Business Ratios 3e PDF

AccountingTools ® Series
Business
Ratios
Guidebook
Third Edition
Steven M. Bragg, CPA

Business Ratios
Guidebook
Third Edition
Steven M. Bragg
Copyright © 2017 by AccountingTools, Inc. All rights reserved.
Published by AccountingTools, Inc., Centennial, Colorado.
No part of this publication may be reproduced, stored in a retrieval system, or

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ISBN-13: 978-1-938910-97-5
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Table of Contents
Chapter 1 - Overview of Measurements ...............................................................................1
What to Measure ..................................................................................................................1
Mandatory Measurements ....................................................................................................3
Breaking with Tradition .......................................................................................................3
Measurement Usage Levels..................................................................................................4
Measurement Timing............................................................................................................5
Measurement Consistency ....................................................................................................6
Measurements and the Soft Close ........................................................................................6
Measurement Clutter............................................................................................................7
Limitations of Ratio Analysis ...............................................................................................8
Chapter 2 - Performance Measurements............................................................................ 11

Overview of Performance Measurements .......................................................................... 11
Sales Returns and Allowances to Sales .............................................................................. 12
Contribution Margin Ratio ................................................................................................ 13
Gross Profit Ratio .............................................................................................................. 14
Operating Income Ratio ..................................................................................................... 14
Net Profit Ratio .................................................................................................................. 16
Deflated Profit Growth ...................................................................................................... 16
Effective Tax Rate .............................................................................................................. 18
Core Earnings Ratio .......................................................................................................... 18
Quality of Earnings Ratio .................................................................................................. 20
Operating Ratio.................................................................................................................. 21
Operating Leverage ........................................................................................................... 22
Breakeven Point ................................................................................................................. 23
Margin of Safety ................................................................................................................. 24
Discretionary Cost Ratio.................................................................................................... 25
Chapter 3 - Liquidity Measurements .................................................................................. 28

Overview of Liquidity Measurements ................................................................................. 28
Cash Conversion Cycle ...................................................................................................... 29
Days Sales in Accounts Receivable ............................................................................... 30
Days Sales in Inventory ................................................................................................. 31
i
Days Payables Outstanding ........................................................................................... 32
Liquidity Index ................................................................................................................... 33
Current Ratio ..................................................................................................................... 34
Inventory to Current Assets Ratio ...................................................................................... 35
Quick Ratio ........................................................................................................................ 36
Cash Ratio .......................................................................................................................... 37
Defensive Interval Ratio ..................................................................................................... 38
Net Working Capital Ratio ................................................................................................. 39
Working Capital Productivity ............................................................................................ 40
Working Capital Roll Forward .......................................................................................... 41
Illiquid Asset Conversion Ratio ......................................................................................... 42
Solvency Ratio .................................................................................................................... 43
Altman Z Score ................................................................................................................... 45
Chapter 4 - Cash Flow Measurements................................................................................ 47

Overview of Cash Flow Measurements .............................................................................. 47
Free Cash Flow .................................................................................................................. 48
Cash Flow Returns ............................................................................................................. 49
Cash Flow per Share ...................................................................................................... 49
Cash Flow Return on Sales ............................................................................................ 50
Cash Flow Return on Assets .......................................................................................... 51
Cash Flow from Operations Ratio ..................................................................................... 51
Cash Reinvestment Measurements ..................................................................................... 52
Cash Reinvestment Ratio ............................................................................................... 53
Funds-Flow Adequacy Ratio ......................................................................................... 53
Chapter 5 - Return on Investment ...................................................................................... 56

Return on Equity ................................................................................................................ 56
Economic Value Added ...................................................................................................... 59
Book Value Analysis........................................................................................................... 62
Net Book Value ............................................................................................................. 63
Tangible Book Value ..................................................................................................... 64
Book Value per Share .................................................................................................... 65
Return on Assets ................................................................................................................. 66
Return on Assets ............................................................................................................ 67
Return on Operating Assets ........................................................................................... 68
Earnings per Share ............................................................................................................ 70
Dividend Performance ....................................................................................................... 72
ii
Dividend Payout Ratio ................................................................................................... 73
Dividend Yield Ratio ..................................................................................................... 74
Chapter 6 - Share Performance Measurements................................................................. 76

Overview of Share Performance Measurements ................................................................ 76
Price/Earnings Ratio.......................................................................................................... 77
Capitalization Rate ............................................................................................................ 78
Total Shareholder Return................................................................................................... 79
Market Value Added........................................................................................................... 80
Market to Book Ratio ......................................................................................................... 81
Insider Buy/Sell Ratio ........................................................................................................ 82
Options and Warrants to Common Stock Ratio ................................................................. 84
Short Interest Ratio ............................................................................................................ 86
Institutional Holdings Ratio ............................................................................................... 86
Chapter 7 - Growth Measurements .................................................................................... 89

Overview of Growth Measurements ................................................................................... 89
Sales Growth ...................................................................................................................... 89
Deflated Sales Growth ................................................................................................... 90
Sales Growth Consistency ............................................................................................. 90
Core Sales Growth ......................................................................................................... 92
Customer Growth........................................................................................................... 92
Expense Growth ................................................................................................................. 93
Profit Growth ..................................................................................................................... 94
Profit Growth ................................................................................................................. 95
Profit Growth Consistency............................................................................................. 95
Affordable Growth Rate ..................................................................................................... 96
Chapter 8 - Constraint and Throughput Measurements .................................................. 99

Overview of Constraint Measurements .............................................................................. 99
Bottleneck Utilization ....................................................................................................... 100
Bottleneck Effectiveness ................................................................................................... 101
Bottleneck Schedule Fulfillment ....................................................................................... 102
Buffer Penetration ............................................................................................................ 103
Bottleneck Maintenance to Operating Ratio .................................................................... 104
Bottleneck Rework Processing ......................................................................................... 105
Post-Bottleneck Scrap ...................................................................................................... 106
iii
Manufacturing Effectiveness ............................................................................................ 107
Manufacturing Productivity ......................................................................................... 108
Manufacturing Effectiveness ....................................................................................... 109
Manufacturing Throughput Time ................................................................................ 110
Delayed Throughput .................................................................................................... 111
Chapter 9 - Cash Management Measurements ................................................................ 113

Overview of Cash Management Measurements ............................................................... 113
Auto Cash Application Rate ............................................................................................. 113
Suspense to Receivables Ratio ......................................................................................... 114
Actual Cash Position versus Forecast ............................................................................. 115
Average End of Day Available Balance ........................................................................... 116
Earnings on Invested Funds ............................................................................................. 117
Unhedged Gains and Losses ............................................................................................ 118
Chapter 10 - Credit and Collection Measurements ......................................................... 119

Overview of Credit and Collection Measurements .......................................................... 119
Days Sales Outstanding ................................................................................................... 120
Best Possible DSO ........................................................................................................... 122
Collection Effectiveness Index ......................................................................................... 122
Measurements Based on Time Buckets ............................................................................ 124
Days Delinquent Sales Outstanding ................................................................................. 125
Average Days to Pay per Collector.................................................................................. 125
Collection Dispute Cycle Time......................................................................................... 126
Deduction Turnover ......................................................................................................... 127
Average Time to First Contact ......................................................................................... 127
Bad Debt Percentage ....................................................................................................... 128
Collection Performance Report ....................................................................................... 129
Average Time to Establish Credit .................................................................................... 130
General Management Measurements............................................................................... 130
Chapter 11 - Customer Service Measurements ............................................................... 131

Overview of Customer Service Measurements ................................................................. 131
On-Time Delivery Percentage.......................................................................................... 132
Order Cycle Time ............................................................................................................. 133
Order Fill Rate ................................................................................................................. 134
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Orders Damaged in Transit ............................................................................................. 135
Customer Turnover .......................................................................................................... 136
First Contact Resolution .................................................................................................. 137
Escalation Rate ................................................................................................................ 139
Caller Abandonment Rate ................................................................................................ 139
Incident Volume ............................................................................................................... 140
Inbound Caller Retention ................................................................................................. 141
Customer Opinions .......................................................................................................... 142
Customer Satisfaction Ratio ........................................................................................ 142
Net Promoter Score...................................................................................................... 143
Chapter 12 - Facility Measurements ................................................................................. 146

Overview of Facility Measurements ................................................................................. 146
Cost per Square Foot ....................................................................................................... 146
Occupancy Cost Ratio ...................................................................................................... 147
Square Feet per Person.................................................................................................... 148
Percent of Storage in High-Cost Locations ..................................................................... 149
Floor Space Utilization .................................................................................................... 150
Cubic Volume Utilization ................................................................................................. 151
Percentage of Storage Bins Utilized ................................................................................ 152
Honeycombing Percentage .............................................................................................. 153
Chapter 13 - Financing Measurements............................................................................. 156

Overview of Financing Measurements ............................................................................. 156
Debt to Equity Ratio ......................................................................................................... 156
Supplier Financing of Assets ............................................................................................ 157
Ability to Pay Measurements ........................................................................................... 158
Interest Coverage Ratio ............................................................................................... 159
Debt Service Coverage Ratio ....................................................................................... 159
Fixed Charge Coverage Ratio ...................................................................................... 160
Cash Coverage Ratio ................................................................................................... 161
Average Cost of Debt ....................................................................................................... 162
Borrowing Base Usage .................................................................................................... 163
Chapter 14 - Fixed Asset Measurements .......................................................................... 165

Overview of Fixed Asset Measurements........................................................................... 165
Sales to Fixed Assets Ratio .............................................................................................. 165
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Accumulated Depreciation to Fixed Assets Ratio ............................................................ 166
Cash Flow to Fixed Asset Requirements Ratio ................................................................ 167
Repairs and Maintenance Expense to Fixed Assets Ratio ................................................ 169
Chapter 15 - Human Resources Measurements............................................................... 171

Overview of Human Resources Measurements ................................................................ 171
Position Fulfillment Speed ............................................................................................... 171
Unfilled Requisitions Ratio .............................................................................................. 173
Recruiter Effectiveness Ratio ........................................................................................... 174
Intern Conversion Ratio ................................................................................................... 176
Cost per Hire .................................................................................................................... 176
Employee Replacement Cost ............................................................................................ 178
Accession Rate ................................................................................................................. 179
Employee Turnover .......................................................................................................... 179
Annualized Compensation per Employee ......................................................................... 181
Net Benefits Cost per Employee ....................................................................................... 182
Sales per Person............................................................................................................... 183
Profit per Person .............................................................................................................. 184
Administrative Staff Ratio ................................................................................................ 186
Ergonomic Injury Rate ..................................................................................................... 187
Outsourcing Cost Effectiveness........................................................................................ 188
Chapter 16 - Inventory Measurements ............................................................................. 191

Overview of Inventory Measurements .............................................................................. 191
Average Inventory Calculation ........................................................................................ 192
Inventory Turnover Measurements .................................................................................. 193
Inventory Turnover Ratio ............................................................................................ 194
Raw Materials Turnover .............................................................................................. 194
Work-in-Process Turnover .......................................................................................... 195
Finished Goods Turnover ............................................................................................ 196
Inventory Accuracy Percentage ....................................................................................... 197
Excess Inventory Measurements ...................................................................................... 199
Obsolete Inventory Percentage .................................................................................... 199
Percent of Inventory Greater than XX Days ................................................................ 200
Returnable Inventory Valuation................................................................................... 201
Opportunity Cost of Excess Inventory ......................................................................... 202
vi
Chapter 17 - Payroll Measurements ................................................................................. 204
Overview of Payroll Measurements ................................................................................. 204
Payroll Transaction Error Rate ....................................................................................... 204
Form W-2c to Form W-2 Ratio ........................................................................................ 205
Proportion of Manual Checks .......................................................................................... 206
Payroll Entries to Headcount Ratio ................................................................................. 206
Outsourced Payroll Cost per Employee ........................................................................... 208
Chapter 18 - Pricing Measurements ................................................................................. 210

Overview of Pricing Measurements ................................................................................. 210
Price Elasticity of Demand .............................................................................................. 211
Cross Price Elasticity of Demand .................................................................................... 212
Throughput per Minute .................................................................................................... 213
Proportion of Discounted Prices...................................................................................... 214
Selling Price Variance ..................................................................................................... 216
Sales Volume Variance .................................................................................................... 217
Chapter 19 - Production Measurements........................................................................... 219

Overview of Production Measurements ........................................................................... 219
Department-Level Performance ....................................................................................... 219
Order Cycle Time ........................................................................................................ 220
Manufacturing Efficiency ............................................................................................ 221
Productivity Cause and Effect Ratio ............................................................................ 222
Degree of Unbalance ................................................................................................... 223
Operational Takt Time ................................................................................................. 224
Equipment Measurements ................................................................................................ 225
Equipment Effectiveness ............................................................................................. 225
Setup Time ................................................................................................................... 226
Unscheduled Downtime Percentage ............................................................................ 227
Maintenance and Repair Ratio ..................................................................................... 228
Average Run Time ....................................................................................................... 229
Yield Measurements ......................................................................................................... 230
First-Pass Yield ............................................................................................................ 230
Material Yield Variance............................................................................................... 231
Expense Proportions ........................................................................................................ 232
Indirect Labor to Direct Labor Ratio ........................................................................... 232
Overhead to Direct Cost of Goods Ratio ..................................................................... 233
Chapter 20 - Product Design Measurements ................................................................... 236
vii
Overview of Product Design Measurements .................................................................... 236
Product Development ....................................................................................................... 236
Number of Design Platforms ....................................................................................... 237
Reused Components Percentage .................................................................................. 237
Design Cycle Time ...................................................................................................... 238
Bill of Material Accuracy ............................................................................................ 239
Financial Outcomes ......................................................................................................... 240
Percentage of Target Cost Attained ............................................................................. 240
Percentage of New-Product Sales ................................................................................ 241
Return on Research and Development ......................................................................... 242
Warranty Claims Percentage ....................................................................................... 243
Chapter 21 - Purchasing Measurements .......................................................................... 245

Overview of Purchasing Measurements ........................................................................... 245
Proportion of Purchase Orders above Threshold ............................................................ 246
Procurement Card Usage Percentage ............................................................................. 247
Proportion of Spend Managed ......................................................................................... 248
Proportion of Spend with Preferred Suppliers ................................................................. 249
Proportion of Certified Suppliers ..................................................................................... 250
Supplier Performance Measurements .............................................................................. 251
Supplier Fulfillment Rate............................................................................................. 251
Supplier Defect Rate .................................................................................................... 252
Supplier Billed Price Variance .................................................................................... 253
Economic Order Quantity ................................................................................................ 254
Proportion of Targeted Inventory Dispositioned ............................................................. 255
Chapter 22 - Payables Measurements............................................................................... 258

Overview of Payables Measurements .............................................................................. 258
Transaction Error Rate .................................................................................................... 258
Full-Time Equivalent Measurements ............................................................................... 259
FTEs per $1 Million of Revenue ................................................................................. 260
Staff Cost per FTE ....................................................................................................... 260
Line Items per FTE ...................................................................................................... 261
Paperless Measurements .................................................................................................. 261
Percent of Paperless Invoices ...................................................................................... 261
Percent of Paperless Payments .................................................................................... 261
Additional Payables Measurements ................................................................................. 262
Chapter 23 - Sales and Marketing Measurements .......................................................... 264
viii
Overview of Sales and Marketing Measurements ............................................................ 264
Sales Productivity ............................................................................................................ 265
Incremental Salesperson Effectiveness ............................................................................ 266
Sales Effectiveness ........................................................................................................... 267
Sales and Marketing as Percentage of Sales.................................................................... 268
Existing Customer Solicitation Ratio ............................................................................... 269
Order Placement Rate ...................................................................................................... 270
Sales per Customer .......................................................................................................... 271
Quote to Close Ratio ........................................................................................................ 272
Sales Backlog Ratio ......................................................................................................... 272
Throughput Measurements............................................................................................... 274
Throughput Quoted ...................................................................................................... 274
Ratio of Throughput Awarded to Quoted .................................................................... 275
Ratio of Throughput Booked to Billed ........................................................................ 276
Marketing Measurements ................................................................................................. 277
Advertising Value Equivalency ................................................................................... 277
Sales to Unique Visitors Ratio ..................................................................................... 278
Direct Mail Effectiveness ............................................................................................ 279
Market Share .................................................................................................................... 280
Customer Lifetime Value .................................................................................................. 281
Glossary ............................................................................................................................... 283
Index .................................................................................................................................... 288
ix
Preface
A typical business churns out an enormous amount of financial and operational
information. It can be quite difficult to sort through this information to understand
how a company is performing. Ratios and other types of measurements can play a
valuable role in analyzing this information. In addition, a system of measurements
can be used to monitor and control the operations of an organization. The Business
Ratios Guidebook is full of ratios and other measurements that can assist in these
interpretation and control tasks. The topics covered include both general and more
specific functional areas of analysis. General analysis topics include measurements
for such areas as performance, liquidity, cash flow, return on investment, and share
performance. More specific functional analysis topics include measurements for
such areas as cash management, credit and collections, fixed assets, inventory, and
product design. As examples of the measurements covered, Business Ratios provides
answers to the following questions:
• How can I test the quality of earnings reported by a business?

• What are the components of the cash conversion cycle?
• How can I tell if the amount of cash flow being generated is adequate?
• What variations on the return on investment concept are available?
• Can I incorporate inflation into the analysis of corporate growth?
• How can I measure the effectiveness of usage of a bottleneck operation?
• How can I measure the effectiveness of the collections operation?
• What measures can be used to track different aspects of customer orders?
• Are there ways to test the ability of the human resources department to fill
open jobs?
• How can I tell if any inventory items are obsolete?
• How can I measure the efficiency of the payroll operation?
• Is there a way to measure the rate of flow through the production process?
The Business Ratios Guidebook is intended for managers, analysts, accountants,

consultants, and students, who can benefit from its broad range of measurement
topics. The book also provides references to the author’s popular Accounting Best
Practices podcast, which provides additional coverage of many measurement topics.
As such, it may earn a place on your book shelf as a reference tool for years to
come.
Centennial, Colorado
October 2017
x
About the Author
Steven Bragg, CPA, has been the chief financial officer or controller of four
companies, as well as a consulting manager at Ernst & Young. He received a
master’s degree in finance from Bentley College, an MBA from Babson College,
and a Bachelor’s degree in Economics from the University of Maine. He has been a
two-time president of the Colorado Mountain Club, and is an avid alpine skier,
mountain biker, and certified master diver. Mr. Bragg resides in Centennial,
Colorado. He has written the following books and courses:
7 Habits of Effective CEOs Cost Accounting (college textbook)

7 Habits of Effective CFOs Cost Accounting Fundamentals
7 Habits of Effective Controllers Cost Management Guidebook
Accountant Ethics [for multiple states] Credit & Collection Guidebook
Accountants’ Guidebook Crowdfunding
Accounting Changes and Error Corrections Developing and Managing Teams
Accounting Controls Guidebook Effective Collections
Accounting for Casinos and Gaming Employee Onboarding
Accounting for Derivatives and Hedges Enterprise Risk Management
Accounting for Earnings per Share Fair Value Accounting
Accounting for Inventory Financial Analysis
Accounting for Investments Financial Forecasting and Modeling
Accounting for Intangible Assets Fixed Asset Accounting
Accounting for Leases Foreign Currency Accounting
Accounting for Managers Fraud Examination
Accounting for Stock-Based Compensation Fraud Schemes
Accounting Procedures Guidebook GAAP Guidebook
Agricultural Accounting Governmental Accounting
Behavioral Ethics Health Care Accounting
Bookkeeping Guidebook Hospitality Accounting
Budgeting How to Audit Cash
Business Combinations and Consolidations How to Audit Fixed Assets
Business Insurance Fundamentals How to Audit Inventory
Business Ratios How to Audit Receivables
Business Valuation How to Run a Meeting
Capital Budgeting Human Resources Guidebook
CFO Guidebook IFRS Guidebook
Change Management Interpretation of Financial Statements
Closing the Books Inventory Management
Coaching and Mentoring Investor Relations Guidebook
Conflict Management Lean Accounting Guidebook
Constraint Management Mergers & Acquisitions
Construction Accounting Negotiation
Corporate Cash Management New Controller Guidebook
Corporate Finance Nonprofit Accounting
xi
(continued)
Partnership Accounting Recruiting and Hiring
Payables Management Revenue Recognition
Payroll Management Sales and Use Tax Accounting
Performance Appraisals The MBA Guidebook
Project Accounting The Soft Close
Project Management The Statement of Cash Flows
Public Company Accounting The Year-End Close
Purchasing Guidebook Treasurer’s Guidebook
Real Estate Accounting Working Capital Management
Records Management
On-Line Resources by Steven Bragg

Steven maintains the accountingtools.com web site, which contains continuing
professional education courses, the Accounting Best Practices podcast, and
thousands of articles on accounting subjects.
The Business Ratios Guidebook is also available as a continuing professional

education (CPE) course. You can purchase the course (and many other courses) and
take an on-line exam at:
www.accountingtools.com/cpe
xii
Chapter 1
Overview of Measurements
Introduction
When someone receives the financial statements of a business, they may not know
how to interpret the presented information. These statements contain a great deal of
information, and yet they do not present it in a manner that allows a reader to
evaluate how certain line items compare to other information, or whether results or
liquidity levels are unusually good or bad. To circumvent this problem, we use
various measurements to interpret financial statements. In addition, managers may
aggregate operational information and use it as the basis for additional measure-
ments that either deal solely with operations, or which are meshed with financial
information to reveal additional insights into a business. Thus, measurements are
used to interpret both financial and operational information.
Measurements also play a key role in controlling operations. Once a system of
measurements has been created, employees will expect that measurements
calculated in one period will be roughly similar to historical results. If not, then an
unusual measurement outcome should trigger an investigation to determine the
reason for the change.
In general, we use ratios as the basis for a system of measurements. Ratios are
used to compare different types of information, so that users can more easily
interpret how one type of information is changing in relation to another. While other
types of measurements are noted in this book, such as trend analysis and various
formulas, the bulk of the measurements described are ratios.
In this chapter, we focus on the interpretation and control aspects of measure-
ments by discussing which measurements to use, how they should be used, and the
frequency of measurement reporting, as well as several related matters.
Related Podcast Episodes: Episodes 222 and 234 of the Accounting Best Practices
Podcast discuss the reporting of performance measurements and how to find the
right metrics, respectively. The episodes are available at: accounting-
tools.com/podcasts or iTunes
What to Measure
When setting up a measurement system, a key concern is what to measure.
Employees have a strong tendency to improve whatever is being measured, so
focusing their attention on the wrong measurement can lead to results that are
injurious to a business. Here are several examples of the issue:
• Sales growth. A common focus of attention is period-over-period increases

in sales. Typically, a business starts with a small number of products and
customer accounts that are sufficiently profitable to pay for additional
rounds of sales growth. However, these additional rounds of growth may
come at the expense of profitability, which gradually declines. In particular,
there is a danger of specifically targeting customers only to obtain more
sales volume, with no regard to how they will contribute to profits.
• Expense growth. Management may closely monitor expenses in order to
keep expense growth in check. However, doing so may lead to the reduction
of several key discretionary expenses, such as research and development,
that are needed to fund future growth.
• Days sales outstanding. A commonly-followed metric is days sales out-
standing, which compares the amount of receivables to sales. The number of
days sales outstanding should generally be kept as low as possible, thereby
reducing the investment in accounts receivable. However, an undue focus on
this measurement could lead to the restriction of credit to customers, which
will in turn result in reduced sales.
• Square feet per person. One of the larger expenses in most organizations is
the cost of facilities, which means that the number of square feet per person
may be closely monitored. A typical outcome of this focus is the installation
of large numbers of cubicles. However, some employees, such as engineers,
require minimal noise in order to concentrate on their work, and so must
have a certain amount of square feet of office space in order to function
effectively.
Consequently, the selection of the most appropriate measurements is crucial.

