Preparation lecture 4 (EC 4)
Performance measures
Can you give some examples of 'performance measures’ or KPI's?
Market-based measures
- Stock price
Accounting return measures
- Return on investment (ROI)
Aggregate financial measures
- Net profit
Disaggregate financial measures
- Sales versus last year
External non-financial measures
- Customer satisfaction
Internal non-financial measures
- Employee satisfaction
- Machine downtime
They vary from aggregate (market-based) to specific (internal NFPM)
A performance measure is a quantifiable indicator used to assess how well an organization is achieving
its desired objectives.
Performance measure properties
Which qualities of the performance measure do you (as an employee) find important?
- Sensitivity: The extent to which (the expected value) of
the PM changes with changes in the agent's effort. If you
make more effort, then you want your PM to be higher.
- Precision: The extent to which (the expected value) of
the PM is influenced by factors outside the control of the
manager.
- Verifiability: the extent to which it is ex ante clear how
the performance measure is calculated
(Assume that the green line is true performance)
Which qualities of the performance measure do you (as a CEO) find important?
- Congruence: the extent to which the performance measure reflects contributions to overall firm
value.
,Does the perfect performance measure exist?
Performance measure properties (2)
Performance measures – Moers (2006)
Measuring managerial actions
Which actions can the CEO of Nespresso take to increase firm value?
ACTION KPI
Improving customer satisfaction Net promotor score
Changing prices Price relative to competitors
Making internal processes more efficient Wast form production
Investing in new product development Number of new products per year
Measuring managerial actions
Specific PMs provide information about a subset of actions. Aggregate PMs provide information about
all actions. This is beneficial because...
- Aggregate measures provide incentives to manager for making tradeoffs among the different
actions he/she can take
- Aggregate measures allow the principal to 'naturally’ constrain the manager's actions to those
actions that increase firm value.
- It is very costly to develop and report specific PMs for every subset of actions
It is sometimes difficult to know all the actions a manager need to do to increase firm value
,Aggregate PMs and delegation
Research methodology
- Survey among managers of 6 different firms (collected through Hay Management Consultants)
- Researcher did a lot of effort to ensure a highly valid survey (do not try this on your own for
your MSc thesis)
- 114 fully completed surveys (response rate of 56%)
- Large within firm variance wrt delegation of decision rights and relative use of aggregate
financial PMs (which is good as one can only explain the effect of X on Y if there is variation in X
and Y)
- Delegation: the extent to which respondents have decision-making authority wrt (1) new
product development, (2) hiring and firing of employees, (3) selection of large investments, (4)
budget allocations, and (5) pricing decisions
- Relative incentive use of financial performance measures: the importance of financial PMs for
evaluation purposes, monetary compensation and nonmonetary rewards (relative to
nonfinancial PMs)
- Control variables: environmental uncertainty, size, number of hierarchical levels
Results
Conclusion
- The association between the relative incentive use of financial performance measures and
delegation of decision rights is positively affected by the relative quality of the financial
performance measures
- The extent to which firms delegate decision rights to business unit managers is (at least
partially) determined by the quality of the financial performance measure
, Performance measures – Abernethy et al (2013)
The intertemporal choice problem among managers
- Intertemporal choice problem: managers have a higher preference for actions from which the
benefits are realized at short(er) term
→Everyone has this problem, not only managers
The intertemporal choice problem
Is this a problem?
YES!
- A continuous preference for actions with short-term benefits leads to less attention/resources
for actions that benefit the firm in the medium and the long run
What are the causes?
- Pressure from evaluation systems and outsiders (investors, analysts,…), a general preference for
immediacy, shorter employment horizons of CEOs.
Question?
- Are there performance measures that can help to mitigate the susceptibility of a manager to the
intertemporal choice problem?
Performance measures
- Prior literature: the optimal performance measure approach
o Design the (optimal) performance measure that reduces managerial short-termism as
much as possible
➔ Focus on one performance measure!
- This paper: the balancing approach.
o BU-managers have profit responsibility and are evaluated based on profit measures,
which are known to induce managerial short-termism
o Which other performance measures (accounting return measures, non-financial
measures) should be added so that performance measurement on balance is as
congruent as possible
➔Focus on a set of performance measures!
