Tag: Operations

In today’s competitive business environment, we need capable metrics to (a) recognize success so we can learn from it and (b) recognize failure so we can correct it. In reverse this means that, without capable metrics, we can’t manage or improve anything – or as H. James Harington said: “Measurement is the first step that leads to control and eventually to improvement. If you can’t measure something, you can’t understand it. If you can’t understand it, you can’t control it. If you can’t control it, you can’t improve it.”

About Measures, Metrics, and Indicators

As a first step, let’s clarify the difference between measures, metrics, and key performance indicators (KPIs). A measure is simply neutral information, a reading from an instrument, such as a scale or compass. A metric is a measure that provides vital information to someone who can influence the measure through direct efforts. An indicator can be a measure or a metric, whereas a key performance indicator (KPI) provides information that is mission-critical for an individual, a team, or a business. For example, revenue is a key indicator for the sales team, but just a measure for the finance team. For a runner, lap-time is a key performance indicator, heart rate is a metric, and her shoe size is just a measure.

Leading versus lagging Indicators

There is one more characteristic we need to understand before developing universal or “golden” metrics – the relationship of the measures to time. We classify indicators as leading and lagging. Leading indicators anticipate future events, while lagging indicators only change after events. Leading indicators are typically input-oriented, hard to measure but easy to improve or influence, whereas lagging indicators are typically output-oriented, easy to measure but hard to improve or influence. Weight loss is a good example; it is clearly a lagging indicator that is easy to measure by stepping on the scale, but not as easy to influence. For weight loss there are two leading indicators, the calories consumed and the calories burned. Calories are easy to influence by the amount we eat and the way we exercise, but much harder to measure than their output, our weight. Let’s translate this to business. Most financial indicators such as revenue, costs, and profit are lagging indicators that track the results of the activities of the company. To effectively manage teams, however, we need to track leading indicators (inputs) that have a strong impact on business performance (outputs).

The 3 Golden Metrics

If you are like most managers, you have certainly asked yourself which metrics matter most. To improve your team’s performance, there are a thousand things you could potentially measure but only a handful that will really help you advance. We can narrow down the field to those metrics that (a) you have direct control over and (b) clearly influence overall business results. Combining those metrics on a single sheet builds the team’s scorecard, which is a key component of any performance management system (PMS). There are two relevant questions that we need to ask: What information is essential to effectively manage a team or department on a daily basis? Which metrics are universally applicable to any business? To manage a team’s performance, we find three factors that are universally applicable and essential to know: (1) the amount of work accomplished within a given time period, (2) how well the work meets customer needs, and (3) the amount of resources consumed to accomplish that work. In short, that’s Quantity, Quality, and Productivity. Those three metrics are universally applicable, no matter if you are running a bakery, bistro, brewery, or bank.

Quantity

The quantity metric tracks the amount of work completed within a given time or the amount delivered by a requested due date. The essential reference points are the production schedule in a make-to-stock (MTS) environment, and the due date per customer order in a make-to-order (MTO) or service business. Common quantity metrics are throughput (units per day) or on-time delivery performance (OTD).

Quality

Quality is a measure of excellence or a state of being free from defects, deficiencies, and significant variations. Quality or “fitness for purpose” can therefore be expressed in positive or negative terms, as success or failure, yield or defect rate. Because most people respond strongly to things that go wrong, most quality metrics track rework, rejects, returns, delays, or backlog, relative to the amount of work completed.

Productivity

The productivity metric looks at the actual output over the actual input, the amount of work completed over the amount of resources consumed, such as units per labor hour or miles per gallon. Productivity is a useful metric when a product or service is made-to-order (MTO) and directly accepted or consumed by the customer. For make-to-stock (MTS) businesses, however, it is more useful to track efficiency, the actual input over the standard input, because the product is first inventoried and not shipped or consumed right away.

Putting it all together

The three golden metrics – Quantity, Quality, Productivity – provide an ideal framework to manage any team in any business. Those metrics are essential to build a team’s scorecard and performance management system (PMS). You might ask: are there any other metrics that are necessary or relevant? The short answer is: it depends on what results you want to drive. But in any case, you should start with the golden three and add only those metrics that improve your level of understanding and control. In addition to the golden three, teams in Lean environments also track housekeeping score (5S) as a leading indicator, and customer satisfaction as a lagging indicator – making a “Golden Five” for the Lean team.

How well do you manage Performance?

Performance metrics are important to any manager in any business, but are only one of many elements of a world-class operating system. If you are interested in evaluating the effectiveness of your current management system, then I recommend that you perform the “Lean Audit”, an online survey to assess the 20 keys to world-class operations here. The Lean Audit is essentially a health-check for any factory or office that allows you to gain better insights on what is already working well and what needs to be improved. As a result you get a maturity score on a 5-point scale, where 5 denotes a world-class level. More information is available in the Lean Audit workbook on Amazon. It includes the research on over 100 companies, checklists for self-assessment, as well as a blueprint to design your journey to world-class status. I look forward to your feedback and further discussions and suggestions on these topics.

