Details: Category: Newsletters

Key Performance Indicators – Tools for Business Performance Management

Every business, large or small, regardless of what it does, depends for its survival on getting certain things right on a regular basis. These things we call the Critical Success Factors. These CSFs relate to the business processes and activities that drive business results. At the top level, these are:

Processes and activities that are important to acquiring and holding customers
Processes and activities that determine revenue
Processes and activities that impact efficiency and productivity
Processes and activities that determine team morale

To know how well your business is managing these CSFs, you need a system of measurement. Key Performance Indicators ARE these measures. You can develop a set of KPIs that will allow you to monitor performance on these critical processes and activities.

The main KPI issues are:

The most useful way of measuring business performance
Deciding the right KPIs for your business
How to construct a KPI that can be measured reliably and consistently
Implementing KPI monitoring in your business
Using KPI data to improve business performance

What you can measure you can manage

Numbers can be used in three ways. These are:

As straight measures of activity – 500 widgets produced this month, two employees left this year
To compare results, for instance, this period’s result against last period’s – sales up 5% on the same month last year and up 2% on year to date against last year
As an indicator of actual business performance against a preset goal – how many sales we wanted this month and how many we have on the board

Now let’s consider each of these in terms of this particular definition of KPIs: KPIs are quantifiable measures of how well you are performing an activity that is critical to the success of your business.

Measuring activity

The first type of measure just records what happened – we produced 500 widgets. Production level is a critical success factor. But measuring just for the sake of measuring doesn’t take us anywhere. If you tell me your reject rate on gizmo production is 5%, what am I to make of it? Is that good? Is it down on previous production runs? Or up? Is it better than the guy down the road does? Is it heading towards the goal I set?

If you remember the definition of a KPI, we emphasised the words ‘how well’. Measurement can only tell us ‘how well’ when we have something to compare against. That’s where the second two ways of using measures come in.

Measuring to compare and assess goal achievement

Measuring to determine goal achievement and to make comparisons to see how you stand relative to others is really the only point of going to the effort of measuring. In these cases, you have set some goal to achieve, whether it be based on what you have achieved previously, or on an industry benchmark you want to match. In these cases, you can use the information to assess how well you are doing in reaching a specific goal.

And depending on the figure, you’ll know if you need to fine-tune your strategy or not. That’s the real point of keeping measures – to be able to monitor business performance and know where you could improve it. My point is, that before you decide to arbitrarily start measuring things, you should take a step back and think about what your goals are in each area – give yourself a target to aim at.

We'll return to this at the end and suggest a way you can use KPI information in a reporting system that will help you continually improve your business performance, but for now, let’s return to just which measures, or KPIs, might be useful for you to track.

Selecting KPIs to monitor

Hundreds of KPIs could be used to track your business’ performance.

You may be familiar with some KPIs even though you haven’t thought of them as such. For instance, the value of production output per employee and your gross profit margin both measure some aspects critical to the success of your operations and can be considered as KPIs. But KPIs are not necessarily those things you measure in dollars. Many equally critical activities, such as ensuring customer loyalty, can’t be measured in dollars and cents.

There are dozens of others we could add. The key to effective measurement though is to identify a small number of KPIs, (say 6-8), that measure the critical activities - and to watch them like a hawk.

So what would make a useful KPI in your situation? Some apply to almost all businesses, such as several key financial ratios. But in deciding others that would be useful to your particular business, there are several things to consider. To be worthwhile monitoring, the KPI should have these characteristics:

Reflect the goals of your business
Be critical to the success of your business
Be measurable
Point to the activities you might need to alter if things start to go off track

After discussing and illustrating each of these, we'll use cash flow as a case study to illustrate some points about KPIs.

Characteristic 1: KPIs Should reflect the business’ goals and ethos

First, your business goals should determine what things you’ll look at to measure.

A city mall cafe providing lunches to workers in the surrounding offices will need to serve its customers promptly and efficiently to meet its overheads and make a good profit. So they don’t encourage customers to linger. Customer turnover is an important goal in their business plan.

