Performance Management

Balanced Scorecard (BSC) — developed by Kaplan and Norton — translates strategy into operational measures. Provides BALANCED view across four perspectives, addressing financial-only measurement limitations.

The four perspectives:

Cause-and-effect linkages (the key insight):

BSC isn't just multiple metrics — it's about CAUSAL CHAINS:

• LEARNING & GROWTH (skilled, motivated employees) →
• INTERNAL PROCESSES (efficient, innovative operations) →
• CUSTOMER (high satisfaction, loyalty) →
• FINANCIAL (revenue, profit, returns)

Bottom-up causation: investments in capabilities and processes drive customer outcomes which drive financial results.

LEAD vs LAG indicators:

• Lag indicators: outcome measures (financial results, customer satisfaction). Tell you what happened.
• Lead indicators: performance drivers (training, process improvements, innovation). Predict future outcomes.
• Good BSC has BOTH — lead indicators warn before lag indicators show problems
• Most companies historically over-rely on lag (financial) indicators

Strategy mapping (Kaplan & Norton — Strategy Maps):

Visual representation of strategy showing CAUSE-AND-EFFECT relationships. Connects:

• Strategic theme (e.g., "operational excellence")
• Objectives across all four perspectives
• Cause-effect arrows linking objectives
• Measures and targets
• Initiatives to achieve targets

Example strategy map (manufacturing):

• FINANCIAL: increase ROCE to 15%
• ↑ caused by ↑
• CUSTOMER: increase market share through quality reputation
• ↑ caused by ↑
• INTERNAL: reduce defect rate from 5% to 1%
• ↑ caused by ↑
• LEARNING: increase Six Sigma certified employees from 10% to 50%

Each level of the chain has measures, targets, initiatives.

Cascading the BSC:

• Corporate BSC sets organisation-wide objectives
• Cascaded to BUSINESS UNITS (with BU-specific measures contributing to corporate)
• Further cascaded to DEPARTMENTS / TEAMS
• Aligns activities at all levels with strategy
• Common pitfall: poor cascading → corporate BSC unconnected to operational reality

BSC IMPLEMENTATION CHALLENGES:

1. Common pitfalls:

• Too many measures (BSC fatigue) — typically 15-25 measures total ideal
• Measures without strategic context (just KPI list)
• No cause-effect understanding
• Failure to cascade properly
• Lack of CEO/board commitment
• Measures gamed or manipulated
• Lag indicators dominating (no lead measures)
• Implementation as one-off rather than ongoing process

2. Linking BSC to compensation:

• Aligns incentives with strategy
• RISK: gaming measures; over-focus on bonus drivers; neglect non-bonus areas
• Best practice: balance metrics; include qualitative judgement; behaviour expectations

3. Adapting BSC for different organisations:

• Public sector / NFP: financial perspective often replaced by "stakeholder value" or "mission"
• Top of map = stakeholder/societal outcomes (not financial)
• Service organisations: heavy focus on customer perspective
• Innovation-led: emphasis on learning/growth

4. Sustainability extension:

• "5th perspective" added by some: environmental/sustainability
• Or integrated through other perspectives (financial impact of sustainability; customer sustainability preferences; process emissions; learning sustainability competencies)
• Aligns with ISSB IFRS S1/S2 disclosures

BSC strengths:

• Balances financial and non-financial measures
• Forces strategic clarity (linking objectives causally)
• Communicates strategy throughout organisation
• Drives alignment of activities
• Provides early warning (lead indicators)
• Holistic view of performance

BSC weaknesses:

• Complexity (many measures; cascading)
• Causal links often assumed but not validated
• Time-consuming to implement and maintain
• Risk of gaming behaviours
• Lag effects between investment and results
• External validity assumed (may not hold)
• Static framework — strategy environment changes

Value-Based Management (VBM) aligns strategic, financial, and operational decisions with value creation for shareholders. Various measures used.

Rappaport's SEVEN VALUE DRIVERS:

Alfred Rappaport (1986) identified key drivers of shareholder value:

1. Sales growth rate
2. Operating profit margin
3. Cash tax rate
4. Working capital investment as % of sales
5. Fixed capital investment as % of sales
6. Cost of capital (WACC)
7. Value growth duration (period of competitive advantage)

Strategic decisions assessed by impact on these drivers → impact on shareholder value.

