FINANCIAL PERFORMANCE MEASURES

What is Performance measures/ How is it used/ What is its problem:

Use to measure and reflect performance of the division or work unit

Used diagnostically to detect performance issues and take routine
corrective actions to get back on track in line with expectations, there is
no alteration of strategy
The type of PMs used and its associated target can lead to
o Unintended consequences:
Negative behavioural effect
Put individuals under pressure for PMs used and associated
target
PMs problems related to goal congruence:
o When performance is purely measured on divisional level
Encourge mgr to act in best int of own div and not the
company
Not goal congruence
Solution: use a bonus split: 75(division perf) 25(corp
perf) to encourage decision making at division level
that is good for firm
o When a PM is used in isolation
Performance perspective: reflect division performance
Behavioural effect perspective: Encourage ST focus on
meeting target than LT benefit, discourage goal congruence,
encourage dysfunctional decision making

What determines the suitability of the PMs:

1.
2.
3.
4.

Linked to strategy
Consistent with value creation
Structure change, responsibility centre change, PM change
Does PM encourage goal congruence decision the behavioural effect of
PM
5. Performance is measured at what level? inidi, div/ unit, org
If performance measured purely on divisional lvl > goal congruence
problem
6. Reflect managerial control and accountability
7. Be relatively objective, timely and responsive
What are the different responsibility centre and their performance
measure?
Cost centres: manufacturing, supporting, discretionary cost

Cost budget and variance compared to benchmark

Efficiency measures

Revenue centres: sales

Revenue budget and variance compared to sales target

Net operating income, net growth in revenue, customer satisfaction index

Profit centres: Retail sales outlet

Profit plan and variances

Net profit margin, Net operating income

Investment centres:

ROI, RI, EVA = measure returns on investments (profitability performance

of the division/ co)

What are the Financial PMs to measure profitability?

1. ROI= NOI/Total asset
a. Measure returns on investment in percentage
b. Problem:
i. When used in isolation, linked to reward system and on
annual basis
ii. Encourages short term focus on meeting targets than LT
benefit, encourage dysfunctional decision making and
discourage goal congruence
iii. Through:
1. Cost cutting R&D, training, staff
2. Defer asset replacement
3. Not investing in projects due to negative ST impact on
ROI when it is overall good for the company in the long
term
c. Solution:
i. Use a comprehensive set of measurements to measure
performance, balance scorecard that is well balance with
ST/LT measures, F &NF measures
ii. Use alternative FM: RI, EVA
iii. Longer assessment period: 3 years >annually
iv. Manager service history
v. Redefine components of ROI
vi. Create a goal congruence environment
2. RI= NOI (cap charge X total asset)
a. Measures profit left over after charging for asset utilisation
b. Measure return on investment in dollar terms
c. Adds value to the firm
d. Offers a different behavioural effect as compared to ROI
3. EVA = (NPAT+R&D)-(cap charge X asset +R&D-CL)
a. Measure return on investment in dollar terms adjusted for economic
factors
b. Reflect shareholders value
c. Worries about economic profit and asset
d. Add values to the company
e. Limitations:
i. Still has a short term focus on decision making
ii. Base on past performance
iii. Reduce to a single FM used in isolation
iv. Just an alternative FM that is better at the org lvl

v. Offers a different behavioural effect as compared to ROI and

RI
The performance perspective & behavioural effect of PMs

Performance P: All reflect the profitability performance of the division or

work unit
BE: different for each PM
o ROI: manager have a ST focus on meeting target than its long term
benefit> dysfunctional decision making: may not pursue project
because of ST impact on ROI
o RI: manager pursue project because positive ST impact on RI, adds
value to the firm
o EVA: manager pursue project because positive ST impact on EVA,
adds value to the firm
Why the different behavioural effect?
o ROI: worries about existing ROI, if ROI is lower will make
dysfunctional decision
o RI: worries about profit left over, existing ROI doesnt matter, less
likely to make dysfunctional decision although ROI is lower because
the project still adds value to the company
o EVA: worries about economic profits, existing ROI doesnt matter,
less likely to make dysfunctional decision although ROI is low but
projects still adds value to the firm and brings in economic profits
Different PMs have different emphasis thus leading to different
behavioural effect

How to use performance measures diagnostically?

