6. How Many Types of Key Performance Indicators (KPIs) are There?
It seems the Holy Grail for scorecards and dashboards seem to be organizations seeking to answer, “What should our key performance indicators (KPIs) be?” At the heart of selecting KPIs should be their linkage to the executive team’s strategy. However, there are different stakeholders in an organization, such as internal managers and investor governance boards. Each stakeholder has different needs. Hence there should be different types of KPIs for different purposes.
Performance measures reported in scorecards and dashboards is one of the core components of integrated enterprise and corporate performance management (EPM/CPM) rivaling in importance other improvement methods such as customer relationship management and managerial accounting. Regardless of the type of KPI, analytics (such as segmentation, correlation, regression, forecasting, and clustering) should ideally be imbedded in each method, and they are critical for employees to achieve and exceed KPI targets.
Author Brett Knowles, founder of the consulting firm PM2 (http://pm2consulting.com) and a veteran of the balanced scorecard thought leader community, has given much thought to the topic of different KPIs for different purposes. In Volume 4, Number 6 of his firm’s Performance Measurement &Management newsletter Brett describes different types of KPIs in an article titled “Five Distinct Views of Scorecards – and Their Implications.” With Mr. Knowles permission, here they are abbreviated with my minor edits:
- Financial Valuation – A scorecard view is needed to describe what the organization does in a way that the financial world can understand: monetary currency (e.g., dollars, Euros). All activities need to be financially valued, including tangible assets (e.g., buildings and inventories) and intangible assets (e.g., brand equity, employee retention, and customer loyalty). Several methodologies exist that grapple with this need, including economic value added (EVA) and activity-based costing (ABC).
The challenge is that more than 80% of value is created by intangible assets, yet traditional accounting systems do not do a good job of capturing intangibles. The balanced scorecard has proven to be a great tool for making the intangible assets visible and valuable.
Information in this area needs to be:
- Centered on outputs, outcomes or deliverables,
- Closely related to existing valuation mechanisms,
- Standard, repeatable and reliable.
- Navigation – Internal managers need to make informed decisions on a frequent basis that are consistent with the medium- and long-term strategy. Strategy, cascaded downward into the organization through a strategic balanced scorecard and into operational dashboards, dictates both what should be done and how important it is. This view of performance measures creates alignment of employees’ actions and priorities across all functional and regional boundaries and consistency across time. This is where the EPM/CPM methods with imbedded analytics play a critical role.
Information in this area needs to be:
- Very responsive to shifts in the work activities,
- Process based,
- Related to overall effectiveness and efficiency.
- Incentive Compensation – Scorecard frameworks lend themselves to rewarding employees for contributing to the success of the organization. Over-performers should be distinguished from under-performers. A key to this view is for the executive team to assign aggressive yet achievable target measures.
Information in this area needs to be:
- Related to the value that the team can control and create,
- Output and outcome related,
- Accurately measurable and repeatable across locations and time.
- Benchmarking – An effective way to determine whether an organization is making progress is to compare it to other “things” (“comparatives”). There are many comparatives available: competitors, best-in-class, world-class. In the true sense, even target, forecast and revised-forecast are all comparatives too.
The challenge with the benchmark view of scorecards is that the data is sparse and with “dirty” quality. Also, there can be apples-and-oranges inconsistencies (e.g., including or excluding data, measuring different start-and-end times of processes). Comparatives do not typically go into enough detail to provide operational insights into diagnosing any identified issues and root causes, nor do they cover the full breadth of the executive team’s strategy.
Information in this area needs to be:
- Available from other sources,
- Understandable and relatively comparable,
- Strategically related to the organization.
- Evaluation – Periodically, there is the need to get an accurate measurement of how the organization is performing. Periodically the organization needs to undertake such activities as customer surveys, employee surveys, supplier assessments, etc.
These activities are too expensive and time consuming to be conducted often enough to be useful for navigation, but can be used to underpin selection and validation of navigation indicators, support incentive compensation models and be used in reporting performance to outside stakeholders.
Information in this area needs to be:
- Survey based,
- Comprehensive and rigorous,
- Closely related to overall deliverables.
Brett summarizes his five views by stating that most organizations need to consider their organization’s performance in two or more of these views. For example, a shared service IT department may need to prove and measure its contribution to the organization’s overall valuation, provide monthly navigational information for the project managers (and service level agreements [SLAs] for their internal customers), and develop a compensation package for use around the globe. They may also need to compare themselves to industry benchmarks.
