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Throw Away Your Financial Statements: Managing by Metrics

Written By: Charles Chewning Jr.
Published On: October 31 2008

Originally published - September 15, 2005

Introduction

Accounting systems have always had two primary goals: track information in detail and generate financial and operational reports. Until recently it has not been technologically possible to do anything else., except process information, create invoices, pay invoices, pay employees, track costs, and generate financial statements at the end of the month. That's fine, but the problem is that financial reports are sometimes generated forty-five or more days after a fiscal period begins and the information they present must, out of necessity, start at the highest, most general level. If the results are below or even above expectations, additional reports may need to be generated and studied in an attempt to determine what went wrong or right. In addition, the factors contributing to poor financial results may have started their downward trend at the beginning of the fiscal period and will therefore still be creating problems forty-five or more days later. I use the word "later" because the drill-down analysis will require several days if not weeks to complete, once the financial statements have been published.

This style of after-the-fact management may have been the only way to conduct business in the past, but technological and more specifically, reporting advances now make it possible to identify these problem areas as they develop.

Management by Metrics

Technology can currently support the concept of digital dashboards that can display information in a graphical format, with whatever level of detail may be required. Rather than starting with the highest level of information analysis and presentation (which are the standard financial statement) users can "flip" their priorities by identifying these critical KPIs, track these values on whatever time frame is best suited, isolate those KPIs that require attention, take steps to improve the KPIs, and then track the results to confirm that the steps taken have the desired effects.

The key to this proactive management style is that if the correct set of KPIs is identified, closely monitored, and effectively managed, the financial statements will take care of themselves. In essence management by metrics eliminates the need to publish financial statements and their underlying operational analysis reports. Managers no longer have to wait for periodic reports and then invest additional time trying to determine what went wrong (or right).

Naturally there is one significant proviso. While the concept of management by metrics will improve efficiency and effectiveness, it will do so only if the correct set of KPIs is identified, responsibility assigned to the correct set of managers, and managers react quickly to an ever-changing set of business imperatives.

To some extent it has always been possible to identify and publish KPIs. Most accounting systems support some form of report writer that allows users to extract the information required and publish that information in report format. In addition most products supports some form of export whereby information can be exported to a spreadsheet and KPI graphs can be created.

The advantage of a digital dashboard is that users do not have to rely on static reports that display a single value or even that value over x number of weeks or months. Presenting graphical information in a spreadsheet is almost the same as a digital dashboard but users do not have to export/import the information or flip from on spreadsheet to another to view multiple KPIs.

Putting Management by Metrics into Practice

Digital dashboards present constantly refreshed information to users and only the information of interest to that user is presented. Unfortunately most accounting software vendors have not yet taken the concept to its most effective potential so we cannot really cite specific systems as examples. I suspect or hope that vendors or resellers will develop their systems further or begin to really understand what Management by Metrics is all about.

The KPI Must Make Sense

While everyone accepts the fact that a picture (in this case a graph or other visual display) "is worth a thousand words", most examples of digital dashboards I have seen depict a bar chart or possibly a pie chart of the top ten customers. My question is quite simple: Is knowing who your top ten customers are (and even their revenue) going to mean anything? Is this information going to help you determine that you are on or off course? Is the information going to induce you to take some form of action? A graphical presentation of your top ten customers does not support any form of action and, therefore, is useless as a KPI.

If a KPI is to be an effective management tool, it must lead to some form of action. If inventory turns is 3.2 and that is unacceptable to the person responsible for managing inventory levels, then that person will take some form of action to increase inventory turns. If the value is acceptable, the person responsible will see this instantly and move on to a review of other KPIs. Each business must therefore define those KPIs that are applicable to their industry or unique to their organization. Of equal importance they should assign specific responsibility for managing these KPIs to individuals.

There is no doubt that if KPIs are to become the powerful management tool everyone assumes they can be, users must spend a significant amount of time determining which KPIs are important to their organization and who should be responsible for their management. This design process must be thorough and it will generate design and implementation costs. The ROI, however, should be significant both in terms of reduced time analyzing results as well as productivity gains as potential problems are identified and addressed earlier than is possible with static reports.

Employ Time-phased KPIs

A single value does not tell a story. It is a static picture taken at a unique instance in time. Financial statements fall into this same category. They are no more than a snapshot of a firm or one of its business units taken at a specific point in time. Since business conditions constantly change, single frame snapshots tell us nothing.

