Tuesday, December 14, 2004

I had a genius for a stepfather

How do you measure success?
by Joseph Pecukonis
Copyright Ó 1995 by Joseph Pecukonis, All rights reserved
If you’re not monitoring it, you’re not managing it, should be every manager’s credo. There is an inseparable union between successful management and good information. This union started in 1494, when a Jesuit monk named Luca Pacioli created the double-entry accounting system. His system is still the foundation of our modern business management systems. Thanks in large part to the IRS, our modern accounting system has developed a level of quality and reliability that seduces us into using it for a far larger role than it was originally intended. But as a management tool, it can fall short. This article evaluates the pitfalls of using our modern accounting system as a management tool and looks at three other monitoring systems that can fill the gap.
Leading and lagging indicators
The modern accounting system is a lagging indicator of financial performance. This means that it is good at showing us what has happened, but it is not good at showing us what will happen. It creates a snapshot of the past. Making management decisions based on a company’s financial data is like driving a car by looking out of the rear view mirror. Using financial data as a predictor of future stock performance has frustrated even Wall Street experts. They would love to have an accurate leading indicator for their stock purchases. Fortunately, there are information systems that can act as leading indicators of financial performance. Some examples that will be examined later are operational metrics, employee attitude surveys, and customer surveys.
Short term and long term focus
The pressure on management is to increase the bottom line. Unfortunately, this tends to focus management on the short term. With the logical result expressed by the phrase, "The quickest way to increase profits is to cut costs". Cutting cost sounds like an improvement in operating efficiency and it can be. It sounds like management is really doing their jobs. In reality, good managers don’t normally operate with excess costs that are available to cut. What gets cut are programs that are investments for the longer term, the future of the company.
There is an optimum level of investment or expenses that result in maximum profits. If management has been doing its job properly, the company should be running at or near this optimum level of efficiency. Cutting costs can cause reduced efficiency, lower morale, and lost opportunities, with the result of lower sales and profits in the future. The profit and loss statement cannot determine future organizational effectiveness. In other words, modern financial reporting systems can encourage reducing costs to increase short-term profits while sacrificing longer-term profits and growth.

This focus on the short term is magnified by the typical management bonus program, which rewards managers on a basis of a percentage of profits. In a discussion with the president of a medium size manufacturing company, I asked him why he didn’t plan for a smaller bonus this year, so that he and his managers could have larger bonuses in future years? He responded, "I have no guarantee that I will be working here next year, so I’ll get all I can right now." Unfortunately, the shareholders and most of the employees will be around next year when the results of not investing properly in the business will be evident.

This situation is similar to having a saboteur within the company. This saboteur plants a financial time bomb disguised as more short-term profits in your company, that will eventually help your competitors and hurt your shareholders and employees. The bomb goes off with a flurry of cost cutting. This starts a vicious circle of reduced earnings followed by more cost cutting. The result is a company with a poverty mentality that cannot adequately compete in the marketplace. Eventually the best employees leave and the damage is virtually irreversible. (For a more detailed examination of this process read, "The Sick Company Syndrome" from "The Entrepreneur’s Manual" by Richard M. White.)

There have been attempts to modify financial reporting to encourage management to operate with a longer-term perspective regarding their incentive programs. One system is called EVA or Economic Value Added. With EVA reporting, expenses for new product development can be pushed out of the current management bonus calculations and included as an expense when the new products enter the marketplace. This is designed to encourage investments, like new product development, without penalizing the bonus or incentive program. EVA addresses only one part of the problem. In the end it is still an accounting statement with the numbers moved around. It also tends to reduce management’s concern about process issues like minimizing time to market and product development effectiveness.

Managers and shareholders will need to look deeper at the elements that determine success. I will examine three alternative systems that measure performance. I believe these are essential for every company to operate at maximum effectiveness.
Operational Metrics "The pulse of the organization"

Measuring the processes within a company is called operational metrics. These measurements contain information that determine the effectiveness of both the processes of the company and therefore, the company as a whole. The following are some of the processes that should be monitored. I learned how effective operational metrics can be in 1985, when I first started monitoring the marketing criteria below. I know this works. I reduced media expenses by 90% and increased sales by 20%!
Marketing Criteria
  • Cost per lead by media type and advertisement. This measures the effectiveness of advertising formats, placement, and repetition. There is a strong correlation between the number of leads in the present month and the sales for next month. Therefore, monitoring the number of leads per month can be an excellent method of forecasting next month’s sales.
  • Sales per lead or close rate. This monitors the effectiveness of the sales literature and the sales process. Sorting this report by geographic area can be effective for monitoring sales rep effectiveness.
  • Time to respond to leads. This should be in the form of a monthly histogram of how long it took to get sales literature to a prospect. Research suggests that the longer it takes to respond to a lead the less likely that person will purchase from your company.


