Important Metrics for Small and Mid-Market Companies — Part 4: Operational Efficiency

In an average month, my organization explores around 50 companies for possible investment. We review everything from organizational structure, culture, and financial performance, to sales systems, competitive position, and leadership style. This gives us an unusual vantage point from which to recognize patterns of success, and failure.

Getting data is never the problem. In fact for most executives, information can be overwhelming. Getting accurate data and interpreting it appropriately is an entirely different story.

In The Ceiling of Brute Force, we discussed what operational areas impede a company from continued growth. In a series of posts, we’re going to break down 19 of the most important key performance indicators (KPIs), which demonstrate how effectively the business is being run. Think of KPIs as the canaries in your coal mines. If one starts going south, you know it’s time to take a closer look.

Presented in a five-part series, here’s our take on what you should pay attention to, allowing you to focus your time, effort, and dollars. The five parts are: Basics, Customers, Team, Operational Efficiency, and Investment. In Part 4, we’re getting technical, describing operational metrics: scaling milestones & contraction triggers, sell-through rate & inventory turns, A/R aging & bad debt, and fixed vs. variable operating expenses.

1. SCALING MILESTONES & CONTRACTION TRIGGERS

KPI Objective: Know your unit economics and what impact an expansion, or contraction, would have on your cost structure.

Unit economics are the direct revenues and costs associated with a particular business model expressed on a per unit basis and serve as the foundation for all business. If you can’t make money on a per-unit basis, the company is cooked.

In general, if per unit cost is decreasing as total number of units sold increases, you’re headed in the right direction. That’s called an economy of scale. But, as the saying goes, the devil can hide [at least for a time] in the details.

As previously noted, focusing on top line revenue growth can be short-sighted. As an example, a manufacturer experiencing an overall increase in sales may then require additional inventory, facility expansion, or have to pay overtime to finish jobs on time, ultimately causing increased operating costs and/or net working capital, leading to a reduction in cash flow and net profit. Knowing milestones at which it is necessary to renegotiate supplier relationships and/or reorganize production accordingly is critical to sustainable growth. Not all opportunities are good ones, especially for a company’s short term financial health.

Conversely, knowing milestones at which revenue contraction will trigger changes in gross margins can be extremely valuable in knowing when to manage overall expenses more conservatively and/or prepare for another downturn. Companies that knew these triggers in 2007–08 could contract over time, rather than being shocked at the end of the year when the problems became blatantly obvious and largely unmanageable. It may seem inconsequential today, but it was the difference between life and death for many organizations.

2. SELL-THROUGH RATE & INVENTORY TURNS

KPI Objective: Know how much inventory you need to maximize efficiency.

Inventory is cash that you can’t spend. It decays over time and is expensive to store and move. For most businesses, it’s also a crucial component of success. Thus, tracking sell-through rate and inventory turns is critical.

Think of sell-through rate as your short-term rate of sales success. Of all the inventory you have on hand, how much was sold over what period of time? The sell-through rate is calculated by comparing the number of units sold during a period of time to the product (or hours in a service-based business) available at the beginning of the time period.

Another good operational efficiency metric is inventory turnover, which is done by dividing COGS by the average inventory. The higher the ratio, the better you’re managing your assets. A ratio of 4 indicates the company sells through its inventory every quarter, and likely keeps around a three month supply of inventory on hand.

For both of these metrics, the numerator and denominator are equally important. Success is either selling more over the same period, or reducing your need for inventory. A mature business should have a stable sell-through rate that might vary based on seasonality. A growing business should have an improving rate as economies of scale kick in and, in earlier stages, the company learns to better manage inventory.

3. A/R AGING & BAD DEBT

KPI Objective: Understand when people pay, what it means for your cash flow, and how it might indicate a deeper issue.

You did the work, now as Rod Tidwell in Jerry Maguire would say, “Show me the money!” In the short term, cash flow is far more important than profitability. Unfortunately a major source of headache for most companies is getting people to pay up.

Accounts receivable (A/R), otherwise known as outstanding customer balances, require careful management. Otherwise, the company may require increased cash or lines of credit to continue operation while waiting to get paid.

An aging report, which usually organizes outstanding balances in 30-day increments, can be used as a tool for anticipating bad debt, or balances that remain unpaid and must be written off. Accountants often anticipate bad debt coverage needs by applying a formula: as an example, (A/R less than 30 days old x 0.5%) + (A/R 31–60 days old x 5%) + (A/R 61–90 days old x 15%). The percentages are determined by historic likelihood of the balance going unpaid in that A/R period.

Consistently high levels of bad debt may indicate issues in A/R management, client quality, or your company’s inability to deliver on client expectations.

4. FIXED vs. VARIABLE OPERATING EXPENSES

KPI Objective: Know on what, and why, you’re spending.

Above all else, you have to understand your cost structure. Revenue can be tough to predict. Costs are not.

Variable costs change with production volume, while fixed costs are a constant expense. Fixed costs are things like rent, management salaries, and insurance, which must be paid even if you aren’t producing anything. We already covered unit economics earlier, so let’s focus on fixed costs.

The novice approach is to “keep costs low.” And while generally that’s more correct than not, there’s nuance to it. It depends on what you’re optimizing for and the nature of your business. R&D budgets, experimental programs, marketing expenses, and technology costs are all technically fixed costs. But, those are also the future of your company and things from which you’d expect a positive ROI.

The trick is to understand what costs support existing and on-going operations versus what is investment. Keeping corporate bloat to a minimum certainly helps, but make sure you don’t sacrifice the future by mistake.

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Part 1: Basics, Part 2: Customers, Part 3: Team and Part 5: Investment are also available to read now.

Brent Beshore is the founder and CEO of adventur.es, a family of companies throughout North America. Read more of Brent’s writings on investing, operating, risk, and not being an asshole. Connect with him on Twitter or LinkedIn.