The Importance Of KPIs And How To Use Them Effectively

Post: The Importance of KPIs and How to Use Them Effectively

The Importance of KPIs

And when mediocre is better than perfect

One way to fail is to insist on perfection. Perfection is impossible and the enemy of good. The inventor of the air raid early warning radar proposed a “cult of the imperfect”. His philosophy was “Always strive to give the military the third best because the best is impossible and second best is always too late.” We’ll leave the cult of the imperfect for the military.

The point is, “if you never miss a plane, you’re spending too much time at the airport.” In other words, if you’re trying to get it perfect 100% of the time, you’re losing out on something better. Such it is with KPIs. Key Performance Indicators are critical to the success and management of a business. It’s one way in which you can guide your business with data-driven decisions.

If you Google the phrase creating key performance indicators, you will get 191,000,000 results. Start reading those web pages and it will take you 363 years of reading day and night to finish. (That’s what ChatGPT told me.) This isn’t even taking into consideration the complexity of the page or your comprehension. You don’t have time for that.

Business areas

Pick a domain. You could (and you probably should) implement KPIs in all business areas of your company: Finance, Operations, Sales and Marketing, Customer Service, HR, Supply Chain, Manufacturing, IT, and others. Let’s focus on finance. The process is the same for the other functional areas.

Types of KPIs

Pick a type of KPI. Lagging or leading which can be either quantitative or qualitative[1].

  • Lagging KPI indicators measure historical performance. They help answer the question, how did we do? Examples include metrics calculated from the traditional balance sheet and income statement. Earnings before interest, taxes, and amortization (EBITA), Current Ratio, Gross margin, Working capital.
  • Leading KPI indicators are predictive and look to the future. They attempt to answer the question, how will we do? What will our business look like in the future? Examples include trends of Accounts Receivable Days, Sales Growth Rate, Inventory Turnover.
  • Qualitative KPIs are measurable and are easier to assess. Examples include the current number of active customers, number of new customers this cycle, or the number of complaints to the Better Business Bureau.
  • Qualitative KPIs are squishier. They may be more subjective, but still important. These include Customer Satisfaction, Employee Engagement, Brand Perception, or a “Corporate Equality Index”.

The hard part

Then, you’ll have endless committee meetings to argue over which KPIs should be Key and which metrics should be just performance indicators. The committees of stakeholders will argue over the exact definition of the metrics that have been selected. It’s at that point where you remember that the company you bought in Europe doesn’t follow the same Generally Accepted Accounting Principles (GAAP) as you do in the US. Differences in revenue recognition and expense categorization will lead to inconsistencies in KPIs like Profit Margin. Comparison of international productivity KPIs suffer from similar problems. Thus the arguments and endless discussions.

That’s the hard part – coming to an agreement on the definition of the KPIs. The steps in the KPI process are actually straightforward.

Any well-run business will go through this KPI process as it grows from a grassroots basement operation to one which can no longer fly under the radar. Venture Capitalists will insist on certain KPIs. Government regulators will insist on others.

Remember the reason you’re using KPIs. They are part of the analytics which help you run your business and make sound, well-informed decisions. With a well implemented KPI system you’ll know where you stand today, what the business looked like yesterday and can predict what tomorrow will look like. If the future is not rosy, you’ll want to make some changes – changes to your processes, your business. If next year’s first quarter profit margin KPI is predicted to be lower year-over-year, you’ll want to look at ways to increase revenue or decrease expenses.

That’s the cycle of the KPI process: Measure – Evaluate – Change. Annually, you’ll want to assess your KPI targets. The KPIs have driven change. The organization has improved. You beat the Net Profit Margin target by two points! Let’s adjust next year’s target upward and see if we can do even better next year.

The dark side

Some companies have been intent on beating the system. Some startup companies, some with Venture Capital funding, have been pushed to generate higher and higher profits, quarter over quarter. The VCs are not in the business to lose money. It’s not easy to continue success over changing marketing conditions and cutthroat competition.

Instead of Measure – Evaluate – Change the process , or change the target, some companies have changed the KPI.

Consider this analogy. Imagine a marathon race where the participants have been training and preparing for months based on a specific distance, 26.2 miles. However, in the middle of the race, the organizers suddenly decide to change the distance to 15 miles without prior notice. This unexpected alteration creates a disadvantage for some runners who may have paced themselves and allocated their energy and resources for the original distance. It, however, benefits those runners who came out too fast to finish the original distance. It distorts the true performance and makes it difficult to compare results fairly. This situation can be seen as an attempt to manipulate the outcome and hide the shortcomings of certain participants. Those who would have clearly failed at the longer distance because they had expended all of their energy would, instead, be rewarded for being the fastest finishers of the race with the new metric definition.

Similarly, in the business, companies like Enron, Volkswagen, Wells Fargo, and Theranos

have been known to manipulate their KPIs, financial statements, or even industry standards to create the illusion of success or hide underperformance. These actions can mislead stakeholders, investors, and the public, similar to how altering the rules of a sports competition can deceive participants and spectators.

Enron no longer exists today, but was once at the top of the food chain as one of America’s most innovative companies. In 2001 Enron collapsed due to fraudulent accounting practices. One of the contributing factors was the manipulation of KPIs to present a favorable financial image. Enron used complex off-balance-sheet transactions and adjusted KPIs to inflate revenues and hide debt, misleading investors and regulators.

In 2015, Volkswagen faced a severe stock hit when they revealed that they had manipulated emissions data in testing their diesel cars. VW had designed their engines to activate emissions controls during testing but disable them during regular driving, skewing the emissions KPIs. But not following the rules, they were able to advance both sides of a balanced equation – performance and reduced emissions. This deliberate manipulation of KPIs led to substantial legal and financial consequences for the company.

Wells Fargo pushed their employees to meet aggressive sales targets for new credit cards. Something unexpected hit the fan when it was discovered that in order to meet their KPIs, employees had opened millions of unauthorized bank and credit card accounts. The unrealistic sales targets and improper KPIs incentivized employees to engage in fraudulent activities, resulting in a significant reputational and financial loss for the bank.

Also in the news recently, Theranos, a healthcare technology company, claimed to have developed a revolutionary blood testing technology. It was later revealed that the company’s claims were based on false KPIs and misleading information. In this case, sophisticated investors ignored red flags and were caught up in the hype of the promise of a revolutionary startup. “Trade secrets” included faking the results in demos. Theranos manipulated KPIs related to accuracy and reliability of their tests, which ultimately led to their downfall and legal repercussions.

These examples demonstrate how manipulating or misrepresenting KPIs can lead to severe consequences, including financial collapse, reputational damage, and legal action. It highlights the importance of ethical KPI selection, transparency, and accurate reporting in maintaining trust and sustainable business practices.

The moral of the story

KPIs are a valuable asset to gauge the health of an organization and guide business decisions. Used as intended, they can warn when corrective action is necessary. When, however, bad actors change the rules in the middle of the event, bad things happen. You shouldn’t change the distance to the finish line after the race has started and you shouldn’t change the definitions of the KPIs that are designed to warn of impending doom.

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