Total Optimal Performance Scores: A Practical Guide for Integrating Financial and Nonfinancial Measures in Performance Evaluation

Total Optimal Performance Scores: A Practical Guide for Integrating Financial and Nonfinancial Measures in Performance Evaluation B Y J OHN B RIGGS, PH.D., CMA; M. CATHY C LAIBORNE, PH.D., CMA, CPA; AND E LIZABETH C OLE, PH.D., CPA TOPS USES EXCEL SOLVER, A MATHEMATICAL OPTIMIZATION TOOL, TO DETERMINE THE MOST EFFICIENT OR TOP-PERFORMING DIVISION IN AN ORGANIZATION AND THEN SCORE OTHER DIVISIONS PERFORMANCE AGAINST IT. EXECUTIVE SUMMARY Most companies use multiple measures to evaluate employee, departmental, or divisional performance. Aggregating multiple measures is subjective and can lead to employee dissatisfaction and game playing. Now there is TOPS (Total Optimal Performance Scores), which uses an objective, mathematical way to aggregate multiple performance measures into a single performance score. Today s competitive markets demand a robust performance evaluation. As organizations realize that profit-based models for evaluating performance are inadequate, models that incorporate both financial and nonfinancial measures of performance have started to appear. Although financial measures are generally lagging measures of performance, nonfinancial measures such as sustainability, learning and growth, and internal process improvements are leading measures of performance that can offer insight about future performance. Models that aggregate dissimilar performance measures typically assign targets or benchmarks to individual measures. Because judgment plays a large role in assigning benchmarks to the performance measures, employees may perceive the targets as arbitrary, and, if they do, employee dissatisfaction and game playing can result. To address this issue, we will illustrate how to imple- MANAGEMENT ACCOUNTING QUARTERLY 11 F ALL 2006, VOL. 8, NO. 1

ment Total Optimal Performance Scores (TOPS). This mathematical optimization tool uses Excel Solver to determine the most efficient or top-performing division in an organization and, subsequently, scores all remaining divisions relative to the 8 top-performing one. While true 7.5 optimization finds the best possible 7 outcome, provided all conditions 6.5 are perfect, TOPS finds the best 6 possible or top outcome 5.5 observed in practice. TOPS evaluates dissimilar performance mea- 4.5 5 sures and aggregates the different 4 measures, such as profit and customer satisfaction, into a single score. 1 This approach provides a constantly moving target that employees can strive toward, yet it seems obtainable because at least one unit obtains a top score. Let s begin with a simple performance evaluation model that does not use TOPS and then show one that does. P ERFORMANCE E VALUATION W ITHOUT TOPS Suppose Myers Company, a fictional company, has four divisions (North, South, East, and West) and uses a profit-based model to evaluate the divisions performances. Myers Company establishes a target, or benchmark, that profit is expected to be 50% of labor costs, with the input being labor costs and the output being profit. Table 1 illustrates the labor costs and profit for the company. Table 1: Inputs and Outputs for Myers Company PROFIT LABOR COSTS North $8 $10 South $7 $13 East $6 $13 West $4 $ 6 Figure 1: Performance in Comparison to 50% Benchmark Profit West North South East Profit is 50% of labor costs Labor $5 $10 $15 Labor Figure 1 presents each division s performance in comparison to the 50% benchmark. The top left corner of the figure, where profit is highest while labor costs are lowest, represents optimal performance, while the bottom right corner of the figure, where profit is lowest and labor costs are highest, represents the worst performance. The line represents the benchmark that profits should be 50% of labor costs. Any division with performance above the line has a positive performance evaluation, and any division with performance below the line has a negative evaluation. Distance from the line represents how much a division exceeded or missed the benchmark. Under this criterion North, West, and South divisions have profit exceeding the benchmark and positive performance evaluations. East has profit less than the benchmark and a negative performance evaluation. North s performance is the furthest distance from the benchmark line, which means North had the best performance relative to the benchmark. In this scenario, North might be dissatisfied being evaluated the same as South and West. Although all three divisions have profit exceeding the benchmark, North s performance exceeds the performance of both MANAGEMENT ACCOUNTING QUARTERLY 12 F ALL 2006, VOL. 8, NO. 1

