Nonfinancial performance measures, externalities and target setting: A comparative case study of resolutions through planning

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Abstract

This paper presents an analysis of the resolution of organisational externalities through the use of nonfinancial performance measures for planning. Using a comparative case study, this paper illustrates how centralised controllers’ choice of nonfinancial performance measures and target setting in two companies provides critical information to decentralised agents regarding how to balance their performance with the performance of other decentralised agents in their organisation. This work complements current management accounting research in that it focuses on the role of nonfinancial performance measures with respect to the design of performance plans for decentralised agents that can be used to internalise externalities. To date, discussions of externalities in management accounting research have primarily focused on how performance measurements can be used as a price mechanism to provide decentralised agents with incentives to internalise externalities. In addition, this case study illustrates some of the difficulties related to acquiring general knowledge about the externalities of nonfinancial performance measures and, therefore, about whether specific nonfinancial performance measures are appropriate for a particular type of organisation.

Introduction

Externalities and their implications have been discussed in management accounting research for decades (Solomons, 1965, Merchant, 1989, Kaplan and Atkinson, 1998). Various methods to resolve externalities, including cost allocations (Zimmerman, 1979, Merchant and Shields, 1993, Zimmerman, 2006), the aggregation of performance measures (Bushman et al., 1995, Keating, 1996), composite performance measures (Dent, 1987, Bouwens and Van Lent, 2007, Baiman and Baldenius, 2008) and subjective performance measures (Gibbs et al., 2004), have been observed in practice and discussed in theory. All are design initiatives used in performance measurement systems to internalise the external effects that one organisational entity may have on another.

Regarding the discussion of nonfinancial performance measures and externalities, the focus in management accounting research has primarily been on how nonfinancial performance measures can be used to measure externalities, make agents responsible for externalities, and provide incentives for the internalisation of externalities (Bouwens and Van Lent, 2007, Baiman and Baldenius, 2008). This paper, in contrast, addresses externalities that nonfinancial performance itself causes and analyses how the value of the measured nonfinancial performance is affected by the externalities that it causes. The paper aims to illustrate the possibility of resolving externalities through centralised performance planning as well as to explain how performance targets provide agents with essential information on how to balance their own performance with the performance of other agents in the organisation.

An externality is a cost or benefit that arises when the actions of one party affect the utility or production possibilities of another party (Brickley et al., 2004). Regardless of whether the context is a market system or a hierarchy, externalities create inefficiencies in economic systems. This is because the decision maker is not fully accountable for all the costs and benefits associated with his or her choices. With respect to performance measurement design, the notion of an externality is useful because it addresses the effect that performance along one dimension may have on the costs and benefits of another organisational entity (employee, team, department, division and so on). These external costs and benefits have a significant effect on the value of the measured dimension of performance from a firm-wide perspective and thereby also on what an appropriate target would be for the performance measure.

Two general approaches to coordination distinguish between the different ways in which management accounting systems can internalise externalities, namely, the price-based system and the planning of quantities system (Milgrom and Roberts, 1992, p. 94). The former relies on the accounting system to provide the employee with the incentives to make the right decisions (regulation by the ‘invisible hand’). The latter specifies and communicates a plan for the employee to make the right decision (regulation by ‘the visible hand’). In management accounting research, the internalisation of externalities has been discussed through price-based approaches, according to which aggregated measures, cost allocations, composite measures, and subjective measures account for external effects in the performance evaluation of the individual and hence provide the individual with the incentives to internalise externalities in his or her decision-making. This paper, however, illustrates how nonfinancial performance measures also play a coordinative role simply by providing employees and managers with information about how to perform to internalise externalities when the measures are elements in performance planning systems.

