UK: Measure cause, not effect.

UK: Measure cause, not effect. - The factors underlying business success don't appear on any financial statement. You have to look beyond the wall of numbers.

by Robert Bittlestone.
Last Updated: 31 Aug 2010

The factors underlying business success don't appear on any financial statement. You have to look beyond the wall of numbers.

Defining business success has never been much of a problem for managers.

Despite the current City fashion for economic value added (EVA) and other new financial measures, everyone knows that if you deliver above-sector profit growth, together with positive cash-flow and a growing dividend, you are certainly succeeding. But just how are you supposed to do that?

Conventional wisdom says that you should talk to your accountant and scrutinise your financial reports. But there's now a growing body of opinion that says this may not help. The problem is that your financial statements measure the outcome of your business, not the reasons underlying your success. Believing you can improve your bottom line by tinkering with your profit and loss (P&L) is like thinking you can make a car go faster by pushing up the speedometer needle with your finger.

Most of the important things that drive our business don't seem to be measured in pounds and pence at all. Instead they are measured in units such as 'satisfaction' or 'motivation' or 'brand awareness' or 'percentage of customers who choose our products first'. Of course, the sales and the profits are important too, but they are outcomes, not causes. The P&L tells you what you have done, but not how you are doing. Imagine if Gary Kasparov had been in training to become a grandmaster but his coach had spent all the time teaching him the rules of chess instead of the strategy. Soon Kasparov would say: 'There's no need to keep telling me the rules: what I want to know is how to play well and win the game.'

Let's consider some simple arithmetic at the heart of the dilemmas of modern business. Profits obviously increase when sales revenues improve and costs are reduced. If we want higher sales volumes, we need high levels of customer satisfaction, which we can help to achieve with a relatively low selling price. But don't we need a high selling price to keep up our revenues? Is it any simpler when we look at the costs instead? People-based costs are obviously the product of headcount times the average wage.

Headcount is driven by productivity, which in turn is driven by job satisfaction, which is at least partly affected by compensation. So the more we pay our people, the better quality staff we will attract and retain and the more productive they will be. That means we will need less of them. But unfortunately, we've just increased the average wage in the process, so it's not at all clear whether we're saving costs overall.

Consider another complication. A higher paid, more motivated workforce is likely to deliver better customer satisfaction, driving up our sales volumes. But will the resulting revenue increase outweigh the higher pay?

Running that new advertising campaign will bump up costs as well, but it is supposed to increase market share. Will that be a net gain or is it simply a feel-good factor for the marketing department? You're not going to be able to crack any of these problems by measuring your P&L account more carefully. None of the 'soft' factors mentioned above are listed in your financial statements. Your balance sheet will simply be a distraction and your cash-flow statement provides no help at all.

In a one-man business, trying to decide between all these interactions is indeed an intuitive process. You just have to think it through and do what feels right. But in a bigger business that approach doesn't work, because everyone has a specialist focus. Production doesn't understand the difficulty of selling; finance doesn't appreciate the dynamics of R&D; in fact nobody apart from the chief executive gets to see the whole picture, and he or she has neither the time nor the grasp of detail to master these interactions.

So what can be done? If only we could measure employee productivity and customer satisfaction and correlate them with improving revenues, we could see at what point increased salaries start to run up against diminishing returns. And we could see by how much the gain in customer satisfaction translates into sales. That way, we wouldn't have to guess how to take these decisions. We would know. But you can't rely on monthly management reports for this information.

What you need instead are three ingredients that don't appear to be taught in the accounting syllabus.

First, you will require a very clear perception of 'what affects what' in your business, in terms of the factors driving your bottom line. This will help you to separate the upstream influences, such as customer satisfaction, from the downstream ones, such as cash-flow. Second, you will need some realistic non-financial performance measurements to help you to calibrate those upstream drivers. Third, you could use a method of combining and presenting these so that you can tell at a glance both whether you are winning and what is holding you back.

What are the do's and don'ts of tackling this yourself? Perhaps the best advice is to be wary of fashionable packaged solutions such as balanced scorecards and economic value added. Instead, use basic common sense.

