The Total Performance Equation.

How can companies build non-financial measures into incentive compensation?

Exponential growth in executive pay levels over the last few years has prompted increased scrutiny of the systems that led to these perceived excesses. In response, companies began examining the relationship between their executive pay programs and their performance. If the link was sufficiently strong -- for instance, a highly paid CEO who consistently delivered a rising share price -- few protested the size of that CEO's pay package. When the pay/performance link was minimal or nonexistent, however, the situation was quite different.

The one given, though -- at least until recently -- was an emphasis on current financial performance. When companies linked pay to performance, they did so almost uniformly through traditional financial and accounting measures, such as earnings per share, operating profit, return on equity or return on capital. These and related measures became the lens through which they (as well as the press, investors and others) assessed executive performance.

But over the past few years, that lens has widened to include non-financial measures that drive shareholder value, including customer and employee satisfaction, operating results and innovation. While such measures aren't yet as prevalent as financial ones, there's little doubt they're growing in popularity. Indeed, a Conference Board study conducted more than four years ago found that even then, executives agreed the most effective incentive plans contained a mix of financial and non-financial measures.

As many academic experts point out -- most notably, Robert Kaplan and David Norton in their book, The Balanced Scorecard -- a company's current financial performance is only part of the total performance equation. Effective management -- and, thus, long-term financial performance -- depend as much on attention to operations, customers, new product development and such as on factors like current earnings growth. In short, executives must focus their attention on a range of activities and be measured accordingly.

Don't Look Back

Much of the interest in using non-financial measures stems from the chief limitation of financial measures: their backward-looking focus. Financial measures only reflect last year's performance and, as such, don't provide incentives for creating future value. Non-financial measures, by contrast, are often prospective -- for instance, creating and bringing a new product to market, building market share over a given period and increasing retention of key customer accounts. These are goals that often require multi-year attention from management and, if achieved, obviously will affect financial performance. This reality is a key to why studies -- such as Wharton's "The Choice of Performance Measures in Annual Bonus Contracts," published in 1995 -- show that non-financial measures are "far better indicators of the long-term desirability of managerial performance."

The increased use of incentives below the senior management ranks also drives interest in non-financial measures. Middle managers, first-line supervisors and even professional and technical employees who increasingly participate in incentive plans have no real control over financial results. Hence, they find a financially driven measure like earnings per share about as meaningful (and motivational) as an incentive based on a rise in gross domestic product. By contrast, these employees can have a lot of control -- sometimes more than senior management -- over variables like operational efficiency, cost management, innovation, quality and so on.

It's important to note that using non-financial measures doesn't in any way conflict with the governing objective of publicly held companies: maximizing long-term shareholder value. Rather, such measures help translate this philosophy into a more meaningful context for managers.

Recent proxy data from the current list of companies in the Fortune 50 confirm how well this trend has taken hold. For instance, over half (52 percent) have incorporated non-financial measures into their executive incentive plans. And of this group, 31 percent actively use non-financial measures, while the remainder has put such measures on the menu from which the board's compensation committee chooses each year.

Weights and Measures 

Academic and industry studies have identified the most common non-financial measures in use today. These include:

* Customer satisfaction.

* Quality of product or service.

* Strategic objectives, such as completing an acquisition or a project milestone, a corporate restructuring or management succession.

* Developmental results, such as employee satisfaction and retention, training, teamwork, personal development, management effectiveness or public responsibility.

* Innovation, such as research and development investments and results, or new product development.

* Technology objectives.

* Market share.

In a 1996 survey of annual incentive design practices at 250 large U.S. companies, Towers Perrin found three major categories of non-financial measures: operational, customer and employee. Fifteen percent of the participating companies used operating measures, 8 percent used customer satisfaction measures and fewer than 2 percent used employee satisfaction measures.

But as companies incorporate non-financial measures into their plans, what should guide their choices?

* A company's business strategy.

* The link to financial measures.

* The nature of the industry in which it operates.

* Its stage in the business life cycle.

Business Strategy

Financial measures tend to promote excessive attention on the short-term, in part because of their retrospective focus. Non-financial measures, though, emphasize the actions necessary for longer-term success. Thus, when a company's strategy depends on long-term changes in product mix, market penetration or improved service delivery, non-financial measures can be effective.

In addition, when a strategy calls for speed to market with a new product, it often makes sense to place extra weight on non-financial measures in annual incentive plans. Companies pursuing an innovation-oriented strategy might want to stress such non-financial measures as intellectual capital development, which is a key determinant of new product development and future profitability, as the Wharton research suggests,

For example, American Express includes a measure of innovation as a modifier in its executive incentive plan. Merck includes the strategic goal of "continued commitment to research" in determining executive bonuses. And Apple Computer includes the development of core competencies in its balanced scorecard.