The various and numerous stakeholders need to initially develop some confidence that the scorecard model adequately describes their view of the organization. Consider building the various views as a way to speed implementation of a pilot scorecard. A simple way to do this is to create a single enterprise-wide strategy map, but link different indicators to it for each of the views.
My feeling is Brett is on to something important. As I have previously written there is confusion and lack of consensus as to what a balanced scorecard is. There is ambiguity. Further many organizations neglect to first construct a strategy map from which to derive its KPIs. A strategy map is orders of magnitude more important than its companion balanced scorecards and cascaded operational dashboards. They are simply feedback mechanisms.
Understanding that there are multiple scorecard views can bring clarification.
This article was previously published on www.epmchannel.com
5. Does Accounting Undermine Managers' Ability to Make Good Decisions?
By Gary Cokins and his IMA CMCQ task force member colleagues
The Center for Managerial Costing Quality aspires to help management accountants and the broader business community recognize and understand the need, the benefits, and a path forward for improving cost information for internal decision support. Our goal is to establish “managerial costing” as a unique and specific function and discipline within the accounting profession with distinctly different principles and requirements from GAAP and external financial accounting.
This website is not just for accountants. It provides resources for the many diverse stakeholder groups affected by the quality of their organization’s managerial costing practices. We encourage you to use the resources available here learn more about how this issue affects the performance of your organization and what you need to do.
There is a misconception that costs are accurate. Information generated by financial accounting-focused systems is limited to organization-wide measurements and often fails at even basic levels of granularity. As a result, profitability by product, service-line, channel and customer is misstated. Cross-subsidized costs are rampant with misallocations—making profitable business divisions or products look bad while unprofitable business lines look good. Effective business portfolio management is difficult in these circumstances.
Further, the usefulness of information is severely limited. Financial accounting-focused systems fail to measure costs of core aspects of the business. By failing to link costs with causes, the unavoidable results are misleading profit margins, unrealistic budgets and forecasts, as well as ill-informed insourcing, outsourcing, offshoring, capital spending and other critical management decisions.
The persistence of 20th Century management accounting practices and systems into the 21st Century is not due to the absence of better, more relevant accounting models. For several decades, management accounting thought leaders have been developing new, more effective models to meet the needs of organizations competing in a worldwide and highly-competitive marketplace. However, the majority of practicing accountants are unaware of, or are ignoring, these superior methods and concepts. As a result, decision making is weakened.
Management accounting practices need to advance. Accounting systems can and should reflect underlying managerial economics that are essential to guiding an organization to higher levels of success. For too long the accounting profession has fallen behind other business disciplines in its commitment to building and sustaining value. It must now move into catch-up mode to provide managers with accurate and useful information based on cause and effect relationships.
Decision makers should demand better managerial costing from their accountants to manage performance and profitability of products, service-lines, channels, customers and their supporting processes. Simply “adjusting” compliance-focused financial accounting systems and traditional costing practices won’t work. It’s an ineffective solution to the larger problem. Better and more robust information is required to make decisions and take action that builds value in an organization. That information is available, but accountants must be committed to, and managers must demand, 21st Century managerial costing solutions.
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4. A Passionate Appeal for Activity-Based Costing (ABC)
Usually I am fairly rational and do not let my personal emotions interfere with how I interact with others. However, as the readers of my blogs and articles may have detected, my more recent writings increasingly reflect my frustrations with old school accountants. I cannot disguise my irritation and annoyance with accountants who refuse to be progressive.
Several of the titles of my articles these past few years provide hints and clues as to the source of my frustrations. They include “Are Accountants Homo Accounticus?”, “Some Accountants are the Blind Leading the Blind”, “Movie Sequel – Pirate Accounts of the Caribbean”, “Cowboy Accountants – The Lawless Frontier”, and “Do Accountants Lead or Mislead?”
Each time I post an article I’ve written like those I receive several personal e-mails that are supportive of my view. Some are even more vitriolic. Receiving these e-mails, and also the publicly posted website comments to my written pieces, further motivates me to continue broadcasting my message of frustration often shaming accountants. I call it MBE or “management by embarrassment.”
