Defining business success has never been much of a problem for managers. If you deliver above-sector profit growth, together with positive cash flow and a growing dividend, you are certainly succeeding. But just how are you supposed to do that? What really drives your business success?
Scrutinising your internal financial reports may not really help you. The problem, is that your financial statements measure the outcome of your business, not the actual drivers of your success. Believing you can improve your bottom line by tinkering with your P&L is like imagining you can make a car go faster by pushing up the speedometer needle with your finger.
Profits obviously increase when sales revenues improve and costs reduce. Sales revenues are simply sales volumes times selling price, so the higher selling price we can achieve for a given level of sales volume, the better. If we want higher sales volumes, we need high levels of customer satisfaction leading to growing market share. We also need to deliver excellent value for money, which we can achieve with a relatively low selling price. But wait a minute: didn’t we just say that we wanted a high selling price to maintain our revenues? How are we going to resolve that contradiction?
Is it any simpler when we look at the costs instead? People-based costs are obviously the product of headcount times the average salary and other personnel costs. Headcount is driven by productivity, which in turn is driven by employee motivation, which is at least partly affected by compensation. So the more we pay our people, within reason, the better quality staff we will attract and retain and the more productive they will be. That means we will need less of them. But unfortunately, we’ve just increased the average wage in the process, so it’s not at all clear whether we’re saving costs overall – another dilemma.
A higher paid, more motivated workforce is likely to deliver better customer satisfaction, driving up our sales volumes. But will the resulting revenue increase outweigh the higher pay? Running that new advertising campaign will bump up our costs as well, but we do it because it’s supposed to increase market share. Will that be a net gain, or is it simply a feel-good factor for the marketing department?
You are not going to be able to crack these problems by measuring your profit and loss account more carefully. None of the “soft” factors mentioned above are listed in your financial statements at all. Your balance sheet will simply be a distraction and your cash flow statement provides no help whatever. So what are you going to do? Is intuition enough?
In a one-man business, trying to decide between all these interactions is indeed an intuitive process that takes place in the owner’s head. You just have to think it through and do what feels right.
But in a bigger business, that approach doesn’t work, because everyone has a specialist focus. Production doesn’t understand the difficulty of selling; finance doesn’t appreciate the dynamics of R&D; in fact nobody apart from the CEO gets to see the whole picture, and the CEO has neither the time nor the grasp of detail to master these interactions. So what can be done in practice?
If only we could measure employee productivity and customer satisfaction and correlate them with improving revenues, then we could see at what point increased salaries start to run up against diminishing returns. And we could see by how much the gain in customer satisfaction translates into sales. That way, we wouldn’t have to guess how to take these decisions. We would know.
So most of the important things that drive our business don’t seem to be measured in £ at all. Instead they are measured in rather strange units, such as “satisfaction” or “motivation” or “brand awareness” or “percentage of customers who choose our products first”. Of course, the sales and the profits are important too, but they are outcomes, not causes.
In some ways, business is rather like chess. The P&L tells you whether you have won, but not how to win. Imagine that Garry Kasparov is in training to become a grandmaster, but his coach is spending all the time simply teaching him the rules of chess, instead of the strategy. After a very short while Kasparov would say “I know all that: it’s obvious. There’s no need to keep telling me the rules: what I want to know is: how do I win?”
If you want to win in business, you can’t rely on your monthly management reports. What you need instead are three ingredients that don’t appear to be taught in the accounting syllabus:
- A clear perception of “what affects what”, in terms of the factors driving your bottom line. This will help you to separate the upstream drivers, such as customer satisfaction, from the downstream outcomes, such as cash flow.
- Some realistic non-financial performance measurements to help you to calibrate those upstream drivers.
- A method of combining and presenting these so that you can tell at a glance both whether you are winning and what is holding you back.
What are the do’s and don’ts of tackling this yourself?
- Arrange an Executive Workshop for the top management team
- Introduce the idea of “Business Driver Diagrams” that visually depict the chain of cause and effect
- Break up into syndicate groups and invite each group to think through the cause-and-effect chain for part of the business
- Ask them to present their initial thinking back to the rest of the executive team
- Encourage a healthy debate about what the drivers really are
- Use this to focus your efforts in measuring non-financial performance
- Present the monthly results visually, using graphs to depict improvements or decline in the key business drivers
- Continually correlate improvements in the drivers with your bottom line success.
If you tackle this seriously, you will start to notice the following benefits:
- Your management team will knit together better, because the process of “brain-dumping” individual mental models of the business helps everyone to appreciate each other’s point of view
- Your conversation about the numbers will begin to touch the core of the business, rather than the periphery
- By focusing on the performance of the upstream drivers, you will gain months or even years of advance warning of future financial problems
- Your planning and budgeting will become real, not simply an annual ritual
- Your bottom line will improve.
Finally, a practical tip. Keep a constant eye on that crucial distinction between causes and effects. Don’t allow yourself to be seduced by those pages of finely-printed numbers in your management reports. Follow your common-sense impulses and you won’t go far wrong.
This post is an updated version of an article originally written by Robert Bittlestone.