Companies competing on the basis of quality also use non-financial measures such as quality improvement goals in their incentive plans. Ford Motor Company uses a quality measure based on warranty performance and customer satisfaction in its annual incentive program for proxy-named executives. Whirlpool uses a measure called "total quality" in its incentive plan; it includes defect levels, cycle time and service incident rates.

Service firms with a quality-oriented strategy also should consider placing relatively more weight on non-financial measures. The reason, according to a Conference Board survey, is that executives think financial measures reward a focus on outputs, not inputs, which threatens service quality. In this spirit, Visa International measures cardmember satisfaction annually and uses it to calculate a percentage of executives' bonuses. And Merrill Lynch includes "quality of service" on the list of possible measures from which its compensation committee chooses each year. Link to Financial Performance and Shareholder Value

Since non-financial measures are leading indicators of results -- or, more precisely, financial performance and shareholder value creation -- it's critical that they actually lead to the right financial performance. Companies should remember that maximizing long-term shareholder value involves earning a financial return in line with investor expectations. Establishing a quantifiable link between non-financial and financial performance provides the analytical rigor necessary to avoid rewarding executives for value-destroying behavior. It also addresses criticisms that non-financial measures are subjective -- and therefore easily manipulated -- by adding objectivity and measurability.

For example, companies that use return on capital (ROC) as their financial measure may want to focus on operational measures (cycle times, throughput volume, etc.) that have the greatest impact on working capital levels or cost of goods sold, two key drivers of ROC. Continental Airlines uses on-time performance as a measure in its management and non-management incentive plans. This measure has a significant, quantifiable impact on revenues (through its impact on customer retention) and profitability in the airline industry.

Nature of the Industry

For companies in regulated industries such as utilities, non-financial measures may actually be a more accurate reflection of the state of the business than financial results. For one thing, the very nature of regulation is predicated on protecting the interests and maximizing the value of a diverse group of stakeholders, including customers and shareholders. Moreover, public utility commissions have historically controlled the rates utilities offer (thus dictating their financial performance), while also mandating specific customer service and employee safety levels.

Not surprisingly, then, it's becoming more common to find companies in regulated industries using measures like customer satisfaction, safety, employee satisfaction and retention, and reliability of service. Northwestern Public Service and Sierra Pacific Resources, for instance, both use company-wide customer satisfaction goals as a measure in their annual incentive plans. And PECO Energy uses both customer satisfaction and employee commitment measures in its annual incentive plan.

Companies in highly cyclical industries also may opt to use non-financial measures to avoid variances that can occur in traditional financial and accounting measures. Because non-financial measures are more long term-oriented, they aren't as likely to be influenced by sharp swings in uncontrollable variables (e.g., commodity prices) that greatly affect financial performance. Common measures include marker share and the quality of a product or service. For example, the 1993 proxy statement for Consolidated Papers explains its use of non-financial measures by saying, "The company's emphasis on long-term objectives is intended to avoid unwarranted emphasis on the short-term swings experienced by the paper industry, which is highly cyclical."

Companies, like people, have a life cycle composed of clear stages, beginning obviously with birth. Each stage demands attention to different variables. Thus, matching measures to these areas of concentration can help focus management's attention on the right things at the right time and strengthen the company through its cycle.

In summary, important as they are, non-financial measures don't replace financial ones. Rather, they should be seen as enhancements to, and leading indicators of, the financial measures in the plan. In addition, because of the criticisms leveled at non-financial measures, including subjectivity and possibility of manipulation, companies should carefully consider implementation issues when incorporating non-financial measures into their plans. These include:

* Evaluating and testing measures thoroughly and carefully before adoption.

* Quantifying the link between non-financial and financial measures to avoid rewarding value-destroying behavior.

* Understanding and addressing the potential difficulty of measuring non-financial measures through existing measurement processes.

* Recognizing some of the difficulties in assessing the ongoing value of non-financial measures, including the difficulty of benchmarking common practices and the uncertainty of financial analysts as to how they should consider non-financial measures.

As more studies prove the relationship among factors like customer satisfaction, purchase behavior and profitability, corresponding numbers of companies will doubtless see the value of integrating non-financial measures into incentive plans to attempt to boost long-term shareholder value. In addition, improved analytic and data processing capability -- especially the ability to test and validate the relationships between non-financial and financial measures -- will help ensure that companies can maintain the links among incentives, a broad set of performance measures and long-term shareholder value.

Ravin Jesuthasan, a principal in Towers Perrin's Chicago office, specializes in value-based management, performance measurement and the design of performance-based incentives. Emory Todd and Annalisa Barrett are executive compensation consultants in Towers Perrin's Stamford, Conn., and Detroit offices, respectively.