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Performance indicators are measurable indicators that demonstrate the achievement of an outcome. They enable decision-makers to assess progress towards the achievement of intended outputs, outcomes, goals, and objectives, and are chosen to reflect the critical success factors of a project.
The term KPI has become one of the most over-used and little understood terms in business development and management. In theory it provides a series of measures against which internal managers and external investors can judge the business and how it is likely to perform over the medium and long term.
The KPI when properly developed should be provide all staff with clear goals and objectives, coupled with an understanding of how they relate to the overall success of the organization. Published internally and continually referred to, they will also strengthen shared values and create common goals.
What are the key components of a KPI?
The KPI should be seen as only Key when it is of fundamental importance in gaining competitive advantage and is a make or break component in the success or failure of the enterprise. For example, the level of labour turnover is an important operating ratio, but rarely one that is a make or break element in the success and failure of the organization. Many are able to operate on well below benchmark levels and still return satisfactory or above satisfactory results.
The KPI should be seen as only relating to Performance when it can be clearly measured, quantified and easily influenced by the organization. For example, weather influences many tourist related operations - but the organization cannot influence the weather. Sales growth may be an important performance criteria - but targets must be set that can be measured.
The KPI should be seen as only an Indicator if it provides leading information on future performance. A considerable amount of data within the organization only has value for historical purposes - for example debtor and creditor length. By contrast rates of new product development provide excellent leading edge information.
Obviously KPI's cannot operate in a vacuum. One cannot establish a KPI without a clear understanding of what is possible - so we have to be able to set upper and lower limits of the KPI in reference to the market and how the competition is performing (or in the absence of competition, a comparable measurement from a number of similar organizations). This means that an understanding of benchmarks is essential to make KPI's useful (and specific to the organization), as they put the level of current performance in context - both for start ups and established enterprises - though they are more important for the latter. Benchmarks also help in checking what other successful organizations see as crucial in building and maintaining competitive advantage.
Criteria in developing a KPI
Is the control information key to the success of the organization?
Can we measure it and influence it?
Does it provide leading edge indications of future developments?
Measures in KPI Development
Gross profit is one key measure to the success of the organization. Research shows that survival rates are linked to levels of gross profit; gross profit margins above that of the competition provide clear evidence of competitive advantage.
Return on capital employed is another key measure of the success of the organisation. The ability to use investment effectively is central to effective long term development.
Z score is a measure of the liquidity of the enterprise and clearly defines positive or negative trends.
The conclusion from this analysis is that in financial reporting the company should concentrate on gross profit, return on capital employed and Z scores as their key performance indicators. Both gross profit and return on capital employed are part of the "model" balanced scorecard for overall objectives that form part of majority of enterprises' planning platform.
The balanced scorecard and KPI's
In addition to the creation of the enterprise balanced scorecard, in which gross profit, return on capital and Z scores are standard elements, the identification of KPI's in each of the operational areas or knowledge centres also assists the enterprise in plan development. These KPI's will change over time, but their creation as part of the initial creation of each knowledge centre will focus and direct their operational activities.
Where else are KPI's valuable?
The KPI is central to a number of other elements in the planning platform which provides the basis for answering the three crucial planning questions:
Where are we?
Where do we want to be (and when)?
How are we going to get there cost effectively?
In addition to the creation of knowledge centres and business monitoring, KPI's have a vital role to play in:
Action planning and implementation with an emphasis on management by objectives;
Training as part of a company wide approach to focusing staff and management on essential operational requirements;
Central to business planning as a core part of the business plan outline;
Identification of necessary actions in change management, exit planning and survival and recovery planning;
They set priorities for investment appraisal, and the choice of emphasis that should be given to the main strategies within the golden circle, consolidation (including cost cutting), market penetration, market development and product development.
Training on key performance indicators, the creation of a business plan and standard operating procedures.
Characteristics of a Good KPI
There's a lot of talk these days about key performance indicators (KPIs). They are the backbone of scorecards and dashboards, which have become an irresistible way for organizations to present performance information to executives and staff.
People use the terms "KPI" and "metric" interchangeably. This is wrong. A KPI is a metric, but a metric is not always a KPI. The key difference is that KPIs always reflect strategic value drivers whereas metrics may represent the measurement of any business activity.
When developing KPIs for scorecards or dashboards, you should keep in mind that KPIs possess distinct characteristics. Although metrics may exhibit some of these characteristics, good KPIs possess all of them.
1. KPIs Reflect Strategic Value Drivers
KPIs reflect and measure key drivers of business value. Value drivers represent activities that, when executed properly, guarantee future success. Value drivers move the organization in the right direction to achieve its stated financial and organizational goals. Examples of value drivers might be "high customer satisfaction" or "excellent product quality."
