1.0 measures such as insensitivity to risks

1.0 Introduction

It was believed for a long time that quantitative
performance measures, such as economic value added (EVA) and return on
investment (ROI), were the only reasonable and efficient ways to measure
business performance and meet the market demand (Barker, 1995). Therefore, non-financial
performance measures, such as key performance indicators (KPI) and balanced scorecard
(BSC), were not used as commonly. However, the proportion of using both
measures has increased recently and the benefits of non-financial performance
measures have been realised by more users (Laura and Corina, 2012). The
ultimate purpose of using these measures is value maximization, rather than
profit or wealth maximization (Shil, 2009). This assignment is going to
critically assess the costs and benefits of both measures. Sections 2 and 3
examine the costs and benefits of quantitative and non-financial performance
measures respectively, taking EVA and KPI as typical examples. Section 4 compares
the two approaches and Section 5 is the conclusion.

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2.0 EVA

2.1 What is EVA

EVA is the difference between net operating profit after tax
and required return on capital (Ilic, 2010). The equation is shown as EVA=
NOPATadjusted – (Invested Capitaladjusted * WACC).

2.2 Benefits of EVA

Stern Stewart & Co (in Ferna?ndez, 2001) state that “EVA
is the only measure that gives the right answer”. Compared to conventional
quantitative measures (ROE, ROI etc.) that only account for profits, EVA takes
both profits and the cost of capital into consideration (Byrne, 1999; Sharma,
2010). This offsets the limitation of conventional measures such as
insensitivity to risks and absence of time value of money, thus consistent with
discounted cash flow (Jakub et al., 2015). Although CAPM as the basis for
calculation of cost of capital might be an impediment in less developed markets,
EVA provides a more accurate measure of value (Ilic, 2010).

 

In order to have a complete view, it is suggested that EVA
should combine with business practice rather than being used alone (Bahri et
al., 2011). There are two main functions of EVA recognized by Jakub et al.

(2015) when EVA is connected to other activities: the management system, and a
way of motivation. EVA as an indicator of the management system could improve
the operation of a business by increasing the efficiency of resource allocation
and reduce unnecessary loss by eliminating unprofitable projects (Costin, 2017).

Therefore, EVA is not merely a quantitative measurement but also a superior
management tool. In addition, EVA can link business objectives to a reward
system, which would align the interests of shareholders and managers and thus
mitigate principal-agent problem (Ilic, 2010; Sharma, 2010).

 

Another benefit not widely recognized is that EVA is
relatively independent of accounting standards (Bahri et al., 2011), so the
result is not affected by a change in standards. This enables long-term communication
among businesses with increased comparability, hence helping to choose the best
alternative with less time and money involved (Costin, 2017). However, due to
this independence, the adoption of EVA is not as common as other measures, so
the scale is inadequate for implementation of this benefit (Ilic, 2010).

2.3 Costs of EVA

There are two commonly accepted drawbacks of EVA.

 

Firstly, EVA is a short-term measurement tool, so is not
suitable for businesses just starting up or focusing on long-term investments
(Costin, 2017; Shil, 2009). Since the value of long-term investment cannot be
measured objectively but only estimated subjectively and the payback of investments
is only received through a slow and incremental process, businesses that invest
heavily during a specific period might have a negative EVA which would indicate
that their value was destructive (Shil, 2009). Hence the adoption of EVA leads
to increased retained earnings and declined investments, which will cause deferment
of profitable projects (Ferna?ndez, 2001; Byrne, 1999).

 

Secondly, due to the existence of inflation or other
factors, the EVA calculated through the method proposed by Stewart would be
distorted, which would increase the possibility of resource misallocation
(Costin, 2017; Shil, 2009). In this case, Warr (2005) proposed using real EVA
in order to correct this limitation of Stewart’s nominal EVA. However, the calculation
process is complex.

 2.4 Relative
literature of EVA

The utility of EVA has been argued extensively in
literature. O’Hanlon and Peasnell (1998 in Zhao et al., 2012) believed that EVA
was better than conventional measures in explaining changes in share price.