Table 2: Division Performance Profit as a Percent of Labor Costs, Assigned Benchmark-to-Actual Comparison North South East West Labor Costs $10 $13 $13 $6 Benchmark Profit 1 $ 5 $ 6.5 $ 6.5 $3 Actual Profit $ 8 $ 7 $ 6 $4 Actual Profit as a % of Benchmark 160% 108% 92% 133% 1 50% of Labor Costs Table 3: Division Performance Profit as a Percent of Labor Costs North South East West Labor Costs $10 $13 $13 $6 Profit $ 8 $ 7 $ 6 $4 Profit as a percent of labor costs 80% 54% 46% 67% Table 4: Division Performance Profit as a Percent of Labor Costs, Observed Benchmark-to-Actual Comparison North South East West Labor Costs $10 $13 $13 $6 Benchmark Profit* $ 8 $10.4 $10.4 $4.8 Actual Profit $ 8 $ 7 $ 6 $4 Actual Profit as % of Benchmark 100% 67% 58% 83% *80% of Labor Costs South and West. Table 2 shows the performance of each division compared to the benchmark performance: profit as 50% of labor costs. North s performance is 160% of the benchmark, followed by West and South. East failed to reach the benchmark by 8%. This approach relies upon an assigned benchmark that might result in suboptimal performance. Assigning a benchmark might encourage behavior that meets the benchmark but does not motivate optimal performance. By determining the benchmark based on observed performance, the need to assign a benchmark is eliminated. The top-performing division serves as the benchmark, and all other divisions are evaluated in relation to the top-performing one. Table 3 shows each division s profit as a percent of labor costs. North is the top-performing division, so the benchmark for profit becomes 80% of labor costs. Figure 2 presents each division s performance in comparison to the 80% benchmark, with the efficiency plane being the straight line where profit is equal to 80% of labor costs. Table 4 shows each division s performance compared MANAGEMENT ACCOUNTING QUARTERLY 13 F ALL 2006, VOL. 8, NO. 1

Figure 2: Performance in Comparison to 80% Benchmark TOPS WITH ONE OUTPUT AND ONE INPUT The performance score TOPS is the ratio of a virtual output to a virtual input that allows the bestperforming division to receive a 8 North performance score of 100%. All other divisions scores are in relation to 7.5 7 South the best-performing division. To 6.5 run TOPS in Excel, apply Solver 6 East so that the division with the best 5.5 relationship between the output 5 profit and the input labor 4.5 costs is equal to 1, or has a score 4 West of 100%. We develop a virtual output and a virtual input by allowing Profit is 80% of labor costs for multipliers that Solver manipulates to ensure that the ratio of output to input is less than or equal to Labor $5 $10 $15 Labor 1 for all divisions. So you can use this optimization to the observed performance benchmark of 80%. tool, we will explain how to set up your spreadsheet North s performance is 100%, with all others a percentage of North s: South at 67%, East at 58%, and West at your spreadsheet. and then run Solver. There are five steps to setting up 83%. Again, this approach uses an objective benchmark 1. Create a table with your division names in column A, for evaluating the divisions performances. the outputs in column B, and the inputs in column C In this simple example we created and evaluated (see Figure 3). performance scores, but this evaluation becomes Figure 3 impractical when there are several divisions and more than one input or output. To identify an objective benchmark and deal with more complex performance evaluations, we implement TOPS using Microsoft Excel Solver. Profit TOPS TOPS uses Solver, an optimization tool, to find the multiplier that assigns a performance score of 100% to the top-performing division. The top-performing division is evaluated as efficient, and all other divisions are evaluated in relation to the top-performing one. Although we manually evaluated North, South, East, and West based on profit as a percent of labor costs, we start our demonstration of TOPS using Solver for the same scenario and then do a more complicated performance evaluation. 2. Determine which cells will be allowed to change. Solver will adjust these cells to find the multiples that allow the best or top unit to be equal to 1, or 100%. In this example, B8 is the cell that is allowed to change for the output (profit), and cell C8 is the cell allowed to change for the input (labor). For simplicity, we refer to these cells as the changing MANAGEMENT ACCOUNTING QUARTERLY 14 F ALL 2006, VOL. 8, NO. 1

