Report
To: The board of DS
From: An Accountant
Date: March 2017
Subject: Strategic performance reporting and reward systems at DS
This report assesses the coherence of the choice of key performance indicators (KPIs) with the mission of DS followed by the assumptions used in their calculation. Other aspects of the presentation of the dashboard report are then evaluated. Finally, an overview of the operation of the building block model and an assessment of two proposed reward schemes are provided.
(i) Linking the mission to the current KPIs
Linking the mission to the current KPIs The mission statement can be broken into several parts. The principal aim is maintainable, profitable growth which is supported by three further goals: developing the best talent; providing world-class services; and being efficient. The KPIs are linked to elements of this statement as follows:
– Operating profit margin shows that the organisation is profitable and also as a margin, it indicates efficiency in cost control.
– Secured revenue indicates the amount of revenue which is contracted and so has greater likelihood of being earned. Contracts give an indication of maintainability though here only in the short term.
– Management retention links to the need for best talent though it does not measure the developing of that talent.
– Order book shows the maintainability into the future of the business though it does not show the average length of the contracts.
– Organic revenue growth shows historic growth and may indicate what the management are capable of into the future.
– ROCE demonstrates the efficiency of profit-generation from the capital base of DS.
None of the measures are external, looking at the competitive environment and so it is not possible to indicate if DS has ‘world-class services’.
(ii) Assumptions underlying the current KPI calculations
Every KPI will involve some assumptions in its calculations. The aim of this section is to highlight how each indicator could be manipulated to show a better picture so that the business can avoid this in the future and the subsequent bad image portrayed in the investing community.
Operating profit margin is a standard performance measure and the only area which can be questioned is the categorisation of costs below this line, for example, the movement of operating costs into ‘exceptional costs’ below this line in order to artificially inflate this indicator. If the $55m reorganisation cost was included in overall operating profit which was $91m (=5·9% of $1,542m) then the business would show an operating margin of 2·3%. The catering business would show a loss of $39m.
Secured revenue represents long-term recurring revenue streams. A good picture will show a high percentage of secured revenue but will be below 100% so that management can indicate that budget targets are being exceeded. It is worrying that the budget is completed well after the year start as this may indicate such manipulation. If the original budgeted revenue figure is used then the secured revenue for 2016 was 82%.
Management retention only includes retention of employees on full-time contracts which at 65% of all managers excludes a material number. Poor treatment (and thus retention) of part-time managers is therefore ignored. This may be a particular issue for managers with young children who often take advantage of such contracts.
Order book is a ‘total ‘value’ figure but is this the cash or present value figure? By choosing cash value of the contract, this will give a much larger figure than the discounted present value, especially where some revenues will not be received for 10 years.
Organic revenue growth is calculated by using the total revenue figure as reported in the accounts. The main purpose of stating organic is that it is growth from within the organisation as it stands and so acquisitions should be ignored. The current figure would fall from 7·2% overall to a less impressive 3·9%.
Return on capital employed (ROCE). Capital employed is being calculated using the statement of financial position figures which may exclude many intangible assets. As such it may overemphasise the tangible capital base which is not as important in a service business such as DS. The focus on this measure can lead to suboptimal decisions.
(iii) Evaluation of the strategic performance dashboard
The current information used by the board is both financial and non-financial allowing different elements of the mission to be measured. However, none of the measures are external, looking at the competitive environment and so it is not possible to indicate if DS has ‘world-class services’. Also, the measures do not focus on shareholder concerns although the mission statement indicates that they are the principal stakeholders. Other measures beyond ROCE might have been expected given that priority, such as EPS or dividend per share. No breakdown of ROCE is provided for each business unit, this may be due to the lack of availability of capital employed figures for the units but it does seem an odd inconsistency since ROCE is the best KPI provided for shareholder use.
No revenue figures are given and as most figures are ratios it is not possible to gauge the absolute scale of the business. It is particularly surprising that an absolute profit measure is not included on the dashboard given the importance of profitable growth to shareholders.
Generally, there is a lack of external figures to allow benchmarking or the assessment of the competitive position of DS.
The breakdown of results into business sectors will help in the judgement of performance of the managers of those units but they may not be comparable, for example, comparing building services and security, it seems that building services is growing more rapidly but with weaker margins. Also, it may be that the employment market is different between each sector and so no comparison of management retention figures is sensible. Again, it may be helpful to provide either an external benchmark through industry averages or an internal one through a historic trend for these sector specific indicators.
The report does have good qualities as it is brief and clearly presented. The use of ratios makes for easy understanding.
(iv) The building block model
The model takes the important step of distinguishing within the dimensions of performance between what is the desired outcome (results) and what are the drivers of those results (determinants). It then highlights the need to measure both within the performance reporting systems of an organisation.
The standards are the target level for the specific measures chosen for each dimension appropriate to an employee’s performance. Employees must take ownership so they need to be persuaded to accept the target and be motivated by the targets. Targets must be achievable and so challenge the employee without being viewed as impossible to achieve and so be demotivating. For example, they must take account of external market conditions which will be beyond the control of the employee, but this can be managed by benchmarking against an industry average. Targets must be fair, for example, different businesses within DS must be measured against their sector (catering, security, etc).
(v) Assessment of the proposed reward schemes
As the board is already considering using the building block model, it is appropriate to outline the main criteria in the model for reward schemes.
Rewards must be
– clear, that is, understood by the managers;
– motivating, that is, of value to the employee; and
– controllable, that is, related to their area of responsibility.
Scheme 1
The scheme has the benefit that it continues with the successful policy of offering an equity share in DS. It continues to utilise the knowledge of the line manager in performing the appraisal. It attempts to address a problem of the current scheme which is that the breadth of the categories gives the line manager scope to continue to show favouritism to specific employees. This is addressed as the bonus for line management will be affected by their appraisal according to performance on this new scheme and it will be helped practically by giving them an expectation of the distribution of bonus shares. This will also mean that forecasting staff costs will be simpler.
However, this scheme does not address the problem that the appraisal categories are vague and do not reflect the KPIs of DS. It also could create a problem as line managers will give bonuses according to the stated expectation, for example, even where all staff are, in absolute terms, performing brilliantly only 20% will get the maximum. Also, there is no mention of the scale of the scheme bonuses as there is for Scheme 2, where the maximum is stated as 50% of basic salary.
Scheme 2
Scheme 2 Scheme 2 loses a key benefit of the current scheme in not rewarding in shares but cash is an acceptable alternative. Cash may well be a preferred option for the managers as it offers a certain value to them. This form of benefit also reduces the desire to manipulate share prices. It sets standards based on the KPIs and so should lead to greater focus by each employee on the goals of DS. Involvement of both strategic and line management in this process should lead to a better set of measures being used.
It is not clear, however, why five targets are being chosen. This seems an arbitrary figure and it may be more sensible to suggest a range from three to six (the number of strategic KPIs) to be decided by the managers in consultation. The size of the maximum reward seems likely to motivate but the equal weighting for each heading may not be effective. It requires that, say, operating profit margin has the same importance as management retention.