The pyramids and pitfalls of performance measurement

http://www.accaglobal.com/en/student/acca-qual-student-journey/qual-resource/accaqualification/p5/technical-articles/the-pyramids.html by Shane Johnson 01 Sep 005 !t has become increasingly important for organisations to de"elop systems of performance measurement which not only reflect the growing comple#ity of the business en"ironment but also monitor their strategic response to this comple#ity. $he need for good performance management is an ongoing issue which should be addressed by the management of all organisations. $his article considers issues which are central to the understanding and assessment of performance measurement within any organisation. $he main issues requiring consideration by management are: lin%ing performance to strategy setting performance standards and targets lin%ing rewards to performance considering the potential benefits and problems of performance measures.

!n attempting to establish a clear lin% between performance and strategy it is "ital that management ensures that the performance measures target areas within the business where success is a critical factor. $he performance measures chosen should: measure the effecti"eness of all processes including products and/or ser"ices that ha"e reached the final customer measure efficiency in terms of resource utilisation within the organisation comprise an appropriate mi# of both quantitati"e and qualitati"e methods comprise an appropriate focus on both the long-term and short-term be fle#ible and adaptable to an e"er-changing business en"ironment. $he last point stresses how important it is that performance measurement systems are dynamic so that they remain rele"ant and continue to reflect the issues important to any business. $here are a number of models of performance measurement which can be used by management. $his article considers the &performance pyramid& of 'ynch and (ross )1**1+1. $he model represents an ac%nowledgement by the writers that traditional performance measurement systems were falling short of meeting the needs of managers in a much changed business en"ironment. 'ynch and (ross suggest a number of measures that go far beyond traditional financial measures such as profitability, cash flow and return on capital employed. $he measures that they propose relate to business operating systems, and they address the dri"ing forces that guide the strategic objecti"es of the organisation. 'ynch and (ross propose that customer satisfaction, fle#ibility and producti"ity are the dri"ing forces upon which company objecti"es are based. $hey suggest that the status of these dri"ing forces can be monitored by "arious indicators which can be deri"ed from lower le"el )departmental+ measures of waste, deli"ery, quality and cycle time. $he performance pyramid deri"es from the idea

The pyramids and pitfalls of performance measurement

that an organisation operates at different le"els each of which has a different focus. -owe"er, it is "ital that these different le"els support each other. $hus the pyramid lin%s the business strategy with day-today operations. !n proposing the use of the performance pyramid 'ynch and (ross suggest measuring performance across nine dimensions. $hese are mapped onto the organisation - from corporate "ision to indi"idual objecti"es. .ithin the pyramid the corporate "ision is articulated by those responsible for the strategic direction of the organisation. $he pyramid "iews a range of objecti"es for both e#ternal effecti"eness and internal efficiency. $hese objecti"es can be achie"ed through measures at "arious le"els as shown in the pyramid. $hese measures are seen to interact with each other both hori/ontally at each le"el, and "ertically across the le"els in the pyramid. 0eorge 1rown )1**2+ e#plains what 'ynch and (ross refer to as &getting it done in the middle& focuses on business operating systems where each system is geared to achie"e specific objecti"es, and will cross departmental/functional boundaries, with one department possibly ser"ing more than one operating system. 3or e#ample, an operating system may ha"e new product introduction as its objecti"e, and is li%ely to in"ol"e a number of departments from design and de"elopment to mar%eting. 4t this le"el, performance focus will be on three needs. 3irst, there will be a focus on the need to ensure customer satisfaction. Second, there will be a focus on the need for fle#ibility in order to accommodate changes in methods and customer requirements. $hird, there will be a focus on the need to achie"e producti"ity which necessitates loo%ing for the most cost effecti"e and timely means of achie"ing customer satisfaction and fle#ibility. 4t the bottom le"el of the pyramid is what 'ynch and (ross refer to as &measuring in the trenches&. -ere the objecti"e is to enhance quality and deli"ery performance and reduce cycle time and waste. 4t this le"el a number of non-financial indicators will be used in order to measure the operations. $he four le"els of the pyramid are seen to fit into each other in the achie"ement of objecti"es. 3or e#ample, reductions in cycle time and/or waste will increase producti"ity and hence profitability and cash flow $he strength of the performance pyramid model lies in the fact that it ties together the hierarchical "iew of business performance measurement with the business process re"iew. !t also ma%es e#plicit the difference between measures that are of interest to e#ternal parties - such as customer satisfaction, quality and deli"ery - and measures that are of interest within the business such as producti"ity, cycle time and waste. 'ynch and (ross concluded that it was essential that the performance measurement systems adopted by an organisation should fulfil the following functions: $he measures chosen should lin% operations to strategic goals. !t is "ital that departments are aware of the e#tent to which they are contributing - separately and together - in achie"ing strategic aims. $he measures chosen must ma%e use of both financial and non-financial information in such a manner that is of "alue to departmental managers. !n addition, the a"ailability of the correct information as and when required is necessary to support decision-ma%ing at all le"els within an organisation.

