Establishing Effective Key Performance Indicators In Your Business

Key Performance Indicators (KPIs) are something every business should be talking about, no matter how big or how small. KPIs provide measurable values that help you determine how well your business is doing. They are commonly used to help business owners achieve their goals and track how well they are reaching their targets.

Learning to use KPI’s effectively allows you to understand performance at every level and for every department in your business. Here are a few ways on how you can establish effective KPIs in your business and change the way your organisation thinks about its performance and decision making.

Setting your accounts up correctly for effective KPI reporting

Before diving into KPIs, it’s critical that your underlying chart of accounts are first designed and set up appropriately with your relevant KPIs already in mind. Unfortunately, this kind of forward planning rarely takes place, although it should.

Although well-intended, many accountants and bookkeeping professionals lack the real-world experience needed to properly understand the commercial realities that impact your business.

For example, if a bookkeeper has a purely ‘translation only’ mindset, the set up of your accounting from day 1 is unlikely to be optimised in a way that allows you to easily extract meaningful performance information.

Understanding the Important KPI’s

There is generally no one size fits all approach when it comes to measuring your organisation’s progress via KPIs. The simple reason being that every business is different. That said, there are three common KPI’s that tend to be helpful across the board, which I’ve addressed further below in this article.

Please note we have purposefully stuck to basics in this article. We see many KPIs used across our client base depending on their size, nature and the specific industry they operate in. If you would like to discuss some of the more specific KPIs that might apply to your business, please feel free to get in touch and we will arrange a time to discuss.

We have also kept the terminology fairly basic and have purposefully avoided using accounting standards definitions or overly technical jargon. We have extensive experience in working with auditors and understand accounting standards intimately: although this is not the intended audience for this particular article.

Here are three of the more common KPI’s that apply in almost all circumstances.

Gross Profit (Revenue (Sales) - Cost Of Goods Sold = Gross Profit) 

Gross profit is the profit an organisation makes after deducting the costs associated with creating and selling its products or the costs associated with providing its services. Gross profit should appear on your income statement and can be calculated by subtracting the cost of goods sold (COGS) from revenue (sales).

Many organisations and entrepreneurs love to boast about their ‘top line’ revenue (sales) figures. However, a business’ gross profit typically tells a far better story in terms of true business performance.

By way of an overly simplistic example, a business that makes total sales of $10 million, but only keeps $100,000, is generally less desirable than a business with total sales of $1 million that gets to keep $500,000.

Gross profit offers insight into how much profit your business is generating and how much of it goes toward meeting your other overhead expenses (being those costs that are necessarily incurred to operate your organisation, although don’t necessarily vary relative to every new dollar in sales you generate).

With gross profit established, it is then vital to keep track of your ‘gross profit margin’.

That is:- gross profit divided by revenue (sales) = gross profit margin (expressed as a percentage).

If you see your gross profit margin declining over time, you may need to start rethinking the inputs (costs) required to deliver your service or product. Is there a lower cost or a more efficient way we can be delivering this product or service?

Alternatively, it might be time to increase your prices, although care should be taken to reflect upon how such an increase might affect the sentiment of your current customers.

It’s a balancing act. Your gross profit margin, as with all KPIs, must be interpreted in the context of your broader business and its commercial landscape. Comparing your gross profit margin to other competitors or substitute service providers in your industry (an exercise known as ‘benchmarking’) is an excellent way to assess how well your business is performing in your market.

Net profit  (Gross profit - overhead expenses = Net profit)

The next KPI that should be tracked closely is of course your business ‘net profit’.

Put simply, net profit is your actual ‘profit in hand’ after working expenses not included in the calculation of gross profit have been paid. In other words, it’s after deducting all of those other expenses that are incurred in the operation of your organisation. These are the costs that don’t necessarily vary with every additional dollar you generate in revenue (sales).

Similar to gross profit margin, your net profit margin is an effective overall / holistic KPI you must have your eyes on. At its most simplistic level, it singles out how effective the business is performing overall and whether or not you’ve got too many unnecessary expenses.

As with the majority of these common ratios, your net profit margin can be benchmarked against industry averages to determine how well your business is performing relative to others in your market. We have experience in this area and can help you do this in a cost-effective manner.

Working Capital Ratio (‘Current Assets’ divided by ‘Current Liabilities’ = Working Capital Ratio)

Businesses don't become insolvent because they are not profitable. They end up insolvent because they run out of cash and can't meet their payment obligations as and when they fall due. Profitable, growing companies also have cash flow challenges because they need increasing amounts of working capital to support additional investment in inventories, research and development, and accounts receivable as they grow. The working capital ratio is a handy tool that can help you manage the risks associated with this pitfall.

By ‘current’ we’re generally referring to both assets and liabilities that are expected to be settled (converted or paid in cash) in less than 12-months.

Current assets commonly include cash in the bank, inventory/stock on hand and accounts receivable (i.e. the money we’re owed).

Current liabilities commonly include accounts payable (i.e. the money we owe to others), GST, PAYG withholding,  income tax, statutory superannuation contributions, credit card balances and any bank overdrafts.

The working capital ratio represents your ability to pay current liabilities with your current assets. In other words, it is a measure of the resources you have around to meet your short term business obligations.

By forecasting working capital and measuring the working capital ratio over time, a business can spot potential cash flow problems ahead of time and plan appropriate action to address those challenges accordingly.

How to Set-up Your KPIs

Whilst I stated this earlier in the article, it is essential and worth repeating.

Before deciding what KPIs to measure, it is critical your underlying chart of accounts are first designed and set up appropriately with your relevant KPIs in mind. Although well-intended, many accountants and bookkeeping professionals are not trained to think about the commercial and performance aspects of your business. If a bookkeeper is purely translation only focused, the set up of your accounting from day one won’t likely be optimised in a way that allows you to easily extract meaningful performance data.

To help you determine which KPIs are the most important for your organisation, you can use the SMART criteria:

Once you settle on the KPIs you wish to use, you can start setting targets where you will measure your performance against each KPI on a regular basis.

How Key Performance Indicators Influence Behaviour

Your KPIs are often the tip of the iceberg, which act more like clues to the stories taking place within your business. By digging deeper, you can clearly see and understand the narrative and expose what corrective action must be undertaken, if any, ahead of time.

This is really the purpose of KPIs as they allow you to be more proactive in your approach. They help you to better predict and set more realistic budgets and goals.

It is important to have a strategic partner with relevant business experience who can help you make sense of the numbers so you can determine the most sensible pathway forward. This assumes you don’t already have this capability covered in-house.

Bonitas Partners Pty Ltd is your partner in discovery. We understand the importance of KPIs and ask all the right questions in order to establish the best ones to keep you on track for success. Our team thinks ahead, so you always know what is needed, including getting your underlying chart of accounts set right (or fixed if less than ideal) from day 1. KPIs aren’t about bookkeeping. They are about deep dives into the key measurements that tell you how you are performing so you can move forward with clarity and sleep better knowing exactly what is going on.