The Total Performance Equation.

• Author: Jesuthasan, Ravin

How can companies build non-financial measures into incentive compensation?

Exponential growth in executive pay levels over the last few years has prompted increased scrutiny of the systems that led to these perceived excesses. In response, companies began examining the relationship between their executive pay programs and their performance. If the link was sufficiently strong -- for instance, a highly paid CEO who consistently delivered a rising share price -- few protested the size of that CEO's pay package. When the pay/performance link was minimal or nonexistent, however, the situation was quite different.

The one given, though -- at least until recently -- was an emphasis on current financial performance. When companies linked pay to performance, they did so almost uniformly through traditional financial and accounting measures, such as earnings per share, operating profit, return on equity or return on capital. These and related measures became the lens through which they (as well as the press, investors and others) assessed executive performance.

But over the past few years, that lens has widened to include non-financial measures that drive shareholder value, including customer and employee satisfaction, operating results and innovation. While such measures aren't yet as prevalent as financial ones, there's little doubt they're growing in popularity. Indeed, a Conference Board study conducted more than four years ago found that even then, executives agreed the most effective incentive plans contained a mix of financial and non-financial measures.

As many academic experts point out -- most notably, Robert Kaplan and David Norton in their book, The Balanced Scorecard -- a company's current financial performance is only part of the total performance equation. Effective management -- and, thus, long-term financial performance -- depend as much on attention to operations, customers, new product development and such as on factors like current earnings growth. In short, executives must focus their attention on a range of activities and be measured accordingly.

Don't Look Back

Much of the interest in using non-financial measures stems from the chief limitation of financial measures: their backward-looking focus. Financial measures only reflect last year's performance and, as such, don't provide incentives for creating future value. Non-financial measures, by contrast, are often prospective -- for instance, creating and bringing a new product to market, building market share over a given period and increasing retention of key customer accounts. These are goals that often require multi-year attention from management and, if achieved, obviously will affect financial performance. This reality is a key to why studies -- such as Wharton's "The Choice of Performance Measures in...