Management should consider the negative impact of using a particular measurement
before rolling it out, and should also monitor the results of its use. In some cases, it
may be necessary to terminate a measurement at once, to keep contrary behavior
from occurring.
There is no ideal set of measurements to follow. Instead, measurements must be
tailored to the circumstances in which a business finds itself. For example, a
company whose investors are willing to plow money into the business in order to
obtain significant market share may be willing to focus solely on sales growth, even
at the expense of profits. Conversely, a company in a monopoly position in a low-
growth industry may have a greater interest in maximizing cash flow. Or, if a market
demands a constant flow of new products, the emphasis may instead be on the time
required to generate new products.
The focus of a business may change over time, necessitating a change in
measurements. Most commonly, a business will shift from an initial growth phase to
a low-growth situation, and so alters its measurements to focus less on sales and
more on profitability. The same issue arises when a business enters a new market. It
is entirely possible that different rules apply to each market, which requires the use
of different measurements. For example, a business may sell its goods through a
chain of retail stores, as well as through an Internet-based direct sales channel. The
2
measurements for the retail stores may include a same-store sales growth trend line,
while the Internet store may require a measurement for the number of page views
converted into sales. In short, a completely different set of measurements may be
required for each market in which a company competes; there may be no common
measurements that are applicable to all of the markets.
Mandatory Measurements
The person most likely to create a formal measurements report is the company
controller, who releases the report as an attachment to the financial statements
following the end of each reporting period. The controller should be mindful of
requirements that certain measurements will be reported, even if they are not critical
to the goals of the company. The need for these measurements is generally triggered
by specific legal or regulatory requirements, or by their traditional use with outside
parties. Consider the following situations:
• Loan covenants. A lender may require that the borrower report on specific
ratios, such as the current ratio, and has the right to call the related loan if
the specified ratio falls below a threshold level. In this case, management
should be made aware of both the current status of the measurement and the
threshold level below which the measurement cannot be allowed to go.
• Public reporting. When a publicly-held company issues financial statements
to the public by way of the Securities and Exchange Commission, it may
choose to include certain ratios or other measurements that provide infor-
mation considered useful for investors. If so, the company should be con-
sistent in providing the same information for all reporting periods presented.
• Regulatory requirements. In some regulated industries, it is required that
certain information be accumulated and reported to the governing regulatory
authority.
Managers should be made aware of the measurements associated with all three of
the preceding areas. However, since these measurements are not necessarily critical
to the long-term value-creating ability of a business, consider shifting them into a
separate part of the measurement report, away from the most critical measurements.
Breaking with Tradition

Many of the measurements described in this book are standard ones that have been
used in business for ages, such as the gross profit ratio, breakeven point, and current
ratio. However, these measurements routinely focus the attention of users on short-
term effects that call for the highest possible levels of liquidity and profitability –
right now. Instead, we advocate the use of a different set of measurements that focus
attention further out in the future. By doing so, it becomes more acceptable to trade
off lower levels of liquidity and profitability now, in exchange for the creation of
value over the long term. This approach should yield a greater return to investors
3
over a number of years, rather than a short-sighted focus that may quickly drive a
company into bankruptcy.
When developing an ideal set of measurements that can be used to drive long-
term value creation, be aware that the measurements initially selected may not have
a direct cause-and-effect relationship with the desired outcomes. For example,
higher levels of employee training may not result in the generation of more ideas to
drive down costs, and reduced employee turnover may not lead to increased
customer service levels. Managers may simply have assumed that there was a cause-
and-effect relationship, and chose to use certain measurements based on their long-
held beliefs about which measurements should work. To avoid this problem,
continually test whether the use of a certain measurement actually leads to a specific
outcome; if not, eliminate the measurement in favor of a more relevant one.
While we have advocated breaking with tradition and using more long-term
measurements, this also creates a conundrum in the evaluation of managers. On the
one hand, we are reducing the emphasis on short-term performance measurements,
which are commonly used to evaluate the tactical abilities of a manager. On the
other hand, the realization of value over the long-term may not be determinable for
quite some time. This means that a long-range measurement system may result in
the performance of an inadequate manager not being noticed for several years. To
avoid this concern, it is useful to continue monitoring short-term performance to
ensure that management is still paying attention to operations, while employing a
series of milestone performance reviews to ensure that managers are also attending
to long-term goals.
Measurement Usage Levels

One danger of using measurements is that they will be presented to an excessive
extent, with every possible ratio and formula crammed into a report. The recipients
of these reports do not know which outcomes are important, and so tend to ignore
the entire report. A better approach is to select only those measurements that
represent a critical issue for the company, and to present them with clear
explanations of why the information is important. Another possibility is to use a
green/yellow/red color code to highlight the status of measurements, in order to
more easily identify outlier results.
When measurement results are curated and then presented with accompanying
information, the presentation can be in several formats. Consider the following
approaches:
• Variances from baseline. A company may have a historical record of
various measurements that reveals little variation over time. Managers want
to see only those measurements that depart from the historical baseline. In
this case, the measurements reported will vary in each period, depending
upon the size of the variance. If there are no variances, no measurements are
reported. This approach works well in a relatively static environment.
• Goal monitoring. The management team may have decided that certain
goals are to be attained, such as increasing the number of customers, ex-
4
panding the number of products offered, or reducing the amount of accounts

receivable. To monitor the company’s progress toward these goals, a specif-
ic set of related measurements are reported. Since the goals may change
over time, so too may the measurements. However, management may still
want to see a few measurements related to prior goals, to ensure that the
company is still complying with previous management mandates.
• Strategic and tactical insights. The person assembling measurements may
note that a few measurements are leading indicators of issues or opportuni-
ties for the company, and decides to present them to management along with
a detailed commentary regarding their importance. For example, a sudden
sharp decline in the ratio of sales backlog to sales is a leading indicator of a
future decline in sales. Or, a spike in bad debts may indicate a decline in the
creditworthiness of customers that may call for a change in the company’s
credit policy.
Ideally, measurement systems should be incorporated into the planning and feedback
loops of a company. For example, a rapidly-growing company will likely experience
a cash shortfall as it funds the assets needed to expand operations. Accordingly,
there is a tight focus on accelerating the receipt of accounts receivable. In this case,
the measurement system can be inserted into the following parts of business
operations:
• The budgeting model, so that days of receivables are estimated as part of
budgeted cash flows.
• The bonus compensation plan, to reward the credit and collection staff if
days of receivables are kept below a certain level.
• The daily collection plan, to direct resources toward those receivables in
danger of passing the days of receivables target.
This detailed analysis can only be accomplished with a few measurements, given the
high level of participation and monitoring that is required. All other measurements
that are considered of less importance can be reviewed by a financial analyst and
brought to the attention of management only if there is a notable variance from
expected results.
Measurement Timing
The timing of measurements can have an impact on the extent to which the
information is acted upon. Of particular concern is avoiding situations where
measurements are being spewed out so frequently that recipients feel inundated with
information, and so take no action. Conversely, a measurement that is only issued at
long intervals can result in the passage of too much time before corrective action is
taken.
To avoid either situation, discuss the appropriate timing of measurement reports
with recipients. In rare cases where constant monitoring is required, a few
5
measurements may be issued on a daily or continual basis. In most other cases, the
default reporting interval is likely to be monthly or quarterly. If daily or continual
measurements are needed, a different reporting system will probably be needed,
such as an automated system that transmits information to desktop dashboards, or
which is manually posted on whiteboards.
Measurement Consistency
When a measurement is being presented for multiple periods, the calculation should
be identical for all periods presented. For example, the inclusion of sales in a return
on sales figure should always be net sales, not gross sales in one period and net sales
in others. Otherwise, results will be so unreliable that managers will learn not to rely
upon the presented information. There are several steps that can be taken to ensure a
high degree of measurement consistency. Consider the following:
• Audits. Have the company’s internal auditors occasionally review the
measurements to ensure that they are being consistently calculated, and re-
port to a senior manager if this is not the case.
• Standards sheet. Create a report on which are listed the calculations for all
measurements. This standards sheet can be distributed to all recipients of
measurement reports, as well as anyone whose performance is being moni-
tored through the measurements. By doing so, everyone is aware of exactly
how measurements are being developed.
• Measurement locks. Ideally, measurements should be included in the
financial statements report writer, and then locked down with password
access. By doing so, it is very difficult for anyone to adjust the calculations
without proper authorization.
An issue with the use of a standards sheet is that the person responsible for reporting
measurements will be pressured by those employees whose performance is being
monitored through the measurements. This pressure will take the form of requests to
use alternative calculations that cast the employees’ performance in a better light. To
counteract this pressure, require the measurements person to seek the approval of a
senior manager (such as the president) before any measurement calculation changes
are allowed.
Measurements and the Soft Close

A soft close refers to closing the books at the end of a reporting period without the
use of many normal closing steps, such as the use of adjusting entries. A soft close is
used to reduce the amount of effort required to close the books, and is considered
acceptable when the resulting financial statements are not being issued outside of the
company. The soft close is not used for more formal financial statement issuances,
such as the year-end financials, because the results may not be entirely accurate.
When the accounting department employs a soft close, any measurements
derived from the financial statements may be somewhat suspect. The results are
6
more likely to be inaccurate if either the numerator or denominator of a ratio

includes information that would normally have been adjusted with a journal entry as
part of the closing process. For example, the absence of a wage accrual in the
income statement would artificially increase the amount of net profit reported, and
therefore alter the results of any ratio involving the net profit figure.
There are several approaches to consider when deriving measurements from soft
close information:
• Skip selected measurements. If the results are sufficiently inaccurate, skip
certain measurements entirely, and only calculate them in periods when a
full set of closing activities have been completed.
• Skip all measurements. The main point behind a soft close is to avoid the
effort required for a full close – which includes the preparation of a set of
performance metrics. Management might agree to avoid all measurements
as part of a soft close.
• Determine variability of results. It is entirely possible that the adjusting
entries not being made in a soft close will result in only minor changes to
measurements. This can be tested by comparing the results of measurements
from soft close periods and normal close periods. If so, the results can still
be released, perhaps along with a cautionary message to recipients.
• Lengthen measurement period. The size of adjusting entries tends to decline
over lengthy measurement periods in relation to the reported results. This
means that a measurement covering a quarterly soft close period is more
likely to be accurate than a measurement spanning just one month for which
a soft close was employed. If testing proves that this is correct, consider
using measurements that cover a trailing three-month period.
Measurement Clutter
The concept of measurement clutter is rarely considered. Clutter arises in the report
format when a large number of measurements are jammed into a report, which
recipients must then sort through for useful information. The following exhibit
illustrates the problem.
Exhibit: A Cluttered Measurement Report

April May June July
Current ratio 2.0:1 1.9:1 2.1:1 2.2:1
Days sales outstanding 48 49 50 57
Debt to equity ratio 0.48:1 0.53:1 0.55:1 0.93:1
Earnings on invested funds 1.32% 1.35% 1.09% 1.13%
Net profit ratio 11.3% 10.9% 12.2% 10.7%
Order fill rate 88.1% 90.9% 91.0% 67.6%
Price/earnings ratio 11.0x 13.7x 12.1x 10.8x
7
The exhibit suffers from several problems. First, it covers multiple periods, when
managers are probably most interested in only the most recent measurements.
Second, an excess degree of precision is being used, which is irrelevant in
determining whether a problem exists. Finally, most of the measurements do not
change over time to a significant extent, and so are irrelevant from the perspective of
triggering any remedial action. All of these issues can be resolved by focusing solely
on those measurements requiring immediate attention. The result is a more narrative
report format, such as the following exhibit that is based on the prior example.
Exhibit: Narrative Analysis of Measurements

Measurement July Result Comments
Days sales outstanding 57 days Jump of seven days caused by the Dorado Ltd. receivable
Debt to equity ratio 0.9:1 Ratio doubled due to borrowings for Atlas acquisition
Order fill rate 68% Caused by raw materials shortage for red widgets
Note how the revised report does not even mention a number of measurements. This
is because those metrics did not change sufficiently during the reporting period to be
worthy of management attention. Instead, the report focuses solely upon actionable
items. This approach completely eliminates management clutter.
Limitations of Ratio Analysis

Ratio analysis is a useful tool, especially for an outsider such as a credit analyst,
lender, or stock analyst. These people need to create a picture of the financial results
and position of a business just from its financial statements. Ratio analysis can be
used to compare information taken from different parts of the financial statements to
gain a general understanding of the results, financial position, and cash flows of a
business. However, there are a number of limitations of ratio analysis to be aware of.
They are:
• Historical. All of the information used in ratio analysis is derived from
actual historical results. This does not mean that the same results will carry
forward into the future. However, you can use ratio analysis on pro forma
information and compare it to historical results for consistency.
• Historical versus current cost. The information on the income statement is
stated in current costs (or close to it), whereas some elements of the balance
sheet may be stated at historical cost (which could vary substantially from
current costs). This disparity can result in unusual ratio results.
• Inflation. If the rate of inflation has changed in any of the periods under
review, this can mean that the numbers are not comparable across periods.
For example, if the inflation rate was 100% in one year, sales would appear
to have doubled over the preceding year, when in fact sales did not change
at all.
8
• Aggregation. The information in a financial statement line item that is being

used for a ratio analysis may have been aggregated differently in the past, so
that running the ratio analysis on a trend line does not compare the same
information through the entire trend period.
• Operational changes. A company may change its underlying operational
structure to such an extent that a ratio calculated several years ago and com-
pared to the same ratio today would yield a misleading conclusion. For ex-
ample, if a constraint analysis system has been implemented, this might lead
to a reduced investment in fixed assets, whereas a ratio analysis might con-
clude that the company is letting its fixed asset base become too old.
• Accounting policies. Different companies may have different policies for
recording the same accounting transaction. This means that comparing the
ratio results of different companies may be like comparing apples and or-
anges. For example, one company might use accelerated depreciation while
another company uses straight-line depreciation, or one company records a
sale at gross while the other company does so at net.
• Business conditions. Ratio analysis needs to be placed in the context of the
general business environment. For example, 60 days of sales outstanding
might be considered poor in a period of rapidly growing sales, but might be
excellent during an economic contraction when customers are in severe
financial condition and unable to pay their bills.
• Interpretation. It can be quite difficult to ascertain the reason for the results
of a ratio. For example, a current ratio of 2:1 might appear to be excellent,
until you realize that the company just sold a large amount of its stock to
bolster its cash position. A more detailed analysis might reveal that the cur-
rent ratio will only temporarily be at that level, and will probably decline in
the near future.
• Company strategy. It can be dangerous to conduct a ratio analysis compari-
son between two firms that are pursuing different strategies. For example,
one company may be following a low-cost strategy, and so is willing to
accept a lower gross margin in exchange for more market share. Conversely,
a company in the same industry is focusing on a high customer service strat-
egy where its prices are higher and gross margins are higher, but it will nev-
er attain the revenue levels of the first company.
• Point in time. Some ratios extract information from the balance sheet. Be
aware that the information on the balance sheet is only as of the last day of
the reporting period. If there was an unusual spike or decline in the account
balance on the last day of the reporting period, this can impact the outcome
of the ratio analysis.
In short, ratio analysis has a variety of limitations that can limit its usefulness.
However, as long as you are aware of these problems and use alternative and
supplemental methods to collect and interpret information, this approach is still
useful.
9
Summary
A system of measurements can be a powerful tool for interpreting information and
controlling the results of a business. However, measurements are only indicators of
underlying issues. When a measurement yields an unusual result, it is always
necessary to dig deep into the underlying information to fully understand the reasons
for the result. This means that the highest-quality measurement report reads more
like an essay than a spreadsheet – the measurement result is presented, along with an
interpretation of the underlying information, and a recommendation regarding the
actions to be taken. Given the volume of research required for an unusual
measurement result, it is necessary to focus on only a small number of measure-
ments. Otherwise, the analyst will be so buried in work that few meaningful and in-
depth analyses will ever reach management.
10
Chapter 2
Performance Measurements
Introduction
Performance measures are designed to evaluate the information on a company’s
income statement at a relatively high level. They make note of the quality of
revenues, and then quantify the proportions of income being generated by different
aspects of the entity. These measures can also be used to evaluate the quality of
earnings, and how closely a business is operating to its breakeven level. In this
chapter, we address an array of performance measurements that can lead to an
understanding of the profit-making capabilities of a business.
Related Podcast Episode: Episode 70 of the Accounting Best Practices Podcast

discusses breakeven and the margin of safety. The episode is available at:
accountingtools.com/podcasts or iTunes
Overview of Performance Measurements

Performance measurements are based on information in the income statement. As
such, we can begin at the top of the income statement to extract information about
revenues, and then work our way down the statement to derive additional types of
information. For example, we can compare sales returns and allowances to gross
sales, which can reveal the extent to which customers are returning goods or
demanding billing reductions.
There are also several sub-headings of information that can reveal the ability of
a company to earn different types of profits. For example, we describe ratios for the
contribution margin (which uses variable costing concepts), gross profit (which
incorporates factory overhead), operating income (which excludes non-operating
transactions), and net profit (which encompasses all of the earning activities of a
business).
We then work through a number of additional measurements that provide
insights into the performance capabilities of an organization. For example, we can
adjust profits for the effects of inflation, strip away non-operating transactions to
focus on the core earnings capability of a business, and look at the relative
proportions of different types of expenses. It is also possible to evaluate the risk of
earnings declines by examining the breakeven point of a business, as well as by
measuring the extent to which sales can decline before losses will be incurred.
A thorough examination of the performance measurements of a business can
yield an excellent overview of its earning capabilities, which can lead to more
detailed investigations that go beyond ratio analysis.
Sales Returns and Allowances to Sales

Sales returns are credits paid to customers when they return goods to the seller,
while sales allowances are reductions in the purchase price of goods granted to
customers to keep them from returning goods. In both cases, a high proportion of
credits allowed to customers is a strong indicator of problems with the underlying
product. Consequently, it is useful to track the proportion of sales returns and
allowances to sales on a trend line, to see if there are any spikes in the percentage.
To calculate the ratio, aggregate all sales returns and allowances for the
reporting period and divide them by gross sales for the same period. The formula is:
Sales returns + Sales allowances

Gross sales
There are two issues with this ratio. First, sales returns and allowances may be
recorded in the same account as gross sales, making it difficult to locate individual
transactions. To remedy the situation, create separate accounts for sales returns and
sales allowances, and store the transactions there. Second, sales returns and
allowances are usually recorded when customers return merchandise or complain
about goods, which may not be the same reporting period in which the related gross
sales were recorded. This can create a mismatch in the ratio, where the returns and
allowances are paired with gross sales for a different period. The issue can be
mitigated by using a broader reporting period, such as quarterly, for calculating the
ratio.
EXAMPLE
Green Lawn Care launched a new battery-powered leaf blower three months ago, and the
customer service department is hearing complaints from customers that the batteries in some
of the units are catching on fire. To track the issue, management asks that the sales returns
and allowances to sales ratio be tracked on a monthly basis, just for sales of the leaf blower.
The result is the following table:
May June July

Sales returns and allowances $13,500 $72,000 $143,000
Gross leaf blower sales $330,000 $365,000 $402,000
Sales returns and allowances to sales 4% 20% 36%
The ratio analysis shows minimal activity for the first month of sales, followed by a hard
spike in returns. This is likely to be a delayed issue with the battery that is not evident during
initial use. Management decides to enact a general recall of the product.
12
Contribution Margin Ratio

The contribution margin ratio is the percentage of a firm’s contribution margin to its
sales. Contribution margin is a product’s price minus its variable costs, resulting in
the incremental profit earned for each unit sold. The total contribution margin
generated by an entity represents the total earnings available to pay for fixed
expenses and generate a profit.
The contribution margin formula is useful for determining the proportion of
profit earned from a sale. The contribution margin should be relatively high, since it
must be sufficient to also cover fixed costs and administrative overhead. Also, the
measure is useful for determining whether to allow a lower price in special pricing
situations. If the contribution margin ratio is excessively low or negative, it would be
unwise to continue selling a product at that price point, since the company would
have some difficulty earning a profit over the long term. The contribution margin
ratio is also useful for determining the profits that will arise from various sales levels
(see the example).
The contribution margin is also useful for determining the impact on profits of
changes in sales. In particular, it can be used to estimate the decline in profits if sales
drop, and so is a standard tool in the formulation of budgets.
To calculate the contribution margin ratio, divide the contribution margin by
sales. The formula is:
Sales – Variable expenses

Sales
The contribution margin ratio does not account for the impact of a product on the
bottleneck operation of a company. A low contribution margin may be entirely
acceptable, as long as it requires little or no processing time by the bottleneck
operation. See the Constraint and Throughput Measurements chapter for more
information.
EXAMPLE
The Iverson Drum Company sells drum sets to high schools. In the most recent period, it sold
$1,000,000 of drum sets that had related variable costs of $400,000. Iverson had $660,000 of
fixed costs during the period, resulting in a loss of $60,000. The key information is:
Revenue $1,000,000
Variable expenses 400,000
Contribution margin 600,000
Fixed expenses 660,000
Net loss -$60,000
13
Iverson’s contribution margin ratio is 60%, so if it wants to break even, the company must
either reduce its fixed expenses by $60,000 or increase its sales by $100,000 (calculated as
the $60,000 loss divided by the 60% contribution margin ratio).
Gross Profit Ratio

The gross profit ratio shows the proportion of profits generated by the sale of goods
or services, before selling and administrative expenses. In essence, it reveals the
ability of a business to create sellable products in a cost-effective manner. The ratio
is of some importance from an analysis perspective, especially when tracked on a
trend line, to see if a business is continuing to provide products to the marketplace
for which customers are willing to pay.
The gross margin ratio is calculated as sales minus the cost of goods sold,
divided by sales. The formula is:
Sales – Cost of goods sold

Sales
The ratio can vary over time as sales volumes change, since the cost of goods sold
contains some fixed cost elements that will not vary with sales volume.
EXAMPLE
An analyst is reviewing a credit application from Quest Adventure Gear, which includes
financial statements for the past three years. The analyst extracts the following information
from the financial statements of Quest:
20X1 20X2 20X3

Sales $12,000,000 $13,500,000 $14,800,000
Cost of goods sold $5,000,000 $5,100,000 $4,700,000
Gross profit ratio 58% 62% 68%
The analysis reveals that Quest is suffering from an ongoing decline in its gross profits,
which should certainly be a concern from the perspective of allowing credit.
Operating Income Ratio

The standard performance measurement for a business is the net profit ratio, but that
ratio suffers from the inclusion of one-time and non-operating gains and losses. For
example, there may be an insurance loss or investment income – neither of which
reveals the true state of the underlying business operations. A way to discern the
underlying level of profitability is to use the operating income ratio, which compares
operating income to only those sales related to operations. To calculate the operating
income ratio, follow these steps:
14
1. Clean up the sales figure by eliminating any “sales” transactions that are
really interest income or one-time gains.
2. Clean up the net profit ratio by eliminating all financing-related interest and
income, as well as gains and losses on one-time transactions. The result is
operating income.
3. Divide the operating income figure by the adjusted sales figure.
The formulation of the operating income ratio is:
Net profit – Non-operating gain and loss transactions

Net sales – Non-operating transactions recorded as sales
When the operating income ratio is calculated in aggregate for an entire entity, it can
mask operating losses at the business unit level, since these losses may be offset by
gains elsewhere in the company. Consequently, it is best to generate the
measurement at a level as far down within the company as possible.
EXAMPLE
Quest Clothiers, maker of rugged outdoor gear, raised $100 million in a private stock
placement two years ago. The company has reported net profits of $4,500,000 and
$5,200,000 in the following two years, but this may be masking losses that are being netted
against interest income on the $100 million of cash. An investor quizzes the company
controller about this issue, and learns that $4,200,000 and $3,100,000 of interest income have
been recorded as revenue in the past two years. Total revenues reported were $62,000,000
and $67,000,000, respectively, in years 1 and 2. The following table eliminates the interest
income to arrive at the company’s operating income ratio:
Year 1 Year 2
Reported revenue $62,000,000 $67,000,000
Less: Interest income -4,200,000 -3,900,000
Adjusted revenue $57,800,000 $63,100,000
Reported net profits $4,500,000 $5,200,000

Less: Interest income -4,200,000 -3,900,000
Operating income $300,000 $1,300,000
Operating income ratio 0.5% 2.1%
The ratio reveals that most of the income reported by the company has really been derived
from its investment of the $100 million of cash, rather than from operations. However, the
situation appears to be improving, since the operating profit quadrupled in Year 2.
15
Net Profit Ratio

The net profit ratio is a comparison of after-tax profits to net sales. It reveals the
remaining profit after all costs of production and administration have been deducted
from sales, and income taxes recognized. As such, it is one of the best measures of
the overall results of a firm, especially when combined with an evaluation of how
well it is using its working capital. The measure is commonly reported on a trend
line, to judge performance over time. It is also used to compare the results of a
business with its competitors.
The net profit ratio is really a short-term measurement, because it does not
reveal a company’s actions to maintain profitability over the long term, as may be
indicated by the level of capital investment or research and development
expenditures. Also, a company may delay a variety of discretionary expenses, such
as maintenance or training, to make its net profit ratio look better than it normally is.
Consequently, evaluate this ratio alongside an array of other metrics to gain a full
picture of a company’s ability to continue as a going concern.
Another issue with the net profit ratio is that a company may intentionally keep
it low through a variety of expense recognition strategies in order to avoid paying
taxes. If so, review the statement of cash flows to determine the real cash-generating
ability of the business.
To calculate the net profit ratio, divide net profits by net sales and then multiply
by 100. The formula is:
(Net profit ÷ Net sales) × 100
EXAMPLE
Kelvin Corporation has $1,000,000 of sales in its most recent month, as well as sales returns
of $40,000, a cost of goods sold of $550,000, and administrative expenses of $360,000. The
income tax rate is 35%. The calculation of its net profit percentage is:
$1,000,000 Sales - $40,000 Sales returns = $960,000 Net sales
$960,000 Net sales - $550,000 Cost of goods - $360,000 Administrative expenses

= $50,000 Income before tax
$50,000 Income before tax × (1 – 0.35) = $32,500 Profit after tax
($32,500 Profit after tax ÷ $960,000 Net Sales) × 100
= 3.4% Net profit ratio
Deflated Profit Growth

When a business operates in a highly inflationary environment, a decline in the
value of its home currency can cause the business to report unusually high profits in
16
comparison to prior periods. To gain a better understanding of the underlying profit

growth of the business, it is necessary to deflate the profits for the current period and
then compare them to the profits reported for the prior period. To calculate deflated
profit growth, follow these steps:
1. Divide the price index for the prior reporting period by the price index for
the current reporting period.
2. Multiply the result by the net profit figure reported for the current reporting
period.
3. Subtract the net profits for the prior reporting period from the result.
4. Divide the result by the net profit figure for the prior reporting period.
The formula is:
Price index for prior period

Current period net profit × - Prior period net profit
Price index for current period
---------------------------------------------------------------------------------------------------------------
Prior period net profit
The use of price indexes only approximates the true impact of inflation on a
business. A price index is based on the changes in prices for a mix of common goods
and services, which a company may not use in the same proportions built into the
index. For example, a price index may have increased primarily because of a jump
in the price of oil, but a company may have minimum expenditures for oil.
Consequently, there can be differences between the deflated profit growth
calculation and the actual impact of inflation on a business.
EXAMPLE
Aphelion Corporation operates telescopes in the Atacama Desert in northern Chile, and uses
the Chilean peso as its home currency. The company reported profits of 5,000,000 pesos in
the most recent year, and 4,500,000 pesos in the immediately preceding year. The price index
for the current year was 127, as opposed to 106 for the preceding year. Based on this
information, the deflated profit growth of the company is:
5,000,000 pesos current 106 Prior period index 4,500,000 pesos prior
× -
period profit 127 Current period index period profit
-------------------------------------------------------------------------------------------------------------
4,500,000 Prior period net profit
17
4,173,228 Deflated pesos - 4,500,000 Profit prior period

= -------------------------------------------------------------------------- = -7.3%
4,500,000 Profit prior period
Thus, when adjusted for inflation, the profits of Aphelion declined by 7.3% in the current
reporting period.
Effective Tax Rate

A major determinant of the net profit ratio just described is the ability of a business
to avoid or defer the payment of income taxes. There are a number of strategies
available for lowering the statutory tax rate to a level far below what would
normally be expected. If a company can successfully engage in a tax reduction or
deferral strategy over a long period of time, the result can be a massive increase in
net profits, with an attendant increase in cash flows.
To calculate the effective tax rate, divide the aggregate amount of income tax
expense stated on the income statement by the amount of before-tax profit reported
on the same document.
Recognized tax expense

Before-tax profit
It can be useful to track the effective tax rate over multiple years, to see if a business
is capable of maintaining a low tax rate over the long term, usually by shifting
reportable income to low-tax locations. A one-year decline in the tax rate is much
less indicative of a corporate tax-reduction strategy, since a company may simply
have blundered into a tax-reduction scenario without intending to do so.
EXAMPLE
Clyde Shotguns manufactures extremely high-end shotguns for wealthy collectors around the
world. The company has a long-term strategy of building production facilities in multiple
countries, each one owned by a separate legal entity. This means that Clyde can utilize
favorable transfer pricing to recognize the bulk of the company’s income in its Ireland
facility, where the tax rate is substantially lower than in other parts of the world where its
other subsidiaries operate. The result in the past year was the recognition of $800,000 of tax
expense on $5,333,000 of before-tax profit, which is an effective tax rate of 15%.
Core Earnings Ratio