SHAREHOLDER VALUE ANALYSIS (SVA):

• DCF-based approach
• Forecast cash flows over PLANNING HORIZON (typically 5-10 years)
• Apply Rappaport's drivers to project cash flows
• Calculate terminal value beyond planning horizon
• Discount at WACC
• Result: business value
• Subtract debt: shareholder value
• Compare to current market value: identify value gap

SVA process:

1. Identify business strategies and forecasts
2. Project cash flows using value drivers
3. Discount at WACC
4. Add terminal value
5. Subtract debt → equity value
6. Compare alternative strategies' value impacts

ECONOMIC VALUE ADDED (EVA — Stern Stewart):

EVA = NOPAT − (Capital × WACC)

• NOPAT = Net Operating Profit After Tax
• Capital = invested capital (equity + debt)
• (Capital × WACC) = capital charge
• POSITIVE EVA = creating value (returns above cost of capital)
• NEGATIVE EVA = destroying value

EVA worked example:

Company has NOPAT £10m; invested capital £80m; WACC 10%.

• Capital charge: £80m × 10% = £8m
• EVA: £10m − £8m = £2m positive
• Company is creating £2m of economic value (above cost of capital)
• If NOPAT were £7m: EVA = £7m − £8m = −£1m destroying value

Why EVA over accounting profit?

• Accounting profit doesn't charge for cost of equity (only debt interest)
• EVA explicitly charges for ALL capital (debt + equity)
• Forces consideration of capital efficiency
• A profitable company can still be DESTROYING VALUE if returns < cost of capital
• Aligns management with shareholder value creation

EVA accounting adjustments:

To make EVA more economically meaningful, various accounting adjustments are made:

• R&D capitalisation: treat as investment (rather than expense)
• Operating leases: capitalise (largely resolved by IFRS 16)
• Marketing/training expenses: capitalise if creating long-term value
• Goodwill amortisation: add back (accounting goodwill amortisation removed; impairment only)
• Restructuring provisions: smooth over time
• Deferred tax: adjust to cash basis

Each adjustment reduces accounting volatility but adds complexity. Stern Stewart originally proposed 160+ possible adjustments; most companies use 10-20.

EVA momentum:

• Year-on-year change in EVA
• Targets: continuous improvement
• Management bonuses linked to EVA improvement (rather than absolute level)

EVA limitations:

• Sensitive to capital base measurement
• Adjustments add complexity
• Not directly understood by all stakeholders
• Short-term EVA can be improved by under-investing
• Doesn't capture future growth options well

MARKET VALUE ADDED (MVA):

MVA = Market value of firm − Total invested capital

• Market value: market capitalisation + market value of debt
• Invested capital: book value of equity + debt
• POSITIVE MVA = market values firm above what was invested
• NEGATIVE MVA = market values below — value destruction

MVA vs EVA relationship:

• MVA = present value of all future EVAs
• EVA: PERIODIC measure (annual)
• MVA: CUMULATIVE measure (lifetime to date)
• Improving EVA over time → growing MVA

MVA worked example:

• Company market cap: £500m; market value of debt: £200m → total market value £700m
• Invested capital: book equity £300m + book debt £200m = £500m
• MVA: £700m − £500m = £200m positive
• Market values company £200m above what shareholders/lenders invested

VBM in practice:

• Strategy: select strategies maximising long-term EVA/SVA
• Capital allocation: invest where returns exceed cost of capital
• Target setting: cascade EVA targets down organisation
• Compensation: link to EVA improvement
• Communication: emphasise value creation in investor communications

Companies known for VBM:

• Coca-Cola (Goizueta era)
• SABMiller (pre-acquisition)
• Siemens, Whirlpool
• Various PE-owned businesses

Critique of pure VBM:

• Over-focus on shareholders alone (cf. stakeholder theory)
• Risk of short-termism if poorly applied
• Cultural fit varies (some industries less amenable)
• Modern shift toward integrated thinking (financial + ESG)

Benchmarking systematically compares performance against external standards or best practices to identify improvement opportunities.

