DISADVANTAGES OF FINANCIAL PERFORMANCE INDICATORS
Concentration on financial indicators means that important goals and factors may be ignored.
Concentration on too few variables
If performance measurement systems focus entirely on those items which can be expressed in monetary terms, managers will concentrate on only those variables and ignore other important variables that cannot be expressed in monetary terms.
For example, pressure from senior management to cut costs and raise productivity will produce short-term benefits in cost control but, in the long term, managerial performance and motivation is likely to be affected, labour turnover will increase and product quality will fall.
Reductions in cost can easily be measured and recorded in performance reports, employee morale cannot. Performance reports should therefore include not only costs and revenues but other important variables, to give an indication of expected future results from present activity.
Lack of information on quality
Traditional ‘responsibility’ accounting systems also fail to provide information on the quality or importance of operations. Drury provides the following example.
‘Consider a situation where a purchasing department regularly achieved the budget for all expense items. The responsibility performance reporting system therefore suggests that the department was well managed. However, the department provided a poor service to the production departments. Low-cost suppliers were selected who provided poor quality materials and frequently failed to meet delivery dates. This caused much wasted effort in chasing up orders and prejudiced the company’s ability to deliver to its customers on time.’
Measuring success, not ensuring success
Financial performance indicators have been said simply to measure success. What organisations also require, however, are performance indicators that ensure success. Such indicators, linked to an organisation’s critical success factors such as quality and flexibility, will be non financial in nature.
GROWING EMPHASIS ON NFPIs
Changes in cost structures, the competitive environment and the manufacturing environment have lead to an increased use of NFPIs.
Impact of changes in cost structures and the manufacturing and competitive environments
These have led to a shift from treating financial figures as the foundation of performance measurement to treating them as one of a range of measures.
Changes in cost structures
Modern technology requires massive investment and product life cycles have got shorter. A greater proportion of costs are sunk and a large proportion of costs are planned, engineered or designed into a product/service before production/delivery. At the time the product/service is produced/delivered, it is therefore too late to control costs.
Changes in competitive environment
Financial measures do not convey the full picture of a company’s performance, especially in a modern business environment.
‘In today’s worldwide competitive environment companies are competing in terms of product quality, delivery, reliability, after-sales service and customer satisfaction. None of these variables is directly measured by the traditional responsibility accounting system, despite the fact that they represent the major goals of world-class manufacturing companies.’
Changes in manufacturing environment
New manufacturing techniques and technologies focus on minimising throughput times, inventory levels and set-up times. But managers can reduce the costs for which they are responsible by increasing inventory levels through maximising output. If a performance measurement system focuses principally on costs, managers may concentrate on cost reduction and ignore other important strategic manufacturing goals.
Many companies are therefore discovering the usefulness of quantitative and qualitative nonfinancial performance indicators (NFPIs). The following definition from CIMA’s Official Terminology is useful because of the examples it provides.
Non-financial performance measures are ‘measures of performance based on non-financial information which may originate in and be used by operating departments to monitor and control their activities without any accounting input.
Non-financial performance measures may give a more timely indication of the levels of performance achieved than do financial ratios, and may be less susceptible to distortion by factors such as uncontrollable variations in the effect of market forces on operations.
Examples of non-financial performance measures:
Proportions of repeat bookings
Customer waiting time
Number of complaints
Number of suppliers
Days’ inventory in hand
Output per employee
Material yield percentage
Proportion of output requiring rework
Manufacturing lead time
Sales volume growth
Customer visits per salesperson
Trend in market share
Number of customers
Customer survey response information
Number of complaints received
Days lost through absenteeism
Days lost through accidents/sickness
Training time per employee.
Client contact hours per salesperson
THE VALUE OF NFPIs
Ease of use
NFPIs do have advantages over financial indicators but a combination of both types of indicator is likely to be most successful.
Unlike traditional variance reports, NFPIs can be provided quickly for managers, per shift, daily or even hourly as required. They are likely to be easy to calculate, and easier for nonfinancial managers to understand and therefore to use effectively.
The beauty of non-financial indicators is that anything can be compared if it is meaningful to do so. The measures should be tailored to the circumstances so that, for example, number of coffee breaks per 20 pages of Study Text might indicate to you how hard you are studying!
