Setting Performance Targets

Carolyn Stringer and Paul Shantapriyan

Setting Performance Targets

Copyright © Business Expert Press, LLC, 2012.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means—electronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 400 words, without the prior permission of the publisher.

First published in 2011 by

Business Expert Press, LLC

222 East 46th Street, New York, NY 10017

www.businessexpertpress.com

ISBN-13: 978-1-60649-137-9 (paperback)

ISBN-13: 978-1-60649-138-6 (e-book)

DOI 10.4128/ 9781606491386

A publication in the Business Expert Press Managerial Accounting collection

Collection ISSN: 2152-7113 (print)

Collection ISSN: 2152-7121 (electronic)

Cover design by Jonathan Pennell

Interior design by Scribe Inc.

First edition: December 2011

Abstract

Targets are an important part of our work life, whether we are setting them or meeting them. Target setting forms part of the budgeting process and the performance management of business units and individuals. Unfortunately the behavioral impacts of target setting on performance are not well understood, and this can lead to serious consequences such as game playing. Target setting is an under-researched area.

Our aim in writing this book is to help fill the gap in target setting for performance. The pivotal issue in target setting is that it is an art as well as a science. Managers must strike a balance between understanding and working with the psychologies of the people undertaking the organizational initiatives and the science of estimating probabilities, preparing budget forecasts, conducting sensitivity analysis, and so forth. We do not tie down the reader with the narrow view of target setting but take a more holistic and richer perspective.

A feature of this book is that we draw on ideas and research across disciplines, which is rarely done in this field. Target setting is an under-researched area, as most of the research is on measurement and incentive compensation. This book fills the gap by drawing insights on target setting from a wide range of sources and across disciplines. Our book introduces the reader to some of the important methods, such as forecasting, sensitivity analysis, and probability analysis. We use practical examples to show how these techniques can be applied in target setting.

Our focus is on highlighting how interrelated the various parts of organizational activities are and how they impact on each other. Therefore, target setting must include an understanding of the organizational context (e.g., people, competitive environment, structure, strategy), as well as the impact of incentive compensation and information flows. From this broad background, this book examines key issues such as which targets to choose, how many targets, and the level of difficulty.

This book is ideally suited for managers and executives. It showcases the critical choices involved in the target-setting process and offers advice on how best to manage and execute it. Budgets are the most well-known organizational target-setting process, so we use lessons learned from budgeting to provide insights for developing other performance targets for financial and nonfinancial measures.

Keywords

Target setting, goal-setting theory, motivation, performance measurement, performance management, strategy, value creation, external and internal benchmarking, relative performance targets, forecasts, target difficulty, stretch targets, highly achievable targets, line of sight, objective performance evaluations, subjective performance evaluations, incentive compensation, capped performance targets, operational budgets, fixed budgets, flexible budgets, rolling forecasts, controllability principle, weightings, short- and long-term targets, activity-based budgeting, Beyond Budgeting Roundtable Group

Contents

Chapter 1: Setting Performance Targets

Chapter 2: Budget Targets

Chapter 3: Target Setting in Changing Conditions

Chapter 4: Performance Targets

Chapter 5: Target Difficulty

Chapter 6: Multiple Performance Targets

Chapter 7: Innovations in Target Setting

Chapter 8: Conclusion: Target Setting, the Lost Art

Appendix—Understanding Probabilities

Notes

References

Announcing the Business Expert Press Digital Library

Chapter 1

Setting Performance Targets

Introduction

When an archer aims at the bull’s-eye, the target, the focus is on getting the arrow from the bow to the red circle in the center of target. This focus requires strength in pulling back the bow string, coordination between the dominant eye and arm with a judgment call as to the wind direction, and angle of the release. We can use the science of physics—the tensile strength of the bow, the aerodynamics of the arrow, and compensation for wind and gravity. Robin Hood knew little of this science but relied on the art and judgment of his craft. Clearly, even in archery, hitting the target is more than just will and effort, it is rather judgment, ability, and the likelihood of hitting the target under environmental conditions. This book discusses not only the science but also the art of target setting.

Figure 1.1. Hitting the target.

Target setting is pivotal to managing performance in an organization. Targets focus the mind of the manager to know what to aim for. The manager then works out how to move the business from where it is to achieve the future expectations. However, no single target perfectly captures all aspects of a business. Therefore, multiple targets are often used.

Virtually all companies set targets, which include multiple short-term targets as well as longer-term strategic targets. To optimize the use of targets, important choices need to be made: How do you set targets in light of changing conditions? Should you set targets using a top-down or a participative bottom-up approach? How difficult should performance targets be? How many targets should be set and how do you weight them? Target setting is "more an art than a science."¹ The art in target setting is in making a balanced decision between competing choices. The following example highlights the serious consequences when organizations make the wrong choices.

