To: The board of Fearties Security (Fearties)
From: An Accountant
Date: September 20X8
Subject: Performance reporting and management issues
This report evaluates the current choice of indicators within the financial perspective of the balanced scorecard and recommends new indicators to cover the additional perspectives of the scorecard. Additionally, the problems of measuring non-financial indicators are discussed. The current management style is evaluated and a new approach is recommended to match the strategy of the business. Finally, advice is given on the setting and use of targets in staff appraisals.
(i) Key performance indicators
The balanced scorecard has four perspectives: financial, customer, internal business process and innovation and growth. Indicators are needed for each perspective. The indicators suggested here are for the use of the board at a strategic level and not detailed operational management.
Financial perspective
The overall business objective is to grow profit without taking excessive risks. This is focused on the financial aspects of the business and so it is consistent that the current key performance indicators (KPIs) are all financial, being taken or calculated from the accounting information supplied with them. However, they are open to criticism.
The figures provided are the absolute values where it may be more useful to provide the year on year change in order to show growth.
                                                               20X8                                  20X7                                  Growth
                                                               $m                                     $m
​​​​​​​Revenue                                                  686                                    659                                    4·1%
Operating profit                                      36                                      34                                      5·9%
Cash flow from operating activities           64                                      64                                      0·0%
Dividends paid                                        14                                      13                                      7·7%
The operating profit figure is less helpful for control purposes than the operating margin which allows for the effect of increased sales activity. The figures above show operating profit improving but, in fact, this just reflects the increased sales, as the operating margin is constant at 5·2%.
The ability to generate cash from operations is one which should indicate if the company is at risk of failure and so it is a valuable measure of risk to the owners.
The dividend growth figure is only for one year and, given the family’s long-term involvement in the business, it might be more helpful to have a five-year average of growth, which can be calculated as 7·0%. This smooths out the fact that dividends are often only changed every few years once an increase appears sustainable.
The return on capital employed (ROCE) ratio is incorrectly calculated. The ratio calculated in the draft report is the return on equity (profit after tax/equity). This may be useful to a family owned business where share values are critical but it does not reflect the efficiency of the use of capital overall. The correct value is 31·3% (operating profit/average capital employed = 36/(21 + 94)). However, this ratio is not of much value to Fearties as it does not have a significant capital base. It requires relatively little capital investment as its activities are mainly about the hiring out of its employees’ time.
The existing KPIs do not adequately reflect the new plan to grow more rapidly by developing new markets. Figures for revenue growth and operating margin should be broken down as they are unlikely to be similar in the different markets.
Customer perspective​​​​​​​
The customer’s views are important for growth and so the scores of a customer survey may be used to indicate their satisfaction. However, as discussed later, there are difficulties in measuring customer satisfaction and so customer retention (through percentage of revenue generated from existing customers) may be a better objective measure.
Reliability is listed as a key selling point and some investigation may be required to identify on what aspects of the service the customers are basing this view. Possible measures could be the percentage of times that a security team of adequate size and experience are sent to each job or number of times when police have to be called to the customer’s location (indicating a problem which the Fearties’ team could not handle).
Internal business process
The operating margin indicator suggested in the financial perspective will supply useful information about the overall efficiency of internal processes.
Based on the issues facing the company, KPIs for this perspective should reflect employee recruitment and retention, so the average number of unfilled vacancies at the company over the year would be a relevant measure.
The success of the company’s training process could be measured by the number and average size of the legal claims against its staff.
Innovation and learning​​​​​​​
Training is a key issue for Fearties, so the percentage of staff who are qualified is an appropriate indicator. The time taken for this training and its costs may also be measures of the organisation’s ability to learn and improve this process.
The operating margin changes over time which are generated in the new markets entered by Fearties would show the organisation’s improvements in these new markets.
Obviously, revenue generated from new services offered would also measure innovation at Fearties. However, there appears to be little appetite for this at present as growth is to be driven from selling existing services in new markets.
[Tutor note: There are many possible KPIs which can be suggested for this scenario and these would be given credit based on the justification offered.]
