John Kay speaks about the need for seamless integration between the three roles of measurement, which he identifies as external reporting, internal control and internal analysis. His major theme is that the requirements for external reporting should be derived from the measures used for internal control which in turn should be based upon the measures used to complete internal analysis. Hence the seamless link between these three roles of measurement.
HOW MEASUREMENT IN ORGANISATIONS HAS CHANGED
Professor John Kay
When I was jogging along the backs this morning and I can see one or two familiar faces in the audience, but not very many, I suddenly thought of the famous words of Lord Kelvin, which actually by chance I happen to have on a Powerpoint slide to show to you this morning. To be quite honest I took this out of Andy’s book and Andy says Lord Kelvin was reported to saying that, we reckon he actually did say it as well. And what Kelvin says, was when you can measure what you are speaking about and express it in numbers you know something about it. Otherwise your knowledge is of a meagre and unsatisfactory kind, it may be the beginning of knowledge, but you’ve scarcely and thought advanced to the stage of science. And I think Kelvin is right and essentially theory without measurement, of which there is actually quite a lot around the business and business school world, is a pretty primitive kind of knowledge. But the point which I would like us to focus on this morning is not Kelvin’s point because I think there is a more important issue for us over the next two days, and that issue is where the converse of Kelvin’s point, which is to say that measurement without theory is no knowledge at all. If theory without measurement is primitive knowledge, if we don’t have a theory of what it is we are measuring, then there is no reason to choose one measure over another, and no basis for attaching significance to any particular measure which we try to use.
Some of you may know that back in the 1960’s when some of the brightest people in the United States were at the court of President Kennedy, the great days of Camelot, one of the games that it is said that these bright people would play with each other, was the game of asking ‘What is the question to which this is the answer’. To give an example of how the game works, one of the best examples was ‘The answer to the question is 9W – what is the question’. There are various answers, but the best, right with the best question you know for that answer is ‘Do you spell your name with a V Herr Wagner. And I want us to go on certainly this morning and throughout these two days asking again and again that particular question. What is the question to which this number is the answer because I think it’s primarily if we focus on that question, that we will get back to thinking about the underlying theory of how business functions and the relationship of our measures to the fundamental objectives and performances of business. Well let me ask that basic question, what is the question to which this number is the answer, about what is clearly the most fundamental of all measures of business performance, which is income or profit. Because the truth is even to that question the answer is not straightforward, even to that answer, the question is not straightforward. If I look at the theory of income and profit measurement I am taken back to John Hicks the Economist whose classic definition of income remains, we ought to define a mans’ income as the maximum value which he can consume during a week and still expect to be as well off at the end as at the beginning. You can see how in 1939 when he wrote this book political correctness hadn’t got in, he was able to say a mans’ income with out the slightest hint of apology. We out to define a mans’ income he said as the maximum value which he can consume during a week and still expect to be as well off at the end as at the beginning. If we want to think of that in corporate terms, what we have to do is change a mans’ income to firms profits. What we need to do is to change consume to distribute, and what we need to do is change the end of the week which was the period over which Hicks measured income, we need to change that to years. And if we go through that quote, making these changes we would get the definition of a firms profit at the maximum value which a firm can distribute during the year and still expect to be as well off as the end of the year as at the beginning.
Well is that really what we are measuring when we measure business profits. If we look at the numbers, if we look at the numbers within the accounts of an old economy company, even more if we look at the numbers in the accounts of a new economy company Amazon or Microsoft, do we really think that we are measuring the maximum value that that company can distribute during a year and still expect to be as well off at the end of the year as at the beginning. Even in relation to these fundamental questions of what is business income, what is business profits, we have a divorce between the underlying concept which we are using and the underlying concept, the underlying theory and the actual measurement which we do, which we add. It’s perhaps not very surprising that Hicks who actually wrote most extensively and thoughtfully about these issues came to the conclusion at the end that we should assume the use of capital and income in economic analysis. There are bad tools that break in our hands and going back to Andy’s observations about the state of performance measurement in the 1980’s perhaps that is actually what happened.
So that if we are to engage in measurement we need to have first of all a sense of what the purpose of our measurement is, what we are trying to achieve with business purpose measurement and we need to be able to relate that to an underlying theory. We need ask what are the purposes business performance measurement and we need to have some theory of the determinants of business performance that enables us to assess which measures are relevant to these purposes and which are not.
