While a performance measurement is defined as the process of evaluating how well organizations are managed and the value they deliver for customers and other stakeholders (Moulin, 2002), a key performance indicator (KPI) is a type of performance measurement that helps to evaluate how well a particular activity is performed. In the context of this article series, a KPI is used to track how successfully business operations, conducive to value creation are performed. The practice of improving business performance through performance measurement is called performance management.
Performance management is becoming increasingly scientific. Yet, while top performing western companies largely embrace performance management to the point of leveraging artificial intelligence (AI) technologies, sub-Saharan African companies lag behind in the notion of using KPIs to improve value creation. The latest example has been Camair-co which, up to the time this article is being published, has never been profitable[1] since its creation partially because of its inability to monitor its KPIs on a weekly basis (Investir au Cameroun, 2017). Failure to sufficiently leverage KPIs to improve business performance is usually attributed to managements’ overconfidence in their business acumen, a tendency to rely on easily accessible information and a habit of falling into a status quo bias of sticking to generally accepted KPIs even though they tend to change over time as industry dynamics evolve (Mauboussin, 2012).
Beyond the above described common traps preventing managers from adequately utilizing KPIs, is a fundamental neglect (from Central African business managers) of their significance in day to day business activities and the stakes they hold for successfully competing in increasingly globalized markets. As such, this article aims to explain why KPIs should be taken seriously. Through business case illustrations, this article reveals how KPIs enhance performance monitoring, establish benchmarking, focuses organizations’ efforts on the right activities, and even help secure financing.
Performance Monitoring
Active tracking of KPIs is important because they help to spot trends, diagnose causes of underperformance and adjust resource allocation to cope with changing market conditions.
StoreCam is a supermarket chain that specializes in the sale of fast moving consumer goods (FMCG) in Congo Brazzaville. For the past 3 years StoreCam’s sales have declined by 35 %. The company’s top management team is worried about the situation because despite having introduced various new products and marketed aggressively, the company still loses market share to new entrants. StoreCam’s situation is further exacerbated by the fact that their sales and inventory data are incomplete, non-maneuverable and thus not sufficient for a proper statistical analysis. After thorough discussions between the top management team members, they decide to hire an independent consultant to help them reverse their persistent sales decline. In order to understand the causes of StoreCam’s eroding sales, the consultant first restored the company’s sales and inventory data and built a database on customer activity in such way that data is complete (i.e. recorded in a regular time interval for at least 3 months for all stores and products being sold), maneauvrable (i.e. ability to track data on specific store or product at a specific period time within seconds of a few clicks), and easily used for statistical analysis. Through a rigorous review and statistical analysis of sales, inventory and customers records, the consultant discovers three main factors negatively affecting sales:
- The most significant sales drop is in the beverage category. Synthetic soft drinks sales, representing 60 % of beverage sales, are declining by 20% CAGR while natural drinks sales are growing by 10 % CAGR
- Overall inventory turnover is unbalanced and decreasing. Some products can take up to three months to sell out while other products run of stock within two days. Store managers tend to wait until overall inventory is below 25 % of initial purchase orders before reordering to maximize supplier discounts. The average lead time for reordering is 5 days, sometimes leaving entire product categories with no products to sell
- Cashier management is inefficient.Even though there are 4 cashier stations per store, only 2.5 are occupied at all times including rush hours. Hence, discouraging visitors looking to make quick purchases during lunch breaks. Moreover, lack of coin change further leave customers dissatisfied having to purchase more goods than intended or abandoning purchase orders altogether.
By restoring StoreCam records on sales and inventory and building a database on customer activity, the consultant has been able to spot trends such as contrasting beverages sales between synthetic and natural soft drinks; large inventory turnover disparities for FMCGs; and an underutilizing of cashiers especially during rush hours. Through data analysis, it has been diagnosed that the combination of those trends account for 85% of sales drop. Based on the spotted trends and the diagnosis of revenue decline, the consultant can already recommend quick resource allocation adjustments such as opening all 4 cashier stations during rush hours and actively securing coin change; ordering larger quantities of products with high inventory turnover and lesser quantities of goods with historically lower inventory turnover; formally setting an inventory threshold quantity per product that is preferably higher than the 25 % of overall initial purchase orders in order to ensure adequate supply of truly demand FMCGs with apparent shortages. Leveraging data as discussed in this case, can only be achieved through active performance monitoring of KPIs.
Benchmarking
KPIs are not only important for performance monitoring, they are also indispensable for benchmarking performance with competitors, production units, and subsidiaries. While performance monitoring helps to see how well a business has performed in a given time period, benchmarking essentially shows to managers how well a business could perform within the market by identifying performance gaps between the benchmarked entities.
Although the consultant has realized that StoreCam’s salvation entails maximizing the average cashier utilization rates per store, focusing on increasing the allocation of natural soft drinks in the beverage category, and increasing inventory turnover, he still needs to demonstrate the extent to which the performance of these factors could be improved. Benchmarking comes in handy to achieve this task.
