A key performance indicator (KPI) is a metric that encapsulates the relevant activities of an area of the company. A KPI is like a reading from the dashboard of a car. The engine temperature gauge doesn’t give you all of the detailed information on engine performance, but it is a key indicator (although a lagging one) of how things are going deep inside the machine. The speedometer also gives you meta-information on your trip, as does the odometer. Modern cars can give you a readout on miles per gallon, which could also tell you something is possibly amiss. Sputtering, black smoke, or complete engine seizure are the utmost in lagging indicators. Before you get to that point, you hope you have some indication when there is a problem, and you can pull the codes from the main computer or have a shop do it, giving you more detailed information on what is happening.

However, most of the time, you just drive or ride without thinking about the internal workings too much. Driving is largely done using management by exception.

Let’s see how this concept applies to business.

Management by exception is a way for management to focus attention on important differences between actual and budgeted amounts.

Performance reports for​ cost, revenue, and profit centers typically list both actual and budgeted amounts​, along with dollar and percentage variances.

For instance, let’s take an example of a small corporation that owns two furniture stores: Big City Furniture in San Francisco, CA, and Small Town Furniture in Cheyenne, WY. The combined budget report looks like this:

 

The board of directors would be most concerned with the $250,000 unfavorable budget variance in operating income. Using a management by exception approach and just looking at percentage variances, sales and the related cost of goods sold stand out. So does the 12% variance in administrative costs. In addition, the 16% variance in janitorial looks significant, but on an actual dollar basis, it’s only $16,000, so it might not be worth pursuing.

What kind of responsibility center would janitorial relate to?

Right. Cost center.

Looking at a flexible budget report, we get a tiny bit more information. The variance between the flexible budget and the static budget takes into account the difference in sales volume, which is accounting for a large part of our unfavorable variance. The difference between actual results and the flex budget takes into account (a) our average sales price was a bit better than expected and (b) the cost of goods sold per item was a bit better than expected. Remember that the flex budget is our static budget if we’d known in advance the exact volume of sales, so it basically isolates price and cost variances from volume variances. Numbers in parenthesis are unfavorable.

 

If management had budgeted for the lower volume of sales, the projected operating income would have been $270,000. Actual results were better than that, but far under the $900,000 anticipated operating income.

Let’s take a look at the actual results by segment:

 

Big City Furniture looks better than Small Town Furniture.

Let’s take a closer look at both:

Gross profit percent for BCF was 45%, and operating income was 5% of sales.

BCF reports 20,000 actual sales, so the average sale was $500. What about Small Town Furniture?

 

Gross profit percent for BCF was 40% and operating income was 7.5% of sales.

Small town furniture reported 6,000 sales so the average sale was $333.33.

Big City still looks better, but let’s not jump to any conclusions. Let’s apply some other metrics. For instance, one of the Key Performance Indicators management might watch is Sales per Square Foot (see this article for more details about KPIs in the furniture industry). Let’s assume BCF has a 50,000 sq. ft space and STF has 8,000 sq. ft.

What kind of responsibility center would Sales per Square Foot relate to?

Right. Revenue center.

Sales per square foot for BCF is $200.00 and sales per square foot for STF is $250.00. Although STF looks better using this metric, it probably only tells us that the store is using its space more efficiently.

Big City has a gross margin of 45% compared to ST at 40%. The static budget was based on 40%. However, operating income for BCF and STF was 5% and 7.5%, respectively. Based on that metric, STF looks better.

What kind of responsibility center would operating profit as a percentage relate to?

Right. Profit center.

Let’s look at the two divisions now as if they were investment centers, and we’ll apply two common KPIs for each: (a) Return on Investment and (b) Residual Income.

Return on Investment

A segment that has a large amount of assets usually earns more in an absolute sense than a segment that has a small amount of assets. Therefore, a firm cannot use absolute amounts of segmental income to compare the performance of different segments. To measure the relative effectiveness of segments, a company might use return on investment (ROI), which calculates the return (income) as a percentage of the assets employed (investment). The formula for ROI is:

ROI = Segment Income/Investment Base

The investment base is often defined as average total assets.

