Definitions Of Terms Used In This Article:
R&D: Research and Development
Product-Centricity: When a company decides to maximize profits through an increase in product volume, which as a result, will drive down costs.
Customer-Centricity: When a company decides to focus its resources and products around the current and future needs of a select set of customers to maximize their long-term financial value to the firm.
Bottom Line: Profit
Sensitivity Analysis: The analysis of the effect an independent variable has on a dependent variable, such as profit.
KPI: Key Performance Indicator
Flow Rate: The number of customers or products going through a process within a given time frame.
Gross Margin: The ratio between gross profit (revenue — costs) and COGS (Cost of Goods Sold)
Most enterprises, if not all of them, are influenced by one key objective, increasing the bottom line. To achieve this arduous goal, businesses may invest a significant amount of capital into their R&D operations, launch a new marketing campaign, fine-tune their products’ price, or even change firm architectures, such as a transition from Product-Centricity to Customer-Centricity. Although these actions impact the bottom line, they require not only an excessive amount of investment but also a substantial amount of time.
An easier way to impact the bottom line would be to conduct a sensitivity analysis on a firm’s operational variables such as flow rate. Such an analysis can give insights into how to yield greater profits as well as the right KPIs for your business to focus on by merely tweaking a firm’s variables. This process is arguably easier than changing attempting to pump out more sales or launch a new marketing campaign.
KPI Trees
The formal name for this kind of sensitivity analysis is called a KPI Tree. A KPI Tree just breaks up a key company objective such as profit, into its separate parts, revenue, and cost. Following this first breakdown, the previously broken up subgroups (revenue & cost) are broken up, and then those resulting subgroups are broken up further until they become small enough to be considered individual independent variables such as marketing per unit or units sold as shown in the image above. After these variables are on the tree, by experimentally changing the value of each of these variables or other variables that aren’t on the tree, you can find which of them have the most impact on the bottom line as well as how to alter them for your business. To formally find the impact an operational variable has on the business objective rather than manually altering each variable, you could take the partial derivative of that goal with respect to an operational variable.
As far as changing a variable is concerned, a firm should record what happens to the business aspiration as you make the value of the variable increase and decrease. An important process to note is that you should not analyze the effect a variable has on the objective in conjunction with the impact of another variable’s modification.
Penne Pesto: KPI Tree Example
“To gain a deeper understanding of how to use a KPI tree, let’s walk through an example. Let’s say that there’s a restaurant called Penne Pesto which has 50 seats and is open 365 days a year for only 4 hours in the evening. Penne Pesto is always full to the last seat even on weekends and holidays. A guest will spend 50 minutes in the restaurant, which includes 5 minutes until the guest is seated and the waiter has taken an order, an additional 10 minutes until the food is served, 30 minutes to eat, and 5 minutes to handle the check-out.
It takes Penne Pesto another 10 minutes to clean the table and prepare it for the next guests. The average guest leaves $20 at Penne Pesto, including food, drink, and tip (tips are collected by the restaurant, employees get a fixed salary).
The restaurant has 10 waiters and 10 kitchen employees, each earning $90 per evening (including any preparation, the 4 hours the restaurant is open, and clean-up). The average order costs $5.50 in materials, including $4.50 for the food and $1 for the average drink. In addition to labor costs, fixed costs for the restaurant include $500 per day of rent and $500 per day for other overhead costs.” [2]
It’s important to note that for the sake of this example, demand is considered to be constant as long as Penne Pesto has room for customers to enter. Regardless of this assumption, this example can still offer an understanding of the power of creating a KPI Tree as well as how it can help find KPIs.
Given all this information, we can create a KPI Tree like the one shown below.
Now that we have this KPI Tree as well as a list of some operational variables from the other image above, let’s see how much of an impact cutting the amount of time spent cleaning tables in half will affect our profit.
Quite surprising, what appeared to be an insignificant change in the amount of time spent on cleaning a table, raised profits by almost 364%! Furthermore, given that the number of customers was really what changed the most as a result of faster table cleaning, this creates a KPI for the business to keep track of, Number of Customers.
Let’s see what would happen if we were to lower our material costs by 25 cents.
Given that our original profit was $36,500, by only reducing our material costs by 25 cents, we were able to yield a 150% increase in profit! Moreover, we now have another KPI for Penne Pesto to keep track of; Gross Margin, since COGS (Cost of Goods Sold) doesn’t tell much about a business on its own.
In the Penne Pesto Example, I’ve only created a short illustration of how to tweak operational variables and analyze their impact. However, typically, you would both add and subtract to the values of all the variables to see which ones have the greatest impact.
Key Takeaways
- Creating KPI Trees can help determine KPIs and provide insights into the impact operational variables have on an overall business objective.
- When breaking up a business objective into individual parts, keep breaking up those parts until each sub-section becomes its own independent variable.
- Record the impact increasing & decreasing each variable’s value has on the business objective.
- Focus on the variables that have the greatest impact on your business objective.
- The important variables will create essential KPIs for your business.
Sources
“Fader, P. (2012). What is Customer CENTRICITY? — Customer CENTRICITY: The limits of PRODUCT-CENTRIC thinking & the opportunities and challenges of Customer Centricity. Retrieved February 22, 2021, from https://www.coursera.org/learn/wharton-marketing/lecture/Wir8N/what-is-customer-centricity” [1]
“Terwiesch, C. (2012). Review of productivity — productivity. Retrieved February 23, 2021, from https://www.coursera.org/learn/wharton-operations/lecture/Bxf2L/review-of-productivity” [2]
