2.3: Assessing Organizational Performance


Organizational Performance: A Complex Concept

Organizational performance refers to how well an organization is doing to reach its vision, mission, and goals. Assessing organizational performance is a vital aspect of strategic management. Executives must know how well their organizations are performing to figure out what strategic changes, if any, to make. Performance is a very complex concept, however, and a lot of attention needs to be paid to how it is assessed.

To illustrate this complexity, consider a scenario: suppose that we offered a $10 bet on a coin toss. If it lands on heads, you win$50. If it lands on tails, you lose your $10 bet. If you lost, was the decision a bad one? Well, of course not. You had a 50% chance of winning$50 and a 50% chance of losing $10. In this case, the expected value (EV) of your bet would be$20, ($50 * 50%) – ($10 * 50%). Thus, the decision to bet was a good one, but still led to a poor outcome (or performance). In short, while one can generally expect good decisions to lead to good performance, it is not always the case. The point of this scenario is to highlight that there are situations where good strategies lead to bad outcomes, especially when low probability crises occur. In the case of COVID-19, for example, solid strategies selected several years ago could lead to poor performance because of unexpected conditions.

Two important considerations are (1) performance measures and (2) performance benchmarks (Figure 2.5). A performance measure is a metric by which an organization’s progress can be gauged. Most executives examine measures such as profits, stock price, and sales in an attempt to better understand how well their organizations are competing in the market. But these measures provide just a glimpse of organizational performance. Performance benchmarks are also needed to assess whether an organization is doing well. A performance benchmark is used to make sense of an organization’s standing compared to its own or a competitor’s financial measures and/or performance indicators. Suppose, for example, that a firm has a profit margin of 20% in 2019. This sounds great on the surface, but suppose that the firm’s profit margin in 2018 was 35% and that the average profit margin across all firms in the industry for 2019 was 40%. Viewed relative to these two benchmarks, the firm’s 2019 performance is cause for concern.

Using a variety of performance measures and benchmarks is valuable because different measures and benchmarks provide different information about an organization’s functioning. The parable of the blind men and the elephant—popularized in Western cultures through a poem by John Godfrey Saxe in the nineteenth century—is useful for understanding the complexity associated with measuring organizational performance. As the story goes, six blind men set out to “see” what an elephant was like. The first man touched the elephant’s side and believed the beast to be like a great wall. The second felt the tusks and thought elephants must be like spears. Feeling the trunk, the third man thought it was a type of snake. Feeling a limb, the fourth man thought it was like a tree trunk. The fifth, examining an ear, thought it was like a fan. The sixth, touching the tail, thought it was like a rope. If the men failed to communicate their different impressions they would have all been partially right but wrong about what ultimately mattered. The point is, an organization must consider organizational performance from various and multiple perspectives to achieve an accurate assessment.

Figure 2.4: The story of the blind men and the elephant provides a metaphor for understanding the complexities of measuring organizational performance.

This story parallels the challenge involved in understanding the multidimensional nature of organization performance because different measures and referents may tell a different story about the organization’s performance. For example, Fortune 500 lists the largest US firms in terms of sales. These firms are generally not the strongest performers in terms of growth in stock price, however, in part because they are so big that making major improvements is difficult. During the late 1990s, a number of internet-centered businesses enjoyed exceptional growth in sales and stock price but reported losses rather than profits. Many investors in these firms who simply fixated on a single performance measure—sales growth—absorbed heavy losses when the stock market’s attention turned to profits and the stock prices of these firms plummeted.

The number of performance measures and referents that are relevant for understanding an organization’s performance can be overwhelming. For example, a study of what performance metrics were used within restaurant organizations’ annual reports found that 788 different combinations of measures and referents were used within this one industry in a single year (Short & Palmer, 2003). Thus executives need to choose a rich yet limited set of performance measures and referents to focus on.