Consider Sears, Roebuck and Co.’s experience with target setting in the early 1990s. Sears set a sales target for its auto repair staff of $147 per hour. This specific, challenging goal prompted staff to overcharge for work and to complete unnecessary repairs.² Ultimately, Sears Chairman Edward Brennan acknowledged that this target had motivated employees to deceive customers. From the Sears, Roebuck and Co.’s experience, obviously maximizing the sales target per hour had a downside. The result was a fall in credibility from a customer perspective, with a falling reputation, a risk not anticipated when setting a single target.

Nordstrom, the fashion retailer known for its exceptional customer service, is another example where performance targets have caused significant problems. Employees were held accountable for difficult performance goals (sales-per-hour). Nordstrom was taken to court because some supervisors were pressuring sales employees to underreport the time they spent on the job to boost their performance to target. The cost for Nordstrom was over $15 million.³

Choosing the Target—Strategic or Operational

How do you choose the target? What is relevant? How frequently do you evaluate performance to target? These are some of the difficult issues you need to consider in setting targets.

As this book unfolds, you will see that certain targets or key performance indicators have operational importance, others have tactical importance, and still other targets will have strategic importance. While targets that address operational efficiency are important in generating profits, it is essential to ensure that these cost-cutting targets do not result in loosing profitable customers. For example, a water company in the United Kingdom tried to find ways of reducing costs and one way was to outsource the call center. This would reduce costs by $10 million and therefore would increase valuable cash flows by $10 million. Unfortunately, this cost control target did not endear the water company to the customer. Customers balked that the overseas call center struggled with their regional accents. Customers were now switching away from the water company, and the likely loss was in excess of $75 million. Clearly, exceeding the operational target of cost reduction had a strategic consequence that needed to be addressed. The call center was then in-sourced back into the United Kingdom, and there was no longer a cost saving but rather a cost increase in the call center as the water company listened to the customers. The moral of the story is the importance of identifying core and noncore activities. The core activities and processes should not be targeted for cost reduction as they provide value to the customer. The key issue is to know what is strategically important and what to target at an operational level. This process requires a series of conversations between managers, support functions and the CEO to determine the right level for performance targets.

It becomes more difficult to understand what the relevant target is. You can paint red dots on every aspect of a business and expect the employees to hit the bull’s-eye on every target. However, each numerical target does not always generate incremental value to the business. Take Mike, a marketing manager for a flour mill. He has been set a sales target of 200 tons of flour per annum. The regular customers are taking 175 tons a year at the normal retail price of $375 per ton. He knows that the cost of manufacturing the flour at the mill is $220 a ton. He thinks he can easily win new customers if the price is dropped. After all, the sales volume of 200 tons is the target. So when a rural township has a new fast food outlet that needs flour, Mike contacts them. As the cost of making the flour is $220 (or so Mike thinks), he sells the flour at $300 a ton delivered. He gets a three-year contract with them for 100 tons a year. Now clearly Mike has exceeded his target, but there is a downside. He has set the price without having a complete set of information. The cost of shipping the flour to the rural client is $100 a ton. This means that the flour now costs $320 to arrive at the rural township and the contract price is $300. The more that Mike sells, the greater the loss. This is an example of a target that gets the manager distracted from generating value to the business.

What may have been more useful to Mike is information sharing between the manufacturing depots, the logistics (transport), and the accounting function so that he had a more relevant target and the means to achieve that target. If Mike had been set a target that captured value generation, then he would have negotiated a price higher than $320.

A valid target is not just something that is easy to measure. There are several thousands of operational measures that are important to the manufacturing manager that, if frequently measured, analyzed, and reported, would pose problems. It is not uncommon to find that many operational measures used in organizations do not get reported.

As budgets are commonly used, this book draws on insights from target setting for budgets to draw implications for setting all performance targets.

Budgets: What Are They and What Use Do They Have?

A budget is a document that allocates resources for a future period. There can be several budgets in an organization: a sales budget, a production budget, a logistics budget, a capital investment budget, and a purchasing budget, to name a few. Each of these budgets will have targets. Therefore target setting is an integral part of budgeting. The overall purpose will be to estimate and match revenues and expenses for a future period, which can range from a month, a quarter, a year, three years. The longer the time line, the greater the uncertainties in estimating, matching, and arriving at a profit figure.

Let us look again at Mike. He has been given a target of 200 tons of flour. He has just won a new customer for 100 tons, boosting the total sales from 175 tons to 275 tons. Well done, Mike. However, that sales budget, a plan, needs to be linked to the purchasing budget. In this way, the purchasing officer can order the right type of wheat at the best price to meet and match the planned sales. The production budget, under the control of the production manager, needs to know when these orders are required. Then the logistics