financial and non financial and non-financial ...

Third International Conference on Production Research – Americas’ Region 2006 (ICPR(ICPR-AM06) IFPR – ABEPRO - PUCPR - PPGEPS PPGEPS

FINANCIAL AND NONNON-FINANCIAL PERFORMANCE MEASURES IN SIX SIGMA INITIATIVES Roberto Antonio Martins UFSCar/DEP/GEPEQ – IFM – [email protected] Ricardo Coser Mergulhão UFSCar/DEP/GEPEQ – [email protected] Abstract: This paper aims to debate, based on literature review, how Six Sigma could also play a very important role in restoring the relationship between financial and non-financial performance measures. The findings from literature review point out that BSC restores the linkage between financial and non-financial performance measurement at strategic level better than at the operational level. On other hand, in Define phase of six sigma project is imperative to calculate the earnings from reducing the variation of process to improve a critical to quality (CTQ) characteristic of product or service. This kind of relationship is different from that one BSC establishes at strategic level. This is more tangible to people dealing with operations than the assumed cause-and-effect relationships of BSC. In order to make good estimation of financial earnings it is imperative to have a cost system that is aligned to operations strategy as Activity Based Costing. The traditional management accounting system based on standard cost and ratios is outdated and could lead to illusive earnings. Therefore, since there is a compatible cost system the Six Sigma can play an important role to restore the relationship to financial and non-financial performance measures at operational beyond the cost of quality system. Keywords: Performance Measurement; Six Sigma; Continuous Improvement.


1

Introduction

Since the financial results reported by Motorola, General Electric and Allied Signal in last decade, Six Sigma has received a lot of attention from managers and practitioners around the world as a new quality improvement program. The Six Sigma remarkable characteristic is the clear linkage between the improvement results and the financial gains (Harry & Schroeder, 2000). Moreover, what is a distinction to precursor quality programs is the emphasis on the definition of level of defects to all phases of process, measuring them, and establishing improvement targets (Marash, 2000). However, the actual performance measurement system (PMS) of most organizations can be a barrier to implement such quality improvement program. Many organizations around the world have extensive PMS’s but they are based on traditional Managerial Accounting. They fail to support the attainment of strategic goals and do not also help to promote a sustainable continuous improvement because of poor relationship between financial and non-financial performance measures (Bititci et al., 1997). The main reason for measuring business performance is to support the decision makers at different hierarchical levels. It is worthy to highlight the information requirements of each decision makers are different for both hierarchical levels and type of activity (planning, controlling, and improving) (Martins, 2000). Hence, this paper aims debate based on a literature review how the relationship between financial and non-financial performance measures is established in Six Sigma projects.

2

Managerial Cost Accounting and Performance Measurement Measurement Systems

Many organizations still have traditional managerial cost accounting systems which were developed more than 100 years ago (Johnson & Kaplan, 1991). Besides this statement was made more than 10 years ago, it still remains true nowadays. The traditional managerial cost accounting systems were developed when mass production was the most suitable production system and cost reductions were attained through scale economies. That time the cost of direct labor was more than 50% of total cost and


the productivity was correlated positively with production speed. In such conditions, the cost management systems provided relevant information regarding productivity and profitability (Johnson & Kaplan, 1991). Nowadays the competition goes beyond cost. Depending on market niches, cost is as important as quality, flexibility, speed, and delivery (Nakagawa, 1993; Slack et al. 2004). The traditional cost management systems are not so comprehensive to cope with all those competitive criteria. Most of them fails to capture the real costs occurred to comply with customer requirements (Sanders & Hild, 2000). The new production technology and the increase of complexity of organizations have changed the weight of each cost component. The labor cost has reduced as much as material and equipment cost has increased. Nowadays the indirect costs generally are greater than direct costs (Bornia, 2002; Nagakawa, 1993). Considering the changes above, a cost management system should be analyzed through the principle (the reason of establishing a costing system) and the method (the procedures to carry out the evaluation of costs) (Bornia, 2002). According to the same author, the principle, in a narrow view, identifies how the fixed costs are considered. They are classified in following categories: • full absorption costing that attributes both the variable and fixed costs to products and it is used for presenting results in formal reports and accounts; • variable costing that attributes only the variable costs to products and it is used for decision making in short term; • “ideal” absorption costing that attributes both the variable and fixed costs except those related to waste and it is used to support the controlling and improving activities. With relation to the method, the Table 1 exhibits a summary, based on Bornia (2002) & Martins (2003) of main characteristics which are relevant to this paper. The Figure 1 shows how it works the costing methods of Table 1 with exception of Standard Cost that it most suitable to support the other methods.


