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Assignment number: BS3234

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Forename(s): Warnakulasuriya WadumesthrigeUdani AmalkaSurname:

Mendis

Word Count: 3907

Page | 1

Page | 2

An analysis of the
consequences of
traditional performance
measurements and
modern performance
measurements
A stakeholder approach
Udani Mendis

A literature review submitted in partial fulfillment of the requirements for the award of BSc in
Accounting and Finance
Page | 3

Abstract

For over centuries performance measurements have been in use, debated over and
developed into new and better measures of performance. There has been a recent
growth in sustainable performance measures that are looking at satisfying all
stakeholder needs unlike the conventional measures where only a financial
performance of an organization was considered. Therefore, this literature review is
focused on analyzing the consequences of conventional performance measures and
modern performance measures to stakeholders.
Hence, the literature review first describes the evolution of modern performance
measures from traditional. It goes on to define performance measures and
measurements.
Finally, it analyses the consequences performance measures has on the main three
stakeholders:

consequences

to

shareholder

wealth

and

value

creation,

consequences in the decision making of employees and the effect of performance

measures on customer satisfaction is discussed in detail.

Page | 4

Acknowledgements

I would like to extend my sincere gratitude to those who contributed in conducting

research and for those who supported me in writing this literature review.
Firstly, I would like to express my gratitude to Professor Kennedy, who gave me the
initial guidance and support. To Kasun Rosa, who never ceased in helping and keeping
me accompanied throughout. Sincere thanks to all of my colleagues for their
unwavering emotional and moral support.
Above all, my utmost gratitude goes to the Holy Trinity for the divine intervention in this
academic endeavor.

Page | 5

Table of contents

Page
Introduction

Definitions of performance measurement

Share Holder Value

11

Impact on decision making and incentives

16

Performance measures and customers

20

Conclusion

23

References

25

Page | 6

Introduction

The practice of traditional performance measures dates back to the early 1900s
where decision making was a focal point of an organization and the respective
responsibilities in decision making were clearly defined (Sharma and Kumar 2012).
Performance measurement systems were designed to measure accountability to
confirm that people met their budget and followed orders states Knight (1998).
The preparation of budgets initially spread as industrial organizations
developed and initiated sophisticated management accounting systems (Johnson
1972) such as standard costing and variance analysis (Bourne and Neely 2003). For
example, a research study carried out by Sord and Welsch in 1962 showed that in
over 95% of the 424 participating US companies, budgets were used to control
overall company performance in the time period. However, the conventional
performance measures used at the time were widely scrutinized due to many
different reasons. Not taking to account the full cost of capital and the undue effect
of accrual accounting leading to poor decision making which therefore failed to
capture an organization's strategy is among those criticisms (Sharma and Kumar
2012). The dysfunctional behavior brought on by the characteristics of traditional
performance measures (Fry and Cox 1989), encouragement towards short term
decision making (Hayes and Garvin 1982) and damaging businesses due to being
focused on internal, financial and departmental performance (Johnson and Kaplan
1989) (Olve, Roy and Wetter 1999).
To overcome the shortcomings of the earnings based performance measures;
alternative, new and more balanced performance measurements were developed in
Page | 7

the 1980s and early 1990s (Bourne and Neely 2003). One of the main concepts
behind the development of modern performance measures was the shareholder
value approach which estimates the economic value of an organization (Stewart
1991). Most commonly associated performance variants of this concept are:
Economic Value Added (EVA), Shareholder Value Added (SHV), Economic Profit (EP)
and Cash flow return on investment (CFROI) (Maditinos, Sevic and Theriou 2005).
Although there are still new performance measures being developed, the traditional
measures mainly appearing in this document are ROI, ROE, EPS and RI. Whereas,
the modern measurements mainly discussed are EVA and measures derived from
the Balance Score Card (BSC) technique.

Page | 8

Definitions of performance measurement

Performance measurement, whether conventional or modern, is a topic that has

been subjected to vast discussions in various contexts. However, it is also a topic
that has been rarely defined.

Performance measurement is generally defined as a regular measurement of

outcomes and results, which generates reliable data on the effectiveness and
efficiency of programs ( Bureau of educational and cultural affairs).
Neely, Gregory and Platts (1995) define performance measurement, performance
measure and performance measurement system as follows.
Performance measurement can be defined as the process of quantifying the
Efficiency and effectiveness of action.
A performance measure can be defined as a metric used to quantify the
Efficiency and/or effectiveness of action.
A performance measurement system can be defined as the set of metrics used
to quantify both the efficiency and effectiveness of actions.

