The Economics Of Performance

In my view, aiming at simplicity and lucidity is a moral duty of all intellectuals; lack of clarity is a sin and pretentiousness is a crime.

Karl Popper

THOUGHTS THAT I LOVE
The theoretical framework (banned for managers who don’t like theory for the sake of so-called pragmatism)

Thinking in terms of performance is not a mere financial monitoring move. It requires a big culture change.

When I started writing this document (in the time of a pandemic), I asked myself about the real meaning of performance in terms of economics and how this concept should be understood. Therefore, I tried to put together some management theories and models. However, while exploring the literature in the field, I eventually understood that the contributions in defining performance have been rather poor and mostly sequential.

With one exception.

I would argue that the late Douglass North[1], the Nobel Prize winner for Economics in 1993, gives the most comprehensive perspective on performance. North extracts the concept of performance from under the exclusively financial understanding and connects it to the concept of institutions. He outstandingly observed that performance is fundamentally connected to human behaviors and organizational/societal culture, rather than to any superior financial monitoring system.

The economists’ understanding of institutions is different than the concepts used in law and political science. Economists (as defined by North) consider institutions as being devised constraints that structure political, economic, and social interactions. Institutions are what provide incentive structure for the choice of behaviors.

North explains the relationship between institutions and performance at the macroeconomic level, even though the fundamentals are rooted in Ronald Coase’s transaction cost theory[2]. Performance is given by the institutional framework that was projected to decrease the transaction costs. Performance is given by the level and structure of the transaction costs. Within the economics of the firm, the North theory of performance is entirely applicable. The performance framework is institutions-behaviors-performance.

PERFORMANCE ANXIETY
(still a theoretical framework)

Business anxiety is related to the frustration that resides in the lack of capacity to perform a business task. Therefore, it is difficult to clearly define this concept because confusion, in a world of uncertainty, is an intellectual sin.

Taking into account the existent performance theories, I am logically following Karl Popper’s observations about intellectuals, aforementioned in the epigraph of this text. My experience shows that performance has been sequentially treated. The imperfection of the performance design is rooted in the disconnections between the theory and the “pragmatic” aspects of business. Nonetheless, here (maybe more than ever), business needs thinkers.  

Let’s take a few critical claims…

• Performance is a fuzzy concept. This shows an obvious lack of simplicity and lucidity. Many high-level managers say that even though they have spent millions to understand and implement a performance system, they have practically failed. They cannot show what performance is at any level. It looks like performance in business is still kept within the profitability zone and considered an “outcome”. In this context, performance was designed to be a financial model. Managers can explain for hours what performance is without any idea about how to truly define it.

• Performance is a pretentious concept. The relationship between the operational realm and the shareholders is, in many situations, poisoned by the mechanics of the performance architecture. The concept is kept only by the leadership – the high-level officers and managers, and for accountants. The operational staff is completely excluded.

• Performance is an ambiguous concept. There are many misunderstandings and failed attempts to intellectually define performance. The most noticeable misunderstanding is between performance and financial efficiency. As a matter of fact, this is the most dangerous of them, as it makes companies inefficient. In many situations, failure is nothing but disengagement of the two.  

Today, the firm’s performance is related to the definition of an economist, who, as an expert, can explain tomorrow why things s/he predicted yesterday do not happen today. The traditional concept of performance seems to be the economic concept that can explain tomorrow why things the management planned yesterday do not happen today.

FINANCIAL vs BEHAVIORAL DIMENSIONS
(still… )

From the methodological view of North’ institutional theory, performance is the institutional effort to diminish the transaction costs. In economics, and related disciplines, a transaction cost is the cost of making any economic trade when participating in a market. 

Obviously, nowadays, a sustained intellectual effort is required in order to translate these macroeconomic concepts into micro economic language. The development of a methodology is a must today, especially when humanity should be reconnected to economic performance.

In a firm’s “language”, we define the components of performance value chain as follows:

1. Transaction cost (a humble extended approach).
   
   1. Any costs to perform a process and project at the operational level;
   1. Bargaining and decision;
   2. Normative spaces enforcements;
   3. Monitoring and corrections
   2. Any costs of trading in the market (the costs with lawyers and legal issues might be an example)


2. Institutions. In a firm, the institutions are formal constraints related to procedures, processes, and rules that define the normative spaces as well as the informal constraints related to taboos, customs, informal relations, etc.


3. Performance. Performance is the immediate result of institutional effectiveness; that means that it is the result of management’s professionalism. There are some behavioral dimensions related to performance as following:
   • Performance is an emotional and behavioral concept.
   • Performance is a management concept more than an exclusively financial one.
   • It is the most relevant tool for management decision making.
   • Performance should be an internal convention, not a general standard.
   • Performance should be an internal communication standard.
   • Performance owners should have a perfect understanding on the variables.
   • Performance management should have a punctual image on the stage where the owners are. It is about black box thinking.
   
   Performance should be about the quality of rules, procedures, norms, and decisions, as well as about the cultural framework of the organization. It is a behavioral concept and not a financial framework. Performance is a dynamic concept that aims to optimize the transaction costs by a real time adaptation of institutions (norms, rule, decisions). This is a big conceptual shift.

THE PERFORMANCE ARCHITECTURE
The start of the pragmatic framework

Reduction of transaction costs is the essence of performance architecture. The architecture is the pragmatic part of this approach that Axiobit defines as the convergent theory of performance.

Based on current research, we propose four levels of indicators.

1. The Scope: significant and measurable decreasing of transaction costs;
2. The Process: improving the institutions (process, rules, decisions) efficiency;
3. The Condition: all designed indicators should be clearly understood and controlled (in almost real time) by the unit managers;
4. The Tool: digital artifact able to capture data (behavioral and others) and information relevant for being transformed into indicators for each management level.

The basis is the performance model of the profit units followed by the investment input and by the back-office support. The financial components of all of these layers can be integrated in the financial level.

One of the business models we applied, in the effort of implementing a performance architecture, is the black box thinking[3] that may help the decision-making framework. Only by implementing this system can managers comprehend their various mistakes and may reconsider the policies, processes, and rules in almost real time. Among other aspects, it promotes a new digital shift.  

THE REQUIRED DIGITAL SHIFT
Beyond the pragmatic framework

For more than 25 years, I’ve been involved in designing and executing software business processes for companies. Business Process Management design and execution have remained the best methods to decrease/optimize the transaction cost. Processes themselves are proprietary “institutions” where management skills are applied. One of the benefits of the processes is the ability to capture a lot of behavioral data and the possibility to correct any aspects of misbehavior.

The interesting dimension is that the managers I’ve been working with over time (in about four countries) were not really interested in capturing this data and processing it. They were exclusively interested in the final financial effect of the implemented processes. This kind of outcome can be exposed only 1-3 months after the event happens. This is rather surprising, as they have a lot of managerial instruments (especially in the behavioral realm) that can be controlled, monitored, and corrected in real time.

The digital shift is pivotal in the moving of the business architecture of performance to a new level. The digital systems should be more oriented to capturing, interpreting, and processing the behavioral aspects of organizations, departments, and/or profit units.

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[1] See Douglass C. North (1990) Institutions, Institutional Change and Economic Performance, Cambridge University Press.

[2] See Ronald Coase (1937). The Nature of the Firm. Economica. Blackwell Publishing. 4 (16): 386–405

[3] See Mathew Syed, Black Box Thinking: The Surprising Truth About Success (and Why Some People Never Learn from Their Mistakes) (2015)