Topics

In this article I want to make some considerations about the way  you can measure the performances of your SBUs meant as  centers of responsibility driven by their managers, people in charge of their “ success”.

Beside the usual financial measures, different from one another according to their nature (profit center, revenue center, cost center, investment center), there are some measures not linked to the financial side but, without any doubt, thought as the main causes/drivers of future financial performances.

Nowadays the importance of nonfinancial measures has reached the top level regardless of their embedding into a Balanced Scorecard.

In this regard, I remind you the BSC includes both financial and nonfinancial measures, both linked to the business strategy.

A success factor for the nonfinancial measures is the easiness to be achieved and to be understood by operating personnel. The latter aspect is of prominent importance to the success of the whole business because you know how effective something is when it is recognized and adopted by someone within the organization.

I like to make some examples of nonfinancial measures and after that, I will make some strategic reflections about the advantage of chosing the linked structure of the SBUs (I mean the choice of cost, profit,  or revenue center).

Since there are many kinds of departments, these measures are good for any sort of companies, both manufacturing ones and service ones.

The choice of adopting the following measures, like other ones not mentioned, should be linked to the strategy of the business and the market where it operates, even if some of them could seem “very” operational.

For instance, if you take a cost leadership strategy, in the manufacturing dpt particular emphasis is given to the bottleneck and cycle time.

You know very well that the higher the output the lower  the unit fixed cost.

At the same time, all the measures considered drivers of the costs incurred take importance.

This list is intended to be an useful but not exhaustive guide.

Purchasing Dpt

• Suppliers delivery performance
• Analysis of stock-outs
• Parts delivery service record
• Inventory levels and timing of deliveries
• "Just in time" inventory control measurements
• % of total requests supplied in time
• % supplied with faults

Manufacturing dpt KPIs

• Cycle time
• Cycle time efficiency (Value-added activity time to total time)
• Cycle time against Takt time (available time to customer demand)
• Lead time (from when an order is received by manufacturing dpt to when it is completed)
• Failure rate (failed products/total output); also according to the number of defects, broken into by kind of defect. (it is not necessary a SIX SIGMA system)
• Production line repair record
• Ability/time to change the manufacturing schedule when the marketing plan changes
• Measurement of scraps
• Tests for components, sub-assemblies and finished products
• Efficiency labour rate
• Annualized failures as a % of sales value
• Failures as a % of units shipped
• Productivity rate (Good Outputs to Resource Inputs)
• Throughput (output delivered to customers)
• Throughtput efficiency (throughput to inputs used)
• .....

Sales and Marketing

• Loyalty rate
• Penetration rate (average number of products per customer)
• Customer satisfaction analysis: for instance NPT-net promoter score as the difference in percent terms between how many customers would recommend the company and how many ones wouldn’t do it-
• Net promoter score
• “Strike rate" - turning inquiries into orders
• Monitoring repeated lost sales by individual salesmen
• Analysis of unit sold by product line; by geographical area; by salesman; by individual customer
• Number of clicks on website advertsing campaign
• Number of sales orders matching the sales shipments
• Variance of the share of the market against competitors
• Share of new projects/products in the industry
• New product / service launch analysis
• Value of warranty repairs to sales over the period
• ....

Sales delivery and service

• Shipments vs. first request date
• Average no. of late shipments days.
• On-time delivery rate
• Response time between a request and first shipment/intervention

.....

* CRT (Customer response time: time between when an order is received by Sales Dpt and when the product/service is delivered to the customer) it’s in my opinion a measure that regards the effectiveness and the customer-oriented nature of the whole organization.

HR

• Head count control
• Mix of staff analysis
• Own labor / outside contractor analysis
• Vacancies existing and expected
• Labor turnover
• Labor turnover vs. local economy
• Absence from work
• Staff morale
• Number of applicants per advert
• Staff evaluation techniques
• ……

Finance dpt

• Speed of reporting to internal managers vs. HQ
• Accuracy of reporting as measured by mis-allocations and mis-postings
• Queries about what reports mean
• ….

Research and Development

• Number of prototypes to total outputs
• Number of the changes in the  product/process features
• Product improvement against potential market acceptance
• R&D vs. competition
• Major program milestones
• Failure rates of prototypes
• ….