cells. Although we put a 1 in the changing cells, you can use any number greater than 0, and Solver will change these cells and give a multiplier that is used to calculate the scores (see Figure 4). Figure 4 Figures 5 and 6 illustrate the next three steps. 3. In column D, calculate the virtual output by multiplying each division s output by the output changing cell. For the North division, for example, in cell D3 multiply North s profit, cell B3, by the output changing cell, B8. For the South division, multiply South s profit, cell B4, by the same output changing cell, B8. 4. In column E, calculate the virtual input by multiplying each division s input by the cell allowed to vary for input, C8. 5. In column F, set up the output/input ratio by dividing the virtual output by the virtual input. Figure 5 shows the Excel formulas, and Figure 6 shows the Excel calculations for steps 3, 4, and 5. Figure 5 Figure 6 Now it is time to run Solver, which involves six steps. 1. In the Tools menu, choose Solver. If Solver does not appear, go to add-ins and add-in Solver. 2. Identify the target cell, and set it to maximize the output/input combination, the performance score. In this simple scenario, only one output and one input exist. Therefore, the scores will be the same regardless of which division s performance score is set as the target cell to be maximized. We set the North division s performance score, F3, as the target cell to be maximized (see Figure 7). 3. Identify the changing cells as changing cells (cells B8 and C8). 4. Identify and add all constraints by clicking the add button. Two constraints are necessary. a. Constrain the performance scores to be less than or equal to 1 for each division. This results in North s performance score being 100% and the other divisions performance scores being relative to North. b. Constrain the changing cells to be greater than or equal to zero. Figure 8 shows the Solver input articulated in steps 3 and 4. 5. Solve by clicking the solve button. Figure 9 shows the Solver solution. MANAGEMENT ACCOUNTING QUARTERLY 15 F ALL 2006, VOL. 8, NO. 1

Figure 7 Figure 8 Figure 9 6. Save the Solver solution. Figure 10 shows the final output from Solver. The Solver solution to TOPS is the same as the manual calculation. Comparing Table 4 and Figure 10 shows the same performance scores calculated using the benchmark of 80% in Table 4 and using Solver in Figure 10. TOPS mathematically determined the line where the top division receives a performance score of 100%, and all other divisions are compared to the top division. Solver results show numbers in the changing cells that, when multiplied by the relevant output and input, evaluate the top division as 100% and all other divisions in relation to the top division. Notice that the changing cells are now 1.11 and.89. Originally these cells were both 1, and Solver changed the cells. Solver found the multipliers 1.11 and.89, which resulted in the performance scores in column F. Solver adjusts the changing cells until the constraints in step 4 are satisfied and the performance score is maximized. Although various multipliers would give the desired result, Solver stops as soon as the criteria are met. TOPS WITH TWO OUTPUTS AND ONE INPUT When a performance evaluation is based on more than one output or input (or both), the intelligence behind TOPS kicks in, so let s now assume that Myers Company evaluates divisions by using an additional output: customer satisfaction. Table 5 displays the data for the four divisions, including the additional output of customer satisfaction. MANAGEMENT ACCOUNTING QUARTERLY 16 F ALL 2006, VOL. 8, NO. 1

Figure 10 Table 5: Inputs and Outputs for Myers Company CUSTOMER SATISFACTION PROFIT LABOR COSTS North 7 $8 $10 South 4 $7 $13 East 6 $6 $13 West 5 $4 $ 6 With two outputs, multiple ways exist to define efficiency. A division might have high customer satisfaction relative to labor costs or high profit relative to labor costs. In addition, a division might have a strong combination of customer satisfaction and profit relative to labor costs. The performance evaluation can be based on any weighting of the outputs, and these possibilities are investigated. As previously discussed, North has the highest profit as a percent of labor costs of the four divisions at 80% (refer to Table 3). A glance at Table 6 reveals that West has the highest customer satisfaction as a percent of labor costs of the four divisions at 83%. Therefore, if only one of the two outputs is considered or is given full weight two divisions, North and West, are deemed efficient North if profit is fully weighted and West if customer satisfaction is fully weighted. It could have been true that one division was superior on both of these dimensions. The power of TOPS is evident in evaluating the effi- Table 6: Division Performance Customer Satisfaction as a Percent of Labor Costs North South East West Labor Costs $10 $13 $13 $6 Customer Satisfaction 7 4 6 5 Customer Satisfaction as a % of Labor Costs 70% 31% 46% 83% Table 7: Division Performance Customer Satisfaction as a Percent of Labor Costs, Observed Benchmark-to-Actual Comparison North South East West Labor Costs $10 $13 $13 $6 Benchmark Customer Satisfaction (83% of Labor) 8 11 11 5 Observed Customer Satisfaction 7 4 6 5 % Benchmark 84% 37% 55% 100% MANAGEMENT ACCOUNTING QUARTERLY 17 F ALL 2006, VOL. 8, NO. 1