Well let us begin this Conference by asking what are the purposes of business performance measurement. And I think the purposes of business performance measurement basically come into three broad categories. First of all business performance measurement is aimed at external reporting. Secondly it is aimed at the purposes of internal control, managing the business better and thirdly it’s aimed at the purposes of internal analysis understanding the business better. And if we think of some of the major innovations in business performance measurement over the last one to two decades, most of them, indeed what I have listed on the right hand side of this screen, as possibly the most significant innovation in business performance measurement, are all I think directly relatable or related to these particular purposes. The DVA is about primarily measures for external reporting, the Balanced Scorecard is directed fairly clearly towards purposes of internal control and management and activity based costing is aimed at purposes of internal analysis. I think we have to acknowledge a full vital function of business performance measurement which is that of internal understanding and communication but essentially the measures which are required to achieve that goal are the same as those that are required for purposes of external reporting internal control and internal analysis. Indeed if we have measures used for internal communication that are different from those that are used for external reporting internal control or internal analysis we have a real problem. So that the measures that have been developed in recent years, or some of the measures developed in recent years, that have given us new insights and new approaches to business performance measurements, are directly related to these purposes of business performance measurement and what I want to do in the rest of my talk this morning, is to say a bit more about some of these and to articulate more explicitly the underlying theory which I think is needed to make effective sense of these particular kinds of measure.
I have said that meaningful measures of business performance are based on a clear statement of purpose, that is that we understand what the purpose of business performance measurement is, and we have underpinning it a theory of what it is that determines business performance. I want to contrast that to some other kind of recent measures used for business performance purposes, of which it seems to me that is not true. If I look at the measures which currently circulate for so called brand valuation for example I go back and ask myself the basic question that these Kennedy people asked themselves in the 1960’s, ‘What is the question to which this number is the answer’. And I have to say when I have tried to push people who are engaged in the subject of brand valuation measurement, I have not in the main had a very clear answer to the question to which the number that is being calculated is the answer. If we are to take it further, I think we have to ask our two questions, ‘What is the purpose of this measure’ for example what is the action on decision that is intended to influence and or what is the theory that underlies this measurement. And I think the reason this kind of measure is unsatisfactory, is firstly that the main purpose which it has is actually some sort of inter-external spin, that is brand valuation of the maintenance of brand value is clearly an important issue for a company but if you ask how do they go about controlling and monitoring their brand performance, it’s not the brand valuation exercise which drives it, it is many other ways in which they quite appropriately in my view look at the relationship which they have with their customers. And the basic problem that makes this literature and this work so unsatisfactory for me is the absence of any very clear theory that underlies the measurement in truth if our friends in marketing were a bit clearer about the underlying theory of what makes brands and what gives brands value, I think it would be much easier to develop a meaningful financial theory in this area. That is an area where to my mind performance measurement is today unsatisfactory and it is unsatisfactory because of these basic issues of failure of effective articulation of purpose or a purpose which is really very little real business significance together with inappropriate or no articulation of theory that underpins it. And I think although much of the talk about intellectual capital today for example is focussing on issues that are clearly important to modern businesses, many of attempts to bring in performance measurement in that area suffer from these kind of difficulties.
So let us go back and remember that our basic purposes of business performance measurement are external reporting, internal control and internal analysis. These are the fundamental issues in putting forward frameworks for business performance measurement is to think not just about these purposes but to think about the ways in which they relate to each other. And this is what I am going to call this morning, seamlessness. As the objective of a set of business performance measurement and what I mean by seamlessness is effectively the underlying integration of these three purposes. That we begin in a sense with internal analysis and it has to be internal analysis and understanding of business processes that drives measures of internal control and it has to be internal control that in turn anticipates external reporting. So that what we should be seeking to do is to find a consistent framework in which the internal analysis of the activities and structure of the business drives it’s mechanisms of internal control which in turn anticipates the results of the business that will be reported to the outside world. And if seamlessness works forward in that way is saying that analysis has to drive control which has to anticipate reporting we need to work back in the same way from the measures which we seek to adopt in terms of external reporting to the internal control systems that are the basis of anticipating these numbers to the internal analysis of our activities which forms the basis for working out these kind of control systems.
So let us start then as I think we must with a basic purpose, the basic theory of business performance measurement which has to start from external reporting and work back from that to measures of internal control and analysis.
