Nonfinancial performance measures – Why they matter?

Written by Zoheir Haider - The Numbers Guys

TO DRIVE THE FINANCIAL PERFORMANCE ENGINE OF YOUR FIRM, YOU NEED TO KEEP A CLOSE WATCH ON THE FUNDAMENTAL VALUE DRIVERS OF YOUR BUSINESS.

Non-financial performance measures are increasingly becoming popular and began to be widely adopted by organizations. They are considered to be superior predictors of the future financial performance of the firm. Executive teams are adopting non-financial performance measures to shape executive behaviour. Non-financial performance metrics such as customer loyalty, employee engagement, product quality, innovation quotient or market dominance have increasingly been adopted to determine the executive compensation.

According to the research conducted by Wharton professors of accounting, Ittner and Larcker (“Coming Up Short on Nonfinancial Performance Measurement,” 2014), the companies that measure a non-financial factor after assessing a real effect on the financial performance, earned 1.5 times greater returns on equity than those companies that did not adopt.

In the following paragraphs, we will discover how the non-financial performance measures are practically used to track and drive the business performance in some of the leading companies around the world.

These examples will make a strong case for non-financial performance measures:

Procter & Gamble’s ‘Five measures of noticeable superiority’

In its 2018 annual report, the Procter & Gamble (P&G), a multinational consumer goods company announced a net sales increased 3% to $66.8 billion, an impressive 8% growth in their core earnings per share, strong free cash flows with adjusted free cash flow productivity of 104%, well above the target of 90%. Significantly, they also improved their market share in 7 of 10 global product categories.

So, how did P&G explain this stellar financial performance? What did they attribute their success to? In other words, what were the underlying value drivers that contributed to their financial success?

P&G marks what they call ‘Five measures of noticeable superiority’.

Let’s hear in their own words:

“P&G is creating and extending competitive advantage through superior product performance, packaging, brand communication, retail execution, and consumer and customer value. ”

SUPERIORITY LEADS TO GROWTH AND VALUE CREATION

“When we excel across these measures of noticeable superiority, we deliver on key business success metrics: Sales, Profit, Market Share, Household penetration and Market size.

Where we achieve noticeable superiority on at least four of the five superiority measures, we deliver on the business success metrics 80% of the time. Where we achieve three or fewer superiority measures, we do not deliver on our desired business outcomes.”

(Extracts from the P&G Annual Report, 2018)

In plain English, P&G has identified and established clear causal links between the value drivers of the business and the success measured in financial terms.

How Novo Nordisk is using nonfinancial reporting to drive financial performance? – A Case Study

Let’s consider another example — of a successful Danish pharmaceutical company, fighting global Diabetes epidemic – Novo Nordisk, which prides itself on measuring its performance on the ‘triple-bottom-line’ framework. It understood early on that the pharmaceutical companies are in the business of “providing healthcare for the good of humankind.” It argued that the industry credibility is under fire because of an intense focus on profitability goals and failure to solve global health challenges. It, therefore made a business case to report its performance in a more integrated manner to guarantee its long-term survival and financial goals.

Novo Nordisk annual report has been awarded as one of the ‘Best Integrated Report’. In its annual reports since 2004, Novo Nordisk has successfully demonstrated the relationships between the economic and nonfinancial performance of the business. It has made a business case for investors to improve nonfinancial performance reporting.

It has identified key strategic areas, where it must excel to deliver the economic contributions – Living our values, Access to health, Our employees, Our use of animals, and Eco-efficiency and compliance. It then adopted several performance indicators to measure progress on these strategic areas, some of which are reproduced below:

Strategic areas and related non-financial performance indicators at Novo Nordisk

Living our values

  • Average of respondents’ answers as to whether management demonstrates in words and action that they live up to our values

Access to health

  • Number of LDCs which have chosen to buy insulin under the best possible pricing scheme.

Our employees

  • Employee turnover rate.

  • Average of respondents’ answers as to whether their work gives them an opportunity to use and develop their competencies/skills.

Our use of animals

  • Housing conditions for experimental animals, considering the needs of the animals.

    Eco-efficiency and compliance

    • The annual improvement in water efficiency

    Novo Nordisk is using the above performance measures to drive its financial performance of the business measured in terms of ‘Operating profit margin, return on invested capital and cash to earnings.

    Web traffic and CEO compensation

    Research carried out at Stanford (“Non-Financial Performance Measures and CEO Compensation: An Analysis of Web Traffic,” n.d.) found out a strong correlation between ‘Web-traffic’ a widely-used nonfinancial measure of success in the internet industry and executive compensation. They found a robust causal association between the ‘web-traffic’ and the traditional financial performance measures such as ‘return-on-assets’ and ‘stock returns’ effectively tying it to CEO compensation.

