The art of creating key performance indicators
How to identify effective indicators? This is one of the most frequently asked questions in regard to Balanced Scorecard. The answer to this question is extremely important because indicators predetermine the way employees would perform tasks they have been assigned. There is a saying “something that can be measured can be done.” Well, this is absolutely true if we are talking about Balanced Scorecard system. Performance indicators focus attention of employees on those tasks and processes which top management considers the most important to succeed in a particular business area. They look like leverages used by top managers to change direction and development paths of an organization. It is possible to say that key performance indicators are the most powerful instruments to introduce changes in a company and lead it in a new direction.
This is the reason why top managers have to be very careful and respectful towards indicators. Effectively indicators can stimulate unprecedented positive changes or plunge the company into absolute chaos. If indicators do not correctly transform strategy and goals of the company into certain everyday operations, the company would stumble all the time. Employees will pursue different objectives, conflict with each other, everyone will be tired and disappointed since enormous efforts will give no results. In other words, the company will work with diligence but no visible results.
Suboptimized processes
For example, if the cargo transportation company measures efficiency with percentage of timely deliveries, this may result in a sharp increase of shipping costs, because this indicator does not prevent logistic manager from sending half empty trucks to timely deliver cargos. To keep these costs at a reasonable level the company should introduce another indicator – percentage of unused load capacity in the trucks. The new combination of indicators would give logistics managers freedom to negotiate with potential and existing customers to change delivery time table for the benefit of both logistics company and a customer.
There is another vivid example – customer support service/information helpdesk. Customer support service may pay bonuses to employees who are serving the largest amount of customers per hour, or those who manage to solve the maximum amount of customer problems. It is clear that employees who receive bonuses for the largest amount of served customers are unlikely to spend their time to understand customers’ problems and provide them with the best solution, especially in case of a complicated problem. In such a situation, some call centers create special groups to handle complicated problems. In such a case, efficiency of employees is measured by how effectively they solve customer problems but not how many customers they manage to serve during an hour.
The above examples prove that choice of key performance indicators is a critical success factor for any Balanced Scorecard. BSC itself encourages company top management to introduce leading indicators instead of lagging ones (financial). However, it is very important to develop the right key performance indicators for operation and tactical environment of the company.
The art of creating KPIs
Development of key performance indicators is rather art than science. The team in charge of developing KPIs may need months to collect information on customer demands, standardization of definitions and rules, setting priorities for KPIs and development of a feedback system. In other words, it may follow all rules and norms for development of KPIs. However, it gives no guarantees for success. The team may fall victim of “analytical paralysis” because of their perfectionism. In reality, the development team should do 80% of work, while the rest 20% of indicators will be added during the initial stages of implementation process. The real work will show how indicators influence the work of employees.
Interpretation of KPIs and their types
Indicators used in Balanced Scorecard are usually called key performance indicators because they make it possible to quantitatively evaluate how well organization is fulfilling operational, tactical and strategic tasks. There are two types of key performance indicators: leading and lagging. Leading indicators evaluate actions influencing future results of the work, while lagging indicators (like most of financial indicators) make it possible to measure results of past work.
Leading indicators are powerful instruments in the Balanced Scorecard. At the same time, it can be very difficult to locate them. They provide measurement with key business value factors and make it possible to forecast future results. Leading indicators quantitatively evaluate current state of a certain parameter (for example, number of contacts with customers per day) or its future value (for example, expected number of contacts with customers in two weeks). At that, the latter option is more effective as it gives sellers and their manager more time to influence results.
Lagging indicators are easy to identify, but to find leading indicators one should possess imagination and persistence. It is necessary to go backwards in search for the most important factor, based on results obtained from evaluation of lagging indicator. Since any lagging indicator (i.e. obtained results) includes many factors, it is necessary to find one or two factors that have the most influence on the results. Here is the list of sample leading indicators and results (lagging indicators).
Leading (first column) and Lagging Indicators
The basic idea about leading and lagging indicators is that lagging indicators without leading indicators will tell you nothing about how results will be obtained. You will also have no alerts and warnings about current problems or success on your way to strategic goals of the company.
At the same time leading indicators without lagging indicators will make it possible for you to concentrate only on the short-term performance. Leading indicators will help you take preventive actions to improve performance and achieve strategic goals.
Naturally, managers would want to have both leading and lagging indicators in each BSC perspective. This is how it is possible to balance them and focus both on the past and future events. Evaluation of leading and lagging indicators is quite a tricky thing. For example you can measure such indicators as customer satisfaction or complaints from customers as lagging indicators since they are based on past data. At the same time you can measure such indicators as timely delivery or errors rate which can serve as leading indicators, since timely delivery and no errors in serving customers improve customer loyalty, and such a customer will be buying more from the company in future. Sometimes lagging indicators can alert business owners and managers, but it can be too late. For example, if error rate is more than 25%, it means that you’re losing customers.
There is a concept that leading indicators are to be used mostly for measuring activity (at process level), while in order to evaluate aggregated effects and results lagging indicators are used.
Summary
Here is the least of characteristics for the “right” key performance indicators:
- The right orientation. Key performance indicators should be always integrated into a corporate system of strategy and objectives
- Individual/targeted responsibility. Every key performance indicator is assigned to an individual employee or a group of employees responsible for relevant results.
- Forecast capabilities. Key performance indicators quantitatively measure factors influencing business cost. That’s why they are leading indicators outlining desired future results.
- KPIs encourage to act. The values of key performance indicators are calculated based on actual data, and thus they make it possible to interfere into processes to improve work results.
- Low number. Of key performance indicators should focus attention and efforts of employees and managers on several high priority tasks without wasting time for secondary issues.
- Easy to understand. Key performance indicators should be easy to understand for ordinary employees and top management. In other words, they should not be based on complex coefficients so that employees know how to influence value of a certain indicator.
- KPIs are balanced and interrelated. Key performance indicators should be well balanced and support each other (be conflict free).
- Actuality. Key performance indicators are to be updated from time to time so that employees and top managers can interfere to correct future results.
- Accuracy. Key performance indicators are to provide top management and employees with the most accurate values. However, it needs saying that it is impossible to create 100% accurate key performance indicator. Sometimes results are affected by irrational factors which no IT system or human being can forecast. For example, employee satisfaction is measured through questionnaires and surveys. But not all employees are honest in their answers.
- Relevance. Every key performance indicator has its life cycle. At first, when indicator is introduced it stimulates and motivates employees. But in course of time its effect becomes weaker, and thus it needs to be “refreshed”, reviewed or even abolished.
To sum it up, it needs saying that there are no universal rules for creation of key performance indicators and implementation of Balanced Scorecard in general. Every business is individual. Thus, suggestions as to BSC implementation can be fairly different. At the same time, the above tips and information may certainly help aspiring strategic managers to successfully implement Balanced Scorecard without making fatal and the most typical mistakes.