Types of benchmarking:

1. INTERNAL benchmarking:

• Compare different departments, locations, or business units within own organisation
• Easy access to data; high comparability
• Limited learning (best practice still defined by what you currently do)
• Examples: comparing manufacturing plants; comparing branches; comparing sales territories

2. COMPETITIVE benchmarking:

• Compare with DIRECT COMPETITORS
• Same industry; similar processes
• Data hard to obtain (commercial sensitivity)
• Sources: published financials; industry reports; reverse engineering products; mystery shopping; trade press; ex-employees
• Risk: commodity replication (everyone the same)

3. FUNCTIONAL benchmarking:

• Compare similar PROCESSES across DIFFERENT INDUSTRIES
• Best for "horizontal" processes (HR, finance, customer service, IT)
• Examples: airline customer service vs hotel customer service; manufacturing logistics vs retail distribution
• More open data sharing (not direct competitors)
• Often produces breakthrough insights (different paradigm)

4. STRATEGIC benchmarking:

• Compare with BEST-IN-CLASS organisations regardless of industry
• Focus on strategic capabilities and approaches
• Highest level — looks at how to compete differently
• Examples: Toyota production system; Disney customer experience; Apple design

Benchmarking methodology — typical steps:

1. Identify what to benchmark: critical processes, performance gaps, strategic priorities
2. Select benchmark partners: who are the best?
3. Gather data: from public sources, surveys, partnerships, consortiums
4. Analyse gaps: where are we vs benchmarks?
5. Establish targets: realistic improvements based on benchmarks
6. Develop action plans: how to close gaps
7. Implement: change management to adopt
8. Monitor and recalibrate: ongoing process

Sources of benchmarking data:

• Public company annual reports
• Industry associations and reports
• Government data (ONS, sector regulators)
• Specialist databases (Capital IQ, FactSet, Bloomberg)
• Benchmarking consortia (sharing data among participants)
• Consulting firms (proprietary databases)
• Customer surveys

Pitfalls of benchmarking:

• Comparing apples to oranges (different business models)
• Copying without adapting to context
• Static view (industries evolve)
• Focus on what's measurable, ignoring qualitative factors
• Assuming "best" means achievable
• Not addressing root causes of gaps
• Imitation as substitute for innovation

Examples of useful benchmarks:

Industry-specific benchmarks:

• Banks: cost-to-income ratio; ROE; net interest margin
• Retail: like-for-like sales; sales per square metre; gross margin
• Hotels: RevPAR (revenue per available room); occupancy; ADR
• Software/SaaS: net revenue retention; CAC payback; magic number; rule of 40
• Airlines: yield; load factor; revenue per available seat-mile (RASM)
• Oil & gas: F&D costs; reserve replacement; production growth

Transfer pricing is the price at which divisions, subsidiaries, or related parties transact with each other. Affects divisional performance and can have significant tax implications internationally.

Why transfer pricing matters:

• Performance evaluation of divisions
• Profit allocation between business units
• Tax allocation (international transfers)
• Behavioural effects (incentives for managers)
• Goal congruence with corporate strategy

Objectives of transfer pricing:

1. FAIR performance evaluation of divisions
2. GOAL CONGRUENCE — divisional decisions support corporate goals
3. AUTONOMY — divisions retain decision-making authority
4. SIMPLICITY — practical to administer
5. TAX MINIMISATION (within legal limits)

Often these objectives CONFLICT — different methods optimise different objectives.

TRANSFER PRICING METHODS:

1. MARKET-BASED:

• Use external market price for comparable products/services
• BEST when active external market exists
• Promotes goal congruence (mirrors what divisions would do externally)
• Easy to verify and administer
• Issues: market price may not exist; quality differences; market conditions vary

2. COST-BASED:

(a) Full cost transfer pricing:

• Transfer at total cost of producing
• Selling division: no profit on transfer
• Buying division: receives at cost
• Disincentive for selling division (no margin)
• Risk of inefficiency (no pressure to control costs)

(b) Marginal cost transfer pricing:

• Transfer at variable cost only
• Encourages internal transfers (low price)
• Selling division loses fixed cost recovery from internal sales
• Less common as sole transfer price

