Alternative Measures of Firm Performance

© Peter Atkinson
July, 2004

The traditional, neoclassical, view of the company sees it as having the sole purpose of maximising profit for its owners. One company is more successful than another, and is able to attract more investment, because its profitability is higher. Information about profitability can easily be gained from looking at the accounts. There are a number of ratios that may be applied to a set of accounts and which are revealing in many ways. Although this way of looking at things is tried and tested, and I believe fundamentally reflects the purpose of the firm, it is not always a useful viewpoint in practice. For a start, the accounts can only ever tell you about the past of the company and this is of limited value when it comes to assessing the business’s future potential.

For example, the stock market does not value shares in a company simply by reading the bottom line in last year’s accounts or applying accounting ratios but instead makes a subjective evaluation of the company based on concrete information about the company’s organisation and activities, information about the market in which it works, a subjective evaluation about the relative importance of each of these pieces of information and a subjective evaluation of the future. This method works for the stock market but it would be unwise for a company’s managers to be wholly focused on the market valuation of their company’s shares. After all, a stock market valuation is made with the knowledge in mind that the stocks may be divested in seconds whereas a company’s mangers should have a rather longer perspective. Shareholder Value Analysis, which forecasts future cash flows and discounts them back to a rough estimate of current value, is an attempt to make financial analysis forward looking but still fails to shed light on the activities that produce these cash flows. In any case there are many organisations such as companies limited by guarantee and public sector organisations that do not issue shares and do not produce accounts that are susceptible to this form of performance measurement.

In a White Paper produced for the Government of Ontario (1), Rob McClean (1994) argues that there has been a paradigm shift in the nature of the firm caused by changes in technology. The paradigm that accountants work with is one of a manufacturing company where the assets that appear on the balance sheet are, for the most part, tangibles like buildings and machinery. For example, Frank Woods’s text books that are used very widely in the UK for teaching accountancy follow this paradigm. McClean argues that we no longer have an economy that is primarily manufacturing orientated but instead have an information orientated economy. This reorientation means that the balance sheet no longer adequately reflects the most important assets of the company – such as value built through product development or skill in marketing the firm’s products - or gives an indication of whether they are increasing or decreasing.

Of course, this is not merely an accounting problem, of how to include the value of intangible assets in the balance sheet but also of how to use information about intangible assets. McClean comments, “... no durable competitive advantage can be based on existing processes or existing products. It is increasingly recognised that companies will be differentiated based on the speed of organizational learning and the ability to effectively mobilize the knowledge base within the organisation. … This new focus on strategy leads to an increased emphasis by managers on the assets that underlie core competencies: people skills, knowledge, information and technological capabilities.” If firms are to be judged on these criteria it follows than managers need some way to measure and monitor these assets.

One of the examples cited by McClean is the Swedish insurance and finance company, Skandia, who, in the early 1990’s, set out to measure the performance on intellectual capital. They tracked specific indicators under the headings: financial focus, customer focus, process focus and renewal focus.

Apart from the issue of the evaluation of the knowledge asset there is an array of possible indicators that might be used to aid an overall evaluation of a firm’s future performance in a rapidly changing business environment. In a Harvard Management Update article , Jonathan Low(1999) (2) suggests a list of non-financial variables that managers actually rely on:

  • The ability of a company to execute its stated strategy
  • The credibility of management
  • The quality of the strategy
  • Innovativeness
  • Ability to attract and retain talented people
  • Market position
  • Management experience
  • Executive compensation
  • Quality of major processes
  • Research leadership

This list is useful but leaves us with two questions: ‘what combination of these indicators will help managers to run a particular firm?’ and ‘what metrics should we use to evaluate these variables?’

The Balanced Scorecard is a management system that “provides a clear prescription as to what companies should measure in order to ‘balance’ the financial perspective.” Developed by Robert Kaplan and David Norton (3) at Harvard Business School in the early 1990’s, it has become a popular system and has been adopted by a number of major firms. It aims to balance the financial perspective with three other viewpoints: the internal business perspective, the customer perspective and the innovation and learning perspective. In this way the Balanced Scorecard requires managers to look at the business from different viewpoints and see the relationships between them.

Four basic questions are asked:

  1. financial perspective - How do we look to shareholders?
  2. internal business perspective – What must we excel at?
  3. customer perspective – How do customers see us?
  4. innovation and learning perspective – Can we continue to improve and create value?

The diagram shows the relationship between the four perspectives and the firm’s strategy (4) so that there is a feedback loop not just for checking the effectives of the internal business processes but also to check these and the other perspectives against the strategic vision and planning to help to prevent strategic drift.

