Archive for April, 2009

Date: April 16th, 2009
Cate: Academia, Measurement
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2009 PMA Conference - Professor Kenneth Merchant: Alternatives to accounting measures

Kenneth Merchant

Professor Kenneth Merchant

The opening keynote speech of Day 1 of the 2009 Performance Management Association conference was given by, Kenneth Merchant, Deloitte & Touche LLP Chair in Accountancy and Professor of Accounting at the University of Southern California Marshall School of Business. Professor Merchant is an expert in management accounting and management control systems with numerous publications in this field.
His speech addressed the challenges practitioners are faced with in selecting and using performance measures. He discussed the flaws of accounting measures and presented four alternatives.

I have structured below my notes from this session. In part one of this blog post, a number of issues with using accounting measures were presented. Several alternatives answering the question “What to use instead?” are presented below.

Part 2: Alternatives to accounting measures

1. Use market measures of performance.

• They have an obvious appeal.
• They also have some problems due to market imperfections, noise, feasibility (i.e. “market expectations problem”).
• For private firms there is no data availability.

Example: The case of Christopher J. Steffen at Eastman Kodak Co.
• January 1993 - Christopher J. Steffen was appointed Chief Financial Officer (CFO) of Eastman Kodak Co.. He had a reputation of cutting costs. Within 2 days, the stock increased $2.2 billion dollars.
• April 1993 - After 11 weeks in the job, he resigns (with few accomplishments). The stock declines with 2.0 billion dollars.
• Questions: What if the period of stay changes with a few months? Should bonuses be paid for the increase in the stock price due to market reactions?

2. Extend the measurement window

• Extend measurement horizon to 3, 5, even 10 years.
• The analysis of profit / market correlation in different windows (1, 2, 5 10 years) by Easton, et al.
1 year: 0.22
2 years: 0.39
5 years: 0.57
10 years: 0.79
• Are you willing to wait 10 years for a bonus? Maybe not, however 3-5 years is doable.

3. Use more informative non-GAAP financial measures of performance.

• “Pro-forma” earnings - exclude line-items that are more distracting than informative.
• Funds from operations (FFOs) - seems to work with Real Estate Investment Trusts (REITs).
• Free cash flow (FCF).
• Earnings before interest, taxes, depreciation, and amortization (EBIRDA).

4. Use combinations of measures

• There are many different approaches. Market and/or financial and/or non-financial measures.

Measure combination example 1: The GE Management Development and Compensation Committee uses a combination of financial indicators and subjective measures in the list of the CEO Goals and Objectives for 2007 and 2008.

Financial Objectives (Continuing operations)

Revenues
Earnings
Earnings per share (EPS)
Cash from operating activities (CFOA)
Return on trading capital (ROTC)
Margins

Strategic & Operational Goals

Sustain operating excellence and financial discipline.
Create a more valuable portfolio of businesses
Drive organic revenue growth at 2 to 3 times GDP
Retain excellent teams and a strong culture
Manage the Company’s risk and reputation
Build an excellent investor base
Lead the Board activities

Measure combination example 2: The Balanced Scorecard, with up to 20-25 measures, with casual links between them, grouped in four perspectives: Financial, Customer, Internal Business and People, Learning and Growth.
• The majority of firms claim to have a Balanced Scorecard. They misuse the term.
• Which set of measures in that circumstances provide the best indication of the value creation?
• Combination of short-term backward looking measures with leading indicators of future performance.
• How many measures should be used? The function is non-linear:

Ken Merchant-perf-vs-meas

Historical background on the use of measures
1954 - General Motors started using measures - 3-7 measures
1960 - Critical success factors

Conclusions

• Good news:
o We are accumulating more and more data about the relationship between market related measures, accounting measures and individual non-financial measures (i.e. customer satisfaction).

• Bad news
o Don’t know when to use each of the 4 alternatives presented. Individual or in combination, in any specific period of time.
o Don’t know about the effects of using concurrently multiple performance measures.
o Over satisfying customers is not good either, as this is generating diminishing returns. There is a limit to “profitable” customer satisfaction.
o The benefits of the BSC may not be sustainable (more research is required on what are the long term effects on BSC implementations in the BSC Hall of Fame companies).
o Still lots of research that needs to be done.

