Management Control

Prof. Dr. Matthias Sohn

Professur für Controlling
 Chapter II:
Financial Results Control
Systems
 Financial Performance
Measures and their Effects

Lecture 5
Learning Goals
• What exactly is economic or shareholder
“value”?
• How can firms measure the financial success of
their enterprise?
• What is financial return and how does it differ
from residual income?
• Why are non-financial dimensions performance
so pivotal for firm success?
 Overview
• Value creation
• Market measures of performance
• Accounting measures of performance
• Investing and operating myopia
• Return-on-investment measures of performance
• Residual income measures
• Performance Measurement Systems

5
 Introduction
The vast majority of organizations control the behaviors of employees through
financial results control systems.

Define the link between

results and different forms
Employee of rewards.
incentive plans

Are used for control-

related purposes
Planning and including the setting of
performance targets or
Budgeting performance definition.

Financial Define the apportioning of

accountability for
Responsibility financial results within
the organization.
Centers 6
Value Creation

7
 Value Creation
Primary objective of for-profit organizations is to
maximize the value of the firm
subject to some constraints, such as
− compliance with laws,
− adequate concern for employees, customers and other stakeholders.

What is an organizations true intrinsic value?

• Value maximization = maximization of economic income.

• Employees can, all else equal, increase economic income by
– increasing the size of future cash flows;
– accelerating the timing of those cash flows;
– making them more certain or less risky.

8
Value Creation

Performance
Measures

Financial Non-financial
measures measures

Market Accounting
measures measures
9
 Value Creation
What makes a performance measure a „good“ measure from a management
control point of view?

Representational criterion
• Is this measure „good to have“ or strategically important?
• Do we really measure the manager and employee behaviour we think we do? Is it a valid
measure?
Measurement systems criterion
• Is there a lack of personal bias in the data?
• Can the measure be compared across different units?
• Do we have the adequate systems to provide us with the data?
User criterion
• To what extent is the measure accepted by managers and employees?
• Is it simple enough for the employee to understand why to use it?
• Can lower-level managers and employees influence performance on these dimensions?

10
Market Measures of
Performance

11
 Market measures of
performance
• One way of assessing value changes is by using market measures of
performance
– Based on changes in the market value of the firm or
– return to shareholders.
• Return to shareholders can be measured directly for any period (yearly,
quarterly, monthly):

Sum of The change

Return to dividends in the market
shareholders paid to value of the
shareholders stock

• Market value is generally viewed as the closest proxy for the firm’s true
intrinsic value.

12
 Market measures of
performance
• Have broad appeal in part, because they provide relatively direct indications
of changes in firm value.
• For publicly traded, exchange-listed firms, market values are available on a
timely (daily) basis.

Precise Relatively accurate Objective (not Understandable Cost effective

(little systematic manipulable by the
biases, assuming managers)
an efficient
information
environment)

13
 Market measures of
performance
Limitations
1. Controllability problems
✗ Can generally be affected to a significant extent only by the top few
managers.
✗ Say little about the performances of individuals lower in the organization.
✗ Even for the top management team may be far from being totally
controllable.
✗ Stock market valuations are affected by many factors that the managers
cannot control:
− Changes in macroeconomic activity (economic growth)
− Political climate (e.g., election results)
− Monetary policy (e.g., interest rate policy)
− General stock market mood (bearish or bullish)
− Noise inherent in firms’ stock prices

14
 Market measures of
performance
Limitations
2. Market values do not always reflect realized performance.
✗ Represent expectations.
✗ Risky to base incentives on expectations.
✗ Expectations are not to be equated with realizations.
✗ May trigger opportunistic motivations by the executives to try to affect stock
prices.

15
 Market measures of
performance
Limitations
3. Potential congruence failure
✗ Markets are not always well informed about a company’s prospects.

4. Feasibility on certain circumstances

✗ Market measures are only readily available for publicly traded firms.
✗ Do not apply to non-profit organizations.

Limitations of market
measures cause
organizations to look Accounting measures,
for surrogate measures specifically accounting
of performance. profits and returns, are the
most important surrogates
used.