These methods focus on incurred costs that reflect the past. Moreover, such view of past are expressed in financial terms and the relationship to the actions taken is quite difficult. This type of information is not appropriate to decision makers involved in improving the performance (McNair et al., 1990). Thus, it is important to balance the financial and non-financial performance measures to reflect the complexity of most organizations (Ghalayini & Noble, 1996). To close this gap, many performance measurement systems have been developed (Martins, 2000). In this paper, the emphasis is on Balanced Scorecard (BSC), Performance Pyramid, and Performance Prism. Table 1: 1: Summary of costing methods (Bornia, 2002; Martins, 2003). Methods Simple ratio

Standard Cost

Cost centers

ABC (ActivityActivity-

Based Costing)

Characteristics Characteristics Function

Weakness

Allocate costs

Compare standard

Allocate costs to

Allocate costs to

following a ratio

cost versus actual

products through

products through

cost

cost centers

activities

The ratio can distort

It is hard to calculate The cost center

the real cost severely the standard cost

should be homogeneous

1

The cost drivers should be well

1

understood

The work in the cost center does not depend on product

As a performance measurement system, the Balanced Scorecard translates the organization’s strategy in four perspectives: financial, customer, business processes, and learning & growth. The performance measures of each perspective are linked in casual relationships. The performance measures of financial perspective are lagging and the performance measures of other three perspectives are leading (Kaplan & Norton, 1992; 1996). Performance Pyramid cascades the corporation vision, in terms of market (external) and financial (internal) objectives, to business operating systems, in terms of customer satisfaction (external) and flexibility and productivity (internal), and departments and work centers, in terms of quality and delivery (external) and cycle time and waste (internal). The external performance measures focus on effectiveness and the internal ones focus on efficiency. These measures are seen to relate to each other vertically


through the hierarchical levels and horizontally at the departments and work centers (Cross & Lynch, 1990).

Cost Centers

Simple ratio

Ratiocriterion criterion Ratio

ABC

CCOOSSTTSS

OSTTSS CCOS

CCOOSSTTSS

IndirectCost Cost Indirect Center #1 Center #1

Indirect Indirect activity #1 activity #1 DirectCost Cost Direct Center#1 #1 Center

Product11 Product Product22 Product

Product11 Product

DirectCost Cost Direct Center#2 #2 Center

Directactivity activity Direct #1 #1

Product22 Product

Product11 Product

Directactivity activity Direct #2 #2

Product22 Product

Figure 1: 1: Distribution of costs for each costing method (Martins, 2003).

The most recently developed performance measurement framework is Performance Prism. It reflects organization’s performance in five perspectives: stakeholder satisfaction,

strategies,

processes,

capabilities,

and

stakeholder

contribution.

Performance Prism starts and ends with stakeholders. Strategies, processes and capabilities are the means to reach stakeholders’ satisfaction. Strategy mobilizes the processes with require the capabilities of organizations. In order to be satisfied, the stakeholders also have to contribute to maintain and develop organization’s capabilities (Neely et al., 2001). These PMS framework try to establish a relationship between the financial and nonfinancial performance measures which are grouped in perspectives, as in BSC and Performance Prism, or categories, as in Performance Pyramid (internal and external). However such frameworks do not close the gap completely as the following critique shows. Regarding BSC, Ghalayini & Noble (1996) argue that such PMS is not applicable at shop floor. Martins (1998) discusses if it is a PMS most suitable for decision makers at top and medium levels of hierarchy than at operations level. Norreklit (2000) argues that the casual relationship is not as simples as the authors suggest and the strategic control framework is not realistic. With relation to Performance Pyramid, Martins (1998) argues that the choice of performance measurement is critical because they should reflect clearly the casual relationship in three levels (corporate, business operating systems, and departments and works centers).


