The concept of Key Performance Indicators (KPIs) is likely not new to you. Most businesses track data to measure their performance in some format.
The most minimalist approach is annual financials for tax purposes – every business (at least those that don’t evade taxes) do at least this.
The annual tax return is a lagging indicator of performance, as in you see performance well after the actual occurrence.
Monthly financials are still lagging, but closer to current.
Weekly revenue & gross margin reports are pretty close current indicators.
Pre-revenue KPIs like customer phone inquiries, sales meetings, closing rates, etc. are examples of leading indicators. These help you forecast how your business will perform in the coming weeks & months.
Any business has hundreds and hundreds of potential KPIs. Tracking all of them is impossible and a waste of time.
So how do you decide what to actually track & review on a regular basis?
In any potential deal, I always start with breaking down a business into its core “value drivers” – the variables that help determine how the business will perform.
Throughout this post, I’ll use a simple example of a hotel (this actually used to be the interview case study I used for prospective PE analysts).
Start with revenue – what determines how much revenue a hotel will make?
Most businesses’ revenue can be boiled down to some breakdown of Price x Volume. For a hotel:
- Nightly Room Rate (Price)
- % of Rooms Booked Each Night (Occupancy Rate)
- # of Rooms (Potential Volume)
In the above, Occupancy Rate x Potential Volume = Volume.
Nightly Rate (or Price) x Volume = Revenue.
Now, you could break down this down further. For example, you could breakout weekends from weekdays:
(Weekend Nightly Room Rate x Weekend Occupancy Rate x # of Rooms) + (Weekday Nightly Room Rate x Weekday Occupancy Rate x # of Rooms) = Weekly Revenue.
You could take a different approach that is more focused on sales & marketing. For example, suppose you drive most of your bookings through advertising on TripAdvisor and Hotels.com. In that case, perhaps you’d track:
- Cost Per Click: Digital Advertising Spend / Total Ad Clicks
- Click Conversion Rate: Total Rooms Booked / Total Ad Clicks
- Revenue per Room Booked: Total Room Revenue / Total Rooms Bookd
That would allow you to measure & finetune the marketing engine that drives your sales. But it still boils down to Price x Volume:
- Revenue Per Room Booked = Price
- Total Ad Spend x Cost per Click x Click Conversion Rate = Volume
Now let’s look at the cost side. You can start by making a list of your costs and allocating them to Fixed or Variable. Importantly, Variable Costs should be defined by what they are variable based on (price or volume).
For a simplified example of the hotel, here’s a sample list:
- Cleaning Staff Costs: Variable to Volume
- Credit Card Processing Fees: Variable to Price
- Cleaning Supplies: Variable to Volume
- Management Staff: Fixed
- Building Costs: Fixed
- Food & Bev Costs: Variable to Volume
- Revenue Share to Travel Booking Sites: Variable to Price
These will also be expressed in the form of simple equations:
- # of Rooms x Occupancy Rate x # of Cleaning Staff Required per Booked Room Night x Cost per Cleaning Staffmember = Cleaning Staff Costs
- Revenue x % of Revenue to CC Processing Fees = Credit Card Processing Fees
- Fixed Costs are generally just fixed, though often have some partial variable component (like utilities) – you’ll have to decide the level of detail you want to get into
All these value drivers combine into how your business makes money.
Another way to think of this is to look at your P&L, pull out all the major items, and figure out all the inputs that determine that number.
Selecting KPIs to Track
Now you have a list of value drivers that determine how your business performs. But which should you actually track on a monthly or weekly basis to be an effective operator?
Your selected KPIs should at least two of these three basic tests:
- Is it important?
- Can I directly & proactively manage or change it?
- Will it help me make decisions?
For example, financial metrics like Revenue & EBITDA & Cash Flow:
- Clearly important as they tell you if you’re making money or not
- Hard to directly & proactively manage – more of an output than an input
- They do help you make decisions as they reveal problems (i.e. if cash flow is far lower than EBITDA, it can reveal an issue with your Accounts Receivable process)
What about the revenue value drivers like Nightly Rate?
- A hotel manager sets the nightly rate directly; it’s not actually giving you any information about customers or the market.
- By contrast, the interplay between Nightly Rate & Occupancy Rate is more interesting – the higher your nightly rate, the lower your occupancy rate will likely be.
- Hotels have created a KPI to capture that concept, which is called Revenue per Available Room (RevPAR) – this is just Nightly Rate x Occupancy Rate.
- This KPI is important (as the primary driver of revenue) & can be proactively managed (by fiddling with Nightly Rate).
On the other hand, a hotel manager likely wouldn’t bother tracking Credit Card Processing Fees. At 3-4%, it’s a real cost, but likely not big enough to be important. Yes, maybe you can cut your bill by 1% with some direct management, but that’s a one-time workstream, not an ongoing decision-making input.
How about Cleaning Staff Costs?
- Let’s assume this is a major cost line item, therefore it is important.
- It’s not helpful to track just total costs per week or month as that can’t be managed directly and won’t help you make decisions (because you don’t understand why it’s going up or down).
- Instead, you may want to break down that line item into its value drivers: Cleaning Hours per Booked Room x Cleaning Staff Cost per Hour.
- Then, if you see your total Cleaning Staff Costs increasing, you can actually understand if it’s being driven by the cleaning crew working slower than usual, or because they are demanding higher wages than in the past.
- Now you can actually make decisions to manage this cost directly – maybe you switch to every other night cleaning service, maybe you investigate why it’s taking the crews longer to clean a room, etc.
Managing to KPIs
Lastly, a word of caution – once you start tracking KPIs in your business, there is a natural tendency to “manage the KPIs” rather than manage the business holistically.
For example, if the hotel manager is hyper-aware of their Cleaning Hours per Room Booked metrics, they may start pushing the cleaning crew to clean too fast, leading to a decline in room cleanliness.
The knock-on effect is that you may not be able to charge as much for the rooms themselves; you managed your Cleaning Costs well, but at the expense of RevPAR and overall revenue.
This is hardest with “squishier” value drivers like brand image. A strong brand is a true value driver - it allows you to charge more than competitors, it helps with customer retention, etc. And it’s extremely hard to measure, so can easily succumb to over-management of measurable KPIs.
Hopefully that’s a helpful summary of identifying value drivers, selecting which should be your KPIs, and avoiding “managing to KPIs”.
After year of being a consumer of KPI reports (while in the PE role), it’s been fun to flip to other side and actively manage & generate KPIs. It’s extremely tempting to manage to KPIs even though I know I shouldn’t. It’s hard to look away from KPI reports.
But at the end of the day, KPI reports serve to 1) get your arms around the business (actually understand how the business is doing), and 2) provide date to support proactive decision making.
As always, I’d love to hear your thoughts, so just hit reply to this email or find me on Twitter