 Types of Measures Applications for Organizations Applications for Individuals Key Measure Key Referent Key Measure Key Referent Liquidity measures: Helpful for understanding if obligations can be paid when due. Current ratio (Current assets/Current liabilities) A ratio of less than 1.0 suggests that the firm does not have enough cash to pay its bills. Cash in your checking account. Do you have enough cash to cover your monthly debts? Leverage measures: Helpful for understanding if debt level is to high. The term leverage refers to the extent to which borrowed money is used. Debt-to-equity ratio Competitors’ debt-to-equity ratios. The use of debt varies across industries. Auto companies, for example, tend to have high debt-to-equity because they must build massive factories. Debt-to-income ratio (Monthly debt payments/ Monthly income) If you have a debt-to-income ratio higher than 40%, you may be on the verge of becoming a credit risk. Profitability measures: Helpful for understanding how much profit, if any, is really being made. Net income (income after taxes) Last year’s net income. An increase shows the firm’s profits are moving in the right direction. Net income (income after taxes) Are you making enough to cover your yearly expenses and save for retirement?

Section Video

What is Organizational Performance? [01:56]

The video for this lesson explains how some organizations assess their organizational performance.

You can view this video here: https://youtu.be/wLXuPgbagJY.

The Balanced Scorecard

To organize performance measures, Professor Robert Kaplan and Professor David Norton of Harvard University developed a tool called the balanced scorecard. Using the scorecard helps managers resist the temptation to fixate on financial measures and instead monitor a diverse set of important measures (Table 2.7). Indeed, the idea behind the framework is to provide a “balance” between financial measures and other measures that are important for understanding organizational activities that lead to sustained, long-term performance. The balanced scorecard recommends that managers gain an overview of the organization’s performance by tracking a small number of key measures that collectively reflect four perspectives: (1) financial, (2) customer, (3) internal business process, and (4) staff learning and growth (Kaplan & Norton, 1992).

Because the concept of organizational performance is multidimensional, wise managers realize that understanding organizational performance is like flying a plane. Pilots must be on track in terms of altitude, air speed, and oil pressure and make sure they have enough gas to finish their flight plan. For tracking organizational performance, assessing how the organization is doing financially is just a starting point. The “balanced scorecard” encourages managers to also monitor how well the organization is serving customers, managing internal activities, and setting the stage for future improvements. This provides a fast but comprehensive view of the organization. As shown below, monitoring these four dimensions can also help individuals assess themselves.

 Scorecard Point Definition You could ask yourself… Financial measures Such as return on assets and stock price—relate to effectiveness and profits. How can I improve my personal wealth? Measures might include cash, savings account, and retirement. Customer measures Such as number of new or repeat customers and percentage of repeat customers—relate to customer attraction and satisfaction. How strong is my social network? The number of new contacts you make over time might reflect this dimension. Internal business process measures Such as speed at serving a customer and time it takes to create a new product and get it to market—relate to organizational efficiency. Am I getting better at my current job? Tracking improvements in personal efficiency such as the time needed to complete a task can be helpful. Learning and growth measures Such as the average number of new skills learned by each employee every year—relate to the future and emphasize that employee learning is often more important than formal training. What skills should I develop now for the future? Although the acquisition of new skills is hard to measure, the attainment of specialized licenses or earning of a graduate degree are tangible benchmarks.

Financial Measures

Financial measures of performance relate to organizational effectiveness and profits. Examples include financial ratios such as return on assets, return on equity, and return on investment. Other common financial measures include profits and stock price. Such measures help answer the key question, “How do we look to shareholders?”

Financial performance measures are commonly articulated and emphasized within an organization’s annual report to shareholders. To provide context, such measures should be objective and be coupled with meaningful referents, such as the firm’s past performance. For example, Starbucks’s 2019 annual report highlights the firm’s performance in terms of net revenue, operating income, and cash flow over a five-year period.

There are three approaches that organizations use to perform quantitative analysis: financial, market-based, and general.

