We understand the value of financial results to inform executives, investors, banks, and board members. But have you designed leading indicators to predict these results? Does your organisation have too many lagging financial measures? Does management keep generating new measures before validating the predictive ability of existing ones?
Many organisations today are simply tracking too many rear-view performance indicators. Top-performing organisations have figured out how to balance key financial measures with leading measures. In this article, I use the retail segment to illustrate key concepts that apply to all industries. “If a customer can’t find what they are looking for at your store 60% of the time, they will shop somewhere else and never come back,” David Brandon, the CEO of Toys R Us, told The Wall Street Journal last year. In measurement terms, the leading indicator – out-of-stock percentage – would predict lost sales or lost customers. This article does not attempt to capture all the measures to accomplish desired outcomes; rather, it focuses on a subset and two short cases to amplify key points.
The retail segment is characterised by a set of constructive measures that have reliably provided executives, boards, and investors with crucial information to inform decisions. A few are:
- Revenue or same-store sales (SSS) percentage. This compares the sales of stores that have been open for at least one year to allow investors and other stakeholders to determine what portion of new sales has come from sales growth (contraction) and what portion can be attributed to opening or closing of stores.
- Gross margin percentage. This is the difference between net sales and cost of goods sold (COGS) divided by sales, often expressed as a percentage. Net sales factors in sales returns and allowances. Managers use margin percentage for most marketing decisions, including pricing, return-on-marketing spending, earnings forecasts, and analyses of customer profitability.
- Inventory turnover. This is a measure of the number of times inventory is sold or used in a time period such as a year. The equation for inventory turnover equals the cost of goods sold or net sales divided by the average inventory. Inventory turnover is also known as merchandise turnover, stock turnover, stock turns, or turns. A low turnover rate may indicate overstocking, obsolescence, or deficiencies in the product line or marketing effort, and that low rate can potentially lower net income. A high turnover rate may indicate inadequate inventory levels, which may lead to back orders or a loss in sales.
In most industry segments, families of measures can go beyond informing management decisions. They also have converged to inform stakeholders, support benchmarking, comply with regulators, enhance operations, and share best practices.
With these measures in mind, consider how well your company identifies corresponding drivers and leading indicators. Given the wide assortment of retail business models, we explore two specific cases to gain more insight.
Leading indicators: The supplier
The first case involves a leading supplier to big-box electronics and consumer products stores. It is essential that the retail stores’ supply chains are tightly synchronised to their sales promotions to ensure availability of the appropriate mix of products for consumers. The global manufacturer and distributor of consumer appliances and electronics not only tracks the financial measures above but also tracks several leading indicators to meet service-level agreements with the retailers. In fact, the measures are tracked hourly and are subject to financial incentives as well as financial penalties for failure to meet performance goals. The supplier’s operations scorecard contained complementary measures (explanation where needed):
- Percentage of complete orders shipped on time.
- Percentage of line items back order per order.
- Order accuracy percentage.
- Percentage of back orders shipped in 24 hours.
- Inventory turnover by stock-keeping unit (SKU).
- Ratio of air freight dollars to limited truck load (LTL) freight dollars: The ratio of overnight delivery costs to scheduled truck freight expense. This is used to analyse the costs of filling orders late. The higher the ratio, the more costly it is to fill customer orders. A high ratio may indicate a breakdown in order fulfillment or inventory management processes.
- Inventory to sales percentage.
- Performance incentive dollars minus performance penalties.
This supplier’s leading measures safeguarded its well-functioning supply chain to ensure retail stores provided service to consumers.
Leading indicators: The restaurant
A national quick-serve restaurant chain tracks 12 financial measures, including those above. The executive team recognised it also had to use leading operational measures to predict and drive financial results.
The chief marketing officer tracks the correlation of limited-time-offer (LTO) advertising effectiveness to both incremental store traffic and incremental bill amount per customer; both are main contributors to same-store sales and gross margin percentage. Through careful testing, the CMO discovered LTO advertisements in the first week of a programme resulted in a 5% increase in traffic and a 4% increase in bill amount per customer in the second and third weeks. The LTO return on investment resulted in a decision to shift operating budget dollars from less successful programmes to double the LTO programmes. This analytical approach benefited the entire system as same-store sales, gross margin, and earnings before interest and taxes have grown considerably.
In summary, financial measures are an indispensable part of companies’ performance, but high-performing enterprises balance them with effective leading indicators and drivers to predict results.
Related CGMA Magazine content:
“World-Class Finance: Better Analysis, Less Cost, Fewer People”: With less staff devoted to compliance, the top finance teams can spend more time and money on forward-looking duties.
“Agility, Creativity in Demand for Finance Professionals”: Several thought leaders weigh in on the skills needed today from finance to become the leaders of tomorrow.
—Bob Paladino (firstname.lastname@example.org) is a business consultant and the author of three books on performance management.