We've looked at business models, and the organizations that can be built to sustain those models. We now turn to looking at those models in action, and asking whether they are actually any good. Unfortunately, it‘s not always easy to tell whether a business model makes sense. Why?
Things that get in the way of measuring business performance
Second: Even if you decide what the parameters are, can they actually be measured? Some are quite straightforward (cash in the bank), some a little harder (customer satisfaction) and some really tricky (“awesomeness”).
Third: The relevant, observable, measurable thing you want to measure may not have happened yet. Even something as “simple” as sales figures may not be available in real time.
But fear not. There are plenty of ways to get a sense of how a business is doing.
Subjective v. Objective measures
Let's begin with the fundamental distinction between subjective and objective measures. The more analytically minded among you will say that business and management are rational activities, and that objective measures of business performance are a more reliable, replicable and scalable basis for running a business. And you would have a point. But business is also about sensing and responding to potentially any feedback that the market provides. And not all of that can be reliably captured in objective statements.
To illustrate the point, let's drop in on our entrepreneur, Alpha, who is enjoying his lunch before the 4pm rush. Alpha is wondering whether this week will be a better week than last. He has a handful of very objective ways of doing so. He started the week with a few coins in his collection cup, and by Friday he will have filled it several times over with cash from customers. He started the week with a full bag of ground coffee, and if he is lucky he will end the week with almost all of it gone. His cash balance and his rate of consumption of ingredients are nice, observable, real-time ways to monitor the performance of his business.
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| Alpha's business performance dashboard |
But he also has a sneaking suspicion that, despite the objective truths of "more money on the table" and "less coffee in the bag", some other dynamics are at play. One is his health. The lucrative night shift has taken its toll on his sleep schedule, and he has a little more trouble getting going in the morning. Also, he's aware that not all his customers are delighted with the standard cup of coffee he serves. He's had a couple of people complain that it doesn't taste as good as it did last week. Both of these are useful indicators - one warns him that his productivity is at risk, the other that he needs to tweak his offering - and both are subjective. The fact that they are subjective makes them no less important.
A note on quantifying measurement: Sometimes people confuse the distinction between objective and subjective with the distinction between quantifiable and non-quantifiable. These are two different axes. It's not always easy to take subjective inputs and quantify them, but it is possible and it is worth doing. Just think of any app you have used recently: Chances are you have been asked to rate your experience. In the same way, it is possible for Alpha to rate his feeling of tiredness, or ask customers to rate the taste of his coffee on a scale, and to track these perceptions over time.
Selecting metrics and creating a set of “management accounts”
How should Alpha use these subjective and objective measures? Which ones are useful? Which ones are trailing indicators (meaning backward looking, for measuring past performance and keeping score) and which ones are leading indicators (meaning they provide a clue to future performance)? How should they be combined to provide a picture that is easy to understand, and can guide decisions? In the case of Alpha's business - as in any business - one of the most important things to track is sales - both in terms of quantities sold and revenue earned. The next most important is the supplies used, both the amounts consumed and the value of those amounts. These metrics are most useful if they are tracked over time, so he can measure progress. He might add a couple of subjective measures too: Comments received from customers, or how tired he feels at the end of the last shift. These might seem a little idiosyncratic, and they absolutely are. And that's absolutely fine! This is Alpha's business, and he can measure its success and its progress by any measure he chooses.
Beta's metrics will likely be similar. Measuring sales and inputs will effectively measure his net profit, and give him some sense of efficiency. In addition, he might come up with a few metrics that are helpful in the context of his business model. If, for example, he finds that customers who get comfortable end up spending a long time drinking lots of coffee, he might start tracking cups per customer. He might find that the number of cigarette butts in his ashtrays are a helpful clue. He might use the count of glucose biscuits distributed as a proxy for a count of loyal customers. And he could layer these up with subjective measures, like the number of times a month that an afternoon shift turns into a "scene", or what the mood was. Again - he can choose whatever metrics he wants. It's his business!
By choosing various metrics by which they will measure their business, Alpha and Beta have taken their first steps to what we call managerial accounting. Management accounts are what we call the records and metrics that executives use to monitor the health of their business, to track performance and to make predictions. As described above, there are some records and metrics that make good sense, and will be used by almost every business. But there are no rules governing these. Managers can include whatever they want in their management accounts. This means that management accounts are extremely useful, but only if you know what the metrics mean. In the case of Alpha and Beta's companies, the audience of any management accounts includes - well, just Alpha and Beta respectively. But what if they wanted to communicate something about their companies to another person? To a lender, perhaps? Or to the tax authorities? This is where financial accounting comes in.
“Management accounting” versus “Financial accounting”: Home slang versus lingua franca
Financial accounting is often described as "the language of business". Financial accounts are based on a (very) large number of conventions that are designed to allow outsiders to understand some aspects of a company's performance. Contrast this with management accounts, the “slang” that companies speak “at home”, which might be more accurate and relevant, but are probably less accessible to investors, regulators, tax collectors and others.
You will have almost certainly had some exposure to financial accounting, and a short text like this is no place for a deep discussion. But let me see if I can compress the essence of the key financial statements into a single paragraph…
In essence, when Alpha starts the week, he notes down the cash he has in hand, his inventory of coffee, sugar and milk, the value of his utensils and equipment, and perhaps the amount of any money he owes or is owed. This information makes up his balance sheet at the start of the period. At the end of the week, he again captures these values. This updated information makes up his balance sheet at the end of the week. His income statement captures the economic impact of the activities that took place between the beginning of the week and the end of the week. Finally, his cash flow statement for the period captures, well, all the cash transactions that occurred.
In the upcoming sections on tools, skills and knowledge that business lawyers should cultivate, you will notice that "familiarity with accounting" is not listed. That's because it is so obviously required that you shouldn't need me to tell you. I will offer one piece of advice: Becoming adept at reading financial statements, and connecting them to the life of the business, is one of the most important things you can learn how to do. But it also takes time. My hope is that through this book, you start to see the connections between the matters you are staffed on, and the financial data you will have access to. Like all the other areas of study I mention, it is ultimately up to you to master the technical material. But I hope that the context you acquire here will help that knowledge to stick and become useful as soon as possible.