Many suitable measures combine elements from the chart shown below. Use it to answer the question below.
|Defects||Second||Range of products||Employees|
|Equipment failures||Minute||Parts/components||Employee skills|
|Warranty claims||Hour||Units produced||Customers|
Here are five indicators, showing you how to use the chart, but there are many other possibilities.
- Services performed late v total services performed
- Total units sold v total units sold by competitors (indicating market share)
- Warranty claims per month
- Documents processed per employee
- Equipment failures per 1,000 units produced
Now think some for yourself but don’t forget to explain how the ones that you chose might be useful.
NFPIs and financial measures
Arguably, NFPIs are less likely to be manipulated than traditional profit-related measures and they should, therefore, offer a means of counteracting short-termism, since short-term profit at any (non-monetary) expense is rarely an advisable goal. The ultimate goal of commercial organisations in the long run is likely to remain the maximisation of profit, however, and so the financial aspect cannot be ignored.
There is a danger that too many such measures could be reported, leading to information overload for managers, providing information that is not truly useful, or that sends conflicting signals. A further danger of NFPIs is that they might lead managers to pursue detailed operational goals and become blind to the overall strategy in which those goals are set.
A combination of financial and non-financial indicators is therefore likely to be most successful.
The balanced scorecard
The need to link financial and non-financial measures of performance and to identify the key performance measures provided the impetus for the development of the balanced scorecard, which we looked at in Study Unit 22.
NFPIs IN RELATION TO EMPLOYEES
NFPIs can usefully be applied to employees.
One of the many criticisms of traditional accounting performance measurement systems is that they do not measure the skills, morale and training of the workforce, which can be as valuable to an organisation as its tangible assets. For example if employees have not been trained in the manufacturing practices required to achieve the objectives of the new manufacturing environment, an organisation is unlikely to be successful. Indeed, in a service industry such an accountant’s business, the people are the key assets
Employee attitudes and morale can be measured by surveying employees. Education and skills levels, promotion and training, absenteeism and labour turnover for the employees for which each manager is responsible can also be monitored.
The weighting attached to employee-oriented NFPIs when assessing managerial performance should be high. High profitability or tight cost control should not be accompanied by 100% labour revenue.
NFPIs IN RELATION TO PRODUCT / SERVICE QUALITY
NFPIs are extremely useful when assessing product/service quality.
Performance measurement in a TQM environment
TQM is a highly significant trend in modern business thinking. We look at it in more detail in Study Unit 17 when we look at Japanese businesses practices and when considering the costs of quality.
Because TQM embraces every activity of a business, performance measures cannot be confined to the production process but must also cover the work of sales and distribution departments and administration departments, the efforts of external suppliers, and the reaction of external customers.
In many cases the measures used will be non-financial ones. They may be divided into three types.
Measuring the quality of incoming supplies
The quality of output depends on the quality of input materials, and so quality control should include procedures for acceptance and inspection of goods inwards and measurement of rejects.
- Inspection will normally be based on statistical sampling techniques and the concept of an acceptance quality level (AQL).
- Another approach that can be used is to give each supplier a ‘rating’ for the quality of the goods they tend to supply, and give preference with purchase orders to wellrated suppliers.
- Where a quality assurance scheme is in place, the supplier guarantees the quality of goods supplied. This places the onus on the supplier to carry out the necessary quality checks, or face cancellation of the contract.
Monitoring work done as it proceeds
This will take place at various key stages in the production process. Inspection, based on random sampling and other statistical techniques, will provide a continual check that the production process is under control. The aim of inspection is not really to sort out the bad products from the good ones after the work has been done. The aim is to satisfy management that quality control in production is being maintained.
‘In-process’ controls include statistical process controls and random sampling, and measures such as the amount of scrap and reworking in relation to good production. Measurements can be made by product, by worker or work team, by machine or machine type, by department, or whatever is appropriate.
Measuring customer satisfaction
Some sub-standard items will inevitably be produced. In-process checks will identify some bad output, but other items will reach the customer who is the ultimate judge of quality. ‘Complaints’ may be monitored in the form of letters of complaint, returned goods, penalty discounts, claims under guarantee, or requests for visits by service engineers.