Figure 11 ciency of the remaining two divisions, South and East. For illustration purposes, this evaluation is presented in three logical steps: profit as a percent of labor costs, customer satisfaction as a percent of labor costs, and any combination (or weighting) of profit and customer satisfaction as a percent of labor costs. Solver assesses the three combinations simultaneously. As before, the first two evaluations can be computed manually. Using profit as a percent of labor costs, Table 4 results still hold true. North is the best-performing division and 100% efficient; South is 67% as efficient as North; and East is 58% as efficient as North. Considering customer satisfaction as a percent of labor costs, West is the bestperforming division and 100% efficient. Table 7 shows the results for customer satisfaction as a percent of labor costs with West as the benchmark. South is 37% efficient, and East is 55% efficient. North and West each have a 100% efficiency rating using one output. Both South, at 67%, and East, at 58%, have a higher efficiency rating for profit as a percent of labor costs than customer satisfaction as a percent of labor costs. A performance evaluation using any combination of the two outputs is where the additional computational power of Solver becomes necessary. Any possible weighting combination can be assessed and the highest performance score used. For example, profit might carry a weight of 60% and customer satisfaction a weight of 40%. Or profit could be weighted 25% and customer satisfaction 75%. Moreover, a minimum weighting can be assigned to all critical factors and the evaluation scores computed accordingly. We begin by illustrating the use of Solver with no minimum weighting and let Solver determine the multipliers that make each individual division look its best. First, create your spreadsheet following the same steps used previously. Figure 11 shows the table with the changing cells identified. Because both customer satisfaction and profit are used in the performance evaluation, include both outputs in the calculation of the virtual output. Also, determine how much each output contributes to the virtual output. In Figure 12, we refer to this as the virtual contribution (see Figure 12, B10 and C10). The evaluation weight is the percentage of the virtual output from each specific output. It is the weighting of the output in the performance score calculation. Next, we maximize each of the performance scores or determine the best combination of the two outputs for each division. To do this, run Solver separately on Figure 12 MANAGEMENT ACCOUNTING QUARTERLY 18 F ALL 2006, VOL. 8, NO. 1

Figure 13 each division. Solver finds the multipliers that make each division look its best by trading off the weights placed on customer satisfaction or profit. Beginning with the North division, Figures 12 and 13 show the Excel spreadsheets prior to running Solver. Figure 12 shows the cell formulas, and Figure 13 shows the cell values. In Figure 12, note that both customer satisfaction and profit are used in the calculation of virtual output (see cell E3). In addition, note that the virtual contribution for the North division is calculated as B3*B8 and C3*C8. If we evaluate the South division, the Excel formula must be changed to B4*B8 and C4*C8 and so on for East and West. Figure 14 shows the cell values after running Solver, which determined that the multiplier in the customer satisfaction changing cell was.65 and the multiplier in the profit changing cell was.68. This means that, in constructing the virtual output for North, customer satisfaction was multiplied by.65, and profit was multiplied by.68. As noted earlier, although multiple solutions are possible, Solver stops the analysis at the first solution where the unit being evaluated is evaluated as high as possible. If the unit under evaluation has a performance score of 100%, it may occur in more than one way. In fact, we know from Figure 10 that North could have a performance score of 100% just using prof- Figure 14 MANAGEMENT ACCOUNTING QUARTERLY 19 F ALL 2006, VOL. 8, NO. 1

Figure 15 it as a percent of labor costs. Cells B10 and C10 in Figure 14 show the virtual contribution or how much of the virtual output comes from customer satisfaction and how much of the virtual output comes from profit. Of the 10.00 in virtual output, 4.573 comes from customer satisfaction, and 5.427 comes from profit. In cells B11 and C11, we have the evaluation weights, which represent the percentage of the virtual output that is derived from customer satisfaction and the percentage of the virtual output derived from profit. TOPS must be calculated for each division under review. Figure 15 shows the Solver solution that gives the best evaluation for the South division. South s performance score is maximized if only profit is considered in the evaluation with customer satisfaction and profit having evaluation weights of 0 and 1, respectively. Later we will look at requiring minimum weights for all inputs. Figure 16 shows the Solver solution that gives the best performance evaluation for the East division, which is when customer satisfaction and profit are equally weighted at 50%. Figure 17 shows the Solver solution that gives the best performance evaluation for the West division. Like the East division, both customer satisfaction and profit have been considered in creating the virtual output. Figure 16 MANAGEMENT ACCOUNTING QUARTERLY 20 F ALL 2006, VOL. 8, NO. 1

