Regular monitoring of the performance of an organisation is a critical function, often carried out by FP&A professionals. Most professionals know what a KPI is, in high level terms, though what is not always so clear, is the inter-relationship between KPIs, and how they relate to measuring key financial metrics such as net or gross profit margin.
Measuring performance of an organisation is so critical, because “what we measure is what we get.”
This post aims to demystify this relationship, along with some real-world examples from companies I’ve worked with.
Some of the key financial metrics included in a P&L statement which are closely watched by business leaders and analysts include gross, operating, and net profit margin. Net profit margin is calculated as net profit after all expenses and taxes, divided by the top-line sales/revenue.
Value Drivers
Value drivers are the factors that affect the organization’s ability to generate economic value. The value drivers for net profit margin include revenues and various expenses incurred, such as cost of goods sold, SG&A, depreciation, finance costs and taxation expenses. The difference between these figures in the net profit. The value drivers for gross profit are sales and cost of goods sold.
Operating value drivers
Once the value drivers for a financial metric have been identified, we next consider the operating value drivers that influence these value drivers. For example, the value driver revenue is a function of volumes sold and price charged – these are operating value drivers. For example, a fashion retailer that sells 1,000 shirts in a month, at a price of $10, results in revenue of $10,000. If the retailer wants to increase revenue from sales, it needs to either sell more shirts, or increase the sales price, or some combination of the two.
KPIs
A KPI is a level of performance within a given area of activity that is required to achieve a desired value driver.
This process of identifying value drivers and KPIs helps a firm to clearly understand the activities that influence a value driver, and helps analysts to build financial models.
The clarity that this process brings, helps firms to gain a better understanding of what is required to maximize the value created by a particular project or initiative, and provides an improved ability to assess a product’s operational risks and opportunities. This in turn helps a company to deliver its strategy and create shareholder value.
Value Driver Trees
A value driver tree is a visual chart which decomposes a financial metric, such as net profit, into all the relevant drivers including value drivers, operating drivers, tactics and KPIs.
This value driver tree schematic was taken from an FP&A course I recently took.
The tree starts on the left-hand side with the financial metric of interest, such as net profit margin. The tree then spreads to the right side, firstly showing the financial value drivers, such as revenue, cost of goods sold, taxes and finance costs. These value drivers are influenced by operating value drivers such as sales volume, new retail channels, new promotions and reducing uncollectible debts. Tactics are then developed to help a firm to achieve the operating value drivers. For example, a firm might begin a campaign of increased social media use, to create awareness about new product promotions, which should in turn increase sales volumes.
I was seconded for 6 months to a fashion retailer which our PE company had acquired, and I was working to help turn around the business. The company had 55 stores throughout the country, under two brands, a lower income brand and a middle-income brand. The retailer sold garments on both a cash and credit basis.
Some of the KPIs that fashion retailers usually monitor and must be made available on a monthly basis include:
- Number of active accounts – these are credit accounts that are actually being used. For example a company may have 300,000 registered credit account holders, but only 150,000 may only be actively used.
- New accounts – these are new credit accounts created, which may lead to increases purchases, and therefore sales.
- Average value of 1st purchase – this is a dollar based value showing the average value of a customers first purchase
- Average value of repeat purchase – this indicates whether a customer is spending more or less on a repeat purchase, and is a key metric to monitor.
- % of existing accounts buying per month – this is effectively the number of average accounts as a proportion of the number of total accounts
- Average balance – average credit balance held by a customer. This is what generates interest income for the company, but if not repaid, can result in defaults.
- Average credit limit – a credit limit is based on a customer’s income. Increases in credit limits means customers have an ability to spend more.
- Average utilisation of credit limit – this indicates how much a customer spends of his/her credit limit
- Stock cover (weeks) – this metric is key and tells a company how many weeks of stock cover a company has in hand. It is imperative a company has sufficient stock to sell, particularly in seasonal upticks such as Christmas.
- Turnover per SQM – this is a sales metric and divides total sales by total square metres of trading space. This is a key metric, since it can indicate if a stock is not efficient enough in terms of sales, and it also helps forecast sales for new stores being added. This provides management with a very clear picture of how a retail company can achieve tangible growth by increasing its store count, increase sales, profits, cash flows and ultimately creating value.
- Sales per employee – this indicates efficiency of employees, and can indicate whether less/more employees are required in stores
Finally, the KPIs measure the effectiveness of the tactics employed to influence the operating factors, in turn driving the value drivers.