5 Steps to Design Key Performance Indicators

A favorite saying in business performance measurement is “what gets measured, gets managed”. This is because it focuses everyone’s minds on what is measured especially if performance is reported, compared to targets and bonuses and remunerations are linked to achieving the desired performance level. 

In our previous posts, we have extensively talked about strategy settings and highlighted different ways to approach business growth. In this article, we will talk about how important it is to have the proper performance measurement in place to ensure your business is on track and if it is moving in line with the strategic direction set previously.

One quick reminder before we dive into performance measurement and setting up proper KPIs is:

Strategy setting is not a once-a-year rain dance, nor is it a once-a-decade consulting project. It must be a skill as deeply embedded in your organization as total quality, cycle-time reduction, or customer service.

Performance: A Process of Value Creation

In pursuit of value creation, business performance management and measurement has an important role to play:

  • Align top-level strategic objectives with the actual performance
  • Make calculated decisions and meaningful actions reliably
  • To be able to find opportunities for improvement or growth
  • Have visibility over problem areas and to prioritize and allocate resources accordingly
  • Monitor actual progress against strategic goals
  • To make sure the organization has sustainable performance over time

Performance can be understood and perceived in different ways. 

One key element when it comes to performance measurement is distinguishing between operational and strategic performance. Operational measures have a short time horizon as they help to measure the short-term performance of the company. In contrast, strategic performance measures are more concerned with business long term sustainability and life cycle. 

Moreover, performance can be expressed in quantitative or qualitative measures as well as through financial or non-financial dimensions.  Also, keep in mind that every industry and organization can have their own specific measures. 

For example, an airline company may present its performance in reference to:

  • Annual revenue year over year: Financial 
  • Seat utilization or revenue per passenger per kilometre: Financial & Non – Financial
  • Passenger Safety: Non-Financial 
  • Customer loyalty: Non – Financial

A retail business, however, might use sales per square-feet which has no relevance to the airline business. 

As you can see, it is important to understand your business’s strategy and to measure the success of its value creation activities over time.

How to Develop and Design Key Performance Indicators

There is no value in setting targets and performance measures if you do not design them properly. Also, keep in mind “KPIs are NOT the same as goals. The goal is the outcome you hope to achieve; the KPI is a metric to let you know how well you are working towards that goal”.

5 Steps to Create Business Performance Metrics or Key Performance Indicators

  1. Define Strategic Goals: In our previous post, we have extensively talked about strategic planning and walked you through exact steps through the process. One important takeaway from defining your strategic goals is gaining a crystal-clear image of what the organization should look like in the future. As a result, you will have a baseline to define critical success factors which are needed for the next step of this process.
  2. Develop meaningful targets: Targets are driven from critical success factors and strategic goals. They are quantified objectives with a designated time period. For example, if one of the CSF is having higher cash flow, achieving $100K of free cash in 3 months can be your defined target. Another example can be increasing month over month revenue by 2% at the end of December.
  3. Define methods, tools and the source data  
  4. Establish the Frequency of Measurement and Reporting: Decide if the you want to measure, report and analyze the metrics on a monthly or quarterly basis. Hence, having a systematic frequency is important to maintain the effective oversight.
  5. Choose the responsible team or individuals: Decide who is going to take care of measurement, record keeping and reporting

Characters of a Good KPI

  • Be based on key success factors
  • Be clear about who the audience is: Board members, sales employees,…
  • Have a balance between short-term operational and longer-term strategic performance
  • Be a mix of past, present & future (Mix of lagging and leading indicators)
  • Balance the needs of all stakeholders (Business owners, employees, suppliers,…)
  • Have a manageable number of metrics instead of having too many abstract indicators: Make this sentence better based on YouTube Video

Lagging Vs. Leading Indicators

Lagging indicators (such as financial metrics) are telling us what has happened in the past whereas leading measures focus on the “ Here and Now” view of performance and showcasing the causes or predicting what is likely to happen in the future.

For example, if the lagging indicator is to increase the profit margin by 5%, you can simply achieve that through costs cutting but you need to also have leading indicators such as market share growth or customer acquisition and retention to make sure cost cutting would not hurt essential parts of the business.

Thus, it is important to embed a mix of leading and lagging indicators into your performance measurement system. As most indicators are linked to each other, they can explain the cause or result of the other. 

Financial Performance measurement

In short, financial measures are categorized as lagging indicators as the numbers are provided after the fact. You can interpret financial performance using ratio analysis from five different perspectives:

  • Profitability
  • Liquidity (Cash)
  • Gearing (Debt)
  • Efficiency
  • Shareholder Return
Example of Different Financial Indicators

Revenue Growth Rate is an indicator of how well a company is able to grow its sales revenue over a given time period. Simply, the revenue growth rates compares the current sales figures (total revenue) with a previous period (typically quarter to quarter or year to year).

Days Sales Outstanding: is the average number of days that receivables remain outstanding before collections.

Operational Performance Measurement

Operational performance measurement enables the efficiency evaluation of your entire production process. These operational performance metrics are important to every business in removing inefficiencies and improving profits. 

Example of Different Operational Performance Indicators

Capacity Utilization Rate measures the extent to which a company is leveraging its full potential. It compares the actual capacity to its potential. For example, you own a meat processing facility and by following the formula below, you will realize you are only utilizing 65% of your facility. So, this insight might spark some ideas on how to better utilize the unused capacity.

Operating Expense Ratio is another indicator of how well a company is managing its operating costs as it shows those costs as a percentage of sales revenue.

Behavioral Consequences of Performance Measurement

Occasionally, efforts to report performance can result in a variety of unintended and dysfunctional consequences:

  • Companies tend to measure what is easy to measure, rather than what is important to measure
  • Other aspects of the business that are not measured are considered unimportant
  • Linking bonuses and remuneration packages to performance measurement targets might risk team and corporate moral as individuals are tunnel visioned on achieving the targets
  • Some may believe that performance MUST be “measured” to be useful. But not every important thing is measurable 

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