If you want to avoid bad strategy decisions a KPI model can help you find your solution.

The fundamental problem.

There is no universal management theory able to guide a manager's decision on a critical business issue. All business operators know that many theories can apply to the situation they confront. Their choice of theory will inevitably influence the decision they make. Even a decision that there is no relevant theory will inevitably influence the decision.

The problem gets worse.

Where do you go for advice? Ask an accountant and you can be confident that you will get a financial solution. Ask a lawyer to get a legal solution. Will you ask a friend to get a solution that minimizes the risk to you? You need a way to make your own decision based on your intimate knowledge of your own business, but it has to be a way that you are confident gives you the best answer. Then you can check it with your advisers.

Let us examine a common situation.

A downturn in sales is attributed to a downturn in demand. The revenue loss leads to a cash flow and liquidity problem. Without action, the business faces insolvency in a matter of months.

Financial theory offers two options; reduce fixed costs, variable costs, or reduce stocks by discounting. Redundancy programmes are but one way of reducing costs by matching capacity to demand in order to maintain gross profit %.

Marketing theories offer alternatives to increase sales, but usually require increases in expenditure and risk. Reductions in marketing spend are usually short-term expedients with long term consequences.

Employee relations theories offer alternative ways of cost reduction, with different implications for the long term future of the business. The net benefits are generally finely balanced.

I am sure you can think of many other theories that could apply to one aspect of this scenario.

I hope this illustration has demonstrated that your choice of theory will constrain your options. The interactions between the theories can be shown if you draw three intersecting circles. Label one as financial, one as employee relations, one as marketing.

It is clear that the optimal decision will be found in the small space where the three theories intersect. No single theory can produce the best answer, so how do you balance up the competing claims from theories that interact, each producing positive and negative outcomes. Your possible range of decisions has been constrained.

The way a strategist approaches complex decisions may point the way.

A strategist will create a set of feasible scenarios. A feasible scenario for our simple illustration is one that optimizes that prospect of business survival, short and long term.

This is only possible if we consider the whole system, the business, its customers, suppliers, employees and competitors. To neglect the reactions of any group will put the business at risk.

Any decision will generate effects from different groups often at a point remote in time and place from the obvious and immediate effect. You do not want to be caught out by unintended consequences.

Start by assessing whether the effect is positive or negative. You can estimate the most likely relationship later when you plug it into your KPI model. At this stage you are assessing the interactions between the different theories.

3. Another example assesses the costs and benefits of a redundancy programme.

a. Cost of redundancy payout. Include accrued leave, redundancy pay entitlements, pay in lieu of notice.

b. Lost time during consultation process.

c. Lost productivity due to morale effects.

d. Cost of replacing staff when business picks up again.

e. Costs of contractors and temporary staff if you get the number wrong.

offset by

f. Monthly savings on wages costs.

4. You will usually find that a likely scenario needs you to consider more than one perspective or theory. You cannot simply add up the positives and negatives associated with each theory perspective to get the net result. Complex systems simply do not behave like that.

Using your KPI Model

Now you can use your KPI model to explore the interactions between the decisions and their effects on the different parts of your system.

1. Enter the new numbers into the input cells in your model. Sometimes you will need to add an input box to your model to accommodate a cost or revenue factor that is not a normal part of your working model.

2. Do not change the algorithms (except to accommodate a new input); there is no change in the relationships between the KPIs.

3. Assess the effect on the key financial ratios your model generates. Changes in Return on funds, Gross Profit % and Asset Turns are obvious points of measurement.

4. Assess the changes on other KPIs that may be important. I suggest you look for changes in:

a. Product segment contribution

b. Customer segment contribution

c. Customer numbers

d. Service level KPIs

e. Marketing spend

f. Overhead ratios

g. Stock turns

By now you are starting to get a good picture of the overall effect on your business system and prospects.

If you try one scenario at a time you will soon have a reasonable understanding of the combination of decisions that will work best for you; that is one that maximizes the benefits and minimizes the harm.

Look for a strategy

The optimal strategy will almost certainly require a number of business decisions.

Your business is a complex system, and there is no certainty that a decision about a single variable in the system will produce the expected result.

Let me offer an example.

A business uses an internal call centre to recruit new customers in New Zealand. A cost cutting review has found that a net saving of $250,000 pa. is available by shifting the call centre to a Mumbai based contractor. The proposal is presented to the board as a simple yes/no decision, without any supporting analysis of customer reaction. The contract specifies the success rate, and the contractor has agreed to penalties for failure to meet the performance indicators. The board accepts this one-dimensional proposal as an net addition to the bottom line.

After 4 months of a 12 month contract the new customer recruitment rate has declined by 10%, due to adverse consumer reaction to the change. Gross profit has declined by $500,000, and market share has dropped by 1.5%.

The Mumbai call centre is losing $10,000 per month to penalties, and is unhappy; its staff are dispirited and productivity is declining. The in-house call centre has been disbanded with significant redundancy costs.

What next?

How does this sort of disaster occur? It has happened too often around the world in recent years for it to be an accident.

What theory, or combination of theories, ruled in the board meeting?

Your instincts are right. The combination of a single financial theory about cost cutting, combined with a one dimensional Employment Relations theory about the financial costs of redundancy is the cause.

How can this type of disaster be avoided?

If the business had examined three scenarios, the usual best/most likely/worst case scenarios from a marketing perspective there is a fair chance that the risk would have been exposed.

If the business had invested effort in developing a robust KPI model it would have been able to test the complex set of flow-on decisions needed to assess the proposal. properly.

The analysis could have quantified the level of reduction in customer recruitment performance that would negate the expected savings from the cost reduction programme. The board could then have made a decision in full knowledge of the risk they were taking..

This example has demonstrated that failure to view the business as a complex system in a complex marketplace leads to errors that can be avoided by a business model that treats the whole business as a system involving interactions of theories and processes. A robust KPI model does exactly that.

The theory works; the practice works and strategy options can be rigorously tested.

If you would like to see a video demonstration of the thinking process using a working KPI model check out this link to Use a KPI Model 1. It will open my file at Screencast.com and take around 5 minutes to listen to me exploring the thought process I use to assess alternative scenarios.

You will see that at every stage of the assessment the point of reference is the business' return on funds. Surely this is where a board of directors or a business owner should keep their focus.