Coming up short on nonfinancial performance measurement

Companies in increasing numbers are measuring customer loyalty, employee satisfaction, and other nonfinancial areas of performance that they believe affect profitability. But they've failed to relate these measures to their strategic goals or establish a connection between activities undertaken and financial outcomes achieved. Failure to make such connections has led many companies to misdirect their investments and reward ineffective managers. Extensive field research now shows that businesses make some common mistakes when choosing, analyzing, and acting on their nonfinancial measures. Among these mistakes: They set the wrong performance targets because they focus too much on short-term financial results, and they use metrics that lack strong statistical validity and reliability. As a result, the companies can't demonstrate that improvements in nonfinancial measures actually affect their financial results. The authors lay out a series of steps that will allow companies to realize the genuine promise of nonfinancial performance measures. First, develop a model that proposes a causal relationship between the chosen nonfinancial drivers of strategic success and specific outcomes. Next, take careful inventory of all the data within your company. Then use established statistical methods for validating the assumed relationships and continue to test the model as market conditions evolve. Finally, base action plans on analysis of your findings, and determine whether those plans and their investments actually produce the desired results. Nonfinancial measures will offer little guidance unless you use a process for choosing and analyzing them that relies on sophisticated quantitative and qualitative inquiries into the factors actually contributing to economic results.     

THE EVA REVOLUTION

Stern Stewart's EVA framework for financial management and incentive compensation is the practical application of both modern financial theory and classical economics to the problems of running a business. It is a fundamental way of measuring and motivating corporate performance that encourages managers to make decisions that make economic sense, even when conventional accounting-based measures of performance tell them to do otherwise. Moreover, EVA provides a consistent basis for a comprehensive system of corporate financial management—one that is capable of guiding all corporate decisions, from annual operating budgets to capital budgeting, strategic planning, and acquisitions and divestitures. It also provides companies with a "language" for communicating their goals and achievements to investors—a language that the market is increasingly coming to interpret as a sign of superior future performance.
The authors report that more than 300 companies have implemented Stern Stewart's EVA framework, including a growing number of converts in Europe, Asia, and Latin America. After describing significant behavioral changes at a number of EVA companies, the article focuses in detail on a single case history—that of auto parts manufacturer Federal-Mogul. Besides bringing about a dramatic change in the company's strategy and significant operating efficiencies, the adoption of EVA also led to an interesting change in Federal—Mogul's organizational structure—a combination of two large business units into a single profit center designed to achieve greater cooperation and synergies between the units.     

Integrative strategic performance measurement systems,strategic alignment of manufacturing,learning and strategic outcomes: an exploratory study

There is considerable interest in the role of strategic performance measurement systems (SPMS), such as balanced scorecards, in assisting managers develop competitive strategies. A distinctive feature of SPMS is that they are designed to present managers with financial and non-financial measures covering different perspectives which, in combination, provide a way of translating strategy into a coherent set of performance measures. There appears to be wide variation in how these systems are configured. However, as yet, there has been little consideration given to identifying underlying information characteristics that might help explain how the systems have beneficial effects. This study identifies a key dimension of SPMS, integrative information, as being instrumental in assisting managers deliver positive strategic outcomes. Three interrelated dimensions of integrative SPMS were identified in this study. The first, strategic and operational linkages, was a generic factor that captures the overall extent to which the systems provide for integration between strategy and operations, and integration across elements of the value chain. The second attribute, customer orientation, focuses on customer linkages and includes financial and customer measures. The third dimension, supplier orientation, is based on linkages to suppliers and includes business process and innovation measures. A model is developed that predicts that integrative SPMS will enhance the strategic competitiveness of organizations. It is proposed that the influence of integrative SPMS on strategic outcomes is indirect through the mediating roles of alignment of manufacturing with strategy and organizational learning. Data from a survey of 80 strategic business units provide varying support for the proposed relationships.     

