1. Technical Paper The importance of non-financial information in decision making and drive for narrative reporting By: Romila Dominique Date: Nov 2009 Abstract This technical paper has described the importance of non financial information in today’s’ fast moving rapidly changing world. Two important models have been presented here. The first Profit tree model shows how to extract the hidden non financial elements (volume drivers) from the financial statements and the second Balance scorecard model shows how to capture the other value driven factors such as customer satisfaction, internal business processes and learning and growth. If these models are adopted and used by companies, all companies can gain their market in this competitive world. Main Heading Contents TOC
1-3
Executive Summary PAGEREF _Toc245633014 3 1.Introduction PAGEREF _Toc245633015 4 2.Defining Non financial Information PAGEREF _Toc245633016 4 3.Benefits of Non financial Information PAGEREF _Toc245633017 5 4.Limitations of Non financial information PAGEREF _Toc245633018 6 5.Proposed Management Tools PAGEREF _Toc245633019 7 6.Non financial information in Reporting PAGEREF _Toc245633020 9 7.Conclusion PAGEREF _Toc245633021 10 Revenue PAGEREF _Toc245633022 I Potential Expenses PAGEREF _Toc245633023 I Bibliography PAGEREF _Toc245633024 V Figures TOC
Figure
Figure 1.1: Report Structure PAGEREF _Toc245633258 4 Figure 5.1: A Balance Scorecard Model PAGEREF _Toc245633259 8 Figure 6.1: Sustainability at work PAGEREF _Toc245633260 9 Appendices TOC
Appendices Headings,1
Appendix 1 - The Profit Tree Model PAGEREF _Toc245633295 I Appendix 2 - Norton and Kaplan Balance Score Card Objectives and Measures PAGEREF _Toc245633296 IV Executive Summary Non financial information has drawn its importance these days due to rapidly increasing competition, dynamic market changes and changing customer needs and wants. Depending only on the financial information for decision making won’t give the competitive edge to companies, other aspects such as volume drivers, quality, customer, employee satisfaction also be included in decision making. First of all the perception that financial statements have only the financial records should change, the companies should know that there are non financial factors attached to each and every financial record. And in this case the non financial factors are considered to be the Volume drivers. It is the responsibility of Management Accountants to identify the crucial volume drivers associated to each costs / income. In this regard a Profit tree model is presented here in order to identify the volume drivers. The other non financial information that a company should focus is quality, employee customer satisfaction, corporate social responsibility, environmental climate change, risks, and opportunities. A Balance scorecard model is presented in this regard. The ICGN (International Corporate Governance Network) is now encouraging the non financial business reporting. Non-financial business information when combined with financial information can provide valuable insight into the overall quality of management, a critical variable in the appraisal of the firm’s financial prospects. Introduction This topic has gained an importance due to the dynamic and highly competitive environment that we are living today. Information material to investor decision making increasingly diverse and active .Long term success in managing a business in today’s complicated economic, environmental and social landscape more and more is depending on factors not considered in financial statements and in some instance thought to be outside the corporation’s sphere of concern. Investors are concerned in assessing a company’s present and future valuation and the competency to understand its opportunities and risks. Today uncertainties and unexpected climate changes have drawn investor’s attention. They are very active in investing in many corporate responsible projects such as (Carbon Trading Scheme), venture capital investments in climate friendly technologies. Likewise a company should also focus on intellectual capital, intangible asset, human capital, reputation, capacity to innovative brands, alliances and other intangible assets that are vital to value creation in the contemporary knowledge and information based economy. These and some other issues such as supply chain management, human resources, and environmental management systems represent growing class of variables that drive performance and valuation. They can have an impact directly on short and long term value creation and destruction. They may have an impact indirectly through effects such as reputation loss or improvement and customer satisfaction and loyalty. Therefore in order to take crucial corporate or investor expectations decisions focusing only on the financial information analysis, environmental friendly projects, and technologies are not enough, non financial information also should be taken into consideration. The issue tree provided below shows the structure of the report; Figure 1.1: Report Structure Defining Non financial Information Any monetary value attached figures are considered to be financial information (can be a dollar, rupee, pound or euro). In general financial information consists of profits margin, earnings, accounting returns, and all financial information represented in the financial statements. Analysing only the figures in the financial statements don’t give the cutting edge to the companies to be competitive and to become a market player. The company should also focus on the volume drivers that could be both cost / revenue drivers and understand the reason for any profits generated and expenses incurred. The volume driver’s such as number of employees, number of orders, number of hours, number of reports produced, numbers of training organised etc. This is considered to be the non financial information which in the end will help the organisation and management to figure out and understand the story behind each profits and costs and make any decisions effectively. It is management’s responsibility to