There are many ways in which the net profit ratio of a business can be skewed by
events that have little to do with the core operating capabilities of a business. To get
to the root of the issue and concentrate on only the essential operations of a business,
18
Standard & Poor’s has promulgated the concept of core earnings, which strips away
all non-operational transactions from a company’s reported results.
There are a multitude of unrelated transactions that can be eliminated from net
profits, some of which are so specific to certain industries that Standard & Poor’s
probably never thought of them. The most common of these unrelated transactions
are:
• Asset impairment charges
• Costs related to merger activities
• Costs related to the issuance of bonds and other forms of financing
• Gains or losses on hedging activities that have not yet been realized
• Gains or losses on the sale of assets
• Gains or losses related to the outcome of litigation
• Profits or losses from pension income
• Recognized cost of stock options issued to employees
• Recognized cost of warrants issued to third parties
• The accrued cost of restructuring operations that have not yet occurred
Many of these special adjustments only occur at long intervals, so a company may
find that its core earnings ratio is quite close to its net profit ratio in one year, and
substantially different in the next year. The difference tends to be much larger when
a company adds complexity to the nature of its operations, so that more factors can
impact net profits.
The calculation of the core earnings ratio is to adjust reported net income for as
many of the preceding items as are present, and divide by net sales. The formula is:
Net profits – Core earnings adjustments

Net sales
EXAMPLE
Subterranean Access, maker of drilling equipment, has reported a fabulous year, with profits
of $10,000,000 on sales of $50,000,000. A credit analyst that rates the company’s bonds is
suspicious of this good fortune, and digs through the company’s annual report to derive the
core earnings ratio of the business. She uncovers the following items:
Profit from favorable settlement of a lawsuit $8,000,000

Profit on earnings from pension fund 500,000
Gain on sale of a subsidiary 3,500,000
Impairment charge on acquired intangible assets -1,000,000
Total $11,000,000
When these adjustments are factored out of the company’s net profits, it turns out that the
core earnings figure is actually a $1,000,000 loss, which results in a core earnings ratio of -
19
2%. Based on this information, the analyst issues a downgrade on the company’s debt, on the
assumption that the multitude of favorable adjustments will not continue.
Quality of Earnings Ratio

The “real” performance of a business equates to the cash flows that it generates,
irrespective of the results that appear in its income statement. Any number of
accruals and aggressive or conservative interpretations of the accounting standards
can lead to a wide divergence between the reported amounts of cash flows and net
income. The greater the divergence, the more an observer must wonder about the
reliability of the information being presented. This issue is addressed by the quality
of earnings ratio, which compares the reported level of earnings to the reported cash
flows. Earnings are considered to be of high quality if the two figures are relatively
close to each other. To calculate the quality of earnings, follow these steps:
1. Obtain the “Cash from operations” line item in the statement of cash flows.
2. Subtract the cash from operations figure from the net profit figure in the
income statement.
3. Divide the result by the average asset figure for the business during the
measurement period.
The formula is:
Net profits – Cash from operations

Average assets
An occasional spike in this ratio can be explained by a company’s compliance with

the accounting standards in regard to a specific issue, and can be entirely legitimate.
However, if the amount of net profits is persistently higher than cash from
operations for a number of reporting periods, it is likely that management is actively
engaged in the inflation of the net profits figure.
EXAMPLE
The Red Herring Fish Company has been having difficulty meeting its loan covenants over
the past few months, and the loan officer is beginning to suspect that something fishy is
going on. She reviews the company’s latest set of financial statements, and extracts the
following information:
Cash from operations $2,300,000

Net profits 4,700,000
Beginning assets 11,000,000
Ending assets 11,400,000
20
Based on this information, she compiles the following quality of earnings ratio:
$4,700,000 Net profits - $2,300,000 Cash from operations

($11,000,000 Beginning assets - $11,400,000 Ending assets) ÷ 2
= 21%
The ratio reveals quite a substantial difference between the cash flows and reported (and
possibly inflated) earnings of Red Herring. The loan officer decides that it is time to send in
an audit team to review the company’s books.
Operating Ratio
The operating ratio is the ratio of production and administrative expenses to net
sales. It excludes financing costs, non-operating expenses, and taxes. Essentially, it
is the cost per sales dollar of operating a business. A lower operating ratio is a good
indicator of operational efficiency.
The operating ratio is only useful for seeing if the core business is able to
generate a profit. Since several potentially significant expenses are not included, it is
not a good indicator of the overall performance of a business, and so can be
misleading when used without any other performance metrics.
To calculate the operating ratio, add together all production costs (i.e., the cost
of goods sold) and administrative expenses (which include general, administrative,
and selling expenses) and divide by net sales (which is gross sales minus sales
discounts, returns, and allowances). The calculation is:
Production expenses + Administrative expenses

Net sales
A variation on the formula is to exclude production expenses, so that only

administrative expenses are matched against net sales. This version yields a much
lower ratio, and is useful for determining the amount of fixed administrative costs
that must be covered by sales. As such, it is a variation on the breakeven calculation
(which is described later in this chapter). The ratio is:
Administrative expenses
Net sales
The operating ratio indicates little when taken as a single measure for one time
period. Since operating expenses can vary considerably across multiple months, it is
better to track the ratio on a trend line.
21
EXAMPLE
Horton Corporation has production expenses of $600,000, administrative expenses of

$200,000, and net sales of $1,000,000. Its operating ratio is:
$600,000 Production expenses + $200,000 Administrative expenses

$1,000,000 Net sales
= 80% Operating ratio
Thus, operating expenses are 80% of net sales.
Operating Leverage
Operating leverage measures a company’s fixed costs as a percentage of all of its
costs. The following two scenarios describe an organization having high operating
leverage and low operating leverage.
1. High operating leverage. A large proportion of the company’s costs are
fixed costs. In this case, the firm earns a large profit on each incremental
sale, but must attain sufficient sales volume to cover its substantial fixed
costs. If it can do so, then the entity will earn a substantial profit on all sales
after it has paid for its fixed costs.
2. Lower operating leverage. A large proportion of the company’s costs are
variable costs, so it only incurs these costs if there is a sale. In this case, the
firm earns a smaller profit on each incremental sale, but does not have to
generate much sales volume in order to cover its lower fixed costs. It is easi-
er for this type of company to earn a profit at low sales levels, but it does not
earn outsized profits if it can generate additional sales.
For example, a software company has substantial fixed costs in the form of
developer salaries, but has almost no variable costs associated with each incremental
software sale; this firm has high operating leverage. Conversely, a consulting firm
bills its clients by the hour, and incurs variable costs in the form of consultant
wages. This firm has low operating leverage.
To calculate operating leverage, divide an entity’s contribution margin (sales
minus variable costs) by its net operating income. The ratio is:
Sales – Variable expenses

Net operating income
Constant monitoring of operating leverage is more important for a firm having high
operating leverage, since a small percentage change in sales can result in a dramatic
increase (or decrease) in profits. A firm must be especially careful when forecasting
its revenues in such situations, since a small forecasting error translates into large
errors in both net income and cash flows.
22
EXAMPLE
Nascent Corporation has the following financial results:
Revenues $100,000
Net operating income $10,000
Nascent has a contribution margin of 70% and net operating income of $10,000, which gives
it a degree of operating leverage of 7. Nascent’s sales then increase by 20%, resulting in the
following financial results:
Revenues $120,000
Net operating income $24,000
The contribution margin of 70% has stayed the same, and fixed costs have not changed.
Because of Nascent’s high degree of operating leverage, the 20% increase in sales translates
into a greater than doubling of its net operating income.
Breakeven Point
The breakeven point is the sales volume at which a business earns exactly no money.
It is mostly used for internal analysis purposes, but it is also useful for a credit
analyst, who can use it to determine the amount of losses that could be sustained if a
credit applicant were to suffer a sales downturn.
To calculate the breakeven point, divide total fixed expenses by the contribution
margin. Contribution margin is sales minus all variable expenses, divided by sales.
The formula is:
Total fixed expenses

Contribution margin percentage
A more refined approach is to eliminate all non-cash expenses (such as depreciation)

from the numerator, so that the calculation focuses on the breakeven cash flow level.
EXAMPLE
A credit analyst is reviewing the financial statements of a customer that has a large amount
of fixed costs. The industry is highly cyclical, so the analyst wants to know what a large
downturn in sales will do to the customer. The customer has total fixed expenses of
23
$3,000,000, sales of $8,000,000, and variable expenses of $4,000,000. Based on this

information, the customer’s contribution margin is 50%. The breakeven calculation is:
$3,000,000 Total fixed costs

50% Contribution margin
= $6,000,000 Breakeven sales level
Thus, the customer’s sales can decline by $2,000,000 from their current level before the
customer will begin to lose money.
Margin of Safety
The margin of safety is the reduction in sales that can occur before the breakeven
point of a business is reached. The amount of this buffer is expressed as a
percentage. The concept is especially useful when a significant proportion of sales
are at risk of decline or elimination, as may be the case when a sales contract is
coming to an end. By knowing the amount of the margin of safety, management can
gain a better understanding of the risk of loss to which a business is subjected by
changes in sales. The opposite situation may also arise, where the margin is so large
that a business is well-protected from sales variations.
The margin of safety concept does not work well when sales are strongly
seasonal, since some months will yield catastrophically low results. In such cases,
annualize the information in order to integrate all seasonal fluctuations into the
outcome.
To calculate the margin of safety, subtract the current breakeven point from
sales, and divide by sales. The formula is:
Current sales level – Breakeven point

Current sales level
Here are two alternative versions of the margin of safety:

1. Budget based. A company may want to project its margin of safety under a
budget for a future period. If so, replace the current sales level in the formu-
la with the budgeted sales level.
2. Unit based. To translate the margin of safety into the number of units sold,
use the following formula instead (though note that this version works best
if a company only sells one product):
Current sales level – Breakeven point

Selling price per unit
The margin of safety concept is also applied to investing, where it refers to the
difference between the intrinsic value of a company’s share price and its current
market value. An investor wants to see a large variance between the two figures
24
(which is the margin of safety) before buying stock. This implies that there is
substantial upside potential for the stock price – or at least, it means any error in
deriving the intrinsic value must be a big one in order to erase the margin of safety.
EXAMPLE
Lowry Locomotion is considering the purchase of new equipment to expand the production
capacity of its toy tractor product line. The addition will increase Lowry’s operating costs by
$100,000 per year, though sales will also be increased. Relevant information is noted in the
following table:
Before After
Machinery Purchase Machinery Purchase
Sales $4,000,000 $4,200,000
Gross margin percentage 48% 48%
Fixed expenses $1,800,000 $1,900,000
Breakeven point $3,750,000 $3,958,000
Profits $120,000 $116,000
Margin of safety 6.3% 5.8%
The table reveals that both the margin of safety and profits worsen slightly as a result of the
equipment purchase, so expanding production capacity is probably not a good idea.
Discretionary Cost Ratio

Discretionary costs are costs that management can choose to avoid during the short
term without interfering with the basic operation of a business. Examples of
discretionary expenses are advertising, research and development, maintenance on
facilities and equipment, and employee training. These costs are typically reduced
when management is attempting to avoid a cash squeeze or wants to bolster short-
term earnings. However, these expenditures must be made over the long term, or
else a company will lose its best employees and experience declining market share
and reduced profits. The discretionary cost ratio is designed to highlight these
expenditures in comparison to sales, preferably on a trend line. If an outside
observer sees a declining ratio over time, this is a clear indicator that management is
deliberately scaling back on these expenses.
To calculate the discretionary cost ratio, aggregate all types of discretionary
costs for the reporting period and divide by net sales. The formula is:
∑ All types of discretionary costs

Net sales
This ratio can be difficult for an outsider to discern, for not all of the discretionary
costs may be separately stated in a company’s income statement. Instead, they may
be aggregated into more general line items, such as “general and administrative.”
25
This level of aggregation can be a particular concern when these costs used to be
separately stated, and are now aggregated, indicating that management wishes to
hide the information.
A decline in the ratio does not always mean that management is deliberately
attempting to bolster short-term results at the expense of long-term results. Instead,
it is possible that changes in the structure of the business have resulted in different
levels of discretionary expenditure. For example, if management decides to
outsource its manufacturing to a third party, then all of the repairs and maintenance
expense associated with the in-house facility will be eliminated. Similarly, all of the
training costs for the production staff will no longer be needed. Thus, the outcome of
this ratio should be examined in light of changes in a company’s underlying
operations.
EXAMPLE
Pulsed Laser Drilling manufactures a laser that drills through solid rock, and which is used
for oil and gas drilling. The product requires a large research and development expenditure,
especially since drillers are demanding a wider bore hole, which requires a much more high-
powered laser. Pulsed Laser’s management decides in 20X3 that it can no longer afford the
amount of research required to support the product, and so sells it to a larger multi-national
company that has greater financial resources. This triggers a massive decline in the
company’s discretionary cost ratio, as noted in the following table:
20X2 20X3
Training costs $320,000 $290,000
Repairs and maintenance 820,000 805,000
Advertising 230,000 190,000
Research and development 4,290,000 1,050,000
Total discretionary costs $5,660,000 $2,335,000
Net sales $22,600,000 $19,450,000

Discretionary cost ratio 25% 12%
In short, the ratio declines, but for a justifiable reason – the company is unable to support a
product, and so accepts fewer discretionary expenses in exchange for a reduced level of
sales.
Summary
When conducting an analysis of a business, many people restrict themselves to the
performance measurements described in this chapter. While performance measures
do form the core of an analysis effort, we must caution that the other ratios presented
in this book must be addressed, particularly those that focus on the liquidity of an
26
organization. For example, an analyst will conclude that a company is growing at a

fast and profitable clip, and does not extend the analysis to see that the business does
not have sufficient cash to support its growth – resulting in severe financial
difficulties. Consequently, use a broad range of measurements to gain a complete
understanding of a business, rather than using just performance measures to view
one aspect of operations.
27
Chapter 3
Liquidity Measurements
Introduction
The liquidity of a business is a primary concern of outside parties. Lenders want to
understand the ability of a borrower to pay back a loan, while suppliers want to feel
secure in extending credit to a customer. Similarly, a prospective investor will not
buy a company’s stock if there is a reasonable risk that the business does not have
sufficient cash to meet its obligations. Given the concerns of these parties, we
present a broad range of measurements that can be used to discern the liquidity of an
organization, using the balance sheet as the primary source of information.

discusses liquidity measurements. The episode is available at: accounting-
Overview of Liquidity Measurements

Liquidity measurements are used to estimate the ability of an organization to pay its
bills. These measurements are rarely used within a company, which has access to
much more detailed cash forecast information. However, they are critical to
suppliers, lenders, and investors, who must infer the state of a company’s liquidity
from information in its financial statements, especially its balance sheet.
The foundation of liquidity is a company’s cash conversion cycle, which is the
time it takes to pay for inbound raw materials, sell them as finished goods, and
collect cash from customers. A business must have sufficient cash reserves to
survive through this process. Accordingly, we examine the components of the cash
conversion cycle, and how to derive each component.
A third party can more easily derive several simpler measures of liquidity than
the cash conversion cycle, simply by comparing different elements of the balance
sheet. The classic liquidity measure is the current ratio, though several issues can
yield misleading results. Consequently, we also note the more conservative quick
ratio and cash ratio, which focus on the most liquid assets and exclude items that
may not be so readily convertible into cash.
We then relate the liquidity of a business to its ongoing expenditures, to see how
long it can survive on anticipated cash flows. This approach is useful when a target
date must be reached with little additional incoming cash expected in the interim.
Another variation is to relate liquidity to sales, which reveals the amount of assets
required to support a certain level of sales. This approach can also be used to
compare current asset levels to expected future sales, to examine asset utilization
levels.
We also make note of those assets that can twist the result of a liquidity ratio by
including items that are not readily convertible into cash. This is a particular
problem when a business has recognized large amounts of inventory, customized
equipment, and intangible assets.
Finally, there is a discussion of the ability of a business to support its long-term
obligations. However, long-term liquidity is not the point of the bulk of the ratios in
this chapter, for long-term issues can be resolved in many ways, such as through the
sale of assets, sale of stock, or roll forward of debt agreements. Instead, we primarily
focus on short-term measures, where these alternative forms of funding may not be
available, and a business must instead rely upon its ability to convert current assets
into cash.
When reviewing the following ratios, keep in mind that there is no perfect target
for a liquidity measurement. While a high level of liquidity is considered to be best,
this may mean that a business is not putting its cash and investments to the best
possible use. Instead, a better alternative could be investing in less-liquid assets,
such as fixed assets, that can generate more cash flow. Also, a company should be
able to meet its payment obligations even with a lower liquidity level by closely
tracking projected cash inflows and outflows. Thus, a lower level of liquidity, if
properly managed, can be indicative of better management than a higher level of
liquidity.
Cash Conversion Cycle

The cash conversion cycle is the time period extending from the payment of cash for
the production of goods, until cash is received from the sale of those goods to
customers. The activities involved in the cash conversion cycle include the
purchasing of raw materials or items to be resold, their storage, the production
process, payments to employees related to the production process, and the sale of
goods to customers. If a company only provides services, then the cash conversion
cycle extends from the date of payments to employees to the receipt of cash from the
sale of services to customers. The cash conversion cycle tends to be much shorter for
the provision of services.
It is important to know the duration of the cash conversion cycle, for this is the
time period over which cash is invested in a business. If the conversion cycle can be
shortened, then cash can be permanently extracted from a business and made
available for other purposes. The steps in the cash conversion cycle that can
potentially be compressed include:
• Placement of orders for goods with suppliers
• Time required for goods to be delivered to the company
• Time required to inspect and log in received goods
• Inventory holding period
• Duration of production process
• Time required to prepare goods for shipment
29
• The delay incorporated into payment terms with customers

• The time required to collect overdue accounts receivable
The cash conversion cycle can be severely compressed through the use of a just-in-
time “pull” system that only produces goods just as they are needed for immediate
sale to customers.
To calculate the amount of the cash conversion cycle, add together the days of
sales in accounts receivable and the days of sales in inventory, and subtract the days
of payables outstanding. For example, a company has 60 days of sales in accounts
receivable, 80 days of sales in inventory, and 30 days of payables outstanding. Its
cash conversion cycle is therefore:
60 Days receivables + 80 Days inventory – 30 Days payables
= 110 Days cash conversion cycle
The calculations for days of sales in accounts receivable, days of sales in inventory,
and days payables outstanding are explained next.
Days Sales in Accounts Receivable

Days sales in accounts receivable is the number of days that a customer invoice is
outstanding before it is collected. The measurement is usually applied to the entire
set of invoices that a company has outstanding at any point in time, rather than to a
single invoice. The point of the measurement is to determine the effectiveness of a
company's credit and collection efforts in allowing credit to reputable customers, as
well as its ability to collect from them. When measured at the individual customer
level, it can indicate when a customer is having cash flow troubles, since the
customer will attempt to stretch out the amount of time before it pays invoices.
There is not an absolute number of accounts receivable days that represents
excellent or poor accounts receivable management, since the figure varies
considerably by industry and the underlying payment terms. Generally, a figure of
25% more than the standard terms allowed may represent an opportunity for
improvement. Conversely, an accounts receivable days figure that is very close to
the payment terms granted to a customer probably indicates that a company's credit
policy is too tight.
The formula for accounts receivable days is:
(Accounts receivable ÷ Annual revenue) × Number of days in the year
For example, if a company has an average accounts receivable balance of $200,000

and annual sales of $1,200,000, then its accounts receivable days figure is:
($200,000 Accounts receivable ÷ $1,200,000 Annual revenue) × 365 Days
= 60.8 Accounts receivable days
30
The calculation indicates that the company requires 60.8 days to collect a typical
invoice.
An effective way to use the accounts receivable days measurement is to track it
on a trend line, month by month. Doing so shows any changes in the ability of the
company to collect from its customers. If a business is highly seasonal, a variation is
to compare the measurement to the same metric for the same month in the preceding
year; this provides a more reasonable basis for comparison.
No matter how this measurement is used, remember that it is usually compiled
from a large number of outstanding invoices, and so provides no insights into the
collectability of a specific invoice. Thus, it should be supplemented with an ongoing
examination of the aged accounts receivable report and the collection notes of the
collection staff.
Days Sales in Inventory

Days sales in inventory (DSI) is a way to measure the average amount of time that it
takes for a company to convert its inventory into sales. A relatively small number of
days sales in inventory indicates that a company is more efficient in selling off its
inventory, while a large number indicates that a company may have invested too
much in inventory, and may even have obsolete inventory on hand.
To calculate days sales in inventory, divide the average inventory for the year by
the cost of goods sold for the same period, and then multiply by 365. For example, if
a company has average inventory of $1.5 million and an annual cost of goods sold of
$6 million, then its days sales in inventory is calculated as:
($1.5 million inventory ÷ $6 million cost of goods sold) × 365 days
= 91.3 days sales in inventory
The days sales in inventory figure can be misleading, for the following reasons:
• A company could post financial results that indicate a low DSI, but only
because it has sold off a large amount of inventory at a discount, or has writ-
ten off some inventory as obsolete. An indicator of these actions is when
profits decline at the same time that the number of days sales in inventory
declines.
• A company could change its method for calculating the cost of goods sold,
such as by capitalizing more or fewer expenses into overhead. If this calcu-
lation method varies significantly from the method the company used in the
past, it can lead to a sudden alteration in the results of the measurement.
• The person creating the metrics might use the amount of ending inventory in
the numerator, rather than the average inventory figure for the entire meas-
urement period. If the ending inventory figure varies significantly from the
average inventory figure, this can result in a sharp change in the measure-
ment.
31
• A company may switch to contract manufacturing, where a supplier

produces and holds goods on behalf of the company. Depending upon the
arrangement, the company may have no inventory to report at all, which
renders the DSI measurement useless.
Days Payables Outstanding

The accounts payable days formula measures the number of days that a company
takes to pay its suppliers. If the number of days increases from one period to the
next, this indicates that the company is paying its suppliers more slowly. A change
in the number of payable days can also indicate altered payment terms with
suppliers, though this rarely has more than a slight impact on the total number of
days. If a company is paying its suppliers very quickly, it may mean that the
suppliers are demanding short payment terms because they are suspicious of the
company’s ability to pay.
To calculate days payables outstanding, summarize all purchases from suppliers
during the measurement period, and divide by the average amount of accounts
payable during that period. The formula is:
Total supplier purchases

(Beginning accounts payable + Ending accounts payable) ÷ 2
This formula reveals the total accounts payable turnover. Then divide the resulting
turnover figure into 365 days to arrive at the number of accounts payable days.
The formula can be modified to exclude cash payments to suppliers, since the
numerator should include only purchases on credit from suppliers. However, the
amount of up-front cash payments to suppliers is normally so small that this
modification is not necessary.
As an example, a treasurer wants to determine his company's accounts payable
days for the past year. In the beginning of this period, the beginning accounts
payable balance was $800,000, and the ending balance was $884,000. Purchases for
the last 12 months were $7,500,000. Based on this information, the treasurer
calculates the accounts payable turnover as:
$7,500,000 Purchases
($800,000 Beginning payables + $884,000 Ending payables) ÷ 2
$7,500,000 Purchases
$842,000 Average accounts payable
= 8.9 Accounts payable turnover
32
Thus, the company’s accounts payable is turning over at a rate of 8.9 times per year.
To calculate the turnover in days, the treasurer divides the 8.9 turns into 365 days,
which yields:
365 Days ÷ 8.9 Turns = 41 Days
Companies sometimes measure accounts payable days by only using the cost of
goods sold in the numerator. This is incorrect, since there may be a large amount of
administrative expenses that should also be included. If a company only uses the
cost of goods sold in the numerator, this creates an excessively small number of
payable days.
A significant failing of the days payables outstanding measurement is that it
does not factor in all of the short-term liabilities of a business. There may be
substantial liabilities related to payroll, interest, and taxes that exceed the size of
payables outstanding. This issue can be eliminated by incorporating all short-term
liabilities into the days payables outstanding measurement.
Liquidity Index
The liquidity index calculates the days required to convert a company’s trade
receivables and inventory into cash. The index is used to estimate the ability of a
business to generate the cash needed to meet current liabilities. Use the following
steps to calculate the liquidity index:
1. Multiply the ending trade receivables balance by the average collection
period.
2. Multiply the ending inventory balance by the average inventory liquidation
period. This includes the average days to sell inventory and to collect the
resulting receivables.
3. Summarize the first two items and divide by the total of all trade receivables
and inventory.
The liquidity index formula is:
(Trade receivables × Days to liquidate) + (Inventory × Days to liquidate)

Trade receivables + Inventory
The liquidation days information in the formula is based on historical averages,

which may not translate well to the receivables and inventory currently on hand.
Actual cash flows may vary substantially around the averages indicated by the
formula.
EXAMPLE
A financial analyst wants to understand the ability of a customer, Hassle Corporation, to

convert its receivables and inventory into cash. Hassle has $400,000 of trade receivables on
33
hand, which can normally be converted to cash within 50 days. Hassle also has $650,000 of
inventory, which can be liquidated in an average of 90 days. When combined with the
receivable collection period, this means it takes 140 days to fully liquidate inventory and
collect the proceeds. Based on this information, the liquidity index is:
($400,000 Receivables × 50 Days to liquidate) + ($650,000 Inventory × 90 Days to liquidate)

$400,000 Receivables + $650,000 Inventory
= 106 Days to convert assets to cash
The larger proportion of inventory in this calculation tends to skew the number of days well
past the liquidation days for trade receivables. In short, Hassle will require a lengthy period
to convert several current assets to cash, which may impact its ability to pay bills in the short
term.
It may appear difficult to obtain the liquidation days information required for this
formula. However, using industry averages can yield a reasonable estimate of the
liquidity index for a business.
Current Ratio
One of the first ratios that a lender or supplier reviews when examining a company
is its current ratio. The current ratio measures the short-term liquidity of a business;
that is, it gives an indication of the ability of a business to pay its bills. A ratio of 2:1
is preferred, with a lower proportion indicating a reduced ability to pay in a timely
manner. Since the ratio is current assets divided by current liabilities, the ratio
essentially implies that current assets can be liquidated to pay for current liabilities.
To calculate the current ratio, divide the total of all current assets by the total of
all current liabilities. The formula is:
Current assets
Current liabilities
The current ratio can yield misleading results under the following circumstances:
• Inventory component. When the current assets figure includes a large
proportion of inventory assets, since these assets can be difficult to liquidate.
This can be a particular problem if management is using aggressive account-
ing techniques to apply an unusually large amount of overhead costs to in-
ventory, which further inflates the recorded amount of inventory.
• Paying from debt. When a company is drawing upon its line of credit to pay
bills as they come due, which means that the cash balance is near zero. In
this case, the current ratio could be fairly low, and yet the presence of a line
of credit still allows a business to pay in a timely manner.
34
EXAMPLE
A supplier wants to learn about the financial condition of Lowry Locomotion. The supplier
calculates the current ratio of Lowry for the past three years:
Year 1 Year 2 Year 3