Performance measures and measurement is about quantifying efficiency and

effectiveness of operations so that value is created for all stakeholders who are
interested or involved in the business. To create value, resources must be used
effectively. One of the uses of performance measures in evaluating whether proper

Page | 9

use has been taken in arriving at the end outcome. A famous saying that is used
among practitioners about this is that what gets measured gets done.
Even though the above definitions are clear and precise, it is the opinion of some
that the very precision has become a barrier in conveying what really a
performance measure is (Bourne, Neely, Mills and Platts 2003). These performance
measures are multi dimensional. They are financial, non-financial, internal, external
and also measures that predict future performance of organizations as well as
quantifying achievements of the past. Although all three definitions are similar as
they all refer to measuring effectiveness and efficiency, it is important to know that
performance measures are not implemented in isolation and that it has an effect on
the environment it operates in.

The purpose of this literature review is to analyze the consequences of traditional

performance measures and modern performance measures. Even though there are
many aspects to be discussed in terms of consequences relevant to performance
measures, a stakeholder approach has been taken due to the increased popularity
and interest in the concept of balancing stakeholder needs and an organization's
performance. Although there are many different stakeholders such as shareholders,
employees, regulators and customers; the three main types of stakeholders who
have a significant impact and interest in an organizations operation have been
focused on this study. Therefore, the consequences of shareholder wealth
maximization, effects on decision making of employees and impact on the
customers due to performance measurements implemented by a management are
discussed.

Page | 10

Share Holder Value

Shareholder requirements of an organization have become more and more

sophisticated with the change in the global economy. This shift in the economic
momentum in the 1980s caused capital markets and most financial institutions to
change their outlook to a more global context (Maditinos, Sevic and Theriou
2005).Furthermore, as Meditinos, Sevic and Theriou discusses in their research,
that

previously

organizations

used

accounting

earnings

based

performance

measures because conventional shareholders were mainly interested in dividends

(2005). Some of the most popular traditional performance measures such as;
Return on Investment (ROI), Return on Equity (ROE) and Earnings Per Share (EPS)
are discussed in this paper.
ROI which is defined as the performance measure used to evaluate the
efficiency of an investment or to compare the efficiency of a number of different
investments (Botchkarev and Andru 2011) while ROE is defined as a companys
profitability measured by its income divided by its equity (Traub 2001). Another
conventional technique of performance measurement widely used is EPS, which is a
measured by dividing the net profit or loss for the period attributable to equity
shareholders outstanding during the period (IAS 33 2003).During the 1950s and
1960s the main measure of an organizations performance was its share price.
Even though it is the same concept addressed in the current era under shareholder
wealth, the lackluster performance in 1970s meant that the share price failed to
reflect a companys real worth. Therefore, the executives whose rewards were

Page | 11

connected to share option schemes shifted the performance techniques into more
controllable, internal financial techniques (Rappoport 1983) such as EPS, ROI and
ROE described above. According to a study, these performance methods were
initially adopted in 1971 where 46 out of 82 largest industrial companies at the time
were using EPS and 5 of them were following ROE (Rappoport 1983). Nevertheless,
the shift in performance measures questions the validity of these techniques in
relation to a companys main objective of creating value for its shareholders.
However, Rappoport further states that these traditional performance techniques do
not provide a strong basis for increasing shareholder value (1983). Thus, more
modern performance measures such as EVA were introduced as an alternative to
earnings based performance measures that are said to reflect the real value of an
organization leading to maximization of shareholder wealth. Introduced as an
indicator of shareholder wealth maximization, EVA is a measure arrived by
modifying RI (Sharma & Kumar 2012). Stewart defines it as the difference
between return on invested capital and the weighted average cost of capital for the
year multiplied by the average amount of invested capital (1991).
Many studies have been carried out in finding the relationship between
shareholder wealth and performance measures in the past decades. Studies
conducted by Auret and Villiers (1998), Sharma and Kumar (2012), Biddle, Bowen
and Wallace (1997), Chen and Dodd (2001) and Black, Bright and Bachman (1997)
reveals that there is a positive association between EVA and stock price. Even
though the said relationship is not perfect, it still suggests that EVA has a strong
effect on share price, thus, yields information deemed important by shareholders
(Sharma and Kumar 2012). However, according to the above mentioned studies; RI
Page | 12

has the highest association with the market value of an organization between
traditional

and

modern

performance

measures

despite

the

perceptions

of

superiority of EVA and other new performance methods.