16
Accounting Measures of
Performance

17
Accounting measures of
performance

Summary or bottom-
Accounting based
line performance
measures
measures

(1) Residual (2) Ratio

Have some appealing
(accounting profit) (accounting
advantages.
measures return) measures

Return on
Net income, investment (ROI),
operating profit, return on equity
EBIT, EBITDA (ROE), return on
assets (ROA)

18
 Return-on-Investment
Measures of Performance

19
 Return-on-investment
measures of performance
• Divisionalized organizations are comprised of multiple responsibility centers,
the managers of which are held primarily accountable for profit or some form
of accounting return.
• Decentralized when authority for making decision is pushed down to lower
levels in organization.

Board of directors

Division 1 Division 2 Division 3

Functions

20
 Return-on-investment
measures of performance

𝑹𝒆𝒕𝒖𝒓𝒏 (𝑩𝒆𝒏𝒆𝒇𝒊𝒕)
𝑹𝑶𝑰 =
𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 (𝑪𝒐𝒔𝒕)

• The profit measure in the numerator of the ROI calculation can be a fully
allocated, after-tax profit measure, or it can be a before-tax operating income
measure.
• Denominator can include
– all the line items of assets and liabilities;
– only controllable assets;
– at a minimum, receivables and inventories.

21
 Return-on-investment
measures of performance
Balance sheet (€000s)
Current assets Current liabilities
Cash €50 Accounts payable €90
Receivables 150 Other current 110
Inventory 150
Total current assets 350 Total current liabilities 200
Non-current assets Non-current liabilities 100
Cost €650 Corporate equity 400
Depreciation -300
Book value 350
Total assets €700 Total liabilities and equity €700
Income statement
Revenue €1,000
Expenses €-850
Depreciation -50 -900
Earnings before interest and taxes 100
Capital charge (€(700-200) x 10%) -50
Residual income (RI) 50
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Return on investment (ROI) = 100/500 = 20%
 Return-on-investment
measures of performance
Sales
Direct costs
Profit MINUS PLUS
Profit as % of DIVIDED BY Selling
sales (ROS) Cost of sales expenses
Sales PLUS
Administrative
Return on expenses
MULTIPLIED BY
investment
Cash
Sales PLUS
Asset turnover DIVIDED BY Accounts
Working capital receivable
Total investment PLUS PLUS

Fixed Inventories
23
investment
 Return-on-investment
measures of performance

• Return on sales (ROS) is a measure of how Division A Division B

efficiently a company turns sales into profits.

• The asset turnover ratio assesses the Revenue $360,000 $100,000

effectiveness with which a company utilizes its
assets to generate revenue. Total Assets $720,000 $400,000

EBIT $72,000 $40,000

Asset turnover 50% 25%

ROS 20% 40%

ROI 10% 10%

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 Return-on-investment
measures of performance
Advantages of ROI-type measures

✓ Single, comprehensive measure that reflects the tradeoffs managers

must make between revenues, costs, and investments.

✓ Provide a common denominator that can be used for comparing

returns on dissimilar businesses, such as divisions.

✓ ROI figures are comparable to other financial returns, such as those

calculated for stocks and bonds.

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Problems Caused by ROI-
Type of Measures

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 Problems caused by ROI-
type of measures
1. Myopia

Conservative bias

Investment myopia

Ignoring of
intangible assets

• Accounting rules do not allow firms to recognize gains until they are realized
and firms to begin recognizing costs when the investments are made.
• Projects with uncertain returns (R&D projects, employee development, and
capital investments) must be expensed over periods that are typically
shorter than those in which returns will be realized.
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 Problems caused by ROI-
type of measures
2. Suboptimization

Investment center A Investment center B Company as a whole

Earnings before 7,200 8,600 15,800

interest and taxes
Assets employed 55,400 34,400 89,800

ROA 13% = (7,200/55,400) 25% = (8,600/34,400) 18% = (15,800/89,800)

Investment center A + Investment center B +

investment investment
Earnings before interest and 11,400 = (7,200 + 4,200) 12,800 = (8,600 + 4,200)
taxes
Assets employed 75,400 = (55,400 + 20,000) 54.400 = (34,400 + 20,000)

ROA 15% = (11,400/75,400) Yes to 23,5% = (12,800/54,400) No to

investment since ROA investment since ROA
increases (from 13% to 15%) decreases (from 25% to 23,5%)
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 Problems caused by ROI-
type of measures
2. Suboptimization

The effect: firm’s capital will gradually be allocated away from its most
successful or, at least, highest-earning divisions and toward its least
successful divisions.

Asset values reflected on the balance sheet do not always represent the
economic value of the assets available to managers for earning current
returns.