Current assets $8,000,000 $16,400,000 $23,400,000
Current liabilities $4,000,000 $9,650,000 $18,000,000
Current ratio 2:1 1.7:1 1.3:1
The sudden rise in current assets over the past two years indicates that Lowry has undergone
a rapid expansion of its operations. Of particular concern is the increase in accounts payable
in Year 3, which indicates a rapidly deteriorating ability to pay suppliers. Based on this
information, the supplier elects to restrict the extension of credit to Lowry.
Inventory to Current Assets Ratio

We just noted a key problem with the current ratio, which is that the inventory
component of the measurement is far less convertible into cash than receivables. We
can measure the extent of this problem by tracking the inventory to current assets
ratio, preferably on a trend line. This ratio can also be used on a prospective basis, to
estimate the amount of investment in inventory as a proportion of current assets. For
example, if management wants to increase the speed of customer order fulfillment,
this translates into keeping more inventory on hand, which increases the inventory
proportion within the ratio.
To calculate the inventory to current assets ratio, divide the total of all inventory
in the balance sheet by current assets. This means that any reserves for obsolete
inventory are also netted against the inventory figure in the denominator. The
calculation is:
Inventory – Related inventory reserves

Current assets
The measure can be affected by changes in how the cost of inventory is compiled,
such as a change from the first in, first out method to the last in, first out method. A
change in the method of overhead allocation can also affect the numerator.
This ratio should not be treated as a stand-alone measurement. Management will
want to know the reason for a sudden change in the metric, which will call for a
detailed report showing exactly which inventory items changed.
EXAMPLE
The owner of Dude Skis is contemplating a change from the company’s historical reliance on
custom ski manufacturing to bulk manufacturing for the middle of the ski market. Doing so
will require stocking substantially more inventory than was the case in the past for prepaid
35
customer orders. The before and after forecasted changes resulting from this decision are as
follows:
Custom Skis Only Mass Market Skis

Inventory $200,000 $800,000
Current assets $1,000,000 $2,670,000
Inventory to current assets ratio 20% 30%
The ratio indicates that the company will have to maintain a higher proportion of inventory
within its current assets. What the analysis does not reveal is the profits resulting from this
strategic move, which could justify the increase in inventory.
Quick Ratio
The quick ratio formula matches the most easily liquidated portions of current assets
with current liabilities. The intent of this ratio is to see if a business has sufficient
assets that are immediately convertible to cash to pay its bills. The key elements of
current assets that are included in the quick ratio are cash, marketable securities, and
accounts receivable. Inventory is not included in the quick ratio, since it can be quite
difficult to sell off in the short term. Because of the exclusion of inventory from the
formula, the quick ratio is a better indicator than the current ratio of the ability of a
company to pay its obligations.
To calculate the quick ratio, summarize cash, marketable securities and trade
receivables, and divide by current liabilities. Do not include in the numerator any
excessively old receivables that are unlikely to be paid. The formula is:
Cash + Marketable securities + Accounts receivable

Current liabilities
Despite the absence of inventory from the calculation, the quick ratio may still not
yield a good view of immediate liquidity, if current liabilities are payable right now,
while receipts from receivables are not expected for several more weeks.
36
EXAMPLE
Rapunzel Hair Products appears to have a respectable current ratio of 4:1. The breakdown of
the ratio components is:
Item Amount
Cash $100,000
Marketable securities 50,000
Accounts receivable 420,000
Inventory 3,430,000
Current liabilities 1,000,000
Current ratio 4:1

Quick ratio 0.57:1
The component breakdown reveals that nearly all of Rapunzel’s current assets are in the
inventory area, where short-term liquidity is questionable. This issue is only visible when the
quick ratio is substituted for the current ratio.
Tip: It may be necessary to determine the ability of a business to pay off its most
essential liabilities in the short term. If so, strip away from the quick ratio all
liabilities that can be safely delayed, and use the remaining liabilities in the
denominator.
Cash Ratio
The cash ratio compares the most liquid assets to current liabilities, to determine if a
company can meet its short-term obligations. It is the most conservative of all the
liquidity measurements, since it excludes inventory (which is used in the current
ratio) and accounts receivable (which is included in the quick ratio).
To calculate the cash ratio, add together cash and cash equivalents, and divide
by current liabilities. A variation that may be slightly more accurate is to exclude
accrued expenses from the current liabilities in the denominator, since it may not be
necessary to pay for these items in the near term. The calculation is:
Cash + Cash equivalents

Current liabilities
If a company wants to show a high cash ratio to the outside world, it must keep a
large amount of cash on hand as of the measurement date, probably more than is
prudent. Another issue is that the ratio only measures cash balances as of a specific
point in time, which may vary considerably on a daily basis, as receivables are
collected and suppliers are paid. Further, the ratio essentially assumes that the cash
37
on hand now will be used to pay for all accounts payable, when in reality the cash
from an ongoing series of receivable payments will also be used. Consequently, a
better measure of liquidity is the quick ratio, which includes accounts receivable in
the numerator.
EXAMPLE
Quest Adventure Gear has $100,000 of cash and $400,000 of cash equivalents on its balance
sheet at the end of May. On that date, its current liabilities are $1,000,000. Its cash ratio is:
$100,000 Cash + $400,000 Cash equivalents

$1,000,000 Current liabilities
= 0.5:1 Cash ratio
Defensive Interval Ratio

A variation on the preceding quick ratio is to use the same set of liquid assets to
determine how long a business can continue to pay its bills. There is no correct
answer to the number of days over which existing assets will provide sufficient
funds to support company operations. Instead, review the measurement over time to
see if the defensive interval is declining; this is an indicator that the company’s
buffer of liquid assets is gradually declining in proportion to its immediate payment
liabilities.
To calculate the defensive interval ratio, aggregate the amounts of cash,
marketable securities, and trade accounts receivable on hand, and then divide by the
average amount of daily expenditures. Note that the denominator is not the average
amount of expenses, since this can exclude any ongoing expenditures made for
assets. Also, only put trade accounts receivable in the numerator, since other
receivables (such as from officers of the company) may not be collectible in the
short term. The formula is:
Cash + Marketable Securities + Trade accounts receivable

Average daily expenditures
There are several issues with this calculation that should be considered when
evaluating its results, which are:
• Expenditure inconsistency. The central flaw is that the average amount of
expenses that a business incurs on a daily basis is not consistent. On the
contrary, it is extremely lumpy. For example, there may be no significant
expenditure required for several days, followed by a large payroll payment,
and then a large payment to a specific supplier. Because of the uneven tim-
ing of expenditures, the ratio does not yield an overly accurate view of ex-
actly how long a company’s assets will support operations.
38
• Receivable replenishment. The cash and accounts receivable figures used in

the numerator are constantly being replenished by new sales, so there should
be more cash available from this source than is indicated by the ratio.
• Receipt inconsistency. Cash receipts tend to be just as uneven as expendi-
tures, so the amount of cash available to actually pay for expenditures may
not be adequate.
EXAMPLE
Hammer Industries is suffering through a cyclical decline in the heavy equipment industry,
but the cycle appears to be turning up. The company expects a cash-in-advance payment
from a major customer in 60 days. In the meantime, the CEO wants to understand the ability
of the company to stay in business at its current rate of expenditure. The following
information applies to the analysis:
Cash $1,200,000
Marketable securities 3,700,000
Trade receivables 4,100,000
Average daily expenditures $138,500
The calculation of the defensive interval ratio is:
$1,200,000 Cash + $3,700,000 Marketable securities + $4,100,000 Receivables

$138,500 Average daily expenditures
= 65 days
The ratio reveals that the company has sufficient cash to remain in operation for 65 days.
However, this figure is so close to the projected receipt of cash from the customer that it may
make sense to eliminate all discretionary expenses for the next few months, to extend the
period over which remaining cash can be stretched.
Net Working Capital Ratio

The net working capital ratio is not actually a ratio at all, but rather the net of all
elements of working capital. It is intended to reveal whether a business has a
sufficient amount of net funds available in the short term to stay in operation. Use
the following formula to calculate the net working capital ratio:
Current assets – Current liabilities = Net working capital
This measurement only provides a general idea of the liquidity of a business, for the
following reasons:
39
• It does not relate the total amount of negative or positive outcome to the
amount of current liabilities to be paid off, as would be the case with a real
ratio.
• It does not compare the timing of when current assets are to be liquidated to
the timing of when current liabilities must be paid off. Thus, a positive net
working capital ratio could be generated in a situation where there is not
sufficient immediate liquidity in current assets to pay off the immediate
requirements of current liabilities.
An alternative version of the ratio compares net working capital to the total amount
of assets on the balance sheet. The formula is:
Current assets – Current liabilities

Total assets
Under this second version, the intent is to track the proportion of short-term net
funds to assets, usually on a trend line. By doing so, you can tell if a business is
gradually shifting more of its assets into or out of long-term assets, such as fixed
assets. An increasing ratio is considered good, since it implies that a business is
minimizing its investment in fixed assets and keeping its asset reserves as liquid as
possible.
EXAMPLE
Spud Potato Farms has $100,000 of cash, $250,000 of accounts receivable, and $400,000 of
inventory, against which are offset $325,000 of accounts payable and $125,000 of the current
portion of a long-term loan. The calculation of the net working capital ratio would indicate a
positive balance of $300,000. However, it can take a long time to liquidate inventory, so the
business might actually find itself in need of additional cash to meet its obligations in the
short term, despite the positive outcome of the calculation.
Working Capital Productivity

The working capital productivity measurement compares sales to working capital.
The intent is to measure whether a business has invested in a sufficient amount of
working capital to support its sales. From a financing perspective, management
wants to maintain low working capital levels in order to keep from having to raise
more cash to operate the business. This can be achieved by such techniques as
issuing less credit to customers, implementing just-in-time systems to avoid
investing in inventory, and lengthening payment terms to suppliers.
Conversely, if the ratio indicates that a business has a large amount of receiva-
bles and inventory, this means that the organization is investing too much capital in
return for the amount of sales that it is generating.
To decide whether the working capital productivity ratio is reasonable, compare
a company’s results to those of competitors or benchmark businesses.
40
To derive working capital productivity, divide annual revenues by the total

amount of working capital. The formula is:
Annual revenues
Total working capital
When using this measurement, consider including the annualized quarterly sales in
order to gain a better short-term understanding of the relationship between working
capital and sales. Also, the measurement can be misleading if calculated during a
seasonal spike in sales, since the formula will match high sales with a depleted
inventory level to produce an unusually high ratio.
EXAMPLE
A lender is concerned that Pianoforte International does not have sufficient financing to
support its sales. The lender obtains Pianoforte’s financial statements, which contain the
Annual revenues $7,800,000

Cash 200,000
Accounts receivable 800,000
Inventory 2,000,000
Accounts payable 400,000
With this information, the lender derives the working capital productivity measurement as
follows:
$7,800,000 Annual revenues

$200,000 Cash + $800,000 Receivables + $2,000,000 Inventory - $400,000 Payables
= 3:1 Working capital productivity
This ratio is lower than the industry average of 4:1, which indicates poor management of the
company’s receivables and inventory. The lender should investigate further to see if the
receivable and inventory figures may contain large amounts of overdue or obsolete items,
respectively.
Working Capital Roll Forward

As a business expands over time, it is possible to use a ratio to estimate whether the
amount of working capital now being used is appropriate. We do this by assuming
that the historical ratio of working capital to sales represents a reasonable
proportion, and then roll this ratio forward to the current period to see how it
compares to the current proportion. If the current proportion has declined, this
represents a reduction in the amount of working capital needed to support sales, and
41
vice versa. To derive the working capital roll forward measurement, follow these
steps:
1. Calculate the percentage change in revenue from the baseline period to the
current period.
2. Multiply this percentage change by the working capital figure for the
baseline period.
3. Subtract the result from the working capital figure for the current period.
The working capital roll forward formula is:
Current period working capital – (Baseline period ending working capital × (1 + percent
change in revenue from baseline period)) = Working capital roll forward
This measurement is most useful when a company is comparing results between

periods that have not been modified by alterations to the business plan, such as
changes in price points, expansions into new geographic regions, and so forth. Such
changes may alter the amount of working capital that must be maintained, rendering
a comparison to working capital in a prior period less applicable to the current
circumstances.
EXAMPLE
Quest Adventure Gear has been expanding rapidly in its core market of rugged travel
equipment. In the immediately preceding year, the company required $1,200,000 of working
capital to support sales of $5,000,000. In the current year, sales increased by 20%, to
$6,000,000, while working capital increased to $1,680,000. The working capital roll forward
for the current year is calculated as follows:
$1,680,000 Current period working capital – ($1,200,000 Baseline working capital × 1.2)
= $240,000
The ratio reveals that Quest’s working capital increased by $240,000 more than expected,
based on a proportional comparison to the baseline period. Further investigation reveals that
the sales manager granted longer payment terms to a large retailer in exchange for its
agreement to sell the Quest line of products.
Illiquid Asset Conversion Ratio

One of the main issues with the validity of liquidity ratios is that some assets on a
company’s balance sheet are unlikely to be convertible into much cash, if any. For
example, intangible assets, goodwill, and heavily customized assets may yield little
or no cash. This is a major concern for lenders and potential acquirers, who want to
know how much cash they can extract from a business.
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To calculate the ratio, aggregate the net book value of all assets for which
conversion to cash may be difficult, and divide by the carrying amount of total
assets. The formula is:
∑ Net book value of illiquid assets

Total recorded cost of all assets
Note that the numerator merely identifies those assets for which conversion to cash
may be difficult. There is no attempt to derive the amount of cash (if any) that can
be extracted from these assets. Thus, the ratio is half an answer – a high ratio
indicates the presence of a potential problem, but it does not reveal the extent of the
problem.
A further issue is that a company may need to hire an outside appraiser to
identify the extent of its illiquid assets. Corporate insiders usually have a good idea
of the cash flows that can be derived from the ongoing operation of assets, but not of
the amount of cash for which an asset can be sold.
EXAMPLE
Muscular Corporation is contemplating the purchase of Active Exercise Machines (AEM),

which manufactures and sells treadmills into the home market. AEM acquired several key
patents related to advanced features of treadmills from a third party for $1,000,000. AEM
also bought a competitor in order to grow into the Seattle market, resulting in the recognition
of a $100,000 customer list asset, plus $250,000 of goodwill. The total amount of assets
recognized by AEM is $1,800,000. Based on this information, Muscular calculates the
following illiquid asset conversion ratio:
$1,000,000 Patents + $100,000 Customer list + $250,000 Goodwill

$1,800,000 Total assets
= 75% Illiquid asset conversion ratio
The ratio is quite high, and initially indicates that AEM’s assets may not be readily
convertible into cash. However, Muscular’s management realizes that the $1,000,000 cost of
patents purchased may result in a notable competitive advantage for AEM, especially if
Muscular can use the patents to block the product development activities of competitors.
Consequently, Muscular extends an offer to the shareholders of AEM to acquire the business.
Solvency Ratio
The solvency ratio is specifically targeted at the ability of a business to meet its
long-term obligations. The ratio is derived from the information stated in a
company’s income statement and balance sheet, and so will not be accurate to the
extent that an organization does not recognize contingent liabilities. The solvency
ratio calculation involves the following steps:
43
1. Add all non-cash expenses back to after-tax net income. This should
approximate the amount of cash flow generated by the business.
2. Aggregate all short-term and long-term obligations of the business.
3. Divide the adjusted net income figure by the liabilities total.
The formula is:
Net after-tax income + Non-cash expenses

Short-term liabilities + Long-term liabilities
A higher percentage indicates an increased ability to support the liabilities of a

business over the long term.
Though this measurement appears simple, its derivation hides a number of
problems. Consider the following issues:
• A company may have reported an unusually high proportion of earnings not
related to its core operations, and which may therefore not be repeatable
during the time period required to pay off the company’s liabilities. Conse-
quently, net after-tax operating income is a better figure to use in the numer-
ator.
• The short-term liabilities used in the denominator are more likely to
fluctuate considerably in the short-term, so the measurement results could
vary widely if calculated just a few months apart. This issue can be mitigat-
ed by using an average short-term liabilities figure.
• The ratio assumes that a company will pay off all of its long-term liabilities,
when it may be quite likely that the business can instead roll forward the
debt or convert it to equity. If so, even a low solvency ratio may not indicate
eventual bankruptcy.
In short, there are so many variables that can impact the ability to pay over the long
term that using any ratio to estimate solvency can be misleading.
EXAMPLE
A lender is reviewing an application submitted by Pensive Corporation to roll over its

outstanding debt of $5,000,000 for an additional three-year period. Pensive reports net after-
tax income of $600,000 and non-cash expenses of $150,000. In addition to the outstanding
debt, Pensive also reports short-term liabilities of $800,000. This information yields the
following solvency ratio:
$600,000 Net after-tax income + $150,000 Non-cash expenses

$800,000 Short-term liabilities + $5,000,000 Long-term liabilities
= 12.9%
The ratio indicates that Pensive could potentially pay off its obligations with earnings over a
period of approximately 7¾ years. The lender must decide whether it wishes to undertake the
44
risk of being repaid over a longer period of time, or whether it should demand repayment
now.
Altman Z Score
The Altman Z Score was developed by Edward Altman, and is used to predict the
likelihood that a business will go bankrupt within the next two years. The formula is
based on information found in the income statement and balance sheet of an
organization; as such, it can be readily derived from commonly-available
information. In its original form, the Z score formula is as follows:
Z = 1.2A × 1.4B × 3.3C × 0.6D × 0.99E
The letters in the formula designate the following measures:

A = Working capital ÷ Total assets [measures the relative amount of liquid
assets]
B = Retained earnings ÷ Total assets [determines cumulative profitability]
C = Earnings before interest and taxes ÷ Total assets [measures earnings away
from the effects of taxes and leverage]
D = Market value of equity ÷ Book value of total liabilities [incorporates the
effects of a decline in market value of a company's shares]
E = Sales ÷ Total assets [measures asset turnover]
A Z score of greater than 2.99 means that the entity being measured is safe from
bankruptcy. A score of less than 1.81 means that a business is at considerable risk of
going into bankruptcy, while scores in between should be considered a red flag for
possible problems. The model has proven to be reasonably accurate in predicting the
future bankruptcy of entities under analysis.
This scoring system was originally designed for manufacturing firms having
assets of $1 million or more. Given the targeted nature of the model, it has since
been modified to be applicable to other types of organizations.
This approach to evaluating businesses is better than using just a single ratio,
since it brings together the effects of multiple items - assets, profits, and market
value. As such, it is most commonly used by creditors and lenders to determine the
risk associated with extending funds to customers and borrowers.
Summary
This chapter has addressed the various proportions of assets and liabilities on a
company’s balance sheet, and how you can infer the liquidity of a business from
these ratios. However, the key missing element is no real knowledge of the timing of
or extent to which cash can be extracted from assets, or when liabilities must be
paid. The result is potentially incorrect approximations and inferences from a
balance sheet.
45
For an alternative viewpoint on liquidity, see the following Cash Flow Meas-
urements chapter; this provides an historical view of the cash flows that a company
has been able to generate. This chapter and the Cash Flow Measurements chapter,
when combined, give a more complete view of the ability of a company to generate
sufficient cash to pay for its current and future liabilities.
46
Chapter 4
Cash Flow Measurements
Introduction
The profitability of a business is usually the main focus of a measurement system.
However, because of the vagaries of the accrual basis of accounting, profitability
does not necessarily equate to the underlying financial health of a business. In this
chapter, we look at measurements related to cash flow, which is a more reliable
indicator. Measurements covered include free cash flow, several variations on cash
flow returns, the sources of cash, and how cash is being used within a business.

discusses cash flow measurements. The episode is available at: accounting-
Overview of Cash Flow Measurements

An outsider reviewing the results of a business would be wise to rely heavily upon
cash flow measurements to form an opinion of the entity. Cash flow analysis strips
away the use of accruals that are mandated under the accrual basis of accounting,
making it much easier to discern the underlying capabilities of an organization.
The most comprehensive measure of cash flow is the concept of free cash flow,
which we introduce as the first (and most important) measurement. It is not a ratio,
but rather an aggregate total of the amount of cash generated by a business, less a
variety of uses. We also note a number of ways in which management can boost free
cash flow. Peruse these items carefully, to be aware of how cash flows can be
bolstered, and not always to the benefit of an organization.
We then turn to several ways in which cash flows can be compared or presented
– on a per-share basis, as a percentage of sales, and as a percentage of assets. These
are all variations on how profits are presented, but with cash flows inserted into the
numerator of the ratios.
There is also a discussion of the source of cash flows. Ideally, nearly all cash
flows should come from operations. If so, this is a strong indicator of the long-term
viability of a business. If cash is instead scraped up from other sources, such as the
proceeds of lawsuits or from minor side businesses, then a company may lack
strategic focus.
We finish the discussion of cash flows with a review of cash usage measure-
ments. These ratios are used to determine the extent to which internally-generated
cash flows are sufficient to fulfill such ongoing requirements as investments in fixed
assets and working capital. A variation on this concept is used to examine budgeted
cash flows.
Not many cash flow ratios are needed, but having a few of them in the mix of
corporate reports should be considered essential. They can provide a useful early
warning if they reveal results not in line with the net profit ratio and other profit-
based measurements.
Free Cash Flow

Free cash flow is the net change in cash generated by the operations of a business
during a reporting period, minus cash outlays for working capital, capital
expenditures, and dividends during the same period. Thus, the calculation of free
cash flow is:
Operating cash flow ± Working capital changes – Capital Expenditures – Dividends
The “operating cash flow” component of that equation is calculated as:
Net income + Depreciation + Amortization
Free cash flow is important because it is an indicator of the financial health of a

business, and particularly of its ability to invest in new business opportunities. The
measure is also used by investors to estimate the amount of cash flow that may be
available for distribution to them in the form of dividends. However, there can be a
variety of situations in which a company can report positive free cash flow, and
which are due to circumstances not necessarily related to a healthy long-term
situation. For example, positive free cash flow can be caused by:
• Selling off major corporate assets
• Cutting back on or delaying capital expenditures
• Delaying the payment of accounts payable
• Accelerating receivable receipts with high-cost early payment discounts
• Foregoing a dividend
• Cutting back on key maintenance expenditures
• Reducing marketing expenditures
• Curtailing scheduled pay increases
• Entering into sale and lease back arrangements for key assets
In these examples, management has taken steps to reduce the long-term viability of a
business in order to improve its short-term free cash flows. Other actions, such as
accelerating the collection of accounts receivable through changes in payment terms
or switching to just-in-time materials management systems, can be beneficial to a
business while still reducing its outgoing cash flows.
Free cash flow can also be impacted by the growth rate of a business. If a
company is growing rapidly, it requires a significant investment in accounts
receivable and inventory, which increases its working capital investment and
therefore decreases the amount of free cash flow. Conversely, if a business is
48
shrinking, it is converting some of its working capital back into cash as receivables
are paid off and inventory liquidated, resulting in an increasing amount of free cash
flow.
An additional consideration is the ability of a business to repatriate cash from a
subsidiary. If a subsidiary is spinning off enormous amounts of cash, the ability to
do so makes little difference to the corporate parent if it cannot access the cash, due
to stringent controls over cash repatriation by the government.
In short, be aware of the general condition and strategic direction of a business
when evaluating whether the state of its free cash flows is beneficial or not.
Cash Flow Returns

In this chapter, we are essentially substituting cash for profitability when developing
measurements. Since the cornerstone of profitability measurement is the return
generated, we will do the same for cash. In this section, we present cash flow per
share, which is a variation on earnings per share. We also present the cash flow
return on sales and cash flow return on assets, which are equivalent to the net profit
ratio and the return on assets, respectively.
Cash Flow per Share

In the Share Performance Measurement chapter, we noted that earnings per share
can be artificially altered via a number of accounting tricks, such as the use of
accelerated revenue recognition and the capitalization of expenditures that would
normally be charged to expense as incurred. It is much more difficult to alter the
reported amount of cash flows that a company generates, so the cash flow per share
figure is a superior way to discern its ability to generate a return for investors. The
measure also indicates the ability of a business to pay a dividend, though any
positive cash flows could be directed to other uses than the payment of investors.
To calculate cash flow per share, add non-cash expenses back to net income, and
divide by fully diluted earnings per share. The calculation is:
Net profit + Non-cash expenses

Average number of common shares outstanding
The numerator in this measurement is not a totally accurate depiction of cash flows,
for it does not incorporate any changes in working capital or new investments in
assets. If these additional changes are significant, factor them into the numerator.
EXAMPLE
The board of directors of Dillinger Designs replaces the retiring CEO with an outsider known
for his aggressively optimistic dealings with investors. The new CEO promptly orders the
company controller to switch from accelerated depreciation to straight-line depreciation, as
well as to pare back the size of the allowance for doubtful accounts. The result is an
immediate boost in earnings per share.
49
A discerning analyst is suspicious of the rapid increase in earnings per share, and revises the
calculation by stripping out non-cash expenses. Her findings are noted in the following table,
which reveals that the cash flow results of the company have worsened under the new CEO:
Last Annual Results First Annual Results

Reported by Old CEO Reported by New CEO
Net profit $18,600,000 $20,900,000
Non-cash expenses $4,800,000 $1,300,000
Average common shares 24,000,000 24,000,000
Earnings per share $0.78 $0.87
Cash flow per share $0.98 $0.93
Upon learning of the financial trickery imposed by the CEO, the board promptly fires him
and persuades the former CEO to return to the position.
Cash Flow Return on Sales

When a business uses the accrual basis of accounting to record its performance, it is
entirely possible that various accruals will twist the reported results to such an extent
that the net profit ratio (net profit divided by sales) will not accurately reflect the
amount of profit from each dollar of sales. If there is a disparity between cash flows
and net profit reported, consider using the cash flow return on sales instead. This
approach focuses on the amount of cash generated from each dollar of sales, and so
provides a more accurate representation of the results of a business.
To calculate the cash flow return on sales, we must first convert the net income
figure into an approximation of cash flows by adding back non-cash expenses
(though this does not factor in changes in working capital or fixed assets), and divide
by net sales for the measurement period. The formula is:

