Operating Rank

Definition

The Operating Rank is the percentile rank of a metric within the relevant Peer Universe of a company. We also refer to the graphic displayed below as the Operating Rank.

Description

The Operating Rank shows the percentile rank of a company relative to the relevant market (Peer Universe) for a certain metric. This allows the assessment of company performance against the competition at one glance since percentile ranks can be interpreted directly. A higher percentile rank is always better than a lower one, irrespective of the number of companies in the Peer Universe, irrespective of the economic cycle, irrespective of the business model, and even irrespective of the observed metric type. The Operating Rank is therefore both an expression and an assessment of company performance.

This method of rank-based performance measurement is used in sports. Actual times, distances and speeds ultimatively matter little in sports. Even goals, points, and hits are irrelevant in the end. What matters only is the final ranking against the competitors. Thanks to this rank-based performance measurement, different sports can be compared directly. For this reason, Olympic medals are tallied per country to assess which country performed best. This is only possible when using rankings. It is not possible by looking at absolute metric values.

Percentile ranks standardise performance and make it universally comparable. The Operating Rank of a company or a business segment is directly comparable between different time periods, different companies (see Operating Rankings), and even different metrics types (see Operating Radar).

Application

The Operating Rank avoides false conclusions even better than the Operating Index as it represents relative company performance purely. While this helps avoiding the same fallacies that the Operating Index already prevents, it further improves performance assessment. Only the Operating Rank shows that the company's performance in 02 is even slightly better than in 01. This cannot be seen in the Operating Index because it does not record how many data points of the Peer Universe lie between company performance and the location parameters of the Peer Universe. The corresponding absolute values are illustrated in the Operating Index graph. This means that the Operating Rank is even more precise than the Operating Index because the statistical distribution of the metric is also taken into account.

The Operating Rank is used in setting bonus targets relative to the market, so-called indexed bonus targets. The advantage of indexing is that the target setting hardly needs any negotiating. Often the necessary performance level becomes apparent at first glance. The target is typically set at the market median or the 50th percentile rank, respectively. Furthermore, since this expection level hardly changes over time, bonus targets have to be negotiated only in larger time intervals. In addition, bonus systems are automatically calibrated with the Operating Rank. As illustrated above, achieving a certain Operating Rank is always equally challenging or in other words just as hard, no matter what performance metric is used. Depending on incentive philosophy, the bonus can vary more or less with the increase or decrease of the Operating Rank. As a rule, we generally recommend 100% target bonus at the 50th percentile rank ("median pay for median performance") and 200% at the 100th percentile rank ("maximum pay at maximum performance"). The corresponding straight line then leads to a zero bonus at the 0th percentile rank ("zero pay for worst performance"). In other words, each improvement in performance leads to an increase in the variable remuneration component. This ensures performance motivation in every situation.)

Thus, the Operating Rank allows for bonus plan designs that are fairer, valid for longer periods of time and require less effort to set and maintain. In addition, the indexed incentive pay approach avoids risks of underpaying as well as overpaying. Both are costly to the company, either because salary expenses are too high or because of the risk of losing highly competent executives. Managers also want to avoid large salary fluctuations because they reduce compensation reliability. This is also known as compensation resilience which the Obermatt Bonus Index, based on Operating Ranks, provides.

Examples

On the Social Science Research Network, there is a paper on Cycle-Proof Performance Measurement and Executive Bonus Plans (PDF download) that provides more details on using Operating Rank in compensation systems.

The financial research company Obermatt AG (about) provides indexing performance analysis such as the Operating Rank to clients. Request a quote for your company by contacting Obermatt AG (contact).

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