Book values say little about the economic value of the assets; that is,
their ability to generate future cash flows.
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 Problems caused by ROI-
type of measures
3. Misleading signals

Net Book Values (NBV)

𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝐶𝑜𝑠𝑡 − 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑇𝑖𝑙𝑙 𝐷𝑎𝑡𝑒

• When NBV is used, ROI is usually overstated.

• The overstatement is larger if the entity includes a relatively large number of older
assets.
• NBV of older assets is below their replacement values:
→ bought in a period of lower prices;
→ have been depreciated longer.

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 Problems caused by ROI-
type of measures
3. Misleading signals

• Assume there have been no Division C Division D

technological advancements → the old
assets perform the same tasks as Profit before
$110,000 $110,000
efficiently as the new assets. depreciation
Depreciation $10,000 $20,000
• Profit before depreciation is identical, but
Division D’s depreciation is twice that of Profit after
$100,000 $90,000
Division C. depreciation
Assets (net
• But C’s ROI is dramatically higher than book value)
$500,000 $3,000,000
D’s, mostly because its assets have a
lower NBV. ROA 20% 3%

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 Problems caused by ROI-
type of measures
3. Misleading signals

• Encourage division managers to Division E

retain assets beyond their optimal life Year 1 Year 2 Year 3
• Not invest in new assets that would Profit before
increase denominator of the ROI $110,000 $110,000 $110,000
depreciation
calculation. Depreciation $50,000 $50,000 $50,000
• Measuring fixed assets at gross book Profit after
value (GBV) – that is, gross depreciation
$60,000 $60,000 $60,000
depreciation conventions that are
Assets (net
used for financial reporting purposes $500,000 $450,000 $400,000
book value)
– minimizes some of these problems.
ROA 12% 13.3% 15%

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Residual Income Measures

33
 Residual income measures
Residual income
• Calculated by subtracting from profit a capital charge for the net assets tied
up in the entity or division (investment center).

Residual Capital Charge

Profit
Income for Net Assets

• Capital is charged at a rate equal to the weighted average corporate cost of

capital (WACC).
• Addresses the financing-type suboptimization problem.

34
Residual income measures
Balance sheet (€000s)
Current assets Current liabilities
Cash €50 Accounts payable €90
Receivables 150 Other current 110
Inventory 150
Total current assets 350 Total current liabilities 200
Non-current assets Non-current liabilities 100
Cost €650 Corporate equity 400
Depreciation -300
Book value 350
Total assets €700 Total liabilities and equity €700
Income statement
Revenue €1,000
Expenses, expect depreciation €-850
Depreciation -50 -900
Earnings before interest and taxes 100
Capital charge (€(700-200) x 10%) -50
Residual income (RI) 50
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Return on investment (ROI) = 100/500 = 20%
Residual income measures
Investment center A Investment center B Company as a whole

Earnings before interest 7,200 8,600 15,800

and taxes
Assets employed 55,400 34,400 89,800

ROA 13% = (7,200/55,400) 25% = (8,600/34,400) 18% = (15,800/89,800)

RI 1,660 = 5,160 = 6,820 =

(7,200 – 0.1 x 55,400) (8,600 – 0.1 x 34,400) (15,800 – 0.1 x 89,800)

Investment center A + investment Investment center B + investment

Earnings before interest and taxes 11,400 = (7,200 + 4,200) 12,800 = (8,600 + 4,200)

Assets employed 75,400 = (55,400 + 20,000) 54.400 = (34,400 + 20,000)

ROA 15% = (11,400/75,400) YES to 23,5% = (12,800/54,400) NO to

investment since ROA increases investment since ROA decreases
(from 13% to 15%) (from 25% to 23,5%)
RI 3,860 = (11,400 – 0.1 x 75,400) YES 7,360 = (12,800 – 0.1 x 54,400) YES
to investment since RI increases to investment since RI increases
(from 1,660 to 3,860) (from 5,160 to 7,360)
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 Residual income measures
Economic Value Added (EVA)

Modified Net Modified Total Weighted

EVA Operating Profit Invested Average Cost
After Tax Capital of Capital

reflects the weighted

average cost of debt
and equity financing

37
Residual income measures

38
Residual income measures

39
 Residual income measures
Economic Value Added (EVA)
Modified Net Modified Weighted
EVA Operating Profit Total Invested Average Cost of
After Tax Capital Capital

