Evaluating KPIs

How would you feel about taking a cross-country road trip without knowing the amount of gas in your tank, your engine’s temperature or your oil pressure? That’s why you have an instrument panel on your vehicle’s dashboard.

Your business can have a dashboard, too, that features key performance indicators (KPIs). Some metrics may be applicable to any business, while others need to be customized for your specific operating conditions. However, if they’re too complicated to create and monitor, you might veer off course or crash while staring at your dashboard.

Profitability

The bottom line on business performance is just that — the bottom line. Over the long run, profitability metrics are important for every business.

But there may be reasons to temporarily operate at a loss. Examples include start-ups breaking into new markets and low-cost producers trying to take away market share from competitors. External conditions (such as a government-mandated lockdown or a natural disaster) may also cause a business to lose money temporarily.  

In most cases, businesses that are losing money have a problem that demands immediate attention. Common profitability metrics include:

• Gross margin [(revenue – costs of sales) / revenue], and
• EBITDA (earnings before interest, taxes, depreciation and amortization).

You can determine the optimum level of profitability for your business by researching common profit ratios for companies in your industry, geographic location and size. Also make sure that you aren’t under-investing in your business’s future.

Beware: Companies that pursue profits at all costs may suffer adverse effects. For example, employees who are spread too thin may feel overworked, leading to burnout, accidents, errors and high turnover. Likewise, companies that pay below-market wages or skimp on benefits and training may experience high turnover and difficulty recruiting skilled workers. Cuts to the marketing budget, failure to maintain equipment and postponed technology upgrades might boost current profits, but they can impair performance and value over the long run.

Employee Productivity

Personnel costs — including salaries, wages, bonuses, payroll taxes and benefits — are typically a company’s biggest expense category. Management wants to make sure the company is getting its money’s worth, especially as labor rates and health care benefit costs have gone up in recent years.

Some companies use labor cost per unit produced as a KPI. A unit may be a product or service. This KPI may be more relevant when you track it over time and see how it correlates to your bottom line, as compared to other cost categories. To illustrate, suppose your business is sufficiently profitable today (however you define that) and your labor cost per unit produced is $100. A year later, your wages remain stable, but you’ve invested in new equipment to help boost productivity. If those tools are effective, you’d expect to have a lower labor cost per unit. However, it may take some time to recoup the cost of your investment.

Alternatively, some companies measure labor time per unit produced. For example, a medical practice might calculate average time spent per patient. That approach lets you isolate the productivity rate of labor from changes in labor cost. This can provide a simpler assessment of the impact of new productivity tools.

These “tools” can also be intangible, such as skills training, that enable employees to do more without another change to their work environment. It could even include the introduction of a new department head or supervisor. By tracking changes in the labor cost or time per unit, you can assess whether the new hire is having a positive effect on productivity.

Some productivity metrics may be industry specific. For example, a clothing retailer might calculate average units or dollars for each sales transaction. Or an auto dealership might calculate vehicles sold per week for salespeople or vehicles serviced per week for technicians.

Another metric to consider is time spent on productive activities vs. administrative ones (such as meetings, filling out forms and paid leave). This KPI helps assess the cost of your “overhead” labor. For example, a law office may compute billable vs. nonbillable hours for its paralegals and junior lawyers. If the percentage of nonbillable hours increases over time it might signal a red flag, especially if accompanied by declining profitability.

Productivity can also be measured qualitatively. For example, suppose your company has a goal to improve customer satisfaction. You might ask customers to complete surveys after they purchase a product or receive a service, and then track the percentage of employees rated at different performance levels. You may decide to reward those with high scores and provide additional training to get under-performers back on track.

Other Target Areas

The rest of your dashboard should be customized based on what drives your company’s value. KPIs differ from one company to the next based on the industry and the company’s objectives. Common examples include:

Operating cash flow. Cash is king. This metric helps management evaluate how much cash is available for immediate spending needs.

Return on assets. This metric (net income / total assets) measures how effectively your company is managing its assets to generate earnings.

Asset turnover ratios. How much revenue is generated for each dollar invested in assets? You might want to look at the big picture (revenue / total assets). Or you might prefer to break it down by different categories of assets and evaluate it in terms of days (rather than the number of times an account turns over). For example, you might compute days in receivables [(average receivables / annual revenue) × 365 days] or days in inventory [(average inventory / annual cost of sales) × 365 days].

Productivity metrics also can be industry specific. For example, a hospital might be evaluated based on revenue per bed or a hotel based on revenue per room. The key when selecting KPIs is that they must be both specific and measurable.

A Custom Approach

These are just a sampling of metrics you can use. When designing your dashboard, the goal is to identify and track the most relevant KPIs. This information can help you make important tactical and strategic decisions in a timely manner to keep your business healthy in today’s volatile market conditions.

Many IT tools, including project management software, are available to help you crunch the numbers. Your financial advisor can guide you in finding the best way to measure and monitor your business performance.