At this point some of you may be asking yourself, OK. What the heck is bugging Gary that he is so frustrated about?” The simple answer is it is the slow adoption rate of applying activity-based costing (ABC) principles as a replacement for the flawed and misleading traditional “cost allocation” methods from standard cost accounting systems. They typically use non-causal cost allocation factors. Examples are the number or amount of direct labor input hours or currency, units produced, sales volume, headcount, or square feet/meters.
Benefits from applying ABC in comparison to traditional cost allocation methods that violate “costing’s causality principle” are too numerous to list here. Key benefits are: (1) extremely more accurate profit and cost reporting of outputs, products, services, channels and customers; (2) transparency and visibility of the “drivers” for work activities and their magnitude; and (3) past period calibrated cost consumption rates that are essential to multiply against future forecasted demand volume and mix that determine resource capacity requirements – workforce headcounts and spending amounts. These rates are needed for what-if scenario analysis, make-versus-buy decisions, and capacity-sensitive driver-based rolling financial forecasts and budgets.
Causality is at the heart of ABC. For example, if the quantity of the activity driver increases 20% then its activity cost should also increase 20%. The work activities are what consume the resource capacity expenses. My opinion is that any CFO/ financial controller or FP&A analyst who are using traditional cost allocation methods and are not using ABC where it is applicable (which is for most organizations) is being irresponsible in their duty to provide valid information to managers and employees. The information they are providing is faulty, distorted and deceiving. Line managers deserve better to support their decisions.
Now read the first letter of the six prior paragraphs as if together they are a two word sentence. My message is blunt: USE ABC !
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3. Put Your Money Where Your Strategy Is
Two easy ways for executive teams to attempt to raise profits is to lay off employees to cut costs or to lower prices to take away market share from their competitors. But these are merely short-term fixes. An organization cannot reduce its costs and prices to achieve long-term sustained prosperity.
Entrepreneurs know the age old adage “you need to spend money to make money.” However, belt-tightening an organization’s spending can be haphazard. Rather than evaluating where the company can cut costs, it is more prudent to switch views and ask where and how the organization should spend money to increase long-term sustained value. This involves budgeting for future expenses, but the budgeting process has deficiencies.
A problem with budgeting
Companies cannot succeed by standing still. If you are not improving, then others will soon catch up to you. This is one reason why Professor Michael E. Porter, author of the seminal 1970 book on competitive edge strategies, Competitive Strategy: Techniques for Analyzing Industries and Competitors, asserted that an important strategic approach is continuous differentiation of products and services to enable premium pricing. However, some organizations believed so firmly in their past successes that they went bankrupt because they had become risk-adverse to changing what they perceived to be effective strategies. Wang Labs, Borders, and Blockbuster are examples.
Strategy execution is considered one of the major failures of executive teams. Dr. David Norton, co-author of The Balanced Scorecard: Translating Strategy into Action, has reported, “Nine out of 10 organizations fail to successfully implement their strategy. … The problem is not that organizations don’t manage their strategy well; it is they do not formally manage their strategy.” In defense of executives, they often formulate good strategies – their problem is failure to successfully execute them.
One of the obstacles preventing successful strategy achievement is the annual budgeting process. In the worst situations, the budgeting process is limited to a fiscal exercise administered by the accountants where the budget is typically disconnected from the executive team’s strategic intentions. A less poor situation, but still not a solution, is one in which the accountants do consider the executive team’s strategic objectives, but the initiatives required to achieve the strategy are not adequately funded in the budget. Remember, you have to spend money to make money.
Value is created from projects and initiatives, not the strategic objectives
A popular solution to failed strategy execution is the evolving method of a strategy map with its companion balanced scorecard. Their combined purpose is to link operations to strategy. By using these combined methods, alignment of the work and priorities of employees can be attained without any disruption from restructuring the organizational chart. The balanced scorecard directly connects to individuals regardless of their departments or matrix management arrangements.
Although many organizations claim to use dashboards and scorecards, there is little consensus on how to design or apply these tools. At best, the balanced scorecard has achieved a brand status but without prescribed rules on how to construct or use it. For example, many companies claim to have a balanced scorecard, but it may have been developed in the absence of a strategy map from executives. The strategy map is arguably many orders of magnitude more important than the balanced scorecard. Therefore, when organizations simply display their so-called scorecard of actual versus planned or targeted metrics on a dashboard, how do the users know that those measures displayed in the dials, commonly called key performance indicators (KPIs), reflect the strategic intent of their executives? They may not! At a basic level, the balanced scorecard is simply a feedback mechanism to inform users how they are performing on preselected measures that are ideally causally linked. To improve, much more information than just reporting your score is needed.