I am now going to give you what at the moment is one of my two favourite slides. I have two favourite slides currently, this is one, the other one concerns the performance of English football league clubs over the last 35 years. That’s the one I use for non-academic audiences so you’re privileged in terms of (272) if not in interest in being given this one instead. If someone asks me a question later I’ll tell you what the football league performance on is about. When Andy gave citations or gave his citation work in his introductory remarks the oldest citation I noticed which was on his list came from 1922. Actually I’ve found the most useful citation for thinking about issues and business performance measurement, goes much further back than that. It goes back to 1817 and it goes back to an economist called David Ricardo who published a book in 1817 a part of which was the theory of the determination of economic rent. And Ricardo’s theory of economic rent was basically simple enough, you ordered all the land in England from the best land to the worst land and you measured the quality of particular land by the return of the yields you would get from growing crops on that particular land. You could order land in that way if you measured the cost of planting the land up to there, then what you discovered was all the land on the left of this point here was what he described as inside the margin of cultivation, the land which was just at the margin of cultivation earns no rent and the measure of the rent which was earned on any particular piece of land was the difference between its return and the return which was being earned on the marginal land in that particular jurisdiction with that particular price of crops. And of course as crop prices rose and fell so this level, so the return would rise or fall, the margin of cultivation would vary and while land at the margin of cultivation would still continue to command more rent, that would either increase or reduce the rent which went to these intra-marginal pieces of land. As I say, it’s a piece of analysis that happened in 1817, it’s a piece of analysis which I believe is still the central piece of thinking about business performance today, because all we have to do reflecting the changes in the economy which have occurred since between 1817 and now and the largest is that agriculture was then in England still the most important form of economic activity while obviously the activities of corporations are today, which simply have to change our ordering from the best land in a particular activity, to the worst land in a particular activity, to the best firm in a particular activity, to the worst firm in that particular activity. We have the equivalent of the margin of cultivation which is simply the point at which a firm is just earning its’ cost of capital and we have the rent which is being earned by an intra-marginal firm, the rent which is the amount a firm earns in its’ activities as a whole and in its particular activities over an above the cost of capital. And that concept that the purpose of business is essentially to maximise achieve and defend economic rents is the key starting point today I believe for any measure of business performance.
Now the truth is, economists have known this theory for 200 years, back since David Ricardo. Economists still write and talk about economic rent, the amount which a firm earns in excess of the cost of capital. One of the things that has stopped it becoming more popular in practical business applications, is of course the title. For this very odd reason that Ricardo was writing at a time when agriculture was still the most important form of economic activity, economists still go on attaching this term economic rent to the amount which a firm earns, over and above the cost of capital. But most people of course think rent is what you pay for house if you don’t actually have a mortgage. Some economists talk about super-normal profits for measuring economic rent, but it is equally rather easy to see why that’s not a term that has caught on very much in the business world either. Stan Stewart the consultants have popularised the analysis of economic rent in the last 10 years or so under the title of economic value added. I have two problems with that. One is I do take some exception to a firm of consultants using a copyright symbol to attach to a concept which has been around for 200 years. The other is that the term value-added is actually something that is already in use by economists, indeed we already levy tax on it and when we talk about value-added in economics we actually mean something different. I tried the term added value to mean economic rent but that hasn’t particularly caught on, so I come back to calling about this, to calling this economic rent. And the purpose of business we are saying is to maximise, create, defend economic rents. And actually if we realise that the object of business is to create rents and that rents are built out of doing things that other people cannot do as well we can understand that the measurement and analysis of rent is capable of forming the basis of performance measurement not just in commercial companies but also in a not-for-profit organisations as well. There is actually a potential link there, both to performance measurement and to strategy for the University of Cambridge as there is for a commercial company based on the analysis of economic rent. But that is a bigger topic than I am going to have time to go into this morning.
We need to focus fundamentally for external reporting purposes on economic rents, but of course economic rents are not what we actually are required to publish and put in the papers, but they are the basis of it because actually economic rent contributes to reported earnings, which are effectively the sum of cost of equity capital employed, shareholders proportion of the cost of business rent, and shareholders proportion of economic rent. And if what external people focus on in measuring business performance is reported earnings, what we are concerned to do is to understand the ways in which earnings derived from economic rent, from business risk, and from the cost of equity capital employed in the business. And equally if we remove from reported earnings the cost of equity capital and the shareholders proportion of business risk, what we are left with is the shareholders proportion of economic rent.