Reviewing many PMS frameworks, including the three reviewed in this paper, Tangen (2004) argues that the new PMS have addressed the underlying concepts to close the gap, but such frameworks do not provide meaningful information to operational levels. The main reason of that is the lack of guidance to measure. The frameworks show what to measure and not how to measure. This can mislead to establish a clear relationship between the financial and non-financial performance measures.

3

Six Sigma

Some authors claim that Six Sigma is the state of art in quality management because such program is an evolution of precursors with unique characteristics (Arnheiter & Maleyeff, 2005). Six Sigma has inherited the Deming’s approach to continuous improvement and some principles from Total Quality Management as focus on the customer, decision making based on facts and data, root cause analysis, structured problem solving, rewards for improving and improvement of processes capability (Arnheiter & Maleyeff, 2005; Evans & Lindsay, 1995). The unique characteristics are the comprehensive structured training, broad definition of value to customers that includes not only quality, but service and delivery, and clear link between the processes improvement and financial gains (Arnheiter & Maleyeff, 2005; Harry & Schroeder, 2000; Rotondaro, 2002; Eckes, 2000). The latter is the most known characteristic. The improvement activities in Six Sigma are carried out through six sigma projects. Snee (2001, p.66) defines a Six Sigma project as “the problem scheduled for solution that has a set of metrics that can be used to set project goals and monitor progress”. The people who lead the projects receive intensive training in quality tools and statistical methods. They are denominated belts, depending of level of training they are black belts, green belts, for instance. The belts apply the DMAIC (Define, Measure, Analyze, Improve, and Control) cycle to develop the six sigma projects (Coronado & Antony, 2002). The projects should be selected in order to achieve both significant quality improvement and considerable financial results (Rotondaro, 2002; Montgomery 2000; Snee, 2001; Harry & Schroeder, 2000). Following this statement, the selection of six sigma projects is critical.


The selection of six sigma project requires three viability analyses: technical, financial, and economical (Carvalho, 2002). The first deals with the risk of figuring out a feasible solution. The second considers the availability of financial resources to invest on projects. The third deals with the cost benefit analysis of project. For this paper the interest is on initial steps of economical analysis since the aim is to discuss the relationship between financial and non-financial performance measures. The selection of six sigma projects is based on three characteristics of six sigma program: customer driven approach, emphasis on decision making based on quantitative data, and priority on saving money (De Mast, 2003). This leads to establishment of relationship between non-financial performance measures, related to customers’ requirements, and financial performance measures, related to cost reduction and financial gains. Such relationship should be established based on reliable data reproducing the casual relationship. This relationship is first established at the Define phase when then cost benefit analysis is performed (Rotondaro, 2002). This analysis is fundamental to make decision of continuing or not the project. As Figure 2 shows, the input to Define phase is financial and non-financial information.

Define

Costing System

Performance Measurement CTQs

Valuationofof Valuation gains gains the IsIsthe project project viable? viable?

Not

Discontinue Discontinue

Measure, Analyze, Improve, Control

Yes

Continue Continue

Figure 2: 2: Selection of six sigma projects

In this phase, the crucial information is the process outcome that is defined in terms of critical to quality (CTQ). The process performance can be measured in terms of sigma


level, defects per million opportunities (DPMO), capability index (Cpk), number of customer complaints and so on. These are typical non-financial performance measures at operational level. The CTQs can be classified in two categories: those related to internal processes (CTQinternal) and those related to market (CTQexternal) (Carvalho, 2002). This categorization agrees with the role played by performance measurement as source of information to guide the improvement activities according to Taylor & Wright (2006). There are three sources: internally unknown but externally known; both internally and externally unknown that requires the development of new capabilities to show the opportunities; and internally known but externally unknown.

