Introduction performance and minimising risk. According to Kaplan and

Introduction

The
main objective of most firms in the modern is to maximise profits as well as
maintaining shareholder interests. Shareholders primary concern is to maximise
their returns from their investment and focus on short term and long-term profit,
strategy and risk minimisation (Rappaport, 2014). In this report I am going to
assess how Quantitative Performance Measures were introduced, as well as the
positives and shortcomings of both Quantitative Performance measures such as net
profit, contribution margin, earnings per share and Non-financial performance
measures. After assessing both financial and non-financial performance measures
I will conclude with which measure is to be preferred as bases for managerial
planning, control and decision-making.

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Financial Measures: Introduction and how
it became outdated

A
successful company will achieve the aims and goals of its shareholders.
Rappaport 2014 informs us that the key objectives of shareholders have always
been to maximise their share value. This may be done through various means; however,
the key ones being improving both long term and short-term profit, improving
strategic performance and minimising risk.

According
to Kaplan and Norton in 1992, Quantitative Measures of Performance were
implemented during the industrial revolution. This may have been done to
facilitate the transition into capitalism. “The measures indicate whether the
company’s strategy, implementation, and execution are contributing to
bottom-line improvement” (Kaplan and Norton 1992). If there is an alignment of
interests between the managers and the shareholders, these measures give
managers a sense of direction in order to achieve the objectives set by the
shareholders.

However,
due to globalisation in the 1980s, firms have been forced to consider other factors
such as Corporate Social Responsibility and Ethics. This highlighted the issue
that traditional quantitative measures of performance were far too simplistic
and only focused on the finances of the firm. With the rapidly industrializing
and competitive environment, failure of QPMs to account for new technologies
and other intangible assets (Kaplan & Norton, 2005), managers soon realised
that this was not allowing them to fully achieve the objectives of the
shareholders.  Due to this, in recent times,
there has been a growing reluctance to only use quantitative performance
measures with firms now preferring to also include non-financial measures.

 

Financial Measures: Short Termism Limitation

One
fundamental limitation to Quantitative Performance Measures is that it focuses too
much on the short-term results. Merchant and Van der Stede (2007: 452-3) assert
that, ‘Management myopia, an excessive focus on short-term performance, is an
almost inevitable side-effect of the use of financial results control systems
built on accounting measures of performance’. Strategic issues can arise if
QPMs lead managers to solely focus on improving the short-term performance instead
of also considering the long-term effects to the firm (Olsen et al., 2007). If
decisions are made with only short-run objectives in mind, this can lead to a
decrease in Research and Development and employee training. Both of these could
eventually lead to an increase in future earnings if given importance in the
managers’ decision making. However, many managers will ignore these long-term
investments to instead focus on improving short-term figures to appear to achieve
shareholders’ objectives. Managers vision of the company becomes confused as
they limit their horizons to short term performance in sacrifice of longer term
gains (Ross, Westerfield and Jaffe, 1993). Although this may not be totally the
fault of the managers since they may have very strict pressures for short term success
from the shareholders. However, this would leave to shareholders being
misinformed about the progress of the company (Johnson and Kaplan, 1987). A
report by Skinner (1986) underlines the importance of investing in new capital and
technology and firms that do not invest in this would be ‘edged out of the
market’. However, this is not to say that Quantitative Performance Measures are
harmful to the company, it merely suggests that it should not be the only means
of decision making taken by managers.

 

 

Non-Financial Measures: Strategic
Focus

Previously
I mentioned a key flaw of financial measures being short-termism, now I’m going
to explain how the strategic focus of Non-Financial Measures can help solve the
issues of short termism. A firm should also focus on customer loyalty, employee
satisfaction, and other performance areas that are not financial but that they
believe ultimately affect profitability (Ittner and Larcker, 2003). Thus,
highlighting the importance of intangible assets such as customer loyalty and
intellectual capital which provide a closer link to a firm’s organisational
strategy instead of just what is recorded on a balance sheet. Since
globalisation in the 1980s, there has been an increased demand for more
effective performance measures which also focus on long term objectives as well
as short term objectives (Atkinson et al, 1997). While there are issues quantifying
intangible assets, non-financial KPIs can provide quantitative measures of
these intangible assets. A study by Ittner and Larcker (2000) scrutinised the
differences in US companies’ stock market values by evaluating the non-financial
KPIs of intangible assets. It found that non-financial factors such as brand
loyalty do in fact make up a large proportion of the true value of the firm. Therefore,
suggesting that the sole use of Quantitative Performance Measures negate a
large proportion of the true value of a firm and thus give the shareholders’ an
inaccurate representation of the performance of their company. Thus, showing
how non-financial FPIs can help resolve the issue of QPMs being ‘too short-term’.

 

Company Direction: Financial vs Non-Financial
Measures

Another
major flaw in Quantitative Performance Measures is the lack of direction in
which the company is heading. Financial measures can only show you how the
company has performed in the past or how it is currently doing. QPMs cannot
tell you how the company will perform in the future.  QPMS can only tell you if there is a failure
in the firm, but it cannot tell you the reason for the performance which fails to
give managers any sense of direction in which the company is going and how to
improve in the future. Whereas non-financial FPIs can help identify the causes
of performance which in turn allow the manager to either correct the problem,
or if the performance is positive, allow the manager to continue with this direction.
Thus, highlighting how crucial non-financial measures are to the planning and
decision making of managers.

 

Non-Financial Measures: Key Value
Drivers

Non-financial
measures provide what is seen as the missing link between customer satisfaction
and the effect on performance of the firm. It may be argued that higher
customer satisfaction would lead to a greater customer loyalty and in turn positively
impact returns. This fact is missed out with financial measures of performance
whereas performance measurement systems such as balance scorecards help
implement it (Ittner and Larcker, 1998). In addition, increased customer
satisfaction will help improve the reputation of the firm (Fornell, 1992),
which in turn can lead to higher profits for the company which is one of the
main objectives for shareholders.

 

Non-Financial Measures: Disadvantages

Although
non-financial measures have plenty important advantages as explained above,
there are a few shortcomings. Non-financial performance measures can be very
time consuming and costly to calculate. This could have an affect on the
performance of the firm as it is an additional cost.

In
addition, non-financial performance measures are calculated in an arbitrary manner
which leads to problems with bias and comparisons. Different firms may value
non-financial measures differently, which makes it difficult for shareholders
to compare their performance against other firms (Eccles & Mavrinac, 1995).

Furthermore,
non-financial performance measures need to be measured accurately or they can
lead to detrimental mistakes that could increase costs for a firm. For example,
Xerox spent millions on customer surveys under the assumption that customer satisfaction
was linked to the performance of the company only to later find out that it was
in fact customer loyalty and that they had wasted money on those surveys (cited
in Axson 2013).

 

 

 

Conclusion

In
conclusion, the decision on whether or not to solely base managerial planning
and decision making on Quantitative Performance Measures depends on the
objectives of the shareholders. If they require short-term success then
financial measures will suffice as that is what they portray. However, since globalisation
in the 1980s, shareholders’ objectives have become more detailed and therefore
are no longer seen as the sole preferred basis for managers. They have been
replaced with Key Performance Indicators which include financial and non-financial
measures aimed at giving shareholders and managers a more accurate
representation of the true value of the company. This increase in popularity to
use non-financial measures can be seen in Van Ginsel (2012). I believe that the
best approach for a manager is to use both financial and non-financial measures
in order to give them the best possible information regarding both short-term
and long-term performance. Said et al (2003) has given evidence supporting the
combination of both financial and non-financial performance measures leading to
higher levels of return.

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