Common use:
1. Set a range of target
2. Measure actual performance
3. Compare the two
4. Use variance to diagnose the performance issue
5. Take routine corrective actions to get performance back on track in
line with expectation/ strategy
If variation is within target range, managers will not be alerted
If variation exceed target range, managers will be alerted to take actions
to improve performance but will not warrant a change strategy
PMs are used diagnostically to implement strategy effectively & conserve
managers attention

NON-FINANCIAL PMS & BSC

What is traditional Finance PMs

ROI, RI, EVA, Profit

Good measure to reflect profitability performance of the division/ manager

Limitations of Financial PMs:

Lag indicators = result based, doesnt provide info on emerging problems

and warning signals
Focus on the past = doesnt identify causes of business performance
ST oriented annual metrics
Unhelpful at operational level
o Bank teller performance measured using orgs EVA, distance
between EVA performance and bank teller activities are too far
apart
o FMs nota suitable measure at operational lvl

We need a more comprehensive set of PMs to measure business performance

What is NF PMs

Leading indicators = the management and monitoring of NF PM leads to

improvement in other measures and outcomes
o Large co track employee engagement index because it is a leading
indicator about organizational performance, if employee feels less
engage, over time it would negatively affect performance
o Monitor and improve customer satisfaction index lead to Increase in
profit
o Monitor and improve market share lead to increase in profit
They are enablers = provide information about organizational activities
Can be developed in many areas: qualitative, productivity,
competitiveness, deliver performance, innovation, supply chain
performance
Can be qualitative or quantitative
o Quantitative: customer satisfaction can be 4.2
o Qualitative: customer seem to be happy when they leave the store

Limitations of NF PMs
1. Difficult to choose the right NF PMs to use
2. Difficult to choose a NF PM that reflects the performance of the div or mgr
(mgr span of control), managerial control and accountability
3. Difficult to measure or quantify

4. The more measures used, the more conflict we have if there is no

integration of measures
What is and why we use BSC?

It is a comprehensive set of ST/LT PMs and F&NF PMs

Measured across 4 perspective: Financial, customers, Internal business
processes, Legal and regulatory
It creates a set of measures that is linked and explains the cause and
effect relationship within an organization between the different measures
and performance
o Improving customer satisfaction, improves sales
o Improving knowledge of workforce, improve revenue
It overcomes limitations of using FPM in isolation

Financial perspective

EVA
Net profit per barrel
Total manufacturing cost per barrel
Net growth in revenue, net growth in ROI, NPM

Customer perspective
Customer satisfactory index
Market share
Internal business process

Cycle time (time to produce a box of beer)

Load schedule
Waste per total production

Learning and growth perspective

Employee engagement index

LT injury free rate
Training hours per employee per year
Hours of community work involved

Limitations of BSC

Difficult to get the right balance of F&NF M

Does the measure reflect the performance of the mgr and div/ the
managerial control and accountability
Does the measure reflect the strategic objective
Is the measure suitable at the different levels within the organization
o Measure suitable for the plant may not be suitable for the co
Difficult to link the strategies and measures to an incentive plan
Common measure bias tend to be bias towards financial perspective
measures so what is the point of the rest?

REWARD SYSTEM and how to DEV REWAD SYSTEM FROM BSC

What factors affect the reward system

Agency issue:
o Senior exec may not act in the best interest of the shareholders ,
not goal congruence unless the incentive plan is structured in a
way that encourages them to act in best int of SH

Evaluation of reward system

1. Who is it for? CEO> senior manager? divisional manager
2. How is it rewarded?
a. Fix pay component fixed annual remuneration
b. Pay-for-performance component ST / LT incentive plan
3. What reward mix?
ST perspective use cash
LT perspective use equity
- Use equity to overcome agency problem, if mgr hold
more equity cause them to think and act in SH interest
- Downside: tempted to increase personal wealth by
altering acc number to maintain or increase share
price
4. What PMs to use? ST/ LT? F/NF?
a. Fixed annual remuneration:
Base on scope of the role and individual performance
b. Short-term incentive plan:
Offer cash incentive
Performance assessed against scorecard measures
c. Long-term incentive plan:
Offer equity incentive: shares and rights awarded with
vesting share criteria
Performance assessed against 3 years financial target
d. PM used link to strategy, consistent with value creation, objective,
timely& responsive, reflect managerial control and responsibility
5. Weightage for managers on different incentive plans changes we go down
the organization:
CEO has more compensation link to LT performance
Manager has more compensation link to ST performance
6. Uses relative performance evaluation:
a. Performance relative to a peer group or benchmark
b. Total SH return vs S&P/ ASX 100 index
Reward system that are structured around bonus pool

Annual shared bonus pool shared among a group of managers

Consideration:
o Size of bonus pool

o
o

How is it distributed
In what form?