The pyramids and pitfalls of performance measurement

$he real "alue of the system lies in its ability to focus all business acti"ities on the requirements of its customers. $hese conclusions helped to shape the performance pyramid which can be regarded as a modeling tool that assists in the design of new performance measurement systems, or alternati"ely the re-engineering of such systems that are already in operation. See 3igure 1. 3igure 1: the performance pyramid )'ynch and (ross, 1**1+ 5a"id 6tley ) 005+7 has obser"ed that other related framewor%s e#ist, such as the results and determinants framewor% by 3it/gerald et al )1**1+, the balanced scorecard by 8aplan and 9orton )1** + and 9eely et al&s performance prism. 4 common thread in all of them is that performance measures should: be lin%ed to corporate strategy include e#ternal as well as internal measures include non-financial as well as financial measures ma%e e#plicit the trade-offs between different dimensions of performance include all important but difficult to measure factors as well as easily measurable ones pay attention to how the selected measures will moti"ate managers and employees.

Setting standards and targets $o set standards and targets, management could choose to ma%e use of benchmar%ing and/or target costing while being mindful of the critical need to lin% rewards to performance as appropriate. Benchmarking 1enchmar%ing is &a continuous, systematic process for e"aluating the products, ser"ices, and wor% processes of organisations that are recognised as representing best practices for the purposes of organisational impro"ement& )Spendolini 1**1+:. $he most common approach is process benchmar%ing, where the standard of comparison is a &best practice& firm which may be entirely unconnected with the benchmar%ing organisation. !t may not e"en operate within the same industry. $he objecti"e is to impro"e performance. $his is best achie"ed through the sharing of information which should be of mutual benefit to both parties ta%ing part in the benchmar%ing programme. 4s a result of recei"ing new information, each party will be able to re"iew their policies and procedures. $he process of comparing respecti"e past successes and failures can ser"e as a stimulus for greater inno"ation within each organisation. Target costing $arget costing should be "iewed as an integral part of a strategic profit management system. $he initial consideration in target costing is the determination of an estimate of the selling price for a new product which will enable a firm to capture its required share of the mar%et. !t is then necessary to reduce this figure to reflect the firm&s desired le"el of profit, ha"ing regard to the rate of return required on new capital in"estment and wor%ing capital requirements. $he deduction of required profit from the proposed selling price will produce a target price that must be met in order to ensure that the desired