Figure 17 Although we know that North is efficient using profit as the performance measure and that West is efficient using customer satisfaction as the performance measure, both are also efficient with a combination of profit and customer satisfaction. Evaluating all possible combinations of outputs, South s performance is still best at 67% when profit has a weighting of 1.00. East receives its highest performance score when both customer satisfaction and profit are considered. Weighting customer satisfaction and profit at 50% each gives East a performance score of 61.54%. TOPS WITH TWO INPUTS AND TWO OUTPUTS TOPS can evaluate any number of inputs and outputs when computing efficiency scores, subject to the limitations of the software. Nonlabor operating costs are added as a second input. The South division will be used for demonstration. Table 8 shows customer satisfaction and profit outputs with labor costs and other operating costs as inputs. Table 8: Inputs and Outputs for Myers Company CUSTOMER LABOR OPERATING SATISFACTION PROFIT COSTS COSTS North 7 $8 $10 $11 South 4 $7 $13 $13 East 6 $6 $13 $11 West 5 $4 $6 $5 Figure 18 shows the TOPS results for the South division. Solver determined that the South division s best Figure 18 MANAGEMENT ACCOUNTING QUARTERLY 21 F ALL 2006, VOL. 8, NO. 1

Figure 19 rating occurs when profit is treated as the only output but both labor costs and operating costs are considered as inputs. More specifically, this occurs when labor costs are assigned a weight of 33% and operating costs a weight of 67%. The South division s efficiency score is 71.79%. R EQUIRING M INIMUM W EIGHTS In Figure 18, TOPS included profit but did not include customer satisfaction in scoring South division s performance. You might, however, determine that all inputs and all outputs must be considered in the performance score. For example, a division could easily continue to increase its labor costs until its satisfaction is high enough to be evaluated as efficient, but, beyond a certain point, customer satisfaction will come at the cost of profits. To consider all inputs and outputs, we add one more constraint in Solver. Looking at Figures 18 and 19, the additional constraint is B11:E11>=.20. Figure 19 shows the performance score for South when all factors are considered by giving each factor a minimum weight of 20% in the evaluation. With Solver shifting 20% of the weight from profit to customer satisfaction, the South division is now forced to use customer satisfaction in computing efficiency or the performance score. As the South division is particularly weak at customer satisfaction relative to operating costs, labor costs gain additional weight here. The constraint of a minimum weight of 20% causes the efficiency score of the South division to fall from 72% to 62%. T HE P OWER OF TOPS TOPS is a powerful model for aggregating dissimilar performance measures into a single performance score. Further, efficiency scores compiled using this approach are mathematically and theoretically correct and are less subject to employee dissatisfaction and manipulation. We have illustrated a simple two-input, two-output model that can easily be expanded to include numerous inputs and outputs. In addition, the minimum weights can be changed from 20% to any desired weight. There are also valid reasons to use maximum weights: With a high number of variables, maximum weights prohibit one or two variables from dominating the computation. On the negative side, Excel s maximization tool has limits to its power. If you add too many constraints, have too many observations, or your numbers are too large, Solver may not come up with a solution. If you find that Solver is insufficient for your needs, there are numerous prepackaged Data Envelopment Analysis software programs available. John Briggs, Ph.D., CMA, is an assistant professor of accounting at James Madison University. He can be reached at (540) 568-3206 or briggsjw@jmu.edu. M. Cathy Claiborne, Ph.D., CMA, CPA, is a professor and director of accounting at Texas Southern University. She can MANAGEMENT ACCOUNTING QUARTERLY 22 F ALL 2006, VOL. 8, NO. 1

be reached at (713) 313-7771 or claibornemc@tsu.edu. Elizabeth Cole, Ph.D., CPA, is an assistant professor of accounting at James Madison University. She can be reached at (540) 568-3089 or coleet@jmu.edu. E NDNOTES 1 TOPS is a simplified form of Data Envelopment Analysis (DEA) found in the academic literature. Many organizations find DEA either too expensive or too cumbersome to use effectively. MANAGEMENT ACCOUNTING QUARTERLY 23 F ALL 2006, VOL. 8, NO. 1