Financial Analysis: This is basically ratio analysis; being able to make “apple to apple” comparisons between firms or annual trends that account for variable volumes, sales, expenses, and profits. Using ratios allows a direct comparison no matter the size of the firm. Table 2.8 provides basic financial ratios organizations use to compare against benchmarks.

 RATIO FORMULA PURPOSE Profitability Ratios Gross Margin Gross Profit /Total Revenue Proportion of revenue related to direct costs (COGS, sales commissions, etc.) Net Profit Margin Net Profit /Net Revenue Profit earned per dollar of revenue Return on Equity Net Profit (or Income)/ Shareholder Equity Profitability in relation to stockholders’ equity; i.e. how well you use equity financing Return on Assets Net Profit (or Income)/Total Assets Efficiency in using assets to generate profit Efficiency Ratios Inventory Turnover COGS /Average Inventory Efficiency of inventory management Accounts Receivable Turnover Net Credit Sales/ Average Acct Rec. Efficiency of AR management Leverage Ratio Debt Ratio Total Liabilities/Total Assets Proportion of assets financed through debt Liquidity Ratio Current Ratio Current Assets/ Current Liabilities Ability to pay short term debts with short term assets like cash & inventory Market Capitalization Outstanding shares X share price Market value of the firm

Market-Based Analysis: This analysis helps determine how the firm compares to its competitors in the market. there are two measures to analyze a firm’s position in the market:

1. Market Share = Firm’s Total Product Revenue / Total Revenue in the industry or market

This measures the percentage of the market that a firm has. For example, if Apple’s revenue from selling iPhones is 25% of all the revenue generated from smartphone sales, Apple’s market share is 25%.

2. Price-Earnings (PE) Ratio = Stock price / Earnings per Share (EPS)

The Price-Earnings Ration determines how much it costs to invest in the company to receive $1.00 in earnings. For example, if one share of stock costs$10, and it produces $2 annually in earnings, the PE ratio is 5, meaning it costs a$5 investment in this company to receive \$1 in earnings. The lower the PE ratio, the better, as far as a simple interpretation goes. However, a higher PE Ratio may indicate the market’s belief that the company is a strong performer and will be growing the stock price.

General Quantitative Analysis: There are other types of data sets that can provide useful information. For example, trend analysis is used to determine how much volumes are changing each year, or extrapolate economic data to make predictions. There most likely is industry-specific data to analyze and use as a comparison for firms.

Performance Indicators: As referenced earlier, financial measures alone will not provide sufficient insight into a firm’s performance. While financial measures always have operational relevance, other performance indicators often provide strategic insight that may not be evident from the financial picture. This section provides some examples of the other kinds of performance measures helpful in strategic management.

Customer Measures

Customer measures of performance relate to customer attraction, satisfaction, and retention. These measures provide insight to the key question “How do customers see us?” Examples might include the number of new customers, customer satisfaction, and the percentage of repeat customers.

Starbucks realizes the importance of repeat customers and has taken a number of steps to satisfy and to attract regular visitors to their stores. For example, Starbucks rewards regular customers through a rewards program that allows customers to redeem the points they have accumulated for free drinks, bakery items, or merchandise. They also offer all customers free Wi-Fi access (Miller, 2010). Often, firms need external measures about their customers as well. For example, demographic data, taste preferences, or social trends.

Internal business process measures of performance relate to organizational efficiency. These measures help answer the key question “What must we excel at?” Examples include the time it takes to manufacture the organization’s goods or deliver a service. Another example of this type of measure is the time it takes to create a new product and bring it to market. Productivity and quality data are other measures often targeted for improvement.

Organizations such as Starbucks realize the importance of such efficiency measures for the long-term success of its organization. For this reason, Starbucks carefully examines its processes with the goal of decreasing order fulfillment time. In one example, Starbucks efficiency experts challenged their employees to assemble a Mr. Potato Head to understand how work could be done faster (Jargon, 2009). The aim of this exercise was to help Starbucks employees in general match the speed of the firm’s high performers, who boast an average time per order of twenty-five seconds.

