.
- Focus on Quantity over Quality: Targets may encourage quantity-based approaches that neglect the quality of service delivery.
- Short-Termism: Political cycles can lead to a focus on short-term targets rather than long-term service improvement.
E) Value for Money Service Provision
Value for money (VfM) is a key concept in assessing performance in the public sector. It involves delivering the best possible outcomes for the resources available. VfM considers:
- Efficiency: Minimizing costs to deliver services.
- Effectiveness: Achieving desired outcomes with the services provided.
- Equity: Ensuring services are distributed fairly and equitably.
Topic 4. Non-Financial Performance Indicators
A) Interaction with Financial Performance Indicators
Financial performance indicators provide a quantitative measure of profitability and solvency. However, they don’t capture the entire picture. Non-financial performance indicators (NFPIs) offer insights into:
- Customer Satisfaction: Measures customer loyalty and perception of service quality.
- Employee Engagement: Assesses employee morale, motivation, and productivity.
- Innovation: Tracks the development and implementation of new ideas.
- Sustainability: Measures the organization’s environmental and social impact.
NFPIs complement financial indicators, providing a more holistic view of organizational performance.
B) Significance of NFPIs for Employees and Product/Service Quality
- Customer Satisfaction: High customer satisfaction leads to repeat business, positive word-of-mouth referrals, and brand loyalty.
- Employee Engagement: Engaged employees are more productive, provide better customer service, and contribute to innovation.
- Product/Service Quality: Tracking quality metrics helps identify and address issues, leading to improved customer satisfaction and brand reputation.
NFPIs related to employees and product/service quality are crucial for long-term competitive advantage.
C) Difficulties in Interpreting Data on Qualitative Issues
NFPIs often deal with qualitative data, which can be challenging to interpret:
- Subjectivity: Data may be influenced by personal opinions and biases.
- Comparability: Standardizing NFPIs across different departments or organizations can be difficult.
- Actionable Insights: Extracting actionable insights from qualitative data requires careful analysis and triangulation with other data sources.
D) Brand Awareness and Company Profile
Brand awareness and company profile impact business performance by:
- Influencing Consumer Choice: Strong brand awareness can lead to increased customer preference and market share.
- Attracting Talent: A positive company profile helps attract and retain top talent.
- Commanding Premium Prices: Strong brands can command premium prices for their products or services.
Investing in building brand awareness and a positive company profile can enhance long-term performance.
Topic 5. The Role of Quality in Management Information and Performance Measurement Systems
A) Japanese Business Practices and Management Accounting Techniques
Several Japanese business practices and management accounting techniques emphasize quality and continuous improvement:
- Kaizen Costing:
Focuses on continuously reducing the cost of production while maintaining quality.
- Target Costing:
Sets a target cost for a product or service based on the desired selling price and a targeted profit margin.
- Just-in-Time (JIT):
Aims to minimize inventory holding costs by receiving and producing materials only when needed.
- Total Quality Management (TQM): A holistic approach to quality management that emphasizes continuous improvement in all aspects of the organization.
B) Quality Management and Performance Measurement Strategy
Quality management is integral to an organization’s performance measurement strategy. It involves:
- Defining Quality Standards: Establishing clear expectations for product, service, or process quality.
- Monitoring and Measuring Quality: Tracking performance against quality standards using appropriate metrics.
- Continuous Improvement: Identifying and implementing ways to improve quality over time.
- Cost of Quality: Understanding and managing the costs associated with quality, including prevention, appraisal, failure, and internal failure costs.
C) Need and Characteristics of Quality in Management Information Systems
High-quality management information systems (MIS) are essential for effective performance measurement. Key characteristics include:
- Accuracy: Information should be free from errors and reflect reality.
- Relevancy: Information should be relevant to the decision-making needs of users.
- Timeliness: Information should be available in a timely manner to be actionable.
- Completeness: Information should provide a complete picture of performance.