The pyramids and pitfalls of performance measurement

rate of return is obtained. $he main theme of target costing is, therefore, what a product should cost in order to achie"e the desired le"el of return. $arget costing will necessitate comparison of current estimated cost le"els against the target le"el. $his must be achie"ed if the desired le"els of profitability, and hence return on in"estment, are to be achie"ed. .here a gap e#ists between the current estimated cost le"els and the target cost, it is essential that this gap is closed. Performance rewards ;anagement will encourage employees to achie"e organisational goals by ha"ing rewards lin%ed to their success or failure in achie"ing desired le"els of performance. !t is critical that management establish an appropriate performance-rewards lin%age. ;anagement should consider a rewards pac%age comprising both financial and non-financial rewards. $ypical organisational rewards include salary increases, bonuses, promotion, and recognition. <mployees may also earn intrinsic rewards through a sense of achie"ement and percei"ed success. ;anagement should also gi"e serious consideration to the establishment of &negati"e rewards& or &punishments& which should be lin%ed to failure to achie"e desired le"els of performance. $hese may include failure to obtain potential rewards, demotions, and possibly the loss of employment. Potential benefits $here are se"eral potential benefits for an organisation that implements a reward scheme: =ewards and incenti"es can ma%e a positi"e contribution to strategy implementation by shaping the beha"iour of indi"iduals and groups. 4 well-designed reward scheme will be consistent with organisational objecti"es and structure. $here is e"idence which suggests the e#istence of a reward scheme pro"ides an incenti"e to achie"e a good le"el of performance. ;oreo"er, the e#istence of effecti"e schemes helps not only to attract but also to retain employees who ma%e positi"e contributions to the running of an organisation. 8ey "alues can be emphasised by incorporating %ey performance indicators in the performancerewards mechanisms which underpin the scheme. $his helps to create an &understood en"ironment& in which it is clear to all employees the performance aspects that contribute to organisational success. 4n effecti"e reward scheme will create an en"ironment in which all employees are focused on continuous impro"ement. Schemes that incorporate equity share ownership for managers and employees ali%e can encourage beha"iour which, in the longer-term, focuses on actions aimed at increasing the mar%et "alue of the organisation. Some of the principal areas that warrant management consideration in the design of a reward scheme include: .hether performance targets should be set with regard to results or effort. !t is more difficult to set targets for administrati"e and support staff since in many instances the results of their efforts

The pyramids and pitfalls of performance measurement

are not easily quantifiable. 3or e#ample, good sales administrators will impro"e le"els of customer satisfaction but quantifying this is e#tremely difficult. .hether rewards should be monetary or non-monetary. ;oney means different things to different people. !n many instances people will prefer increased job security which results from impro"ed organisational performance and adopt a longer-term perspecti"e. 3or these employees share option schemes might appeal. .ell-designed schemes will correlate the prosperity of the organisation with that of the indi"iduals it employs. .hether the reward promise should be implicit or e#plicit. <#plicit reward promises are easy to understand but in many respects management will ha"e their hands tied. !mplicit reward promises such as the promise of promotion for good performance is also problematic since not all organisations are large enough to offer structured career progression. !n situations where not e"eryone can be promoted, a range of alternati"e reward systems need to be in place to ac%nowledge good performance and encourage commitment from the wor%force. $he si/e and time span of the reward. $his can be difficult to determine especially in businesses which are subject to seasonal "ariations. 4cti"ity le"els may "ary and there remains the potential problem of assessing performance when an organisation operates with surplus capacity. .hether the reward should be indi"idual or group-based. .hether the reward scheme should in"ol"e equity participation. Such schemes in"ariably appeal to directors and senior managers but should arguably be open to all indi"iduals if &perceptions of inequity& are to be a"oided. $a# implications also need to be considered.

Performance measures - benefits and problems 1erry, 1roadbent and 6tley )1**5+5 suggest that the following benefits can be deri"ed from the use of performance measures: (larification of the objecti"es of the organisation. $he de"elopment of agreed measures of acti"ity. 4 greater understanding of the processes within the organisation. $he facilitation of comparisons of performance between different organisations. $he facilitation of the setting of targets for the organisation and its managers. $he promotion of the accountability of the organisation to its sta%eholders.

