How to make financial and nonfinancial data add up.
Management accountants sometimes are asked to do the impossible. For example, how can a 10% reduction in operating cycle time be compared with a 12% reduction in repair costs? How is it possible to compare a 5% improvement in on-time deliveries with a 7% decrease in the amount of returned merchandise from customers? How can these data be dovetailed into a report on an enterprise's overall business results?
Obviously apples cannot be compared adequately with oranges.
Or can they?
The data-incompatibility issue surfaces repeatedly among management accountants. And although few agree on a solution, they do agree that no effective business assessment is complete without the proper recognition and evaluation of both nonfinancial and financial performance measurements. This article suggests a way to turn incompatible data into information available for quantitative management decisions.
The solution involves creating an index that weighs the financial impact of nonfinancial performance. The index can include a number of areas (lead time, production cycle times, productivity, product quality, on-time delivery, market penetration, employee relations, etc.), and once established, it can be combined with conventional financial data such as profit contribution, cost reduction and variance to produce an overall performance gauge.
The indexing idea originally was outlined by J.L. Riggs and G.H. Felix in Productivity by Objectives (Englewood Cliffs, New Jersey: Prentice-Hall, 1983). The nonfinancial performance index proposed in this article derives its mechanism from a technique the authors called the objectives matrix approach.
SETTING UP THE INDEX
Setting up a nonfinancial performance index is very intuitive; as such, a description of the concept sounds more complex than it really is. The easiest way to describe the concept is to set out an example of how a management accountant would create such an index.
The management accountant begins by selecting the nonfinancial areas to be included in the index. While a nonfinancial performance index can measure many factors, tracking three to seven areas in any one study produces the most accurate, consistent results. Fewer than three and more than seven tend to produce results that are less reliable.
This example evaluates three performance areas: a product's production cycle, its quality and its delivery. In exhibit 1, at right, these three areas head the appropriate columns. Another column, to the left of the others, is the performance index, with a scale of 0 to 10 (10 represents the best performance; O, the worst). Actually, any convenient scale can be used. Some index makers prefer to use a scale of 1 to 5. They find it easier and say it's as accurate as a lto-10 scale. In special circumstances, when gains become more difficult, or easier, as performance improves, a nonlinear scale may be more appropriate.
The index maker now selects measurable gauges for each area. In this example, production cycle (raw material to finished product) time is measured in hours; product quality is quantified by determining the percentage of items rejected by quality control; and delivery is measured by the percentage of deliveries made on time, which is highly correlated with how well customers are satisfied.
In addition, management establishes three performance levels for each area: the current performance level, the absolutely best level and the worst. Management must decide what overall index level is considered normal for the entire production process. While management can select any level between 0 and 10, the index maker should be aware the normal level will reflect how ambitious management wants to be in motivating staff. For example, if level 3 is used as normal, there are 7 steps to ascend before the top is reached--quite a stretch. And if 7 is selected, the message to staff is they need not reach too far to achieve their maximum. Generally, it's desirable to aim for a middle level.
In this example, management selects level 4 as the overall normal index for the three areas. This is illustrated with a color band stretching across the matrix at performance index line 4.
The next step is to develop the numbers for the matrix. For production cycle time, management decides the best cycle is 2 hours, the worst is 40 hours and normal is 25 hours. Thus, 40 is lined up with the lowest level on the production index, O. Likewise, 2 is lined up with the best level, 10. And 25 is lined up with the just-selected normal level, 4.
For product quality, the best performance is 1%, which means 1 out of 100 items produced is rejected. Therefore, 1 is lined up with 10 on the performance index. The worst performance is 12% rejections; therefore, 12 is inserted on line O. In addition, since the normal rejection rate is 5%, 5 is inserted next to 4 on the production index.
For on-time delivery, 100% is the best performance and 80% the worst; so 100 is inserted on the top line of the performance index and 80 on the bottom line. Since the normal on-time delivery is 90%, 90 is placed on the 4 level.
In the next step, the index maker fills in the numbers in each column in between the highest, lowest and normal levels so there are gradations between the three levels (see exhibit 2, page 63).
CALCULATING THE INDEX
Once the columns are complete, the management accountant needs to evaluate them and produce the number to be used in the financial-nonfinancial comparison. Management enters the actual performance data for each category in a row across the bottom of the matrix. That number is usually, but doesn't have to be, the predetermined normal level for each of the three categories (see exhibit 3, page 63).
In this example, the actual current cycle time is 21 hours, somewhat better than the 25 hours considered normal. The figure lines up with an index of 5--the score earned for cycle time.
In the quality category, the actual performance is 5.1%; that falls closest to 5% in the matrix, with a performance index of 4the score earned for quality. And in the delivery area, the actual level is 90%; that, too, lines up with the normal performance index level of 4-the score earned for delivery.
The score-earned line reads 5, 4 and 4; at this point management must assign a relative weight to each area. The weights reflect management's judgment on each category's relative impact on the business's bottom line. Of course, the sum of the weights must total 1. In this example, management gives cycle time and quality each a rating of .4 and on-time delivery a rating of .2. Management apparently places twice as much importance on cycle-time and quality improvement as it does on delivery.
Next, each score is multiplied by its weighting factor to obtain the index value for each area: 2 for cycle time, 1.6 for returned items and .8 for on-time delivery. Add the three values and the resulting number, 4.4, is the overall index, or the nonfinancial performance index.
LINKING WITH FINANCIAL FIGURES
Now that a nonfinancial performance index is established for three nonfmancial benchmarks of the company, that figure can be compared with financial information. This example assumes the manufacturing department that makes this product is a cost center to which a cost savings goal has been assigned of, say, $150,000, or 30% of the actual cost of $500,000 in the previous period. Management also can use the same technique in indexing nonfinancial results to establish the cost savings.
Management decides the normal expected savings will be between $120,001 and $130,000; a midpoint index of 5 is assigned to that level. Achieving a savings of over $170,000 is the best the group can accomplish, so an index of 10 is assigned to that amount. The worst the group can achieve is something under $80,000, so a zero index is assigned to that. Exhibit 4, below, shows the completed index.
If the cost center actually realizes a cost savings of $115,000, the financial performance index earned is 4, which now can be combined with the above nonfinancial performance index of 4.4, using a weight management chooses. Assuming equal weights (.5) are used for financial and nonfinancial performance, an overall performance indicator of 4.2 will result [financial performance (4 x . 5) + nonfinancial performance (4.4 x .5) = 4.2]. Of course, the ordinal scales and weights can be refined by management.
The flexibility of the nonfinancial performance index approach used here, especially in assigning scales and in calculating the final index, is an attractive feature for management accountants seeking to measure their businesses' operations. If properly used, it can integrate management priorities into a formal performance measurement system that can increase employee awareness of the crucial nonfinancial performance.
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|Author:||Lee, John Y.|
|Publication:||Journal of Accountancy|
|Date:||Sep 1, 1992|
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