What are Key Performance Indicators (KPIs) and how to use them in practice

Only things that are measured get managed. That it’s why it is vital for every business to have well-defined KPIs. In this post, I will show you the main concepts around KPIs. For more details, I recommend checking my online course: KPI and metrics for Management Consultants & Managers

What are KPIs?

Let’s first start by defining what are KPIs. KPI stands for Key Performance Indicator. We use this term to describe important, from the business point of view, metrics. Most firms concentrate on increasing profit. However, the profit is a metric that you can calculate usually only at the end of the month. That’s why you need other metrics that will help you decide whether you are moving in the right direction. Moreover, many people and departments do not understand their impact on the profits. Therefore, we have to create a set of metrics that will indicate to people that they are doing the right things, which in the end will help boost profits.

To sum up, to manage a business and suggest to people what to do, we need a lot of additional metrics. The most important metrics in the business we will call Key Performance Indicators.

How to define KPIs?

You can define the KPIs by using 2 main approaches: the bottom-up approach and the top-down approach. The bottom-up approach is very simple – you define many different metrics, and you select out of them 5-10 that you will consider the most important ones. This approach has a big drawback – you may be missing the big picture and not really understanding the mechanics of the business.

That’s why it is a better idea to use the top-down approach. In this approach we define the KPIs in 5 steps:

1. Define the Strategy. Good KPIs can only be defined if you have clarity on the strategy. We have mentioned that most firms will concentrate on profits. However, you will have plenty of firms that at some stage will mainly focus on size (revenues, number of customers). You also need exact values to define proper KPIs. That’s why knowing the strategy is vital.
2. Pick the Business Model. The same goal defined by the strategy can be achieved through different business models. For example, I can achieve USD 100 M of profits in selling clothes, by operating 3 different business models: traditional Retail (with physical offline stores), e-commerce, marketplace. Every business model will have a different set of KPIs. That’s why you have to have clarity on that before you start defining them.
3. Identify Drivers. KPI is just a metric that measures certain phenomena that helps or make it difficult to achieve the goal defined by the strategy. The main things that impact the goal we call drivers. It’s important to remember that the same driver can be measured with different KPIs. For example, how much you earn will depend on how happy the customer is with the product. You can measure that happiness by looking at the average score given by the customers, or the Net Promoter Score. You will have also different drivers in every business model.
4. Define the KPIs. Once you have clarity on drivers, you can start coming up with different metrics. Some of those metrics will be selected to be KPIs. Firms, use plenty of metrics for different things. Usually, you will have 5-10 metrics in the group of KPIs.
5. Set Targets for KPIs. Last but not least, once you have selected KPIs, you should set targets that should be linked with the goal set in the strategy. For example, if my goal is to have USD 500 M in revenues, I have 250 customers, and one of the KPIs is the Average Revenue Per 1 customer, then to achieve my goal I should set the target for the Average Revenue Per 1 customer to be USD 2 M.
   

What is a good KPI?

Many firms have KPIs, but some of those metrics may be poorly defined and lead them to make bad decisions. Let’s see what makes a metric a good KPI. We will start with a short video that summarizes what a good KPI is:

Now let’s discuss in a bit more detail:

1. KPI should not be a vanity metric. A vanity metric is a metric that looks nice because it’s big but does not really impact the goal we want to achieve. Vanity metrics can be easily manipulated. A great example if the number of downloads of a mobile app. You can have many downloads (generated via advertisement) but hardly any users. If the mobile app is not serving its purpose people may download it but will not use it after a day or two. So, if you concentrate on downloads you will always see growth, yet this growth will not lead to bigger profits in the future
   
2. KPI should be SMART. Let’s see what the SMART rule stands for when it comes to KPIs
   
3. Every KPI should be assigned to somebody (a person or a team). KPIs describe drivers. For the driver to impact the goal, we have to assign the KPI to somebody who can come up with ideas on how to improve it. If you believe that the quality of the product measured with the percentage of faulty products is important, then you should assign this KPI to somebody who can decide what to do to improve this specific KPI.
4. The person knows the KPI and can influence it.
5. KPIs should be a part of the motivation/bonus system. The best way to influence the behavior of people is to do it through their bonuses. That’s why KPIs should have an impact on how much they earn. In this way, you align their motivation with the strategy of the firm.
6. KPIs should be aligned in the organization with main business goals. As we have mentioned we use KPIs to impact the drivers and in this way to increase the chance of achieving the goal (higher profits, higher sales, higher market shares). For this to work, we have to align the strategy with drivers and KPIs. If you use the proposed top-down approach this condition should automatically be met.
   