  • Ratio of overhead costs to direct labor costs. It’s surprising that management tends to focus on the cost of direct labor when the manufacturing overhead is many times greater. If the overhead rate is over three times the direct labor rate, you have a problem. Overhead can be reduced by properly utilizing computer information systems like Material Resource Planning (MRP). Unfortunately, most companies that claim to be using MRP are still operating with inventory restock levels to trigger inventory purchases. If you are using restock levels or are manually counting your inventory, you are not using MRP.
  • Percentage of rejects or rework. This can be an early warning of defects before the product goes out the door. Quality problems internally raise the cost of doing business and quality problems that go out the door can destroy a business. The better manufacturing companies monitor rejects in parts per million instead of percents. A common phase among professionals in the quality area is that, "If you are measuring quality in percent, you have a problem."
  • Inventor turns ratio. This monitors the effectiveness of your purchasing and shop floor systems. It also indicates the effectiveness of your sales forecasting system.
  • Shop floor-processing time. There is a direct relationship between how long it takes to convert raw materials to finished goods and production effectiveness. Shortening the shop floor processing time will improve inventory turns, working capital, and cash flow. If you reduce processing time from four weeks to one week, you will convert 25% of work-in-process to cash!
  • Rush shipping and expediting charges. When there is a problem with production it usually shows up in extra shipping charges. Management should always be watching this indicator.
  • Cost variance from standard. This metric is effective in anticipating production or purchasing problems and the effect of inflation. It amazes me how many companies claim to be using standard costing and never review these variances.

Human Resources

  • Percent employee turnover. It costs approximately $7,500 to replace the average employee. Does one manager have a much greater employee turnover than the norm?
  • Accidents per thousand work hours. Accidents are avoidable and cost money. In Singapore, companies are required to set a safety standard that, "An employee cannot hurt themselves, even if they try." This may seem like an extreme approach. It is not extreme, because these companies are doing this with the result of significantly lower on the job accident rates.
  • Employee Opinion Surveys. This is critical feedback about employee perceptions. It is so important I will cover this in depth later in this article.

Product development

  • Time to market, and time to break-even. Every development project should have a graph posted in a common area that shows the accumulated development costs for each project and the accumulated profits. This will show both time to market as well as the time to break-even.
  • Labor hours per task. This will monitor both the effectiveness of personnel as well as create a basis for more accurately forecasting and budgeting future projects. This can take some of the guesswork out of managing technical type people and supply the supporting data to justify capital purchases.
  • Engineering change order costs. Getting a product into production is only part of the job of product development. The cost and quantity of engineering changes is directly related to the quality of the development effort.

It is a common misconception that getting data from an organization increases employee workload and therefore reduces organizational effectiveness. This is true if the data is collected manually. I recommend a system of databases and bar readers. This way as each employee does his or her work; the data is available for management reporting. Then reporting is a transparent and painless function.

Because these metrics are leading indicators of financial performance, I cannot stress enough the importance of monitoring these processes. But monitoring is only half of the system. The other half is the presentation. Graph and post these data for employees in their public areas. Graphs allow the easy analysis of trends.This system tends to motivate just by having the data public. When employees understand that they are being measured in an area, they are more likely to start looking for ways to improve. To amplify this effect, the trends in the operational metrics should determine bonuses. In other words, the people who can affect a particular operational metric should be rewarded for improvements in their area.

Employee Attitude Surveys

Surveys provide a powerful management tool that can convert subjective information into objective data. Employee attitude surveys provide a tool to monitor the level of morale, uncover organizational and personnel problems, and EEOC (Equal Employment Opportunity Commission) issues. These surveys can also be used to provide a "Needs Assessment" if management decides to enlist the help of a consultant. Then a follow-up survey can be done to measure the consultant’s effectiveness. Employee attitude surveys provide the feedback management needs to make effective decisions.

