Two Insights that Metrics Don't See
These Shortfalls Could be Costing You Money
July 29, 2014
I’m not going to tell you what metrics and Key Performance Indicators (KPIs) you should be tracking - not in this article at least. I’ll assume that you, the pragmatic and analytical reader, read financial statements often. And hopefully, you've determined what KPIs make the most sense for your business. Instead, I will to share the inherent shortfalls of some common metrics, such as financial statements and sales reports.
#1 Metrics Shortfall: Metrics, like financial statements, although helpful, focus on what has already happened.
Whatever you’re reading on your financial and management reports has already happened. They are telling you the performance of previous management decisions and the earlier performance of your employees. The problem is that we sometimes make management decisions based on sunken costs, meaning things that have already happened.
Let's use relationships to illustrate this point. Let's say you are in a bad relationship (haven't we all been there?), and you're considering staying in the relationship or moving on. When weighing whether to stay or leave, your brain automatically starts thinking about all the experiences you have shared and the memories you've created. In essence, these are all the sunken costs. Sunken costs is an economic term used to categorize all the costs already incurred in a decision.
Here's the key: all those memories and experiences you've had with the person you're considering leaving already happened; therefore, they should not have any weight in the decisions you're making now.
We often forget this, and we place more weight on choices that affirm past investments. It happens both in relationships and in business.
All the business choices that have been made in the past should not matter when planning the strategy for your business' future. However, metrics can give you an idea of how past management decisions performed, which can help you avoid bad decisions in the first place (ie. Getting into a bad relationship in the first place).
#2 Metrics Shortfall: Metrics can’t measure opportunity costs, and that could cost you.
Again, just like management reports tend to place a bias toward sunken costs in our decision making, they also often fail to report opportunity costs.
Opportunity cost is also a term borrowed from economics. It’s used to measure all the costs associated with possible future choices. Of course, standard financial reports don’t tell you what could have happened and your KPI’s will focus the effectiveness of your past decisions.
To explain the nature of opportunity costs, let’s use a new example.
Let’s say that you are considering whether to attend college, and you decide against it. Four years pass. Assume you are making $26K a year and that with a college degree you would be making $40k a year. The opportunity cost of not going to college would be $14K. You just lost thousands of dollars and you didn’t even know it!
Metrics, like Key Performance Indicators and financial statements, focus on measuring the present and provide you some report of your previous performance. They can’t measure what never happened but could have.
In truth, you should pay close attention to your financial statements and you should have key performance metrics. In fact, often historical data can provide valuable information to guide your decisions. It just should not be the only thing guiding them. Push to correct the sunken costs bias. It’s often the things that we could have done, but we didn’t that cost us the most.