In most cases, KPIs are not financial metrics. Rather, KPIs reflect how well the organization is doing in areas that most impact financial measures valued by shareholders, such as profitability and revenues. As such KPIs are "leading" not "lagging" indicators of financial performance. In contrast, most financial metrics (especially those found in monthly or annual reports) are lagging indicators of performance.
2. KPIs Are Defined by "Executives"
Executives define value drivers in planning sessions which determine the short- and long-term strategic direction of the organization. To get the most from these value drivers, executives need to define how they want to measure their organizations' performance against these drivers. Unfortunately, too many executives terminate strategic planning sessions before they define and validate these measurements, otherwise known as KPIs. The results are predictable, giving proof to the adage, "You can't manage what you don't measure."
3. KPIs Cascade throughout an Organization
Every group at every level in every organization is managed by an "executive" whether or not the person carries that title. These executives may be known as "divisional presidents," "managers," "directors," or "supervisors," among other things. These "executives" also need to conduct strategic planning sessions that identify the key value drivers, goals, and plans for the group. At lower levels, these elements may be largely defined and handed down by a group higher in the hierarchy.
However, in every case, each group's value drivers and KPIs tie back to those at the level above them. In other words, all KPIs are based on and tied to the overarching corporate strategy and value drivers. In this way, top-level KPIs cascade throughout an organization, and the data captured by lower-level KPIs roll up to corporate wide KPIs. This linkage among all KPIs, which can be modeled using strategy mapping software, supports flexible analysis and reporting at any level of granularity at any level of the organization.
4. KPIs Are Based on Corporate Standards
The only way cascading KPIs work is if an organization has established standard measurements. This is deceptively hard. It can take organizations months if not years to hash out the meaning of key measures or entities, such as "net profit" or "customer." In some cases, organizations can only agree to disagree and use metadata to highlight the differences in reports. Only with enough top executive support can organizations overcome the political obstacles associated with standardizing definitions for commonly used KPIs.
5. KPIs Are Based on Valid Data
When pressed, most executives find it easy to create KPIs for key value drivers. In fact, most industries already have a common set of metrics for measuring future success. Unfortunately, knowing what to measure and actually measuring it are two different things. Before executives finalize a KPI, they need to ask a technical analyst if the data exists to calculate the metric and whether it's accurate enough to deliver valid results. Often, the answer is no! In that case, executives need either to allocate funds to capture new data or clean existing dirty data. Or they need to revise the KPI. Providing cost estimates for each approach will help executives decide the best course of action.
6. KPIs Must Be Easy to Comprehend
One problem with most KPIs is that there are too many of them. As a result, they lose their power to grab the attention of employees and modify behavior. many KPIs makes it difficult for employees to peruse them all and take requisite action.
In addition, KPIs must be understandable. Employees must know what's being measured, how it's being calculated, and, more importantly, what they should do (and shouldn't do) to positively affect the KPI. This means it is not enough to simply publish a scorecard; you must train individuals whose performance is being tracked and follow up with regular reviews to ensure they understand and are acting accordingly.
7. KPIs Are Always Relevant
To ensure that KPIs continually boost performance, you need to periodically audit the KPIs to determine usage and relevance. If a KPI isn't being looked at, it should probably be discarded or rewritten. In most cases, KPIs have a natural lifecycle. When first introduced, the KPI energizes the workforce and performance improves. Over time, KPIs lose their impact and should probably be revised. Most organizations review and revise KPIs quarterly.
8. KPIs Provide Context
Metrics always show a number that reflects performance. But a KPI puts that performance in context. It evaluates the performance according to expectations. The context is provided using 1) thresholds (i.e. upper and lower ranges of acceptable performance), or 2) targets (i.e. predefined gains, such as 10% new customers per quarter), or 3) benchmarks, which can be based on industrywide measures or various methodologies, such as Six Sigma. In addition, most KPIs indicate the direction of the performance, either "up," "down," or "static."
9. KPIs Empower Users
As stated above, you can't manage what you don't measure. But a corollary is that you can't manage what you don't reward. To be effective, KPIs must be reinforced with incentives. It's important not to link incentives to KPIs until the KPIs have been fully vetted. Often, KPIs must be tweaked or modified before they have the desired effect.
It's also critical to revamp business processes when implementing KPIs. The business process needs to empower users to take the appropriate action in response to KPIs. The last thing you want is informed but powerless users. That's a recipe for disillusionment and poor morale.