identify the crucial non financial information which adds value to their company as well as to the investors / stake holders. Since different stakeholders have different levels of interests and power and their expectations also differ accordingly. The selection of crucial non financial information has to be vital and should not be conceptually misleading. In addition to the volume drivers the other perspective of non financial information are environmental risks such as climate change, matters affecting employees, customers, suppliers, host communities, intellectual property ,intangible assets like brand name which are crucial to success, ethics, governess arrangements, innovation and quality. This non financial information may depend on the company strategy, industry or sector specific. Benefits of Non financial Information As mentioned in section 4, companies have to be aware about the volume drivers behind every income / expense incurred. Since the management is responsible when investors ask questions on the income / expense incurred. Considering volume drivers will help the management when it’s provided with some series of proposals. By not only depending on the results generated through NPV, Payback period, and IRR identifying the correct value added volume drivers will make them to take decisions effectively. In addition to this by understanding the volume drivers the management can also utilise this non financial information for future budgeting, and variance analysis. Non financial information is more long termed focus than financial information. Financial measures mostly focus on annual and short term performance of accounting indicators. They do not deal with quality, reputation, brand name, customer satisfaction (customer loyalty, customer complaints), competitor’s movements and human issues. But for long term sustainability in a competitive market and to achieve organisational strategic goals and mission considering the non financial information in decision making is crucial. The non financial data helps to evaluate internal performance and measure the employees and customer satisfaction. In real life non financial information has a direct impact on a company’s future expected financial targets, which have been explained below in simple terms. When employees in the organisation are satisfied, they will be motivated and encouraged to work so that they will produce good deliverables on time for their clients or customers, therefore the firm could gain satisfied customers who are willing to place more orders to the firm in future as well. This will eventually have an impact on profits / gross margin in future and will help the company to perform well in the market and boom Company’s financial position. Then it is also argued that drivers of success in many industries are intangible asset, such as intellectual capital and customer loyalty rather than the hard assets that are shown in the financial statements. It is difficult to quantify intangible assets in financial terms but the non financial data could provide indirect quantitative indicators of a firm’s intangible assets data. Finally, the management must know value added performance driven non financial information and the level of noise in the measures. Noise refers to the changes in the performance measures that are exposed to other outside PEST factors and not within the control of the organisation or management. A manager must be aware of the level of success based on the level of noise and external environmental factors. They should also be aware of how much success is due to their actions otherwise they will not have any indicators that they need to optimize their effect on performance. Generally many non financial measures are less susceptible to external noise than accounting measures; their use may improve manager’s performance by providing more accurate evaluation of their actions. This will reduce the risk imposed on managers when determining pay. Limitations of Non financial information Even though non financial information has its own advantages it’s also has its own drawbacks and limitations. The first limitation of non financial information is time and cost. The management spends more time in identifying the crucial value added non financial information. Value of time is more important in these days, since all players are in an active process of competing other players. Some time the management is left in the middle of an ocean in order to spot the suitable value driven non financial measure for their company. For example if they consider focusing on customer satisfaction what is to consider in customer satisfaction measure, whether it’s number of customer complaints? Customer loyalty level? Number of unique customers introduced for the company? Likewise covering each key non financial measures and identifying the correct ones will consume more valued time of the company and will push the management to focus on this measurement process too much to degenerate into exercises which add very little amount of value to reach future strategic goals. This will make the employees too to focus on reporting, presenting and discussing countless of quality indicators and reducing the time spend on other management activities and time spend on serving customers. The second limitation of non financial measure is that unlike financial measure which has basic formulas and financial equations to calculate and compare non financial measure has no proper or common denominator. Some targets are in percentages and some are in quantities and some are measured in subjective ways. Some companies try to measure performance using weighted average of the measures, some try to measure in terms of strategic importance (say do not agree to strongly agree), others assign subjective target for non financial measures 40% dissatisfied customers among 100 served, 60% employee satisfaction, 30% on market growth, the end result generated from the subjective targets and measures cannot be used for comparison purposes because a common denominator is not used for calculation which can lead the management