EVA® FOR BANKS: VALUE CREATION, RISK MANAGEMENT, AND PROFITABILITY MEASUREMENT

This article presents a complete ranking of America's 100 largest bank holding companies according to their shareholder value added. This research, the first of its kind for the banking industry, defines an EVA measurement for banks and presents evidence of EVA's stronger correlation with bank market values than traditional accounting measures like ROA and ROE. Besides developing EVA and MVA as analytical tools for viewing the economic performance of the organization from a shareholder perspective, the authors also present a framework for calculating EVA at all levels of the organization, including lines of business, functional departments, products, customer segments, and customer relationships. The implementation of an EVA profitability measurement system at the business unit (or lower) level requires methods for three critical tasks: (1) transfer pricing of funds; (2) allocation of indirect expenses; and (3) allocation of economic capital. Although solutions to the first two are fairly straightforward, the allocation of capital to business units is a major challenge for banks today. In contrast to the complex, “bottom-up” approach used by a number of large banks in implementing their RAROC systems, the authors propose a greatly simplified, “top-down” approach that requires calculation of only the volatility of a business's operating profit (or NOPAT). The advantage of using NOPAT volatility is that it allows EVA analysis at any level of the organization in a way that captures the volatility effects from all sources of risk (credit, interest rates, liquidity, or operations). While such a top-down approach is clearly not meant to take the place of a comprehensive, bottom-up RAROC analysis, it is intended to provide a complement–a high-level “check” on the detailed, bottom-up risk management procedures and controls now in place at most banks. Moreover, for those banks that have developed extensive funds transfer pricing, cost allocation, and RAROCstyle capital allocation systems, the EVA financial management system can either be integrated with those systems or serve as an independent economic assessment of the bank's business risks and returns.     

EVA IN THE E&P INDUSTRY: THE CASE OF NUEVO ENERGY

This article presents a case study illustrating some aspects of the new business model discussed in the roundtable above. Continuing a major theme in the roundtable, the authors begin by arguing that the long‐run failure of the E&P industry to create shareholder wealth stems to a large degree from weak or distorted incentives held out to the top executives and managers of most large, publicly traded companies. This article traces the incentive problem to the lack of an effective wealth creation metric to guide the financial management process. Although the industry employs a variety of accounting‐based performance measures, none is a reliable measure of wealth creation. In place of traditional financial metrics such as earnings, annual cash flow, and return on capital, this article recommends a performance evaluation and incentive compensation system that is tied to the use of a “reserve‐adjusted” EVA measure—one that exhibits a strong statistical correlation with changes in shareholder wealth in the E&P business. The greater explanatory power of this new measure reflects the reality that changes in the value of reserves in the ground can greatly outweigh changes in annual earnings or cash flows. As the focal point of a compensation plan, EVA has advantages over stock options in that it can be calculated at various levels in the organization, even at the level of a single well, whereas stock prices only exist for the company as a whole. For this reason, an EVA incentive system permits a clearer “line of sight” between pay packages and the performance of the part of the business for which managers are directly accountable. Perhaps even more important, EVA can be calculated (using an “internal hedging” mechanism) in a way that removes the impact of changes in oil prices on the incentive outcome. And, as demonstrated in the case study of Nuevo Energy, such internal hedging allows companies to give their employees a much greater share of wealth created with far less cost than by simply granting stock or stock options.     

The performance measurement manifesto

The leading indicators of business performance cannot be found in financial data alone. Quality, customer satisfaction, innovation, market share--metrics like these often reflect a company's economic condition and growth prospects better than its reported earnings do. Depending on an accounting department to reveal a company's future will leave it hopelessly mired in the past. More and more managers are changing their company's performance measurement systems to track nonfinancial measures and reinforce new competitive strategies. Five activities are essential: developing an information architecture; putting the technology in place to support this architecture; aligning bonuses and other incentives with the new system; drawing on outside resources; and designing an internal process to ensure the other four activities occur. New technologies and more sophisticated databases have made the change to nonfinancial performance measurement systems possible and economically feasible. Industry and trade associations, consulting firms, and public accounting firms that already have well-developed methods for assessing market share and other performance metrics can add to the revolution's momentum--as well as profit from the business opportunities it presents. Every company will have its own key measures and distinctive process for implementing the change. But making it happen will always require careful preparation, perseverance, and the conviction of the CEO that it must be carried through. When one leading company can demonstrate the long-term advantage of its superior performance on quality or innovation or any other nonfinancial measure, it will change the rules for all its rivals forever.     

