>technicalmatters

PERFORMANCE MEASUREMENT

Richard Bull explains the three effs: efficiency, effectiveness and efficacy.
Management accountants can
1 The enterprise stewardship model
make an important contribution
towards maximising the value and
success of an enterprise. One way we
do this is by setting appropriate targets
for financial performance, translating
them into operating requirements and
then measuring performance against
them. But there are many measures
of value and of success, which like
beauty are very much in the eye of
the beholder and can be assessed in
different ways from different viewpoints.
The value a company represents
can be assessed in terms of, say, the
value of the assets on its balance
sheet or its expected future profits.
Measures of success may include its
stock price or market share, but can
also cover other factors depending on
the companys particular vision and
strategy, such as its use of natural
resources or its contribution to society.
It is important to understand how
financial results can measure the
different dimensions of a companys
vision and strategy. A common twodimensional view distinguishes
between resource-based and marketled strategies. The former seeks to
make the most of the resources
available; the latter seeks to meet the needs of can be. Measures of effectiveness assess the
the market. But a third dimension is becoming value of output produced from a given set of
increasingly important to the brand image
resources. This subtly shifts our focus from
and differentiation of a company. Its the way
measuring inputs to measuring outputs.
we express, and live up to, our companys
With financial measures it represents a shift
purpose and vision and the extent to which from measuring cost to measuring value.
we achieve our own definition of success. This A success-led strategy focuses on how well a
is what we might call a success-led strategy.
company can achieve its vision and purpose
In order to measure these three
as intended the level of efficacy it achieves.
dimensions we need to understand each type This is a little-used term but one that aptly
of strategy. A resource-based strategy
describes this third dimension of
focuses on how efficiently a companys
performance. Measures of efficacy assess
resources can be used. Measures of
the degree to which the inputs produced the
efficiency take the inputs to a process and
intended result and thereby contributed to
assess how economically they are used to
the achievement of the enterprises true
produce a given output. They tend, therefore, purpose. Here we venture into aspects of
to focus on cost. A market-led strategy
value that are often less tangible and have
focuses on how well a company can respond more to do with measuring success. The
to demand and add value how effective it
three dimensions can, therefore, be

categorised by three effs: efficiency,

effectiveness and efficacy.
When we use financial metrics, they
tend to be quantitative by nature, so
they are most appropriate as measures
of efficiency. The more we understand
the processes that lie behind them, the
more we can use them qualitatively to
measure the effectiveness of those
processes. But, if true success is to be
measured by the efficacy of an
enterprises performance, we need to
relate measures to the quintessential
nature of that enterprise. When
assessing the role of performance
measures eg, financial ratios in a
model of success for a business, it is
useful to recognise their contribution in
these three dimensions. In this way we
can ask appropriate questions to
assess how well a companys strategies
are achieving its goals.
Having recognised the three
dimensions of performance
measurement, how can we apply them
to the full scope and complexity of a
business and choose the most
appropriate measures at each step?
The enterprise stewardship model
uses the metaphor of a building (see
panel 1). The questions of efficiency,
effectiveness and efficacy apply at each stage
of construction. This story can be told in
financial terms, as it will be here, but it can
encompass less tangible currencies such as
time, skills and reputation.
The six key stages are as follows:
1 The people with the original idea for the
business need to test the potential
demand for it before investing.
2 Theyll need financial or other backing
from elsewhere and will have to borrow.
3 When using these funds they should
primarily consider the ultimate
customers requirements.
4 Having established an asset base, the
business then procures the bits and
pieces it needs in order to produce,
sell and deliver its products and services,
thereby adding value.

financial management

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>technicalmatters
2 Choosing ratios for performance measurement in the three dimensions

PROCESS

DIMENSION
Efficiency
the economic use ofscarce resources

Effectiveness
the production of a result or effect

Efficacy
the production of the intended results

Growth management

Dividend payout ratio

Book to market value ratio

Actual to plan performance

Tax management

Effective tax rate

Net after-tax profit rate

Investment equivalent of tax paid

Value-add management

Gross margin

Net margin

Customer loyalty

Asset management

Productivity rates

Asset turnover rates

Employee turnover rate

Funding management

Average interest rate

Debt coverage ratio

Share turnover rate

3 Asking strategic questions in the three dimensions

PROCESS

DIMENSION
Efficiency (quantitative)

Effectiveness (qualitative)

Efficacy (quintessential)

Growth management

How can we make best use of the

distribution and reinvestment of profits?

How can we maximise the growth and

value of the firm from the profit available?

How can we optimise the realisation of

our vision from the profit available?

Tax management

How can we minimise the amount of tax

we pay?

How can we maximise the profit

available to the firm?

How can we ensure that the tax the firm

pays complements our vision?

Value-add management

How can we deliver our product or

service at the lowest cost?

How can we maximise the value that

people receive?

How can we optimise the benefit that

our vision provides?

Asset management

What is the least amount of resources

we need for what is required?

What is the best quality that our

resources can produce?

How can we best use those resources to

enable our vision to be realised?

Funding management

What is the cheapest method of raising

the funds we need?

What are the most secure and

lowest-risk sources of funds?

What sources of funding will best help

us to sustain our firms vision?

5 T
 he business takes a share of the value it
adds (or deducts), as profit (or loss), which
is then subject to tax.
6 It is able to apply the disposable profit left
over, either in the form of dividends or by
retaining it for future investment.
This six-step process can be applied to
any business. The sub-processes have inputs
and outputs that enable their performance to
be measured using ratios of inputs to
outputs. For example, funding management
can be measured by the firms gearing ratio;
its asset management by its asset turnover
ratio; its value-add management by its profit
margin; its tax management by the effective
rate it pays; and its potential for growth by
the amount of retained profits it achieves.
But such ratios can be crude measures of
the overall performance of a process. It is
helpful, therefore, to look at each process
and pick the most appropriate measure for
each of the three dimensions. Panel 2
provides an example of ratios that can be

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financial management

chosen to measure these dimensions for the

more tangible stages above ground. From it
we can see that financial ratios are most
relevant to measures of efficiency. They can
also be applied as measures of effectiveness.
But they need to be supplemented with nonfinancial measures when seeking to measure
the efficacy of the business.
We can also use the enterprise
stewardship model to prompt strategic
questions across the three dimensions of
each process in a business. Questions of
efficiency focus on the economic use of
scarce resources: how can we do things as
cheaply as possible? Questions of
effectiveness focus on the product or service:
how can we maximise the value we add?
And questions of efficacy focus on the results
intended: how can we best realise our
corporate vision? Panel 3 sets out a range of
questions prompted by examining each
stagein the business process above the
ground and across each dimension.

Financial results must be monitored and

reported for both management and statutory
purposes. But, by recognising the wider
dimensions of their business, management
accountants can participate more fully in the
wider debates that concern some of the less
tangible, but no less crucial, aspects of
maximising value and success. They can
contribute by measuring the right things and
prompting the right questions.
Richard Bull ACMA is an award-winning
business writer. This article is adapted
from his latest book, Financial Ratios:
How to Use Financial Ratios to Maximise
Value and Success for Your Business
(CIMA Publishing, 29.95). To order your
copy at a 20 per cent discount and with
free P&P, call +44(0)1865 474010 quoting
reference code ASB5, or order online at
http://books.elsevier.com/accounting,
adding the same code to the box. The
offer expires on December 31.