So that in terms of underlying purposes business performance, are measurement for purposes of external reporting is fundamentally driven by the creation, maximisation defence of economic rent. But if we follow the path which I defined earlier of going from business purpose to underpinning theory, to appropriate measurement we have to ask ourselves the question in relation to these purposes, the purpose being the creation of rent, what is it that actually creates rents. So to move from our external reporting to internal reporting to internal control structures we have to go through the analytic process of asking how it is that rent is generated in business. And the way in which rent is created in business takes us directly back to the Ricardian theory of economic rent that said the reason people inside the margin of cultivation earn rents in agriculture is because there is a limit to the amount of good quality land that there is and for essentially the same reason the only way in which you can create rents in modern business are by holding distinctive capabilities. By being able to do things not just that are better than other people but that are better than other people in ways that these people cannot imitate even after they realise the benefits which they create for you. So rents in business come from distinctive capabilities such as brands and reputation, such as strategic assets, such as innovations and such as internal and what I called internal and external architecture. The structure of relationships and the unique and distinctive structure of relationships which firms enjoy either internally with their employees or externally with their customers and their suppliers.
Now that theory I believe gives us the basic link from these external reporting requirements which are in theoretical terms focussed around the creation, defence maximisation of rents, to the mechanisms of internal control, because what our measures of internal control ought to be aimed at, is keeping tabs on these factors which lie behind the firms ability to generate economic rents. So if we ask what should be on a firms balanced scorecard, the matrix of factors which it applies in its’ internal control system, the answer is the key measures are going to be the ones which are relevant to the creation and maintenance of its’ economic rent. So we move in that way from understanding the distinctive capabilities of the firm to the balanced scorecard. If competitive advantage is based on architecture, on structures of relationships internally, or with suppliers and customers, then our measures ought to have a corresponding emphasis on employees satisfaction and on supplier and relationships. If our distinctive capabilities rest largely on brands and reputation then it’s appropriate for our scorecard to look rather more at customer oriented measurements. If our distinctive capabilities are based on strategic assets, on incumbent market positions of various kinds then it will be important for our measures to look at market position and the government relations which are typically central to the maintenance of strategic assets. And if our distinctive capabilities are based on innovation, then this will be important to put a corresponding emphasis in internal control systems on technical capabilities and achievements. But of course and this is in a sense the whole point of the balanced scorecard, we have to focus and emphasise these aspects but not exclusively to the exclusion of other aspects that matter, because for every business it will be true that whichever its distinctive capabilities are based on, hygiene levels so to speak of other capabilities are going to be needed anyway. In this way I hope you can see how a firms balanced scorecard should be driven by the requirements of its’ external reporting system.
I talked about external reporting, moving from there to measures of internal control. We go on from measures from internal control to measures of internal analysis. And if our theory of business purpose and business activity is based on the creation, generation and maintenance of economic rents, how does that take us back to the objectives of internal analysis. When we measure performance in order to understand our businesses better what does this rent perspective say about what we should be doing. And I think the objectives and internal analysis in these terms are first of all and fundamentally to understand where the rents that are being generated in a multi-activity organisation. The objectives of internal analysis are also as it were to serve some of the same purposes that are served by external reporting but to de-centralise that internally, because reporting reward and performance internally is clearly as important as report reward and performance in relation to external environment. You can argue about whether that second heading on the slide is a matter of analysis of control it falls in fact somewhere between the two. And of course our purpose of internal analysis, is simply that understanding the business and the business structure rather more clearly helps us in a whole variety of ways to manage the business better.
So if following our purpose theory measurement parody we say that we need to look at the purposes of internal analysis this is why we are doing internal analysis in a context which is set by the external reporting framework generated by the need for us to create economic rent. And when I gave you the links earlier of saying that EVA related to external reporting, that balanced scorecard related to mechanisms of internal control, activity based costing related to measures of internal analysis, we can see that activity based costing is in a sense designed to answer fundamentally the first of these questions. And actually in relation to seeing how that operates, many of you who tried to apply activity based costing within organisations, will understand the difficulty which you come up against in defining in its asking what exactly are the criteria which are appropriate for defining cost centres in this particular business. Now I think there is intriguing theory coming out of all of this that will enable us to move towards effective answers to these questions, which are to relate that the definition of internal cost centres to these purposes of external rent generation essentially we discover that the way our cost allocation ought to be driven is by imagining that all the activities of the firm were owned by different people and then in what is effectively again theoretic framework, we are asking what is the range of solutions to the cost allocation problem or the cost assignment problem as it would then become, that these different activity owners would come across, and the intriguing answer of the mathematics of that is to say that if the firm generates no rent there is actually only one answer to that particular allocation problem. So there is an area there which I believe is intriguing and I believe requires more development of that link between activity based costing, rent identification, and the almost gain theoretic analysis of how that kind of allocation gets done.