7. KPIs should be reported and analyzed on regular basis. Some firms, define great KPIs but don’t measure them or measured them irregularly. If you want to influence the behavior of people, you should provide them with feedback (the value of KPIs) frequently. A great example is production firms. They will measure KPIs every day for every day. Moreover, they show the KPIs on big tables visible to everybody.
8. KPIs should be used to make decisions. If KPIs truly reflect drivers, then you should also incorporate KPIs into the decision-making process. For example, if you want to start a new project you should be aware of which KPI it will change and by how much. Thanks to this you can later check the success or failure of the project.

Drivers for different business models.

As we have mentioned, before defining KPIs you should identify drivers. Every business model will have different drivers. We mainly identify them by disaggregating the whole business, using the top-down approach, into smaller items. To show you how it can be done, let’s look at a few examples.

1. Marketplace. By marketplaces, we mean sites that are the middlemen between sellers and buyers. A great example of a marketplace is Udemy (teachers vs students), Amazon (sellers vs buyers), Airbnb (hosts vs guests). Let’s look at drivers for this business model:
   
2. Restaurant. Now let’s look at drivers for a chain of restaurants
   
3. Retail. Retailers are the businesses that operate offline, physical stores in which they sell third-party goods and their own brands (private labels). Let’s look at drivers for this business model:
   
4. Hotel. Now let’s look at drivers for a chain of hotels
   

It’s important to notice that most firms will operate more than 1 business model. That’s why for every business model, the business unit, you should define separate sets of KPIs. For example, Amazon is running e-commerce, marketplace, SaaS, B2B services, and B2C services.

What do we use the KPIs for?

Peter Drucker, the famous management guru, has said that “What gets measured gets done”. This summarizes the role of KPIs in firms. Let’s now briefly discuss how in practice KPIs will be used

1. Strategy. Most firms will define a strategy not only on a high level (e.g., profit to be achieved in 5-10 years) but also will model the values of KPIs that you need to achieve to reach the goal. Below you have an example of defining goals for KPIs using the backward approach:
   
2. Bonus system/Motivating people. KPIs are the pivotal part of any bonus system. People are great at acting according to the rewards and penalties. KPIs are perfect for making sure that people do what is best for the firm.
3. Manage the business. Also, KPIs are widely used to manage the whole firm. You will use them not only to motivate people but also to decide how many resources you need to achieve the goal
4. Financial Modeling and Forecasting. KPIs enable you to build dynamic models in Excel that will reflect the reality of the business. Thanks to KPIs you can see how changes in their values will impact the financial goals. Let’s have a look at an example of such a model using KPIs for e-commerce business
   
   Check also other financial models:
   1. Retail Business Model
   2. Real Estate (short-term rental) Business Model
   3. Restaurant Business Model
   4. Consulting Business Model
5. Understanding the business. KPIs will help you better understand the business. As we have mentioned they should be based on drivers that are important for achieving the goal in a specific business. KPIs enable you to quantify the importance of specific drivers. This in turn will allow you to set priorities and allocate resources. In the same way, by using KPIs you can understand not only your business but also the competition.

That’s in short. As always, I recommend checking for more examples of our online course  KPI and metrics for Management Consultants & Managers. You will find there +5 hours of content and more than 100 lectures, that will teach you all the things you need to define and use KPIs.

Have a look also at our posts on Cost Reduction and Generating More Cash.

We have also 3 other short movies on important aspects of KPIs:

1. Cascading KPIs
2. Input vs Output KPIs
3. Proxy KPIs
4. How to set the value for KPIs