In general, there are two types of employee attitude surveys, the General Assessment survey of the organization and the 360o or Peer Review survey. The General Assessment survey consists of a series of questions regarding the organization and environment that are grouped by logical categories. Every employee answers these questions anonymously. After the results are tabulated, management receives an overview of which categories and questions received the lowest scores. These are the areas, from the employees’ perspective, that need the most attention. The good news is that in many cases, employees’ perceptions can be changed by improved communications or by changing some policy or procedure. When management acts on the results of a survey it can have an enormously positive effect on both morale and therefore productivity, with benefits throughout the organization. It should be stressed that if management is not committed to acting on the results of a survey, then they should not do one. It is much more damaging to do a survey and not follow-up than to not do one at all. Before performing any survey, management should make the commitment to communicate the results to the employees, and then act on the information received. If this is not done, then employees will view any future surveys as a waste of time and will think that management does not care about their opinions.

The second type of employee attitude survey is the 360o or Peer Review survey. This survey consists of a department or group of employees that anonymously evaluate each member of the group. Each person is given his/her individual results and an indication of how they scored relative to the rest of the group. The manager gets to see a summary of all the scores, as well as individual results to use in determining training needs and employee performance management.
The power of this approach is that employees present a different side to their boss than they do to each other. This is why the boss is usually the last to know about employee problems and backstabbing that can destroy productivity. This type of survey keeps relationships honest. How many "team killers" do you have in your organization?

Presently, the fastest growing expense in an organization is the cost of employee rights, harassment, and discrimination claims. An example of this cost is that the Chubb Group of Insurance Companies and Philadelphia Insurance Company have introduced employment practices liability (EPL) policies, with annual premiums from $100 to $150 per employee. (Quoted from Nation’s Business April 1994.) Part of what makes these claims so expensive to defend against is that the employer is assumed to be guilty and is expected to prove his/her innocence. This is an enormous disadvantage. How would you prove that you are not, "maintaining an environment of harassment?" Management needs to be proactive. An employee attitude survey can gauge these areas. No matter what the outcome of the survey, the company wins. If the company scores well in this area, then fine. But if it scores low, management can implement an improvement program and then six months later repeat the survey. Either way, management is protected.

Management can also use this data as support for performance reviews. Performance reviews are something that consumes a lot of time and most managers do them poorly. As a result, when a manager wants to terminate an employee, they often find that they have not properly documented this decision. Peer reviews are self-documenting and are very effective.

Customer surveys

Every business needs to have a graph in a common area that charts customer satisfaction. Customer satisfaction is the result of the efforts of the whole organization, so everyone must be aware of the customers’ perceptions. This is where the "rubber meets the road." If a customer has a bad experience with your product or service, your company will rarely get a second chance. There is no amount of advertising that will bring them back. You have to know the bad news first. An unhappy customer will tell many other potential customers about their experience.

There is no standard method for customer surveys, and the responses may vary from the time of the sale throughout the life of the product or service. It may be valuable to segregate the results by the length of time the customer has used the product or service.
You can collect feedback with return-reply cards, phone follow-up or follow-up sales calls. When you do this, it is important to ask your customers to be very candid. Most customers will be happy to give their opinion.


There are many ways to monitor the performance of an organization. Financial reporting tends to be the predominate method of management feedback. Managers, and even members of boards of directors, should look deeper into the organization by using both operational metrics and opinion surveys to better gauge performance and determine bonuses.

Most companies are an open loop system. Control, directives, and policies travel down the organization, but feedback from the bottom does not travel back up. Open loop systems tend to be under utilized at best and unstable in the worst cases. This system is like a person who has no feeling from the neck down. "Everything must be OK, I don’t feel a thing." But there could be major problems that take time to surface, and once they do, are not obvious as to the cause or cure. As an example, our person with the feeling disorder could be bleeding from a limb. The head would notice that there is less response from the body but not know what to do to fix it. The head would just try harder to get the body to move. This is the dynamic in many organizations today.

Management needs to know how the employees and the customers perceive their decisions, directives, and policies. Surveys are one of the only ways to do this. I recently asked Sherry Fox, President of Business Survey Systems in Denver, "If surveys work so well then why do so few companies do them?" She replied that, "There is a fear in top management that the results will not be good, so only the best run companies tend to do surveys."

Anything worth doing is worth measuring. Getting the right information and using it, is crucial to the performance of an organization. Every company should be monitoring operational metrics, employee, and customer attitudes.

No comments: