Short-List KPIs: Why Manufacturers Need More Than Historic Data
(This story originally appeared in Manufacturing Dive)
By Chris Delaney
When it comes to managing their business, manufacturers need much more than historical financials to project their future revenue, profitability and liquidity. Historic numbers simply capture what has happened in the past—but traditionally do a poor job predicting where a company will be in the near (3-6 months) or distant future (1-2 years).
To make matters worse, most smaller manufacturers simply rely on financial statements as their historical data to help make decisions, but this is only the first level of information that they need to understand. Historical numbers will tell you if you grew, but they will not tell you why. Key questions are: Where is the growth and why? Is it sustainable? Which customers? Which divisions? How profitable was the growth and does it represent a new opportunity for investment?
If your company is in growth mode, forget historic numbers and focus on the key KPIs that are going to be predictive of future growth and profitability. KPIs are easier to project and do a better job at forecasting future financials than historical data alone. Is there a new customer onboarding or is a recession coming? Are customers going to leave shortly? New mergers on the horizon?
A handful of KPIs will create a more accurate forecast for manufacturers, which is invaluable.
Here’s a good place to start:
Sales Pipeline KPIs
Most manufacturers have a sales pipeline, which is the life blood of the company, but they tend to do a poor job in predicting future revenue. Typically, that is because it’s not systematic nor consistent, and because it’s done in an ad hoc manner. “Garbage in, Garbage out” is what I typically see. Without reliable reports on future revenue, moving forward will be a challenge.
Bottom line, manufacturers tend to not break down the sales data in ways that are meaningful. Start with the next 12 months and start framing it in two different ways. What is my core business (existing customers and existing SKUs in the marketplace)? Where are they and how can they be forecasted? I traditionally look at the core business in three ways: 1) what do you know (for example, future purchase orders that might be on hand, 2) what do you think (sales forecast provided by a customer) and 3) what are you guessing (no purchase orders or forecasts provided, but looking at historical data on how this customer typically behaves). On top of that, what is the new sales pipeline? What do we expect to “hit” and when? If one utilizes this simple technique from a “bottoms up” perspective, overlaying “core business” and future growth, forecast will be more reliable than what any historical data would predict.
Revenue forecasts, by nature, will never be perfect. But performing forecasts utilizing the above technique and in a consistent manner will always be more predictive than historical data alone. And further, and perhaps more importantly, it will also allow management teams to better predict future performance by allowing an analysis of “what we thought back then and why” and comparing it to actual results. The easiest example of this is the new sales pipeline. Last year, you had a $10 million dollar sales pipeline and you predicted 50% of that would translate into incremental revenue over the next 12 months. Well, what happened? Did that pipeline translate into $3 million, $5 million or $8 million of actual revenue and how do you use that information to forecast the business over the next 12 months when the current sales pipeline is $15 million?
When it comes to gross margins, manufacturers struggle with the real cost of delivering something out of the business. We used to call it “unit economics,” matching revenue to expenses per widget.
Manufacturers understand direct costs and margins, but they have trouble quantifying semi-fixed costs, which are items that feature both fixed components—set expenses—and variable components that are based on activity like utilities, maintenance, R&D and labor to name a few.
Overhead costs that are not part of direct labor or materials can be tricky to assess. They tend to show up on the income statement in different places. Your KPIs will break out the valuable parts that will serve as the basis of managerial accounting and forecasting.
For example, a customer may require a special batching process to make the product. If the management team doesn’t understand the semi-fixed costs, the magnitude of increasing quantities and capturing indirect costs can create a situation where the true profitability of a project is not fully understood and could create problems in the future. In such a situation, the economics around a 30,000-unit order (after allocating for indirect costs) may still lead to attractive margins, but a 5,000-unit order may and will create an inability to scale into the future.
Working Capital KPIs
From a number’s perspective, working capital is current assets divided by current liabilities.
More importantly, this number, which should range from 1.2 to 2, tells your management team and investors if you can sustain day-to-day operations in the short term. Your KPIs should include inventory levels, accounts receivable and accounts payable.
Improving working capital could look like standardizing payments terms and providing incentives to speed up cash collections. Outsourcing operations, selling assets or leasing assets could improve your cashflow and generate a more favorable tax treatment moving forward. While paying vendors in a timely fashion may seem counter-intuitive, it could allow you to negotiate better terms in the future based on your strong relationships.
This set of KPIs is about liquidity—the more, the better—for all your stakeholders.
If you can’t measure something, then you can’t manage it.
For manufacturers, the utilization rate deserves plenty of attention. It has been stated that 80% is the goal for utilization, but a recent survey shows that reality is a different story.
More manufacturers believe their company’s utilization rate hovers around 50%, which takes into account setups, breakdowns, as well as staff breaks. Unfortunately, tracking revealed a 26% rate, a far cry from the industry standard.
The utilization rate is the time manufacturing assets are being used to produce output. In other words, actual output divided by capacity times 100.
Developing better benchmarks and better reporting processes will improve your utilization rate. Creating a score card for all your KPIs will put the short list of KPIs in front of senior leadership so they have a quick idea about what the company looks like today and tomorrow.
KPIs won’t give you the “answer,” but they will help management make better decisions.
The short list of KPIs is where the process begins.
(Chris Delaney, MBA, is a director in CFO Consulting Partners’ private equity portfolio company practice with an emphasis on manufacturing, business services, health care and specialty finance companies.)