You can measure the financial performance of your business in many different ways. And you probably do so. Operating income, EBITDA margins, free cash flow, ROIC and others. All of these metrics are quantifiable and understood by the different audiences that need to know the status of your company, such as investors and markets in general. The audiences understand these metrics and they can easily compare them with targets and benchmarks. They are important, but at the end of the day, these metrics represent only a static picture of a fiscal period, and can only tell you so much about the fitness level of the business, therefore managers should not rely on conventional financial metrics alone to grow profitably. Then there are the KPIs, or key performance indicators. These are considered process metrics and often used to track specific areas. They should tell you whether you are making headway towards attaining your targets or not. They are internal to the company, but the line between KPIs and financial metrics is not always clear. KPIs measure activities normally associated with customers, suppliers, internal processes, workforce and so on. The difficult part with KPIs is that you can easily have too many of them, diluting focus and creating effort in the direction of the trivial many, versus the vital few. Managers need to be selective when choosing KPIs. I propose there are two other critical and often neglected pointers, which lie between the internal workings of the company and the financial results. These are business productivity (or efficiency) and complexity. I call them the “vital few success indicators” but they could very well be called the forgotten metrics, since only a handful of companies use them to evaluate their strength or fitness level. Whether you classify these two indicators under financial metrics or KPIs, there are hardly any established standards to compare them with. They are dimensionless and can only be tracked over time versus a baseline. In spite of their non-conventional nature, productivity and complexity metrics can’t be neglected if you want to grow profits consistently overtime. Usual KPIs, EBITDA margins, ROIC, or any other financial metric alone, can only tell you how the business looks like today, or in the recent past. They can’t easily tell you about the company’s robustness level to endure market challenges in the long run. It’s like judging the internal health of the patient by looking at a photograph! On the other hand, superior productivity and reduced complexity have proven time-over-time to be the best predictors of profitable longevity. And here’s why. Productivity is generally defined as a measure of output per unit of input. Broadly stated, business productivity should be measured in terms of total value captured from the market over the total value of resources being applied to capture that value. In financial terms, it’s the ratio of your total contribution margin dollars over your total fixed cost or overhead dollars. It basically tells you if you are earning enough with your products and services to cover for all the non-variable expenses associated with running the business, including SG&A. A productivity index (PI) of one or less than one, tells you that your products and services are either not being valued enough by the market, are using resources in excess or a combination of both. A PI of two, means that you are 100% efficient in capturing value from the market and are less vulnerable to its ups and downs, and so on. This is a powerful concept, since contribution margin is a better correlation coefficient between the market environment and the internal structure of the company. The ability of a company to profit adequately from a product or service starts with sound contribution margins and there is little or nothing managers can do to improve the profitability of the business, if there are negligible contribution margins to begin with. Cutting overhead alone will not make it in the long run. PI is a true indication as to whether the company is succeeding or failing in its market environment. As examples, manufacturing companies with products delivering contribution margins in the upper 30’s or lower 40’s, and total overhead in the range of 15% of sales, tend to have productivity indices in the area of 2 to 3. On the other hand, if the contribution margins are between 20% and 30%, the company will have to reduce overhead to close to 10% of sales, in order to have a PI in the neighborhood of 2. If you don’t have high value-added products and higher contribution margins you will need to lean out your company’s overhead more aggressively, in order to stay within a PI of 2. In our experience, manufacturing companies with a PI between 2 and 3 are the ones that can be called truly “scaleable” and those that can maintain higher profit margins during a significant revenue downturn. These scaleable companies return far superior profit margins as they grow and stay between a PI of 2 to 3. Those companies that wait to fix the PI, only after it has dropped closer to 1, are the ones that spend more effort and money to get back in shape during a downturn. Evidently you want to work towards moving the productivity index well above one by increasing contribution margins and reducing fixed costs (read complexity). I know these are not trivial tasks, but this is where the 80/20 business process can play a major role by optimizing your portfolio to increase contribution margins and by simplifying your company to reduce complexity costs (read overhead). And here is where complexity metrics come into play. Complexity inevitably creeps into the company as the business grows. It hides in too many products, too many people, too many plants and so on. Complexity is what drives the excessive overhead; therefore we can say that business productivity is the inverse of business complexity. It looks obvious when you tie the amount of fixed costs to complexity, but unfortunately it is not that intuitive. Complexity is a “silent killer” and builds up extra costs slowly over time. It does to your business the opposite of capturing synergies and actually creates discord when you have multiple growth drivers at the same time. Add more sales people to deal with more customers and you will eventually add more customer support people, more products, more plants and so on, increasing complexity overtime along with extra marginal overhead, without even noticing. Guaranteed! Part of the answer to tackle complexity before it destroys your productivity is to make it visible to the organization, developing leading indicators. The good indicators will give the company a warning sign, to look closer into its overhead levels, even as productivity indices get better. Some examples of commonly used complexity indicators are: product line complexity (contribution margin dollars per SKU, number of SKUs added or deleted during the month), transactional complexity (contribution margin dollars per sales invoice), supply chain complexity (process cycle efficiency) and a global complexity index (GCI) that you can use to track a dimensionless number or a combination of multiple complexity factors. A GCI example is as follows: Overtime, growth in these leading indicators can point to a pile up of complexity costs, signaling it is time to use 80/20 data analytics to pin point where the costs are hiding. You will never get rid of complexity entirely, but you can always make things simpler, for example, using simplification tools in the 80/20 toolbox to simplify the product line, streamline business and manufacturing processes, therefore reducing overhead and boosting productivity. One can say that 80/20 helps identify the vital few and simplicity helps deal with the trivial many. As John Maeda defines in his book The Laws of Simplicity[i], simplicity is about “subtracting the obvious and adding the meaningful.” By embracing business productivity and complexity metrics you have a better chance of knowing what is really important and weeding out complexity before it impacts you financial results. [i] John Maeda - The Laws of Simplicity (Simplicity: Design, Technology, Business, Life) – The MIT Press, 2006
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