Bonus plan
1.
2.
3.
4.

KPM: ROI
Size :
Form: cash
How to distribute:
a. Bonus pool divided between different level of managers
b. Bonus distributed to managers on basis of number of bonus unit
awarded
i. ROI=5%, one bonus unit
ii. For each full percentage point above 5% a further bonus unit
awarded until a cap of 6 bonus unit
iii. Monetary value of bonus unit is found by dividing bonus pool
by total number of bonus unit earned by all managers

Bonus plan evaluation

When bonus plan linked to performance measure

o Mgr want to increase bonus by max ROI, may cause dysfunctional
decision making
Even if mgr ROI increase, bonus may still decrease because other mgr also
has an increased ROI, hence bonus distribution is limited to bonus pool
size

Use BSC to develop a bonus plan

1. Set targets for performance
2. Measure actual performance using a BSC
3. Compare the two and calculate the variance between actual performance
and its associated target
4. Decide the weights to assign to the different perspective and its
measurements:
a. More weights on Financial perspective
b. So award 4 points for every positive variance under the financial
perspective
c. Award 2 points for every positive variance under the rest
d. Calculate the total weighted variance points for each division
5. Use the weighted variance point on manager performance to evaluate
their performance
6. After considering the performance from the BSC and discussing it through
with the managers, the remuneration committee will decide the managers
deserve how much for performance on a scale of 1 -10 , 5 being average
and 10 being outstanding
7. The bonus pool size is decided
8. The bonus is distributed to the manager on basis of the number of bonus
unit awarded:
a. Base on the performance evaluation scale,
b. A performance rate of 5 is awarded 1 bonus unit
c. Every full percentage point above 5 is further awarded 1 bonus unit

d. Monetary value of bonus unit is found by dividing total bonus pool

with the total number of bonus unit earned by all managers.

Problems with using BSC to develop a bonus plan

Difficult to get the right balance of F&NF M

Does the measure reflect the performance of the mgr and div/ the
managerial control and accountability
Does the measure reflect the strategic objective
Is the measure suitable at the different levels within the organization
o Measure suitable for the plant may not be suitable for the co
Difficult to link the strategies and measures to an incentive plan
Common measure bias tend to be bias towards financial perspective
measures so what is the point of the rest?
Difficult to assign weights to the different perspective, how to know which
is more important > may lead to unintentional behaviour to max one pers
@ the expense of another
Arbitrary conversion of the weighted variance points on mgr performance
on to a number of the performance scale index
o There may be possible inadvertent errors
o Intentional bias
o Collapsing the BSC into an arbitrary scale number may cause
disaggregated info on mgrs performance lost
Even if process is fair, manager may not be able to see the causal link
between the performance and bonus

How the BSC can be used as a diagnostic tool or interactive tool

Diagnostically> specify a target range for the variances > as

long as variance within range mgr ignore it, if outside, it
alerts mgr and routine corrective action taken in line with
existing strategy , performance issue may not warrant a
change in strategy unless a long-term trend
Interactively> analyse market trend to identify opp or threats
as early to adj business strategy accordingly , mkt share
interactively focus firm perf relative to competitors >result
inform regular revision and adjustment of business strategy
to enhance competitive advantage

REVENUE ANALYSIS : CAUSE OF PROFIT DEVIATION FINDING OUT MORE

INFO
Use market-related data to further analyse the profit deviation

Overall profit variance due to

o Cost variance
Efficiency/ cost variance
Non-variable cost variance
o Revenue variance
Volume
Mkt size, share, product mix
Price
Selling price, Variable cost variance, NV cost variance
By comparing the flexible budget and the profit plan we get the variance
for the profit deviation
o WE want to unpack the variance to get more information on what
causes this variance? Why are we selling more or less than
expected?
o The revenue is higher or lower than expected because of volume
effect (competitive effectiveness) or price effect (operating
efficiency). Tell us more about the organizations performance
o WE want to know the proportion of volume and price effect
Using the information we get, we can make better future decisions
o Can use info in a routine fashion to diagnose performance issue and
improve performance
o Can use info interactively to compare performance with
competitors, develop new plans

How to unpack the deviation in profit?