However, a restaurant in the local shopping centre may decide that high customer satisfaction will bring in the repeat and higher-spending customers it needs. In this case, the goal is to encourage repeat business by eliminating any reason for customer complaints.

In each instance, the choice of KPI to monitor will need to reflect the goal of the particular establishment. To see what that KPI might be, we need to look at the critical success factors that would drive the achievement of the goal.

Characteristic 2: KPIs should derive from Critical Success Factors

Continuing to look at the mall cafe example, where the critical success factor is customer turnover rate, (because that’s what drives profitability in this business). To measure that, the appropriate KPI would be the number of customers per table per opening period.

On the other hand, for the more ‘relaxed dining’ establishment trying to encourage repeat business, the critical success factor is customer satisfaction, and a suitable KPI might be the number of customer complaints – which they hope to reduce to a bare minimum through providing excellent service.

Note that in each case the KPI is derived from the critical success factor particular to that business. And by the way, note that each of these businesses already had a clear business plan that dictated their business goals in the first place. It’s really important to know what your business is really about and where you want it to go before setting up KPIs – you may be measuring irrelevant factors, ones that aren’t your real critical success factors at all.

Characteristic 3: KPIs must be measurable

The third characteristic of a useful KPI is that it must be measurable. Sounds obvious, but there’s a bit more to it than meets the eye at first glance. To get it right you ought to establish in writing four things about each chosen KPI:

A name for it
A definition of what it involves
The actual method you will use to measure it
Your goal, or performance target for this KPI

Constructing A KPI

We can construct a KPI in various ways, but some are effectively useless. The critical difference is in getting the description to a level of detail that makes it measurable in a way that gives a meaningful result. There are a few things you could improve on in documenting a KPI so let’s start with the title.

A KPI itself isn’t about doing anything like reducing defects. It’s the measure, not the desired outcome, so Defect Rate is better than Reduce Defect Rate.

Then, and this is the truly significant point, it must define what’s involved in reducing defect rate - a way of measuring it. Are defect products measured in number, component cost or lost sale value? It’s not so important which way you decide on this. What is important is that you do decide on a definite measure and, having decided, you stick with doing it that way – changing what you include in your KPI or the way you measure it will mean figures can’t be compared from one period to another or to your target, so they won’t be of any use to you.

Third, it explains just how the information is to be gathered, disseminated and used. These are very useful procedures to have sorted out as we will see.

And finally, if you haven’t thought out what the target should be, you probably won’t know when you have defects down to an acceptable level. Sure, you might know they are down this month on last month, but in the long run, what do they need to get down to be acceptable?

Characteristic 4: KPIs should allow for correction

This brings us to the last characteristic of a useful KPI – how it should point to the activities you might need to alter if things start to go off track. Since KPIs are the measures of those processes and financial markers that are critical to your business’ success when they move in the right direction you know you're on track towards achieving your objectives. When they move in the wrong direction you know you have an issue to address. So they really ought to point to just what is contributing to the problem so you can do something about changing things. You may decide you have a problem with cash flow, but is it due to slow-paying customers, poor internal cash management processes, not enough sales, or a combination?

To determine this you’ll need to drill down just a bit further by using sub-system KPIs.

KPIs for different activities – sub-system KPIs

Earlier we said a business should have only a few KPIs, maybe 6-8, to measure their CSFs and judge how they were performing in achieving their goals. That’s for tracking the company as a whole.

In reality, the business-wide goal may be interpreted into different activities for different activities or processes. So while the company goal may be to improve cash flow, for the sales activity this may translate as improving income by increasing sales, while for accounts it might mean reducing days in receivables – that revenue from increased sales is no use until you receive it! A former boss of mine used to say the sale wasn't complete until the money's in the bank. So now we have to introduce KPIs to measure how sales are going and how days in receivables are going. At times we may set up two or three KPIs in each area and we refer to these as sub-system KPIs.

When it comes to using KPIs to target areas needing correction, it’s necessary to take this more granular approach and set up several KPIs that track what’s going on in individual areas in detail.

An example will give you some idea of how this works. Cash flow is a CSF for any business because if a business runs out of money it will cease to exist. Hence, the processes involved in tracking and maintaining cash flow require measurement through KPIs. This example will also illustrate how measuring sub-system KPIs can pinpoint areas you need to work on.