The first part of this paper uses a simple microeconomic model to illustrate the planning problem and to analyse how a firm's optimal level for a given dimension of nonfinancial performance is affected by externalities. In addition, the ways in which economic relationships encourage adjustments in performance targets as a way of internalising positive or negative externalities is considered. Two propositions are derived regarding how externalities resulting from nonfinancial performance measures can be resolved through nonfinancial performance planning. The second part of this paper illustrates the relevance of the propositions using a comparative case study. The case study contains externalities at two different companies with respect to the same three nonfinancial performance measures. Both companies develop, produce, and sell measurement technology and are similar in terms of strategy and a wide range of other context variables. The similarities between the two organisations under analysis offer an opportunity to illustrate the contingent nature of externalities in addition to the relevance of the propositions. In both companies, externalities were resolved by adjusting performance targets set by central planners. Negative externalities also meant that some dimensions of nonfinancial performance were eliminated from the performance measurement system.

This paper contributes to existing research by analysing how performance planning by centralised controllers plays an important role in reducing problems with externalities and myopia. This analysis supplements discussions in the management accounting literature in which the resolutions of externalities have primarily been portrayed as a matter of providing employees and managers with the right incentives. This paper illustrates that sometimes the provision of information (through performance planning) may serve as the sole intervention. In this context, performance targets play an essential role and target setting relies on an analysis of how some dimensions of performance influences other dimensions of performance that subsequently affect firm value.

The reminder of the paper is structured as follows. Section 2 contains a conceptualisation of the economics of nonfinancial performance and externalities, which is the basis for outlining two propositions concerning how the planning of nonfinancial performance can resolve externalities. Section 3 introduces the comparative case study. Section 4 presents an analysis of the externalities associated with three nonfinancial performance measures and their effect on the design of performance measurement systems. Section 5 presents a summary and discussion regarding the case study findings as well as a reflection on the contingent nature of nonfinancial performance externalities and the value of nonfinancial performance measures in organisations. The paper ends with concluding remarks in Section 6.

Section snippets

Nonfinancial performance measures, externalities, and value creation

In this section, the problem of nonfinancial performance externalities is conceptualised, and the use of planning and target setting as methods for resolving externalities is explored. The section begins by illustrating how nonfinancial performance externalities are created due to interdependencies among organisational tasks. Second, the different ways in which management accounting systems may resolve externalities are briefly outlined, with planning as one example. Third, the economics of

Introduction to the case study

The purpose of this section is to introduce the case study. First, the aim of the case study is outlined. Next, the two companies that are included in the study are briefly introduced. Third, the three nonfinancial performance measures under analysis are presented, and the purpose of nonfinancial performance measurements in the two companies is discussed. Finally, the data collection method on which the case study is based is described, and the principles for data analysis are outlined.

Analysis: three dimensions of nonfinancial performance and their external effects on sales engineer customisation in two organisations

This section reviews the externalities of three dimensions of nonfinancial performance that were discussed in Company A as well as in Company B. The first dimension (i.e., probe accuracy) was a quality issue in the manufacturing system. The two other dimensions (that is, reduction of components on printed circuit boards and reduction of product parts) were related to design-for-manufacturability.

Discussion: externalities and nonfinancial performance measurement system design

This section contains a review of the findings from the comparative case study of the externalities of the three dimensions of nonfinancial performance. It also contains a discussion regarding to what extent and under what conditions the propositions outlined in Section 2 were confirmed with respect to the resolution of the externalities. Furthermore, the roles that nonfinancial performance targets played as coordination devices as well as how information about externalities was communicated by

Conclusions

This paper highlights that the problem of externalities is not only caused by myopic decision makers with no incentive to internalise the external effect of their decisions. The problem is also caused by decision makers with the best intensions that nevertheless lack information about how their actions affect others or how to correct them to act in the interest of the organisation. This paper illustrates how controllers’ choice of performance measures and target setting plays a central role in

Acknowledgements

The author appreciates helpful comments and suggestions from Robert Scapens (editor-in-chief), Ivar Friis, Jan Mouritsen, Tamás Vámosi, two anonymous reviewers and participants at the First Workshop on Management Accounting as Organizational and Social Practice (MASOP), HEC, Paris, 2008.

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