Table 1: Benchmarking
Based on the benchmarking of StoreCam with 3 competitors of similar sizes operating in the same market, the consultant deduces that 1) preferences for natural soft drinks over non-natural soft drinks is a consumer trend in the beverage market observed consistently across all benchmarked competitors. 2) Natural soft drinks sales growth could be improved by as much as 5% per year. 3) StoreCam underperforms average industry inventory turnover of 25.6 restocks per year and by carefully reordering the most sold FMCGs, the company could increase the turnover 12.5 more times within a year. 4) Average cashier utilization rates lag by 20 percentage points to the industry leader.
The sample benchmark analysis illustrated in the business case illustration II helps to establish performance gaps with competitors that can be used to develop improvement milestones. Such milestones cannot be unrealistic since similar competitors achieve them. From the results of a proper benchmarking exercise, we can begin to explore the depth of effort required to remain competitive on the market. One of the perks KPI management is the ability compare and determine performance gaps to be bridged within organizations.
Focus on what matters
Although KPIs are much needed for performance monitoring and benchmarking. They also come in handy to refocus the attention of managers on key factors that truly influence the performance of a business operation.
Figure 1: KPI Decomposition
From the cases in point previously illustrated we can already infer that inventory turnover, cashier utilization rate and sales growth of particular product categories are relevant KPIs for supermarkets. Nevertheless, business improvement could be sustained if organizational KPIs are decomposed and linked into concrete and quantifiable objectives which managers should acheive. For instance, cashier utilization rates could be further translated into the objective of minimizing customer payment processing time (including waiting time). The lesser the customer payment processing time, the higher cashier utilization rate. Inventory turnover could be maximized by holding business managers accountable for the frequency of key items stock-outs. The more frequent stock outs occur the more that managers should be penalized. Other operational KPIs that can be used to maximize managers’ accountability for sales are items per purchase, average sales value, sales per employee or customer conversion ratio.
By breaking down company KPIs into operational objectives for employees, they become more committed to supporting the company’s overarching goal and forces them to focus their efforts on business activities that truly matter to the firm’s performance.
Secure Financing
Besides focusing managers, benchmarking and monitoring performance, KPIs have the added benefit of helping investors to determine business’s capacity to take on and repay debt services and/or earn sufficient returns on investments.
Aside from developing a strategy to boost StoreCam’s sales, the company’s management team sought XAF 100 Million in external financing to invest in new delivery trucks. As such the consultant has been tasked with laying KPIs that would help financiers have a better understanding of the company’s financial potential.
Table 2: Credit Statistics
Through discussions with lenders, they decided to fix a leverage ratio covenant of 3x EBITDA, an interest ratio covenant of 7x EBITDA, and Debt Service Coverage Ratio (DSCR) of 1.4x to StoreCam. When comparing the company’s likely credit ratios to the lenders’ covenants, the consultant concludes that although StoreCam has the capacity to funds its investment entirely on debt, it would likely break the interest coverage convenant on the first projected year (see table 2). Hence, the lenders should consider paid-in-kind notes as debt funding solution for StoreCam.
Figure 2: Valuation Summary
When considering equity funding from investors as a means for achieving its investment plan, the consultant determined the fair price of the company should be between 350 Million and 375 Million XAF based on a combination valuation methods comparing KPIs of multiple companies. It implies that in order to raise XAF 100 Million in equity, the company shareholders would have to sell between 26 % and 28 % of their shares.
KPIs are useful for securing debt financing because through them lenders can estimate a company’s ability to repay debt. As illustrated in the 4th case, leverage ratios, usually defined as the total amount of debt divided by EBITDA, is a standard KPI to estimate how much debt a company carries. Covenants on leverage ratios usually fix a maximum debt capacity upon which a company is not allowed to exceed without penalty fees. Likewise, the DSCR is almost always carefully analyzed by lenders because it is metric that measures a company ability to repay principal and interest on debt with free cash flows. Covenants on the DCSR also typically fix a ratio ceiling to the lending entity.
In terms of equity financing, valuation ratios such as enterprise value (EV) to EBITDA, EV to Sales or EV to number of customers in the retail industry tend be used in comparison with industry peers and past transactions to estimate the enterprise value of company. By deducing net debt from the enterprise value, we obtain the market equity value of the company. With the equity value of the company, we can estimate how many shares we can sell for a given funding requirement. Not only do financial ratios help to determine the equity value of a business, they also show the most value creating KPIs. For instance based on the valuation summary on Figure 2, we know that StoreCam can maximize value creation by increasing its number of customers.
Afterthoughts
Active performance management through KPIs is fundamentally neglected due to a combination managerial overconfidence, a lack of will to look for value drivers, and a tendency to rely on old established metrics even though they change over time. However, through KPIs we can monitor performance more accurately; we can determine performance gaps through benchmarking, we can channel managerial efforts on truly value creating business activities and we can secure better financing. At the heart of the necessity problem of KPIs is a generational conflict between the scientific and intuitive management. Older managers tend to rely more on their intuitive business acumen while younger managers usually embrace more the use of KPIs through advanced technologies to get an edge over competition. In reality, scientific and intuitive management complement each other in the art of performance management. Establishing and tracking the right performance metrics require a good deal of analytical skills and rigor. Negus Advisory prides on guiding companies in the development of their very own customized KPIs to enhance performance. On the second part of this article series, we will dive into the determinants of an effective use of KPIs for performance enhancement.
By Arnold Kamanke
[1] Consistently reporting negative net earnings