Indexing Operating Performance
Indexing operating performance measures internal accounting performance against the performance of industry peers.
The objective of indexing is the assessment of operating performance. Without indexing, performance measurement would be distorted by external effects, such as macroeconomic factors.
Indexed operating performance measurement applies the same approach to performance assessment that investors or shareholders follow when evaluating key financial ratios. An investor assesses the investment opportunity relative to alternative investment opportunities and thus implicitly assesses relative performance following the principles of indexing operating performance.
The assessment of indexed operating performance measurement can be implemented in two ways:
Firstly by comparing the difference of the internal performance with the average or the median of the performance measurements of peer companies. For actual key metrics, this difference is called Operating Alpha.
Secondly by calculating a percentile rank of the internal performance relative to peer companies. This percentile rank is called Operating Rank.
Furthermore, indexing operating performance uses a series of methods of analysis, such as Operating Index, Operating Trend, Operating Radar, Operating Ranking, Operating Contribution, and Operating Distribution, which can be found here.
Differentiation to Benchmarking
Indexing operating performance differs from traditional benchmarking in its approach. Traditional benchmarking does not apply the investor perspective but focuses primarily on peer companies with similar products or business processes. Conversely, indexing considers companies with similar sales or supply risks in the peer universe; these peers are therefore exposed to similar operating risks from a shareholder perspective. The research company Obermatt compiles Peer Universes from an investor perspective for its clients. The primary goal of benchmarking is the enhancement of particular products and processes compared to a benchmark ("best in class"). The goal of indexing is the performance assessment of operating activities that exclude the impact of external factors, such as business cycles, resource price changes, or customer demand.
Advantages of Indexing
Indexing operating performance has two distinct advantages:
- Neutralizing external factors: Comparing internal performance assessment relative to an external Operating Index eliminates the impact of external factors, since these impact both the internal performance and the external index in the same way. The difference between the value of a key figure from internal accounting and the average or median of this key figure in the operating index is called Operating Alpha.
- Standardizing of key figures: Stating the key figure from internal performance assessment as a percentile rank against the operating index delivers a standardized performance measurement. A certain percentile rank is always equally good, regardless of the time period or the financial metric. In this manner, performance assessment becomes universally comparable.
These two advantages enhance operating management tasks in three areas: in compensation programs, in strategic planning, and in investment analysis.
Benefits of Bonus Programs
In indexed bonus programs, objectives would not be set as absolute targets but as indexed bonus targets. The advantage is the elimination of the impact of external factors from the bonus target. The bonus target eases when the operating index decreases and rises when the operating index increases. Thus, true operating performance is compensated and not the effect of economic cycles. As a neutral party, Obermatt maintains Operating Indices for its clients to link their bonus targets to an objective, third-party Operating Index.
Benefits in Strategy and Investment Analysis
In strategic and investment decisions, key figures are not compared as absolute values but as Operating Alpha or Operating Rank (as a percentile rank). The advantage is the direct comparability of dissimilar key metrics in dissimilar businesses and in dissimilar reporting periods. By expressing a key metric as a percentile rank, an objective assessment of the key metric is obtained which illustrates how a company really performed compared with its peers. Obermatt provides the required indexed performance measurement data for strategic planning and controlling on a regular basis so that strategic planners and controllers can focus on the planning, modeling, and interpretation of performance.