In my last article, I shared the merits of adopting open-book management. As discussed there, each business should identify and regularly display key performance indicators (KPIs) to fully engage employees in creating desired outcomes.
While some of these will be unique to each business, there are a handful of KPIs that should be employed in every for-profit enterprise. Among those are a few critical metrics from the income statement. They include:
• Revenue (sales)
• Cost of goods sold (COGS or cost of sales)
• Gross profit
• Operating expenses (general and administrative expenses)
• Net profit (earnings before interest and taxes/EBIT or earnings before interest, taxes, depreciation and amortization/EBITDA)
Each of these income-statement metrics focus on aspects of running a business profitably. Notice that I have not included any measure of earnings after interest, taxes, depreciation and amortization. Why? Because these items have nothing to do with the operations of the business. Interest expense is a function of how the business is financed, taxes don’t have anything to do with how well the company is run, and depreciation and amortization are accounting conventions that have nothing to do with operations.
Also notice that each of the KPIs mentioned is a lagging indicator; that is, it is the result of other factors that create that outcome. These other factors are also often measureable, and are known as leading indicators. With lagging indicators, open-book management raises several essential questions:
• How can we increase revenue?
• How can we reduce COGS?
• How can we increase gross profit? (An answer to the revenue and COGS questions will provide the answer.)
• How can we reduce operating expenses?
• How can we increase net profit? (As the ultimate lagging indicator on the income statement, answers to the preceding questions will create a favorable answer here.)
As management and frontline employees discuss these questions, they should recognize that not all income-statement dollars are created equal. An additional sales dollar ($1) is decreased by the COGS associated with it (let’s say $0.50) and by the operating expenses that might correspondingly be costed against it (let’s say $0.40). In this example, an additional sales dollar contributes only 10 cents to the bottom line ($1-($0.50 + $0.40)).
If, however, you discover cost reductions of $1 (in either COGS or operating expenses), the entire dollar goes to the bottom line. In other words, to get the same impact of a dollar of cost savings, you would have to sell $10. The investment in cost savings literally increases profitability faster than does increasing sales!
That said, revenue should not be ignored. It’s often a first instinct to reduce price to increase sales. While this might bring in new sales, it must be recognized that reducing price without an equivalent reduction in COGS hurts gross profit unless the volume of sales increases significantly.
Price reduction is an easy answer, but the better solution to revenue enhancement is generally to improve product or service quality (hopefully without an increase in COGS), thereby enhancing the ability to sell the value proposition inherent in the product offering.
The answers are not always clear cut, but one thing is clear: before any of these KPIs can be optimized, employees need to better understand the existing metrics. This can be done through the use of dashboards that measure and display leading indicators that drive financial outcomes. Some executives will choose to share metrics expressed in dollars, while others will opt for ratios, percentages, ratings or scales. Whatever the measure used, executives need to start engaging their team in the process of improving financial outcomes. Newcomers to open-book management often find that their income statement is a very good place to start.
Richard Tyson is the founder, principal owner and president of CEObuilder, which provides forums for consulting and coaching to executives in small businesses. For 22 years, CEObuilder has successfully brought about an outstanding financial return for CEO and executive clients through providing leading-edge content in the areas of strategizing, team-building, problem-solving and managing for results, as well as the use of proprietary learning and coaching models.