to make wrong decisions. The third drawback is the lack of casual links between measures. This means, companies invest in customer survey programs in order to measure the level of customer satisfaction but in real the value driver could be customer loyalty and not customer satisfaction level. Improper measures like this will lead the management to focus attention on wrong objectives and improvements cannot be linked to future outcomes. For example Xerox spent millions of dollars on customer surveys in order to measure customer satisfaction and translate the end results into improved financial performance. Later on they found out no such links between the measures. As a result Xerox shifted to measure customer loyalty which was found to be a leading indicator for financial performance. The fourth limitation of non financial measure is the lack of statistical reliability whether the measure will actually represents what it supposed to represent, rather than random measurement error. Say a customer satisfaction survey can consist of few questions and few respondents. Some respondents won’t have time to fill these surveys also they will simply ignore them. When it comes for employee surveys it is very difficult to capture real feelings and emotions of employees with certain amount of questions. At the end final results of these measures will generally represent poor statistical reliability and will put the management in a difficult position for effective decision making for comparison and for comparison purposes among departments and other market players. The final limitation is, even though the non financial measures miss to capture many dimensions of organisational performance, implementing evaluation techniques with many measure and indications will cause to measurement disintegration. This happens when an excess of measures which weakens the effect of the measurement and decision making process. Providing only the advantages and listing down the disadvantages won’t help any company to improve or manage their business. Solutions and ideas have to be provided in terms of how to overcome the limitations of non financial information and how to get the maximum use of the information. Therefore, the debate is how to use and implement the non financial measures effectively and get the maximum benefit out of it by overcoming its drawbacks is discussed above. Proposed Management Tools Before implementing any tools, first the management should understand their stakeholders and identify which non financial measure or indicator adds value to them and maximises their wealth, because management should not indulge time in non value adding activities, and investments. The value of non financial information can be extracted by using these tools. The first management technique is the Profit tree analysis which helps to extract the non financial elements (in this case the volume drivers) from the financial statements and the other tool is the Balance scorecard which captures the most important elements of business such as customers, internal business, and process, learning and growth categories. The Profit tree model is presented in Appendix 1 considered some potential revenue and expenses and associated volume drivers attached to the revenue and costs. This model can be adopted by any company but should be modified according to their financial statements. By identifying the volume drivers the management can clearly identify the crucial drivers and make any further decisions. This tool also could be used for budgeting and variance analysis. This model will be useful for any organisation to drill down the profit and loss account and figure out the drivers behind each profits and costs. Now no one can say that financial statements shows only the financial records there are also the hidden non financial factors (volume drivers) behind each and every income and costs. If those drivers are handled properly, any management could have satisfied financial statements in the near future! Apart from the hidden non financial factors in the financial statements the management should also capture the other crucial business perspectives such as customers, internal growth, learning and innovation and finally financial perspective. External stakeholders look at a range of non-financial performance measures to assess and evaluate how well a company is meeting its corporate responsibility objectives. These are seen as a proxy for good management. To communicate this information, companies require relevant non-financial key performance indicators, or KPIs.
The best suited approach to capture these elements is the Balance scorecard developed by Robert Kaplan. This approach is a measurement system that enables organizations to clarify their vision and strategy, and translate both into action. Each company should ask the following questions as presented in Figure 2.0 in all these perspectives. Figure 5.1: A Balance Scorecard Model As mentioned in the limitations, it’s the organisations responsibility to choose the crucial correct non financial indicators that are value driven, appropriate and what the investors or the stakeholders will be interested in without selecting and focusing on all measures which can consume more time and cost and lead to improper decisions. There have to be measurement integration between non financial measures and, links between financial measures and non financial measures which should be focused on (unlike what Xerox did). Statistical reliability and scaling can be improved by aggregating all the measures. As shown in Figure 2.0 in each business perspective objectives have to be clear and communicated within the organisation, in order to get a proper understanding. Some non financial objectives and measures related to these four perspectives that any organisation can select and focus on have been presented in Appendix 2 presented by Kaplan and Norton. These two models clearly show the importance of non financial information in decision making in organisations. Using these models will provide a cutting edge for all companies. Just knowing and understanding