IntroductionThemain objective of most firms in the modern is to maximise profits as well asmaintaining shareholder interests. Shareholders primary concern is to maximisetheir 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 toassess how Quantitative Performance Measures were introduced, as well as thepositives and shortcomings of both Quantitative Performance measures such as netprofit, contribution margin, earnings per share and Non-financial performancemeasures. After assessing both financial and non-financial performance measuresI will conclude with which measure is to be preferred as bases for managerialplanning, control and decision-making. Financial Measures: Introduction and howit became outdatedAsuccessful company will achieve the aims and goals of its shareholders.Rappaport 2014 informs us that the key objectives of shareholders have alwaysbeen 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, improvingstrategic performance and minimising risk.Accordingto Kaplan and Norton in 1992, Quantitative Measures of Performance wereimplemented during the industrial revolution. This may have been done tofacilitate the transition into capitalism.
“The measures indicate whether thecompany’s strategy, implementation, and execution are contributing tobottom-line improvement” (Kaplan and Norton 1992). If there is an alignment ofinterests between the managers and the shareholders, these measures givemanagers a sense of direction in order to achieve the objectives set by theshareholders. However,due to globalisation in the 1980s, firms have been forced to consider other factorssuch as Corporate Social Responsibility and Ethics. This highlighted the issuethat traditional quantitative measures of performance were far too simplisticand only focused on the finances of the firm.
With the rapidly industrializingand competitive environment, failure of QPMs to account for new technologiesand other intangible assets (Kaplan & Norton, 2005), managers soon realisedthat this was not allowing them to fully achieve the objectives of theshareholders. Due to this, in recent times,there has been a growing reluctance to only use quantitative performancemeasures with firms now preferring to also include non-financial measures. Financial Measures: Short Termism LimitationOnefundamental limitation to Quantitative Performance Measures is that it focuses toomuch on the short-term results. Merchant and Van der Stede (2007: 452-3) assertthat, ‘Management myopia, an excessive focus on short-term performance, is analmost inevitable side-effect of the use of financial results control systemsbuilt on accounting measures of performance’. Strategic issues can arise ifQPMs lead managers to solely focus on improving the short-term performance insteadof also considering the long-term effects to the firm (Olsen et al., 2007).
Ifdecisions are made with only short-run objectives in mind, this can lead to adecrease in Research and Development and employee training. Both of these couldeventually lead to an increase in future earnings if given importance in themanagers’ decision making. However, many managers will ignore these long-terminvestments to instead focus on improving short-term figures to appear to achieveshareholders’ objectives. Managers vision of the company becomes confused asthey limit their horizons to short term performance in sacrifice of longer termgains (Ross, Westerfield and Jaffe, 1993). Although this may not be totally thefault of the managers since they may have very strict pressures for short term successfrom the shareholders. However, this would leave to shareholders beingmisinformed about the progress of the company (Johnson and Kaplan, 1987). Areport by Skinner (1986) underlines the importance of investing in new capital andtechnology and firms that do not invest in this would be ‘edged out of themarket’. However, this is not to say that Quantitative Performance Measures areharmful to the company, it merely suggests that it should not be the only meansof decision making taken by managers.
Non-Financial Measures: StrategicFocusPreviouslyI mentioned a key flaw of financial measures being short-termism, now I’m goingto explain how the strategic focus of Non-Financial Measures can help solve theissues of short termism. A firm should also focus on customer loyalty, employeesatisfaction, and other performance areas that are not financial but that theybelieve ultimately affect profitability (Ittner and Larcker, 2003). Thus,highlighting the importance of intangible assets such as customer loyalty andintellectual capital which provide a closer link to a firm’s organisationalstrategy instead of just what is recorded on a balance sheet. Sinceglobalisation in the 1980s, there has been an increased demand for moreeffective performance measures which also focus on long term objectives as wellas short term objectives (Atkinson et al, 1997). While there are issues quantifyingintangible assets, non-financial KPIs can provide quantitative measures ofthese intangible assets. A study by Ittner and Larcker (2000) scrutinised thedifferences in US companies’ stock market values by evaluating the non-financialKPIs of intangible assets. It found that non-financial factors such as brandloyalty 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 alarge proportion of the true value of a firm and thus give the shareholders’ aninaccurate representation of the performance of their company. Thus, showinghow non-financial FPIs can help resolve the issue of QPMs being ‘too short-term’. Company Direction: Financial vs Non-FinancialMeasuresAnothermajor flaw in Quantitative Performance Measures is the lack of direction inwhich the company is heading. Financial measures can only show you how thecompany has performed in the past or how it is currently doing. QPMs cannottell you how the company will perform in the future. QPMS can only tell you if there is a failurein the firm, but it cannot tell you the reason for the performance which fails togive managers any sense of direction in which the company is going and how toimprove in the future. Whereas non-financial FPIs can help identify the causesof 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 anddecision making of managers.
Non-Financial Measures: Key ValueDriversNon-financialmeasures provide what is seen as the missing link between customer satisfactionand the effect on performance of the firm. It may be argued that highercustomer satisfaction would lead to a greater customer loyalty and in turn positivelyimpact returns. This fact is missed out with financial measures of performancewhereas performance measurement systems such as balance scorecards helpimplement it (Ittner and Larcker, 1998). In addition, increased customersatisfaction 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 themain objectives for shareholders. Non-Financial Measures: DisadvantagesAlthoughnon-financial measures have plenty important advantages as explained above,there are a few shortcomings. Non-financial performance measures can be verytime consuming and costly to calculate. This could have an affect on theperformance of the firm as it is an additional cost. Inaddition, non-financial performance measures are calculated in an arbitrary mannerwhich leads to problems with bias and comparisons.
Different firms may valuenon-financial measures differently, which makes it difficult for shareholdersto compare their performance against other firms (Eccles & Mavrinac, 1995).Furthermore,non-financial performance measures need to be measured accurately or they canlead to detrimental mistakes that could increase costs for a firm. For example,Xerox spent millions on customer surveys under the assumption that customer satisfactionwas linked to the performance of the company only to later find out that it wasin fact customer loyalty and that they had wasted money on those surveys (citedin Axson 2013). ConclusionInconclusion, the decision on whether or not to solely base managerial planningand decision making on Quantitative Performance Measures depends on theobjectives of the shareholders. If they require short-term success thenfinancial measures will suffice as that is what they portray.
However, since globalisationin the 1980s, shareholders’ objectives have become more detailed and thereforeare no longer seen as the sole preferred basis for managers. They have beenreplaced with Key Performance Indicators which include financial and non-financialmeasures aimed at giving shareholders and managers a more accuraterepresentation of the true value of the company. This increase in popularity touse non-financial measures can be seen in Van Ginsel (2012). I believe that thebest approach for a manager is to use both financial and non-financial measuresin order to give them the best possible information regarding both short-termand long-term performance. Said et al (2003) has given evidence supporting thecombination of both financial and non-financial performance measures leading tohigher levels of return.