10. KPIs Lead to Positive Action
Finally, KPIs should generate the intended action-improved performance. Unfortunately, many organizations allow groups to create KPIs in isolation. This leads to KPIs that undermine each other. For example, a KPI for a retail store might track stock outs (when it lacks enough merchandise on hand to meet demand) but the regional warehouse has an incentive to carry minimal inventory. If the regional warehouse does too good a job, it may not have enough inventory to keep the retail shelves stocked when there is a surge in demand for certain merchandise.
Another problem is human nature. People will always try to circumvent KPIs and find loopholes to minimize their effort and maximize their performance and rewards. Good KPIs are vetted before deployed and closely monitored to ensure they engender the intended consequences.
Importance of KPIs
Key Performance Indicators (KPIs), which are sometimes referred to as Key Success Indicators (KSIs), are the metrics that a company (or a department within a company) chooses to measure its success against.
They can be both hard financial measures (such as number of sales, or revenue, or costs) or they can be soft non-financial measures (such as customer satisfaction).
A KPI is simply a metric that is tied to a target. Most often, a KPI represents how far a metric is above or below a pre-determined target. KPI's usually are shown as a ratio of actual to target and are designed to instantly let a business user know if they are on or off their plan without the end user having to consciously focus on the metrics being represented.
The KPIs help the company to assess how it is doing in terms of the targets that it has set itself, and they can act to incentivise superior performance. Often KPIs are linked to staff review appraisals - e.g. if the customer support team meets its customer satisfaction KPI, then its members get their yearly bonus.
As you can no doubt appreciate, KPIs have to be specific and capable of measurement. It's no good having KPIs that say:
- We want to increase customer satisfaction
- We want to increase sales
These are far too woolly! Instead, they would need to be along the lines of:
We want to achieve a score of 90% 'very satisfied' or 'satisfied' in our 2007 customer satisfaction surveys
We want to achieve 10,000 sales of our product by the end of 2007
KPI help change the way people do their jobs, approach their day, and deal with daily roadblocks.
KPI help people focus on the "big picture". KPI help people distinguish the important from the trivial, the "must be done" from the "could be done" and allow employees to set their own priorities. When the boss passes and sees performance charts, questions follow. People begin to learn the importance of those measures.
KPIs are an invaluable means of ensuring that your company focuses on what's important and that targets are met and exceeded. The focus placed on them should come right from the top, and their importance then needs to be cascaded throughout the organization. It's no good senior management taking them seriously if the sales staff haven't bought into them.
Types of KPIs
Key performance indicators come in three types:
Process KPIs measure the efficiency or productivity of a business process. Examples include "Product-repair cycle time," "Days to deliver an order," "Number of rings before a customer phone call is answered," "Number of employees graduating from training programs," and "Weeks required to fill vacant positions."
Input KPIs measure assets and resources invested in or used to generate business results. Examples include "money spent on research and development," "Funding for employee training," "New hires' knowledge and skills," and "Quality of raw materials."
Output KPIs measure the financial and nonfinancial results of business activities. Examples include "Revenues," "Number of new customers acquired," and "Percentage increase in full-time employees." Three particularly common output KPIs that are used by managers include:
Return on investment (ROI): Return on investment represents the benefits generated from the use of assets in a company, unit, or group-or on a project. ROI is helpful to top executives, finance managers, board members, and shareholders. A possible way to express return on investment is to divide net income (revenues less expenses less any liabilities, such as taxes) by total assets. ROI measures how effectively managers have used resources, and can be figured as follows:
ROI = Net Income/Total Assets
Economic value added (EVA)â„¢: EVA, popularized in the 1990s by U.S. management consultancy Stern Stewart & Co., is defined as the value of a business activity that is left over after you subtract from it the cost of executing that activity and the cost of the physical and financial capital deployed to generate the profits. In the field of corporate finance, EVA is a way to determine the value created, above the required return, for a company's shareholders. It's therefore useful to senior management, boards, and shareholders and other investors. EVA is calculated as follows:
EVA = Net operating profit after taxes minus (net operating assets multiplied by the weighted average cost of capital)
Shareholders of a company receive a positive EVA when the return from the equity employed in the business's operations is greater than the (risk-adjusted) cost of that capital.
Market share: The percentage of sales in a given industry segment or sub-segment captured by your company.
All three types of KPIs-process, input, and output-generate valuable performance information. A mix of the three types ensures a comprehensive picture of your unit's or organization's performance
While an organization may have hundreds or thousands of metrics, it should only have a few dozen KPIs that focus employees on the key activities that deliver the most value to the organization.
In essence, KPIs are communications vehicles. They enable top executives to communicate the mission and focus of the organization and grab the attention of employees. When KPIs cascade throughout an organization, they ensure everyone at every level is marching together in the right direction to deliver the most value to the organization as a whole.