In terms of the information presented in the capital gains and losses by each
performance measure, EPS proves to provide more valuable information than EVA
according to Meditinos, Sevic and Theriou (2005). Copeland (2002) also found
similar results that prove EPS is more superior to EVA even though both measures
have a low explanatory power. However, studies conducted by Worthigton and
Wallace (2001) and Biddle, Bowen and Wallace (1997) both show that RI and EVA
provide less information in explaining stock returns than other performance
measures such as Earnings Before Extraordinary Items (EBEI) despite the highest
correlation with stock price. Chen and Dodd (2001) also report results consistent
with the above mentioned, proving that some measures like operating income has a
higher explanatory power than both RI and EVA.
Irrespective of the irrelevance of the information provided by individual
performance measures, they prove to be more valuable when combined together.
For example, Meditinos, Sevic and Theriou (2005) states that the combination of
EPS and EVA represents the most satisfactory explanation for stock returns in
Greek stock market. Worthington and West (2001) and Chen and Dodd (2001)
presents results that suggest EVA proves to be a useful measure in measuring
financial performance when combined with EPS.
On the other hand, some academics and practitioners are of a different
opinion about performance measures and its effect on increasing shareholder
Page | 13

wealth. Copeland (2002) explains that it is not earnings or earnings growth, and or
EVA or the change in EVA that drives the stock price. He further goes on to explain
that performance measures such as EVA and EPS and its growth is all uncorrelated
to the changes in shareholder wealth of the same period. According to the research
conducted by Copeland (2002), it is the expectations that create value of an
organization, thus increasing shareholder wealth through increased share prices not
performance measures. An example quoted by Copeland (2002) to prove this fact is
the fall in Intels stock value by 6% in 1998 even though earnings and EVA were
positive with an earnings growing by 19% over 1997. The same could be said
regarding the fall in Apples share price in 2013 even after reporting the companys
highest profit (Ashby 2013). Hence it is important to meet expectations of
shareholders while implementing performance measures.
The research data collected proves that there has been a recent shift towards
fulfilling shareholder requirements from a business due to the increased investment
opportunities worldwide and the risks it creates. However, the shift towards
shareholder

value

addition

attracted

the

interest

of

investors,

academics,

practitioners and regulators. Shareholder wealth is associated with the stock price
of an organization. Thus the relationship performance measures have with the
share price changes have been studied across the world for many decades. Even
though modern performance measures were introduced as alternative techniques,
superior to earnings based measures; both EVA and RI showed a strong positive
relationship with stock market changes. However, this attributed superiority of
modern performance is questioned due to its low explanatory power of the changes
in shareholder wealth compared to more traditional methods such as EPS. Although
Page | 14

both conventional performance measures (e.g. EPS, RI and ROI) and modern
performance measures (e.g. EVA) does not yield the best results in increasing
shareholder value, a combination of the two methods is founded to provide valuable
information for investors. However, academics such as Copeland (2002) argue that
what really matters is not the association or the information provided by various
performance measures; but the expectations of shareholders. Which is a valid point
considering performance measures do not operate in isolation and the fact that the
environment has an effect on these measures the same way it effects the
environment.

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Impact on decision making and incentives

In the past two decades, there has been a rise in the interest of performance
measures with frameworks on performance measurement such as BSC and bench
marking gaining popularity among academics and consultants (Hoque 2004). With
the additional advantage in falling cost of information technology (Borthick and
Roth 1997) and the increased attention towards performance evaluation, the
pressure to improve an organizations performance has increased. Thus, leading to
increased pressure on managers in making smart decisions incorporating both
qualitative and quantitative information.
However, before considering the decisions to be made, it is vital to
understand the objectives of decision making and the performance measures that
influence these objectives. As shareholders are one of the most important
stakeholder groups of a business, shareholder wealth maximization is the center of
all management decisions made. In increasing shareholder wealth, as discussed
above, Eva is considered the superior performance measure to be implemented.
This is because it takes into account the cost of capital and cash flows which has a
greater

association

with

the

share

price

unlike

earnings

(Kaplan

2012).

