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Anthony Tjan

Anthony Tjan

Posted: October 27, 2010 11:20 AM

The Fallacy of Financial Metrics

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In both entrepreneurial and larger companies, we too often spend time focusing on the desired financial performance target, rather than the inputs that drive those numbers. Because boards, investors and management demand an objective way to measure performance, we often go right to the result without focusing on what caused those results.

Financial performance is a result, a byproduct, a consequence of something else. The financial "numbers" ultimately represent the scorecard we care about, but they do not help us understand how to score. When we ask management teams what are the most important drivers (or what we call operating metrics) of their financial results, I usually see one of two reactions: a) a dog-in-front-of-the-television blank stare or b) a further breakdown of financial results: "sales on the West Coast drove the results." When pressed further, we may get even further sales breakdowns, which tell us little. As my partner, Dick Harrington, says, "We end up slicing baloney with a scalpel" and are talking too much about the "what" without getting the "why."

Operating metrics are the inputs that correlate or drive the desired results of a business. If you focus on the inputs, you need to worry less about the financial outputs. Examples of inputs include customer convenience, product quality, customer retention, or customer referral rate.

Let me provide a couple of concrete examples. In many of our retail or restaurant investments, we espouse a value proposition of convenience. The more convenient we can make the experience, the happier the customer will be, and the more likely we will have customer repeat and referral, meaning not just higher revenues but higher quality of revenues. How does convenience translate into a measurable operating metric? As a proxy for convenience we measure metrics such as turn-away rates and wait times for service. That is, when a prospective patron walks in or makes a call for a reservation how often do we turn them away because we are full or short-staffed? We want that turn-away number as low as possible to reinforce convenience. If we detect a repeat issue we can see how to solve it, perhaps through improved reservations systems or increased staffing. Other metrics we might measure include weekly cleanliness scores, customer loyalty, and periodic customer satisfaction reviews. Of course we will look at these operating metrics alongside the financial and more quantitative results, but again -- the point is to uncover the correlation between operating drivers and financial outcomes.

Businesses need to focus on the 3-5 metrics that represent the most important drivers of value creation. It helps align an organization towards doing the right thing in a repeatable and scalable manner. When you just ask a team to chase results on a plan, you may never be sure what drove that result even if you are successful. There is a difference between having a good year of numbers and a sustainable business model that allows for more predictable year-over-year results. From a managerial tool perspective, a weekly or monthly dashboard that highlights not just the financial results, but also the operating metrics is smarter and more actionable. A dashboard with operating metrics serves effectively as an exception-based report where you look for deviations from the norm of operating metric levels and then consider whether the issue is systemic or one-off.

It is true that people behave based on what they are measured by. Here are some guidelines on setting a culture driven by operating metrics and measuring your team on the right stuff:

1. Ensure management understands the difference between operating metrics and financial metrics - operating inputs versus financial ratios. The latter is for number-crunching analysts to focus on, the former is for managers and it is what will make the latter automatic.

2. Clearly communicate across the organization a small number of the most important operating metrics. It takes some thought to filter through the many possible inputs / operating metrics, but pick only the 3-5 that have the highest correlation to the desired financial goals.

3. Regularly review an operating metric dashboard, but focus on exceptions. You'll be able to scan the health of your business very quickly. In an earlier blog, I interviewed superstar Oprah doctor and cardiac surgeon Mehmet Oz, and discussed the vitals for good personal health. Indeed, an excellent analogy is that operating metrics should represent the blood pressure and cholesterol levels of a company. Focus on the right ones, regularly measure them, and if they are out of whack, do something before your company has a heart attack.

This article first appeared on Harvard Business Publishing on June 8, 2009.
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