Modified Net Operating Profit After Tax:

𝐸𝐵𝐼𝑇 20,458
− 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥𝑒𝑠 𝐸𝑉𝐴 = 14,963 − 153,933 × 9.85% = −199M
− 5,495
+/− 𝐴𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡𝑠 +/− 0
= 𝑁𝑂𝑃𝐴𝑇 = 14,963
Modified Invested Capital (= Equity + long-term liabilities):
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 260,015
− 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑡𝑖𝑒𝑠 − 88,403
− 𝐶𝑎𝑠ℎ − 17,679
= 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 153,933

𝑊𝐴𝐶𝐶 = 9.85%
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 Residual income measures
𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡
𝑊𝐴𝐶𝐶 = 𝑟𝑒 × + 𝑟𝑑 × 1 − 𝑇 ×
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑟𝑒 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝑟𝑑 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡
𝑇 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒
𝑟𝑒 = 𝑟𝑓 + 𝛽 × (𝑟𝑚 − 𝑟𝑓 )
𝑟𝑓 − 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 Typically 10year U. S. Treasury Bond yield
𝛽 − 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝛽 𝐹𝑎𝑐𝑡𝑜𝑟
𝑟𝑚 − 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡

(1 − 𝑇)
𝑟𝑑 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 ×
𝐷𝑒𝑏𝑡

41
 Residual income measures
✗ Suffers from objectivity problems as the EVA adjustments
require considerable judgement.
✗ Managers can bias EVA just as they can accounting numbers.
✗ Controllability problems.
✗ Additional understandability problems.
✗ Complex and not as widely familiar.
✗ Expensive, requiring considerable assistance from consultants and systems
and management development and training time.

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 Evaluation of Accounting
Performance Measures
Advantages
1. Can be measured on a timely basis relatively precisely and objectively.
✓ Accounting rules have been set and described to in great detail by
accounting rule makers (IASB).
✓ Precision stems from the existence of accounting rules.
→ Different people assigned to measure the profit of an entity for any given period
will arrive at approximately the same number.
→ Independent auditors provide, mandatorily or voluntary, an objectivity check of the
accounting calculations.
2. Accounting measures are at least conceptually congruent with the
organizational goal of profit maximization, where profit is an archetypal
accounting construct.

43
 Evaluation of Accounting
Performance Measures
Advantages
3. Accounting measures can be largely controlled by the managers whose
performances are being evaluated.
→ Measures can be tailored to match the authority limits of any level of manager,
from the CEO down to lower management levels.
4. Understandable
→ Managers are familiar with the measures.
5. Inexpensive
→ Most firms have to measure and report financial results to external stakeholders.

44
Evaluation of Accounting
Performance Measures
Disadvantages

1. Accounting systems are transactions-oriented

2. Dependent on the choice of measurement methods

3. Often conservatively biased

4. Ignore some economic values and value changes

5. Profit reflects the cost of borrowed capital but ignores the cost of
equity

6. Profit figures focus on the past

45
Accounting measures of
performance

46
Non-Financial Performance
Measures

47
Non-Financial Performance
Measures
Why?

Financial measures → Lagging measures

Non-financial measures → Leading measures

They are indicators of whether current financial performance is also

sustainable in the future.

Managers may not undertake useful long-term actions to obtain short-

term profits.

Financial measures are perceived as too abstract by many employees.

48
 Non-Financial Performance
Measures
Customer-oriented measures:

BOOKINGS MARKET SHARE CUSTOMER CUSTOMER CUSTOMER

SATISFACTION RETENTION LOYALTY

49
 Non-Financial Performance
Measures
Business process-oriented measures:

CAPACITY ON-TIME DELIVERY QUALITY

UTILIZATION

50
 Non-Financial Performance
Measures
Employee-oriented measures:

NUMBER OF EMPLOYEE EMPLOYEE EMPLOYEE

TRAINING HOURS RETENTION INDEX SATISFACTION HEALTH
COMPLETED PER
EMPLOYEE

51
 Non-Financial Performance
Measures
Innovation and environment-oriented measures:

NUMBER OF NEW NUMBER OF CO2 FOOTPRINT

PRODUCTS/SERVI DEVELOPMENT
CES LAUNCHED PROJECTS
STARTED

52
 Non-Financial Performance
Measures
Sustainability targets and dimensions
Environmental dimension
Energy consumption 50

Yes, general, Yes concrete, Carbon footprint 49

not quantitative 24% quantitative
25% targets
targets Recycling 27

Water consumption 24

Waste volume 23

No, 24%
but planned 27% No Social dimension
Energy consumption 43

Employee satisfaction 40

Diversity and equal opportunities 32

Education and training 20

Fair working conditions at suppliers 16

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WHU Controller Panel 2022
 Non-Financial Performance
Measures
Limitations

✗ Are they aligned with corporate goals?

