1.0 IntroductionIt was believed for a long time that quantitativeperformance measures, such as economic value added (EVA) and return oninvestment (ROI), were the only reasonable and efficient ways to measurebusiness performance and meet the market demand (Barker, 1995). Therefore, non-financialperformance measures, such as key performance indicators (KPI) and balanced scorecard(BSC), were not used as commonly.
However, the proportion of using bothmeasures has increased recently and the benefits of non-financial performancemeasures have been realised by more users (Laura and Corina, 2012). Theultimate purpose of using these measures is value maximization, rather thanprofit or wealth maximization (Shil, 2009). This assignment is going tocritically assess the costs and benefits of both measures. Sections 2 and 3examine the costs and benefits of quantitative and non-financial performancemeasures respectively, taking EVA and KPI as typical examples. Section 4 comparesthe two approaches and Section 5 is the conclusion.
2.0 EVA2.1 What is EVAEVA is the difference between net operating profit after taxand required return on capital (Ilic, 2010). The equation is shown as EVA=NOPATadjusted – (Invested Capitaladjusted * WACC).2.2 Benefits of EVAStern Stewart & Co (in Ferna?ndez, 2001) state that “EVAis the only measure that gives the right answer”. Compared to conventionalquantitative measures (ROE, ROI etc.
) that only account for profits, EVA takesboth profits and the cost of capital into consideration (Byrne, 1999; Sharma,2010). This offsets the limitation of conventional measures such asinsensitivity to risks and absence of time value of money, thus consistent withdiscounted cash flow (Jakub et al., 2015). Although CAPM as the basis forcalculation 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 EVAshould combine with business practice rather than being used alone (Bahri etal., 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 away of motivation. EVA as an indicator of the management system could improvethe operation of a business by increasing the efficiency of resource allocationand reduce unnecessary loss by eliminating unprofitable projects (Costin, 2017).Therefore, EVA is not merely a quantitative measurement but also a superiormanagement tool. In addition, EVA can link business objectives to a rewardsystem, which would align the interests of shareholders and managers and thusmitigate principal-agent problem (Ilic, 2010; Sharma, 2010). Another benefit not widely recognized is that EVA isrelatively independent of accounting standards (Bahri et al., 2011), so theresult is not affected by a change in standards.
This enables long-term communicationamong businesses with increased comparability, hence helping to choose the bestalternative with less time and money involved (Costin, 2017). However, due tothis independence, the adoption of EVA is not as common as other measures, sothe scale is inadequate for implementation of this benefit (Ilic, 2010).2.3 Costs of EVAThere are two commonly accepted drawbacks of EVA.
Firstly, EVA is a short-term measurement tool, so is notsuitable for businesses just starting up or focusing on long-term investments(Costin, 2017; Shil, 2009). Since the value of long-term investment cannot bemeasured objectively but only estimated subjectively and the payback of investmentsis only received through a slow and incremental process, businesses that investheavily during a specific period might have a negative EVA which would indicatethat their value was destructive (Shil, 2009). Hence the adoption of EVA leadsto increased retained earnings and declined investments, which will cause defermentof profitable projects (Ferna?ndez, 2001; Byrne, 1999).
Secondly, due to the existence of inflation or otherfactors, the EVA calculated through the method proposed by Stewart would bedistorted, which would increase the possibility of resource misallocation(Costin, 2017; Shil, 2009). In this case, Warr (2005) proposed using real EVAin order to correct this limitation of Stewart’s nominal EVA. However, the calculationprocess is complex. 2.4 Relativeliterature of EVAThe utility of EVA has been argued extensively inliterature. O’Hanlon and Peasnell (1998 in Zhao et al.
, 2012) believed that EVAwas better than conventional measures in explaining changes in share price.Although there is no sufficient evidence to show that EVA improves stockperformance, it is claimed that the profitability of firms using EVA is aboveaverage (Ferguson et al., 2005). However, Paulo (2002) commented that EVA isthe same as other performance measures and accounting information is becomingless relative to stock price and return.3.0 KPI3.1 What is KPIAccording to Velimirovic? et al.
