Deciding on the performance measures

How do we decide which key performance indicators (KPIs) are suitable for a specific person or thing? A good performance measure should:

1. Provide incentive to divisional manager to make decisions which are in the best interests of the overall company - that means, the KPIs must promote goal congruence, not dysfunctional decision making by the manager. To achieve the goal congruence, KPIs should not cause the managers to think of themselves only, financial performance indicators (FPIs) are the one that cause this problem, eg. if manager's performance is measured by residual income (RI), he may not accept a project that gives him negative RI at the beginning of the project but in fact the project has a positive net present value (NPV). Although present value of RI is equal to NPV, if negative RI can cause manager to lose bonus, he will not accept the project although the project can maximise shareholders wealth or improve overall profitability of the organisation.

2. Take into account the principle of controllability - managers should only be held accountable for what they can control, therefore it is important to look at what the managers are responsible to. Looking at the responsibility centres, we can understand that each responsibility centre's manager must be assessed using different KPIs. For example, for a cost centre manager, profit should not be used as the KPI, instead standard costing variance analysis should be used (more common one), if the manager is a production manager, material usage variance and labour efficiency variance could be under their control (however you should realise that sometime they are not, eg. sales director wants the production manager to produce more units which caused adverse material usage variance. Therefore, KPIs must not ignore principle of controllability.

3. Recognise long-term and short-term objectives - measures such as return on investment (ROI), RI, net profit margin are all short-term measures. They do not recognise the long-term performance. FPIs are being critised that they will cause short-termism behaviour. However, FPIs such as price/earning ratio will be useful as share price in market can indicate the true performance of the manager. Non-financial performance indicators (NFPIs) are very useful to avoid short-termism, eg. measure the performance of a production manager by looking at cost per unit and quality of the product, with this manager cannot manipulate his performance. Balanced scorecard is useful for this point, it includes FPIs and NFPIs and also focus on the critical success factors (CSFs). CSFs are performance requirements that are fundamental to an organisation's success. With balanced scorecard, it looks at four perspectives:
(a) Financial
(b) Customer
(c) Internal business process
(d) Learning and growth
For each perspective, CSFs are identified and KPIs are identified for each CSF.

Therefore, a good performance measure is important because it can assist the organisation to remain sustainable and also growth. The above does not intended to provide knowledge on KPIs but examples are taken since they are related to the 3 points stated.