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5.1 Scientific principles of performance measurement

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by Fabienne S.

Four principles of a good performance measure

4.

  1. Alignment principle:

    Be influenced by A's effort in the same way as the outcome desired by P

    • Suppose, as above, effort is multidimensional. For example: a desired outcome for P is long-term value of the firm, which depends on efforts spent stimulating sales, cultivating good customer relationships, maintaining good public image, quality standards, etc...

    • But the measure of performance P uses to evaluate and reward A is just, e.g., short-term accounting profits.

    • Even though the desired outcome (the long-term firm value) and observed measure of performance (the accounting profit) are both influenced by the same set of actions (e.g., time spent on sales vs. customer service), they may be influenced differently by the same actions.

    —>The misalignment between the desired outcome and the available performance measure, which are both functions of the same actions, reduces efficiency and must be corrected.


Implications of the principle

  • A good performance measure p must be aligned with desired outcome 𝑦: 𝛿1 / 𝛾1 , must be close to 𝑦: 𝛿2 / 𝛾2 .

  • Simply a high correlation between p and y is not enough. To see this, suppose 𝑦 = 𝑒1 + 𝜂 and 𝑝 = 𝑒2 + 𝜂, so p and y are correlated via the shared noise term 𝜂, while p is clearly a useless measure of the effort important for y.

    For example, accounting earnings (typical performance measure p) and the share price (a function of y) may be correlated not only because the same actions positively affect both, but also because of the random events such as business cycle.

—>Benchmarking helps to control for the effects of common shocks on p and y (recall the informativeness principle).


Author

Fabienne S.

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