Although there is no sufficient evidence to show that EVA improves stock
performance, it is claimed that the profitability of firms using EVA is above
average (Ferguson et al., 2005). However, Paulo (2002) commented that EVA is
the same as other performance measures and accounting information is becoming
less relative to stock price and return.

3.0 KPI

3.1 What is KPI

According to Velimirovic? et al. (2011), KPI are “financial
and non-financial measures that organizations use to reveal how successful they
were in accomplishing long lasting goals”.

3.2 Benefits of KPI

KPI includes both quantitative and qualitative information that
should reflect critical aspects of business operations (P.C. Chan and P.L.

Chan, 2004). Satisfying critical success factors ensures that the project
succeeds and KPI helps the business to operate within the budget and strategy. This
offsets the limitation of traditional measures such as lack of focus on crucial
factors (Sanchez and Robert, 2010). In addition, as with EVA, managers and
employees would be motivated greatly to achieve goals and objectives by linking
KPI to a reward system (Velimirovic? et al., 2011).

 

As all firms are different, there is no general set of KPI
that fits every firm (Toor et al., 2010). Selecting proper KPI that is
consistent with a firm’s norms, values and long-term goals is of vital
importance, and is a “multi-criteria decision-making” problem (Carlucci, 2010).

Analytical hierarchy process (AHP) and SMART goal setting methods are often
used for prioritization of KPI. AHP suggests that decision-making should follow
three principles; “decomposition, comparative judgment and synthesis of
priorities” (Shahin and Mahbod, 2007). The SMART acronym stands for “specific,
measureable, attainable, realistic and time-sensitive”, and this guides the
goal setting process (Shahin and Mahbod, 2007). The two methods allow both
qualitative and quantitative information to be used and thus give a
comprehensive view. This provides a guidance for strategic plan (Velimirovic?
et al., 2011).

3.3 Costs of KPI

However, it should be mentioned that the number of KPI used should
always be limited. Involving too many KPI increases the redundancy of
information, which leads to information overload and reduces the efficiency of resource
allocation (P.C. Chan and P.L. Chan, 2004; Carlucci, 2010).

 

It is also argued that KPI is set from a long-term view, and
therefore needs updating continuously. Therefore, many uncertain and intangible
effects will arise during the process, which are difficult to measure precisely
(Sanchez and Robert, 2010). Whereas Rodriguez et al. (2009) suggested that quantitative
relationship at the performance measurement system (QRPMS) can be used to
mitigate this problem. QRPMS aims to discover and quantify the relationship
between KPI and goals, and provides a detailed and measurable solution by following
the idea of SMART.

4.0 Comparison of EVA and KPI

From above analysis, we can conclude that both EVA and KPI
can be used internally and externally for management and motivation purposes.

EVA is a quantitative measurement and shareholder approach while KPI is a
non-financial measurement and stakeholder approach. Compared to KPI, EVA is hard
to understand and not used as widely as KPI due to the complex calculations. Although
KPI gives a good framework to guide business activities, it lacks details on direction
of specific actions. In addition, as KPI does not only involve mathematical
calculation but also subjective opinion and judgement, it requires managers to have
a deep understanding of KPI in management process. There is no doubt that EVA
is the only measure that is directly connected to shareholders, but it does not
mean that quantitative measures are preferred as bases for planning, control
and decision-making. Many studies show that it is necessary for managers to
take both quantitative and qualitative aspects into consideration, and just
using any one of them alone would reduce management quality and efficiency
(Laura and Corina, 2012; Barker, 1995). The stakeholder’s interest and opinions
are equally important as that of the shareholder. (Jepsen and Eskerod, 2009).

5.0 Conclusion

Taking EVA and KPI as examples of quantitative and
non-financial performance measurement respectively, both have costs and
benefits. For example, both measures have management and motivation functions. EVA
considers the cost of capital which increases the measuring of accuracy and is
more independent of accounting standards, but is only suitable in the
short-term, so sometimes might be affected by inflation and other factors. KPI
includes financial and non-financial information so offers a comprehensive view
of the business but can cause information overload. Though EVA is linked more
directly to the needs of shareholders, focusing on merely one measurement may
lead to weak and insufficient results. In conclusion, there is no preference in
managerial planning, control and decision-making.