Total net sales
This measurement should be tracked on a trend line to spot long-term tendencies for
cash flows to decline. If this is the case, management should engage in a thorough
review that may culminate in corrective action to reverse the decline. Also, compare
this result to the same measurement for competitors, to see how the company
performs in relation to a common benchmark.
EXAMPLE
Grissom Granaries operates grain barges and a tugboat on the Mississippi River, transporting
grain on behalf of clients. The new president of Grissom is concerned about the company’s
low ongoing cash balance, and asks the CFO to calculate the cash flow return on sales for the
business. The result shows minimal cash flow. The hefty depreciation charge provides a clue
as to where the problem lies. Further investigation reveals that the barges and tugboat are
50
continually running aground, resulting in much faster hull replacement cycles than had been
originally anticipated, and therefore excessive investments in fixed assets. The president
responds by firing the tugboat captain and installing sonar on the tugboat.
Net profit -$1,800,000

Depreciation $2,000,000
Net sales $25,000,000
Cash flow return on sales 0.8%
Cash Flow Return on Assets

In an asset-intensive industry, it makes sense to measure the productivity of the large
investment in assets by calculating the amount of cash flow generated by those
assets. When linked to a performance measurement system, the likely result is a
continual reduction in the amount of fixed assets and inventory in proportion to
sales.
To calculate the cash flow return on sales, we must first convert the net income
figure into an approximation of cash flows by adding back non-cash expenses
(though this does not factor in changes in working capital or fixed assets), and divide
by total assets as of the end of the measurement period. The formula is:

Total assets
Though a generally useful measure, there are two concerns to be aware of:
• Depreciation. If a company uses an accelerated depreciation method and
there is a large investment in fixed assets, the total assets figure in the de-
nominator will decline with great rapidity, resulting in improved ratio per-
formance without management actually doing anything. This problem can
be rectified by using straight-line depreciation instead.
• Replenishment. Fixed assets should be replaced when their useful lives have
ended, to keep from incurring too much maintenance expense. If manage-
ment wants to manipulate the asset base to improve the ratio, it could elect
to retain assets well past the point at which they should have been retired.
This measurement is not overly useful in those industries where there is a minimal
fixed asset investment, such as service industries or those relying on intangible
assets.
Cash Flow from Operations Ratio

Ideally, the bulk of the cash flow generated by a business should come from its core
operations. The cash flows from ancillary activities should be quite minor.
Otherwise, the entity is relying on non-core activities to support its core activities.
51
The calculation of this ratio first requires the derivation of cash flow from
operations, which requires the following calculation:
Income from operations

+ Non-cash expenses
- Non-cash revenue
= Cash flow from operations
An example of non-cash revenue is deferred revenue that is being recognized over

time, such as an advance payment on services that will be provided over several
months.
Once cash flow from operations has been derived, we then divide it by the total
net income for the entity. The calculation is:
Cash flow from operations

Net income
Ideally, the ratio should be fairly close to 1:1. A much smaller ratio indicates that a
business is deriving much of its cash flow from sources other than its core operating
capabilities.
EXAMPLE
Blitz Communications recently raised $50 million through an initial public offering, and
promptly parked all of the cash in investments. In the following quarter, the company’s net
income rose from $400,000 to $900,000. Further investigation reveals the following cash
flow from operations ratio:
Preceding Quarter Current Quarter

Cash flow from operations $390,000 $375,000
Net income $400,000 $900,000
Cash flow from operations ratio 98% 42%
The ratio reveals that the core operations of the business have generated less cash than had
been the case before the company went public. The entire source of the increased net income
has been the investment income generated by the cash the company obtained from investors
when it went public.
Cash Reinvestment Measurements

It may be useful to track the uses to which a company puts its cash flows. In this
section, we review one ratio designed to examine actual cash usage, as well as
another ratio that is intended to examine the usage of expected cash flows.
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Cash Reinvestment Ratio

One of the more interesting cash flow ratios does not examine the sources of cash
flow, but rather how cash flow is used. The cash reinvestment ratio focuses on the
proportion of cash flow that is invested back into the business – specifically, in fixed
assets and working capital. The inverse of this ratio would reveal the amount of cash
flowing out of a business, such as through dividends paid to investors. If the ratio is
very high, it can be indicative of a business that is rapidly growing, and which
therefore needs all of its excess cash to fund further expansion. However, a high
ratio can also indicate that a business is barely profitable, so all of its cash is needed
to maintain operations.
To calculate the cash reinvestment ratio, aggregate the amount of any increases
in the gross amount of fixed assets, as well as any changes in working capital, and
then divide by net income plus non-cash expenses. The gross amount of fixed assets
is used instead of the net amount, so that the effects of depreciation are excluded.
The calculation is:
Increase in gross amount of fixed assets ± Changes in working capital

Net income + non-cash expenses
When interpreting this ratio, it is of some importance to recognize when a business

is using more assets than would be required by a lean operation. This calls for the
development of turnover ratios for receivables, inventory, and fixed assets, which
can then be compared to other companies in the industry. If these ratios indicate low
asset turnover levels, there could be a problem with the manner in which a business
is being managed.
EXAMPLE
A prospective buyer is reviewing the financial statements of Giro Cabinetry, which reveals a
very high cash reinvestment ratio of 95%. However, the company is generating net profits of
20%, which indicates a high level of available cash, while sales are only increasing at a rate
of 10% per year. The buyer digs further and examines the company’s asset turnover ratios.
Accounts receivable average 45 days old, which is normal for the industry. The proportion of
fixed assets to sales is also normal. However, average inventory is 200 days old, which is far
beyond the industry average. After more investigation, the buyer learns that Giro has an
antiquated materials management system that results in very large amounts of excess
inventory. The inventory is still usable, so the investor decides to buy the company, install a
new job control system, and sell off the excess inventory.
Funds-Flow Adequacy Ratio

A key component of a corporate budgeting process is the examination of forecasted
cash flows, to see if the cash flows will be sufficient for all projected company
requirements, such as additions to working capital and fixed assets, as well as
planned dividends to shareholders. This examination can be conducted with the
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funds-flow adequacy ratio. To calculate the ratio, aggregate all of the cash
requirements just noted and divide this total into the projected net cash outflows
from the operations of the business. The formula is:
Net budgeted cash available from operations

Budgeted increase in fixed assets + Budgeted increase in working capital + Expected
dividends
If the outcome of this ratio is more than 1:1, then the business can internally
generate sufficient funds for all of its needs. If the ratio is less than 1:1, then the
budget can be recast to require fewer expenditures, or additional financing can be
included in the budget to cover the shortfall.
The ratio can also be used to judge the historical ability of a company to fund its
own cash requirements. If the company has continually suffered cash shortfalls in
prior years, it is entirely likely that a more optimistic target in the budget will not be
achieved.
EXAMPLE
The budget analyst for Camelot Construction (maker of wedding props) is reviewing the first
draft of management’s budget for the next year. She is suspicious of the amount of cash flow
projected to be produced by the company, and decides to compare it to actual results for
previous years. She does so using the funds-flow adequacy ratio, as shown in the following
table:
20X1 Actual 20X2 Actual 20X3 Budgeted

Results Results Results
Cash available from operations $250,000 $235,000 $680,000
Cash usage $280,000 $305,000 $400,000
Funds-flow adequacy ratio 89% 77% 170%
The table reveals that the proposed budget is a fantasy. Based on its historical results,
Camelot is quite unlikely to generate anywhere near the cash flow noted in the first iteration.
The analyst appears before a round table of company managers to state her findings.
Summary
One note of caution in regard to cash flow measurements is that the numerator of
many ratios calls for an approximation of cash flows. This approximation is derived
by adding non-cash expenses back to net income and subtracting out the effects of
any accrued revenue that is being recognized in the period. However, the result may
not match actual cash flows, for it does not incorporate any changes related to
working capital or fixed assets. For an increased level of accuracy, consider
including these additional items in your cash flow measurements.
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This chapter is primarily designed to highlight the cash-generating ability of a

business. For additional information about cash-related topics, read the Liquidity
Measurements chapter; this chapter addresses whether a business has sufficient cash
flows to meet its obligations.
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Chapter 5
Return on Investment
Introduction
From the perspective of the investor, the most vital information is the return on
invested funds. This information can be derived in a variety of ways, such as by
examining the return on equity, or comparing the cost of capital to the return
generated on invested funds, or perhaps by examining the book value of a
company’s assets. Other investors are more focused on an examination of dividends,
and especially in proportion to reported profits. In short, there are many ways to
view the concept of return on investment.
In this chapter, we examine the ways in which return on investment can be
measured, and also point out how each approach can yield inaccurate or misleading
results, or force managers to adopt incorrect strategies. As we note in the Summary
section, all of these measurements are flawed to some extent, and so should be
supplemented by an examination of the competitive fundamentals of a business.
Return on Equity
The return on equity (ROE) ratio reveals the amount of return earned by investors on
their investments in a business. It is one of the metrics most closely watched by
investors. Given the intense focus on ROE, it is frequently used as the basis for
bonus compensation for senior managers.
ROE is essentially net income divided by shareholders’ equity. ROE perfor-
mance can be enhanced by focusing on improvements to three underlying
measurements, all of which roll up into ROE. These sub-level measurements are:
• Profit margin. Calculated as net income divided by sales. Can be improved
by trimming expenses, increasing prices, or altering the mix of products or
services sold.
• Asset turnover. Calculated as sales divided by assets. Can be improved by
reducing receivable balances, inventory levels, and/or the investment in
fixed assets, as well as by lengthening payables payment terms.
• Financial leverage. Calculated as assets divided by shareholders’ equity.
Can be improved by buying back shares, paying dividends, or using more
debt to fund operations.
Or, stated as a formula, the return on equity is as follows:
Return on Net income Sales Assets

Equity = × ×
Sales Assets Shareholders’ equity
Return on Investment Measurements
EXAMPLE
Hammer Industries manufactures construction equipment. The company’s return on equity

has declined from a high of 25% five years ago to a current level of 10%. The CFO wants to
know what is causing the problem, and assigns the task to a financial analyst, Wendy. She
reviews the components of ROE for both periods, and derives the following information:
Profit Asset Financial

ROE Margin Turnover Leverage
Five Years Ago 25% = 12% × 1.2x × 1.75x
Today 10% = 10% × 0.6x × 1.70x
The information in the table reveals that the primary culprit causing the decline is a sharp
reduction in the company’s asset turnover. This has been caused by a large buildup in the
company’s inventory levels, which have been caused by management’s insistence on
stocking larger amounts of finished goods in order to increase the speed of order fulfillment.
The multiple components of the ROE calculation present an opportunity for a

business to generate a high ROE in several ways. For example, a grocery store has
low profits on a per-unit basis, but turns over its assets at a rapid rate, so that it earns
a profit on many sale transactions over the course of a year. Conversely, a
manufacturer of custom goods realizes large profits on each sale, but also maintains
a significant amount of component parts that reduce asset turnover. The following
illustration shows how both entities can earn an identical ROE, despite having such
a different emphasis on profits and asset turnover. In the illustration, we ignore the
effects of financial leverage.
Comparison of Returns on Equity

ROE Profit Margin Asset Turnover
Grocery Store 20% = 2% × 10x
Custom manufacturer 20% = 40% × 0.5x
Usually, a successful business is able to focus on either a robust profit margin or a

high rate of asset turnover. If it were able to generate both, its return on equity
would be so high that the company would likely attract competitors who want to
emulate the underlying business model. If so, the increased level of competition
usually drives down the overall return on equity in the market to a more reasonable
level.
A high level of financial leverage can increase the return on equity, because it
means a business is using the minimum possible amount of equity, instead relying
on debt to fund its operations. By doing so, the amount of equity in the denominator
of the return on equity equation is minimized. If any profits are generated by funding
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activities with debt, these changes are added to the numerator in the equation,
thereby increasing the return on equity.
The trouble with employing financial leverage is that it imposes a new fixed
expense in the form of interest payments. If sales decline, this added cost of debt
could trigger a steep decline in profits that could end in bankruptcy. Thus, a business
that relies too much on debt to enhance its shareholder returns may find itself in
significant financial trouble. A more prudent path is to employ a modest amount of
additional debt that a company can comfortably handle even through a business
downturn.
EXAMPLE
The president of Finchley Fireworks has been granted a bonus plan that is triggered by an
increase in the return on equity. Finchley has $2,000,000 of equity, of which the president
plans to buy back $600,000 with the proceeds of a loan that has a 6% after-tax interest rate.
The following table models this plan:
Before Buyback After Buyback

Sales $10,000,000 $10,000,000
Expenses 9,700,000 9,700,000
Debt interest expense --- 36,000
Profits 300,000 264,000
Equity 2,000,000 1,400,000
Return on equity 15% 19%
The model indicates that this strategy will work. Expenses will be increased by the new
amount of interest expense, but the offset is a steep decline in equity, which increases the
return on equity. An additional issue to be investigated is whether the company’s cash flows
are stable enough to support this extra level of debt.
A business that has a significant asset base (and therefore a low asset turnover rate)
is more likely to engage in a larger amount of financial leverage. This situation
arises because the large asset base can be used as collateral for loans. Conversely, if
a company has high asset turnover, the amount of assets on hand at any point in time
is relatively low, giving a lender few assets to designate as collateral for a loan.
Tip: A highly successful company that spins off large amounts of cash may generate
a low return on equity, because it chooses to retain a large part of the cash. Cash
retention increases assets and so results in a low asset turnover rate, which in turn
drives down the return on equity. Actual ROE can be derived by stripping the excess
amount of cash from the ROE equation.
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Return on equity is one of the primary tools used to measure the performance of a
business, particularly in regard to how well management is enhancing shareholder
value. As noted in this section, there are multiple ways to enhance ROE. However,
we must warn against the excessive use of financial leverage to improve ROE, since
the use of debt can turn into a burden if cash flows decline.
A case can be made that ROE should be ignored, since an excessive focus on it
may drive management to pare back on a number of discretionary expenses that are
needed to build the long-term value of a company. For example, the senior
management team may cut back on expenditures for research and development,
training, and marketing in order to boost profits in the short term and elevate ROE.
However, doing so impairs the ability of the business to build its brand and compete
effectively over the long term. Some management teams will even buy their
companies back from investors, so that they are not faced with the ongoing pressure
to enhance ROE. In a buyback situation, managers see that a lower ROE combined
with a proper level of reinvestment in the business is a better path to long-term
value.
Economic Value Added

The economic value added (EVA) measurement compares the cost of capital of a
business to the rate of return it generates, to see if the business is creating any value
in excess of its cost of funds. If the economic value added measurement turns out to
be negative, this means a business is destroying value on the funds invested in it. It
is essential to review all of the components of this measurement to see which areas
of a business can be adjusted to create a higher level of EVA. A possible outcome of
the measurement is that a business is destroying so much value that it should be sold
off or shut down, and any residual funds returned to investors.
To calculate EVA, determine the difference between the actual rate of return on
assets and the cost of capital, and multiply this difference by the net investment in
the business. Additional details regarding the calculation are:
• Eliminate any unusual income items from net income that do not relate to
ongoing operational results.
• The net investment in the business should be the net book value of all fixed
assets, assuming that straight-line depreciation is used.
• The expenses for training and research and development should be consid-
ered part of the investment in the business.
• The fair value of leased assets should be included in the investment figure.
• If the calculation is being derived for individual business units, the alloca-
tion of costs to each business unit is likely to involve extensive negotiation,
since the outcome will affect the calculation for each business unit. This can
mean that the best negotiators will avoid expense allocations, making their
EVA results look better.
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These bullet points should make it clear that EVA is not a simple ratio – it is a
carefully calculated formulation that requires a lengthy analysis to derive. Thus, the
following formula for EVA masks a great deal of cost accounting:
Net investment × (Actual return on investment – Percentage cost of capital) = EVA
EXAMPLE
The president of the Hegemony Toy Company has just returned from a management seminar
in which the benefits of EVA have been trumpeted. He wants to know what the calculation
would be for Hegemony, and asks his financial analyst to find out.
The financial analyst knows that the company's cost of capital is 12.5%, having recently
calculated it from the company's mix of debt, preferred stock, and common stock. He then
reconfigures information from the income statement and balance sheet into the following
matrix, where some expense line items are instead treated as investments.
Account Description Performance Net Investment

Revenue $6,050,000
Cost of goods sold 4,000,000
General & administrative 660,000
Sales department 505,000
Training department $75,000
Research & development 230,000
Marketing department 240,000
Net income $645,000
Fixed assets 3,100,000

Cost of patent protection 82,000
Cost of trademark protection 145,000
Total net investment $3,632,000
The return on investment for Hegemony is 17.8%, using the information from the preceding
matrix. The calculation is $645,000 of net income divided by $3,632,000 of net investment.
Finally, he includes the return on investment, cost of capital, and net investment into the
following calculation to derive the EVA:
($3,632,000 Net investment) × (17.8% Actual return – 12.5% Cost of capital)
= $3,632,000 Net investment × 5.3%
= $192,496 Economic value added
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Thus, the company is generating a healthy EVA on the funds invested in it.
The EVA concept can be expanded upon to include an examination of changes in

EVA over time. While a simple trend line can be used, an alternative measure is to
compare changes in EVA to sales over time. To do so, divide the change in EVA by
annualized sales. The formula is:
Ending EVA – Beginning EVA

Annualized sales
This approach reveals the ability of a company to maintain positive EVA growth as
it (presumably) increases sales. If the result is negative, then it is likely that the
effort and funding expended to gain additional sales resulted in a net destruction of
shareholder value.
EXAMPLE
As of the beginning of the current fiscal year, Hegemony Toy Company had recorded
positive EVA of $192,000. During the current year, the president of Hegemony has pursued
a strategy of expanding distribution in the Far East market. The result has been a stellar 25%
increase in sales, to $8,000,000. However, doing so has required a significant investment in
inventory and regional warehouses, as well as up-front fees. The result is a decline in EVA to
$150,000. The EVA momentum calculation for this year of activity is:
$150,000 Ending EVA - $192,000 Beginning EVA

$8,000,000 Sales
= -0.5% EVA momentum
The decision to expand may still be the correct one. Despite the loss in EVA momentum, the
geographic expansion might still pay off, if the company can increase income on its new and
larger asset base, and by tweaking its distribution system to generate more profits.
The EVA concept will certainly focus the attention of management on the returns
generated on invested funds. However, a case can be made that an excessive focus
on EVA will drive management away from riskier or longer-term investments,
where the payback may not occur at all, or not for a long time (as noted in the last
example). These types of investments are critical to the long-term competitiveness
of a business, and yet might be avoided by management in favor of less-risky
investments or ones with more assured payoffs.
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Book Value Analysis

The book value of a business is the amount of assets stated on its balance sheet,
minus the liabilities listed on the balance sheet. Or, stated as a formula, book value
is:
Assets – Liabilities = Book value
Book value is a commonly-used measure of the value of a business, probably

because it is so easily derived from the published balance sheet of a company. The
information could be used to estimate the most appropriate price of a company’s
stock, such as by comparing the market price of the stock to its book value. Or, the
book value concept could be one possible basis for deriving the value of a company,
when a potential acquirer wants to issue a bid to the owners of the target company.
Also, lenders commonly use book value to estimate whether a prospective or current
borrower is a good credit risk. In short, book value has many possible uses.
Despite the widespread use of book value, it is a seriously flawed measurement.
The problem is that the amounts stated in a company’s balance sheet do not
necessarily match their current market values. Instead, some are recorded at their
original purchase prices, while others are adjusted to their market values as of the
balance sheet date. The problem is exacerbated by the Generally Accepted
Accounting Principles (GAAP) framework, which enforces the recordation of the
most conservative values for assets. The issue is less of a problem if the
International Financial Reporting Standards (IFRS) framework is used, since IFRS
allows for the upward revaluation of some assets. The following bullet points
illustrate the problem for a selection of transactions that are recorded and updated
using GAAP:
• Investments. Depending on the types of securities held as investments, they
are marked to market at the end of each reporting period. When this is not
possible for longer-term investments for which there are no fair market val-
ues available, the recorded cost remains the purchase cost.
• Inventory. The lower of cost or market rule states that the recorded value of
inventory must be reduced to its market value if market value declines be-
low recorded cost. However, there is no provision for increasing the record-
ed amount of inventory if the market value of inventory increases. Further,
the last in, first out (LIFO) inventory costing method is designed to record
the lowest possible inventory cost in environments where prices are increas-
ing over time.
• Fixed assets. Fixed assets are only recorded at their initial purchase costs,
after which these amounts are reduced over time by depreciation. They may
also be reduced more rapidly if it is determined that their values have been
impaired. However, there is no way to increase the recorded amount of a
fixed asset if the market value of the asset increases.
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A further issue with book value is the incorporation of intangible assets into the
balance sheet. An intangible asset is a non-physical asset that has a useful life
spanning more than one accounting period. Examples of intangible assets are
software developed for internal use, patents, and copyrights. If a company internally
generates intangible assets, the business cannot record these assets on its balance
sheet. In some cases, the value of these assets represents the primary value of an
entire business, so the book value calculation may wildly underestimate the value of
the organization.
Conversely, an acquirer is allowed to record that portion of the purchase price of
an acquiree that can be allocated to the intangible assets of the acquiree. For
example, a portion of the purchase price may be allocated to an intangible asset
called “customer relationships,” which is then amortized over the presumed
remaining life of those relationships. In some cases, these intangible assets can be
considered specious at best, and yet are included in the book value calculation
because they are listed on the balance sheet.
A further problem with acquisitions is that any portion of the purchase price that
cannot be allocated to tangible or intangible assets is recorded as “goodwill,” which
appears in the balance sheet as an asset. In some cases, goodwill can represent a
large part of the assets listed on a company’s balance sheet, and so can radically
skew the calculation of book value.
For the reasons enumerated here, we do not recommend using the book value
concept for the purposes of assigning a value to an entire business. The value
derived would be nearly arbitrary, and could bear little relationship to the actual
market value of the entity. That being said, it may be possible to apply the book
value concept to an individual asset, which is called net book value. Another
alternative is to strip away intangible assets from the book value calculation,
resulting in tangible book value. These concepts are discussed next.
Net Book Value

Net book value is the original cost of an asset, less any accumulated depreciation,
accumulated depletion, accumulated amortization, and accumulated impairment.
These elements are:
• Original cost. This is the acquisition cost of an asset, which is the cost
required to not only purchase or construct the asset, but also to bring it to the
location and condition intended for it by management. Thus, the original
cost of an asset may include such items as the purchase price, sales taxes,
delivery charges, and setup costs.
• Depreciation. The depreciation, depletion, or amortization associated with
an asset is the process by which the original cost of an asset is ratably
charged to expense over its useful life, less any estimated salvage value.
Thus, the net book value of an asset should decline continually over its use-
ful life.
• Impairment. This is a situation where the market value of an asset is less
than its net book value, in which case the remaining net book value of the
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asset is written down to its market value. Thus, an impairment charge can
have a sudden downward impact on the net book value of an asset.
While net book value also does not necessarily equate to market value, it is devoid
of the goodwill issue that plagues use of the book value concept when applied to an
entire business. Also, the net book value concept can bear some relationship to the
lowest possible market value of an asset, since the use of impairment will keep an
asset value from rising too high. As such, this concept tends to establish the lower
end of the actual value of an individual asset.
EXAMPLE
Fireball Flight Services operates a small business jet, which it acquired for $5,000,000.
Management expects that the jet will have a salvage value of $2,000,000 in ten years. The
company uses the straight line method to depreciate the jet over its 10-year expected useful
life. This means that the jet is being depreciated at a rate of $300,000 per year, which is
calculated as:
($5,000,000 cost - $2,000,000 salvage value) ÷ 10 years = $300,000 per year
After three years, Fireball has recorded depreciation of $900,000 for the jet, which means
that it now has a net book value of $4,100,000. At that time, the company conducts an annual
impairment test, and concludes that the market value of the jet has declined to $3,500,000.
The company records an impairment charge of $600,000, which brings its net book value
down to $3,500,000. At the time of the impairment charge, the net book value of the jet
approximates its market value.
Tangible Book Value

Another variation on the book value concept is to remove all intangible assets from
the book value formula. Doing so eliminates the inflation of asset values caused by
the presence of goodwill, as well as other assets created as part of a corporate
acquisition. However, some of these intangible assets may have significant value, so
anyone using the tangible book value concept should sort through the various
intangible assets and determine which are to be eliminated and which ones retained.
This can turn into a qualitative exercise, where different analysts arrive at different
tangible book values based on their own perceptions of the worth of certain
intangible assets. Consequently, if this measurement is to be used, it should be
accompanied by a detailed analysis of each intangible asset included in or excluded
from the measurement, as well as justifications for the amounts included.
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The calculation of tangible net worth is to subtract all liabilities listed on a

company’s balance sheet from all tangible net assets stated on the balance sheet. By
“net assets,” we refer to assets from which all contra accounts, such as the allowance
for bad debts, depreciation, and amortization, have been subtracted. The formula is:
Tangible net assets – Liabilities = Tangible book value
EXAMPLE
Nefarious Industries has engaged in a number of hostile takeovers in the past decade,
resulting in a group of subsidiaries for which Nefarious paid a total of $15,000,000 more
than could be assigned to the tangible assets of the subsidiaries. The result is the following
intangible assets recorded on the consolidated financial statements of the company:
Intangible Asset Type Amount

Customer lists $1,500,000
Internet domain names 500,000
Licensing agreements 4,000,000
Water rights 3,500,000
Goodwill 5,500,000
Total $15,000,000
The consolidated balance sheet of Nefarious reveals a total of $32,000,000 in assets and
$8,000,000 in liabilities. A prospective investor is attempting to determine the tangible book
value of the company, and concludes that the licensing agreements and water rights listed as
intangible assets have actual value. The other intangible assets are discarded. Based on this
review, the investor concludes that the adjusted tangible book value of the company is:
$32,000,000 assets - $7,500,000 intangible assets with no value - $8,000,000 liabilities

= $16,500,000 Adjusted tangible book value
Book Value per Share

We have provided extensive warnings about why book value should not be used. If
you still insist upon using it, the best method is to calculate book value on a per-
share basis. The main reason for doing so is that the primary user of book value is an
outside investor, who wants to compare the market value of shares owned to their
book value, and so needs a measurement that is presented on a per-share basis.
The measurement is typically calculated on the basis of just common stock, with
the effects of preferred stock eliminated from the calculation. By doing so, the result
shows the amount that a common shareholder might receive upon the liquidation of
a business.
To calculate book value per share, subtract preferred stock from stockholders’
equity and divide by the number of common shares outstanding. Be sure to use the
65
average number of shares in the denominator, since the period-end amount may
incorporate a recent stock buyback or issuance, and so could skew the results. The
formula is:
(Stockholders’ equity – Preferred stock) ÷ Average common shares = Book value per share
Note that the numerator in this formula appears to differ from the classic definition
of book value, which is assets minus liabilities. However, since assets minus
liabilities equal shareholders’ equity, the resulting numbers are identical.
EXAMPLE
Grissom Granaries has $15,000,000 of stockholders’ equity, $3,000,000 of preferred stock,

and an average of 2,000,000 shares outstanding during the measurement period. The
calculation of its book value per share is:
$15,000,000 Stockholders’ equity - $3,000,000 Preferred stock