Nonfinancial and financial performance measures: How do they affect employee role clarity and performance?

Two recent studies have found that comprehensive performance measurement systems comprising both financial and nonfinancial measures (e.g., balanced scorecard) are positively related to managerial performance through role clarity. It is, however, unclear if these results are from the use of financial measures or from the use of nonfinancial measures. It is also unclear if these effects are achievable by using nonfinancial measures alone. This study provides insights into prior studies' findings by distinguishing those effects arising from nonfinancial measures from those arising from financial measures. Based on a sample of 121 managers, the results indicate that nonfinancial measures, by themselves, significantly influence managerial performance through role clarity. More importantly, they also indicate that the effect of nonfinancial measures on role clarity is substantially stronger than that through financial measures.     

HOW TO USE EVA IN THE OIL AND GAS INDUSTRY

The use of EVA in the oil industry has lagged behind that in most other industries because the accounting information reported by oil and gas concerns does such a poor job of representing management's effectiveness in adding value for shareholders. The essence of the problem is that the exploration activities of oil companies create assets whose changes in value are recognized by the stock market long before they are reflected on income statements or balance sheets. As a result, all accountingbased performance measures, including generic measures of EVA (which are derived from accounting information), fail to provide meaningful goals, decision tools, or compensation benchmarks.
This article provides a new, EVAbased framework for performance measurement and incentive compensation for oil and gas firms—and for companies in extractive industries in general. The authors show that, when adjusted by a publicly available measure of hydrocarbon reserve value known as "SEC-10," EVA's ability to explain annual stock returns rises from under 10% to almost 50%. Moreover, because SEC-10 has several important limitations as a measure of reserve value, there is considerable additional room for improving EVA's explanatory power. And the actual implementation of an EVA financial management system for an individual oil company can and should be based on more precise estimates of reserve value than those provided by SEC-10.
To this end, the authors provide an approach to hydrocarbon reserve valuation that captures the "real option" value of undeveloped reserves. By incorporating real option values, this new EVA financial management system for oil companies aligns management's incentives with the goal of creating shareholder wealth by rewarding managers for creating real option value as well as current cash flow—and by forcing managers to consider the optimal "exercise" of such strategic options.     

How do different performance measures affect managerial time orientation? Empirical evidence from sales managers in the oil and gas industry

This study investigates the relative effect of performance measures on managerial time orientation. We collect survey data on the actual time allocation of sales managers for tasks that affect financial performance on the short-, medium-, and long-term horizons. In addition, we obtain survey data on the specific metrics used by an oil and gas firm and classify them into three groups: traditional accounting (gross margin and budgeted costs), nonfinancial (market share and sales volume), and accounting returns (economic value added — EVA). Based on partial least-squares analysis, our results suggest that, in our setting, both nonfinancial and accounting return measures can supplement traditional accounting metrics to mitigate potential short-term orientation by inducing sales managers to consider mainly not only sales tasks but also investing tasks, which will affect the firm results more than a quarter ahead. In addition, our results imply that accounting return metrics are not better than nonfinancial measures in inducing a longer-term orientation in our research setting.     

Four rules for taking your message to Wall Street

Managers fail to communicate effectively with Wall Street for all sorts of reasons. But neglecting the investment community--particularly the analysts whose opinions shape the market and whose recommendations often make or break a company's share price--can knock the most carefully conceived and brilliantly executed strategy off course. The companies that struggle the most with providing good information to analysts are those in rapidly evolving industries, where the gap between traditional performance metrics and economic realities is at its widest. In these industries, a company's strategy and the variables that govern its performance can change radically in a short time. What's more, the metrics used to report performance often fail to capture the drivers of value in today's information economy. Few accounting measures are helpful when it comes to assessing the intangible assets--knowledge, skilled employees, and so forth--on which many of today's fastest-growing companies build their strategies. According to Amy Hutton, an associate professor at Harvard Business School, there are four basic rules for clear communications with Wall Street. First, make sure that your company's financial reporting reflects your strategy as closely as possible. Second, popularize the nonfinancial metrics that best predict--and flatter--the performance of your businesses. Third, appoint managers with recognized credibility to your strategic operations. Finally, cultivate the market experts who cover the industries in which you seek to compete. Hutton shows how AOL successfully followed these rules as it significantly changed its strategic direction and competitive arena.     