    Netflix and Tesla

    Innovation-driven companies like Netflix and Tesla are increasingly measuring their organisational performance based on nonfinancial performance measures such as ‘new domestic and international subscriber counts’ and ‘production outputs or productivity gains’ respectively. They continue to accumulate huge financial losses in the process as they concentrate their energies and efforts to gain market-dominance and continue to invest resources to build capabilities. Under such circumstances, for the market analysts, the only tangible criterion of whether the business is moving in the right direction to deliver long-term sustainable value, is the nonfinancial performance aspect. The stock market performance of these companies is largely determined by how well they are performing in meeting their nonfinancial targets that will ultimately drive and decide their financial successes in the future.

    Case for nonfinancial performance reporting

    Traditional financial performance measures such as financial earnings and accounting returns-based indicators have limitations, in the sense that they are ‘lagging indicators’ of the firm’s performance. They offer a rear-view glimpse of what has already transpired in the past. In a fast-changing business environment, they have little value to drive managerial action on the correct course for future success.

    Businesses that attach too much importance to financial performance suffer from a condition called ‘short-termism’. Short-termism has been defined as “excessive focus on short-term results at the expense of long-term interests”.

    Professor Michael J. Mauboussin of Columbia Business School, in his research (“The True Measures of Success,” 2014) explains the unwarranted obsession with short-termism through a phenomenon known as an ‘Availability heuristic’. He explains the availability heuristic as a tendency to attach importance to events or matters based on how readily ‘available’ the information about them is to us. We tend to attach higher importance to information that we have come across recently or that is oft-repeated and frequent. This explains the excessive obsession of executives with quarterly earnings, that is driven by ‘availability heuristic’ and which can essentially take away management’s focus from the important matters such as strategy fundamentals and drivers of long-term value creation.

    Nonfinancial performance measures can shift the management focus from short-termism to long-term prospect of achieving its strategic outcomes and sustained competitive performance.

    Another problem with the pure accounting-based financial performance measures is that they can be significantly affected by the accountant’s judgment and subjectivity. They are also largely dictated by the accounting conventions such as ‘historical-cost basis’, which does not allow attaching financial-value to such forward-looking value drivers and predictors of long-term business success such as customer loyalty, employee skills and talent, or intellectual capital on the balance sheet.

    Nonfinancial measures are superior predictors of the future economic performance of the firm. They act as a missing link between the value-driving activities and economic performance of the firm. They are also more closely tied to the corporate and business-level strategy of the firms. Managers can use them as a compass or GPS to track or navigate the business progress and undertake course-correction adjustments well in advance of the release of earnings call by the CFO.

    HOW TO DO IT RIGHT?

    Nonfinancial performance measures are not without its limitations and they must be done right, otherwise, they will simply waste management’s time and resources without guaranteeing any tangible returns.

    Measure what matters – step by step

    • Determine nonfinancial measures which contribute to long-term success i.e. they have a positive effect on the strategic outcomes of business and ultimately its financial performance.
    • Next step is to examine and establish clear causal linkages (which reveal cause and effect relationships) between the nonfinancial performance measures and determine how they will positively impact on the financial performance
    • The causal models then are tested and validated with the help of statistical tools such as ‘multiple-regression analysis’ to establish relationships between the variables such as customer loyalty and earnings, production efficiency and shareholder value etc. The results of regression analysis will determine the degree of correlation between the dependent (financial performance) and the independent variables (underlying value drivers). It must, however, be remembered that correlation does not equate or denote a causal relationship. There may be other factors which are contributing to the financial performance and therefore, the impact of such factors must be quantified and isolated. Noise factors must also be eliminated, which are essentially the environmental factors outside the control of business managers.

    According to the research pointed earlier by Ittner and Larcker, (“Coming Up Short on Non-financial Performance Measurement,” 2014), “…non-financial performance measures will offer little guidance unless the process for choosing and analyzing them comes to rely less on generic performance measurement frameworks and managerial guesswork and more on sophisticated quantitative and qualitative inquiries into the factors actually contributing to economic results”

    • Rank performance measures on their relative importance derived from the strength of causality. Management attention should consider the relative importance of the measures while directing managerial action to improve performance.
    • Management by objectives: Determine how measures can stimulate and guide managerial action. Align management reward-schemes with the attainment of nonfinancial performance objectives.
    • Refining the model: Causal modelling should be an ongoing exercise and done at regular intervals.

    If done properly, non-financial performance measures will definitively improve the economic performance of the business by directing managerial action on the things that matter, as we have seen in the example of the P&G.

