By Rhett Molitor
The late, great management guru Peter Drucker once said, “You can’t manage what you can’t measure.” In other words, if you don’t track your numbers, there’s no way to know what’s right, what’s wrong, and what’s working to make it better.
Every business owner should always be striving to improve and refine their business finances. COVID-19 has exposed many companies’ financial weak links, so there’s no better time than now to get to tracking and build in a constant improvement culture.
We’ve put together a Top 5 list that applies to just about any business. Still, it would be best to do some additional research on the key performance indicators for your industry and business size.
Be warned: KPIs can be a bottomless pit of calculations, so don’t overwhelm yourself. If you’re just getting started, start with three to five and make sure they are useful to your decision-making before adding on more. Less is more.
Here are the Top 5 numbers every business should know and why you should track them:
1. Gross profit margin
Gross profit margin is a measure of how much is left from sales after subtracting direct costs. For example, if you generate $100 in sales from products that cost you $60, you have a gross profit margin of $40 (a 40 percent gross profit margin).
Sufficient gross margin leaves you with enough money to cover overhead expenses and still have a net profit left at the end of the day to invest back into the business. If your gross margin is too low, you may need to raise prices, cut your cost of goods, or a little of both. The gross profit margin varies widely by industry. For example, the hospitality industry might be around 75 percent, while many retailers might be 25 percent or lower. Make sure to measure against your sector and continuously work to improve your numbers.
The contribution margin is another critical metric. It’s similar to gross profit but looks more at direct and indirect variable costs based on your sales. For eCommerce companies, this can be a useful number as it will pick up things like merchant service fees and outgoing shipping charges.
2. Net income
After gross profit comes operating expenses. Once removed, you’re left with net income (also known as net profit). This is what’s left to reward owners and stockholders for their work and risk-taking or reinvestment.
Because of operating expenses, net profit is always going to be smaller than gross profit. Remember the comparison we made in gross profit? The hospitality industry’s net profit often plummets below 10 percent, and retail often drops to 5 percent or less. If there was sufficient gross margin to work with, improving net income is about managing overhead expenses.
3. Customer acquisition cost
Like the name says, this is how much it cost you to acquire a new customer. Of course, it’s not always easy to know what brings new customers to you. The simplest way to measure CAC is to divide the total amount spent on marketing and advertising by the number of new customers you gained during that time.
Although some retail industries may expect to spend only about $10 to acquire a new customer, others — like financial services and banking — may spend $200 to $300 on a new customer. A good guideline is to compare the cost of a new customer to the lifetime value of one, or how much profit you can expect from them over their lifetime of buying from you. Balance these two numbers well, and you’ll be consistently profitable and scalable.
4. Sales growth
Sales growth is a fundamental, meat-and-potatoes kind of metric. To keep growing and thriving as a company, you need to expand your customer base and continually increase your sales. Without sales growth, you’ll find your sales decreasing and be forced to cut costs to stay afloat continuously.
Track sales growth year-to-year or month-to-month to catch trends in time and adjust your sales strategy accordingly.
This number tells you how many months you could operate if your sales came to a screeching halt. As you can imagine, COVID-19 put this to the test and, without Paycheck Protection Program loans, many businesses wouldn’t last more than a month or perhaps even after one pay run.
Managing this number also helps you build a good habit of maintaining appropriate cash reserves. Cash reserves are the business equivalent of your emergency fund. If your cash reserves get too low, you could be in trouble if sales take a downturn. On the other hand, if your cash reserves are too large, you may be missing out on better uses of that cash, like investing in the business of paying off debt that’s costing your interest.
A rough formula to quickly estimate your runway is to take Cash + Accounts Receivable and divide by your monthly Operating Expenses (or “burn”).
How to keep track of KPIs
So, how do you go about tracking your KPIs?
All the data you need comes from your accounting system (like Xero). The numbers are all there, you just need to know how to see them, and then you need to commit to monitoring them and following through on required changes.
You can sync your accounting application with financial analysis apps like Fathom or Microsoft’s Power BI. Fathom has a wonderful feature called “goal seek” that allows you to do a little what-if analysis to figure out where you can tweak your numbers to solve for your goal, including which drivers are the most impactful.
Even without a KPI system, you can create a simple Microsoft Excel worksheet to input a few numbers to calculate your KPI manually.
Remember, measuring KPIs can get out of hand, so we thought it would be useful to provide you with Fathom’s KPI glossary to review and obtain a good handle of the full range of KPIs out there and how to use them.
With the right KPIs and the right technology, you can run your business smarter. Block out the time for quarterly or monthly reviews of your key metrics and commit to actionable steps to improve in the next period. It’s up to you to make sure what gets measured gets improved.
Rhett Molitor is a co-founder at Basis 365 Accounting who provides cloud-based outsourced accounting and bookkeeping services for e-commerce, software and technology, and professional services businesses across the United States.