-owe"er, they also draw attention to the potential problems that may de"elop from the use of performance measures by an organisation. $hese could include: tunnel "ision sub-optimisation myopia measure fi#ation misrepresentation

The pyramids and pitfalls of performance measurement

misinterpretation gaming ossification. !t is "ital that management gi"e detailed consideration as to whether there are li%ely to be problems in using performance measures as targets for the organisation and its managers. 6f particular importance is the need to assess whether the use of performance measures will help to pro"ide accountability of the organisation and its employees to the sta%eholder. $his raises the question of the compatibility )congruence+ of indi"idual and organisational goals. !ndi"idual goals may focus on financial and non-financial areas such as remuneration, promotion prospects, job security, job satisfaction, and self-esteem. $here may be a conflict for each indi"idual between actions to ensure the achie"ement of indi"idual goals and/or organisational goals. $he list of potential problems cited by 1erry, 1roadbent and 6tley may be illustrated in the conte#t of any type of organisation. $he comments which follow are illustrated in the conte#t of what could occur )although should not occur+ in a firm of practising accountants. $unnel "ision may be seen as undue focus on performance measures to the detriment of other areas. 3or e#ample, efforts to ensure a staff utilisation ratio of > ?, measured in terms of chargeable hours as a proportion of total hours a"ailable, may lead to inadequate documentation of client records and de"elopments in areas such as communication and teamwor%. Sub-optimisation may occur where undue focus on some objecti"es will lea"e others not achie"ed. 3or e#ample, an audit partner may be focused on winning new clients but this may result in inadequate super"ision regarding the wor% of current clients. ;yopia refers to short-sightedness leading to the neglect of longer-term objecti"es. 4n undue focus on generating current client income could be to the detriment of longer-term goals such as practice de"elopment or inno"ations in approaches to the management of client affairs. ;easure fi#ation implies beha"iour and acti"ities in order to achie"e specific performance indicators which may not be effecti"e. 3or e#ample, using too junior staff on an audit in order to limit costs might result in much re-wor%, costly delays, and client dissatisfaction. ;isrepresentation refers to the tendency to indulge in creati"e reporting in order to suggest that a performance measure result is acceptable. 3or e#ample, a client sur"ey report statistic might indicate that *5? of respondents indicated their satisfaction with a particular ser"ice pro"ided by the practice while in actual fact only a carefully selected 0? of clients were sent the questionnaire. ;isinterpretation in"ol"es the failure to recognise the comple#ity of the en"ironment in which the organisation operates. .ithin an accountancy practice, one partner might be focused on the achie"ement of profit whereas another partner might be focused on winning high-profile clients, and another paying attention to establishing a local reputation. .ithin such a scenario, the e#istence of multiple moti"es creates a comple# en"ironment in which the objecti"es of the principal players may not always coincide. 0aming is where there is a deliberate distortion of the measure in order to secure some strategic