✗ How are these measures related to financial outcomes?

✗ How can I set the “right” performance targets?

54
Example Measures for
Responsibility Centers

55
 Example Measures for
Responsibility Centers
Head office

Investment
centers

Division A Division B

Profit Business unit Business unit

1 2
centers

Production Research and

Sales unit
unit development

Revenue Engineered Discretionary 56

center expense center expense center
 Example Measures for
Responsibility Centers
• Return on Investment (ROI): ROI measures the return generated from
investments made by the head office. It evaluates the profitability of
projects, acquisitions, and other capital expenditures, providing insight
into the effectiveness of resource allocation.

• Earnings Before Interest and Taxes (EBIT): EBIT represents the

operating profit of the company before accounting for interest and taxes.
It's a widely used financial metric that reflects the core profitability of the
head office's operations.

• Economic Value Added (EVA): EVA is a financial performance

measure that can be applied at various levels of an organization,
including both individual business units and the corporate head office.

57
 Example Measures for
Responsibility Centers
Head office

Investment
centers

Division A Division B

Profit Business unit Business unit

1 2
centers

Production Research and

Sales unit
unit development

Revenue Engineered Discretionary 58

center expense center expense center
 Example Measures for
Responsibility Centers
• Profit Margin: Measure the percentage of profit earned on the revenue
generated by the business unit. This indicates the unit's ability to
manage costs and generate profitability.

• Market Share: Assess the company's market share within its industry or
specific markets, indicating its competitive position and ability to capture
a larger portion of the market.

• Customer Retention Rate: Track the percentage of customers retained

over a specific period, reflecting the unit's success in maintaining
customer loyalty and satisfaction.

59
 Example Measures for
Responsibility Centers
Head office

Investment
centers

Division A Division B

Profit Business unit Business unit

1 2
centers

Production Research and

Sales unit
unit development

Revenue Engineered Discretionary 60

center expense center expense center
 Example Measures for
Responsibility Centers
• Sales Revenue: This measure evaluates the total revenue generated by
the sales unit, indicating its effectiveness in generating income for the
company.

• Sales Growth Rate: Tracking the percentage increase in sales over a

specific period helps assess the unit's ability to expand its customer
base or increase product/service sales.

• Sales Conversion Rate: This metric assesses the efficiency of the

sales team by measuring the percentage of leads or prospects that
convert into paying customers.

61
 Example Measures for
Responsibility Centers
Head office

Investment
centers

Division A Division B

Profit Business unit Business unit

1 2
centers

Production Research and

Sales unit
unit development

Revenue Engineered Discretionary 62

center expense center expense center
 Example Measures for
Responsibility Centers
• Production Efficiency: This metric evaluates the unit's ability to
produce goods or deliver services efficiently by measuring factors like
production cycle time or service delivery time.

• Quality Control Defect Rate: Monitoring the number of defects or

errors in the production process helps maintain product/service quality.

• Inventory Turnover: Inventory turnover measures how quickly the unit

sells or uses its inventory, indicating its ability to manage inventory
efficiently.

63
 Example Measures for
Responsibility Centers
Head office

Investment
centers

Division A Division B

Profit Business unit Business unit

1 2
centers

Production Research and

Sales unit
unit development

Revenue Engineered Discretionary 64

center expense center expense center
 Example Measures for
Responsibility Centers
• Product/Service Development Rate: Tracking the rate at which new
products or services are developed and launched demonstrates the
unit's innovation and market responsiveness.

• R&D Project Success Rate: This metric evaluates the percentage of

R&D projects that successfully result in new products, services, or
technologies, indicating the unit's effectiveness in innovation.

• Intellectual Property (IP) Portfolio Growth: Measuring the growth of

patents, trademarks, and other intellectual property assets demonstrates
the unit's ability to protect and leverage its innovations.

