How to make leading indicators work in your favor
By Alan Hart
In traditional budget preparation people look at past performance (revenue, expenses, etc.) and try to set a new budget based on these numbers and a set of reasonable goals, so the new budget usually scales from a previous year. Use of drivers is limited and reliance on key performance indicators (KPIs) hardly exists.
By using past actual performance data, for example: sales, gross margin and operating expenses, many key KPIs can easily be measured and presented. Examples might include revenue per employee, revenue per square foot of retail space, office expense per employee, utilities expense per square foot of building space and many more, only limited by your imagination.
These KPIs, while important in measuring actual results, only tell a story after the accounting books have been closed for the period (month, quarter, year), allowing them to be compared with prior periods’ KPI values and with budgeted data. They are known as lagging indicators and represent the output they portray to measure.
Since reacting to this data is usually difficult and often contrasts with goals (i.e., trying to directly change these KPIs may not yield the desired results), there has to be a better, and more balanced approach in dealing with this challenge.
In contrast, leading indicators represent the input they measure and have an advantage of allowing organizations to influence actual results through the controlling of these indicators.
A company’s leading indicators can be compared to economic leading indicators. These are indicators that change in advance of changes in the economy, for example: Durable Goods Orders is an economic leading indicator that provides insight into future revenues in the manufacturing industry. Similarly, an organization’s set of leading indicators can provide management insight into future performance of the company.
Every organization can employ leading indicators in the course of charting its business. If we stop and think about it for a moment, we can come up with examples in every imaginable type of enterprise. Here are a few simple examples:
Software publisher: Visitor traffic to the website, number of actual pages visited and number of submitted inquiry forms can become an important leading indicator of future revenue.
Call center with billing revenue: Call abandonment rate, average time to resolve an incident; call center queue metrics, etc.
Manufacturing Companies: Book to bill ratio, trailing 90-day bookings, productive labor-hours in an accounting period, etc.
Monitoring and influencing key leading indicators is a lot easier than doing the same with lagging indicators.
Now that we’ve seen the differences between leading and lagging indicators, it becomes logical to realize that using both types of indicators in combination will allow a company to affect the desired output through controlling the input, its leading indicators. In other words, since it is generally easier to affect leading indicators and knowing the relationships between the lagging indicators (the output) and the leading indicators (the input), an organization can be more successful in achieving its goals through working with both sets of indicators.
The idea is to use known leading indicators in your industry or even your specific business (within an industry sector) and intelligently affect budget components used in putting together the company’s annual budget and periodic forecasts or re-forecasts. With the right technology and a little know-how this can become a reality.
As seen on Centage’s Budgeting and Forecasting Experts Blog