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How to Use Key Performance Indicators

By: Timothy J. Hilligoss, CPA, MST

There's a management axiom that says "If you can measure it, you can manage it." An important part of the measuring process is developing key performance indicators (or KPIs) that can help you define and gauge your progress toward reaching goals.

KPIs are quantifiable measurements that reflect your organization's critical success factors. No two companies' or organizations' KPIs will be the same—they will vary depending on the type of organization (non-profit vs. for-profit, for example), industry and, of course, each organization's specific goals and objectives.

Mission and Goals

Before you can identify which performance indicators are the most important ones to be monitored and measured within your organization, you must first have a well-defined mission statement and clear, measurable goals. Your KPIs will emerge from and support your mission statement and goals.

The most important characteristics of KPIs are that they be specific and measurable, and that you be able to compare them to a benchmark. A KPI simply stated as "Increase sales," for example, cannot be measured. Better: "Increase sales revenue by 10 percent each year for the next three years."

Before setting such a goal, however, you need to know whether a 10 percent increase is good or bad. To determine this, you need benchmarks to compare this number to and put it in perspective.

Benchmarks can be prior years' performance or industry averages. For example you could compare your accounts receivable collection time (or AR days — see below) to your terms of sale and industry averages to see how well you're doing against your peers and your own internal standards.

The best sources for information on industry averages and benchmarks are your industry trade association and the Risk Management Association (RMA), which publishes RMA's Annual Statement Studies each year. This is a comprehensive list of financial performance statistics for small and mid-sized businesses, derived primarily from the financial statements of business borrowers and organized by Standard Industrial Classification (SIC) code. Visit www.rmahq.org for details on how to order.

Financial KPIs

On the financial side, KPIs often include common ratios and metrics such as:

- Shows how many times current debt could be paid off with current assets. The formula: Current Assets ./. Current Liabilities

- Measures debt capacity. The formula: Total Debt ./. Shareholder's Equity

- Measures how long it takes to collect the money that's owed to you. The formula: AR x 365 ./. Annual Sales

- Measures how long you take to pay your vendor invoices. The formula: AP x 365 ./. Cost of Goods Sold

- Shows how often your inventory "turns over" in a year. The formula: Cost of Goods Sold ./. Inventory

You should have specific goals for the financial ratios and metrics that you determine are key for your business. For example, four times a year is a common inventory turn, and 3:1 or less is generally considered an acceptable debt-to-equity ratio for companies seeking bank financing.

Again, don't just look at these ratios in isolation, but compare them from quarter to quarter or year to year to look for trends that can help you improve financial management.

For example, if accounts receivable days is improving from quarter to quarter, this likely reflects an overall improvement in your collections efforts. By monitoring your cash flow cycle - the cycle of cash conversion from inventory to sales to receivables and back to cash again - you can benchmark everything from a slowdown in receivables collections to an increase in inventory turnover.

Non-Financial KPs

While KPIs are often thought of within the financial realm, non-financial indicators can be just as useful - and often more so, depending on the organization. Here are a few common non-financial business indicators expressed as KPIs:

: Percentage of calls answered within the first three rings, or e-mails returned within 24 hours.
: We will answer 90 percent of calls to the customer service department within the first three rings, and return 90 percent of e-mails within 24 hours.

: Level of employee turnover.
: We will maintain an employee retention rate of at least 90 percent.

: Number of units rejected by quality control.
: The reject rate for units on the assembly line will not exceed 1 percent.

: Percentage of clients retained in one year.
: We will maintain a client retention rate of at least 90 percent during the upcoming year.

: Number of new customers acquired.
: We will acquire five new customers each month for the next year, or a total of 60 new customers over the next year.

Get Everyone Onboard

KPIs should be clearly communicated to everyone in your organization so that all stakeholders have a clear picture of what indicators you have deemed to be most important, but especially to anyone who may have a direct hand in making them happen. Explain them in company and department meetings, mount them on the walls in your hallways or lunchroom, and post them on your intranet or even your Web site.

You can even use them as a "carrot" by basing employee bonuses or other incentives on the achievement of KPIs. Just be sure everyone knows what the targets are, and keep employees regularly informed about progress toward reaching them.

We can help you determine key performance indicators for your organization. For assistance, please contact Tim Hilligoss, Shareholder at Clayton & McKervey, P.C., at 248.208.8860 or thilligoss@claytonmckervey.com.

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