Copyright ©2011 Taylor & Francis Group, an informa business

Chapter 2

UNDERSTANDING ORGANIZATIONAL PERFORMANCE

A simple concept but difficult to define with precision.

Why? Because performance is: Multi-dimensional

Paradoxical Metrics may oppose each other High performance in the present may misguide future

performance attempts

The measure of managerial success

What is Performance?

How to Measure Performance?Two traditional indicators of firm

performance:

Firm Value

Profitability

Are These Measures Satisfactory?Observations on value:

Commonly measured as share $ x # shares outstandingIs the most valuable firm the best performer?How do you value a privately held company?What is the relationship of book value to market value?What about future earning potential or intangible

resources? VC Rule: “Bet on the entrepreneur, not the idea”

How does uncertainty affect the estimation of firm value? Value is forward-looking, but subject to human bias,

insufficient information, and error

While value is a key measure of performance, it has some limitations and presents some problems.

Observations on profitability:An important yet deceptively simple measure,

that can be difficult to interpret.Profitability can be measured in absolute and

relative terms. Profitability occurs on a continuous basis but is

reported in discrete increments.Profitability is backward looking, reporting what

has occurred but offering little insight into what is occurring now or what might occur into the future.

How Reliable are these Indicators?

Profitability in Absolute & Relative terms Consider two options:

A $350,000 profit on $10,000,000 in sales A $ 100,000 profit on $2,000,000 in sales

What industries are these firms in?

What about the assets used to generate these profits?

What about the debt or equity required to finance these two firms?

Profitability – When and How to Measure

Why does this matter?Firms earn profits with each transaction, yet

measure profit in fixed increments.The inconsistency can be confusing and lead

to misinterpretation.Problems can arise through extraordinary

events. Timing is an issue; when are revenues and

expenses actually recorded?Is profit in a particular period always what it

seems?

Profitability – Other Concerns Even when measured accurately and

interpreted correctly, profits reflect past events.

In looking forward, profitability may reflect changes in market conditions or competitive advantages that could render a firm unprofitable in the future.

In comparing across firms, profitability may not capture meaningful differences in context or in the underlying drivers of performance.

What Should Be Done?Most of these concerns can be addressed

through the use of multiple measures, designed to capture:

Performance over time

Performance from different perspectives

Performance in its proper context

Consider Performance Over TimePerformance today is no guarantee of future

performance.

Arthur Andersen, K-Mart, RCA, IBM, Xerox, PanAm – all industry leaders at one time, lost ground later.

Business is a game that never ends.

Past success can insulate against the need for change, leading to complacency and a lack of vigilance and creativity.

Consider Performance from Different PerspectivesMany different ways to approach performance

ROA/ROE MeasuresProfitability MeasuresResource Management MeasuresLiquidity and Leverage Measures

Three common and powerful measures:Altman’s ZTobin’s qEconomic Value Added (EVA)

Altman’s ZZ = 0.12*(working capital/total assets) + 0.14*(retained earnings/total assets) + 0.033*(EBIT/total assets) + 0.0006*(market value of equity/ book value of

debt)

+ 0.999*(sales/ total assets)Firms with Z < 1.8 are in great distressFirms with Z > 3.0 are in no distressFirms with intermediate values have varying

distress. Generally speaking though, higher numbers indicate stronger performance.

Tobin’s qTobin’s q is the ratio of a firm’s market value

to the replacement cost of its assets.

Reflects the value of a firm’s intangible assets.

Market value incorporates market value of all shares along with the book value of total debt.

Replacement cost of assets can be estimated by the book value of the assets.

Tobin’s q

Where, MVE = market value of common and preferred sharesBVD = book value of total liabilities (debt)BVA = book value of total assets

Economic Value AddedEVA captures economic profit, incorporating

accounting profit, and the firm’s cost of capital.

EVA is calculated as net operating profit after taxes (NOPAT) less the weighted average cost of capital (WACC).

NOPAT = EBIT – Taxes on EBIT.

WACC is the average cost of debt and equity.

Trade-OffsEach of these measures has advantages and

disadvantages. EVA is a powerful tool but requires considerable

time and sophistication to calculate. Tobin’s q is simple and powerful but cannot be

applied easily to private firms. Altman’s Z is simple and accessible but provides

limited insight into ongoing and future performance.

Thus, it is imperative to consider performance from as many perspectives as practical and possible.

Performance in ContextWhat does it really mean to say that a firm

is successful and performing well?Should performance be assessed relative

to sales, to assets, or to investments? How about comparisons to recent history

or to market conditions? Do all firms even pursue the same goals?

Should we incorporate goals and objectives into the assessment of performance?

Having the right points of reference:

Different industries will offer different competitive realities and so have different performance levels. Nature of industry competition (Porter’s 5 forces)Number of competitors (e.g., monopoly v. perfect

competition)

Selecting the proper reference group against which to benchmark is a key to measuring and interpreting performance.

Performance in Context

Performance in ContextPerformance Referent Hierarchy

Closest Competitor(s)/Strategic Group↓ ↓ ↓

Intra-Industry Firms↓ ↓ ↓

Inter-Industry Firms

Looking at trends:

It is important to consider historical trends.

Is performance improving or declining?

Did the firm start from a strong or a weak position?

The same exact record will be viewed very differently by fans of the New York Yankees and the Washington Nationals.

Performance in Context

Different objectives can lead to different performance:

Porsche’s market share is small fraction of Ford’s. Does that mean that Porsche is less successful?

Performance must be measured and assessed in relation to the firm’s purposes, goals, and intentions.

Performance in Context

Porsche’s statement of philosophy says:

“For Porsche, exclusivity applies in many aspects. Particularly in the fact that for a long time the company has drawn on traditional models. Money alone cannot produce inventiveness. It is far more the pressure of having to prove oneself against the competition again and again. Porsche relishes its role as David amongst the Goliaths in this world.”

Performance in Context

Ford’s vision and mission statement is:

“Our vision is to become the world’s leading consumer company for automotive products and services. We are a global family with a proud heritage, passionately committed to providing personal mobility for people around the world. We anticipate consumer needs and deliver outstanding products and services that improve people’s lives.”

Performance in context

An approach to performance measurement that incorporates multiple types of measures, financial and non-financial, into a single “balanced” measure.

While there is no uniform method for creating a balanced scorecard, the measures that are used should incorporate the interests and contributions of all important stakeholders.

Kaplan & Norton’s Model: (1) financial, (2) customer, (3) internal business practices, and (4) learning and growth (expansion)

Triple Bottom Line (3 P’s): People (Social), Planet (Environmental), and Profits (Economic)

A Balanced Scorecard

Taking Stock of PerformancePerformance can be measured in different ways

and the measures can change with time.

Strategic management is a systematic framework of relationships and associations that, when understood well, can facilitate the quest for performance.

Good strategic managers must understand performance and how the measures of performance can influence decision making and action.