Key Performance Indicators (KPI – 2 of 2)

As noted in the first KPI segment – Revenue is one performance indicator; Net Income is another performance indicator – what drives these measures and what defines successful company performance?  In this second segment I’m going to look at the importance of including non-financial measures in the Key Performance Indicator set of metrics.

Use of financial measures for monitoring company performance has a long history, but became disassociated from underlying processes in the mid to late 1970’s as noted by Johnson & Kaplan (1987)1.

After 1925 a subtle change occurred in the information used by managers to direct the affairs of complex hierarchies.  Until the 1920s, managers invariably relied on information about the underlying processes, transactions, and events that produce financial numbers.  By the 1960s and 1970s, however, managers commonly relied on the financial numbers alone (pp. 125-126).

The problem with reliance on financial numbers without additional non-financial metrics is due to the fact that financial indicators are typically lagging indicators resulting in longer feedback times.  The ability to effectively respond with appropriate corrective action is compromised with increased feedback time, as is evident with the example of adjusting water temperature from a faucet vs. a shower.

Feedback is circular: we feel the temperature at a faucet relative to desired temperature; adjust; receive new feedback; and adjust again until desired temperature is reached.  The same circular process occurs in a shower, but because of the increased delay in feedback time the tendency is to adjust before full feedback is received, resulting in over-correction and additional iterations of the feedback/adjustment cycle.

Based on this premise Fowke (2011)2 hypothesized that increasing use of non-financial measures with the reduced feedback time would result in improved company performance.  Results from the study show that though increasing performance was correlated with increasing measures from both categories, the rate of increase of use was much greater for use of non-financial measures:

Average Number of Measures Used Relative to Performance

In addition, non-financial measures were more correlated to firm value than financial measures with the high performers’ (Kruskal-Wallis) mean score for non-financial measures being higher than for financial measures.  By contrast, medium and low performers exhibited the opposite:  higher mean scores for financial measures than for non-financial measures [p ≤ 0.05 for non-financial measures and p ≤ 0.1 for financial measures] as exhibited in the following graph (p. 146):

The study included survey results from 76 publicly traded companies representing 29 different 3-digit NAICS categories. Company performance was ranked low, medium, or high (standardized by 3-digit NAICS category to eliminate cross industry variance) based on percent change in 1-year rolling average stock price (to eliminate seasonal or year-end variance) over a 5-year period.

Using KPI metrics that provide rapid feedback from a broad scope of business functional areas is correlated to improved performance!

References:

1Johnson, H. T., & Kaplan, R. S. (1987). Relevance Lost, The Rise and Fall of Management Accounting. Boston: Harvard Business School Press.

2Fowke, R. (2011). Performance Measures for Managerial Decision Making: Performance Measurement Synergies in Multi-Attribute Performance Measurement Systems. (Doctoral dissertation, Portland State University, © 2010).  ProQuest-CSA, LLC, Ann Arbor

Attributions:

By Phoenix7777 [CC BY-SA 4.0 (http://creativecommons.org/licenses/by-sa/4.0)], via Wikimedia Commons

Dropping Faucet by Ángelo González from Dodro, España licensed under the Creative Commons Attribution 2.0 Generic       license.