2,000,000 Average common shares outstanding
= $6.00 Book value per share
Return on Assets
A central reason why a business asks investors for money is to fund the acquisition
of assets, of which there are many types – receivables, inventory, fixed assets, and
so forth. Consequently, it behooves an investor to inquire into the return
subsequently generated from those assets, which is called the return on assets ratio.
Ideally, the assets as a group should generate a significant return, indicating that the
company is capable of investing shareholder funds in an effective manner.
The return on assets measurement can be misleading, for a variety of reasons.
Consider the following situations:
• Request for additional funds. A company has thus far generated a high
return on assets, and asks investors for more funds, so that it can acquire
additional equipment. In this case, investors are making the assumption that
the return generated in the past will continue in the future, which may not be
the case. The additional funds may be used for an entirely different purpose
than the funds invested previously. Consequently, simply basing an invest-
ment on the historical return on assets is dangerous; there should also be an
inquiry into how the additional funds will be used, and how this varies from
previous investments.
• Small asset base. In some cases, a company does not require a large amount
of assets in order to conduct operations. For example, it may provide ser-
vices, in which case its primary asset may only be accounts receivable. In
these situations, the return on assets may appear astronomical. However,
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because there are so few assets, it is questionable whether the measurement

should even be used. Instead, use it only for asset-intensive operations.
• Asset replenishment. The fixed assets upon which this measurement is
partially based are being continually reduced by depreciation, which makes
the return on assets figure appear to increase over time as the carrying
amount of the assets declines. This issue is not material if a company is con-
tinually replenishing its fixed assets with new purchases, thereby keeping
the total amount of fixed assets relatively consistent from period to period.
However, if management is not reinvesting in the business, then the impact
of depreciation will gradually reduce the total carrying amount of assets,
resulting in a higher return on assets, but also an older and less-efficient
infrastructure. This issue can be spotted by reviewing the trend line of
maintenance expenses; if the expense is rising over time, it could mean that
an entity is spending more money to maintain older machines.
Given these issues, any measure of the return on assets should be treated with a
certain amount of caution.
Next, we will address the primary return on assets calculation, followed by a
variation on the concept that focuses on those assets actually being used to operate a
business.
Return on Assets
The generic return on assets measurement is designed to measure the total return
from all sources of income from all assets. The formula is:
Net income
Total assets
The measurement is certainly a simple one, but its all-encompassing nature also
means that the result may not yield the type of information needed. Consider the
following issues:
• Non-operating income. The numerator of the ratio is net income, which
includes income from all sources, some of which may not be even remotely
related to the assets of the business. For example, net income may include
one-time gains or losses from lawsuits or hedging activities, as well as inter-
est income or expense. This issue can be avoided by only using operating
income in the numerator.
• Tax rate. The net income figure is net of the company’s income tax liability.
This liability is a result of the company’s tax strategy, which may yield an
inordinately low (or high) tax rate. Also, depending on the tax strategy, the
tax rate could change markedly from year to year. Because of the effect of
tax planning, a non-operational technical issue could have a major impact on
the calculated amount of return on assets. This concern can be sidestepped
by only using before-tax information in the measurement.
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• Cash basis. The net income figure can be significantly skewed if a company
operates on the cash basis of accounting, where transactions are recorded
when cash is received or paid out. This issue can be avoided by only using
the measurement on a business that employs the accrual basis of accounting.
• Cash holdings. The total assets figure in the denominator includes all assets;
this means that a company with a significant amount of undistributed cash
reserves will reveal a lower return on assets, simply because it has not cho-
sen to employ the cash. This problem can arise not only for a successful
company with a large amount of cash earned, but also for a company that
has recently sold a large amount of stock, and has not yet employed the re-
sulting cash hoard. This issue can be avoided by subtracting cash from the
total assets figure in the measurement, or by using a cash amount considered
sufficient to support the ongoing operation of the business.
These concerns are in addition to the asset replenishment issue already noted earlier
in this section. Given these problems, we suggest an alternative measurement, which
uses operating income in the numerator and subtracts all cash from the denominator.
The formula is:
Operating income
Total assets - Cash
EXAMPLE
Bland Cabinets, a maker of mass-produced cabinets for apartment complexes, has net income
of $2,000,000, which includes a one-time lawsuit settlement cost of $500,000. The company
has assets of $11,000,000, of which $1,000,000 is excess cash that the board of directors
intends to issue to shareholders as a dividend. For the purposes of calculating Bland’s return
on assets, the lawsuit settlement cost is added back to the net income figure, while the
$1,000,000 of excess cash is subtracted from its total assets figure. The resulting calculation
is:
$2,500,000 Adjusted income

$10,000,000 Assets net of excess cash
= 25% Return on assets
Return on Operating Assets

The general version of the return on assets just noted is based on the assumption that
all of the assets recorded in a company’s balance sheet are actually being used
productively to generate income. This is extremely unlikely, as there are always
excess amounts of receivables, inventory, and fixed assets that are not needed or
should never have been acquired. For example:
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• Receivables. A company may be allowing employees to borrow cash from

the company, which are recorded as non-trade receivables. There may also
be trade receivables on the books that are unlikely to be paid, and for which
there is not a sufficient reserve in the allowance for doubtful accounts.
• Inventory. There may be a large amount of inventory on hand that is
effectively obsolete, in that it will not be used for a long time, if ever. If
there is not a reserve that offsets the amount of this obsolete inventory, the
reported inventory asset is likely too high in comparison to the profits being
generated.
• Fixed assets. Some fixed assets may have fallen into disuse, and so are no
longer involved in the generation of income. These assets are likely to be
tucked away in odd corners of the business, and are still being depreciated
down to their salvage values.
An alternative format for the return on assets measurement can be used that
sidesteps all of these issues. The return on operating assets measurement focuses
attention on only those assets used to generate a profit. This means that all
unnecessary receivables, inventory, and fixed assets are removed from the assets
listed in the denominator of the return on assets calculation, yielding the theoretical
return that could be achieved if a company were making optimal use of its assets.
The formula is:
Net income
Total assets – Assets not used to generate income
The return on operating assets figure can be extremely effective if used properly.
Management can use the resulting measurement as a target figure, and then
determine how to eliminate the excess assets that were subtracted from the
denominator. The result should be a gradual decline in the asset base of the business,
which may generate extra cash that can either be returned to investors through a
dividend or stock buyback, or used to invest in more productive assets.
EXAMPLE
The Hegemony Toy Company, maker of military games, has acquired a number of assets
through acquisitions, and may no longer need some of the assets. The president tells the
controller to develop a return on operating assets measurement, with the intent of spotting
equipment that can be disposed of. The controller assembles the following information:
Net income $500,000

Total assets listed on balance sheet 17,000,000
Excess assembly line 500,000
Excess plastic molding facility 1,500,000
Excess warehouse 750,000
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Based on this information, the controller suggests that the return on operating assets is:
$500,000 Net income

$17,000,000 Total assets - $2,750,000 Excess assets
= 3.5%
The behavior that can be engendered by use of this measurement can be troubling,
so it should be employed with caution. The following scenarios may arise:
• Gaming. Managers will realize that any assets not included in the measure-
ment will eventually be considered excess, and therefore likely to be elimi-
nated. Consequently, expect them to game the system by classifying unnec-
essary assets as necessary assets.
• Excessive asset reduction. Some assets may not be used frequently, but can
be useful if production levels spike, when they can be used as excess capaci-
ty. This is a particular issue when assets are stripped away that were being
used to maintain an even flow of goods into a bottleneck operation. The
result can be foregone profits that the terminated assets might otherwise
have generated.
• Tighter credit. Management may conclude that the accounts receivable asset
can be reduced by restricting the amount of credit granted to customers.
However, doing so may also reduce the amount of net income, since there
may be fewer resulting sales. If this situation arises, be sure to adjust the
numerator by a reasonable estimate of lost profits.
Earnings per Share

One of the classic measures of the value of a company’s shares is earnings per share
(EPS). EPS measures the amount of a company’s net income that is theoretically
available for payment to the holders of its common stock. A company with a high
EPS is capable of generating a significant dividend for investors, or it may plow the
funds back into its operations to generate more growth; in either case, a high EPS is
presumed to indicate a potentially worthwhile investment, if the market price of the
stock is acceptable to the investor.
When researching the performance of a company, EPS is likely to be the first
metric found. Despite its prevalence, EPS only yields a snippet of information about
the underlying valuation of a company. Consider the following issues:
• Accrual basis. EPS information is only reported by publicly-held compa-
nies, all of which report their financial statements using the accrual basis of
accounting. Because of the accounting rules used for the accrual basis, there
can be a significant difference between the cash flows generated and the
profits or losses reported. It is quite possible that a company might report
skyrocketing profits, and yet have no cash on hand that could be used to pay
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dividends. This issue can be avoided by focusing instead on the cash infor-
mation reported in the statement of cash flows.
• EPS orientation. Company managers can artificially bolster EPS by cutting
back on such discretionary expenditures as marketing, training, and research
and development. This excessive focus on short-term results will likely lead
to a long-term decline in the competitiveness of a business.
• Quarterly basis. A publicly-held company reports its financial results once
every three months, so the focus of EPS is only on the last three months.
Given the vagaries of many markets, it is entirely possible that a company’s
reported EPS will fluctuate over the course of a year, giving investors the
impression that earnings are unreliable. This issue can be avoided by only
focusing on annual EPS.
• Dilution. EPS information is reported by a company in two formats, one of
which is fully diluted earnings per share. Diluted EPS incorporates every
possible financial instrument issued by a company that might be convertible
into common stock. This is an extremely conservative ratio, since many
common stock equivalents are never converted into common stock. Conse-
quently, the measurement can report an unusually low EPS number that is
not indicative of the actual performance of an entity. The issue can at least
be mitigated by instead using the basic earnings per share figure, which does
not presume dilution from common stock equivalents.
Given these issues, EPS should not be the only measurement used when evaluating
an investment in a company.
To calculate earnings per share, subtract any dividend payments due to the
holders of preferred stock from net income after tax, and divide by the average
number of common shares outstanding during the measurement period. The
calculation is:
Net income after tax – Preferred stock dividends

Average number of common shares outstanding
EXAMPLE
Kelvin Corporation has net income after tax of $1,000,000 and also must pay out $200,000 in
preferred dividends. The company has both bought back and sold its own stock during the
measurement period; the weighted average number of common shares outstanding during the
period was 400,000 shares. Kelvin’s earnings per share is:
$1,000,000 Net income - $200,000 Preferred stock dividends

400,000 Common shares
=$2.00 Earnings per share
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A variation on the EPS concept is to track it on an annual trend line. If the trend is
positive, then an organization is either generating an increasing amount of earnings
(thereby improving the numerator in the ratio) or buying back its stock (thereby
improving the denominator in the ratio).
An alternative to tracking EPS on a trend line is to measure the percentage
change in earnings per share over time. This yields a quantitative examination of
EPS, rather than the more visual representation of a trend line. To calculate the
percentage change, divide the incremental change in EPS by the EPS for the
preceding reporting period. The calculation is:
Incremental change in EPS

EPS from preceding reporting period
EXAMPLE
Kelvin Corporation reported earnings per share of $2.00 in last year’s financial results, and
has reported $2.10 earnings per share in this year’s financial statements. The percentage
change in EPS is:
$2.10 Latest EPS - $2.00 Preceding EPS

$2.00 Preceding EPS
= 5% Incremental change in EPS
The use of a trend line or the percentage change in EPS calculation focuses attention
on the long-term ability of a company to create value by increasing earnings per
share. However, it also places pressure on management to do so, sometimes to the
extent that they will stretch the accounting rules to continue reporting increasing
EPS. This issue can only be spotted with an intensive review of a company’s
financial statements and accompanying disclosures, to see if management is using
more aggressive accounting techniques over time. If so, a likely result is a long
series of EPS increases, followed by a sudden and significant decline in EPS, when
management can no longer use trickery to maintain its reported results.
Dividend Performance
When an investor is inclined to buy the shares of a company that issues dividends,
this person or entity is called an income investor. An income investor values the
stock based on the ability of the issuer to reliably pay out a predictable dividend on
an ongoing basis. This type of investor is likely to use the dividend payout ratio to
determine the proportion of company income being paid out in the form of
dividends, to see if the dividends are sufficiently large, and if they can be sustained.
Investors also use the dividend yield ratio to calculate the return on their investment,
based on a comparison of dividends paid and the market price of the stock. Both
ratios are described in this section.
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Dividend performance ratios are primarily used by investors, not the companies
in which they invest. Nonetheless, the board of directors (which authorizes
dividends) should be aware of the impact of their decisions on dividends. Also, the
investor relations officer, who is the primary point of contact with the company for
investors, should also be conversant with these ratios.
Dividend Payout Ratio

Investors who want a dividend will evaluate a company based on its dividend payout
ratio. This ratio is the percentage of a company’s earnings paid out to its
shareholders in the form of dividends. There are two ways to calculate the dividend
payout ratio; each one results in the same outcome. One version is to divide total
dividends paid by net income. The calculation is:
Total dividends paid

Net income
The alternative version essentially calculates the same information, but at the
individual share level. The formula is to divide total dividend payments over the
course of a year on a per-share basis by earnings per share for the same period. The
calculation is:
Annual dividend paid per share

Earnings per share
EXAMPLE
The Conemaugh Cell Phone Company paid out $1,000,000 in dividends to its common
shareholders in the last year. In the same time period, the company earned $2,500,000 in net
income. The dividend payout ratio is:
$1,000,000 Dividends paid

$2,500,000 Net income
= 40% Dividend payout ratio
Investors interested in the long-term viability of a series of dividend payments will

likely track the dividend payout ratio on a trend line, to see if a business is
generating enough income to support its dividend payments over a number of years.
If not, they may sell off their shares, thereby driving down the stock price. If an
investor sees that the payout ratio is nearly 100% or greater than that amount, then
the current dividend level is probably not sustainable. Conversely, if the ratio is
quite low, investors will consider the risk of a dividend cutback to also be low, and
so will be more inclined to buy the stock, thereby driving up its price.
Investors may also look at the reverse of the dividend payout ratio to see how
much of earnings are being retained within a business. If the retention amount is
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declining, this indicates that the company does not see a sufficient return on
investment to be worthy of plowing additional cash back into the business. From this
perspective, a declining retention rate will drive away those growth-oriented
investors who rely on an increasing share price.
In short, investors rely on ratio analysis on a trend line to determine whether a
business is issuing an appropriate amount of dividends, and may alter their stock
holdings based on the outcome of this analysis.
From the perspective of a company that is issuing dividends, the main concern is
whether the business is capable of issuing a certain dividend amount on a sustained
basis. If cash flows have a history of being quite variable, then it will make more
sense to set a dividend that can be paid even when the company is suffering through
a low point in its business cycle. Conversely, if cash flows are quite stable, then a
higher dividend can likely be sustained over time. An additional concern is whether
there are internal uses for cash that will generate greater returns for investors over
the long term than an immediate dividend. If so, the company’s board of directors
must weigh the two alternatives and decide how the cash should be used.
Dividend Yield Ratio

The dividend yield ratio reveals the amount of dividends that a company pays to its
investors in comparison to the market price of its stock. Thus, the ratio is the return
on investment if an investor were to have bought shares at the market price on the
measurement date.
To calculate the ratio, divide the annual dividends paid per share by the market
price of the stock at the end of the measurement period. Since the stock price is
measured on a single date, and that measurement may not be representative of the
stock price over the measurement period, consider using an average stock price
instead. The calculation is:
Annual dividends paid per share

Market price of the stock
EXAMPLE
Horton Corporation pays dividends of $4.50 and $5.50 per share to its investors in the
current fiscal year. At the end of the fiscal year, the market price of its stock is $80.00, which
is a representative value for its shares over the entire year. Horton’s dividend yield ratio is:
$10 Dividends paid

$80 Share price
= 12.5% Dividend yield ratio
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When deriving and using this measurement, be aware of the following issues:
• Consistent dividend measurement. The calculation should be based only on
dividends paid, not on dividends declared but not yet paid. Otherwise, there
is a risk of double-counting, where dividends declared are included in the
measurement for one period, and then included again in the measurement
for the next period when the dividends are actually paid.
• Consistent share price measurement. If you elect to use an average market
price for the stock that spans a number of days or months, use the same av-
eraging technique for all measured periods. Otherwise, a likely result is in-
consistent measurements that reveal little about the actual yield being gener-
ated. This is a particular problem when a company’s share price is highly
variable.
Summary
The return on investment concept is based on the ability of a business to generate an
adequate return for investors over a long period of time. This return is ultimately
based on non-financial measures, such as product design skill, a monopoly situation,
excellent store locations, or a productive research and development department.
None of these items are readily apparent in any of the measurements described in
this chapter. Instead, the measurements discussed here rely upon reported financial
information or market prices, which are the best financial evidence of company
performance. Nonetheless, these ratios are a weak alternative to a more in-depth
analysis of the competitive positioning and future prospects of a business, which
requires a great deal of investigative work. Only by engaging in this advanced level
of examination is it possible to develop a comprehensive view of the likely return on
investment of a business. Company managers should also attend more to the
fundamentals of a business, rather than using financial engineering to give the
appearance of improved performance to investors.
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Chapter 6
Share Performance Measurements
Introduction
A key concern of the investment community is whether to invest in the shares of a
company, which involves multiple types of analysis. Investors are also interested in
leading indicators of possible changes in the value of their shares, which they can
use to decide whether to sell or hold the shares. In this chapter, we address a number
of measurements that can assist in the investment decision, as well as other measures
that can provide clues regarding future share prices.
Overview of Share Performance Measurements

The decision to invest in a company is based on a wide array of factors,
encompassing the measurements in many chapters of this book that can be used to
interpret the operating and financial condition of an entity. In addition, an investor
must evaluate the price of a company’s stock, and whether that price fairly reflects
the earnings power of the business.
In this chapter, we address several measurements that can be used to evaluate
the price at which a share is currently selling. The price/earnings ratio compares the
price of the stock to the most recently reported earnings of a business, while the
capitalization rate derives the implied rate of return on share holdings. We also
review the concept of total shareholder return, which compiles the total return for
shareholders, based on dividends received and changes in the price of the stock.
We also look at the market value added concept, which calculates the difference
between the market value of a business (i.e., the extended price at which all of its
shares are currently selling) and the book value of invested capital. This measure
provides a clue to the ability of management to generate value. A less-relevant
(though common) measurement is the market to book ratio, which compares the
market value of a business to its book value; the trouble is that book value is an
accounting measure that may have little relevance when deriving the underlying
value of a business.
We then turn to the prediction of the direction of a company’s future stock price.
One approach is the insider buy/sell ratio, under which the buying and selling
activities of corporate insiders can be used to guesstimate whether insiders believe
the current share price is too high or low. Another indicative measure is the options
and warrants to common stock ratio; this ratio can be used to predict how many
stock options and warrants may be converted to stock, which can in turn lead to a
decline in the price of the stock, since more shares now have a claim on the residual
value of a business. Yet another indicative measure is the short interest ratio, which
quantifies the amount of interest by short sellers in a company’s stock. Since short
sellers usually conduct a large amount of investigation into the financial statements
of a business, it is possible that a spike in short interest indicates problems that will
lead to a stock price decline.
We conclude with the institutional holdings ratio, which measures the amount of
a company’s shares held by institutional investors in relation to the amount of
trading volume. The outcome of this measurement is neither good nor bad; it merely
reflects how large blocks of stock holdings can impact a variety of issues related to a
business.
Price/Earnings Ratio
The price/earnings ratio is the price currently paid on the open market for a share of
a company’s stock, divided by its earnings per share. The ratio reveals the multiple
of earnings that the investment community is willing to pay to own the stock. A very
high multiple indicates that investors believe the company’s earnings will improve
dramatically, while a low multiple indicates the reverse. If the ratio is already high,
there is little chance for the stock price to climb even higher, so there is significant
risk that the share price will slide lower in the future.
The investment community usually forces a stock price upward based on future
expectations for such issues as new patents, new products, favorable changes in the
laws impacting a company, and so forth.
To calculate the price/earnings ratio, divide the current market price per share by
fully diluted earnings per share. The formula is:
Current market price per share

Fully diluted earnings per share
It is also possible to derive the ratio by dividing the total current company
capitalization by net after-tax earnings. In this case, the formula is:
Current company market capitalization

Net after-tax earnings
Yet another variation is to build an expected price earnings ratio by dividing future
earnings expectations per share into the current market price. This is not a firm
indicator of where the ratio will actually be in the future, but is a good basis for
deciding whether the stock is undervalued or overvalued.
There are several issues with the price/earnings ratio to be aware of. Consider
the following problems:
• Manipulation. Earnings information can be manipulated by accelerating or
deferring expense recognition, as well as through a variety of revenue
recognition schemes. A more accurate measure of the value that the invest-
ment community is placing on a company’s stock is the price to cash flow
ratio. Cash flow is a good indicator of the results of operations.
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• Industry-wide effects. Changes in the ratio tend to impact every company in

an industry at the same time, because they are all subject to the same market
forces, with slight differences between the various companies. Thus, a fa-
vorable change in the ratio may not be cause for excessive jubilation for a
job well done, since the change may not be traceable to a company’s per-
formance at all, but rather to changes in its business environment.
• Timing. The price of a company stock may fluctuate wildly in the short
term, as such factors as takeover rumors and large customer orders excite
investors and impact the price. Consequently, the ratio can be dramatically
different if the timing of the measurement varies by just a few days.
EXAMPLE
The common stock of the Cupertino Beanery is currently selling for $15 per share on the
open market. The company reported $3.00 of fully diluted earnings per share in its last
annual report. Therefore, its price/earnings ratio is:
$15 Market price per share

$3 Earnings per share
= 5:1 Price/earnings ratio
Capitalization Rate
It can be useful to derive the rate of return that investors expect on a company’s
stock, based on its current market price and the associated price/earnings ratio. We
do this by simply reversing the price/earnings ratio, so that fully diluted earnings per
share are divided by the current market price per share. The formula is:
Fully diluted earnings per share

Current market price per share
Since it contains the same information used for the price/earnings ratio noted in the
last section, the capitalization rate should be considered to suffer from the same
issues. Therefore, allow for possible manipulation of reported earnings, effects
impacting the entire industry, and short-term variations in the price of the stock
being examined.
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EXAMPLE
A major institutional investor is interested in purchasing the shares of Atlas Machining

Company, which has seen a major decline in its share price over the past year, due to
concerns about its facilities in a country where there is a major ongoing insurgency. Despite
the insurgency, Atlas has continued to report robust earnings of $3.50 per share in each of the
last two years. The investor’s target rate of return on its investments is 15%. The
capitalization rate for Atlas for the past two years is as follows:
Last Year Current Date

Earnings per share $3.50 $3.50
Market price per share $43.75 $21.88
Capitalization rate 8% 16%
The rapid drop in stock price has doubled the capitalization rate of Atlas over the past year,
which makes this a reasonable investment opportunity that exceeds the investor’s target rate
of return.
Total Shareholder Return

When an investor buys the shares of a company, the return generated by the
purchase will be derived from a combination of the change in the share price over
the measurement period, plus any dividends paid by the company in the interim. The
formula (on an annual basis) is:
Ending stock price – Beginning stock price

+ Sum of all dividends received during the measurement period
= Total shareholder return
The total return can then be divided by the initial purchase to arrive at a total
shareholder return percentage.
This measurement can be skewed if a shareholder has control over a business. If
this is the case and the company is sold, then the shareholder will likely be paid a
control premium in exchange for giving up control over the entity.
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EXAMPLE
An investor purchases shares of Albatross Flight Systems for $15.00 per share. One year
later, the market value of the shares is $17.00, and the investor has received several
dividends totaling $1.50. Based on this information, the total shareholder return is:
$17.00 Ending stock price – $15.00 Beginning stock price

+ $1.50 Dividends received
= $3.50 Total shareholder return
Based on the initial $15.00 purchase price, this represents a 23.3% total shareholder return.
Market Value Added

The market value added concept derives the difference between the market value of
a business and its cost of invested capital. When market value is less than the cost of
invested capital, this implies that management has not done a good job of creating
value with the equity made available to it by investors. To derive market value
added, follow these steps:
1. Multiply the total of all common shares outstanding by their market price.
2. Multiply the total of all preferred shares outstanding by their market price.
3. Combine these totals.
4. Subtract the amount of capital invested in the business.
The formula is:
(Number of common shares outstanding × Share price)

+ (Number of preferred shares outstanding × Share price)
- Book value of invested capital
= Market value added
This measurement should only be used if a company’s stock is robustly traded on an

established stock exchange. Otherwise, a few occasional trades could trigger
substantial changes in the market price of the stock. It may be possible to derive the
market value of shares by engaging an appraiser to provide an estimate.
Also, be aware that the current stock price may be based on changes in investor
confidence in the market or industry as a whole, and do not relate to the performance
(or lack thereof) of management in running a business.
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EXAMPLE
The investor relations officer of Cud Farms is preparing a press release that reveals the
increase in market value added since the new management team was hired. The analysis is
based on the following information:
Prior Year Current Year

Number of common shares outstanding 5,000,000 5,700,000
Common stock price $4.00 $4.20
Number of preferred shares outstanding 400,000 375,000
Preferred share price $11.00 $11.30
Book value of invested capital $18,000,000 $20,625,000
The market value added for the prior year is calculated as follows:
(5,000,000 Common shares × $4.00 price)

+ (400,000 Preferred shares × $11.00 price)
- $18,000,000 Equity book value
= $6,400,000 Market value added
The market value added for the current year is calculated as follows:
(5,700,000 Common shares × $4.20 price)

+ (375,000 Preferred shares × $11.30 price)
- $20,625,000 Equity book value
= $7,552,500 Market value added
Based on this analysis, the investor relations officer can highlight an increase of $1,152,500
in market value added since the new management team was hired.
Market to Book Ratio

A common measure of the value of a company’s shares is the market to book ratio,
which compares the market price of a company’ stock to its book value per share. If
the market price is well above the book value, this is said to be an indicator of the
additional value that the investment community is placing on the ability of a
company to earn a profit.
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To calculate the market to book ratio, divide the ending price of the company’s
stock by the book value per share on the same date. The formula is:
Ending market price of stock

