“We need to increase our turnover!”
“Our gross margin has to improve or we are in trouble!”
“The next year is critical for our company.”
I have been hearing these sort of comments since I joined the company 10 years ago. During this period the turnover has almost doubled and the gross margin has gone up in a similar fashion and I still hear the exact same comments.
Are these comments well-founded? Do they make sense?
If we keep increasing sales and gross profit, when will it be enough? when will we be out of trouble? when will we be able to say that it was a good year?
The answer is “it’s unknown” because success is not defined.
This is like taking a plane without a destination. We keep flying and flying and never arriving. We won’t be able to land unless we know where do we want to go.
Year after year the company kept reinvesting all the profits back into the business without distributing dividends to its shareholders. They were not happy. The reasons for not distributing dividends?
“We need to increase our turnover!”
“Our gross margin has to improve or we are in trouble!”
“The next year is critical for our company.”
I had to stop, take some distance and think. We needed to ask ourselves the right questions.
What represents success for us?
Does turnover and gross profit define success for us?
If not, what does define success? and almost as important, what value for each KPI (Key Performance Indicator)?
With these insights we decided to sit down and define what success meant for us.
After a few initial attempts writing KPIs we found out it was not as easy as we thought. There are hundreds of KPIs used by all sort of companies and you can measure pretty much everything. But our problem was that they were not capturing what success meant for us.
(1) As a first step we defined some rules to help us define the right KPIs:
• They should be objective
• Easy to obtain (measure)
• As few as possible (but not too few)
• Only indicators that measure success.
• No vanity metrics (turnover, app downloads, …)
• No activity metrics (These are for finding out why things are not working)
• They must capture what success means for us, where do we are today and the speed at which we are moving towards our target.
(2) The second step was to actually get a minimum set of KPIs that could capture what success represented to us. After many back and forths we came down to the following KPIs:
1. EBITDA
2. Profitability. (ROCE) Return On Capital Employed
3. Financial risk short-term
4. Financial risk long-term
5. Differentiation
6. Innovation to market
7. Product concentration
8. Product robustness
9. Vendor concentration
10. Vendor robustness
11. Customer concentration
12. Customer robustness
13. Customers gain
14. Customers lost
15. Recurring sales
16. Staff productivity
17. Staff turnover
I won’t get into the details of what each KPI means and how each of them is calculated because for your company they will probably be very different. If you want to know more about the rationale behind any of them let me know in the comments and I will expand on them.
(3) The third step was to assign concrete values to each KPI.
Here is where it gets exciting. Let’s use EBITDA as an example.
We want each KPI to hold a value between 0 (worst) and 10 (best) so we have to find out what 10, or in other words, success, means for us. We considered 2 million Euros to be a 10 for us.
With this information we needed to “build” the function f(x) so for each value of x (EBITDA) we will obtain our corresponding value in our KPI. Don’t get scared by this, you can make it as complex or as simple as you want. In our case we decided that if EBITDA is negative that will be 0 points and a for any positive EBITDA it will receive points depending on the magnitude to a maximum of 10 and starting at 5 points instead of 0.
This is the final formula for the function:
(Remember x = EBITDA for this KPI)
if x <= 0 then f(x) = 0 points
if x > 0 and x < 2000000 then f(x) = ((x*5)/2000000) + 5 points
if x >= 2000000 then f(x) = 10 points
Now that we have the formula we need to calculate the actual values for each year. We considered we will measure each KPI once per year, at the end of the financial period. We will calculate the values for the previous years and, for the current year, we will use the sales and expenses forecast presented by the CEO and approved by the Board of Directors.
A positive outcome of measuring all KPIs on a range of values from 0 to 10 is that it’s very easy to see how good is the performance without thinking about how they are calculated. For instance, if you get a 9 on the EBITDA KPI you know you are doing very well without having to remember the 2 million Euros mark each time, even if eventually you decide to change the 2 million mark.
(4) The fourth step is to assign weights to each KPI. (Column Weight in the picture below)
Not all KPIs are equally important. For instance for us, since we are in the middle of a business model transformation, it was very important the KPI number 5, Differentiation. This KPI measures the contribution to the EBITDA of each type of products (commodities, branded, etc). We wanted to increase the contribution of some of these groups, therefore, this KPI was weighted higher than other KPIs less important for us.
This methodology is much more powerful than standard spider web models where all dimensions have equal weight.
(5) The fifth and final step is to get the overall KPI. This is the most important KPI since it combines the information from all the other ones. It’s simply the weighted average using the weights from the previous step.
And here we go. We got our final value ranging from 0 to 10 that measures where we are today and how fast are we moving towards our success mark. This distance is conveniently measured in number of years to get there.
In our case we can see that it will take almost 6 years to achieve success taking into consideration how much we improved from year 2016 to 2017.
If we achieve the values forecasted for 2018 we could achieve success in just a bit over 2 years. Don’t take these values too seriously since as you can see we didn’t get values for all KPIs and years yet, hence how low are the final SCORES.
The “success” column will have a 10 for each category since that’s our target.
I hope you find this “success KPIs model” useful. I liked it so much that I started applying it to my personal life too.