Performance measures
Can you give some examples of 'performance measures’ or KPI's?
Market-based measures
- Stock price
Accounting return measures
- Return on investment (ROI)
Aggregate financial measures
- Net profit
Disaggregate financial measures
- Sales versus last year
External non-financial measures
- Customer satisfaction
Internal non-financial measures
- Employee satisfaction
- Machine downtime
They vary from aggregate (market-based) to specific (internal NFPM)
A performance measure is a quantifiable indicator used to assess how well an organization is achieving
its desired objectives.
Performance measure properties
Which qualities of the performance measure do you (as an employee) find important?
- Sensitivity: The extent to which (the expected value) of
the PM changes with changes in the agent's effort. If you
make more effort, then you want your PM to be higher.
- Precision: The extent to which (the expected value) of
the PM is influenced by factors outside the control of the
manager.
- Verifiability: the extent to which it is ex ante clear how
the performance measure is calculated
(Assume that the green line is true performance)
Which qualities of the performance measure do you (as a CEO) find important?
- Congruence: the extent to which the performance measure reflects contributions to overall firm
value.
,Does the perfect performance measure exist?
Performance measure properties (2)
Performance measures – Moers (2006)
Measuring managerial actions
Which actions can the CEO of Nespresso take to increase firm value?
ACTION KPI
Improving customer satisfaction Net promotor score
Changing prices Price relative to competitors
Making internal processes more efficient Wast form production
Investing in new product development Number of new products per year
Measuring managerial actions
Specific PMs provide information about a subset of actions. Aggregate PMs provide information about
all actions. This is beneficial because...
- Aggregate measures provide incentives to manager for making tradeoffs among the different
actions he/she can take
- Aggregate measures allow the principal to 'naturally’ constrain the manager's actions to those
actions that increase firm value.
- It is very costly to develop and report specific PMs for every subset of actions
It is sometimes difficult to know all the actions a manager need to do to increase firm value
,Aggregate PMs and delegation
Research methodology
- Survey among managers of 6 different firms (collected through Hay Management Consultants)
- Researcher did a lot of effort to ensure a highly valid survey (do not try this on your own for
your MSc thesis)
- 114 fully completed surveys (response rate of 56%)
- Large within firm variance wrt delegation of decision rights and relative use of aggregate
financial PMs (which is good as one can only explain the effect of X on Y if there is variation in X
and Y)
- Delegation: the extent to which respondents have decision-making authority wrt (1) new
product development, (2) hiring and firing of employees, (3) selection of large investments, (4)
budget allocations, and (5) pricing decisions
- Relative incentive use of financial performance measures: the importance of financial PMs for
evaluation purposes, monetary compensation and nonmonetary rewards (relative to
nonfinancial PMs)
- Control variables: environmental uncertainty, size, number of hierarchical levels
Results
Conclusion
- The association between the relative incentive use of financial performance measures and
delegation of decision rights is positively affected by the relative quality of the financial
performance measures
- The extent to which firms delegate decision rights to business unit managers is (at least
partially) determined by the quality of the financial performance measure
, Performance measures – Abernethy et al (2013)
The intertemporal choice problem among managers
- Intertemporal choice problem: managers have a higher preference for actions from which the
benefits are realized at short(er) term
→Everyone has this problem, not only managers
The intertemporal choice problem
Is this a problem?
YES!
- A continuous preference for actions with short-term benefits leads to less attention/resources
for actions that benefit the firm in the medium and the long run
What are the causes?
- Pressure from evaluation systems and outsiders (investors, analysts,…), a general preference for
immediacy, shorter employment horizons of CEOs.
Question?
- Are there performance measures that can help to mitigate the susceptibility of a manager to the
intertemporal choice problem?
Performance measures
- Prior literature: the optimal performance measure approach
o Design the (optimal) performance measure that reduces managerial short-termism as
much as possible
➔ Focus on one performance measure!
- This paper: the balancing approach.
o BU-managers have profit responsibility and are evaluated based on profit measures,
which are known to induce managerial short-termism
o Which other performance measures (accounting return measures, non-financial
measures) should be added so that performance measurement on balance is as
congruent as possible
➔Focus on a set of performance measures!