Perhaps you could start by arranging an executive workshop for the top management team. Next, why not introduce ways of visually depicting the chain of cause and effect. Then you can break up into syndicate groups and invite each group to think through the cause-and-effect chain for their part of the business. Your groups could then at least present their initial thinking back to the rest of the executive team. After a suitable period of debate, you could perhaps use this to focus your efforts in measuring non-financial performance. Presenting the monthly results visually is another useful device and gives everyone the chance to see improvements or otherwise. Finally, it is vital that you continually correlate improvements in the drivers with your bottom-line success.

ICI Melinex was a global polyester films business recently bought by Du Pont. Before the purchase chief executive Jim Alles noted: 'The only way you could do this sort of exercise in the past was if you had a finance department that was highly skilled in management forecasting and wasn't already pressurised by routine finance tasks. The beauty of this approach is that it brings the talent level in the finance department up to a much higher level, by training the key players to free up much of the time that they previously spent on routine activities, so that they can support the general managers more effectively.'

His CFO, Scott Steele, agreed: 'At a recent executive workshop we focused on identifying and agreeing business drivers, including non-financial drivers, so that we could subsequently include those metrics in our management reports and analyses. One syndicate group looked at the sales to gross margin line and the other explored the gap between gross margin and profit before tax - which obviously included fixed costs.' When the two groups compared notes, said Steele, there was a lot of constructive overlap.

'We had recently completed a global strategy review and the session confirmed key aspects of that strategy. But it was the first time we had attempted as a team to agree on key drivers, so it was a great success.'

If you tackle the issue of performance measurement seriously, you should notice immediate benefits. Your management team will knit together better, because the process of 'brain-dumping' individual mental models of the business helps everyone to appreciate each other's point of view. More importantly, your conversation about the numbers will begin to touch the core of the business, rather than the periphery. Third, by focusing on the performance of the upstream influences, you will gain months or even years of advance warning of future financial problems. Fourth, your planning and budgeting will become real, not simply an annual ritual. Most fundamentally, your bottom line will improve.

Finally, a practical tip. Keep an eye on that crucial distinction between causes and effects. Don't allow yourself to be seduced by those pages of finely-printed numbers in your management reports. Follow your common-sense impulses and you won't go far wrong.

Robert Bittlestone is a founding member of the Foundation for Performance Measurement

WILLIS CORROON

SPOT THE TRENDS BEHIND THE NUMBERS

Willis Corroon is an international insurance broking company which assists its clients in the management, financing and transfer of risk.

It is represented through 261 offices in 74 countries. When John Reeve joined the group as executive chairman, one problem he soon found was that the organisation's monthly internal financial reports did not make it at all easy to discern important trends and focus management attention on the real issues.

Says Reeve: 'When I received the first set of board and group executive committee reports, I spent hours with a calculator trying to draw any inferences or trends from them. Each document was simply a wall of numbers.

I quickly became aware that the board, and perhaps more importantly senior management, did not really grasp the numbers and their implications and were not taking them seriously enough, except at the most superficial level.' The main reason for this, Reeves adds, was that he received pages and pages of numbers in which important information was buried. 'I realised that we needed something which was much more focused, much more visual and with a very short bullet point commentary warning of adverse trends and raising issues and questions.' A full array of non-financial indicators may show, for example, that it is productivity in sales that is tailing off. 'You know,' adds Reeve, 'what the problem is and you can ask what can be done about it. Non-financial measures let you get behind the numbers more explicitly.'

At the divisional level, where they live with these problems day-to-day, the measures very often do confirm what managers already think. But sometimes there are surprises, because they have not appreciated the outcome quite so explicitly. 'We are much less likely these days to deceive ourselves that we are going to achieve a certain target than we would have been 18 months to two years ago. At that time we would have realised it in the end, but it would probably have been too late. We are now on top of any difficulties much earlier and we can do things to overcome them, for example, by seeking profit from another source to get us back on track.'.

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