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Governance Challenges of Performance Measurement

Richard M. Steinberg | January 25, 2011

Boards have few responsibilities as important, or as difficult, as ensuring that relevant measures are in place to assess corporate performance. Measures are critical to such governance responsibilities as determining the effectiveness of established corporate strategy and tracking its implementation, and appropriately motivating and compensating the chief executive and management team.

Against a backdrop of shareholder cries for boards to “pay for performance,” directors are working diligently to identify the right measures. But it's not easy, and many boards continue to struggle toward that goal. Directors are also challenged in determining how best to comply with performance-related disclosure requirements of the new Dodd-Frank law and Securities and Exchange Commission regulations.

There's substance in the oft-used phrase, “you get what you measure.” Measure the wrong things and results can be disastrous. Measure the right ones—aligned with the strategic plan and related business objectives—and managers are motivated and work together toward achieving corporate goals.

As with most governance issues, one size does not fit all, and performance measurement certainly is no exception. So, each board must determine how best to achieve its measurement objectives.

It's All About Linkage

Shareholders want to see a fair if not superior return on their investment. The measures that typically drive share price include profit, earnings per share, cash flow, and other assorted value-added and return metrics. These financial measures are benchmarked against competitors and peers, and depending on investor and analyst preferences and models, an array of additional financial metrics are used to measure corporate performance with an eye toward future prospects. These market-facing financial measures are useful to managements and boards to measure company performance, but they are really just the starting point.

Looking beyond financial measures, some companies use any of a wide range of “canned” measures to assess performance. But there is another, usually more effective approach, that can create a better fit for the specific circumstances of a particular company. It begins with identifying what drives value and then linking those drivers to relevant factors providing a foundation for forming a cohesive measurement process.

Managements and boards know what drives financial performance for their organization and focus on such familiar metrics as revenue, sales growth, operating margin, working capital, leverage, cost of capital, and growth duration. And they ensure strategic plans are aligned with these drivers. For example, a strategy may focus on such initiatives as developing new products or services, opening new markets, developing new distribution channels, growth through acquisitions, and other objectives.

Because strategies and performance goals must be risk based, another step in the linkage process is identifying, assessing, and managing related risks. For instance, if a strategic initiative is growth through acquisitions, attention must be given to risks related to reliability of information on targets, due diligence processes, competitors' goals and positioning, and issues surrounding synergies, cultures, and integration. Opportunities and risks are identified and dealt with to ensure strategic intent is realistically attainable with desired risk-reward relationships.

While a sufficient number of targeted measures are important, some companies have fallen into a trap of measuring so many things that attention is unnecessarily diverted from truly relevant matters.

With plans for managing risks in place, performance measures can be formulated, often in context of an established categorization. For instance, one category may be the “customer,” with such performance measures as market share, on-time delivery rates, returns, customer satisfaction, existing product duration, brand awareness, and related trend lines and benchmark comparisons. “Research and development” might be another category, using measures for sales of new products, product quality, product life cycle (including time to market and investment payback and duration), and innovation measured by numbers of new patents or new product pipeline. “Operations” might be another, with such measures as procurement costs, production costs, downtimes, cycle times, warehousing and distribution, and related logistics costs, and so on. “Human capital” might be another category, looking at measures for recruiting, development, retention, satisfaction, percentage of jobs filled internally, workplace environment factors, and the like.

What's important here is a clear linkage to strategic initiatives and related risks. With linkage build in, measures can be established for motivating and rewarding personnel, from the CEO on down. At a top level, measures might include such financial metrics as total shareholder return, revenue growth, and return on assets, but also should include a scorecard dealing with all key responsibilities. Moving downstream in the organization, measures become more granular, but always directly linked with the objectives of the business unit and overall corporate strategy.

Shaping performance measures to a company's specific culture, environment, and orientation is also critical. For example, a large pharmaceutical company that is stressing new product development will want to focus on measures related to testing protocols, the FDA approval process, and timely marketplace acceptance. A company developing supplies for the office and consumer markets will measure new product development and related innovation metrics. An airline will focus on such measures as load factor, fuel costs, on-time arrival, customer loyalty, and employee satisfaction, to name a few.

Ultimately, there must be linkage back to the financial metrics that shareholders use to measure value. In that sense, the process comes full circle.

A Mix of Measurement Types

In addition to measures that are both financial and non-financial, the measurement process must include those that are short and long term, absolute and relative, and quantitative and qualitative. Each serves a purpose and a balanced mix usually is best. Measures may be scored in a range, where a minimum represents barely acceptable performance and a maximum greatly exceeding expectations. And some measures may be adjustable, based on external economic or other factors.

Measures should be both lagging—in terms of past performance—and leading. Looking through the rearview mirror can be useful to assess accountability and provide proper reward. But measures that foretell future performance also are important. Customer satisfaction measures—repeat business, brand loyalty, and cross selling of new products, for example—can be valuable predictors of continued success. Similarly, personnel development, measured by skills assessments, performance evaluations, and advancement rates are also good forward-looking metrics. And pipelines of customer orders and new products and cycle times are used to project future accomplishments.

While a sufficient number of targeted measures are important, some companies have fallen into a trap of measuring so many things that attention is unnecessarily diverted from truly relevant matters. It's necessary to keep the number of measures manageable.

The Board's Oversight Role

A board is not responsible for devising either measures or the measurement process. That's management's job. But it is responsible for ensuring that management has instituted meaningful measures to enable management to track and monitor performance and take swift corrective action where needed.

A board's role includes ensuring it receives reliable measurement information to carry out its oversight responsibilities. A board needs to discuss with management why and how the established measures make sense for the company. A board may want to see measures in prescribed formats, with variances from targets and trend lines. Whatever the presentation, the board needs to know that it is getting the right information, on a timely basis, with management's analysis of where issues lie and what management plans to do. And where measures need refinement or replacement, the board needs to be similarly apprised. Ultimately, the board needs to know that a process is firmly in place to provide the information they need to conduct meaningful oversight and assess progress toward effective strategy implementation and achievement of stated goals.

No, it's not easy. But it is an important part of the job.