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HOW CAN KEY PERFORMANCE INDICATORS BE USED EFFECTIVELY?

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On our former KPI article, it was argued that key performance indicators (KPIs) were to be taken seriously because they enable performance monitoring and benchmarking, they help executives and financiers to evaluate firms’ bankability, and they are a means to focus managerial efforts on organizations’ overall goals.

However, most of the positive KPI attributes discussed could be lost if inappropriately used. For instance, poor performance metrics might not encourage the desired behavior from employees; irrelevant metrics not clearly linked to the overall organizations overarching goals will not help performance. Unwise performance targets will not incentivize workers to rise to operational challenges. Therefore, knowing how to select and use KPIs are just as important as understanding their relevance.

This article is meant to discuss on the two key characteristics that makes good KPIs (persistence and predictability) and elaborate on the (de)construction of value creation metrics.

 

Characteristics of Key Performance Indicators

A good key performance metric should reliably reveal causality. There are two defining characteristics that shows cause and effect: persistence and predictability. A performance metric that is statistically persistent means it shows that the outcome of a given action at one time will be similar to the outcome of the same action at another time; a metric that is deemed statistically predictive means that there is a causal relationship between the actions the statistic measures and the desired outcome.

Persistence

Performance indicators that assess activities requiring skill are persistent. For example, if you measured the performance of a trained sprinter running 100 meters on two consecutive days, you would expect to see similar times. Persistent statistics reflect performance that an individual or organization can reliably control through the application of skill, and so they expose causal relationships.

It’s important to distinguish between skill and luck. One should think of persistence as occurring on a continuum. At one extreme the outcome being measured is the product of pure skill, as it was with the sprinter, and is very persistent. At the other, it is due to luck, so persistence is low. When you spin a roulette wheel, the outcomes are random; what happens on the first spin provides no clue about what will happen on the next.

Predictability

To be useful, performance metrics must also predict the result you’re seeking. For instance, the US baseball team, Oakland Athletics upon recognition through statistical analysis that on-base percentage told more about a player’s likelihood of scoring runs than his batting average did allowed the team to recruit winning players at more competitive transfer fees. The former statistic reliably links a cause (the ability to get on base) with an effect (scoring runs). From this discovery, baseball recruiters have drawn the conclusion that a team’s on-base percentage is better for predicting the performance of a team’s offense. A business performance metric should also be predictive because it helps to ensure that the monitored KPIs truly influence desired corporate objectives.

Absence of predictability and persistence in a KPI can be devastating. For example, in the corporate world, EPS is the most popular performance indicator. However it is not necessarily conducive to shareholder value creation. Theory and empirical research tell us that the causal relationship between EPS growth and value creation is tenuous at best. Similar research reveals that sales growth also has a shaky connection to shareholder value.

 

Fitness of Indicators

It is possible to organize performance measurement according to three different perspectives. First, the intrinsic value that a company has generated historically can be explored through its financial statements. This set of metrics gauges what we call a company's performance. Second, the view that metrics can also gauge a company's ability to create economic value in the future and the risks that might prevent it from doing so. These metrics assess what we call the company's health. The third set of metrics assesses the capital market performance of the company, including the expectations factored into its share price and the way they have changed, as well as a comparison between a company's market valuation and its valuation on the basis of its business plans. An understanding of its performance and health provides the context for developing this accurate assessment of its share price performance.

In using all these metrics, it is important to understand the impact of factors outside management's control: For instance, the influence of rising oil prices on an oil company profitability as opposed to better exploration techniques. To use any metric that assesses how a company is doing, you must strip out the impact of such factors.

In the following sections we explore all the three perspectives from which we can organize performance measurement.

Intrinsic Value

Some ways of measuring a company's financial performance are better than others. Metrics, such as return on invested capital (ROIC), economic profit and growth, which can be linked directly to value creation are more meaningful than traditional accounting metrics like EPS. In essence, intrinsic value comes from a combination of ROIC increases, cost of capital reductions, and heightened growth. These KPIs are better than classic accounting metrics because they are more persistent and predictive.

Health: To Scope Value Creation Potential

Health metrics surpasses those for historical performance by their predictive nature. For example, it's important to know whether a company has the products, the people, and the processes to continue creating value. Assessing the risks a company faces and the procedures in place to mitigate them is an important dimension of all efforts to measure health. To identify a company's key health metrics, we start with a value creation tree illustrating the connections between a company's intrinsic value and the generic categories of health metrics: the short-, medium-, and long-term factors that determine a company's long-term growth and ROIC (See Figure 1). Every company will have its own health metrics, but the eight generic categories in Figure 1 can ensure that it systematically explores all the important ones.