1. The variance between the planned CM and the flexi budget CM, indicates
that profit is higher or lower than expected.
2. This variance can be explained by 2 offsetting components: mkt size , mkt
share and product mix variance
3. Market size variance
a. Given planned market share and standard product CM, company
would have gain XX profit dut to overall gowth in mkt, especially..
b. Fav profit cause by actual mkt size being diff from expected
c. Why?
i. Maybe caused by the external environment like gov subsidy,
cause more ppl to buy, or general increase in demand
4. Market share variance
a. Given act market size, loss of profit due to loss in mkt share
( offsetted by mkt share gain in the other product)

b. UNFAV profit because market share is lower than expected

c. Why?
i. Given growth in mkt size, our mkt share is lower in
proportion. It indicates our organizational performance is not
well. Probably because of managerial performance
5. Overall, this variance analysis tells us that the favourable profit variance is
because market growth is bigger than expected because of ext factors ,
little to do with org performance
6. Product mix variance
a. Chang in avg cm x act unit vol
b. Is due to actual sales ratio of product is different from expected
Whole story

Revenue increase because

o Actual market size is a lot bigger than expected because of external
demand
o But revenue performance is dragged by share market lower than
expected
Manager performance evaluation:
o Cannot hold them responsible for changes in market size outside of
their span of control
o Might look at market share

Use this market info diagnostically,

Say the overall strategy is ok,

But the reason for lower rev performance is due to managerial actions and
decisions
It is a routine assessment, wouldnt cause strategy to change

Use this interactively

Say the info tell us, the deviation may be due to a poor strategy
Trend in poor performance indicate problem with strategy and goals rather
than performance, have to rethink strategy

We look at info differently

BUDGETING for expenses & PROFIT PLANNING

Profit planning
1. Company has some strategies
2. Gave some expectations: targets, goals
3. Ask us what they should do?
a. So we analyse the alternate course of actions
b. And the financial impact of it
c. Eg. We drop some products because demand not going strong
forward, what is the financial effect
d. Question do our strategy create value? Enuf value to attract sh and
lenders? Do we have enuf cash to fund the strategies
4. Make a conclusion on actions that should be taken
5. And prepare budget
3 wheels of profit planning

Cash: sales> ac receivable > opt cash > inventory

Profit: sales >opt exp> profit> investment in ass
ROE: profit> asset utilization> ROE> Shhs eq
It highlights the connections btwn the different financial constructs

Planning and budgeting for different cost centres: difficulties with

aspect of planning and budgeting

Engineered cost centres:

o Production
o We know the OP no can plan for IP no
o Relationship between OP and IP is engineered
o Can easily plan for budget
Discretionary cost centres
o RND
o Harder to plan because
o There is not a clear and direct relationship btwn OP no and RND exp
o Harder to plan, need to make discretionary decision on how much
should we budget the RND expense for
o Usually we use the incremental budgeting
o But we can use the program budgeting to structure budgets around
projects than funding a total amount to the department

STRATEGIC CAPITAL INVESTMENT

Classification of investment

Regulatory investment:
o due to reg compliance
o go for lowest cost, most cost effective way
Operational investment:
o Asset replacement, enhance operating efficiency, increase
capacity , upgrade
o Use CAPEX decision model: NPV, IRR, PP, ARR fine provided all
relevant data are incuded
Strategic investment:
o Investment in new tech, new mkt, new products that involve change
in strategy
o Eg: acquisition, merger
o Goggle bought utube for 1.6 bil as a strategic decision to diversify
business
But just breaking-even so why investment?
What was the decision model that they used?