Some companies adopt a more pro-active approach to monitoring customer satisfaction by surveying their customers on a regular basis. They use the feedback to obtain an index of customer satisfaction which is used to identify quality problems before they affect profits.
Quality of service
Service quality is measured principally by qualitative measures, as you might expect, although some quantitative measures are used by some businesses.
- If it were able to obtain the information, a retailer might use number of lost customers in a period as an indicator of service quality.
- Lawyers use the proportion of time spent with clients.
Fitzgerald et al identify 12 factors pertaining to service quality and the following table shows the measures used and the means of obtaining the information by British Airports Authority, a mass transport service:
|Service quality factors||Measures||Mechanisms|
|Access||Walking distances Ease of finding way around||Customer survey and internal operational data
Quantity, quality, appearance of food
|Availability||Equipment availability||Internal fault monitoring system and customer survey
Customer survey and internal operational data
|Cleanliness/tidiness||Cleanliness of environment and equipment||Customer survey and management inspection|
|Comfort||Crowdedness of airport||Customer survey and management inspection|
Clarity of labelling and pricing
|Customer survey Management inspection|
|Courtesy||Courtesy of staff||Customer survey and management inspection|
|Friendliness||Staff attitude and helpfulness||Customer survey and management inspection|
|Reliability||Number of equipment faults||Internal fault monitoring systems|
|Responsiveness||Staff responsiveness||Customer survey|
|Security||Efficiency of security checks
Number of urgent safety reports
|Customer survey Internal operational data|
Qualitative factors are not easily measured and so, in management accountancy, they can be ‘those factors which can be expressed in monetary terms only with much difficulty or imprecisi
There will often be no conclusion that you as the management accountant can draw from qualitative information. Your job is to be aware of its existence and report it under the heading of ‘other matters to be considered’. In practice of course, many decisions are finally swayed by the strength of the qualitative arguments rather than the cold facts presented in the quantitative analysis, and rightly so.
Exam Focus Point
As a general guideline, if you are asked to comment on qualitative issues, you should consider matters such as the following.
- The impact on or of human behaviour. What will be the reaction on the factory floor? How will managers feel? Will customers be attracted or deterred? Can suppliers be trusted?
- The impact on or of the environment (‘surroundings’). Is the country in a recession? Is government or legislation influential? Are there ‘green’ issues to be considered? What is the social impact? What action will competing companies take? Is changing technology a help or a hindrance?
- The impact on or of ethics. Is the action in the public interest? Are we acting professionally? Are there conflicts of interest to be considered? Will fair dealing help to win business? Are we treating staff properly?
Brand identity conveys a lot of information very quickly and concisely. This helps customers to identify the goods or services and thus helps to create customer loyalty to the brand. It is therefore a means of increasing or maintaining sales.
Where a brand image promotes an idea of quality, a customer will be disappointed if his experience of a product fails to live up to his expectations. Quality control is therefore of utmost importance. It is essentially a problem for service industries such as hotels, airlines and retail stores, where there is less possibility than in the manufacturing sector of detecting and rejecting the work of an operator before it reaches the customer. Bad behaviour by an employee in a face-to-face encounter with a customer will reflect on the entire company and possibly deter the customer from using any of the company’s services again.
Brand awareness is an indicator of a product’s/organisation’s place in the market. Recall tests can be used to assess the public’s brand awareness.
Company profile is how an organisation is perceived by a range of stakeholders. For example, stakeholders may have a negative attitude towards an organisation, perhaps as a result of an ethical issue or a crisis that has struck the organisation and perhaps of the associated media comment. Market research can determine company profile and marketing campaigns can improve it if necessary.
- Concentration on financial indicators means that important goals and factors may be ignored.
- Changes in cost structures, the competitive environment and the manufacturing environment have led to an increased use of NFPIs.
- NFPIs do have advantages over financial indicators but a combination of both types of indicator is likely to be most successful.
- NFPIs can usefully be applied to employees.
- NFPIs are extremely useful when assessing product/service quality.
- Qualitative factors are ‘those that can be expressed in monetary terms only with much difficulty or imprecision’.