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 Strategic Performance
Measurement Systems
-
The Balanced Scorecard

66
 The Balanced Scorecard

• The BSC systematizes the various measures into a number of

perspectives.
• The link between strategy and performance measurement is
emphasized.
• The BSC is built on the idea of cause-and-effect relationships among
measures.
• It can be associated with incentives.

67
 The Balanced Scorecard

Employee Process Customer Owner

perspective perspective perspective perspective

Product quality Profitability

Customer
loyality

Employee Sales
satisfaction Delivery lead
time

Growth

Source: Ericsson Network Intelligence. 68

 The Balanced Scorecard
What ist the Vision &
Vision of the Mission
future?

Shareholders Customers Processes Innovation

How will we
Differ?
Financial persp. Customer persp. Internal persp. Learning persp.

What are the

Critical Success
Factors?

What are the

Crititcal
Measurements ?
Balanced Scorecard

69
Source: Kaplan, R. and Norton, D. (1993) Putting the balanced scorecard to work, Havard Business Review
 The Balanced Scorecard
Financial perspective

• Strategic objectives
• Critical success factors
• Performance measures (e.g.
contribution margin, return on
investment, residual income)

Customer perspective Internal business perspective

• Strategic objectives Vision and • Strategic objectives

• Critical success factors strategy • Critical success factors
• Performance measures (e.g. • Performance measures
market share, customer (e.g.production defect rates, cycle
satisfaction index) time reduction)
Innovation and learning
perspective
• Strategic objectives
• Critical success factors
• Performance measures (e.g.
percentage of sales from new
products, number of training hours
per employee)
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 The Balanced Scorecard

• Empirical evidence suggests that non-financial measures are associated

with future financial performance (Ittner & Larcker, 1998).
• Research also finds that both financial and non-financial performance
improve following the implementation of a BSC (Banker, Potter &
Srinivasan, 2000).
– Because it is a more complete reflection of corporate performance.
– It reflects a stakeholder view of the firm.
– It addresses understandability problems.

But implementing a BSC is not always effective:

• How to measure non-financial performance?
• Managers put more weight on financial measures.
• Many relationships between leading and lagging indicators are
nonlinear.

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 Summary
• For-profit organizations aim to maximize shareholder or firm value, which is a
long-term, future-oriented concept.
• Market measures of performance come with many advantages, but also
severe disadvantages and are thus often supplemented by accounting
measures of performance.
• Management myopia is an inevitable side-effect of the use of financial results
control systems built on accounting measures of performance.
• Firms need to weigh the costs and benefits of both accounting and market
measures of performance against each other and find satisfying schemes for
their purposes.
• Multidimensional performance measures with a strategic focus such as the
BSC are popular and counter some of the caveats of single measures.
• An all-purpose performance measures (or performance measurement
system) that meets all control objectives effectively without triggering any
potential harmful side effects does not exist.

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The Frescent Business Case
-
Sustainability and the
Balanced Scorecard

73
 Business Case Study III
-
Frescent: Sustainability and the
balanced scorecard

74
The Frescent Business Case

Frescent was a manufacturer of beauty products, such as skincare, hygiene and

haircare. The company was listed on the stock exchange. It had grown rapidly in the
past decade and now employed 300 people, primarily in marketing and product
development, but also in manufacturing. Investors had increasingly been asking
questions about sustainability. Kendall Spencer, the company CFO, had recently sat
in a meeting where the sustainability analyst at one of its largest owners, an
institutional investor, had questioned how the company’s formal strategic vision, “To
give consumers a more enjoyable daily life by developing and selling safe,
sustainable and high-quality beauty products”, was reflected in KPIs and reward
systems.
Frescent had published a sustainability report for some years, and had also employed
Alex North, a sustainability specialist who had so far worked primarily with supplier
control and the environmental impact of packaging. Moreover, Kendall’s co-workers
in the finance department had begun to suggest a there was misalignment between
the sustainability claims made externally and the internal management control
system.