Decision models used to analyse investment

CAPEX decision model

o Traditional tools
o NPV measure time value of money, is a rough estimation of
expected future CF in dollars , might not be accurate and objective
o IRR measure time value of money in %
o PP time taken to recover investment , used in conjunction with
others , easy to use at screening stage
o ARR- link to our financials
Cost-benefit analysis
Simulation
Sensitivity analysis

Evaluating strategic investment

CAPEX might not be adequate or suitable because

o The strategic issue is at the forefront
o Financial tools show that it doesnt generate positive returns
o Uncertainty in future cash flow streams
o Short term benefit hard to quantified and isolate
o Large outlays, long payback period , benefits that comes in the later
part of the CF stream is penalized by the Discounted Cash Flow
analysis
o Doesnt capture other benefits like high quality, shorter lead time,
environmental imact because they are hard to quantified
o Doesnt capture the synergies of the investment that might flow to
other parts of the business because it is hard to quantified and
show its financial effect
o Ignores the moving-baseline risk, risk of not investing.

DCF presumed that not investing means there is a

continuation of cash flow stream. But cannot assume that,
because if we dont invest we might fall behind our
competitors , so donot invest becomes declining cf
So other than financial tools we need to include non-financial
tools into our decision making model:
1. Alignment of proposal with strategy
2. Risk of moving-baseline
3. Reputation impact
4. Impact on employees (cultural fit), customers and mkt
5. Impact on structural cost drivers (scope, scale complexity)
a. When virgin add new international line ned to increase
scope, scale and complexity
6. Capability and ability of managers
7. Synergies and integration with other parts of the business
8. Quality of the info supporting the proposal
9. Feasibility and cost of reversing the decision
10.Sustainability effect(environmental, social, ethical)

So types of information to include in our decision making model:

1. Financial information: NPV, IRR, PP, ARR
a. Cash flow based
b. Non-cash flow base
2. Non-financial information
a. Quantitative
i. Non-monetized : quantified on a scale on index not dollar
terms
ii. Monetized: in dollars
b. Qualitative
i. Judgement, intuition
Decision framework
1) What are the components of the decision making model ? factors

We have 2 components
Financial: NPV, IRR, PP, ARR
Non-F : Effect on community, effect on environment, synergies &
integration with other parts of the business, strategic fit, cultural fit,
impact of changes in management, competitive effect (buy skype ,
google canot buy), employee fit, feasibility and cost of reversing
decision, alignment with strategy, reputation impact, impact on
structural cost drivers, risk of moving baseline, quality of info

2) Are the components qualitative or quantitative?

o
o

Financial tools are quantitative

Non-F tools can be both quali or quanti:
Strategic fit can be quantified by measuring on a scale of 1-5
Or can be qualitative by basing it on judgement

3) How is it accounted for in the evaluation process:

At the start: strategic fit which is about judgement

Screening process: PP
Analysis process: Financial tools that require calculation

Lecture 11: Risk management

o Type of risk: Strategic, Operational, Financial, Legal and regulatory

o
o

What each entails and examples

>>How to manage these risk:
Set conduct barrier and belief system
Set internal control
Market analysis?
>>Potential risk or risk profile:
Strategic risk: impediment in achievement of hgh lvl goals
aligned with and support mission
Mkt-related activitiy: supplier behaviour, customer
change preference, availability of substitute products ,
mkt trends, consumer health concern
Competitive dynamics
Techno innovation
Operational risk: anything that damage the co ability to
provide product and services
Extent of formalized procedures and protocol
employess ability to follow protocol
co ability to safeguard asset and info
ability to response to crisis
cyber security
damage due to natural events
production process need to comply with strict practices
security to prevent contamination
impact of changes in key personnel
avoid mistake in processes
Financial risk: exposure to & potential shortfall in liquidity
Financial crisis
Increase in input cost due to natural events
Potential reduction in CF
Risk of acquisition/ foreign investment
Foreign exchange risk, hedging
Impact of acquisition of leverage and gearing levels
Legal and reg: exposure to & ability to comply with applicable
and impending law and reg
Food and safety law
Lending reg
Consumer protection
Banking and finance reg
Foreign invst law
Irrigation law
Livestock law
Export law
>>How to manage risk:
Set conduct boundaries through code of conducts: what
cannot do
Set belief system
Set internal control, structural safeguard: clear line of
hierarchy authority, system safeguard: transaction timely,

accurately securely recorded and reported, staff safeguard:

enough training, job rotation, special assignment
Minimize market-related strategic risk
Scan mkt, swot analysis
Attend org meeting and networking event wif
competitors
Minimize operational risk

Conduck internal system checks