What I have been trying to do in this very brief half hour or so this morning, is to emphasise rent as the central purpose of business activity and to try and explain the ways in which thinking about the theory of business performance in these terms drives performance measurement firstly in the field of external reporting, secondly in the area of internal control, and thirdly in the area of internal analysis. And to try and suggest the agenda which I believe is required for moving the debate on business performance measurement along, in a way that has these characteristics and these underlying theory. Because what I believe we get out of thinking about business activities in these sort of terms is what I talked earlier about, as seamlessness. That is the objective of a set of business performance measures which are ultimately the internal analysis should drive internal control which in turn should anticipate external reporting and to achieve a structure that actually does that which analysis drives control to anticipate reporting, we actually have to work back from the theory of performance measurement for the internal analysis of our business activities and business purposes we are right which is needed in order to achieve that. Once we have that kind of seamlessness in our thinking which works back and in our generation of numbers which runs forward so that nothing can happen in terms of external reporting that has not been previously anticipated by what we see in terms of our performance measurements and internal control and what has been created for us by our earlier work of internal analysis once we have achieved that we have what I call seamlessness and we have a situation in which there are essentially no surprises in the business. And that it seems to me is always the ultimate purpose of business performance measurement. In many ways the test by which we understand when a business has its business performance measurement systems effectively in control much under control, much of the value of business performance measurement for us today is in teaching managers things which they do not already know, the final achievement of business performance measurement I think is where managers are not going to learn things they don’t already know from the operation of development of their business performance measurement system. The objective of seamlessness is ultimately no surprises. And I can’t think of a more downbeat note than ‘no surprises’ in which to end a talk this morning, but still that’s the one with which I am going to do it. Thank you very much.
Question – Sorry couldn’t hear the question.
Answer – But what’s the implication of that. I think you are quite right, that the reason we have complex modern organisations of the kind we do, is that we have much larger elements of common cost and joint costs that we do. As I was explaining or hinting in what were really only a few remarks at the end about the relationship of ABC to all of that, you know what that is about, is about providing us with a mechanism for understanding organisations, in terms of the distribution of allocation of joint and common costs. And as I was explaining in the case in which there is no rent and aggregate being produced by the organisation there is actually only, there is essentially a unique allocation of costs to activities. Whatever the complexities of joint costs and common costs within the organisation. Where there is rent generation then there becomes, as it were discretionary scope for the allocation of costs on top of that. But actually I think that’s the link, you know between the idea of rent generation on the one hand and the problem which we have in any complex organisation of allocating joint and common costs to particular activities, particular products and particular markets.
Answer – Well that’s essentially, you know the red queen story, that the nature of the competitive market is you have to run very hard to stay where you are. That on the one hand it remains true, and it’s true as I said for non-commercial organisations as well as commercial organisations. You know that rent creation defence maximisation is the object of a business activity. In effectively competitive changing markets, people are actually going to find it very hard to succeed in doing that, and succeed in doing it on a sustained basis. But that is the nature of a fast moving competitive environment. And the one thing that is certain is that if you don’t aim at earning rents, you don’t as it were get above what Ricardo called the margin of cultivation. And the business analogy of being inside, outside the margin of cultivation is that you are not in business any more. So that the purpose has not changed by the competitiveness of the structure an environment.
Answer – You are certainly making one I think, plausible criticism of what I was saying this morning, that in my fairly short discussion of the purposes of external reporting I was implicitly assuming that what one wanted to report externally was the truth, and it’s not entirely clear that in all business that is always the case. The one defence I can put up for my position there, is even if you want to tell lies to other people it is better not to tell lies to yourself, so you need the measures anyway. There is a more serious point in what you said in which I am kind of in danger of contradicting my previous answer but will try and avoid doing so, which is of course there are lots of rents around in modern business. Indeed what people talk about is Q the ratio of market value of companies to tangible replacement cost of asset, is in a sense the measurement