Source: McKinsey, 2008; Figure 1: Value Creation Tree

Source: McKinsey, 2008; Figure 1: Value Creation Tree

Short-Term Metrics

Short-term metrics explore the factors that underlie historical performance and help indicate whether growth and ROIC can be sustained at a given level or probably rise or fall. They fall into three categories:

  • Sales productivity (1) metrics explore the factors underlying recent sales growth. For retailers, these metrics include market share, a retailer's pricing power relative to its peers, the pace of store openings, and same-store sales increases.
  • Operating-cost productivity (2) metrics explore the factors underlying unit costs, such as the cost of building a car or delivering a package. UPS, for example, is well known for charting out the optimal delivery paths of its drivers to enhance their productivity and for developing well-defined standards on how to deliver packages.
  • Capital productivity (3) metrics show how well a company uses its working capital (inventories, receivables, and payables) and its property, plant, and equipment. Dell revolutionized the personal-computer business by building products to order and thus minimizing inventories. Because the company keeps them so low and has few receivables to boot, it can operate with negative working capital.

Medium-Term Metrics

Medium-term metrics go beyond short-term performance by looking forward to indicate whether a company can maintain and improve its growth and ROIC over the next one to five years (or longer for companies with extended product cycles, as in pharmaceuticals). These metrics fall into three categories:

  • Commercial-health (4) metrics, indicating whether a company can sustain or improve its current revenue growth, include the metrics for its product pipeline (the talent and technology to market new products over the medium term), brand strength (investments in brand building), regulatory risk, and customer satisfaction. Metrics for medium-term commercial health vary widely by industry. For a pharmaceutical company, the obvious priority is its product pipeline and its relationship with governments—a major customer and regulator. For an online retailer, customer satisfaction and brand strength may be the most important considerations.
  • Cost structure health (5) metrics gauge a company's ability, as compared with that of its competitors, to manage its costs over three to five years. These metrics might include assessments of programs like Six Sigma, which companies such as General Electric use to reduce their costs continually and to maintain a cost advantage relative to their competitors across most of their businesses.
  • Asset health (6) metrics show how well a company maintains and develops its assets. For a hotel or restaurant chain, for instance, the average time between remodelings may be an important driver of health.

Long-Term Strategic Health

Metrics of long-term strategic health show the ability of an enterprise to sustain its current operating activities and to identify and exploit new areas of growth. A company must periodically assess and measure the threats—including new technologies, changes in public opinion and in the preferences of customers, and new ways of serving them—that could make its current business less attractive. In assessing a company's long-term strategic health, specific metrics are sometimes hard to identify, so more qualitative milestones, such as progress in selecting partners for mergers or for entering a market, are needed.

Besides guarding against threats, companies must continually watch for new growth opportunities in new geographies or in related industries; many Western companies, for example, have begun preparing to serve China's enormous, fast-growing markets.

Organizational Health

Metrics are also needed to determine whether a company has the people, the skills, and the culture to sustain and improve its performance. Diagnostics of organizational health typically measure the skills and capabilities of a company, its ability to retain its employees and keep them satisfied, its culture and values, and the depth of its management talent. Again, what's important varies by industry. Pharmaceutical companies need deep scientific-innovation capabilities but relatively few managers. Companies expanding overseas need people who can work in new countries and negotiate with the governments there.

Stock Market Performance

The most common approach to measuring the stock market performance of a company is to calculate its total returns to shareholders (TRS), defined as share price appreciation plus dividend yield, over time. This approach, however, has severe limitations because in the short run TRS embodies speculations about the future performance of a company more than its actual underlying performance and health. Under such context, it becomes challenging for companies to deliver high TRS because the market may think that management is doing an outstanding job, but this belief has already been factored into share prices.

One way of overcoming the limitations of TRS is to employ complementary measures of stock market performance such as the market value added (MVA) and the market-value-to-capital ratio. The MVA expresses the difference between the market value of a company's debt and equity and the amount of capital invested. The market-value-to-capital ratio is the ratio of a company's debt and equity to the amount of capital invested. Market-value-to-capital ratios and MVA complement TRS by measuring different aspects of a company's performance. TRS measures it against the financial markets' expectations and changes in them. Market-value-to-capital ratios and MVA, by contrast, measure the financial markets' view of the future performance of a company relative to the capital invested in it, so they assess expectations about its absolute level of performance.

 

Afterthought

A good KPI ought to be statistically persistent (reflect mostly skills consistently) and predictive (allows to make inference on the future performance). Asserting historical performance is not a sufficient condition for proper performance measurement. In the context of business, KPIs should (1) be linked to the creation of intrinsic value through the ROIC, growth or cost of capital; (2) address a company’s health i.e. its ability improve and sustain performance in the future and (3) its stock market performance (if listed). Specifics KPIs may vary depending on businesses’ sizes, growth stages, geographical locations and industries. Negus Advisory specializes in the development and analysis of key performance metrics.

 

By Arnold A. KAMANKE

 

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