Book value per share
There are numerous problems with this measurement that limit its practical use.
Consider the following issues:
• The comparison is of the market value of a business to the historical costs at
which assets were recorded. There is no realistic reason why an asset base of
any particular size should relate to a particular multiple of market price.
• Accounting standards mandate that some quite valuable intangible assets
may not be recorded in the accounting records. In businesses where intangi-
bles are the chief competitive advantage, this means that the market to book
ratio will be inordinately high.
• Accounting standards mandate the use of accruals, reserves, and deprecia-
tion that can artificially alter the value of assets, irrespective of their real
market value.
• The market price of the stock used in the numerator is as of a specific point
in time, which may not closely relate to the average price of the stock in the
recent past.
EXAMPLE
An analyst is reviewing the share performance of Failsafe Containment, which manufactures

reactor vessels. The current market price of the company’s stock is $20.00, and the book
value per share is also $20.00, resulting in a market to book ratio of 1:1. However, further
investigation reveals that the company has substantial real estate holdings, for which the
recorded book value is substantially lower than their likely resale prices. Consequently, the
analyst assigns a buy rating to the company’s stock, which also attracts the attention of
several corporate raiders that subsequently purchase the company and sell off the real estate
for significant gains.
Insider Buy/Sell Ratio

In a publicly-held company, a large number of shares are typically held by corporate
insiders. These insiders have the best access to information about the current and
prospective performance of the business, and so are much more likely to sell their
holdings when they believe the market price of the stock is likely peaking. Since
these transactions must be reported to the Securities and Exchange Commission
(SEC) and are therefore public knowledge, it is not especially difficult for an outside
investor to obtain and analyze stock transactions by insiders. The logic followed by
an analyst is that a high proportion of insider sales of company stock to insider
purchases of stock is indicative of an insider belief that the stock price will go no
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higher. This information can be used by an investor to decide when to alter holdings
of a company’s stock.
To calculate the insider buy/sell ratio, aggregate the number of insider purchases
of company stock over the measurement period, and divide by the aggregate amount
of insider sales of company stock over the same period. The formula is:
Aggregate insider stock purchases

Aggregate insider stock sales
A ratio of less than one indicates that insiders believe that the price of the stock is
peaking, while a ratio of greater than one indicates the reverse.
This is not an easy ratio to interpret, for corporate insiders may have excellent
reasons for purchasing and selling company stock that have nothing to do with their
perceptions of the company’s prospects. Consider the following situations:
• A company recently went public, and many employees holding shares must
wait six months before they are allowed to sell their shares. They will un-
doubtedly do so in six months.
• A newly-hired CEO is required to purchase $1 million of company shares as
a condition of her employment.
• A CFO wants to purchase a new house, and sells enough shares to cover the
purchase price of the home.
• Employees have such lucrative stock options pending that it would be
foolish not to buy shares, irrespective of the future direction of the compa-
ny’s performance.
If the ratio is to be used as a valid indicator of the future direction in which the price
of a stock may turn, consider the following situations that may be most applicable:
• There is a broad sell-off or purchasing pattern among multiple employees.
• Employees are incurring debt in order to buy shares.
• Employees in the accounting department, who presumably have the best
understanding of company performance, are showing a decided buying or
selling trend.
EXAMPLE
Six months have passed since Armadillo Industries went public. During the past week,
Armadillo employees have finally had their shares registered, and have been actively
liquidating their holdings in the company. An outside analyst reviews the following
information to see if there is a discernible trend in insider activity:
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Transaction Number of Transaction

Employee Title Type Shares Date
Engineering manager Sell 300,000 November 3
Marketing director Sell 185,000 November 3
Chief financial officer Buy 25,000 November 4
Chief information officer Sell 160,000 November 4
Production manager Sell 325,000 November 5
Chief executive officer Buy 15,000 November 6
Controller Buy 5,000 November 6
The information in the table results in an overwhelmingly negative insider buy/sell ratio of
0.046. However, the analyst also notes that every one of the stock sale transactions involved
a mid-level manager who might have simply been cashing in for the first time. All of the
managers most closely associated with the company’s finances are quietly buying up small
blocks of shares. Based on his analysis of the information, and despite the outcome of the
ratio, the analyst believes that the company will report above-average results when its next
quarterly results are released.
Options and Warrants to Common Stock Ratio

A company may elect to pay third parties with warrants for various services, and
compensate its employees with stock options. If the business does so extensively,
this can create an inordinately large pool of options and warrants that could be
converted to common stock in the near future, resulting in significantly reduced
earnings per share, and therefore a possible reduction in the stock price. Because of
this dilutive effect, outside analysts like to monitor the amount of outstanding
options and warrants.
An analyst will not consider all options and warrants to be convertible into
common stock. Instead, they will focus on just those instruments that are currently
“in the money,” which means that the designated exercise price is below the current
market price of a company’s common stock. In this case, someone could (for
example) exercise a stock option at a designated price of $5.00 and immediately
earn a profit of $1.00 if the market price is $6.00. Conversely, if the market price
were $5.00 or less, no option or warrant holder would find it profitable to purchase
common stock with their instruments, and so would let them expire unused.
Given the importance of being in the money, an analyst is only interested in
these options and warrants, which may be far fewer than the total pool of options
and warrants outstanding. Consequently, the calculation of options and warrants to
common stock is to divide the grand total of in the money stock options and
warrants by the total number of common shares currently outstanding. The formula
is:
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Stock options in the money + Warrants in the money

Total common shares outstanding
The measurement could be further refined to exclude those stock options that have
not yet vested, since the holders of these options cannot yet exercise the options.
It may be useful to re-measure this ratio based on a modest prospective increase
in the company’s market price, rather than the current price. Doing so may
significantly boost the number of shares beyond the level indicated by the initial
measurement. This can warn outside investors that a run-up in the stock price could
result in a large block of additional shares being issued.
EXAMPLE
Creekside Industrial has recently gone public through an initial public offering. An analyst is
reviewing the information submitted by Creekside to the Securities and Exchange
Commission to ascertain the extent to which existing stock options and warrants may trigger
the issuance of additional shares in the near future, thereby watering down the price of
Creekside’s stock. The analyst finds the following information:
Common shares outstanding 50,000,000

Warrants in the money 1,000,000
Options in the money and vested 3,500,000
Options in the money and vesting in one year 750,000
Options in the money if price rises 20% 2,750,000
Options in the money if price rises 20%, and vesting in one year 10,000,000
The analyst converts this information into a series of ratios that compare the options and
warrants under various circumstances to common stock, which is noted in the following
table:
[cumulative] In the Money In the Money

In the Vesting in with 20% Price with 20% Increase
(000s) Money Now One Year Increase & Vesting in 1 Year
Options and warrants 4,500 5,250 8,000 18,000
Number of common shares 50,000 50,000 50,000 50,000
Ratio 9% 11% 16% 36%
The analyst notes that the amount of stock outstanding is likely to increase to a modest extent
in the near future and in one year, but that the real risk is associated with a 20% increase in
the price of Creekside’s stock. If that happens, an additional 18,000,000 stock options will be
in the money, which could result in a cumulative total of 36% of the existing balance of
shares being issued. The analyst concludes that any run-ups in the price of Creekside stock
should be closely monitored.
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Short Interest Ratio

Short sellers profit from declines in the price of a company’s stock. They do so by
examining the financial statements and prospects of a company in great detail; if
they find a business whose prospects appear poor, or which seems to be inflating its
financial results, then they target this entity for short selling. Short selling involves
the sale of borrowed stock, which a short seller expects to buy later on the open
market at a lower price, earning a profit on the decline in price.
It can be useful to track the interest of short sellers in a company’s stock, since
this can presage an abrupt decline in the price of that stock, especially once the short
sellers begin to publicize their findings in an effort to create bearish sentiments
about the stock. The easiest way to track short seller interest is through the short
interest ratio. To calculate it, obtain the aggregate amount of short interest (which is
available from several websites) and divide by the average daily trading volume for
the stock. Short interest is the number of shares that investors have sold short, and
which they have not yet closed out. The formula is:
Short interest
Average daily trading volume
The outcome of this analysis is the number of days that it would take short sellers to
cover their positions in the company’s stock, which they would likely have to do if
the price of the company’s shares starts to rise (since an increase in price generates
losses for a short seller).
There are several analyses that can be derived from the short interest ratio.
Consider the following situations:
• A prolonged and significant short interest ratio reveals a great deal of
downward pressure on a stock by short sellers; however,
• When the ratio exceeds 2:1, short sellers will likely need to start buying
shares in order to cover their positions, which can create a short-term spike
in the stock price.
• Also, the ratio can be applied to entire industries, to see if short sellers are
bearish on the fundamentals of an industry. If so, this is a strong indicator
that stock prices will be flat or fall across the sector.
Institutional Holdings Ratio

The investors in a publicly-held company are typically comprised of a small number
of institutional investors, such as pension funds, and a large number of retail
investors (i.e., individuals). It is generally considered good to have a large
proportion of institutional shareholders, for the following reasons:
• They indicate that a sophisticated investor is willing to buy into the compa-
ny
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• The investor relations department can more easily sell shares in large blocks
to a small number of these investors
• The investor relations staff can more efficiently concentrate its publicity
efforts on a small group of shareholders
However, institutional investors are not always a benefit to a company, for the
following reasons:
• They can cause a major decline in a company’s stock price if they decide to
sell off their holdings over a short period of time
• They can use the voting power conveyed by their share holdings to pressure
management to take certain actions, such as issuing dividends
• Their holdings can represent such a large part of the total pool of stock that
the number of shares readily available for trading is relatively small
In short, there is no optimum level of institutional holdings to target. Instead, be

aware of long-term trends in the activity ratio, and how this activity may impact the
company’s position in the public markets.
To calculate the institutional holdings ratio, divide the total trading volume by
the period-end holdings of institutional investors. The measurement period is three
months, since the holdings information comes from the Form 13F filings that
institutional investors must file on a quarterly basis. The formula is:
Total trading volume

Institutional investor stockholdings
EXAMPLE
The Excalibur Shaving Company recently went public, selling a massive number of its shares
to a small group of institutional investors. The trouble is that there are so few remaining
shares that retail investors are complaining of an inability to trade their shares. Accordingly,
the investor relations department contacts several institutional investors to see if they will
part with some of their holdings. The results appear in the following table:
One Month Six Months

After IPO After IPO
Total trading volume 2,500,000 10,000,000
Institutional investor stockholdings 50,000,000 30,000,000
Institutional holdings ratio 5% 33%
The table reveals that the investor relations department has succeeded in convincing some of
the institutional investors to part with their shares, since the total holdings of this group have
markedly declined. The change has resulted in a significant benefit, as activity in the
company’s stock has quadrupled.
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Summary
The measurements addressed earliest in this chapter, such as the price/earnings ratio,
can certainly give an investor a general feel for whether the shares of a company are
over or undervalued. However, the decision to invest in a company should not be
based on just the measurements noted in this chapter. Instead, a comprehensive
review of both the financial and operational condition of a business should be
conducted, as well as of the industry in which it operates, to arrive at a complete set
of information that can be used as the basis for an investment decision.
We also attempted to make it clear that the measures used to indicate the future
value of shares are highly interpretive. The inputs to these measurements should be
closely examined before relying upon the measurements themselves. Also, these
leading indicators are no match for a detailed and ongoing review of a business, so
that all factors impinging on the ability of an organization to provide shareholder
value are fully understood.
There is some cross-over between the topic of this chapter and the measure-
ments provided in other chapters. Book value per share and earnings per share are
both included in the Return on Investment chapter.
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Chapter 7
Growth Measurements
Introduction
One of the primary indicators of the value of a business is the rate at which it is
growing. An investor is much more willing to pay a high price for a company’s
shares when there are strong indications of rapidly-increasing sales and profits. In
this chapter, we focus on different ways to measure growth, taking into account such
issues as inflation, the number of customers, and the results of core operations.
Overview of Growth Measurements

The most common indicators of the viability of a business are its reported sales and
profits, and in particular the growth of these two figures over time. However, growth
figures are subject to a certain amount of interpretation, sometimes resulting in
reported figures that are misleading, if not downright fraudulent. In this chapter, we
employ several concepts to yield more accurate views of growth. These concepts
are:
• Consistency. Both sales and profits are subject to spikes and drops, especial-
ly when management focuses too much on the pursuit of a small number of
large sale transactions. Tracking the consistency of sales and profits over
time can put a spotlight on high levels of variability.
• Core results. A company may be involved in a variety of extraneous
activities that either add to or detract from its results. We suggest stripping
away these activities, and focusing instead on the results of only the core
activities of a business.
• Deflation. The use of an inflation index can be employed to reduce the
reported amount of sales, which is useful in a highly inflationary economy
where prices must be continually raised to keep pace with inflation.
We also describe the affordable growth rate, which is the concept that a certain
amount of assets are required to generate sales, and which therefore can be used to
estimate the maximum rate of growth that a business can attain. While asset usage
levels can be altered over time, thereby altering the ratio, we believe the underlying
affordable growth rate concept to be sound, and recommend its use.
Sales Growth
Growth in sales is among the most highly-touted metrics of a business. Because of
its popularity, sales growth is also subject to a certain amount of inflation. In this
section, we propose several measures that can drill down to the underlying ability of
Growth Measurements
an organization to generate sales. One concept is deflated sales growth, which is

particularly useful in a high-inflation environment. Another option is sales growth
consistency, where the focus is on the avoidance of sharp spikes and drops in sales
over time. Yet another possibility is core sales growth, where the emphasis is on the
ability of an entity’s key operations to generate sales.
Deflated Sales Growth

In an inflationary environment, it is relatively easy for a company to report
continually increasing sales, for it can routinely ratchet up its prices. It is possible to
factor out this inflationary increase by deflating the reported sales level by the
amount of the consumer price index, or some similar measure of inflation. To
calculate deflated sales growth, follow these steps:
1. Determine which inflation index to use for the deflation calculation. The
consumer price index is most commonly used.
2. Divide the price index for the preceding year by the price index for this year,
and multiply the result by the net sales of the business for the current year.
This yields the deflated sales for the current year.
3. Subtract the net sales for the preceding year from the deflated sales for the
current year, and divide by the net sales for the preceding year.
The main issue with the measurement of deflated sales growth is to apply the same
type of inflation index to the measurement from year to year, so that ongoing
measurements are comparable.
EXAMPLE
Viking Fitness has opened a chain of health clubs in a country that is experiencing a high rate
of inflation. In the preceding year, the country had a consumer price index of 132. In the
current year, the index increased to 158. In the preceding year, Viking reported sales of
58,000,000 pesos. In the current year, the company reported sales of 73,000,000 pesos, with
no additional health clubs having been opened. Based on this information, Viking’s deflated
sales growth is:
(73,000,000 Pesos × (132 CPI ÷ 158 CPI)) – 58,000,000 Pesos

58,000,000 Pesos
= 5.2% Deflated sales growth
Thus, despite the high inflation rate, the company did indeed succeed in increasing its same-
location sales by 5.2% during the current year.
Sales Growth Consistency

A sign of careful management is when sales grow at a consistent rate. This is
indicative of a measured roll-out of new products, geographical sales regions, stores,
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Growth Measurements
and so forth. Sales growth consistency gives some indication of the ability of a
business to continue growing at a reasonable pace into the future. The reverse
situation, where sales continually spike and then crater, is indicative of a more
opportunistic environment where management pursues a small number of large sales
transactions that may not be repeatable in the future.
To measure sales growth consistency, aggregate the number of consecutive
reporting periods over which net sales have exceeded the net sales from the prior
period.
It is easier to report a high level of sales growth consistency if the measurement
is tracked over longer reporting periods. For example, measuring consistency on an
annual basis eliminates the impact of an occasional month during the year when
sales might decline, which is particularly important if sales are seasonal. A common
measurement interval for publicly-held companies is to report sales growth
consistency on a quarterly basis, which matches the frequency with which these
companies must report their financial results to the public.
An issue to be aware of is that a company might use an allowance for sales
returns and accrue estimated sales returns that have not yet occurred. If this
allowance were to be manipulated, it is possible to create an ongoing series of net
sales increases, thereby allowing for the false reporting of a lengthy period of sales
growth consistency. For example, a company could create a large sales return
reserve in a month when gross sales are high, and cut back on the reserve in periods
when gross sales are low; doing so has the net effect of creating artificially smooth
sales growth.
EXAMPLE
The new president of Medusa Medical is devising an investor relations packet that highlights
the company’s ability to grow its sales in the crucial snake oil therapy market. The company
routinely experiences large amounts of customer returns, based on their perceptions of the
outcome of snake oil therapy, so net sales tend to be quite different from gross sales. Over
the past six quarters, the company’s net sales calculation has been:
Gross Sales Net

Sales Returns Sales
Quarter 1 $1,500,000 $275,000 $1,225,000
Quarter 2 1,600,000 240,000 1,360,000
Quarter 3 1,650,000 200,000 1,450,000
Quarter 4 2,000,000 570,000 1,430,000
Quarter 5 2,150,000 190,000 1,960,000
Quarter 6 2,190,000 205,000 1,985,000
Despite the ongoing increases in gross sales, the large amount of sales returns creates a
decline in net sales in the fourth quarter. Accordingly, the president can only report sales
growth consistency for the past two quarters.
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Growth Measurements
Core Sales Growth

A large part of the sales increases reported by a business may be related to a variety
of changes outside of the core operations of the organization. Examples of these
changes are:
• Sales from acquired entities
• Sales due to changes in accounting standards
• Product price increases
Once these additional factors have been subtracted from the “additional” sales
reported by a business, it is entirely possible that the underlying entity’s sales have
actually declined. The formula is:
(Change in sales from preceding year – Sales from acquired entities – Revenue recognition
changes – Product price increases) ÷ Sales in preceding year
This can be quite an illuminating measurement, since even management may have
no idea that core sales growth is actually negative.
The main issue with the measurement is how long to continue excluding the
various factors from the sales growth calculation. For example, the operations of an
acquired entity may be fully integrated into the core operations of a business, at
which point its revenues can also be considered part of core sales.
EXAMPLE
The senior management team of Pianoforte International has been boasting to investors that
the company has achieved a massive 25% increase in sales during the past year, attaining a
total of $18,750,000 in sales from the previous year’s results of $15,000,000. At the
beginning of the year, the company enforced a 5% price increase. There was also a one-time
increase in revenue of $1,000,000 related to a change in revenue recognition policy. Finally,
the company acquired a competitor, which added $3,000,000 in sales. Based on this
information, the core sales growth of the company was:
($3,750,000 Change in sales - $3,000,000 Acquired revenue - $1,000,000 Recognition change -

$750,000 Price increase) ÷ $15,000,000 Sales in preceding year
= -6.7% Core sales growth
Thus, the company actually experienced a decline in its core sales growth during the year,
which was only evident once all the extraneous factors were eliminated from the total sales
figure.
Customer Growth
If a company is to increase its sales over time, it will likely be mandatory to do so by
increasing the number of customers. While it is possible to increase total revenue by
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Growth Measurements
increasing the volume of sales transactions with existing customers, this approach
cannot be followed forever. Instead, management must focus on the continuing
search for new customers. To measure customer growth, follow these steps:
1. Establish a minimum sales threshold, below which minor customers are
ignored for the purposes of this calculation.
2. Aggregate the number of customers with which the company has had sales
above the threshold level for the measurement period.
3. Aggregate the number of customers having had sales above the threshold
level for the preceding period.
4. Subtract the number of customers above the threshold from the preceding
period from the number of customers above the threshold for the current
period, and divide by the number of customers above the threshold from the
preceding period.
The calculation is:
(Number of customers above threshold in current period – Number of customers above

threshold in preceding period) ÷ Number of customers above threshold in preceding period
While useful, this measurement does not focus any attention on the profitability of
customers. Thus, a company could go to great lengths to acquire certain customers,
only to find that the incremental profit associated with these new customers is
inconsequential or even negative. To monitor profitability, use profits above a
predetermined threshold in the preceding formula, rather than sales.
EXAMPLE
Lethal Sushi is a chain of sushi restaurants that only sell exotic fish, some of which are
poisonous. Lethal has a frequent customer program, and has found that these repeat
customers generate the bulk of its business. However, given the nature of the food being
served, the company has to keep locating new customers as its existing customer base dies
off. In the most recent quarter, the marketing director initiated a new campaign to attract
customers (“Want to take a chance?”). As a result, the number of people in the frequent
customer program rose from 920 to 990. This results in a customer growth rate for the
quarter of 7.6% (calculated as 70 new customers, divided by the preceding customer base of
920).
Expense Growth
Management should be extremely cognizant of any changes in expense levels over
time, and promptly investigate the reason for any upward spikes. One tool for
identifying these spikes is to measure expense growth. This can be done in aggregate
for all expenses, but the result provides little actionable information. Instead,
consider measuring expense growth for individual expense line items in the income
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Growth Measurements
statement. To calculate expense growth, subtract the prior period’s expense from the
current period’s expense, and divide by the prior period’s expense. The formula is:
Current period expense – Prior period expense

Prior period expense
This measurement works particularly well when tracked on a trend line over a
number of reporting periods. By doing so, it is easier to spot situations where
expenses are recorded twice in one period and not at all in another. This is a useful
tool for spotting anomalies in expenses as part of the period-end closing process.
The main issue with the expense growth measurement is that it converts
monetary changes into percentage changes, so that the user cannot see the size of
any monetary changes over time. For example, compensation expense (typically a
large line item) may increase by only a few percentage points, but the increase may
represent a large monetary increase. Thus, a 1% increase in a baseline compensation
expense of $10,000,000 is a $100,000 increase.
EXAMPLE
Henderson Industrial is in a flat growth industry, and so must maintain tight control over its
costs in order to generate a profit. Accordingly, the key measurement followed by the
management team is an expense growth trend line, stated as the percentage change in
expense from period to period. The following table provides a sample of the expense growth
trend line.
Quarter 1 Quarter 2 Quarter 3 Quarter 4

Compensation 1% 1% 4% 1%
Depreciation 0% 0% 0% 10%
Maintenance -3% 0% 8% -3%
Travel 4% -3% 5% 14%
Utilities 0% 20% 0% -18%
The table reveals that several people were hired in the third quarter, thereby increasing the
compensation expense. Also, new equipment was purchased in the fourth quarter, resulting
in an increase in depreciation expense. The capital purchase was triggered by a large increase
in maintenance expense in the third quarter, when a machine broke down. Travel costs
increased because of the new hires in the third quarter. Finally, the company is located in a
warm climate, so utility costs routinely increase during the summer months.
Profit Growth
A business is quite likely to trumpet high profit levels to its investors and the general
public. However, profits tend to fluctuate a great deal over time, since they are
impacted by swings in sales and expenses. In this section, we use the profit growth
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Growth Measurements
and profit growth consistency measurements to obtain a better understanding of the

scale and long-term viability of the profits being reported.
Profit Growth
A company can have excellent sales growth, but unless that growth is combined
with solid gross profit margins and expense controls, there may be no net profits. To
monitor this most important area of the income statement, management should track
profit growth over many periods.
To measure profit growth, subtract the net profits for the preceding period from
net profits for the current period, and divide by net profits for the preceding period.
The formula is:
Net profits for current period – Net profits for preceding period
Net profits for preceding period
There are several variations on this measurement. Consider running it for operating
income, in order to focus on just the results of the core operations of the business.
Another approach is to calculate the growth in before-tax income, which strips away
any variability in income caused by tax planning.
In order to report more consistent profit growth, it helps to use a relatively broad
measurement period, such as a quarter or year. Achieving consistent period-over-
period growth on a monthly basis is quite difficult.
EXAMPLE
Nautilus Tours just spent $5,000,000 to purchase a submarine, with which it plans to take
tourists to visit local marine reefs. Given the large expenditure, the owner of Nautilus wants
to ensure that there is continual profit growth; otherwise, he will sell off the submarine to cut
his losses.
In first two quarters since Nautilus acquired the new submarine, the company had profits of
$50,000 and $32,000, respectively. This is negative profit growth of 36%, which is caused by
an unusually high level of maintenance on the submarine. Given the negative trend, the
owner promptly sells the submarine.
Profit Growth Consistency

It is quite difficult to achieve an ongoing increase in profits over time, since doing so
requires the coordination of gradual increases in the customer base, new product
rollouts, and tight expense control. Profit growth consistency is even more important
than sales growth consistency, since it showcases the ability to manage all aspects of
a business.
To measure profit growth consistency, aggregate the number of consecutive
reporting periods over which net profits have exceeded the net profits from the prior
period.
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Growth Measurements
As was the case for the sales growth consistency measurement, it is easier to
report a high level of profit growth consistency if the measurement is tracked over
longer reporting periods, thereby avoiding seasonal profit declines. For this reason,
the minimum comparison period that should be used is a quarterly period.
Unfortunately, there are many ways in which profit growth consistency can be
fraudulently achieved. For example, the recognition of certain expenses could be
delayed, or revenue recognition policies could be altered. Also, it is possible to delay
expenditures on such discretionary expenses as employee training and advertising.
In short, organizations can go to great lengths to report profit growth consistency,
which may not reflect the true profitability of the entity.
EXAMPLE
The president of Logger Construction Company is determined to report profit growth

consistency from year to year, no matter what actions must be taken. There has been
consistent profit growth for the past four years. However, the initial indication of profits for
the current year shows a decline of $150,000 from the preceding year’s profits of $1,300,000.
To boost reported earnings, the president requires the controller to alter the percentage of
completion reported for several construction projects, resulting in a “revised” profit figure of
$1,400,000, and therefore a fifth consecutive year of profit growth consistency.
During the annual audit, the auditors uncover the percentage of completion changes, and
report their findings to the company’s audit committee. The board of directors promptly fires
the president.
Affordable Growth Rate

The central issue for many companies is the correct rate at which a business should
grow, since growing too fast can strain the financial resources of an organization.
This rate of growth can be estimated by assuming that a certain proportion of assets
to sales must be maintained in order to fund future growth. The assumption is valid
in most cases, since a certain amount of receivables, inventory, and fixed assets are
required for each dollar of revenue generated. To calculate the affordable growth
rate, follow these steps:
1. Subtract dividends paid from the amount of net profits reported for the year.
The result should be an approximation of the cash generated by the business,
and which is still available to fund future growth.
2. Divide this amount by stockholders’ equity for the preceding year that was
derived from tangible assets. In other words, aggregate all tangible assets
listed on the balance sheet and subtract all liabilities to arrive at tangible
stockholders’ equity. Intangible assets are excluded from the measurement,
since these assets can be artificially manufactured through acquisitions.
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Growth Measurements
The formula for the affordable growth rate is:
Net profits – Dividends