- Security: Information systems should be secure from unauthorized access and data breaches.
D) Six Sigma and DMAIC
Six Sigma is a quality improvement methodology focused on minimizing defects and achieving near-perfect performance. It utilizes the DMAIC (Define, Measure, Analyze, Improve, Control) cycle:
- Define: Define the problem or opportunity for improvement.
- Measure: Measure the current performance level using relevant data.
- Analyze: Analyze the data to identify root causes of problems.
- Improve: Develop and implement solutions to address the root causes.
- Control: Monitor and control the process to ensure sustained improvement.
Topic 6. Performance Measurement and Strategic Human Resource Management Issues
A) HR Management and Performance Measurement
Performance measurement plays a crucial role in HR management:
- Performance Rating: Evaluating employee performance against established goals and competencies. This data can be used for:
- Identifying training and development needs.
- Making decisions about promotions and compensation.
- Providing feedback and motivation to employees.
- Suitable Remuneration Methods: Linking rewards to performance can incentivize employees to achieve organizational goals. Here are some remuneration methods:
- Performance-related Pay: Salaries or bonuses based on individual or team performance metrics.
- Profit-sharing: Sharing a portion of company profits with employees based on overall performance.
- Stock Options: Granting employees the right to purchase company stock at a predetermined price, aligning their interests with shareholders.
B) HR and Corporate Strategy
HR practices should be aligned with the organization’s corporate strategy. The Building Block model illustrates this relationship:
- External Environment: Factors like market conditions, technology, and competition.
- Strategic Objectives: The long-term goals of the organization.
- HR Policies and Practices: Recruitment, training, compensation, and performance management practices.
- Outcomes: Employee satisfaction, engagement, and contribution to achieving strategic objectives.
C) Reward Practices and Performance Measurement
Linking reward to performance measurement can have both advantages and disadvantages:
Advantages:
- Motivation: Rewards can incentivize employees to achieve higher performance levels.
- Alignment with Strategy: Performance-based rewards can encourage behaviors that support the organization’s strategy.
- Employee Engagement: Recognition and rewards can increase employee engagement and satisfaction.
Disadvantages:
- Short-Termism: Overemphasis on short-term performance measures can discourage long-term strategic thinking.
- Gaming the System: Employees may focus on manipulating metrics to get rewards rather than genuine performance improvement.
- Internal Competition: Performance-based rewards can create unhealthy competition within teams.
Topic 7. Other Behavioural Aspects of Performance Measurement
A) Accountability Issues
Performance measurement systems can raise accountability concerns:
- Sandbagging: Employees may deliberately underperform in the planning stage to make targets appear easier to achieve.
- Focus on Metrics over Outcomes: Overemphasis on specific metrics can lead to employees neglecting other important aspects of their job.
- Gaming the System: Employees may manipulate data or find loopholes in the system to improve their performance metrics.
B) “What Gets Measured, Gets Done”
The statement “What gets measured, gets done” highlights the importance of performance measurement. When activities are measured and tracked, they receive more attention and resources. However, this statement has limitations:
- Focus on Measurable Activities: Important but less measurable activities may be neglected.
- Unintended Consequences: Overemphasis on measurement can lead to the issues mentioned in section (a).
C) Management Style and Performance Measurement Systems
Management style should be considered when designing performance measurement systems:
- Autocratic Style:
May require top-down performance measurement with clear targets and controls.
- Participative Style:
May involve collaborative goal setting and performance measurement with employee input.
- Laissez-faire Style: May require less formal performance measurement systems with a focus on self-management.
Effective performance measurement systems need to be adapted to the specific management style and organizational culture.
Conclusion
This in-depth content provides a comprehensive overview of the topics covered in the ACCA APM Chapter on Strategic Performance Measurement. It incorporates extensive theories, illustrations, and practical considerations for each topic. By understanding these concepts, future accountants can design and implement effective performance measurement systems that support organizational goals and contribute to long-term success.