Are Nonfinancial Metrics Good Leading Indicators of Future Financial Performance?
It’s become increasingly popular to use nonfinancial measures such as customer satisfaction in performance management frameworks and executive compensation schemes. But how well does that work?
In recent years, more and more companies have begun using nonfinancial measures as leading indicators of future financial performance. Inspired by strategic management performance tools including Robert S. Kaplan and David P. Norton’s popular balanced scorecard, corporate boards have extended executive compensation schemes to embrace measures for, among other things, customer satisfaction, employee engagement, and openness to innovation. Inclusion of such measures is thought to encourage behaviors that some say have the power to increase the company’s long-term value rather than simply maximizing short-term financial performance.
Although the notion of using nonfinancial metrics such as customer satisfaction to shape executive behavior is attractive to managers, the extent to which including these measures in compensation schemes actually improves company value and financial performance is a matter of debate. Research, including a study by Timothy Keiningham, Sunil Gupta, Lerzan Aksoy, and Alexander Buoye published in MIT Sloan Management Review, has shown, for example, that customer satisfaction is often a weak leading indicator of a company’s future financial performance. Other nonfinancial measures, such as employee engagement and product quality, have displayed similar weaknesses, raising critical concerns about their usefulness.
Skepticism about the relevance of such nonfinancial metrics as useful leading indicators of financial performance has been fed by concerns that executives often lack accurate information on their company’s performance on nonfinancial metrics, the specific relationship between the nonfinancial metrics and future financial performance, and the contexts in which such relationships are likely to be more or less pronounced. Academics, including Harvard Law School professors Lucien A. Bebchuk and Jesse M. Fried, have gone so far as to argue that the inclusion of nonfinancial metrics in executive compensation schemes can actually weaken rather than improve the design of strategic performance management systems. For example, senior executives may prioritize enhanced customer satisfaction without appropriately balancing satisfaction metrics with other areas of organizational performance. In some instances, this can lead to a falloff in financial performance (for instance, if frontline employees give away products and services for free to meet their customer satisfaction goals).
Most of the research to date about performance measures used to determine CEO compensation has focused on standard financial indicators such as accounting earnings and stock performance. Studies have found that linking compensation to accounting earnings incentivizes CEOs to maximize short-term financial performance.