(c) Cost-plus transfer pricing:

• Transfer at full cost + agreed profit margin (e.g., 10% mark-up)
• Selling division earns return; buying division pays reasonable price
• Common in practice
• Issues: setting "right" margin; rewards higher costs

(d) Two-part tariff:

• Variable charge per unit + fixed annual charge
• Variable: marginal cost (encourages efficient short-term decisions)
• Fixed: contribution to fixed costs and profit (covers capacity)
• Theoretically optimal but complex to administer

3. NEGOTIATED:

• Divisions negotiate transfer price between themselves
• Promotes autonomy
• Can lead to optimal decisions when divisions have similar bargaining power
• Issues: time-consuming; conflicts; suboptimal outcomes if power imbalanced

OPTIMAL TRANSFER PRICING — economic principles:

Minimum acceptable transfer price (selling division's perspective):

• If selling division at FULL CAPACITY: marginal cost + opportunity cost (i.e., external selling price)
• If selling division has SPARE CAPACITY: marginal cost (variable cost) of producing internally
• This is the minimum price for which selling division would supply

Maximum acceptable transfer price (buying division's perspective):

• The lower of:
  • External market price for similar input
  • Net marginal revenue from using the input (revenue − any external value-add costs)

Transfer should occur if minimum < maximum. Negotiated price within this range.

Worked example — capacity decision:

Division A produces components; can sell externally at £100 each. Variable cost £60. Division B uses components in final product. External market price for similar component £100. Two scenarios:

Scenario 1: Division A at full capacity (selling all external)

• Minimum transfer price (A): £60 (variable cost) + £40 (lost contribution from external sale) = £100
• Maximum transfer price (B): £100 (external market alternative)
• Transfer price range: exactly £100 → no internal transfer benefit
• Division B should buy externally if internal at same price (no loss to A)

Scenario 2: Division A has spare capacity

• Minimum transfer price (A): £60 (variable cost only — no opportunity cost)
• Maximum transfer price (B): £100 (external alternative)
• Transfer price range: £60 to £100
• Internal transfer creates value; negotiated price within range
• If A and B both want to maximise own profit: aggressive negotiation

INTERNATIONAL TRANSFER PRICING — TAX CONSIDERATIONS:

OECD arm's length principle:

• Cornerstone of international transfer pricing rules
• Related parties should transact at prices that would be agreed between unrelated parties (arm's length)
• Prevents PROFIT SHIFTING to low-tax jurisdictions
• Adopted by virtually all OECD countries (including UK)

OECD transfer pricing methods (in order of preference):

1. CUP (Comparable Uncontrolled Price): market-based; preferred when comparable transactions exist
2. Resale price method: working back from final selling price
3. Cost plus method: cost + arm's length mark-up
4. Transactional Net Margin Method (TNMM): net profit margin compared to comparables
5. Profit split method: profits split based on contribution to combined activity

UK transfer pricing rules:

• TIOPA 2010 (Taxation (International and Other Provisions) Act)
• Requires UK companies to apply arm's length principle to related party transactions
• Applies to medium and large enterprises (small enterprises generally exempt)
• DOCUMENTATION requirements (since 2023): master file, local file, country-by-country reporting
• HMRC enforcement; significant penalties for non-compliance

BEPS (Base Erosion and Profit Shifting):

• OECD initiative addressing tax avoidance via transfer pricing
• 15 actions to align taxing rights with economic substance
• Country-by-country reporting (CbCR) for groups with revenue ≥ €750m
• Master file and local file documentation
• Limited to substantive economic activity

Pillar Two (15% global minimum tax):

• Effective for groups with revenue ≥ €750m
• Top-up tax to ensure 15% effective rate in each jurisdiction
• Reduces incentives for aggressive transfer pricing
• UK adopted via Multinational Top-up Tax (MTT) — effective AP from 31 December 2023

Common transfer pricing risks:

• HMRC challenges to pricing (long, costly disputes)
• Double taxation (different countries' adjustments)
• Documentation gaps (penalties)
• Reputational risk (tax avoidance allegations)
• Need for advance pricing agreements (APAs) with tax authorities

Divisional performance measurement evaluates the performance of business units, divisions, or subsidiaries within a larger group. Critical for resource allocation, accountability, and management evaluation.