Source: Frank Hartmann, Kalle Kraus, Göran Nilsson, Robert Anthony, & Vijay Govindarajan. (2020). 75
Management Control Systems
The Frescent Business Case

Frescent had published a sustainability report for some years, and had also employed
Alex North, a sustainability specialist who had so far worked primarily with supplier
control and the environmental impact of packaging. Moreover, Kendall’s co-workers
in the finance department had begun to suggest there was misalignment between the
sustainability claims made externally and the internal management control system.
One afternoon, one of Kendall’s co-workers, a controller, came into Kendall’s office.
I just bumped into Alex by the coffee machine. We got to talking about integration,
and the fact that rm none of our key metrics relates to sustainability. I am increasingly
gelling a sense we should do me something about this.
For years, a balanced scorecard (BSC) was the main management control tool that
integrated Frescent’s financial and non-financial performance, building on the
strategic mission. The dimensions and metrics had been carefully chosen and
adapted over the course of a decade, and the tool was generally seen to function
well.

Source: Frank Hartmann, Kalle Kraus, Göran Nilsson, Robert Anthony, & Vijay Govindarajan. (2020). 76
Management Control Systems
 The Frescent Business Case
Frescent‘s balanced Financial
scorecard: Contribution marging
Sales growth
ROCE

Customers To give consumer a Internal

Key customer order size more enjoyable daily life
by developing and processes
Market share Inventory turnover
Influencer outreach selling safe, sustainable
and high-quality beauty Consumer complaints
products

Innovation and
learning
New product sales (%)
R&D/total expenses (%)
Number of products in
stage-target
77
The Frescent Business Case

Frescent’s products were in the mid-price range, pharmacies and department stores
were the key retail outlet, and the BSC reflected this with a KPI on the average order
size of key customers, like the cl major pharmacy chains. It had also become
increasingly important to market products through influencers on social media
platforms, and thus one metric in the ‘customers’ perspective was a compound metric
of how many individuals were reached by, and interacted with, Frescent’s influencer
campaigns. The company manufactured some products internally, and others through
contractors. As the products would be used directly on consumers’ skin and hair,
products that caused irritation or allergic reactions could have a disastrous impact on
sales revenue. The company therefore included safety of products as part of the
mission statement, and closely followed the number of consumer complaints filed.
Top management was rewarded based on return on capital employed (ROCE).

78
The Frescent Business Case

The focus of Alex North’s work so far was the outcome of a mapping of key
sustainability issues the firm had conducted with the help of external sustainability
consultants a few years ago. The consultants had produced a materiality analysis,
where issues were assessed based on their importance to the business. One finding
was that consumers were increasingly concerned about the use of plastic in
packaging, and many young women looked especially for products with organic
ingredients. While Frescent had an eco range, the sales of which had grown to 7 per
cent of total sales in only three years, these issues had not been of concern
historically. In the country where Frescent had its largest portion of sales, there had
peen political proposals to introduce a mandatory declaration (on the product
container) of its environmental footprint, including 𝐶𝑂2 , emissions and water use, from
the manufacture of each product. It currently looked like the proposal would get a
narrow-margin majority in the parliament, and the consultants had recommended that
Frescent address this somehow.

Source: Frank Hartmann, Kalle Kraus, Göran Nilsson, Robert Anthony, & Vijay Govindarajan. (2020). 79
Management Control Systems
The Frescent Business Case

With the recent investor questions, and the internal pressures building up, Kendall
concluded that the BSC needed to be revisited. He knew that any such process
required bottom-up participation from different levels and departments. To start off the
discussion, however, Kendall decided to sit down with the controller and Alex North,
the sustainability specialist, and make a first suggestion that could be circulated
beforehand. Your task is to help Kendall and colleagues with the first draft of the
updated BSC.

Source: Frank Hartmann, Kalle Kraus, Göran Nilsson, Robert Anthony, & Vijay Govindarajan. (2020). 80
Management Control Systems
Questions

1.Which perspectives would be suitable for an update of Frescent’s

BSC?

2.Suggest a few appropriate KPIs in each such dimension. Make sure

to argue for your choice, and how it relates to the overall strategy. You
should also outline any potential challenges to implementing your
suggested updated BSC.

3.Would you suggest any changes to the reward system?

81
 Literature
Merchant, K. A., & Van der Stede, W. A. (2007). Management control systems: performance
measurement, evaluation and incentives. Pearson education.

Ittner, C. D., & Larcker, D. F. (1998). Are nonfinancial measures leading indicators of financial
performance? An analysis of customer satisfaction. Journal of Accounting Research, 36, 1-
35.

Banker, R. D., Potter, G., & Srinivasan, D. (2000). An empirical investigation of an incentive
plan that includes nonfinancial performance measures. The Accounting Review, 75(1), 65-92.

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