The pyramids and pitfalls of performance measurement

ad"antage. $his may in"ol"e deliberate under-performing in order to a"oid higher targets being set. 3or e#ample, when conducting an audit, a manager might become aware of a potentially lucrati"e opportunity to supply consultancy ser"ices. !f such ser"ices were not budgeted for in respect of the forthcoming year then the manager would undoubtedly be percei"ed in a good light when a contract for those ser"ices suddenly came to fruition. 4nother e#ample of gaming would be the restriction of departmental consultancy earnings in one year in order that the target for the ne#t year will not be increased and/or to hold bac% consultancy possibilities which are in the pipeline in order to create slac%. 6ssification, which by definition means &a hardening&, refers to an unwillingness to change the performance measure scheme once it has been set up. 4n e#ample might be the use of a standard set of questions in a questionnaire to test client satisfaction with a particular ser"ice. 0ood responses may simply indicate a poorly-structured questionnaire, rather than a high degree of client satisfaction. Addressing the problems 6ne should ac%nowledge that imperfections will e#ist in any performance measurement scheme. 0eorge 1rown )1**2+ has outlined a number of actions that may be ta%en in order to minimise the impact of imperfections which may e#ist. $hese are as described below. Involving staff at all levels in the development and implementation of the scheme @eople are in"ol"ed in the achie"ement of the performance measures at all le"els, and in all aspects, of an organisation. !t is important that all staff are willing to accept and wor% towards any performance measures which are de"eloped to monitor their part in the operation of the organisation and in the achie"ement of its objecti"es. $his should help to reduce the e#tent of gaming and tunnel "ision. Being fle ible in the use of performance measures !t is best to ac%nowledge that performance measures should not be relied on e#clusi"ely for control. 4 performance measure may gi"e a short-term measure which does not relate directly to actions which are ta%ing place in order to lead to an impro"ed longer-term le"el of performance. $o some e#tent it should be ac%nowledged that impro"ed performance may be achie"ed through the informal interaction of indi"iduals and groups. $his fle#ibility should help to reduce the e#tent of measure fi#ation and misrepresentation. !eeping the performance measurement system under constant review $his should help to o"ercome the problems of ossification and gaming. 4nother requirement in o"ercoming problems is to gi"e careful consideration to the dimensions of performance. 4ctions that may be ta%en include quantifying all objecti"es )howe"er difficult this may appear to be+ and to try and focus on measuring customer satisfaction. <fforts to quantify an objecti"e will impro"e the efforts to understand and ta%e action to achie"e the intended output of the objecti"e. Such actions should help to o"ercome sub-optimisation. ;easuring customer satisfaction is a "ital goal. .ithout continuing and impro"ed le"els of customer satisfaction, any organisation is underachie"ing and is li%ely to ha"e problems in its future effecti"eness. @ositi"e signals from performance measures earlier in the "alue chain are only of rele"ance if they contribute to the ultimate requirement of customer satisfaction. 6nce again, tunnel "ision and sub-optimisation should be reduced through recognition of this requirement.

The pyramids and pitfalls of performance measurement

(onsideration should also be gi"en to the audit of the system. See%ing e#pert interpretation of the performance measurement system should help in considering the li%ely incidence of any or all of the problems cited abo"e. !t is important that this issue is considered at arms length and is not influenced by the "iews of those operating the scheme. !n addition, maintaining a careful audit of the data used should help to reduce the incidence and impact of measure fi#ation, misinterpretation, or gaming. $his is because any assessment scheme is only as good as the data on which it is founded and how such data is analysed and interpreted. !t is also rele"ant to recognise %ey features necessary in any scheme. 6nce again, such measures should help to o"ercome the range of problems outlined abo"e. 8ey features will include: nurturing a long-term perspecti"e among staff. $his may be difficult to achie"e where rewards such as bonus or promotion are based on relati"ely short-term measures. trying to limit the number of performance measures. 1etter to focus on the %ey e"ents which are li%ely to result in customer satisfaction. $oo many performance measures may simply dissipate effort and could lead to conflicting actions. de"eloping performance benchmar%s which are independent of past acti"ity. $his refers to the need to focus on the way ahead - and how, by appropriate action, to impro"e from whate"er the current situation may be. Shane Johnson is e aminer for Paper P" #eferences 1. 'ynch = ', and (ross 8 3, ;easure upA: Bardstic%s for (ontinuous !mpro"ement )1st edition, 1**1+, 1lac%well )CS4+. . 1rown 0, 4ccountability and performance measurement, Students& 9ewsletter, 6ctober 1**2. 7. 1erry 4 D, 1roadbent D, and 6tley 5 $, ;anagement (ontrol: $heories, !ssues and @erformance ) nd edition, 005+, @algra"e ;acmillan. :. Spendolini ; D, $he 1enchmar%ing 1oo%, )1**1+, 4merican ;anagement 4ssociation. 5. 1erry 4 D, 1roadbent D, and 6tley 5 $, ;anagement (ontrol: $heories, !ssues and @ractices )1st edition, 1**5+, ;acmillan @ress