Types of responsibility centres:

Investment centre measures — ROI vs RI:

Return on Investment (ROI):

ROI = Profit / Investment (capital) × 100%

• Most common divisional measure
• Easy to understand and compare
• Allows comparison between divisions of different sizes
• Industry-comparable

ROI critical issue — investment decisions:

• Manager focused on maximising ROI may REJECT positive-NPV projects that REDUCE divisional ROI
• Goal incongruence with corporate value maximisation

Worked example — ROI dysfunction:

Division currently: Profit £20m on Capital £100m = ROI 20%. Group cost of capital 10%.

New project: Profit £6m on additional capital £40m = project ROI 15%.

• Project ROI 15% > group cost of capital 10% → ACCEPT (creates value)
• BUT: divisional ROI after project: (£20m + £6m) / (£100m + £40m) = 18.6%
• Divisional ROI DECLINES from 20% to 18.6%
• If manager bonus tied to maintaining ROI: REJECT the project
• Goal incongruence — value-creating project rejected

Residual Income (RI):

RI = Profit − (Capital × Cost of capital)

Same example with RI:

• Division RI before: £20m − (£100m × 10%) = £10m
• Division RI after: £26m − (£140m × 10%) = £12m
• RI INCREASES by £2m → manager accepts
• Aligns with value creation

RI advantage: any positive-EVA project (i.e., return > cost of capital) increases RI. Goal congruence achieved.

RI disadvantages:

• Absolute measure — favours larger divisions
• Comparison between divisions less straightforward
• Cost of capital determination subjective
• Less intuitive than ROI percentage

Practical balance:

• Many companies use BOTH measures
• RI for investment decisions; ROI for benchmarking and compensation
• EVA increasingly preferred (RI with adjustments)

CONTROLLABILITY PRINCIPLE:

• Managers should be assessed only on items they CAN CONTROL
• Distinction: CONTROLLABLE COSTS (manager can affect) vs UNCONTROLLABLE COSTS (allocated centrally)
• Controllable measures: own division's revenue, direct costs, capital investment decisions
• Uncontrollable: head office overhead allocations, group financing, group taxation
• Unfair to penalise manager for things outside their control
• BUT: some "uncontrollable" items still relevant (e.g., shared service costs that division uses)

CONTROLLABLE PROFIT:

• Profit minus only those costs the manager controls
• Excludes: head office allocations, depreciation on assets manager didn't choose, currency adjustments outside scope
• Cleaner basis for performance evaluation

Common divisional performance issues:

1. Short-termism:

• Annual measures incentivise short-term thinking
• Cutting R&D, training, maintenance to boost current performance
• Damages long-term value
• Mitigations: longer-term measures (3-5 year), strategic milestones

2. Manipulation and gaming:

• Year-end revenue acceleration / cost deferral
• Inventory build-up to absorb fixed costs (boost current period)
• Provisions managed to smooth earnings
• Setting easy targets to ensure achievement
• Mitigations: longer-term focus, multiple measures, qualitative judgement

3. Sub-optimisation:

• Each division optimising own measures may sub-optimise group
• Transfer pricing examples
• Internal customers not served (preference for external)
• Capacity hoarding
• Mitigations: shared performance measures, group-level incentives

4. Data issues:

• Allocations of group costs (often arbitrary)
• Transfer prices may not be fair
• Asset valuations affect ROI/RI
• Currency translations distort comparisons

BEST PRACTICE in divisional performance:

• Multiple measures (financial + non-financial)
• Balance short and long-term
• Apply controllability principle
• Adjust for circumstances beyond manager's control
• Qualitative judgement alongside metrics
• Regular review and adjustment
• Connection to strategy (BSC alignment)
• Compensation linked but not solely

The most effective performance management systems INTEGRATE strategy, measurement, and behaviour through aligned design.

Levers of performance management:

Robert Simons identified FOUR LEVERS OF CONTROL:

1. Beliefs systems: communicate core values and direction (mission, vision)
2. Boundary systems: define what should NOT be done (codes of conduct, risk limits)
3. Diagnostic control systems: monitor critical performance variables (BSC, financial reports)
4. Interactive control systems: stimulate strategic dialogue (used by senior managers to focus attention on strategic uncertainties)

EFFECTIVE control balances all four levers — not just diagnostic measures.

