Question

When only a single measure of performance is used, the measure tends to become an end in itself,
more important than the economic performance that it attempts to represent. Discuss the problems
which could arise in the context of the aforementioned statement. (30 marks)

The complex environment in which many modern businesses operate makes it impractical for any but the
smallest firm to be centralized. Some degree of decentralization will be vital to capture the benefits from
the specialized information and response flexibility of local managers. Decentralization is the practice of
delegating decision-making authority to the lower levels. In decentralized units, the discretion of selecting
and implementing actions reside with the manager. However, there is difficulty in the specification of a
local performance measure, which will be required to guide the decisions and assess the performance of
managers and their centres. Despite the benefits that can be derived from decentralization, it is not without
its shortcomings. In the context of performance measure, when only a single performance measure is used,
the measure tends to become an end in itself, more important than the economic performance that it attempts
to represent.
A response to complex business organizations is to emphasize central control. In reality, no central
management can possibly know everything about an organization’s many activities and thus cannot make
all the decisions. Therefore, some decisions will have to be made at the local level. However, there is a
challenge in balancing the cost and benefits from decentralized decision making. Good management relies
on a reconciliation of decentralization with coordinated control.
Successful managers must continuously track key variables in the external environment so that the firm can
act before external events overwhelm them. The contingency theory predicts that the complexity of a firm’s
environment will determine the complexity of the firm’s internal structure. T. Burns and GM Stalker
discovered a predictable relationship between the external environment and the firm’s management
structure in their study. Their study revealed that when the external environment is stable, the internal
structure is mechanistic whereas, in rapidly changing environments, the internal structure is organistic.
Decentralization is important because of the need for information specialization, timeliness of response,
conservation of central management time, computational complexity as well as the training and motivation
of managers. Present practice provides evidence of five types of decentralized operating units, namely,
standard cost, revenue, discretionary expense, profit and revenue centres.
Standard cost centres can be established when output can be measured and the input required to produce
each unit of output can be specified. This centre will be useful when we can objectively measures output,
including timeliness and quantity of physical units. Revenue centres may be responsible for the setting of
selling price. The responsibility entrusted to it will determine on what it is evaluated. If pricing policy is
determined within the ambits of the centre, it will be evaluated on gross revenues whereas, if the centre has
no price setting responsibility, it will be evaluated on physical volume and sales. When a performance
measure is chosen for a revenue centre, the centre should be motivated to maximize gross operating margins
rather than just sales revenue. If evaluated solely on sales revenue, managers may be motivated to make
dysfunctional decisions which could increase sales revenue but decrease overall corporate profitability.
Discretionary expense centres are appropriate for units that produced outputs that are not measured in
financial terms or units where no strong relationship exists between resources expended and results
achieved. The dysfunctional aspect of these centres reside in the fact that without any good measure of
output, budget and actual expenditures may yield little insight regarding these centres operating efficiency
and effectiveness. Profit centres are units in which managers have almost complete operational decision
making responsibility and evaluated by profit measure. An investment centre has all of the responsibilities
of a profit centre in addition to the authority for working capital and physical assets. Return on investment
is a typical performance measure for investment centres.
In a decentralized organisation, managers have discretion in selecting and implementing actions.
Performance measures are necessary to guide managers in decision making and to assess their performance
and that of their units. The organization communicates how a local manager should behave and how this
behavior will be evaluated through these measures. Since an effective model for decentralization must speak
cogently to decentralized responsibility with centralized control, central management needs to determine
guidelines and incentives that fosters local decision making and coordination that are compatible with
overall corporate goals, which is a difficult task. In attempting to maximize the incentive function given,
the local manager, will attempt to improve their local measure to the exclusion of all other goals or
measures. Increasingly, executives are aware of the shortcomings of using only financial measures of
performance as the local reward measure. It is considered that a more equitable basis for evaluating
performance is one which includes a broad set of financial and nonfinancial measures which should be
derived from the mission and strategy.
It is impossible in complex and uncertain environments for any single performance measure to achieve
perfect goal congruence between a decentralized unit and the overall corporation. To reduce the negative
impact of this problem, companies are using a balanced set of measures to communicate company- level
strategy to local divisions. When only a single measure of performance is used, the measure tends to
become an end in itself, more important than the economic performance that it attempts to represent.
In a revenue centre the sales force may be motivated to sell only high priced items in an attempt to maximize
revenue rather than contribution margin. Any single measure may be manipulated to benefit the
decentralized unit at the expense of the corporation.
Another problem arises as most measures of performance are based on internal achievement rather than
external opportunities. A unit may be perceived as having performed well because it exceeded last year’s
performance or budgeted measure. The good performance may have been caused by an unexpected
expansion of demand in the industry. When viewed against overall industry performance, the decentralized
unit may not have maintained its market share or relative profitability.
Furthermore, another pitfall in using only a single performance measure occurs when the future economic
consequences from current activities are ignored. Typical performance measures usually ignore longer term
effects which generally arise from expenditures on intangibles, namely, research and development,
advertising and promotion, plant design maintenance, human resource development and quality control.
The uncertain outcome of these expenditures may cause managers to be reluctant in making expenditures
on these intangibles, since they could dilute performance measures and reduce incentives which are tied to
performance. The adverse impact of neglecting these expenditures will show up later.
Interaction among organizational units can introduce problems when these units focus narrowly on their
performance measures. This is exemplified in transfer pricing process of goods and services which is rife
with contention. Even assuming that the transfer pricing issues can be resolved, there are other issues which
aggravate the situation. The quality of the product or service and the timeliness of the transfer will affect
the operation of the receiving unit. The financial impact of varying quality and delivery times will be
difficult to assess.
The performance of one unit or other units may impact the performance of another unit. For instance, the
manufacturing plant efficiency may be affected by the quantity and timing of output demanded from it
which are in part determined by the sales division activities. It can also be argued that the performance of
the manufacturing department can affect the performance of the sales division. One remedy would be for
part of the performance measure of the manufacturing division to depend on the level of sales. This measure
would incentivize managers of individual units to cooperate, avoid unnecessary frictions and stress a
corporate rather than a local viewpoint when managing their operations
More generally, the performance of measure of individual local units could include a component which
reflects the performance of other units. This must be pursued carefully. A unit can only be assessed on
another unit’s performance to the extent that its actions impacted adversely on the performance of the other
unit.
Undesirable consequences will occur if too much reliance is placed on a single measure of performance,
particularly a financial one that ignores longer term, less objectively measured consequences of current
period decisions. The performance of a unit can be assessed in terms other than financial such as, customer,
internal business process and learning and growth.
Finally, using only a single measure of performance in the context of decentralization can give rise to
unintended goal incongruity ad externality problems. The trend in performance measurement in recent years
has been towards a broader view of performance, covering both financial and non-financial indicators as
organizations become increasingly aware of the ramifications of using only a single measure of
performance for decentralized units.
(1443 words)
Must write at least 35 wpm.