The Operating Rank shows the percentile rank of a company relative to the relevant market (peer universe) for a certain value driver (financial metric). This allows the assessment of company performance against the competition at one glance since percentile ranks can directly be interpreted. A higher percentile rank is always better irrespective of the number of companies in the peer universe, irrespective of economic cycles, irrespective of the business model and even irrespective of the observed financial metric. The Operating Rank is therefore also an assessment of company performance.
This method of rank-based performance measurement is applied in sports. Times, distances and speed matter little in sports. Even goals, points and hits are irrelevant in the end. What counts solely is the 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 performance values.
Percentile computation standardizes performance and makes it comparable universally; the Operating Rank of a company or a business division is directly comparable between different time periods, different companies (also refer to Operating Rankings) and even different financial metrics (also refer to Operating Radar).
False conclusions can be better avoided with the Operating Rank than with the Operating Index. The Operating Rank illustrates only relative company performance. This helps avoid the same fallacies which the Operating Index also prevents. But more than that, it further improves performance assessment. As shown in the graph above, 2005 and 2008 are the best years, and 2003 and 2004 are about the same (the corresponding absolute values are illustrated in the Operating Index graph).
The Operating Rank is even more precise than the Operating Index for this type of reading because the statistical distribution of the financial metric is also considered. Thus, it is only definitely discernible with the Operating Rank that company performance in 2004 was better than in 2003. This is not illustrated with the Operating Index, because the number of peer universe data points between company performance and the location parameters of the peer universe are not captured. In Obermatt's experience, such distribution effects arise in about one-third of Operating Ranks. Obermatt supports its clients to identify the impact of such distribution in performance assessments.
The Operating Rank is also applied in setting bonus targets relative to the market, so-called indexed bonus targets. The advantage of indexing is that the target setting hardly needs negotiating. Often the necessary performance level becomes apparent at first glance (generally the median or the 50th percentile rank, respectively). Furthermore, since this hardly changes over time, bonus targets have to be negotiated only in larger time intervals. At the same time, the bonus system is calibrated with the Operating Rank. As illustrated above, achieving a certain Operating Rank is always equally challenging or in other words just as hard. Depending on incentive philosophy, the bonus can vary more or less with the increase or decrease of the Operating Rank. We generally recommend 100% target bonus on the 50th percentile rank, 200% target bonus on the 75th percentile rank and 300% on the 100th percentile rank (after elimination of outliers). The corresponding line then results in a 0% target bonus on the 25th percentile rank and a negative bonus declaration for lower levels.
Thus with the Operating Rank from Obermatt, one can design bonus plans more fairly (against market development), which are valid for longer periods (as Operating Rank) and easy to set (without respective calibration per financial metric or business area). The indexed incentive pay approach avoids overpaying or underpaying. Both are costly to the company, either because salary expenses are too high or because of the risk of losing highly competent executives. The indexed approach is also in the interest of executives, as it compensates for operating performance and not for economic cycles and other external factors.
To exemplify the development of a typical Operating Index, we cite the Swiss luxury goods company Richemont (PDF download). Hermann J. Stern's article in the German Corporate Governance magazine comments on the application of the Operating Index for Executive Management and the Board (German: PDF download). On the Social Science Research Network, there is a paper on Cycle-Proof Performance Measurement and Executive Bonus Plans (PDF download). In "Finanz und Wirtschaft" Raiffeisen Bank Group is quoted as an example for the Operating indexed bonus targets based on the Operating Index for Swiss Banks (PDF download).
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