What Are Key Performance Indicators and Why Are They Important?
“You can’t manage what you can’t measure.”
We have heard it again and again. This phrase seems to be the creed of the business world. There is something about assigning a number and correlating that with meaning to prove we are being successful.
Just like in sports, success is measured by the score. In business, success is measured managed by numbers. In many cases, these measurements are tracked and monitored to help management gauge the performance of the company, and these kinds of metrics are referred to as Key Performance Indicators (KPIs).
In business, many of a CFO’s responsibilities are to develop KPIs applicable to the company, regularly support the analysis of those KPIs, and driving changes that directly improve KPIs. All of these actions are done to hopefully improve the future value of the company.
Start the ConversationThe Importance Of KPIs To Business Success
Businesses are multi-faceted and so a company needs to monitor several different KPIs to provide insight into how the business is performing. Some of these measurements may be more basic, like inventory turnover. While other KPIs can be more involved, such as employee utilization or profitability by an individual client or product line.
Once KPI goals are defined, it is important to understand how those measurements can be used to enhance the performance of the business. For example, JPMorgan Chase & Co was able to reduce their fully burdened labor costs by $3.2 million annually by eliminating voice mail for consumer-bank employees.
Another great example is with one of our very own brewery clients. We were able to increase profits by 15% after adjusting their pricing and distribution strategies following a detailed analysis of their profit margins by individual product line.
It’s important to understand that knowing what to measure matters and then making operational changes to influence those measurements directly can have a significant impact on the bottom line. If you measure many things that don’t matter, you’ll end up with a ton of meaningless data.
What Are The Examples Of Key Performance Indicators?
KPIs will be different for every business. Below are some basic examples, how they can be calculated, what they measure, and the best way to use the measurement to improve profitability.
Days Sales Outstanding
(Accounts Receivable) / (Sales on Credit or Terms) x (Number of Days the Sales Represent)
This KPI measures how many days of sales are in accounts receivable. Hopefully, this measurement will be at (or near) what your credit terms are. For example, if you have credit terms of 45 days, your day’s sales outstanding should be close to that number. This KPI can be impacted by offering a slight discount for early payment to reduce outstanding accounts receivable.
Read More: Managing Your Revenue Cycle: 6 Accounts Receivable Best Practices
Inventory Turnover
(Cost of Goods Sold) / (Average Inventory) x (12 Months)
This KPI measures the number of times the inventory is sold–or the amount of turnover–in one year. An inventory turn of 1 would mean you sell all your inventory once a year, whereas an inventory turn of 12 would indicate you sell your inventory every month. This KPI is influenced by reducing slow-moving or excess inventory, or by increasing sales, which will, in turn, improve cash flow.
Days Sales in Inventory
(Average Inventory) / (Cost of Goods Sold) x (Number of Days)
This KPI measures how many days of inventory is on hand. It is similar to inventory turnover but indicates the number of days until inventory is sold. For example, if the day’s sales in inventory are 30 days, then the inventory turns would be 12 (or once a month). You can affect this KPI by carrying the least amount of inventory necessary to meet demand.
Working Capital
(Current Assets) – (Current Liabilities)
This KPI measures the available assets to meet short-term financial obligations. These types of assets can include cash, investments, or accounts receivable. A company can analyze financial health by seeing which available assets can meet short-term financial debts. To calculate working capital, subtract current liabilities from current assets such as the examples mentioned earlier.
Return on Assets
(Net Income) / (Total Assets)
This financial KPI measures the rate of earnings generated from invested capital in assets and can be affected by increasing earnings and/or reducing invested capital.
Return on Equity
(Net Income) / (Shareholder’s Equity)
This financial KPI measures the return on capital invested by shareholders of the company and can be affected by increasing earnings and/or reducing the amount invested by shareholders.
What KPIs Are Important To Measure?
KPIs for capital-intensive industries (manufacturing, distribution, telecommunications, transportation, etc.) often focus on how effective and efficient assets are utilized to produce a return. Whereas KPIs for service-based organizations (i.e., companies that bill people, hours, or projects to clients) tend to focus on utilization (percentage of total working time charged to customers) to drive profitability.
Most businesses, regardless of the industry, should measure KPIs that focus on generating positive cash flow from operations. Companies should also monitor how quickly it can turn sales into cash (days sales outstanding) or how long the money is invested in inventory (days sales in inventory).
The important thing is to determine what measurements are most appropriate for your specific business and industry. One way to do that is to look at other companies in the same industry and identify what measurements they are using. Those analyses can also be used as benchmarks to compare your business against others in the same industry.
Read More: Analyzing Employee Utilization Rates to Drive Profitability for Professional Services Firms
Talk to An ExpertHow Signature Analytics Can Help
Profitability is the easiest and most straightforward measurement of a company’s success. However, if you want to take your business to the next level, it is also important to look at other key performance indicators that can drive profitability and how they can be influenced to increase and drive performance. If you need help identifying, monitoring, and influencing KPIs to improve the current and future value of your business, contact us today for a free consultation.