One source of confusion in the strategy management process involves misunderstandings of the role of projects and initiatives. For the minority of companies that realize the importance of first developing their strategy maps before jumping ahead to design their balanced scorecard KPIs, there is another method challenge. Should organizations first select and set the targets for the balanced scorecard KPIs, and subsequently determine the specific projects and initiatives that will help reach those targets? Or should the sequence be reversed? Should organizations first propose the projects and initiatives based on the strategy map’s various theme objectives, and then subsequently derive the KPIs with their target measures afterward?
We could debate the proper order, but what matters more is that the projects and initiatives be financially funded regardless of how they are identified. Value creation does not directly come from defining mission, vision and strategy maps. It is the alignment of employees’ priorities, work, projects and initiatives with the executive team’s objectives that directly creates value. Strategy is executed from the bottom to the top. Using a fishermen’s analogy to explain this: Strategy management tells you where the fish are, but it is the projects, initiatives and core business processes that catch the fish.
Four types of budget spending: operational, capital, strategic, and risk
The overarching process begins with strategy formulation and risk mitigation and ends with financial budgeting and rolling forecasts. Some budgets and rolling financial forecasts may distinguish the capital budget spending from operational budget spending, but rarely do organizations segregate the important strategic budget spending and risk budget spending for risk mitigation.
A key point is that the budget depends on and is derived from two separate sources: (1) a future demand-driven source (operational) and (2) three project-based sources (capital, strategy, and risk).
Ideally, the strategy formulation by the executive team uses meaningful managerial accounting information, such as understanding which products and customers are more or less profitable today and are potentially more valuable in the future. With this additional knowledge, the executives can determine which strategic objectives, as mentioned typically displayed in a strategy map with its associated balanced scorecard, to focus on.
The operational budget, those expenses required to continue with day-to-day repeatable processes, is calculated based on forecasted volume and mix of “drivers” of processes, such as the sales forecast, multiplied by planned unit level consumption rates that are calibrated from past time periods (and ideally with rates reflecting planned productivity gains). This demand-driven method contrasts with the too-often primitive budgeting method of simply increasing a cost center’s prior year’s spending level by a few percentage points to allow for inflation. The operational budget spending level is a dependent variable based on demand, so it should be calculated that way.
Regardless of whether an organization defines the strategic initiatives before or after setting the balanced scorecard’s KPI targets, it is important to set aside strategy spending and risk mitigation spending not much differently than budgeting for capital expenditures. Too often, the strategy funding is not cleanly segregated anywhere in the budget or in driver-based rolling financial forecasts. It is typically buried in an accounting ledger expense account. And enterprise risk management (ERM) spending must also be included. As a result, when financial performance inevitably falls short of expectations, it is the strategy projects’ “seed money” and the risk mitigation spending that gets deferred or eliminated. The priority must be reversed. Organizations must protect strategy and risk mitigation spending and allow them to go forward as they are key to competitive differentiation for successfully accomplishing the strategy – and doing it safely.
Put your money where your strategy is!
Managing strategy is learnable
Organizations with a formal strategy execution process dramatically outperform organizations without formal processes for this. Building a core competency in strategy execution creates a competitive advantage for commercial organizations and increases value for constituents of public sector organizations. Managing strategy is learnable. It is important to include and protect planned spending for strategic projects and initiatives and risk mitigation spending in budgets and driver-based rolling financial forecasts. The three types of projects (capital, strategy, risk) lead to long-term sustainable yet safe value creation. Driver-based operational expense planning assures that the correct level of employee head count and spending are in place to achieve planned profits.
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2. How Marketing and Finance Think Differently
This is a fictitious story about the wide gap and personality differences between the function of the chief marketing officer (CMO) and that of the chief financial officer (CFO). I made up the two characters in this story. But how different might they be from a real pair of a CMO and CFO that you may know (or who works for your employer)?
The haunting question
My fictitious CMO and CFO, Sandy and Jim, are both men, but their gender would not alter this story. They were hired into their C-suite roles at the same time about a year ago, and both were recruited from other companies.
Sandy and Jim have both had enough time in their first year to stabilize the moderately disorganized departments they inherited from their predecessor CMO and CFO that they replaced. Each of them feels that their time and opportunity are now to make real progress and substantial improvements for their company.