Date: April 16th, 2009
Cate: Academia, Measurement
1 msg

2009 PMA Conference - Professor Kenneth Merchant: On accounting measures

Professor Kenneth Merchant

Professor Kenneth Merchant

The opening keynote speech of Day 1 of the 2009 Performance Management Association conference was given by, Kenneth Merchant, Deloitte & Touche LLP Chair in Accountancy and Professor of Accounting at the University of Southern California Marshall School of Business. Professor Merchant is an expert in management accounting and management control systems with numerous publications in this field.
His speech addressed the challenges practitioners are faced with in selecting and using performance measures. He discussed the flaws of accounting measures and presented four alternatives. I have structured below my notes from this session.

Part 1: On accounting measures

• For management purposes accounting measures are badly flawed. The primary role of a corporation is to create and maximize shareholder value. However, accounting measures tell you little about value. Accounting measures are backwards looking. Value measures are future looking.
Evidence: A research study analysed 172 large firms that averaged an earnings per share (EPS) growth of over 15% over a 6 year period. Their correlation between annual earnings (before extraordinary items) and annual value changes was not as strong as anticipated. These correlations are discussed in several research papers: Easton et al (1992): .22, Biddle et al (1997): .25 and Erkens & Merchant (2005): Annual.18 and Quarterly .13

• Alternative financial-measure specifications are not much better. Correlations with market returns, annual (Biddle et al., 1997)
* Earnings before extraordinary items: .25
* Residual income : .16
* EVA(TM): .15
* Cash flow from operations: .14

• Flaws of accounting performance measures:
* Fail to identify real problems in a timely basis
* Lead to poor decisions, resulting in allocation of resources to “dogs” and not to “stars” and excessive short term orientation (myopia)
* Gamesmanship - ethics issues

• Why using accounting measures? Why do firms use them anyway?
* Nice to have a single, global performance indicator.
* Earnings/returns correlations are positive.
* Some nice measurement properties: timely, understandable, inexpensive, precise, objective and controllability can be tailored to the role (easy to disaggregate)
* Habit - i.e. DuPont chart has a long tradition - ROI = Sales margin * Asset turnover
* Misconceptions, such as: “Profit making firms should make profits” and ” Quarterly EPS reports drive stock prices”.
* Political expediency

• Do Accounting Measures work anywhere? What do we do if they don’t work? Answer: It should be an industry by industry analysis of annual accounting earnings / market correlations. Correlations based on information obtained from Quarterly Earnings and Market Presentations (Erkens and Merchant):
* Overall: .18
* High: Oil and gas: .58, Mining/construction: .35, Manufacturing (misc.) .32
* Low: Pharmaceuticals: .04 (annual), Chemicals - .03 (Q) and Mining and construction - 0.2 (Q)

…To be continued in Part 2 - What to use instead of accounting measures?

Date: April 15th, 2009
Cate: Academia

2009 Performance Measurement Association Conference

PMA 2009

The highly successful PMA series of conferences have been running since 1998. This year’s edition is hosted by the University of Otago’s School of Business in Dunedin, New Zealand. The conference will take place between 14-17 April 2009 and has among the keynote speakers:
• Professor Robert Chenhall of Monash University, Australia;
• Professor Ken Merchant of the University of Southern California, USA; and
• Professor Andy Neely from Cranfield School of Management, UK
Details about the conference and the conference papers are available at: http://www.pma.otago.ac.nz

Date: April 14th, 2009
Cate: Uncategorized

Lift-off

Canaveral launch july 1950 - first us rocket

The launch of this blog coincides with my attendance at the 2009 Performance Management Association Conference, organised in Dunedin, New Zealand.

Organisational Performance Management is the area in which I am currently focusing my research efforts and the majority of the posts on this blog will be addressing topics under this theme.

In addition this blog will also cover topics from related disciplines and organisational capabilities such as strategy, enterprise architecture, project management, service management and systems thinking.

Image Credit: NASA/U.S. Army