Working Capital is the key indicator for capital tied up in the company, equivalent to the sum of accounts receivable and inventory, minus accounts payable. Most companies focus on inventory management to control Working Capital levels, while accounts payable is often difficult to influence due to supplier pressure. However, significant potential for improvement lies within accounts receivable management, which is often neglected by companies. Key to success is the improvement of collections and dispute resolution cycles. To achieve this, I have developed an innovative and proven three-dimensional customer segmentation matrix approach that delivers significantly better results when targeting tied-up capital reduction.

Goals of improved Working Capital management

Working Capital represents tied-up capital and, therefore, financial risk, especially with regards to accounts receivable. A reduction of Working Capital has the potential to free up cash for investments and, at the same time, particularly for accounts receivable, minimizes the risk of bad debt and, eventually, costly write-offs. Moreover, when managed properly, it educates customers about committed and reliable payment behavior.

Sophisticated Working Capital management enhances detection and reduction of mismanagement in any of the underlying processes, and thereby increases profit margins. Working Capital improvement has three goals: firstly, to reduce accounts receivable to the lowest level possible, which is mainly determined by the standard payment terms of the industry; secondly, to manage stock at a maximum service level at minimum cost; and thirdly, to increase payment terms with suppliers to delay cash outflows. At the same time, it is critical to avoid damaging the company’s key performance indicators (KPIs), such as sales, while optimizing Working Capital.

We often encounter similar shortcomings in accounts receivable among our clients. These include the tendency to have numerous payment terms in use, even multiple terms for the same customer. Poor communication between Headquarter and Business Unit is another common problem. Also, companies often have unnecessary and expensive credit insurances in place and fail to formalize level settings and authorization while setting initial credit limits – mostly for new customers. Companies often lavishly allow high levels of overdue debt and do not have days of sales outstanding (DSO) targeting linked to cash targeting. Ownership of key processes is often unclear or disputes are predominately solved by issuing a credit note – a very costly procedure, which can consume the entire profit margin. Overall, key process managers often do not measure or do not know current DSO and best possible DSO (BPDSO) levels.

Optimization tool and methodology for accounts receivable

Related to these shortcomings, some companies attempt to address these issues with a two-dimensional customer segmentation process. However, the majority of these companies fail to include the right analyses and metrics and, therefore, do not realize the benefit from this process. The better approach is demonstrated by the enhanced customer segmentation cube that I developed. The cube includes three dimensions: average overdue, customer size and customer’s strategic importance.

Figure 1: Illustrative cube for customer segmentation, selecting high-impact customers

Segmenting customers by a third dimension makes the process more sensitive for identifying ‘bad payers’ who offer the highest potential for freeing locked-up cash. The customer segmentation cube permits the development and application of highly differentiated collection strategies, individually tailored to each group of customers. If applicable, further customer segmentation categories can be added.

Methods for reducing DSO

Accounts receivable improvement requires cross-functional commitment and continuous communication to achieve sustainable change, including: new customer set up, sales and contract management, risk management, order processing and billing, cash targeting and collection management, cash allocation, and dispute and deduction management.

More specifically, methods primarily applied to reduce disputed DSO include sophisticated customer segmentation, state-of-the-art dispute management (including a proactivity approach) and a root cause analysis with cause elimination. Methods to decrease ‘allocation’, ‘past due’ and ‘within tolerance’ DSO limits include account cleaning, contract management and a sophisticated collection process management accompanied by the right set of tools and metrics. Finally, a standardization of payment terms can be applied to reduce DSO in all new contracts. Therefore, DSO can be significantly reduced, with overdues often cut in half in the short to medium term, to deliver substantial benefits.

Figure 2: Example of DSO before and after the professional reduction project

Measuring success for accounts receivable

DSO as a KPI is an important metric to measure the success of an accounts receivable improvement project and to prove its independence from sales. Statistically, about one third of DSO improvements result from payment term standardization and about two thirds from improved collection strategies.

To ensure a smooth transition to new processes and methodologies, improvement projects need to be well prepared and professionally implemented. Miscommunication with customers and incomplete or disjointed implementations can jeopardize customer relationships and put sales performance at risk. Bearing in mind that businesses are highly diverse, every company requires a specially tailored and customized approach to Working Capital optimization. ‘Off the shelf’ solutions are a dangerous undertaking.

Figure 3: Example of DSO development before and after the consultancy project

Conclusion

Working Capital projects are critical for unfreezing cash, which allows companies to address their most urgent needs, such as making investments, guaranteeing production flow, improving customer satisfaction, managing bad debt and avoiding major write-offs. The latter is becoming more and more important in a globalized business environment, particularly in times of crisis and increasing numbers of customer bankruptcies.

The best starting point is yet again accounts receivable management, which frees up cash relatively quickly. Nonetheless, a simultaneous accounts payable and inventory improvement project is recommended to improve both supplier management and production flow.

My experience is that only a holistic approach covering all three Working Capital-related areas can unveil the complete list of a client’s shortcomings, often linked to each other. As mentioned, these shortcomings, and the excessive issuing of credit notes, can cause significant losses and, hence, a reduction of the company’s overall profitability.