There’s no argument that the bottom line matters in business. However, in recent years, companies of all sizes have started to discover how nonfinancial measures can contribute to overall success.
“These days, companies are clearly creating value through means other than a capital-intensive production system,” says Amy Pawlicki, director of business reporting assurance and advisory services for the American Institute of Certified Public Accountants (AICPA) in Washington, D.C. “There are also a number of intangible drivers that, if carefully chosen, can give business leaders a better perspective on where value is created—over and above what they would get looking at standard financial reporting metrics.”
A growing body of research shows that nonfinancial measures deserve consideration in an overall review of a company’s growth prospects. For example, a 2005 Stanford University study of more than 100 retail banks examined nonfinancial metrics such as customer satisfaction, employee turnover, speed of loan processing and average number of products and services purchased by customers against total overhead costs, including the expense of interest paid on deposit accounts. According to the study, banks that did a good job of strategically linking nonfinancial measures to an overall business assessment increased the accuracy of future earnings forecasts by up to 15 percent.
But identifying and accurately using nonfinancial measures is easier said than done. In a recent survey by The Economist, nearly three-quarters of chief financial officers said their companies were under greater pressure from stakeholders to track nonfinancial performance measures. However, only 34 percent of those CFOs said their companies did a good or excellent job of using nonfinancial data regularly.
“Typically, companies aren’t going to get the mix right the first time, which means that they need to be flexible and willing to course-correct,” says John Morrow, an AICPA vice president who is helping oversee a series of research projects on the effectiveness of nonfinancial measures. “That’s important to remember, because anything you begin to measure will tend to drive behaviors in the company—some of which may not be what was intended.”
How do companies fall into the trap of unintended consequences? In a landmark 2003 report, University of Pennsylvania business professors Christopher Ittner and David Larcker said that most business leaders make four key mistakes when selecting and using nonfinancial measures:
• Not linking measures to strategy
• Not validating the assumptions behind the links
• Setting the wrong performance targets
• Measuring results incorrectly
On the other hand, the authors laid out six detailed steps to help business leaders maximize the value of nonfinancial measures:
Develop a causal model. In their research, Ittner and Larcker discovered that only 23 percent of the companies they interviewed consistently built diagrams showing a cause-and-effect relationship between selected nonfinancial measures and desired business outcomes. For instance, a fast-food chain in the study sought to improve its cash flow and stock price. With that in mind, it built a model that showed how better employee selection would lead to better workplace satisfaction and performance, which, in turn, would result in higher customer satisfaction and repeat business. By validating the potential effect of those nonfinancial measures, the company could focus on targets that actually contributed to bottom-line goals.
Gather data. Most mid-sized and large companies already gather a variety of nonfinancial data on customers, employees and markets. However, the information is often widely dispersed throughout the organization. To avoid duplication of effort, Ittner and Larcker suggest that companies tap departmental managers for a widespread assessment of nonfinancial data that may already exist. This step not only supports accurate development of the cause-and-effect model but also gives a company an opportunity to unify its reporting tools.
“Most companies have multiple databases full of information that isn’t connected, and that’s not a very efficient way to operate,” Pawlicki says. When companies gather this data, they should look for ways to make it available in an integrated system—creating a single repository for key information used in business decision making, she says.
Turn the data into information. Companies can use quantitative or qualitative analysis tools to unlock the value of raw data. For instance, a major retailer in the University of Pennsylvania study used regression analysis to determine how a handful of nonfinancial activities in employee relations and customer satisfaction actually drove performance. In another example, Ittner and Larcker said a supplier of industrial gases tested its assumptions by conducting customer focus groups. Reviewing the results, the company found that customers regarded technical assistance—not improved billing services—as most important. That finding was critical to selecting the right nonfinancial value driver.
Continually refine the system. While experts generally agree it’s not necessary to rebuild the causal model every year, smart companies will continue to monitor any external or internal changes that may weaken original effectiveness. To stay ahead of this issue, one information technology company in the Pennsylvania study appointed a team to review company efforts and customer outcomes each quarter. In these reviews, the team analyzed the company’s current financial and nonfinancial metrics, assessing whether or not those measures remained relevant. The team presented summaries of these discussions to the company’s executive management team.
Base actions on findings. This commitment helps ensure companies act only on nonfinancial measures promising the greatest financial reward. For example, a financial services company in the Pennsylvania study found that employee satisfaction, data processing quality and customer satisfaction were the key drivers of financial performance. To that end, the company shifted its budgeting approach to support those measures and began requiring managers to show how they would measure success in those three areas each year.
Assess outcomes. While this is a critical final step, Ittner and Larcker said only a small percentage of companies they surveyed actually bothered to audit the effectiveness of their nonfinancial measures. By foregoing regular assessments, companies lose the opportunity to learn what worked and, more importantly, where mistaken assumptions or bad data led to subpar results.
By following this six-step process, your company can make smarter decisions about how to identify, test and apply nonfinancial measures that can bolster your bottom line. IBI