this models won’t help organisations to perform well, implementing this models in the correct time is what matters. Finally, how this captured non financial information should be incorporated and presented in a business reporting has been discussed. Non financial information in Reporting Figure 6.1: Sustainability at work Source – sustainability at work Those days there were only financial issues were presented for information but these days a narrative reporting should include all three aspects on information which has been shown in Figure 3 which is known as the non financial business reporting. Listed down are the features of non financial business reporting as per ICGN - International Corporate Governance Network: The presented information should be genuinely informative and include forward-looking elements where this will enhance understanding Be material, relevant and timely Describe the company’s strategy, and associated risks and opportunities, and explain the board’s role in assessing and overseeing strategy and the management of risks and opportunities Be accessible and appropriately integrated with other information that enables investors to obtain a whole picture of the company use objective metrics where they apply and evidence-based estimates where they do not Use key performance indicators that are linked to strategy and facilitate comparisons Be strengthened where possible by independent assurance that is carried out having regard to established disclosure standards applicable to non-financial business reporting, such as those issued by the IASB For further details, please refer the bibliography. Conclusion As Management accounts we do not focus only on the financial records but also on the drivers associated with costs and income. The volume drivers are considered to be non financial information. In addition to this the other side of the business perspective that should be focused on a business is quality, customers, employees, risks climate, CSR etc. The models that have been presented to capture these measures are Profit tree model and Balance score card. Implementing these models in decision making and in the reporting process will give the companies the cutting edge and of course the competitive advantages to out stand their competitors. In concluding all companies should try to adopt these models and understand the importance of non financial information. Appendices Appendix 1 - The Profit Tree Model Revenue Number of products sold / services are considered to be the possible volume drivers for revenue. But this may differ company to company. Potential Expenses The highlighted factors are the possible volume drivers associated with the potential expenses. These potential revenue and cost elements could be arrived from the financial statements (e.g. Profit and Loss). It is the responsibility of each Management Accountant to identify the potential volume drivers and proceed the analysis. Appendix 2 - Norton and Kaplan Balance Score Card Objectives and Measures PerspectivesTypical ObjectivesTypical MeasuresFinancial1.Create new sources of revenue 2.Increase revenue per customer 3.Increase customer profitability 4.Improve Sales productivity 1.Revenue from new customers and products 2.Share of wallet 3.Revenue mix vs. target 4.Profits per customer (activity-based costing) 5.Cost of sales (by channel) Customer1.Increase customer satisfaction (with value proposition) 2.Increase customer loyalty 3.Create raving fans 1.Percentage of highly satisfied customers 2.Customer retention 3.Depth of relationship 4.Percentage of business from customer referrals Internal ProcessSelection1.Understand segments 2.Screen unprofitable customers3.Target high-value customers 4.Manage the brand 1.Contribution by segment 2.Percentage of unprofitable customers 3.Number of strategic accounts 4.Brand awareness/preference Source: Working knowledge Norton and Kaplan Bibliography Christopher, I., & David, L. (2000, 12 02). Non-financial Performance Measures: What Works and What Doesn't: Knowledge@Wharton. Retrieved from http://knowledge.wharton.upenn.edu/article.cfm?articleid=279 INTERNATIONAL CORPORATE GOVERNANCE NETWORK. (2008). IGCN Statement and Guidance on Non - financial Business Reporting. London: International Corporate Government Network. http://www.icgn.org/best-practice/documents/-/page/50/ S. Kaplan, R., & David, P. N. (2003, 07 14). Keeping Your Balance With Customers - HBS Working Knowledge. Retrieved from Harvard Business School: http://hbswk.hbs.edu/item/3588.html W. N. (2001). Financial Times. Retrieved from http://sundaytimes.lk/030330/ft/news1.html Balance Scorecard. (2009). Retrieved from The Balance Scorecard Application for the LearnCentre Platform: http://www.learn.com/learncenter.asp?id=178441&page=16 Sustainability At Work: The Connected Reporting Framework. (n.d.). Retrieved from The Connected Reporting Framework http://www.sustainabilityatwork.org.uk/strategy/report/0 About the Author Romila Dominique is Business Research Executive at London-based business intelligence and research based company BQu. She has 2 years’ experience in Market Research and Business management. As a management graduate, she gained a BSc from the London School of Economics UK in Economics and Management. She is also a CIMA Passed Finalist. Contact her at romila.dominique@bquintelligence.com Further information can be obtained on: romila.dominique@bquintelligence.com. DISCLAIMER: This document has been produced by the Analyst named at the beginning of the document and is the views of the Analyst based on the information available at the time. BQu does not certify that this information is accurate or of its validity. Where possible the source of the information is indicated and the client should go back to the original source if he or she is in any doubt about its validity. Clients act on this information entirely at their own risk. BQu is a subsidiary of PERItempo Limited a company registered in the UK (registration number 5142955). Correspondence address: 25 Lindfield Gardens, London NW3 6PX and a registered company in Sri Lanka, BQU Lanka (Pvt) Ltd.