Business Information Bulletins - "Common business questions and answers"

 

What are K.P.I.'s and how do I use them to improve my business?

What they are, why they do work and how to use them. 

WHY USE K.P.I.’s

  • Because the numbers aren't reality

  • They simply reflect reality

  • The underlying activity is the reality

  • Manage the reality

 

The numbers, in isolation, don’t tell you enough about how your business is running : they merely reflect one financial outcome in a specific period – a day, a month, a year, a quarter!!

It is not until you arrange various “numbers” into relevant INDICATOR formulae, that you can compare different parts of your business, in relation to each other, and over required periods of time to produce key trends in your business.

This is why they have the name: –

KEY = important or critical

PERFORMANCE = indicates activity, execution of intent, time and fulfillment of purpose

INDICATOR = a reference point or, to direct attention to

It is important to select those indicators that are relevant to your business AND your current strategy.  Measurements must be made at similar intervals if trends are to reflect what is really happening over time.

The Key Message is: "What you can measure, you can manage!"

In deciding what are the most relevant KPI’s for your business environment and operational objectives, always ensure you rank (i.e. from most to least impact on your business) your selected KPI’s.   WHY????

Because you will probably only be able to efficiently measure 4/5 indicators at one time – otherwise you become distracted from running your core business – which is not to spend large amounts of time (yours and your staff) measuring, recording and adjusting business direction and focus each month.

The objective is to use your KPI’s to "track your progress against PRE-SET objectives and milestones" – not measuring for the sake of measuring (although the information may still be useful).

It is critical to decide what to measure and how often.  It is obviously difficult and time-consuming to measure everything, therefore those performance indicators that have the most immediate impact on the business should be considered first.  Also, it is important to decide exactly how long any key indicator should be measured for and at what point the “optimum score for the business” has been reached.

Remember, there is no one key performance indicator that spells success or failure (other than perhaps liquidity i.e. no cash = no business), most KPIs are inter-related – i.e. changes in one can often directly impact others.

KPI Examples

NB. Each table reflects the use of KPIs for different analyses and projections and all KPIs are shown in red.

Table 1.   Use of the previous three years P & L history to forecast the next year’s overall financial targets.

In this example, the company is targeting (in 2005) a significant lift in both SALES and OPERATING PROFIT.  The impressive profit gain (= +$211k or 390%) has come from an increase in sales of $349k (= +11.3%), a slight improvement in gross margin (assumed from the trend evident in the previous three years, i.e. 36.7% => 37.4% => 39.7% => 41.0%), and a small reduction, in dollar terms, in expenses (i.e. $27K). 

The net effect is a significant return to an acceptable profit rate from what looks like historically poor profit performances.  Any operating profit that is returning less than 5% on sales indicates the need for a serious re-evaluation of operational and financial efficiencies.

  2002 2003 2004 2005 Budget
Sales ($ 000's) 2990 3148 3101 3450
Gross Profit 1097 1178 1230 1414
Gross Profit Margin (% of Sales) 36.7% 37.4% 39.7% 41.0%
Expenses 1040 1113 1176 1149
Expense Ratio (% of Sales) 34.8% 35.4% 37.9% 33.3%
Operating Profit 57 65 54 265
Op. Profit (% of Sales) 1.9% 2.1% 1.7% 7.7%
Net Profit After Tax (@30% rate) 39.9 45.5 37.8 185.5
Tax Paid Profit (% of Sales) 1.3% 1.5% 1.2% 5.4%

Ratio Calculation Examples: -

 

 

 

(a) Gross Profit Margin ?

1097 / 2990

=     0.3668

or     36.7%

(b) Expenses ?

1176 / 3101

=     0.3792

or     37.9%

(c) Operating Profit ?

265 / 3450 

=     0.0768

or     7.7%

(d) NPAT ?

45.5 / 3148

=     0.01445

or     1.5%

Table 2.   Uses a quarterly budget forecast format to present the annual budget targets.

This allows management to breakdown the annual performance objectives into more manageable reporting timeframes.  A further breakdown would be into individual months for the full year – this then allows very tight targets to be set and monitored, probably on a weekly basis.  It this process of gradually reducing business objectives into their smallest manageable segments that really leans heavily on the use of KPIs.

If one month’s performance comes in below target, the team will know immediately by how much and probably why!  They can then readjust effort for the following months to pick up the drop in performance.

2005 Budget

Qtr 1

Qtr 2

Qtr 3

Qtr 4

Total

Sales ($ 000's) 835 871 890 854 3450
Gross Profit 325 348 365 376 1414
Gross Profit Margin (% of Sales) 39% 40% 41% 44% 41.0%
Expenses 317 314 294 224 1149
Expense Ratio (% of Sales) 38% 36% 33% 26% 33.0%
Operating Profit 8 34 71 152 265
NBPT (% of Sales) 1.0% 3.9% 7.8% 17.8% 7.7%
Net Profit After Tax 5.6 23.8 49.7 106.4 185.5
Tax Paid Profit (% of Sales) 0.7% 2.7% 5.6% 12.5% 5.4%

Table 3.

This table shows an example of how the financial logic generated by key performance indicators can be extended over a five-year projection.  Assuming the business information accuracy is high and management assumptions are realistic, the company now has a five-year vision of what is possible if each year delivers its intended targets.

The real objective of this type of business planning is that the company will always be striving to meet or better its performance targets.

As economic conditions and industry performance changes (as they will over time), these targets will need to be constantly reviewed and revised using the latest company performance and market information.

For example, if 2005 only ends up (for whatever reason) with $120k tax paid profit ( = 3.5% instead of 5.4% of sales), it may be prudent to lower 2006 -2009 targets by a percent or two.  The key objective is to use the immediate past performance to shape the reality and logic of possible future performance. 

We often hear the world’s largest corporations predicting their full year profit figures – this is how they do it!

 

2005 Budget

2006

2007

2008

2009

Annual Growth rates +11% +8% +6% +5% +5%
Sales ($ 000's) 3450 3726 3950 4147 4354
Gross Profit 1414 1528 1659 1742 1872
Gross Profit Margin (% of Sales) 41% 41% 42% 42% 43%
Expenses 1149 1231 1284 1327 1372
Expense Ratio (% of Sales) 33% 33% 32.5% 32% 31.5%
Operating Profit 265 297 375 415 480
OBPT (% of Sales) 7.7% 7.8% 9.5% 10% 11%
Net Profit After Tax (@30% rate) 185.5 208 263 291 336
Tax Paid Profit (% of Sales) 5.4% 5.6% 6.7% 7.0% 7.7%
*$ Operating Profit Growth Rate +390% +12% +26% +10.6% +15.6%
TARGETS AFTER ADJUSTMENT          
Net Profit After Tax 120 168 218 249 283
Tax Paid Profit (% of Sales) 3.5% 4.5% 5.5% 6.0% 6.5%

These examples, showing the generation and use of key performance indicators, should clearly emphasize to small business owners the commercial importance and necessity of undertaking this exercise during both the planning of future business periods and during the annual execution of those plans!

The Business Solutions Shop can help you develop and use KPIs to improve business performance!!

 

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