Let’s take a look at total assets for BCF:

 

Average total assets would be (5,400,000 + 5,000,000)/2 = 5,200,000

ROI = Operating Income/Average total assets = 500,000/5,200,000 = 9.6% (rounded to the nearest tenth percent)

Now let’s look at STF:

 

Average total assets would be (740,000+760,000)/2 = 750,000

ROI = Operating Income/Average total assets = 150,000/750,000 = 20.0% (rounded to the nearest tenth percent)

If management was looking to select one of the two stores to replicate, they would want to replicate Small Town Furniture based on ROI, because a $5.2 million investment in a Big City store would return 9.6%, which is $500,000, while the same investment in seven Small Town stores would return 20%, which is over $1 million per year.

Determining the investment base to be used in the ROI calculation is a tricky matter. Normally, the assets available for use by the division make up its investment base. But accountants disagree on whether depreciable assets should be included in the ROI calculation at original cost, original cost less accumulated depreciation, or current replacement cost. Original cost is the price paid to acquire the assets. Original cost less accumulated depreciation is the book value of the assets—the amount paid less total depreciation taken. Current replacement cost is the cost of replacing the present assets with similar assets in the same condition as those now in use. A different rate of return results from each of these measures. Therefore, management must select and agree on an appropriate measure of investment base prior to making ROI calculations or interdivisional comparisons.

Here is another example of how to calculate ROI:

You can view the transcript for “How to Calculate ROI (Return on Investment)” here (opens in new window).

Residual Income

Residual income (RI) is defined as the amount of income a segment has in excess of the segment’s investment base times its cost of capital percentage. Each company based on debt costs establishes its cost of capital coverage and desired returns to stockholders. The formula for residual income (RI) is:

RI = Income − (Investment x Cost of Capital Percentage)

When a company uses RI to evaluate performance, the segment rated as the best is the segment with the greatest amount of RI rather than the one with the highest ROI.

Critics of the RI method complain that larger segments are likely to have the highest RI. In a given situation, it may be advisable to look at both ROI and RI in assessing performance or to scale RI for size.

Let’s use average total assets again for our investment amount, and let’s say management’s hurdle rate or expected rate of return is 14.8% (that’s what the budget was based on).

• For Big City, investment of $5.2 million times 14.8% = an expected income of $769,600. The division only made $500,000, which means it fell short by $269,600.
• Small Town had average total assets of $750,000. Multiply that by 0.148 and you get an expected income of $111,000, which the store beat by $39,000.

Based on the amount of money invested in the store, the Small Town model is more profitable.

When calculating RI for a segment, the income and investment definitions are contributions to indirect expenses and assets directly used by and identified with the segment. When calculating RI for a manager of a segment, the income and investment definitions should be income controllable by the manager and assets under the control of the segment manager.

In evaluating the performance of a segment or a segment manager, comparisons should be made with (1) the current budget, (2) other segments or managers within the company, (3) past performance of that segment or manager, and (4) similar segments or managers in other companies. Consideration must be given to factors such as general economic conditions and market conditions for the product being produced. A superior segment in Company A may be considered superior because it is earning a return of 12%, which is above similar segments in other companies but below other segments in Company A. However, segments in Company A may be more profitable because of market conditions and the nature of the company’s products rather than because of the performance of the segment managers.

A manager tends to make choices that improve the segment’s performance. The challenge is to select evaluation bases for segments that result in managers making choices that benefit the entire company. When performance is evaluated using RI, choices that improve a segment’s performance are more likely also to improve the entire company’s performance. Still, top management must use careful judgment whenever performance is evaluated.

Here is another example of how to calculate residual income:

You can view the transcript for “23– Measures of Residual Income” here (opens in new window).

Key Performance Indicators, both leading and lagging, can provide feedback, communicate expectations, serve as benchmarks, motivate managers, and promote working toward common goals and objectives.

Here are a few more KPIs for our furniture managers suggested by the Furniture World Magazine.

Asset turnover: sales revenue / average total assets

	Asset Turnover	Days Sales in Assets
BCF	1.92	190 days
STF	2.67	137 days
Static budget	2.22	164 days

 

Gross Profit Return on Inventory: gross profits / average inventory

	Gross Profit Return on Inventory
BCF	1.64
STF	1.88
Static budget	1.82
Industry benchmark	2.86

Industry benchmark found here.

Good managers will have a few Key Performance Indicators that communicate the overall health of the organization without being overwhelming. For instance, a lumberyard manager may watch the number of sales orders outstanding, the number board feet of lumber in the kiln, and the number of board feet of raw materials lumber available. The idea is to watch what you need to watch and nothing more. That is why they are called “key” performance indicators. They are the ones that give you the most information in one metric.

Now, check your understanding of KPIs.