KPIs in action: Cash flow – aligning strategies

The most common KPI for cash flow is days in receivables – the average number of days it takes for you to get paid. Too long, and you can experience critical cash flow bottlenecks.

You put in place a way of measuring days in receivables and find it is sufficiently outside the industry average to be worrying. Tightening up could improve the situation quite a lot.

You look for remedies – and there are many. Among them, going for an aggressive collection policy – you know, calling up your debtor the first day after the due-by date, sending in the debt collectors a week later. That sort of stuff. Great, you’re getting your money in record time. But with what consequence?

That’s right – customers might end up feeling harassed and take their business elsewhere.

So what went wrong? There’s been a failure to look at the bigger picture. Looking at both sides of the equation allows us to come up with a happy medium and ensure that your team understands that you are not prepared to have days in receivables decrease at the expense of customers, that is, at the expense of another CSF, that of maintaining or increasing customer numbers.

Lesson 1 with KPIs – when considering remedies, assess the likely impact of your strategy on the business overall. The action you choose must not push the achievement of one CSF at the expense of another or the achievement of one goal at the expense of another.

By the way, we have some suggestions about collecting what you're owed and managing your debtors - almost universal - issues in almost every business.

KPIs in action: Cash flow – pinpointing actions

A business’s overall goal translates into a set of goals for different activities. With cash flow, for sales activities, this might be simply to ‘increase sales by 2% each quarter', or whatever. Achieving this will help the business achieve better cash flow. The KPI for this will be gross sales value.

So, we’re monitoring gross sales and we note that it’s not improving. What do we do? Well, you can’t pinpoint exactly where you need to focus your corrective action if you are unsure of why gross sales have dipped. And you can determine that by having set up some KPIs to measure the activities around sales itself. By looking at these sub-system KPIs of sales we have a better opportunity to identify the real issue.

Generally, sales are made by obtaining sales leads and converting those to actual sales. If we look at the sub-system KPIs of the leads generated and the leads converted, we can quickly see what area isn’t performing. We are then able to take action based on whether we need to address our advertising and marketing to generate leads, or whether or not it is our sales process and methods that need work.

We can then also decide if we require additional information and what type of additional information is required to make an even more informed decision. Say, for example, that conversion rates were dropping, we may then need to dig further into differences in salespeople’s conversion rates or even look at seasonal comparisons.

If we are routinely keeping this type of information we can notice trends and react much faster to changed circumstances.

Managing KPI information

Let’s turn to what’s involved in collecting and managing data for a KPI monitoring system. There are several things to keep in mind here:

The information should be easy to gather
You need to gather it regularly
The information you gather needs to get to the right person, that is, the one responsible for the process it measures
The information should be promoted among team members
Remedial actions need to be coordinated across the operating units

Let’s look at each in turn.

KPI data should be easy to gather

In the design stage, you must establish that the process is measurable and that the benefit the information will provide outweighs the cost of obtaining and maintaining the data.

The person who controls the process generally understands the most efficient and effective way to measure that process. They will have a much better idea in terms of obtaining useful data to demonstrate where issues arise and motivating the team to achieve the desired results.

If the data can be collected and or analysed electronically to save the time of doing it manually, so much the better.

Gather KPI data on a regular basis

For KPIs to be useful in the management process they need to be compiled and reviewed regularly. How regularly individual KPIs are monitored is dependent on the KPI itself and the process it is measuring. The general rule is that the further down the process level of the organisation, the more focused on specific functional activity, the greater the frequency of the reporting.

The frequency of reporting becomes more evident once a KPI is defined. There is no point having a KPI reported on daily, when nobody looks at it for 30 days or if there is nothing that can be done to adjust the process anyway.

Still, at the manager level, a lot of numbers ought to be checked regularly – sales for the previous day, the backlog of orders or deliveries, how much inventory is available and so on. All can provide early warning of developing problems and allow them to be dealt with.

Get KPI data to the right person – pronto!

KPIs need to be available to the right person or people in the organisation. They shouldn’t sit on the boss’ desktop if they need to be seen by the people in charge of the operation they report on.