Learning and Growth Measures

Learning and growth measures of performance relate to the future. Such measures provide insight to ask the question, “Can we continue to improve and create value?” Learning and growth measures focus on innovation and proceed with an understanding that strategies change over time. Consequently, developing new ways to add value will be needed as the organization continues to adapt to an evolving environment. Employees may need additional training and skills to make a strategy achievable, or the firm may need to hire for the needed skills. An example of a learning and growth measure is the number of new skills learned by employees every year.

One way Starbucks encourages its employees to learn skills that may benefit both the firm and individuals in the future is through its tuition reimbursement program. Employees who have worked with Starbucks for more than a year are eligible. Starbucks hopes that the knowledge acquired while earning a college degree might provide employees with the skills needed to develop innovations that will benefit the company in the future. Another benefit of this program is that it helps Starbucks reward and retain high-achieving employees.

Measuring Performance Using the Triple Bottom Line

Ralph Waldo Emerson once noted, “Doing well is the result of doing good. That’s what capitalism is all about.” While the balanced scorecard provides a popular framework to help executives understand an organization’s performance, other frameworks highlight areas such as social responsibility. One such framework, the triple bottom line, emphasizes the three P's: people (making sure that the actions of the organization are socially responsible), planet (making sure organizations act in a way that promotes environmental sustainability), and traditional organization profits. This notion was introduced in the early 1980s but did not attract much attention until the late 1990s.

Figure 2.5: The triple bottom line emphasizes the three Ps of people (social concerns), planet (environmental concerns), and profits (economic concerns).

In the case of Starbucks, the firm has made clear the importance it attaches to the planet by creating an environmental mission statement (“Starbucks is committed to a role of environmental leadership in all facets of our business”) in addition to its overall mission (Starbucks, 2011). In terms of the “people” dimension of the triple bottom line, Starbucks strives to purchase coffee beans harvested by farmers who work under humane conditions and are paid reasonable wages. The firm works to be profitable as well.

Key Takeaway

• Organizational performance is a multidimensional concept, and wise managers rely on multiple measures of performance when gauging the success or failure of their organizations. The balanced scorecard provides a tool to help executives gain a general understanding of their organization’s current level of achievement across a set of four important dimensions. The triple bottom line provides another tool to help executives focus on performance targets beyond profits alone. This approach stresses the importance of social (people) and environmental (planet) outcomes, as well as profit.

Exercises

1. Given your major, what sets of measures and indicators have you been trained to analyze and value?
2. How might you apply the balanced scorecard framework to measure performance of your college or university?
3. Identify a measurable example of each of the balanced scorecard dimensions other than the examples offered in this section.
4. Identify a mission statement from an organization that emphasizes each of the elements of the triple bottom line.

References

Jargon, J. (2009, August 4). Latest Starbucks buzzword: “Lean” Japanese techniques. Wall Street Journal, A1.

Kaplan, R. S., & Norton, D. (1992). The balanced scorecard: Measures that drive performance. Harvard Business Review, 70–79.

Miller, C. (2010, June 15). Aiming at rivals, Starbucks will offer free Wi-Fi. New York Times, 1B.

Short, J. C., & Palmer, T. B. (2003). Organizational performance referents: An empirical examination of their content and influences. Organizational Behavior and Human Decision Processes, 90, 209–224.

Starbucks. (2011). Our Starbucks mission statement. http://www.starbucks.com/about-us/company-information/mission-statement.

Image Credits

Figure 2.4: Hanabusa, Itcho. “Blind monks examining an elephant.” Public Domain. Retrieved from en.Wikipedia.org/wiki/File:Blind_monks_examining_an_elephant.jpg.

Video Credits

Word Glossary. (2019, March 18). What is Organizational Performance? [Video]. Youtube. https://youtu.be/wLXuPgbagJY.

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