Nonetheless, opponents of modern performance measures choose profit based

measures such as ROE and ROI due to its simplicity and familiarity despite the lack
of relationship with share value (Kaplan 2012).
It is a widely stated fact that traditional profit based performance measures
encourage short termism (Ittner, Larcker and Meyer 2003). Short termism, defined
Page | 16

as a cognative limitation that effects decision making (Miller 2002) or is generally

used with myopia to denote a temporal orientation that prioritizes the near term
over the longer term (Marginson, McAulay, Roush and Zijl 2009. Merchant and Van
der Stede (2007) state that management short termism or myopia is an inevitable
side effect of basing decisions based on results built on accounting based
performance measures. In response to these shortcomings of backward looking
financial performance measures, non-financial performance measures have been
introduced (Ittner, Larcker and Meyer 2003). These future oriented performance
measures include satisfaction of customers, staff attitude and quality (Sliwka
2002).
One of the main implications of performance measures is that it creates
dysfunctional and defensive behavior that might force an employee to give false
information (unintended or intended) to their superiors. This is a consequence that
performance measures have on self esteem of employees. Employees may be
encouraged to pursue actions that build a positive image of themselves among their
subordinates and superiors (Roberts 1991) in order to maintain self esteem or to
avoid embarrassment, vulnerability or threat (Argyris 1999).
Therefore, an effective reward system that motivates employees to contribute their
best effort in achieving the performance targets is crucial. Armstrong (2006)
explains

that

an

effective

reward

system

will

motivate

employees,

their

commitment and progress discretionary behavior in obtaining a set financial or nonfinancial target. Although many studies conducted favors non-financial performance
measures such as customer satisfaction or quality, many studies support accounting

Page | 17

performance measures (Hashim 2000). Nonetheless, it is the opinion of other

academics that as a consequence of implementing of non-financial performance
measures, financial targets are indirectly achieved (Roger 1996) (Chritina and
Gursoy 2009).
As discussed earlier in this literature review, an increasing number of
organizations have adopted modern performance measures ( e.g. Norton and
Kaplans BSC and Accentures performance Prism) in measuring non-financial
performance measures such as employee satisfaction and customer loyalty which
are believed to increase earnings ultimately (Ittner and Larcker 2003). The
consequence of this is that employees are provided with valuable information
needed in achieving strategic objectives. Also, it gives managers an advantage to
glimpse the progress of the company before any financial decision is pronounced.
Even though these positive consequences are supposed to result in increased
company performance, few companies realize them due to failure in identifying,
analyzing an acting on the correct non-financial and financial performance
measures (Ittner and Larcker 2003). This lack of integration of the performance
measures with company value, cash low or earnings lead to self serving employees
manipulating measures to earn higher rewards. For example, Ittner and Larcker
(2002) explains a situation where managers have taken undue advantages as
follows. Bricks and Mortar, a large retail bank implements a reward scheme based
on the customer satisfaction scores. A polling company is hired by the bank to
record the customer satisfaction. However, the polling company only surveyed
customers who physically entered the bank branches. So, a bank manager who had

Page | 18

earlier received a lower score in customer satisfaction; coax customers by offering

them food and beverages.
Therefore, the said superiority of modern non-financial measurements are false
because it is clear that both traditional and modern performance measurements are
subject to manipulation equally. According to Ittner and Larcker (2002), nonfinancial performance measures are more damaging than conventional performance
measures which are at least governed by rules. It cannot be determined for sure
that performance measures, whether conventional or modern, cause managers and
other employees to take wrong decisions or whether it is in the inherent nature of
humans to feel superior amongst fellow colleagues. By the research data collected,
it seems that reward schemes implemented with the use of performance measures
might be influencing these decisions of employees.

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Performance measures and customers

Customers are one of the major set of stakeholders in an organization. Therefore,

all activities of an organization must be in line with customer satisfaction. However,
conventional companies did not have separate performance measures to measure
customer satisfaction, but they rather attached the level of customer satisfaction to
the bottom line profit (Soderlund and Colliander 2015). The financial dimension
alone will not provide a holistic view of the company (Sordo et al 2012), since nonfinancial aspect of a business accounts for 50% to 80% of a firms value (Kim and
Lee 2007). Therefore, in order to bring both financial and non-financial aspects of
an organization into the spotlight, Kaplan and Norton (1992) developed Balanced
Scorecard (BSC) as an innovative performance measure.
Balanced Scorecard offers managers a better platform to measure the performance
of the business (zpeynircia, Ycenurenb, Apakc and Polatc 2014). BSC discusses
about four dimensions which are important to a business. They are financial,
customer, internal processes, learning and growing dimensions. The importance of
the customer dimension is that, if the customers are not satisfied, they are likely to
opt for substitutes. Therefore, even though the company is financially stable at the
moment, they will be vulnerable going into the future (Kaplan and Norton 1996).
They go on to explain, when developing metrics to measure customer satisfaction,
different types of the customers and the processes which are used to satisfy
customers must be analyzed.

