Week 7 - Performance evaluation

Question 1

6 reasons why Accounting performance measures may not reflect ECONOMIC VALUE (although used by many firms)

Answer 1

1. transactions-oriented
2. DEPEND on measurement METHOD
3. CONSERVATIVELY BIASED
   - all acct. rules allow losses to be realised immediately but takes long time to realise profits
4. IGNORE INTANGIBLES
   - where businesses derive a huge value from, eg. quality of employees
5. IGNORE cost of capital/RISK
   - profit no. won’t reflect risk but discount rate would
6. focus on past

> > therefore, not all firms use accounting measures

Question 2

Myopia problem

Answer 2

= Short-term focused

1. By evaluating employees on the basis of acct. measures, you incentivise them to UNDERINVEST relative to the efficient level to create VALUE
   - b/c cash inflows are not matched with cash outflows + employees won’t share the same benefits as the firm if they leave the firm before cash inflows are realised
   - b/c investment now can take a long time before income/cash inflows are realised

Question 3

2 causes that can worsen the Myopia problem (Dechow)

Answer 3

1. If the employee has a SHORTER HORIZON
   - (Dechow) CEOs in their final year of office manage discretionary investment expenditure (R&D) to improve short-term earnings performance
2. and/or MORE FREQUENT DISCLOSURE of acct. numbers, eg. quarterly vs annually

Question 4

4 ways to overcome Myopia

Answer 4

1. Reduce short-term pressure
   - use LESS FREQUENT performance measurements, eg. to annually
2. Use EQUITY-BASED INCENTIVES, which are based on expectations of firm value
   - to measure changes in shareholder value DIRECTLY
   - caveat: equity-based pay doesn’t fully solve the problem b/c rational investors in the market anticipate managers become myopic when they care about stock prices, which incentivises all other managers to be myopic although they might not be doing so in the first place
3. IMPROVE ACCT. MEASURES (strong theoretical theories supporting this but not used by many co.s in practice)
   » problems:
   - profit -> UNDERINVESTMENT b/c investments immediately decrease profits
   - ROI = profit/assets -> SUBOPTIMISATION b/c some profitable investments may still decrease overall ROI & the firm might reject the investment based on ROI, although should accept from firm’s perspective (eg. if can borrow money from bank for 1% and get higher returns of 8%)
   » RESIDUAL INCOME is a better method but not used by many co.s in practice b/c might be difficult to calculate on a division/project level as opposed to firm level
4. Use a SET of drivers of future value
   - using multiple measures in a contract provides an effective and appropriate mix of incentives
   - like the Balanced Scorecard which uses a set of performance measures

Question 5

Balanced scorecard (Kaplan and Norton, 1992)

Answer 5

• Complement financial with non-financial measures
• Non-financial measures are “leading” indicators” of performance
  1. Customer perspective
  eg. customer satisfaction, market share, delivery time
  2. Internal processes perspective (what the firm must do internally to meet customer expectations)
  eg. productivity, defect rates, waste
  3. Innovation and learning perspective
  eg. Nokia and Kodak were reluctant to adopt technological advancements & did not react to the new strategies in the industry, so now wiped out
  4. Financial perspective

Question 6

How to build/improve a Balanced scorecard

Answer 6

Get data and continuously test
1. Causal links
2. Relative importance/redundancy
eg. TD Canada Trust, Bank of the Desert (A) case

*regression and statistical analyses are very important!

Question 7

What makes a good Balanced scorecard?

Answer 7

1. Tells the story of the strategy
   - every measure is part of a chain of cause-and-effect linkages to outcome
2. A roadmap that provides guidance & ADDRESSES the LACK of DIRECTION
3. Ties measures to BALANCED INCENTIVES to AVOID MYOPIA
   - these are important actions for future performance

Question 8

3 limitations of the Balanced scorecard

Answer 8

1. In practice, BSCs are typically NOT balanced
   - financial dimension is still overweighted although having some non-financial measures is still better than nothing
2. Many dimensions - how to measure/pay attention to all?
3. Challenging/costly to set targets and keep up

Question 9

Johansen’s case
What do the 3 performance measures tell us?
1. Profit measure (net income)
2. Sales measure (store sales growth)
3. Pure COST MEASURE (gross margin)

Answer 9

1. Natural tradeoff between sales and costs
2. To grow org. in a more aggressive strategy; signalling to competitors also
3. Pure cost measure only measures the COGS since sales and profits already covered by the other 2 measures
   » later removed to avoid a pure focus on cost reduction, which previously hurt customer service performance

Question 10

Johansen’s case
Benefits of having 2 targets (baseline and stretch targets) for each dimension?

Answer 10

1. Keep MOTIVATION high after reaching 1st target
2. Reduce GAMING around 1 target; avoids TARGET RATCHETING

Question 11

Johansen’s case
Points to note about customer service measure + 2 suggested improvements

Answer 11

1. Important to have a LARGE SAMPLE for surveys for REPRESENTATIVENESS
   - but also no way to hold employees accountable (PRONE TO MANIPULATION)
2. Customer satisfaction score is NOT INFORMATIVE of company OBJECTIVES, nor really measure what they want about the average customer (prone to manipulation)

Improvements
1. REPEAT ORDERS / how often customers return
- give more info about the average customer
2. Mystery shoppers

Question 12

Johansen’s case
“Is the new system effective?” - what to consider?

Answer 12

Are the performance measures likely to induce CONGRUENT BEHAVIOUR?
ie. Are they ALIGNED with STRATEGY, and match store managers’ responsibilities?