4

Reestablishing the Relationship between Financial and nonnon-Financial Performance Measures at Operational Level

The new PMS’s – like BSC, Performance Pyramid, and Performance Prism – seems to fail to reestablish the casual relationship between financial and non-financial performance measures at operational level. According to Tangen (2004), such frameworks point out what to measure, but it is still missing how to do it. It is worthy to note that the performance measure is most visible part of PMS to majority of employees and helps to compel people to take action. On the other hand, the selection of six sigma projects, during the phase Define, requires both the definition what will be improved (CTQ) and the valuation of likely financial gains mainly in terms of cost reduction. This calculation establishes the relationship between financial and non-financial performance measures at operational level. The use of CTQinternal and CTQexternal as a starting point in the economical analysis of six sigma projects considers the critical business processes, and customers. The calculation of likely financial gains also considers the shareholders in terms of cost reduction. BSC, Performance Pyramid, and Performance Prism also establish relationship between such perspectives, but in six sigma projects the relationship is established at operational level, considering the improvement of business process related to CTQ. The relationship is clearer than posed in new PMS frameworks.


However, in order to create accurate casual relationships is vital to have reliable performance measures. It is important to remember the traditional managerial accounting systems do not capture well the real costs. This is could be the Achilles’ heel of establishment of relationship. Thus, the principles and methods of costing systems play a key role as in other change management programs like Lean Manufacturing. Today the indirect cost is the major part of many organizations’ costs. This fact demands a good match between costing methods and principles. Otherwise, the cost benefit analysis could distort the gains of projects resulting in an incorrect selection of projects. After all, the CTQ and correlated business process could be improved, but the financial gains will not be attained. This threats seriously the Six Sigma implementation because of poor results. Regarding the match between principles and costing systems, it seems the principle of variable cost is inappropriate because it does not consider the indirect costs which are part of fixed costs. It is worthy to note that the principle of variable cost ignores the fixed costs completely. The full absorption costing principle is preferable to “ideal” absorption principle because it provides more realistic description of cost of products to carry out the cost benefit analysis. It is important to note that the full absorption takes in account all process inefficiencies what can overestimate the real costs. With relation to costing methods, the ABC is most suitable because it will provide better information regarding the aggregation of costs while the activities of business process are performed. This method is most appropriate when it is necessary more details about the indirect costs. Nevertheless, when the amount of indirect cost is not significant it is possible to use the either cost center or simple ratio. These methods provide less information than ABC.

5

Final Remarks

This paper contributes to debate of establishing casual relationships between performance measures at operational level. First, it is clear the traditional accounting


managerial systems fail to provide meaningful information to decision makers at different levels of organization. The new generation of PMS – like Balanced Scorecard, Performance Pyramid, and Performance Prism – attempts to close such gap, but they only succeed at strategic level. There is still a missing link at operational level. The casual relationships at strategic level are very aggregate and take much time to happen what make them meaningless at operational level. Six Sigma is a quality improvement program which carried out the improvement activities on projects. The selection of such projects is a critical step and takes in account the customer satisfaction, through the improvement of business process variability correlated to a CTQ, and the cost benefit to organization in terms of cost reduction. It is imperative to establish a reliable clear relationship between non-financial (CTQ) and financial performance measures (cost reduction) in order to select feasible six sigma projects. Nevertheless, the establishment of casual relationship still depends on good costing systems. Therefore, Six Sigma helps to establish casual relationships between financial and nonfinancial performance measures at operational level. This is a contribution to enhance the information available to decision makers, but it still depends on good choice of principle and method to costing system. It is an “ad-hoc” activity rather than an integral part of performance measurement system at operational level. This means more research efforts are necessary to really close such gap.

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