And they shouldn’t go for action to team members who have no control over the activity that is being measured. Ensure the person who is expected to operate on the information has been involved in the setting up of the project so you can count on their buy-in, and that they have the authority to make things happen.

Promote KPI data within the team

It can be very useful in promoting company policy and getting buy-in to make sure team members see some of the data that is being gathered – particularly in their area of operations. This can be done as a scoreboard, that is, a chart or handout, to the team. It can show the numbers that drive business profitability - sales, COGS, etc. and the KPIs for the critical success functions in their area. Some companies even include the team’s bonus evaluation forecast based on the to-date KPI indicators for profit! It can be a pretty good motivator.

Providing the scores and explaining the situation is one way of keeping them focused on the jobs that really need doing and encouraging them to move the KPIs in the right direction.

Of course, you may need to do some training around this – how many of your team would know what ‘operating efficiency’, ‘turnover’ or ‘gross margin’ mean if you presented these figures to them cold? But once they do understand what they mean, and have them available, you can also use them to brainstorm ideas on improving the situation.

Remedial actions need to be coordinated

We’ve already discussed this in the cash flow study so here are a couple of examples just as a reminder.

Actions to achieve KPI targets may conflict with each other in terms of achieving the overall plan. For example, the goal to minimise inventory stocks may jeopardise another goal such as improving customer order fill rate. You still set up the KPIs, but you need to consider the strategies for achieving the individual goals so the overall plan isn’t damaged.

Another example: If the goal was to build gross sales, the sales team might achieve it through massive discounting. So if one of your KPIs here was ‘number of sales per salesperson’ it might look pretty good. But it’s not a viable strategy and you’d need to have either ruled out discounting as a strategy from the beginning or maintain KPIs on net margins, gross margins and cost per sale, to ensure it didn’t get out of hand.

The way you choose to improve a critical number has to be consistent with the overall business plan.

KPIs and business performance management

Well, that’s pretty well it for how to create KPIs, but as mentioned in the beginning, we gather KPIs for a reason – and that reason is to improve business performance. And the basis of improvement is monitoring. There are three main ways of monitoring performance:

Have a business plan to guide your activities.
Benchmark your activities against other businesses or the industry to see how you stand.
Carry out regular financial analyses of operations.

Each of these will provide you with the essential underpinnings of a useful KPI system – goals you want to achieve. Knowing the goal allows you to identify CSFs, and knowing your CSFs points to the KPIs you’ll need to track.

KPIs, your business plan and financial reports

Having a documented business plan provides the opportunity to set out just what you want your business to achieve and how you’ll go about getting there. In doing this exercise you gain a very realistic appreciation of your market, your competitive positioning and your capabilities. But a good marketing plan will also develop some realistic goals to aim for and these become the targets for the KPIs you measure. So you know that the KPIs you are monitoring are the right ones for showing if the business is going in the direction the plan has set out.

I also recommend that you have a set of key financial ratios prepared regularly as well – not just your profit and loss account and balance sheet but also a detailed monthly cash flow analysis for instance. Your financials form a major set of KPIs for your business.

KPIs and benchmarking

Remember that KPIs relate only to your own firm – they measure how your operations are working out; so many sales per salesperson, so many days in receivables etc. But, apart from the fact that these might show you are moving in the right direction, what do they say about how you stand with regard to what other firms are achieving?

If you take the KPI figures from several similar firms and use them to construct a chart showing the average figure for poor-performing firms, the industry average overall, and how the best performers rate, then you have a benchmark against which you can compare your performance.

This sort of information can provide you with target figures for your KPIs.

KPI monitoring systems

The best way to make sure KPI monitoring happens is to set up a system for regular reporting of results. Some accounting software packages allow for this and again.

Conclusion

Some people refer to KPIs as their ‘critical numbers’ and that’s no exaggeration of their importance.

When you consider that a well-designed and regularly monitored set of KPIs can provide you not just with a knowledge of how your business is performing, but also target the areas where remedial action ought to be applied, then you can understand why they take them so seriously.

They really are the basis of effective business performance management.

Key Performance Indicators (KPI's)