Although the Balanced Scorecard is prescriptive in that it requires managers to consider all four viewpoints it is flexible in that it does not try to prescribe what metrics should be used to help answer the four questions. The metrics are determined by the firm’s strategy. This method requires managers to identify the drivers of their strategic intentions and then the underlying drivers of those drivers. For example, if a firm aims to provide a high level of customer satisfaction in its provision of a technical support service then a driver of that strategic aim will be the level of relevant technical knowledge among the staff. In turn, the underlying drivers of this knowledge pool might be identified as training and staff turnover. The firm might then introduce a formal test that all the technical support staff is required to pass and one of the metrics might be what proportion of that staff at any one time have passed the test.

In order to put the BS into practice, the firms needs to identify its goals, arising from its strategy, and then the specific measures to monitor them for each of the four perspectives. Kaplan and Norton recommend firms to have five or six metrics for each perspective giving a total of 20 to 24 metrics altogether. More than this, they say, would be too many for manager’s to digest.

In the area of customer perspective they suggest that customers’ concerns fall into four categories: time, quality and service, performance and cost. They cite an example of a firm that produces high value medical equipment whose customers require very high reliability (5). From the firm’s strategy comes the goal of meeting the objective of providing high reliability and from this goal arose the metrics of percentage equipment up-time and mean-time response to a service call. They point out that companies might use third parties to evaluate customer satisfaction such as the automotive industry’s use of the JD Powers quality survey.

In the area of internal business processes, the firm should identify and measure their core competencies. The metrics chosen should provide a link between the firm’s strategy and what employees do day-to-day. In this way all the employees in the firm will feel that they can directly influence the success, or otherwise, of the firm’s strategy so that the metrics themselves become a motivator. Karen Carney (6) suggests that these metrics might be presented to employees formally as ‘scoreboards’ displayed publicly, eg on PC desktops, so that they are constantly aware of them.

In an article published in 2002, Loren Gary (7) cites an interview with David Norton conducted in the context of the BS having a track record and there being a recession in the US economy. Norton says that the most common mistake in firms’ attempts to implement the BS is a failure to link metrics to strategy often because the firm does not actually know what the drivers of their strategic goals are. He says that managers must have a balance between the long-term objective of growth and the short-term objective of productivity. In a recession the focus tends to shift to the short-term but it would be a mistake to change the strategy, or the metrics, just because of current economic conditions.

A recent article by Christopher Itner and David Larker (8)bemoans companies that “…have adopted boilerplate versions of non-financial measurement frameworks such as Kaplan and Norton’s Balanced Scorecard, Accenture’s Performance Prism, or Skandia’s Intellectual Capital Navigator.” These authors confirm Norton’s comments about the absolute necessity of linking measures to the firm’s strategy and they go on to point out that as the data is gathered and used the linkages should be validated to ensure that the metrics are indeed useful ones.

In a fast changing business environment it is essential that managers and other stakeholders are able to evaluate a firm in terms of its future potential. Financial measures of performance are inevitably historical and fail to engage with the actual drivers of the firm’s success; non-financial performance measures must be used. By introducing a system like the Balanced Scorecard, managers are enabled to identify drivers of success in terms of the firm’s strategy and continuously monitor progress in a way that both motivates staff and feeds back to the strategy. Providing that a system like this is used intelligently, with a genuine desire to measure the firm’s drivers of success in respect of its strategy, these alternative measures are very useful indeed.

1. Rob McClean, “Performance Measures in the New Economy”, Task Force to Review the Ontario Technology Fund, White Paper, http://mclean.matrixlinks.ca/PerfMeasNE.html

2. Jonathan Low (1999), “Gauging Results: What Measures Matter?”, Harvard Management Update

3. Robert Kaplan and David Norton (1996), Balanced Scorecard: Translating Strategy into Action, Harvard Business School Press

4. from www.balancedscorecard.org

5. Robert S Kaplan and David P Norton (1992), “The Balanced Scorecard – Measures that Drive Performance”, Harvard Business Review, January-February 1992.

6. Karen Carney (1999), “Successful Performance Measurement: A Checklist”, Harvard Management Update, November, 1999.

7. Loren Gary (2002), “How to Think About Performance Measures Now”, Harvard Management Update, February, 2002

8. Christopher D Itner and David F Larker (2003), “Coming Up Short on Nonfinancial Performance Measurement”, Harvard Business Review, November 2003