Performance management lifecycle:

1. STRATEGY translation into operational measures
2. Cascading objectives and measures
3. Target setting (challenging but achievable)
4. Resource allocation aligned with priorities
5. Performance monitoring and reporting
6. Evaluation and feedback
7. Reward and consequences
8. Learning and adjustment

Linking compensation to performance:

Common compensation structures:

• BASE salary (market-rate fixed)
• Annual BONUS (typically 20-100% of salary; tied to annual performance)
• LONG-TERM INCENTIVE PLANS (LTIPs): typically 3-5 year vesting; share-based
• Combination of FINANCIAL and NON-FINANCIAL targets

Annual bonus design considerations:

• Multiple measures (financial + operational + behavioural)
• Threshold (minimum to earn anything)
• Target (full payout)
• Maximum (cap)
• Payout curve (linear vs accelerating)

LTIPs (Long-Term Incentive Plans):

• Performance period typically 3 years
• Common metrics:
  • EPS growth
  • TSR (Total Shareholder Return — vs peer index)
  • ROCE / ROIC
  • Strategic targets (e.g., revenue from new segments)
  • ESG metrics (increasingly important)
• Share-based settlement (alignment with shareholders)
• Vesting subject to performance + continued employment

UK Corporate Governance Code on remuneration:

• REMUNERATION POLICY approved by shareholders (binding vote every 3 years)
• REMUNERATION COMMITTEE (chaired by independent NED) sets policy
• Disclosure of CEO pay ratio (UK companies with >250 employees since 2019)
• Increasing focus on ESG-linked remuneration
• Investor pressure on excessive pay; "say on pay" votes

Pay vs performance issues:

• Pay-for-performance studies show modest correlation (often disappointing)
• "Pay for failure" — generous severance for poor performers
• Median CEO pay vs median employee pay ratios growing
• Risk-taking incentives (asymmetric — upside captured; downside limited)
• Reputational concerns and shareholder activism

Behavioural considerations:

Performance management profoundly affects BEHAVIOUR. Goodhart's Law: "When a measure becomes a target, it ceases to be a good measure" — because people optimise for the measure, not the underlying objective.

Examples of dysfunctional incentives:

• Sales targets → channel stuffing, premature recognition
• Production targets → quality compromises
• Cost targets → corner-cutting, deferred maintenance
• Customer satisfaction surveys → coaching customers, gaming sample
• EPS targets → buybacks rather than investment
• Compliance metrics (e.g., Wells Fargo cross-selling scandal)

Mitigations:

• Multiple measures (no single dominant metric)
• Mix of leading and lagging indicators
• Qualitative judgement alongside quantitative
• "Behaviour expectations" alongside outcomes
• Regular review and adjustment of targets
• Strong tone from top about ethics
• Whistleblowing channels
• Ethics-based culture (not just metrics)

Modern trends in performance management:

1. Continuous performance management:

• Move from annual reviews to ongoing feedback
• Real-time data and dashboards
• OKRs (Objectives and Key Results) — quarterly cycles
• Adaptable to changing strategy

2. ESG integration:

• Climate metrics in incentive plans
• Diversity, equity, inclusion (DEI) targets
• Stakeholder satisfaction (not just shareholder)
• Long-term value creation focus

3. Data analytics and AI:

• Predictive analytics for performance
• Algorithmic management (controversial)
• Real-time dashboards
• Improved data-driven decision making

4. Stakeholder capitalism:

• Beyond pure shareholder value (cf. Business Roundtable 2019)
• Multiple stakeholder considerations in measurement
• Aligns with UK Companies Act 2006 s.172
• Integrated reporting (financial + ESG)

For SBM exam — performance management questions:

• Apply BSC framework with cause-effect linkages
• Calculate EVA, MVA where appropriate
• Apply ROI vs RI for investment decisions
• Consider transfer pricing impacts (especially international)
• Discuss controllability principle
• Address behavioural and ethical considerations
• Connect performance management to strategy and compensation
• Consider ESG and stakeholder dimensions