Key performance indicators (KPIs) are a standard performance measurement device. What gets measured gets managed, as the mantra goes. For working capital management, the main KPIs employed are days’ payables outstanding (DPO), days’ sales outstanding (DSO) and days’ inventory outstanding (DIO). But are they always the right measurements? Are there others that would tell a more compelling story? And how should businesses reconcile the KPIs used by different functions when they are in conflict with each other?
Back to basics
Broadly speaking, KPIs are used to monitor and communicate progress towards an objective. The objective could be financial, productivity-related or operational and are generally used to communicate between individuals and departments; between departments and senior management; and between senior management and shareholders.
Bank of America Merrill Lynch Global Transaction Services’ advisory director for EMEA, Bruce Meuli (pictured right), describes this information hierarchy as “a triangle with strategy at the top, business level in the middle and operational at the bottom. At the very top, you’re looking at C-suite and external stakeholders which tend to be very high level outcome metrics relating back to key financial metrics. At the business entity level, they are usually more attuned to that business entity or line.”
There are differences in the frequency of use of KPIs as you move through this hierarchy as well, he says. “If you go from top to bottom, the use changes slightly, the top being more end-results/financial cycle. Operational KPIs tend to be more continuous, intra-month, and more dashboard-driven. They are usually based around the performance of a process or an operation function.”
“What are we trying to solve?”
When the goal posts shift, for example when a working capital management plan is implemented, how should KPIs change?
Before changing the measurement, businesses need to ensure that they are still asking the right question. Meuli says that corporates are moving away from asking ‘How are we measuring against objective A?’ towards ‘What are we trying to solve?’
Working capital KPIs such as DPO, DIO and DSO “are used frequently because they’re relatively straightforward and recognised. They do have value,” Meuli says. But it’s important to acknowledge that the true value comes from telling a complete story as opposed to presenting a point-in-time view.
“Most people start out with one objective, which is nominal working capital – in effect, how to take cash out of the business,” he says. “But you can then look at, for instance, surety of the supply chain, or return on cash or capital, on excess cash you have sitting in the balance sheet; or you might be looking at enabling different functions with working capital – reinvesting in the working capital cycle.”
From these new questions, new problems arise he says: for instance, “How can we measure intangibles such as risk?” and “What data inputs will be used and are they of sufficient quality?”
One problem is that data quality is not always under the control of businesses – and quality has to be balanced with how quickly the information is needed. However, the introduction of new technologies could improve data richness by making it possible to access a wider range of better quality data. Meuli suggests that data improvement will come through “granularity of information – be that information on the data”. But he warns that “you also need to have the granularity for controlling a process from a business process management (BPM) perspective.”
Also, the rise in automated processes will naturally improve data quality and the time in which the data is received. “Where it used to be best efforts by individuals, this is being replaced by a data quality infrastructure allowing for business process management, which is managed digitally and within certain business criteria. So you’re getting alerts to how a process is either working or failing during the process, which provides the ability to put in place some of those end-process metrics,” Meuli says.
KPIs give you wings
When Lufthansa’s head of supply chain finance, Alexander Pawellek, set up the airline’s supply chain finance programme as part of a wider working capital initiative, he came across similar challenges. By harmonising the key performance indicators – such that, for example, everyone was calculating working capital in the same way – the interests of the various business units were aligned and the business was able to gain a greater understanding of overall performance.
It’s vital to drill down and examine whether individual business units are consistent in terms of how they define current assets and current liabilities, for example. For some, that might include everything from cash to tax liabilities and even to pension liabilities. Others will exclude all tax-related items and tax liabilities.
Meuli adds, “If you’re just looking at DPO at a high level, then you’re not understanding the underlying factors that are driving those figures or looking at the origins of any differences – which means you’re unable to act on that information. The information then becomes interesting but not necessarily of value.”
With working capital calculations Meuli suggests, “Cash and cash equivalents, as figures in the balance sheet, are not included in the cash conversion cycle; whereas cash does have a cost of carry and it is working capital tied up within the business. So, at Bank of America Merrill Lynch, for example, we include cash within our working capital definition, which fits with wider definitions of working capital in the market.”
What is key, however, is that however working capital is calculated it should be consistent across the business.
Historically, treasury and procurement had differing objectives with a different set of measurements and KPIs. Typically, procurement was a ‘cost and control’ function looking at ways to negotiate better terms or better discounts. Treasury, however, was accountable for cash. This can lead to conflicts where procurement wants to drive down cost but treasury looks at rates of return.
But with the emergence of working capital management as a key objective those silos are being broken down. Meuli says that corporates are reconciling this difference by using broader working capital measures. “The classic situation” is where, say, procurement wants to extend DPO, purely because of the working capital benefit, but treasury wants to reinvest in working capital through a dynamic discounting programme to get a better return on capital – which seems counter intuitive to the extension of the DPO objective. “But if you’re measuring working capital from a return on capital employed perspective, then both functions are working to the same end.”
Corporates need to understand what question they are trying to answer and how that fits into the overall business objectives, especially when it relates to enterprise-wide programmes such as working capital improvements.
Increasingly, businesses are seeing working capital “as an extended enterprise discipline, including suppliers and customers and any third-party vendors,” Meuli says. Some are creating a new job role: a working capital champion or cash conversion manager, “who effectively sits across all the functions and views working capital at enterprise level.” Meuli says, “Cash is not just a balance, it’s a flow; meaning that working capital can be managed proactively along the extended enterprise.”