Last week by coincidence of timing Sandy and Jim met at the coffee station on the floor of their offices. The story’s plot began to thicken when without giving it much thought Jim, the CFO, asked Sandy, the CMO, what Jim considered to be a straightforward question. Jim asked, “Would marketing and sales behave differently if they knew how profitable to our company each of our company’s customers is? They currently know the amount of sales from each customer reported from the billing system, but the sales and marketing staff do not know the amount of profits that each customer contributes to our company’s bottom line.”
There was a long silence. Jim wondered to himself, “Ooh. Maybe Sandy thinks I’m intruding in his affairs.” Sandy eventually replied to Jim, “Hmmm. Let me think about that for a while. I’ll get back to you.” They then returned to their respective offices to resume the routine daily toil of their job and duties.
Second thoughts from the CFO’s question
Later that day Jim became uneasy. He began worrying if with his question he had adversely affected what until then had been a friendly relationship with Sandy and Sandy’s marketing team. Jim thought to himself, “I know it was just an innocent question. But golly. If all that marketing and sales focus on is increasing our market share and growing sales, then they may not be thinking about growing the most profitable sales.”
Meanwhile later that same day Sandy pondered Jim’s coffee station question. It stimulated Sandy to think about one of their customer segments that his marketing staff had just initiated a targeted marketing campaign to promote selling their kitty litter product. The promotion’s theme was “scoop that poop.” Sandy began to worry. He thought to himself, “I wonder if that theme might offend some of our customers and in turn their retail store consumers. Is this a problem?”
Third thoughts about the CFO’s question
The more that Jim thought about his chance coffee station encounter and his offhand question to Sandy, the more that Jim began to worry. Jim thought to himself, “I know that we have a wide range of low to high maintenance and demanding customers independent of their sales volume they purchase from us. I wonder if Sandy understands what differentiates the most profitable from the least profitable customers to us – and worse yet unprofitable customers. I wonder if Sandy knew this information if it would change his thinking and mindset about the marketing deals, offers, discounts, special services, and all those other things that his staff comes up with to lift sales volume.”
Meanwhile Sandy also continued to ponder Jim’s question. For the kitty litter “scoop the poop” marketing campaign, they provided their customers’ retail stores with cardboard floor displays of an attractive blond hair female model holding a red kitty litter scooper. Sandy now worried and questioned to himself, “Should we have selected a less attractive and brunette model that more women might relate to? Should the color of the scooper been green representing ‘go’ and not the red one implying ‘stop’?”
Fourth thoughts about Jim’s CFO question
That night Jim lost sleep. He began to question if he was successfully fulfilling his CFO governance role to have fiduciary control of the corporate assets and effectively serve as a strategic advisor to the CEO and the board of directors. Jim worried. He wondered, “Should I be forcing Sandy to shift his mindset along with the sales vice president to view customers as investments in a portfolio? This shift would maximize the return on investment (ROI) from customers which in turn would optimize the rate of shareholder wealth creation.”
That same night Sandy also lost sleep. His marketing team was instructing their customers’ store outlets to position the kitty litter cardboard display with the attractive blond to be located near the retailer’s food aisle. Sandy worried. He thought to himself, “Maybe there would be relatively higher sales if the display was positioned near the retailer’s hardware goods aisle.”
A butterfly’s wings – marketing versus finance
It has been said that the random flap of a butterfly’s wings in Africa can impact the wind in the Sahara desert that evolves into the hurricanes that causes devastation to the Eastern United States of America. Sandy thought to himself, “What little marketing tweak here might we do to stimulate a consumer’s purchase there?”
In contrast, Jim disturbed himself into a cold sweat conflicted with fear for keeping his position as CFO. He thought to himself, “Am I failing to defend the profit maximizing interests of our company’s shareholders and defending global Capitalism?”
The wide gap between marketing and finance
As I stated in the opening to this article, there is a wide gap and personality differences between the function of the CMO and CFO.
But maybe the gap is not that wide. Marketing thinks to act locally for global impacts to increase sales. Accounting thinks to take actions that lift the most profitable sales. Their common focus is what actions to take. Accounting should provide marketing the insights for decisions, and marketing should take actions.
Later that week Jim updated his resume and Sandy asked the product development team, “Can we possibly change the color of our kitty litter?”
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