Strategic considerations about organization structure of SBUs

The choice of the kind of center (profit, revenue or cost one) affects the nature of the evaluation of the performances in a sense that both financial and non financial measures change as a result of it.

Many people think the Sales dpt to be always a Revenue center, the Manufacturing dpt a cost center but, as a matter of fact, the reality of a well-managed company shouldn’t be like that.

To be more clear I will take some examples that derive from the choice of the strategy.

1. Cost leadership strategy

The firm chooses to compete on price and as a result the search for a lower cost is constant. The manufacturing of its products is made according to some standards in terms of features and their quality level.

In these cases the Manufacturing dpt produces for the warehouse  and the Sales dpt takes the products from the warehouse to sell and deliver to the customers.

The former dpt is a cost center, the latter is a revenue center and the indicators of performance are the “drivers” of cost for the manufacturing dpt and of revenue for the sales dpt.

2. Differentiation strategy

The firms adopting this strategy are focused on intercepting the changes in the customer preferences and requirements and meeting them by new features of their product/service.

This happens particularly when you deliver tailored output or the market is very dynamic.

On the organization side the design, sales and manufacturing dpts have to be synchronized. How?

All of these dpts should be structured as profit centers  so that they are requested to attend both to customer preferences and  manufacturing costs. You see that if you are evaluated on both sides you’ll do your best to improve both of them.

By making this way, the performance measures linked at the same time to revenue and costs are put in place.

The choice of the kind of responsibility center is also important to other aspects that fall outside of the scope of this article and for further details you can get in touch with me by looking at the page “Contacts”.

There are some methods to evaluate a business as a whole and that can happen both on the side of shareholders, investors and when an acquisition is taking place.

On the side of shareholders and investors (when an acquisition is not concerned) you have to calculate the value of the equity.

The main methods are four:

1. Discounted cash flows.
2. Book value.
3. Market Capitalization.
4. Multipliers.

Hereafter, I’ll explain my favourite: 1 and 4.

In my opinion the most realistic way and that one taking into account both the financial market side and the real market one (customer point of view) is the Multiplier method.

It divides the Market Stock Price to  a value, such as earnings/sales/cash flows per share and then the result is multiplied to the correspondent value, earnings/sales/cash flows.

You could see some limitations, when you use the earnings, such as the different methods to evaluate the inventory and/or other accounting methods different from other companies, so that the result is not comparable to the other firms.

When that is the case, then, you could use as a reference the sales or the cash flows, and, as you can see, there are two kinds of factors taken into consideration that make this method one of my favourite ones: the value given to your share by the financial market and the financial results the company yields on the field.

In some cases, when you aren’t listed on the stock exchange, for instance, you cannot use this method.

Then, you can use the discount cash flow techniques, but remember to discount also the cash flows falling outside the time horizon of your plan.

To be more precise, if you have a 5-year plan, the present value of the free cash flows from the 6^th year on must be counted according to the formula of an annuity with a continuing life, that is the inverse of the usual way.

Guess that you think to have from the sixth year on a free cash flow of € 100000 per year and a waac of 7%.

Then, the present value is: 100000/0,07.

The resulting amount must be discounted by using the discount factor of the latest year (in this case the 5^th).

The sum of the whole plan free cash flow must be added to marketable securities and then you must subtract the value of long term debts.

That’s the value of your company.

Whatever way you have use to calculate the value of the equity, if there is an acquisition ongoing you must consider the debts and the cash also.

So the value of the enterprise is: Equity + debt – cash.

This following way could be very interesting.

The value attributes of a product or service must be traced back to some of the activities performed by the business unit. The respective costs of the latter are the basis for the calculation of the revenue multipliers.

It starts by spotting the activities giving value to a product/service, meeting the single requirements from customers (i.e. quality, option availabilty, post-sale service......), then allocating the indirect costs incurred to one or the other value -added activity for each product/service on the basis of some drivers in two steps (for further details about this  stage you can get in touch with me).

Perform a customer survey (disregard all the kinds of manager opinions, external view only) attributing a percent weigh to the features of the product/service (for instance, 30% quality, 50% option availabilty, 20% post-sale service).