EVA AND DIVISIONAL PERFORMANCE MEASUREMENT: CAPTURING SYNERGIES AND OTHER ISSUES

This article makes three basic points about divisional performance measurement that managers should keep in mind when attempting to choose between EVA and more conventional, accounting-based measures. First, no divisional performance measure, whether it be EVA, divisional net income, or ROA, is capable of capturing synergies among divisions—those shared benefits or costs that make the sum of the parts worth more than the whole. And EVA is neither more nor less effective than more conventional financial measures in deterring divisional managers from taking actions that increase divisional profits at the expense of corporate value. Thus, there is a fundamental contradiction in the very attempt to evaluate the divisions of a multi—divisional firm as if they were independent companies. If there are synergies, divisional performance measures—even those employing transfer prices—are likely to prove inadequate in some respects (and this article recommends some methods for encouraging synergies that might be used to supplement if not replace divisional measures). But if there are no synergies, then top managers should re-examine their business strategy and consider selling or spinning off divisions. Second, a given performance measure's degree of correlation with stock returns should not be management's sole, or even its most important, criterion in choosing to adopt a given performance measure. A better method for evaluating performance measures is to weigh the behavioral or incentive benefits of a given measure against all direct and indirect costs associated with its implementation. In making such a costbenefit analysis, the incentive benefits from the tighter linkage of rewards to share prices provided by more market-based measures should be traded off against the greater market risk and exposure to other uncontrollables imposed by such measures as well as the costs involved in changing the firm's internal accounting and reporting systems. Third, the EVA practice of “decoupling” performance measures from GAAP accounting, while having have potentially significant incentive benefits, also has potential costs in the form of increased auditing requirements and the possibility of litigation.     

EVA Momentum: The One Ratio That Tells the Whole Story

Virtually all corporate managers use ratios like profit margin, earnings growth, and return on equity to set goals, analyze operations, and measure success or failure. Yet all ratios are wrong in the sense that every one of them can make it appear that operations are improving when a business actually is faltering, and vice versa .
In this article, one of the pioneers of the modern economic profit school of financial management claims to have discovered a new ratio that accurately consolidates all the pluses and minuses of decisions and operations into a single reliable overall measure that cannot be increased without truly creating value. "EVA Momentum," as the measure is called, is the change in a company's economic profit (or EVA) in a given period divided by its sales in the prior period. In other words, it is the size-adjusted change in economic profit.
The author goes on to demonstrate why most companies can use EVA Momentum as both their overarching financial target and the best way to keep score for multiple business lines. The article also shows why EVA Momentum is a better performance measure than ROI and that, as a diagnostic and management tool, it provides a more effective alternative to the popular DuPont ROI formula. Unlike the DuPont formula, EVA Momentum reflects the contributions to overall performance of important factors such as profitable growth, strategic retrenchment, and the quality of resource allocation decisions in general. At the same time, it provides a more accurate and informative means of examining performance, weighing tradeoffs, identifying investment opportunities, and prioritizing initiatives—all on the basis of their expected impact on a company's market value.     

SOME NEW EVIDENCE ON EVA COMPANIES

The study of companies using EVA and EVA-like systems discussed in the previous article provides evidence of changes in managerial behavior, such as reduced capital expenditures, increased share repurchases, and increased residual income, but stops short of concluding that such changes have increased shareholder value. This article presents evidence that directly addresses the issue: Do companies adopting EVA add more value for their shareholders than their industry competitors? The author reports that U.S. companies adopting EVA during the period 1987–1996 outperformed the median firms with the same SIC codes by 28.8% during the four-year period including and following the year of adoption. This paper also provides evidence of significant operating improvements that help explain such increases in shareholder value. But, in contrast to the finding of the Wallace study cited above, the capital expenditures of EVA companies increase (although at a slower rate than for S&P 500 companies) after going on to EVA.     

