Business consultant Josh Patrick says that most businesses 1) don't know how to identify key performance indicators, and 2) aren't sure what to do with them once they do recognize the KPIs.
Photo credit: Image courtesy Josh Patrick, Stage 2 Planning Partners
We are taught that our most important measurement in business is the profit or loss that we have at the end of the year. Many of us work for an entire year before we know what that number is. And, once we find out what our profit or loss is, we then put the report away and never look at it again.
If we spend a little more time with our financial reports, we might look at our balance sheet. We often don't understand what the different numbers mean and then put that report away also.
I believe the main reason we don't use our financial reports in a meaningful manner are the following reasons:
- We don't understand how to read our basic financial reports.
- Our financial reports don't come to us in a timely manner.
- We don't share our financial information with anyone in the company (as if the others in our company would have any better understanding of our numbers than we do, right?).
- We don't make the financial reports a roadmap for how we can measure our company performance, and we don't work with key areas of our company that drive the important numbers on our financial statements.
- We don't understand why our basic financial reports are the raw information needed for knowing what the drivers are that influence the financial return our business provides.
Enter key performance indicators
Key performance indicators are the two or three numbers from our financial reports (profit and loss statement, balance sheet and cash flow statements) that spell the difference between success and failure. These numbers are often not the ones we look at first when we review our reports.
Key performance indicators are often numbers that we don't understand because we don't know which numbers are key and which numbers are not key on our financial statements. The key numbers are the measurements that can easily help us significantly improve the financial, service or efficiency in our companies.
Working with a key performance indicator (KPI) allows you to understand what the drivers are in your business to make your business better. For example, in some businesses knowing not only how much inventory you have on hand, but how long it takes to sell your inventory might be a key performance indicator. For others, the amount of cash your business has on hand can be a key performance indicator. And, still for another business a key performance indicator might be gross profit that the business produces.
The important thing to remember when thinking about the concept of a key performance indicator is to know which three or four numbers in your financial reporting package tell you show successful your company has been. Once you figure out which numbers are important, we can then move to the second step, what drives those key performance indicators in a positive or negative direction.
Drivers, the breakfast of champions.
Understanding what KPIs are important in your business is a good start. To make good use of your new understanding of KPIs you must know what the drivers are for those KPIs. To improve your business, you must not only measure what your key performance indicators are, you must also know actions will improve those key performance indicators.
For example, if we have inventory turns as a key performance indicator, it's important to know how often it takes us to sell the inventory we have on hand. If it takes us four months to sell our inventory and we have $500,000 of inventory on hand, then we will cycle through this inventory four times per year.
If we believe that we can improve our inventory turns from four times per year to eight times per year, we'll end up creating $250,000 of cash. This can be found money, but first we need to understand what specific actions in our company cause us to have $500,000 in inventory. Are there things we can measure or do that will help us increase how fast we turn our inventory? Or, to put it another way, are there things we can do to decrease the amount of inventory we need to keep on hand?
The actions or things that we can do to improve our inventory turns is called drivers. In and of themselves, KPIs won't do much to improve our business. Understanding and taking actions to improve the drivers in our business will result in improving KPI numbers which makes our businesses better.
A side conversation into the concept of open book management
I often have conversations with business owners about implementing a KPI program in their company. We often get hung up in sharing numbers with the employees in the company I'm speaking with. If we want to improve the financial operations of our companies, we need to be prepared to share certain financial information with our employees.
If we're going to identify key performance indicators in our company and then notice what drives those numbers, we need to share this information with the people who work in our organizations.
Sharing information about what actions we want to take, measuring those actions and posting results from new actions is called open book management. Opening certain financial reporting and the measurements to everyone in our company will often spell the difference between excellent and mediocre financial performance.
If you're not willing to share all of your financial numbers with your employees, start small and see how working on one key performance area with shared drivers helps your business. If you see a positive result (and we think you will) expand the program to other KPI's you may want to see improved.
Let's say that your business averages a cash balance of $100,000 at the end of every month. You also find that even though you average $100,000 in cash you often find yourself in a position where your checking account is overdrawn and you actually have a negative cash balance. When this happens your bookkeeping department gets tense, you slow payments to suppliers and you're not able to negotiate favorable terms or prices with your suppliers.
One of our KPI goals might be to improve our cash position where the worst that we ever end the month with is $100,000 and we want to improve our average ending cash balances to $250,000. We have now designed a goal for a key performance indicator.
The next step we have is to figure out what are the things that we do that influence what our drives our cash balance. These things are called drivers. For our sample company, some of the drivers they have are:
- Gross profit
- Labor costs per unit sold
- Average receivables and days those receivables are open
- Amount of money required every month for note payments
- Average amount of inventory on hand and how long it takes to sell that inventory
We have five different drivers that we've identified that influence how much cash we'll have at the end of the month. We've decided that we can only work on two of them over the next six months.
Because there are five drivers which we have identified, we need to choose which of the two would have the largest effect on cash and which two would be the easiest to design operational changes that will help improve our cash position. With good luck the ones that are the easiest to implement would also be the ones that would have a large effect on cash.
Up to this point we've not had to share any of this information with anyone in our company. We could design changes we want made and then demand that our employees implement those changes. Or we could communicate what our goals for cash improvement are and get input from our employees on which of the five would give us the best return for effort.
Choosing the later brings our employees into the conversation about what makes our business better. I've always believed that our employees are experts at their job. Asking for their opinion about specific actions we can take often produce results that are much better than those I ever could come up with by myself.
Embarking on a program to focus on key performance areas will help make your business better. Just identifying the key performance areas of your company is a good start. Identifying the drivers for those key performance areas helps you achieve a higher-level success. Letting your employees participate in the process moves you from being a top-down company to one where all are expected to participate.
The economic environment that we live in today doesn't allow us the luxury to ignore parts of our business that could be made better. Tools exist to help us identify areas of our business that can be improved. You can implement a process in your company that will improve financial performance, service levels and cash. All you need to do is start thinking about your business in an integrated manner.
About the author: Josh Patrick, CFP, CLU, ChFC, is principal of Stage 2 Planning Partners, South Burlington, Vt., and specializes in working with closely held business owners on a variety of concentrated issues that are unique to owners of private firms. He can be reached at 877-880-5112; email: firstname.lastname@example.org; www.stage2solution.com.