(ii) Problems of non-financial performance indicators​​​​​​​
Problems of non-financial indicators can stem from the lack of familiarity of management with them. This is a particular problem for Fearties given its history of using financial indicators. Such non-financial indicators can have issues in the different areas of recording/processing and then interpreting the information.
Customer satisfaction is a good example of an indicator with such difficulties.
Customer satisfaction is often surveyed and the results are expressed in language. It can be difficult to tell if a complaint which describes service as ‘poor’ is more or less serious than one which describes service as ‘unacceptable’.
The most common way to try to overcome this problem is to turn the data into quantitative data. For example, surveys often use scoring systems to capture data on service. A scoring system will often ask the customer to rank their satisfaction at the service provided on a scale of 1 to 5 with ‘1’ representing ‘completely satisfied’ and ‘5’ representing ‘totally dissatisfied’.
However, the problem remains that such scoring systems are still subjective, and it has often been found that there is a tendency to score toward the middle as people tend to feel uncomfortable using the extreme scores of 5 or 1. However, Fearties may suffer from an over-reaction response as the events it deals with are dramatic. For example, if there was a burglary at a factory, then the loss is all blamed on Fearties’ failure and a bad score given.
Also, there is the difficulty in interpreting qualitative data, such as customer satisfaction. It is essentially subjective since it is based on people’s opinions. For example, in assessing quality of service, people have different expectations and priorities and so are unlikely to be consistent in their judgements. At Fearties, customer complaints will be driven by such opinions. Some customers may expect there will never be a security incident but this is out of Fearties’ control since it is criminal actions which will generate some of these cases.
One way to reduce the effect of subjectivity is to look at trends in performance since the biases in opinion will be present in each individual time period but the trend will show relative changes in satisfaction.
(iii) Management style​​​​​​​
The current style at Fearties would appear to be budget-constrained. The targets set are all financial and are short term in that they are only for the next financial year. This style of management leads to a focus on cost control and often staff are not rewarded if they take actions which will require investment or the foregoing of short-term profit, such as marketing to build a reputation for reliability as an outsourcing partner.
The profit-conscious style evaluates managers on their ability to build long-term profits for the business. This style would appear to suit Fearties’ strategic goals but it does not emphasise non-financial issues such as recruitment and retention. It would not fit with the increased importance of these non-financial factors under the balanced scorecard approach to management.
In the non-accounting style, budgetary information plays a less important part of staff’s performance evaluation. It suits an emphasis on quality and on operational factors. It would fit with many of the new non-financial indicators being proposed from the balanced scorecard. However, it may not be strategically suitable for Fearties due to the importance to the family of the financial returns from the business.
Overall, a profit-conscious approach is recommended but one which uses both financial and non-financial indicators from the balanced scorecard to support the long-term financial goals of the company. The profit-conscious style will suit the financial needs of the family and its long-term goal of growth while a supporting non-accounting approach will suit some of the operational arms of the business, for example, dealing with legal compliance and employee issues.
(iv) Targets and the appraisal process​​​​​​​
The existing system of targets will have to be modified to reflect the new balanced scorecard approach. This will involve the use of new non-financial indicators which will require explanation to the member of staff.
Non-financial targets are subject to the measurement problems noted earlier and, particularly, problems of subjectivity on the assessment of performance may become areas of dispute in appraisal. In order to address this difficulty, a historical analysis should be performed to use as a benchmark for future targets. There is also the possibility that, without such analysis, the targets set are unachievable or else too easy and so lead to unnecessary costs.
It will also be important that targets are controllable and so it will be necessary to review their areas of responsibility to ensure that the new targets reflect the performance of that individual. It will also be important to consider external factors which might require adjustment when considering the final appraisal. An example of this would be if legislation changed requiring higher qualifications for employees and so making recruitment more difficult or training more costly.
Appraisal is the process of collecting and reviewing data on an employee’s work which will provide an assessment of their capabilities and potential in order to improve performance, for example, by training. There is a danger that an over-focus on targets leads to a failure to consider helping the employee to advance.
A further issue with the use of targets in appraisal is that what gets measured gets done. This means that the choice of targets is important in focusing the employee on their tasks. The new balanced scorecard approach should assist in creating a broader assessment of the employee’s performance and aligning these with the strategy of the business as a whole.​​​​​​​