Performance Measurement Systems

Quick Answer: Performance measurement systems combine financial and non-financial metrics to evaluate organizational success. Key financial measures include ROI, Residual Income, and EVA for investment centers. The Balanced Scorecard provides a comprehensive framework covering financial, customer, internal process, and learning perspectives.

Effective performance measurement goes beyond traditional financial metrics to include indicators that drive long-term success. This section covers both financial performance measures for investment centers and comprehensive frameworks like the Balanced Scorecard.

The Balanced Scorecard

The Balanced Scorecard, developed by Kaplan and Norton, provides a comprehensive framework for measuring organizational performance across four perspectives.

The Four Perspectives

Strategy Mapping

The Balanced Scorecard uses cause-and-effect relationships:

Learning & Growth → Internal Processes → Customer Satisfaction → Financial Results

Example Chain:

1. Train employees on new technology (Learning)
2. Reduce production defects (Internal Process)
3. Improve product quality perception (Customer)
4. Increase sales and margins (Financial)

Developing a Balanced Scorecard

Step 1: Define Strategic Objectives

• What does success look like in each perspective?

Step 2: Select Key Performance Indicators (KPIs)

• 3-5 measures per perspective
• Mix of leading and lagging indicators

Step 3: Set Targets

• Specific, measurable goals for each KPI

Step 4: Identify Initiatives

• Action plans to achieve targets

Example Balanced Scorecard

Return on Investment (ROI)

ROI is the most widely used measure for evaluating investment center performance.

Formula

$\text{ROI} = \frac{\text{Operating Income}}{\text{Average Operating Assets}}$

Or, using the DuPont formula:

$\text{ROI} = \text{Profit Margin} \times \text{Asset Turnover}$

$\text{ROI} = \frac{\text{Operating Income}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Average Operating Assets}}$

ROI Example

Division C has the highest ROI, but Division B contributes the most absolute profit.

Advantages of ROI

• Easy to calculate and understand
• Comparable across divisions of different sizes
• Encourages efficient asset utilization
• Widely recognized benchmark

Problems with ROI

1. Underinvestment problem: Managers may reject projects with positive NPV if they lower division ROI

Example:

• Current ROI: 25%
• New project: 18% ROI (above 12% company cost of capital)
• Manager rejects the project because it lowers division ROI
• Company loses value-creating opportunity

1. Short-term focus: Managers may defer maintenance or cut R&D to boost short-term ROI

2. Asset base issues: Old assets with low book values inflate ROI

Residual Income (RI)

Residual Income overcomes ROI's underinvestment problem by measuring absolute dollar returns above the required return.

Formula

$\text{RI} = \text{Operating Income} - (\text{Required Rate of Return} \times \text{Average Operating Assets})$

Or:

$\text{RI} = \text{Operating Income} - \text{Capital Charge}$

RI Example

Now we see Divisions A and B create equal value ($200,000 RI each).

Investment Decision with RI

Using the earlier example:

• New project: $1,000,000 investment, $180,000 operating income (18% ROI)
• RI from project = $180,000 - (12% × $1,000,000) = $60,000

Since RI > 0, the project creates value. Managers using RI will accept it.

Advantages of RI

• Encourages value-creating investments
• Uses dollar amounts (intuitive)
• Can use different required rates for different risk levels

Disadvantages of RI

• Not comparable across divisions of different sizes
• Requires determining appropriate required return
• Still affected by asset valuation issues

Economic Value Added (EVA)

EVA is a refined version of residual income that uses after-tax operating profit and the weighted average cost of capital (WACC).

Formula

$\text{EVA} = \text{NOPAT} - (\text{WACC} \times \text{Invested Capital})$

Where:

• NOPAT = Net Operating Profit After Taxes
• WACC = Weighted Average Cost of Capital
• Invested Capital = Total capital (equity + debt) invested in the business

Adjustments for EVA

EVA typically requires accounting adjustments to convert to economic reality:

EVA Example

• NOPAT: $2,400,000
• Invested Capital: $15,000,000
• WACC: 10%

$\text{EVA} = \$2,400,000 - (10\% \times \$15,000,000) = \$2,400,000 - \$1,500,000 = \$900,000$

The company created $900,000 of value above its cost of capital.

Comparing ROI, RI, and EVA

Key Performance Indicators (KPIs)

KPIs are specific, measurable metrics that track progress toward strategic objectives.

Characteristics of Good KPIs

Leading vs. Lagging Indicators

A balanced set includes both types—leading indicators to predict future performance and lagging indicators to confirm results.

Benchmarking

Benchmarking compares performance against reference points to identify improvement opportunities.

Types of Benchmarking

Benchmarking Process

1. Identify what to benchmark
2. Research benchmark partners
3. Collect comparable data
4. Analyze performance gaps
5. Implement improvements
6. Monitor progress over time

Common Benchmarks