The Impact of Enterprises’ Shadow Banking Activities on Business Performance: A Test Based on Mediator Effect of Investment Scale and Investment Efficiency

ABSTRACT

In recent years, China’s financial sector has gradually been alienated from the real sector, allowing financial innovation and regulatory arbitrage add their own value to finance. High interest rates in the financial industry have led to changes in the real sector, revealing a trend toward “financialization” and “quasi-financialization”; a typical example of this includes nonfinancial enterprises’ shadow banking activities. In this article, we use annual data from 2004 to 2015 of A share listed companies on the Shanghai and Shenzhen Stock Exchanges, to examine the influence of nonfinancial enterprises’ shadow banking activities on business performance. The results show that, overall, enterprises’ shadow banking activity improve operating performance. In addition, from the perspective of earning structure, nonfinancial enterprises’ shadow banking business increases financial benefits, but has a significantly negative effect on operating income. Further tests show that enterprises engaged in shadow banking activities will impact operating income through the two intermediary variables of investment scale and investment efficiency. However, the negative effect of investment in crowding out operating income is greater than that of the efficiency-improving effect on operating income. This article provides policy guidance in terms of recognizing diverse aspects of shadow banking system that divorce the real economy from the financial economy.     

Assessing the Performance of Business Unit Managers

Using a sample of 140 managers, we investigate the use of various performance metrics in determining the periodic assessment, bonus decisions, and career paths of business unit managers. We show that the weight on accounting return measures is associated with the authority of these managers, and we document that both disaggregated measures (expenses and revenues), and nonfinancial measures play a greater role as interdependencies between business units increase. The results suggest separate and distinct roles for different types of performance measures. Accounting return measures are used to create the proper incentives for managers with greater authority, while disaggregated and nonfinancial measures are employed in response to interdependencies.     

Is American business working for the poor?

At first glance, poverty seems to have little to do with business. When most people--managers included--think about poverty, they assume that people are poor because they are isolated from the mainstream economy, not productive participants in it. But according to Harvard University professors Mary Jo Bane and David Ellwood, this is a misleading image of the true face of poverty in the United States today. Most poor adults--and a full 90% of poor children--live in families where work is the norm, not the exception. Poor people often work or want to work. But at the low-wage end of the American economy, having a job is no guarantee of avoiding poverty. Poverty is a business issue, then, because the American poor are part of the American work force. And this poses a problem for managers. In a more competitive and fast-changing economic environment, the performance of companies increasingly depends on the capabilities of their employees. In response to this human-resource challenge, more and more managers are embracing the language of "empowerment". And yet how can low-wage employees believe empowerment when their experience of work is, quite literally, impoverishment? It is unlikely that American companies can create the work force of the future with the poverty policies of the past. Fortunately, there are some simple policy mechanisms that can assist the working poor without putting an undue burden on business. Enacting them, however, requires managers to see poverty policy as one part of a national human-resource strategy that links the strategic concerns of companies to a broad social agenda.     

EVA AND TOTAL QUALITY MANAGEMENT

Both TQM and EVA can be viewed as organizational innovations designed to reduce “agency costs”—that is, reductions in firm value that stem from conflicts of interest between various corporate constituencies. This article views TQM programs as corporate investments designed to increase value by reducing potential conflicts among non-investor stakeholders such as managers, employees, customers, and suppliers. EVA, by contrast, focuses on reducing conflicts between managers and shareholders by aligning the incentives of the two groups. Besides encouraging managers to make the most efficient possible use of investor capital, EVA reinforces the goal of shareholder value maximization in two other ways: (1) by eliminating the incentive for corporate overinvestment provided by more conventional accounting measures such as EPS and earnings growth; and (2) by reducing the incentive for corporate underinvestment provided by ROE and other rate-of-return measures. At a superficial level, EVA and TQM seem to be in direct conflict with each other. Because of its focus on multiple, non-investor stakeholders, TQM does not address the issue of how to make value-maximizing trade-offs among different stakeholder groups. It fails to provide answers to questions such as: What is the value to shareholders of the increase in employees' human capital created by corporate investments in quality-training programs? And, given that a higherquality product generally costs more to produce, what is the value-maximizing quality-cost combination for the company? The failure of TQM to address such questions may be one of the main reasons why the adoption of TQM does not necessarily lead to improvements in EVA. Because a financial management tool like EVA has the ability to guide managers in making trade-offs among different corporate stakeholders, it can be used to complement and reinforce a TQM program. By subjecting TQM to the discipline of EVA, management is in a better position to ensure that its investment in TQM is translating into increased shareholder value. At the same time, a TQM program tempered by EVA can help managers ensure that they are not under investing in their non-shareholder stakeholders.     