The actual or estimated total revenues are to be broken into the same categories, each of them with the value achieved by using the respective percent preference.

For each category divide the respective revenues to the respective indirect costs in order to get the REVENUE MULTIPLIERS.

Afterwards you are able to see whether you are spending or not in the right direction.

In the context of variance analysis very often the companies take advantage only of some from a great variety of formulas. 

As a matter of fact, there are many other "pieces" unknown to a lot of business people that are very useful to better see the standing of the BU both as a whole and and about its single elements. 

That's the case for the revenue variances that are usually broken into Volume Variance and Selling Price variance. 

On the base of them the managers make their consideration about the profitability of the products, the work of Sales Dpt and so on. 

Now I will present a not very used analysis that, in my opinion, is vey helpful for general assessments but pays off a lot for the evaluation of Sales dpt when you are dealing with old products, going through the maturity stage of their life cycle, and their success is linked more to the ability of the "Salesmen" than to the features of the items themselves. 

Here is the magical formula: 

Market share deviation =(Actual Mkt Share - Budg. Mkt Share) x Actual Mkt Size* x Budg. Price per Unit* 

* It's expressed in units and it concerns the number of units sold by all the competitors (including the company making the analysis). 

* * Take note that, if you are analysing many products into a market segmant, you have to take into account the Weighted-average budgeted price (Total Revenues/total of units sold). 

What does it mean? 

You will be able to quantify the deviation of revenues compared to the budgeted amount due to the difference in the market share. 

Why is it important for evaluating the Sales dpt in some cases? 

As I have written above, for the old products, going through the maturity stage of their life cycle, the success is linked more to the ability of the "Salesmen" than to the features of the items themselves. 

The ability of the Salesmen and in particular the Sales Dpt Manager in this case is gauged in comparison with the ability of the comptetitor's Salesmen. 

In order to extend the usefulness of this "formula" for the business unit as a whole, you can take into account the "Contribution Margin per Unit" instead of the Unit Price. 

 if you have any questions, get in touch with me.... 

As you know the weight of the overheads has increased over the years and accounts for the most part ot the total expenses of a BU.

Let alone their importance to budget purposes, product costing, pricing, performance evaluation and so on.

Many financial managers use old ways to estimate the indirect costs (overheads), just a small part is able to use more accurate methods.

For those managers, management accountant not up-to-date to these statistical methods I will present one of them.

Let me start from the consideration that many categories of overheads, as a matter of fact, are in part fixed costs and in part variable ones.

The much used formula Future activity level divided by Latest activity level multiplied by Old overheads amount multiplied by Inflatione rate is flawed.

In fact, it makes all the expenses variables with regards to the level of activity (output or other drivers).

The way I am presenting doesn'have this bad feature.

Here it is.

1) You have to take into account the past level of overheads and the respective drivers (for instance handling expenses with batch numbers) month by month.

2) Choose the lowest level and the highest level.

3) Through one of these levels, calculate the unit variable cost and the fixed part.

4) Multiply the unit variable cost by the expected level of the respective drivers for the period we want (month, quarter , year) and then add the fixed part.

Of course, some attention must be paid to the time when we observe extraordinary past event.

With reference to the istance we made,  we don't have to consider those periods characterized by recurrent machine breakdowns that reduce the working hours and the output.

In numbers:

Formula

X = a + (b x Y)

 Input Data

X = value of estimated Handling Costs

a = fixed quantity of X

b = unit variable cost of handling costs per batch.

Y = the cost driver, the number of batches.

Lowest level = March 

Batches = 333

Handling costs = 2251

Highest level = May

Batches = 362

Handling costs = 2303 

b = (highest costs - lowest costs)/ (highest drivers - lowest drivers) = € 1, 8 per batch

a = X - (b x Y) = € 2303 (May data) - (€1,8 x 362) = € 1651

 If we made use of March's data, the fixed part a would be the same.

Returning to the beginning equation and writing the amounts calculated:

X = € 1651 + (1,8 x Y)

Replacing in the above equation the expected level of batches (Y) you'll get the estimated overheads (X).

That way just presented is one of some statistical methods you can use.

If you want some other details, get in touch with me.