Let's return for a moment to the example of inventory turns. If 3.2 turns is acceptable, a second question has not been answered: In which direction is inventory turns headed? If the value last month was 3.4 and this month was 3.2, then what's important is the trend, not the absolute value. If 3.0 represents an unacceptable value for inventory turns, then the trend appears to be heading downward and the inventory manager may want to analyze the situation in more depth and start to take action before inventory turns becomes unacceptable. This then becomes pro-active management, not reactive management and that's exactly the management style you want to practice.

Utilize Straight-line Graphs

Rather than looking at this month's value for inventory turns and then flipping back to another report that shows last month's value, inventory turns should be displayed in a single view that clearly shows not just the values, but the trend. Line graphs are the best vehicle to handle this time-phased analysis.

In some instances, specific KPIs may vary wildly from month to month and therefore obscure the actual trend. In this case, users may want to use some form of averaging such as a six month smoothed average. By using a running average based on several time periods, the volatility is dampened and the trend exposed.

Smoothing does tend to reduce volatility, but it has a hidden flaw that must be taken into consideration. The smoothed average can hide the fact that the most recent time periods are more negative than past periods' values. In this case users must be ready to react more quickly. Some averaging equations allow users to give more weight to current values and this may be preferable to equations that give the same weight to all period values.

Straight-line graphs are more useful than other types of graphs but users need to determine which technique will give them the best possible view of their operations. Again this takes time and study, but if you are going to utilize graphical KPIs, you must be prepared to do it correctly.

Establish Target KPIs

Now that users have identified which KPIs should be utilized, and have created time-phased line graphs to display this information, one last step should be taken. Again returning to the example of inventory turns, the fact that inventory turns is 3.2 and is above some pre-determined acceptable value, users should now take the last step to further strengthen this KPI display: add a second line to indicate the target value. Now the inventory manager cannot only see where inventory turns last month, where it has been and by interpolation where it appears to be going, but also he/she can see how that value compares against targets that have been set.

These target values perform essentially the same function as budgets. Managers now have something against which they can compare their actual results. Users can and should consider establishing different values for each time period to reflect expected improvement. While the target for January may be 3.4, the target for December could be 3.6 to reflect the fact that upper level management expects inventory turns to be improved. Alternately the values could rise and fall depending on seasonal or other expected fluctuations. Business is slow during the first and last quarter, thus leading to an expected reduction in inventory turns. However, order increase during the second and third quarters and therefore inventory turns should increase as well.

Summary

Digital dashboards, browser-based accounting, and .NET technology give users the ability to move away from traditional reporting systems that produce endless pages of reports that report on business conditions after-the-fact. As users adopt new technology, they should also adopt new methods by which they calculate, display and react to critical business indicators.

Financial reports are no more than an instantaneous picture of the organization at a specific point in time. While many products do support drill-down and therefore users can eventually identify the factors which have influenced less than acceptable performance, a great deal of time may have passed while the organization continues to slide downward.

Rather than supporting drill-down on reports after-the-fact, users should practice a form of bottom-up management whereby they identify the critical causative factors and base their decisions on these core values. By doing so managers can react more quickly and ultimately these improvements will be reflected to the financial statements.

It is actually a positive business practice to track KPIs over a period of years. Users could have identified KPIs and created reports that listed the values over any number of periods. Users could have even exported this information to spreadsheets and created the same graphs we have been discussing; even to the point of including target values and target graphs.

Digital Dashboards provide one additional and critical feature. Users can define KPIs, assign them to individual users for tracking and management, display this information on their digital desktop, and finally having this information refreshed and current.

Management by metrics isn't a new technique. It's just a technique few organizations understand how to implement. Technology now allows us to display information more readily in a graphical format. It's up to us to determine those success factors that are critical to our unique business entity and it's up to us to make sure people understand how to utilize this management technique effectively.

About the Author

Charles Chewning, Jr. is president of Solutions, a Richmond, Virginia-based (US) consulting firm specializing in accounting software selection. He is considered a leading software selection expert. Chewning has written a number of accounting software reviews and is a frequent speaker on the subject of accounting software selection as well as sales and marketing. He is the publisher of The Accounting Library (http://www.andrewscg.com) and can be reached at cchewning@accountinglibrary.com.

 
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