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As soon as it gained recognition, 60% of the Fortune 1000 were using the BSC (Silk
1998). Furthermore, the topic BSC became a dominant topic related to performance
measures in academic journals as Kaplan and Nortons (1992) publication had been
one of the most cited articles (Neely 2005). However, in contrast to the popularity
gained by BSC, there were some studies which suggest that there are failures of
BSC and they question the effectiveness and the validity of some assumptions
associated with BSC (Ittner and Larcker 2003) (Lipe and Salterio 2000) (Norreklit
2000). For example, in China implementing BSC has been faced with some
difficulties due to the unavoidable strategic limitations associated with BSC.
(Brignall 2002) (Neely 2005)(Norreklit 2000). According to the researchers, Zeng
and Luo (2013), the main reasons for the inconstancy of BSC in China are,
ambiguous validity of the cause-and effect relationship, strategic control barrier,
common measure bias and obese and static nature.
Traditionally, customer satisfaction is assumed to be implied by the profit of the
company. However, in a study which was done on universities, Lynch and Cross
(1991) mention that, due to the following two reasons, financial performance of a
company does not project the level of customer satisfaction.
I

Financial measurements neglect the contribution of intangible assets, such as

customer loyalty. Therefore, the assumed connection between financial

II

performance and customer satisfaction is not valid.

The financial measurements refer to past management, whereas, in order to
drive business dynamics, lead to factors such as customer satisfaction must
be considered. Therefore, in order to get a proper idea about a holistic view

Page | 21

of the organization, lagging measures must be integrated

with

the

performance drivers (Goold & Quinn, 1990).

Traditional financial measurements are also seen as short term oriented, since
strategic approach, which looks into the future, has not been involved in such
measures. (Sordoa, Orellia, Padovania, Gardinia 2012). Therefore, traditional
financial measurements are unlikely to provide a proper picture about the customer
satisfaction of a company. In order to overcome this weakness of traditional
financial

measures,

Newman

(1975)

suggests

that,

traditional

performance

measures should be backed by quantitative and qualitative leading measures.

The level of customer satisfaction is a main factor which has a direct impact on the
sustainability of an organization. Therefore, companies must be attentive about
how satisfied their customers are and they should use a proper set of performance
measurements to evaluate the level of customer satisfaction.
When analyzing the academic researches carried out on measuring customer
satisfaction of an organization, it can be clearly visible that the modern thinking is
to use a holistic approach such as BSC, rather than using financial measurements to
measure the level of customer satisfaction effectively. The main reason for this can
be identified as financial measurements follow an empirical approach which does
not consider about the future conditions of the organization. Due to this belief,
many companies are currently using the defined concept of BSC. However, there
are some instances where it has been proved that BSC approach has failed due to
the way it has been adopted by the organizations.

Page | 22

Conclusion

In conclusion,, the literature review on traditional performance measurements and

modern performance measures has identified the and analyzed the consequences
the respective measures has on shareholders, employees and customers.
As shareholders are considered as the most important stakeholder I the stakeholder
group, naturally, the ultimate objective of an organization becomes delivering what
is expected from them by the main stakeholder group. Therefore, it is the main
financial objective to increase shareholder wealth. In achieving this, performance
measures play a key role by measuring whether a companys operations are using
its resources effectively in creating value for the shareholders. Hence, the use of
different performance measures (modern or conventional) has consequences in how
value is created due to their inherent flaws and benefits.
On the other hand, performance measures are attached to reward schemes of
managers so that the business strategy and individual needs of employees are
aligned. The implication of this is that some employees will take advantage and
manipulate the outcome of the set performance measures to gain undue benefits.
However, performance measures could de motivate and pressurize employees into
taking short term decisions. Although there are significant disadvantages of using
either traditional or modern performance measures, it is also crucial to keep
employees motivated and satisfied.

Page | 23

Happy internal customers, in other words employees, lead to satisfied external

customers. With the recent growth in the economy to satisfy not only shareholders
but all other stakeholder groups, modern performance measures such as BSC have
been introduced. This is because the conventional accounting based performance
measures were mainly focused on internal attributes I creating value for a
company. With globalization and the development of markets, it is not appropriate
for organizations to be measuring its performance using backward looking financial
measures. After all, for a business to succeed, market satisfaction and perceptions
are important. Therefore, the implementation of modern performance measures has
resulted in satisfied customers due to the developments in quality and service.

Page | 24

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