(2011), KPI are “financialand non-financial measures that organizations use to reveal how successful theywere in accomplishing long lasting goals”.3.2 Benefits of KPIKPI includes both quantitative and qualitative information thatshould reflect critical aspects of business operations (P.C.
Chan and P.L.Chan, 2004).
Satisfying critical success factors ensures that the projectsucceeds and KPI helps the business to operate within the budget and strategy. Thisoffsets the limitation of traditional measures such as lack of focus on crucialfactors (Sanchez and Robert, 2010). In addition, as with EVA, managers andemployees would be motivated greatly to achieve goals and objectives by linkingKPI to a reward system (Velimirovic? et al.
, 2011). As all firms are different, there is no general set of KPIthat fits every firm (Toor et al., 2010). Selecting proper KPI that isconsistent with a firm’s norms, values and long-term goals is of vitalimportance, and is a “multi-criteria decision-making” problem (Carlucci, 2010).
Analytical hierarchy process (AHP) and SMART goal setting methods are oftenused for prioritization of KPI. AHP suggests that decision-making should followthree principles; “decomposition, comparative judgment and synthesis ofpriorities” (Shahin and Mahbod, 2007). The SMART acronym stands for “specific,measureable, attainable, realistic and time-sensitive”, and this guides thegoal setting process (Shahin and Mahbod, 2007). The two methods allow bothqualitative and quantitative information to be used and thus give acomprehensive view.
This provides a guidance for strategic plan (Velimirovic?et al., 2011).3.3 Costs of KPIHowever, it should be mentioned that the number of KPI used shouldalways be limited. Involving too many KPI increases the redundancy ofinformation, which leads to information overload and reduces the efficiency of resourceallocation (P.C. Chan and P.L.
Chan, 2004; Carlucci, 2010). It is also argued that KPI is set from a long-term view, andtherefore needs updating continuously. Therefore, many uncertain and intangibleeffects will arise during the process, which are difficult to measure precisely(Sanchez and Robert, 2010). Whereas Rodriguez et al. (2009) suggested that quantitativerelationship at the performance measurement system (QRPMS) can be used tomitigate this problem. QRPMS aims to discover and quantify the relationshipbetween KPI and goals, and provides a detailed and measurable solution by followingthe idea of SMART.
4.0 Comparison of EVA and KPIFrom above analysis, we can conclude that both EVA and KPIcan be used internally and externally for management and motivation purposes.EVA is a quantitative measurement and shareholder approach while KPI is anon-financial measurement and stakeholder approach.
Compared to KPI, EVA is hardto understand and not used as widely as KPI due to the complex calculations. AlthoughKPI gives a good framework to guide business activities, it lacks details on directionof specific actions. In addition, as KPI does not only involve mathematicalcalculation but also subjective opinion and judgement, it requires managers to havea deep understanding of KPI in management process. There is no doubt that EVAis the only measure that is directly connected to shareholders, but it does notmean that quantitative measures are preferred as bases for planning, controland decision-making. Many studies show that it is necessary for managers totake both quantitative and qualitative aspects into consideration, and justusing any one of them alone would reduce management quality and efficiency(Laura and Corina, 2012; Barker, 1995). The stakeholder’s interest and opinionsare equally important as that of the shareholder. (Jepsen and Eskerod, 2009). 5.
0 ConclusionTaking EVA and KPI as examples of quantitative andnon-financial performance measurement respectively, both have costs andbenefits. For example, both measures have management and motivation functions. EVAconsiders the cost of capital which increases the measuring of accuracy and ismore independent of accounting standards, but is only suitable in theshort-term, so sometimes might be affected by inflation and other factors. KPIincludes financial and non-financial information so offers a comprehensive viewof the business but can cause information overload. Though EVA is linked moredirectly to the needs of shareholders, focusing on merely one measurement maylead to weak and insufficient results. In conclusion, there is no preference inmanagerial planning, control and decision-making.