advantages Non-financial measures offer four clear advantages over measurement systems based on financial data. First of these is a closer link to long-term organizational strategies. Financial evaluation systems generally focus on annual or short-term performance against accounting yardsticks. They do not deal with progress relative to customer requirements or competitors, nor other non-financial objectives that may be important in achieving profitability, competitive strength and longer-term strategic goals.
For example, new product development or expanding organizational capabilities may be important strategic goals, but may hinder short-term accounting performance. By supplementing accounting measures with non-financial data about strategic performance and implementation of strategic plans, companies can communicate objectives and provide incentives for managers to address long-term strategy.
Second, critics of traditional measures argue that drivers of success in many industries are "intangible assets" such as intellectual capital and customer loyalty, rather than the "hard assets" allowed on to balance sheets. Although it is difficult to quantify intangible assets in financial terms, non-financial data can provide indirect, quantitative indicators of a firm's intangible assets. One study examined the ability of non-financial indicators of "intangible assets" to explain differences in US companies' stock market values.
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It found that measures related to innovation, management capability, employee relations, quality and brand value explained a significant proportion of a company's value, even allowing for accounting assets and liabilities. By excluding these intangible assets, financially oriented measurement can encourage managers to make poor, even harmful, decisions. We Suggest... Jeremy Siegel on the Market: Rough Going for Now, but Stocks Still a Good Bet Re-examining Stock Options as a Way to Compensate Executives
Measures That Matter: Aligning Performance Measures With Corporate Strategy Building Companies That Leave the World a Better Place The Art and Science of Measuring CEO Performance Third, non-financial measures can be better indicators of future financial performance. Even when the ultimate goal is maximizing financial performance, current financial measures may not capture long-term benefits from decisions made now. Consider, for example, investments in research and development or customer satisfaction programs.
Under U. S. accounting rules, research and development expenditures and marketing costs must be charged for in the period they are incurred, so reducing profits. But successful research improves future profits if it can be brought to market. Similarly, investments in customer satisfaction can improve subsequent economic performance by increasing revenues and loyalty of existing customers, attracting new customers and reducing transaction costs.
Non-financial data can provide the missing link between these beneficial activities and financial results by providing forward-looking information on accounting or stock performance. For example, interim research results or customer indices may offer an indication of future cash flows that would not be captured otherwise. Finally, the choice of measures should be based on providing information about managerial actions and the level of "noise" in the measures.
Noise refers to changes in the performance measure that are beyond the control of the manager or organization, ranging from changes in the economy to luck (good or bad). Managers must be aware of how much success is due to their actions or they will not have the signals they need to maximize their effect on performance. Because many non-financial measures are less susceptible to external noise than accounting measures, their use may improve managers' performance by providing more precise evaluation of their actions. This also lowers the risk imposed on managers when determining pay.
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