    Limitations of non-financial performance measures

    • Time and cost – some business executives have argued that their time is better spent on improving customer loyalty instead of on collecting data, compiling reports and communicating results using tens of performance measures to the executive team. However, this argument is flawed, as Peter Drucker has said ‘What gets measured, gets managed’. However, it crucial to report only those measures which are effectively improving strategic results. Ittner and Larcker argue that it is best to avoid what they call ‘Measurement disintegration – “overabundance of measures which essentially dilutes the effect of the measurement process”. It should also be limited to ideally five to six key indicators. There is no way your CEO can keep an eye on the dashboard containing 300 different meters, while driving business performance without making a serious accident.
    • Difficult to convince management to shift finance orientation to underlying factors of business success. To overcome this inertia, finance professionals have an important role to play. They must first adopt the business mindset and develop an appreciation of value drivers and strategic initiatives of the business which are essentially delivering the business performance.
    • Lack of common denominator such as quantities, percentages etc., unlike financial performance which can be measured in clear dollar terms. This can be problematic for a variety of reasons such as inconsistency in reporting, subjectivity and dysfunctional behavior in that managers ‘pick & choose’ only favorable measures to earn financial rewards. Finance professionals should again take a lead to identify and potentially eliminate such dysfunctional behavior which leads to goal incongruity.
    • Using standard ‘off-the-shelf’ bucket classifications such as those used in the ‘balanced scorecards’ or ‘the performance pyramids’ without first establishing the causal links explained above won’t help much and would essentially be an exercise in futility.
    • Don’t copy measures used by others. They may not apply to your firm. Measures should have direct linkages with the strategic outcomes, value drivers of the business, and the environmental factors such as unique competitive rivalry in your industry.
    • For non-financial performance measurement process to be effective, it must have top-management support. It is also important that selected measures consistently feature in the performance reports and form part of management discussions on business performance. They must also be tied to performance-based reward schemes to effectively channel employee behavior towards the attainment of agreed-upon objectives.

    Conclusion

    The non-financial performance measures are a wonderful tool in the hands of modern-day organisations to navigate its strategic journey. Care must be taken to select only those performance measures which are contributing to the strategic success of the firms. Finance professionals also have to change their mindset from just reporting financial numbers to developing a deeper understanding of business fundamentals. They must also adopt a multi-disciplinary mindset to understand functions outside the finance domain such as marketing and operations to deliver lasting value to the business and become a valuable contributor to the strategic discussion of the business.

    REFERENCES

    1. Coming Up Short on Nonfinancial Performance Measurement. (2014, August 1). Retrieved August 16, 2019, from https://hbr.org/2003/11/coming-up-short-on-nonfinancial-performance-measurement
    2. The True Measures of Success. (2014, August 1). Retrieved August 16, 2019, from https://hbr.org/2012/10/the-true-measures-of-success
    3. Non-financial Performance Measures: What Works and What Doesn’t. (n.d.). Retrieved August 16, 2019, from https://knowledge.wharton.upenn.edu/article/non-financial-performance-measures-what-works-and-what-doesnt/
    4. Non-Financial Performance Measures and CEO Compensation: An Analysis of Web Traffic. (n.d.). Retrieved August 16, 2019, from https://www.gsb.stanford.edu/faculty-research/working-papers/non-financial-performance-measures-ceo-compensation-analysis-web
    5. Nonfinancial Data Can Predict Future Profitability. (n.d.). Retrieved August 16, 2019, from https://www.gsb.stanford.edu/insights/nonfinancial-data-can-predict-future-profitability
    6. Are Nonfinancial Metrics Good Leading Indicators of Future Financial Performance? | MIT Sloan Management Review. (2016, June 13). Retrieved August 16, 2019, from https://sloanreview.mit.edu/article/are-nonfinancial-metrics-good-leading-indicators-of-future-financial-performance/
    7. Short-Termism. (n.d.). Retrieved August 16, 2019, from https://www.cfainstitute.org/en/advocacy/issues/short-termism
    8. Annual Reports | P&G. (n.d.). Retrieved August 16, 2019, from http://www.pginvestor.com/CustomPage/Index?keyGenPage=1073748359
    9. Novo Nordisk Honoured for Best Integrated Report | Justmeans. (n.d.). Retrieved August 16, 2019, from http://www.justmeans.com/press-release/novo-nordisk-honoured-for-best-integrated-report
    10. Integrated reporting. (n.d.). Retrieved August 16, 2019, from https://www.novonordisk.com/sustainable-business/performance-on-tbl/more-about-how-we-work-and-report/integrated-reporting.html

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