In my discussions with many CEOs and CFOs it is always interesting to see what is measured and tracked. However, many times they are not measuring the right things. Here are five suggestions of what and howto measure.
1. Measure your mission / differentiation goals.
In reading the goals or mission statements of many companies, often you will see "we provide superior service to our clients". This is a very worthwhile goal or aim; however, once I get involved with a company I notice that there is no metric of customer service and satisfaction that is tied into key metrics and that drive performance bonuses. Furthermore, those that are measured are often measured in isolation and are not tracked in blind tests against those the of competitors or potential customers that didn't choose the company's products or services. Whatever is claimed to be the company's differentiation and vision should be measured and tracked to ensure that is what is being delivered.
2. Make sure you measure your strategy expectations
If embarking on a new strategic initiative ensure that you know what your expectations from the strategy are and then develop the appropriate metrics to measure its performance. Again many companies embark on new strategies and the metric tracked is often the financial contribution. Tracking financial contribution is also a worthwhile aim; however, it is the result and cannot always tell you what is driving those results. I like to think of it as measuring Return on Equity, rather than doing it through the
Du Pont analysis. While both give you the same result, the latter is much more informative as it breaks down the ROE return into different performance metrics allowing you to understand what is driving the ROE as well as do better industry comparisons. In addition, this analysis should be broken down more to look at the key drivers of revenue and expenses. As I have said on prior blogs, usually its a handful of items drive 90% of the returns so these are the one that need to be focused on, not all the noise around them.
3. Measure cash
Cash is king and all CFOs know this. However, I find that many CEOs and CFOs in small to midsized companies are not always sure of what revenue does to cash. A simple measure that I like to look at is what I call Cash generated for $1 of Revenue. The formula for this is:
Cash Generated/Revenue = Net Margin - (Net Working Capital / Revenue) + [(Depreciation + Amortization - Capital Expenditure) / Revenue]
A company that I was involved with was proud of their net margin but was always cash strapped. Applying the above formula I got:
C/R = 9.3% - 24.5% + 1.5% = -13.5%
Thus for every additional dollar of revenue, the company needed $0.135 of additional cash to fund the cash shortfall. Thus the company's strategy of aggressively growing sales could drive them into bankruptcy if they were unable to raise capital to fund this growth. Many companies have found success to be lethal and this was another example.
As I learned many years ago from a wise adviser - fix the pipe before forcing more product through it. The key in the above was to focus on the company's Net Working Capital and reduce it so that the company was generating cash for every dollar of additional revenue. Once that had been accomplished they could drive sales aggressively.
4. Tie compensation to variables that employees can influence and will continue to influence
During my career I have worked with a number of large and small companies and can say that often a large piece of the incentive compensation of many departments has been tied to things that they have no control over. Examples of this are:
a. Net contribution of the department
In firm bonuses were tied to net contribution of the department to the corporate profits. While this makes sense at a high level, the issue faced was that 50% of the department's costs were allocated by corporate HQ over which the department had no control. Doing some research it was determined that if the department could operated on a true stand alone basis with no allocated costs, it would save 10% of its costs. Thus it was proposed setting up the division separately where they would have full control over their costs, but this was rejected on the basis that if they did that then the additional costs would have to born by other departments.
Tie your employees bonuses to their direct costs which they control and measure those! If the HQ is allocating central costs then senior management is in charge of those costs and they should be rewarded on control of those costs. To often bloated central costs are divided up between departments and no looks at them carefully because they are not measured in a meaningful way.
b. Tied to operational results which excluded the departments activities
In another firm I have experience with the M&A department's compensation was tied to corporate profitability; however, the M&A department is really a cost center and there is little it can do for the overall costs of the company. Better metrics would be to tie it to the value generated by the transactions it executed, the time and effectiveness of integration planning, minimizing the costs of third party professional in doing transactions etc. These are items it could control and employees would be more incentivized to meet their objectives. So the key is to develop the appropriate metrics to drive the results that are sought.
c. Sales compensation tied to a 10 year future income stream that is not guaranteed.
Finally, I have come across situations where the sales team is incentivized by the potential revenue they generate for the company. Again this would seem to be the right motivation. However, the salesmen were being paid the present value of a ten year contract and in no example did I ever see the projections for income do anything but go upwards in a linear fashion (unless it was a hockey stick!). However, looking back over the company's history this had never once been the case in a ten year contract - Yes Virginia business cycles are real. Finally, once the salesmen signed a client they had no incentive to ensure the client stayed with the company for the full 10 years or generated the potential income on which they had been compensated. When I discussed this with the finance department they were all aware of the issues but said that if they changed the compensation all the salesmen would leave. They were helpless. A worrying signal about the corporate culture!
5. General Statistics
This may be an odd heading but I see time and time again people using statistical tools without the full appreciation of them so here are two simple reminders. For example I see people doing lots of regression analysis in Excel to project some future cost or revenue item, but when I ask if the date sample is normally distributed I get blank stares - you cannot do regression analysis if its not!
a. Need sufficient data to draw conclusions
It is amazing how many projections or statistical inferences are developed off a few data samples. Just as a reminder if you have 100 samples the error bounds on the results are 10%, to get the error bounds down to 3% the sample size needs to be 1,000. Therefore, it is always worrying when a few samples, i.e. less than 50 have been used to generate some estimate and the estimate is given with definite precision from an Excel model. There are no ranges in the model, and it all falls back into the precision vs accuracy issue.
b. Correlation does not imply causality
This seemly obvious rule is one that it would appear no television forecast has ever been made aware of. Listening to statements like "the team that is leading at the end of the 1st quarter always wins" makes me want to cry. But I see the same logic applied in corporate modeling and measurements where the equivalent of "the coin has been tails the last four throws so it will be again" is expressed with confidence. There is little question of what drives what or why the results are correlated. Remember you derive a formula to match any set of data points but it may be meaningless.
c. Measure the important stuff
As I mentioned above and as represented in the Pareto Principle, 20% of the variables drive 80% of the results. Thus focus on those items that drive the results and spend time and effort to measure and understand them correctly. The rest are not as important and can easily estimated as they will not affect the ultimate outcome significantly.
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