Financial and nonfinancial performance measures: How do they affect job satisfaction?

Recent interest on the use of nonfinancial measures (e.g. in the Balanced Scorecard) generally assumes that such measures are essential to overcome the inadequacies of financial measures. However, it remains unclear (1) if the behavioural effects of these nonfinancial measures are different from those of financial measures; and (2) whether these effects are influenced by the relative importance of nonfinancial measures vis-à-vis financial measures. This study hypothesises that the use of performance measures for performance evaluation will significantly affect managers' job satisfaction. However, these effects are indirect through the managers' perceptions of the fairness of these measures and the interpersonal trust these measures promote. Based on a sample of 70 managers, these expectations are supported by the results. More importantly, the results also suggest that (1) the process by which nonfinancial measures affect employee job satisfaction is not different from that of financial measures, and (2) the relative importance of nonfinancial measures vis-à-vis financial measures has no significant effect on employee job satisfaction. These results may have important theoretical and practical implications.     

BANK OF AMERICA ROUNDTABLE ON BUSINESS UNIT EFFICIENCY VERSUS LEVERAGING CORPORATE COMPETENCIES

Corporate strategist C.K. Prahalad begins by observing that the efficiency achieved by U.S. companies in recent years, brought about in part by EVA and EVA-like systems, is a necessary condition for wealth creation in the new competitive environment. For this reason, the EVA movement is now spreading to Europe and Asia. But, as Prahalad goes to argue, efficiency is not a sufficient condition for wealth creation; equally important is the quest for profitable growth opportunities. And this raises a potential objection to EVA and indeed all divisional performance measurement systems: They could end up reducing long-term growth and value by discouraging managers from capturing synergies among business units and leveraging core competencies to the fullest extent possible.
Following Prahalad's discussion of the problem of capturing synergies and leveraging cross-unit capabilities in large, multi-business companies, moderator David Glassman explores potential solutions with top executives from a number of U.S. and Canadian companies. Among the most promising suggestions are significant managerial stock ownership (as exemplified by a plan used at Baxter International), a cross-unit auction system for evaluating large infrastructure investments pioneered by Stern Stewart, and, probably indispensable, strong encouragement of business unit collaboration by an active and accessible CEO.     

STRATEGY AND SHAREHOLDER VALUE CREATION: THE REAL OPTIONS FRONTIER

The current interest in real options reflects the dramatic increase in the uncertainty of the business environment. Viewed narrowly, the real options approach is the extension of financial option pricing models to the valuation of options on real (that is, nonfinancial) assets. More broadly, the real options approach is a way of thinking that helps managers formulate their strategic options—the future opportunities that are created by today's investments—while considering their likely effect on shareholder value. But if the real options framework promises to link strategy more closely to shareholder value creation, there are some major challenges on the frontier of application. In the first part of this paper, the authors tackle the question, “What is really new about real options, and how does the approach differ from other wellestablished ways to make strategic decisions under uncertainty?” This article provides a specific definition of real options that relies on the ability to track marketpriced risk. Using examples from oil exploration and pharmaceutical drug development, the authors also show how specific features of the industry and the application itself determine the usefulness of the real options approach. The second part of the paper addresses the question: Given the many differences between real and financial options, how should a real options application be framed? The authors examine the use of real options in the valuation of Internet companies to demonstrate the required judgment and tradeoffs in the framing of real options applications. The case of Webvan, an online grocer, is used to illustrate the inter‐action between strategy, execution, and valuation.