Tangible stockholders’ equity in preceding year
The affordable growth rate is a useful metric, but must be considered in relation to
several issues that could potentially vary over time, yielding different results. These
issues are:
• Asset usage. A company may alter its business practices to reduce the
amount of assets needed to support a given amount of sales. For example,
production could be outsourced, thereby reducing the need for fixed assets.
Similarly, a just-in-time production system could reduce the need for a large
investment in inventory.
• Borrowings. The measurement assumes that lenders will continue to offer
debt to the company in roughly the same proportion of debt to assets that
they did in the past, which provides cash for growth. This assumption may
be incorrect, based on the general availability of credit and the perceived
ability of the company to support a certain debt load.
• Cash flows. Net profits are assumed to equate to cash flows, which may not
be the case. The use of accrual-basis accounting may result in reported net
profits that are significantly different from cash flows.
• Dividends. Dividends may be issued in the form of stock, which does not
represent a cash outflow.
• Equity. The owners of the company may be willing to increase stockholders’
equity by selling shares to additional investors, which gives the company a
large amount of cash to use as the basis for a growth spurt.
Despite the issues noted here, the affordable growth rate is a reasonable tool for
estimating the proper long-term rate of growth of a business.
EXAMPLE
The management team of Snyder Corporation is under pressure from the investment
community to expand its sales in the coming year. To educate investors about the company’s
proper growth rate, the investor relations officer decides to formulate the affordable growth
rate. Snyder’s net profits for the current year were $12,000,000, dividends issued were
$4,000,000, and the company’s tangible net worth in the preceding year was $80,000,000.
Based on this information, the company’s affordable growth rate is:
$12,000,000 Net profit - $4,000,000 Dividends

$80,000,000 Tangible net worth in preceding year
= 10% affordable rate of growth
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Growth Measurements
Summary
If any concept is to be gained from this chapter, it is to use trend line analysis for
sales, expenses, and profits. By doing so, the reader can easily discern patterns in the
ability of a business to generate adequate returns over the long term, and trace the
causes of these returns to specific line items in the income statement.
Another issue related to growth measurements is changes in the ability of a
business to generate cash flows over a long period of time. It can be argued that cash
flows are more important than profits, since profit levels can be artificially increased
through various types of accounting trickery. It is much more difficult to interfere
with the proper reporting of cash flow information. For a full discussion of these
measurements, see the Cash Flow Measurements chapter.
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Chapter 8
Constraint and Throughput Measurements
Introduction
The constraint is one of the most poorly-understood concepts in business today, as
well as the related concept of throughput. When a company is operating in
accordance with the concepts of constraint management and throughput
maximization, it may realize a substantial increase in profitability, as well as a
reduced need for fixed assets. In this chapter, we explain the constraint and
throughput concepts, and then present a number of measurements that can be used to
monitor these items.
Related Podcast Episodes: Episodes 43 through 47 of the Accounting Best

Practices Podcast discuss constraint analysis. They are available at: accounting-
Overview of Constraint Measurements

The measurements in this chapter are based upon the core underlying concept of the
bottleneck – this is the chokepoint through which work must flow before a finished
product can be delivered to the customer. The bottleneck concept is more formally
known as the constraint. Examples of constraints are:
• A production workstation that must process some aspect of the work
flowing through a production facility
• A raw material that is in short supply
• A highly-skilled salesperson who is responsible for most incoming orders
Constraints are usually difficult to eliminate. For example, a production workstation

might be extremely expensive, or there is no alternative source of raw materials, or
the level of training required to develop another salesperson is excessive. For these
reasons, it makes more sense to tightly manage a constrained resource to maximize
its usage. There are several ways to measure a constrained resource, including its
overall level of utilization, the operator’s ability to fulfill the assigned production
schedule, and the nature of any downtime.
Constraint maximization means that a bottleneck should never be allowed to run
out of work. This is a particularly important notion if the bottleneck is located in the
production area, where it is likely to be a work center. A constrained work center
should always have a buffer of inventory in front of it that can be drawn upon if the
upstream workstations stop sending materials to the bottleneck. The buffer should be
especially large if the flow of goods into the bottleneck operation is highly variable.
Clearly, the amount of usage of this buffer should be measured.
Another concept is throughput, which is revenues minus all totally variable
expenses. Throughput must be maximized at all times in order to pay for the fixed
costs of a business and generate a profit. More specifically, the amount of
throughput that flows through the constrained resource must be maximized, since
the bottleneck controls the ability of a business to generate profits. Throughput can
be monitored through a combination of measurements, including bottleneck
schedule fulfillment, manufacturing effectiveness, and delayed throughput.
Bottleneck Utilization
In most production operations, there is a particular work station that is perpetually
overworked, and which keeps the rest of the facility from maximizing its production
potential – this is the bottleneck operation. A key focus of the manufacturing
manager is to ensure that this work station is fully supported and utilized at all times,
which makes the bottleneck utilization metric one of the more important
performance measures that a company can track.
To calculate bottleneck utilization, divide the actual hours of usage of the
operation by the total hours available. Depending on how closely management
watches this metric, you may want to re-calculate it every day. The formula is:
Actual hours of bottleneck usage

Total hours in the measurement period
While important, the bottleneck utilization metric does not track the profitability of
the work being run through the bottleneck operation. Thus, it could be utilized
nearly 100% of the time, but with only low-profit items being manufactured, the
company’s profitability would still be low. Thus, this metric should be used in
combination with an analysis of the profitability of products being scheduled for
production.
EXAMPLE
Mole Industries runs a small production line that creates motorized tunneling devices for
cable laying operations. The bottleneck in the production line is the paint booth. The paint
booth runs for three shifts, seven days a week, while the rest of the production line runs for a
standard eight-hour day, five days a week. Management is concerned that the paint booth
will limit the production line’s ability to expand, and wants to know what bottleneck
utilization it has. The calculation is:
152 Actual hours of operation

168 Hours in a week
= 90% Bottleneck utilization
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The calculation shows that there are only 16 additional hours of bottleneck time available,
and it is likely that the paint booth staff will have a difficult time making those few
additional hours available, given ongoing maintenance requirements. Thus, the management
team needs to discuss whether it should invest in an additional paint booth or outsource some
painting to a supplier. It may make more sense to build a new paint booth if there is an
expectation of a large and permanent increase in sales (which would pay for the investment
in a new paint booth), whereas outsourcing may be the better option if sales are not expected
to increase much beyond the current level.
Bottleneck Effectiveness
The classic measure of the bottleneck is the utilization measurement described in the
last section. However, bottleneck utilization only addresses the efficiency of an
operation – the amount of time during which it is in operation. What is of just as
much importance is the effectiveness of the operation, which is the amount of
throughput generated per hour of bottleneck time. Ideally, the bottleneck should
have both a high utilization rate and high effectiveness, in order to maximize the
total amount of throughput generated.
To calculate bottleneck effectiveness, divide the total amount of throughput
dollars generated by the number of hours that the bottleneck was in operation. The
formula is:
Total throughput dollars generated

Total hours of bottleneck operation
Note that the throughput figure used in the numerator is not just the throughput
passing through the bottleneck, but rather the throughput of the entire production
operation. We use this more expansive figure in order to account for the ability of
the logistics staff to route work around the bottleneck, such as through outsourcing.
This means that bottleneck effectiveness can be improved in multiple ways, such as:
• Shifting work away from the bottleneck to increase throughput without
using the bottleneck
• Improving the speed of operation of the bottleneck, so that more units can
be processed per hour
• Increasing product prices to increase throughput per unit
• Reducing the cost of materials to increase throughput per unit
EXAMPLE
Horton Corporation’s management team recently bought the company in a leveraged buyout,
and needs to reconfigure the company to generate more cash, so that the debt used to
purchase the company can be paid off. The company’s widget splicing operation is the
constrained resource in the production area. The industrial engineering staff concludes that
the best way to increase throughput per hour is to shorten the changeover time for new
widget jobs at the splicing operation. The current changeover time for the splicer is 15% of
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its total operational time. The splicer currently generates $100 of throughput per minute of
operating time, and the machine operates for an average of 35,000 minutes per month.
After two months of effort, the engineering staff succeeds in shortening the 15% changeover
time to 10% of operating time. Doing so frees up an additional 1,750 minutes per month,
which represents an increase in throughput of $175,000. Following this engineering work,
the company’s bottleneck effectiveness is:
$3,675,000 Throughput
36,750 minutes
= $100 per minute
Interestingly, the bottleneck effectiveness of the company in the preceding example

did not increase. Instead, it stayed the same, despite an increase in the number of
minutes available for operation. The reason for the lack of change was that the
operation became more efficient (with more operating time available for use), but the
amount of throughput generated for each hour of use did not change.
A common side-effect of an increased level of bottleneck utilization is that
bottleneck effectiveness declines. The reason is that the highest-throughput jobs are
presumably already being processed through the bottleneck, so increasing its
efficiency only makes room for the processing of jobs that presumably have lower
throughput levels.
Bottleneck Schedule Fulfillment

We noted in a prior section that it is possible to completely fill the time of a
bottleneck operation without generating any profit. This situation arises when the
bottleneck is filled with low-profit or no-profit work. Someone attempting to report
a high level of bottleneck usage could do so by working on a large-volume, low-
throughput job, without generating any benefit for the company as a whole. To
detect this situation, consider measuring how well the bottleneck operation
completes its assigned work schedule.
To measure fulfillment of the bottleneck schedule, aggregate the number of jobs
completed at the bottleneck operation by the number of jobs scheduled for the
operation. The ratio is:
Number of scheduled bottleneck jobs fulfilled

Total number of scheduled bottleneck jobs
This measurement works best when there are a large number of jobs scheduled at the
constrained operation. If there are just a few massive jobs during the measurement
period, then this measurement could vary wildly from period to period. For example,
if there are only two long-duration jobs scheduled in the measurement period and
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one job is still ongoing at the end of the month, then the measurement will result in a
paltry 50% fulfillment rate.
Of course, if the contents of the work schedule contain minimal amounts of
throughput, then even fulfilling the schedule will not generate much profitability for
a business. Thus, use of this measurement should be coupled with an examination of
the throughput associated with each job assigned to the bottleneck operation. If the
assigned throughput is low, then the company has pricing problems with the
products it is selling.
EXAMPLE
Oberlin Acoustics builds concert-grade guitars. The sound board construction facility is the
bottleneck of the company, since this area requires detailed work with expensive hardwoods,
such as Brazilian Rosewood and Tasmanian Blackwood. Recently, this area has been
experiencing problems with the completion of the more dense wood sound boards, which
require the attention of the most experienced craftsmen. Consequently, the sound board
manager has been bolstering his bottleneck utilization measurement by spending more time
on spruce sound boards, which are easier to complete.
To ensure that the sound board facility spends more of its time on the higher-throughput
hardwood sound boards, the CFO mandates that the bottleneck schedule fulfillment
measurement be tracked. The results for the past three months are as follows:
Scheduled Completed Bottleneck

Hardwood Hardwood Schedule
Month Sound Boards Sound Boards Fulfillment
September 200 84 42%
October 210 97 46%
November 190 93 49%
The measurement indicates that the sound board manager is slowly ramping up the staffing
needed to complete the hardwood sound boards in a more timely manner. It appears that this
measurement should continue to be tracked over a long period of time, to ensure that the
facility is appropriately staffed.
Buffer Penetration
As noted earlier, an inventory buffer is positioned in front of the bottleneck machine
in the production area, which is used to ensure a steady flow of work into the
bottleneck. By doing so, utilization of this work station is maximized. However,
there is a cost of funds associated with maintaining too large a buffer, so there is a
countervailing incentive to keep this buffer at a modest size. Consequently, a
reasonable management task is to fine-tune the size of the inventory buffer by
tracking buffer penetration. Buffer penetration is the proportion of the buffer that is
used up at any point in time. It is never acceptable to allow the buffer to reach zero,
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since this implies that the bottleneck operation is being starved of resources. Instead,
the level of buffer penetration must be examined continually to determine how close
it has come to being eliminated, possibly resulting in some adjustment to the size of
the buffer.
To calculate buffer penetration, divide the number of jobs at the bottleneck for
which materials had to be accessed from the buffer by the total number of jobs at the
bottleneck. The calculation is:
Number of job requiring buffer usage

Total number of jobs at the bottleneck
It is particularly important to look at the trend line of this measurement, to see if an

increasing proportion of jobs are accessing the buffer. If so, it may be necessary to
increase the size of the buffer. Conversely, if the buffer is rarely or never accessed, it
may be possible to reduce the size of the buffer.
The buffer penetration report can also be used to evaluate the performance of the
upstream workstations that are feeding jobs to the bottleneck operation. If the buffer
is routinely being penetrated, it is quite likely that the cause is production or raw
materials sourcing issues somewhere in front of the bottleneck.
Bottleneck Maintenance to Operating Ratio

When the constrained resource in a business is a work center within the production
department, the bottleneck likely involves equipment that must be properly
maintained. This can be a significant problem when the maximization of profits
mandates that this work center be operated 100% of the time, three shifts per day,
365 days per year. Given the need to maximize profits, the maintenance work
associated with a bottleneck should be carefully planned in advance, practiced, and
then executed at the highest possible speed. This high degree of preplanning is
rewarded by increased throughput, which generates more profitability. Thus, when it
comes to maintaining the bottleneck operation, time is money.
A good way to measure the amount of downtime associated with maintenance is
to compare maintenance time to the amount of time that the bottleneck operation is
functioning. Doing so emphasizes to the maintenance staff the importance of
minimizing the time that the bottleneck is not available for production purposes. The
calculation is:
Bottleneck downtime caused by maintenance

Total bottleneck operating time
While this measurement does a good job of focusing attention on maintenance, it

could promote the use of short-term fixes, rather than more extensive overhauls that
could reduce the long-term amount of maintenance required. For example, if a
bearing is wearing out on a machine, the maintenance staff could conduct a minor
lubrication fix in a few minutes, or break down the machine and replace the bearing.
The latter solution is the best solution over the long term, but a maintenance
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manager focusing too closely on the maintenance to operations ratio might opt for
the reduced short-term amount of downtime offered under the first option.
The measurement of this ratio should be modified if the bottleneck operation is
not being operated on a 24 × 7 basis, but rather on a reduced schedule. In this
situation, the maintenance staff should always be encouraged to engage in
maintenance operations outside of the core operating hours of the bottleneck
operation. The recordation of bottleneck downtime caused by maintenance should
therefore only be recorded if the downtime occurs within the regularly scheduled
working hours of the bottleneck.
EXAMPLE
Bland Cabinets makes mass-produced cabinets for apartment buildings. Nearly all of its
products are run through a high-speed drum sander. Given the cost of this equipment,
management is reluctant to purchase an additional unit, so the single sander is operated
around the clock in order to handle the volume of cabinet components. The drum sander
must be disassembled at regular intervals for maintenance, as well as to replace the sanding
drum. The average amount of maintenance time per month is currently 12 hours, while the
sander is fully operational for the remaining 228 hours. This results in a bottleneck
maintenance to operations ratio of:
12 Maintenance hours
= 5.3%
228 Operating hours
While the 5.3% result initially appears acceptable, the production manager realizes that the
amount of throughput passing through the drum sander is $6,000 per hour. Consequently, the
12 maintenance hours per month when the sander is not operational is costing the company
$72,000 per month of lost throughput. Given the amount of money involved, a consultant is
hired at a cost of $1,000 per day to examine the time required to conduct maintenance, and
arrives at a time-compressed alternative procedure that reduces maintenance to six hours per
month. This expenditure reduces lost throughput by half, to $36,000 per month.
Bottleneck Rework Processing

There may be instances where a job is processed through the bottleneck operation,
only to find that a product requires refinishing work at the bottleneck. Such rework
has a negative impact on the bottleneck in two respects, which are:
• The bottleneck was already used to process the product, so any additional
work on the product is a waste of bottleneck time that could have been used
to generate throughput via some other product.
• Rework is typically presented to the bottleneck operation in small quantities
or even as single units. This may call for a time-consuming equipment
changeover to process the units, and if the changeover is lengthy, this repre-
sents an additional expensive use of bottleneck time.
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To measure the amount of bottleneck rework processing, divide the total amount of
rework time at the bottleneck by the total hours of operation of the bottleneck. The
calculation is:
Hours of rework time consumed by bottleneck

Total operating hours of bottleneck
The amount of bottleneck rework processing is a valuable measure to track,

especially when the cause of the rework is also noted. Management can use this
information to track down what caused the out-of-specification condition that
requires re-use of the bottleneck operation, and ensure that the condition does not
happen again. However, the staff that operates the bottleneck is likely to under-
report rework time, especially if they believe the amount of rework is immaterial.
Thus, this is one of the more difficult measures to derive, despite being one of the
more useful constraint measurements.
EXAMPLE
Spade Designs manufactures chrome-plated trowels for the fine art of digging up potatoes.
The chrome plating process is the bottleneck of the company’s production facility, since a
large number of trowels are discovered to have non-uniform coatings in their electroplating.
When this happens, the Spade staff must run them through the chrome-plating process again.
In the most recent month, the chrome plating operation spent 72 hours on rework issues, as
compared to 650 hours of total operation. The bottleneck rework processing percentage is
calculated as follows:
72 Hours rework time at the bottleneck

650 Hours total bottleneck operating time
=11.1% Bottleneck rework processing
Post-Bottleneck Scrap
In a prior section, we addressed how maintenance activities interfere with the
amount of time available at the bottleneck operation. The same logic applies to any
scrap that occurs downstream from the bottleneck. Anything processed at the
bottleneck that is subsequently scrapped represents a loss of bottleneck time that
cannot be recovered.
The amount of bottleneck time lost through scrap can be calculated by aggregat-
ing the bottleneck time consumed by each item scrapped, and multiplying by the
average amount of throughput per minute generated by the constraint. The
calculation is:
∑ (Bottleneck minutes used to process scrapped items) × Average throughput/minute
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The amount of scrap that occurs after the bottleneck is not to be confused with scrap
that occurs before the bottleneck. When scrap is flushed out of the system before the
bottleneck, this is actually a benefit to the company, since these items are being
spotted and removed before they waste precious bottleneck time.
The main problem with the measurement is building a system to track scrap
throughout the production area and then discern the amount of bottleneck time used
by these items. A considerable amount of manual effort may be required to collect
the information. However, given the benefit of knowing the lost amount of
throughput caused by post-bottleneck scrap, it may be worth the effort.
EXAMPLE
Radiosonde Corporation fabricates weather balloons that are sent into the upper atmosphere
with attached instrument packages. The constrained operation of the business is the extrusion
work station, which creates the material used in the balloons. The average throughput
generated by this machine is $50 per minute.
A downstream operation from the extruder is the attachment work station, where the straps
for the instrument package are bonded to the balloon. The bonding process tends to overheat,
causing the balloon to melt at the attachment points and rendering the entire balloon
unusable. Though this problem is infrequent, the production manager wants to highlight the
problem by quantifying the post-bottleneck scrap. In the past month, four balloons were
scrapped at the attachment work station. Each of these balloons required 100 minutes of
processing time at the extrusion work station. The resulting post-bottleneck scrap figure is
derived as follows:
4 Units × 100 Minutes × $50 Throughput/minute = $20,000
Even though only four units are being scrapped per month, the throughput lost from the
melting problem is costing Radiosonde $20,000 per month.
Manufacturing Effectiveness
The bottleneck portion of a production facility may involve quite a small part of the
total manufacturing operation, and so is strongly influenced by how well it is
integrated into and supported by the surrounding operations. Consequently, it is
useful to apply the throughput and constraint concepts to these surrounding
operations, using the following measurements.
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Manufacturing Productivity
The entire manufacturing function should be able to generate the largest possible
amount of throughput at the lowest possible cost, which is known as manufacturing
productivity. A well-run operation should be able to reduce the cost of operations
while maintaining or increasing the level of throughput generated. The calculation
is:
Throughput generated
Production expenses recognized
Ideally, manufacturing productivity should be tracked on a trend line, to see if

continual improvements are being made. However, be aware of the following issues:
• Half of this measurement is throughput, which is dependent on prices
charged – and over which the manufacturing department has no control.
• Production expenses can be reduced by maintaining tight control over labor
costs. However, doing so may drive away the most experienced staff, which
eventually can impact the overall productivity of operations.
• Management could manipulate the measurement by shifting some produc-
tion expenses into the administrative area. If so, consider adding administra-
tive expenses to the denominator, which reduces the ability of anyone to
hide expenses.
• Some expenditures may be recorded as assets, so that they do not appear in
the denominator. If so, impose tight controls over which expenditures can be
capitalized.
• The production manager may be tempted to cut back on the production
capacity of the business in order to reduce production expenses. Doing so
may impede the ability of a business to keep the bottleneck operation fully
fed with incoming jobs. Consequently, be sure to pair this measurement with
an analysis of when the bottleneck is starved of incoming work.
In short, the manufacturing productivity measurement can be used to model how

changes in production expenses incurred will alter the amount of throughput
generated. The following example illustrates the concept.
EXAMPLE
The industrial engineering manager of Grubstake Brothers wants to install an automated

metal stamping operation with the company’s backhoe production facility. The net additional
cost of doing so will be $100,000, on top of the current monthly production expense of
$900,000. The production facility currently generates $1,400,000 of throughput, which is
expected to increase to $1,700,000 as a result of the automation. The before-and-after
manufacturing productivity resulting from this change is as follows:
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Before After
Throughput generated $1,400,000 $1,700,000
Production expenses recognized $900,000 $1,000,000
Manufacturing productivity 1.56x 1.7x
Since manufacturing productivity is expected to increase as a result of the automation

project, the requested investment should be approved.
Manufacturing Effectiveness
The preceding discussion of manufacturing productivity focused on the ability of the
entire production area to reduce operating costs in relation to the amount of
throughput generated. Manufacturing effectiveness focuses on the amount of
throughput generated, rather than the cost of creating the throughput. In effect, the
focus shifts from expenses to revenue.
To determine the level of manufacturing effectiveness, divide the total amount
of throughput generated during the measurement period by the number of hours
during which the bottleneck operation was in use. The calculation is:
Throughput generated
Number of bottleneck hours used
The ability to increase throughput can hinge upon a number of activities, such as:
• Reduce scrap levels occurring after the constrained resource, so that more
net throughput makes its way through the entire production process.
• Enhance the processing speed of the bottleneck operation, such as through
faster equipment changeovers or an investment in higher-speed equipment.
• Reconfigure products so that they use less processing time at the bottleneck.
• Outsource work so that a job requires no bottleneck time at all.
However, a change in manufacturing effectiveness may not be caused by the

production staff at all. Instead, it is quite possible that the mix of products sold has
changed, so that the amount of throughput generated is varying even in the absence
of any process enhancements by the production staff. For example, if the
engineering department creates a hot new product that is in great demand, the
marketing department will set a high price point for it that results in a massive boost
in throughput – which has nothing to do with production. Conversely, a discount
offered to customers by the sales department could lower throughput to the point
where manufacturing effectiveness looks catastrophically bad.
EXAMPLE
New Centurion Corporation translates Latin texts to English for its university customers.
This task is done by the company’s new TransSCRIBE machine, which automates much of
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the translation process, leaving a staff of trained scholars to verify the resulting texts. The
machine is the constrained resource in the company, since the conversion process is
extremely slow, even for a computer.
The translation manager of New Centurion has found that the effectiveness of the
TransSCRIBE machine can be greatly enhanced by having the staff clean up incoming texts,
deleting stray marks on the documents and ensuring that they are properly positioned for
scanning. Doing so also reduces the amount of review time by the scholars, since the
translations are cleaner when the inputs are better (thereby validating the concept of garbage
in, garbage out).
The translation manager institutes these input changes, with the following results in the
manufacturing effectiveness of the operation:
Before After
Throughput generated* $375,000 $460,000
TransSCRIBE hours used* 240 240
Manufacturing effectiveness $1,563/hour $1,917/hour
* Measurement period is one month
Manufacturing Throughput Time

Manufacturing throughput time is the amount of time required for a product to pass
through a manufacturing process, thereby being converted from raw materials into
finished goods. The concept also applies to the processing of raw materials into a
component or sub-assembly. The time required for something to pass through a
manufacturing process covers the entire period from when it first enters
manufacturing until it exits manufacturing – which includes the following:
• Processing time. This is the time spent transforming raw materials into
finished goods.
• Inspection time. This is the time spent inspecting raw materials, work-in-
process, and finished goods, possibly at multiple stages of the production
process.
• Move time. This is the time required to move items into and out of the
manufacturing area, as well as between workstations within the production
area.
• Queue time. This is the time spent waiting prior to the processing, inspec-
tion, and move activities.
The concept of manufacturing throughput time is primarily oriented toward the

reduction of time required by the manufacturing process, so that you can increase
the amount of throughput flowing through the system and thereby boost
profitability. The bulk of the time spent in manufacturing tends not to be in
processing, but rather in inspection, moves, and queues. Thus, it is easiest to reduce
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manufacturing throughput time by eliminating as much inspection, move, and queue

time as possible.
EXAMPLE
The production manager of Mole Industries wants to calculate the manufacturing throughput
time for the Ditch Digger Mini product. He accumulates the following information:
Processing time 3.0 hours

Inspection time 0.5 hours
Move time 1.0 hour
Queue time 12.0 hours
The total manufacturing throughput time for the Ditch Digger Mini is 16.5 hours. The
production manager has a golden opportunity to reduce the throughput time, since the
amount of queue time is almost three-quarters of the total throughput time, and can probably
be reduced without too much trouble.
Delayed Throughput
An intense focus on throughput should not end at the constrained resource. It is
entirely possible that the amount of throughput passing through the bottleneck is
greater than the amount actually shipped to customers. This problem arises when
there are problems in the production process downstream from the bottleneck
operation that delay shipments. This can be a particular problem when the bottleneck
is early in the production process, so that work must still pass through a number of
work stations before a finished product can be shipped. Conversely, it is less of an
issue if the bottleneck is one of the last processes before shipment.
If there appears to be a significant shortfall in the amount of recognized
throughput, measure it with the following steps:
1. At the end of the period, compile the total amount of throughput dollars
actually shipped and recognized as income.
2. Compile the total throughput dollars scheduled to be shipped in the period,
as per the production schedule.
3. Subtract the amount of throughput actually shipped from the total amount
scheduled.
4. Divide by the total throughput dollars scheduled to be shipped in the period.
The calculation is:
Scheduled throughput dollars – Actual throughput dollars shipped

Scheduled throughput dollars
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This is not one of the easier measurements to compile, since there may be many
shipments during the reporting period. The best approach is to use a report writing
package and a standard costing system to create a computerized report that matches
the price of each product shipped to its standard variable cost; the report writer then
states the difference between the two as throughput, and aggregates throughput for
the period to arrive at total throughput shipped.
EXAMPLE
Giro Cabinetry produces western-style cabinets, which require a heavy coat of lacquer as the
final production step. Though not the bottleneck, flaws in the finish caused by dirt particles
have delayed the delivery of multiple orders, resulting in a decline of monthly throughput of
$50,000 from the scheduled $800,000. The effect of this delayed throughput is as follows:
$800,000 Scheduled throughput - $750,000 Actual throughput shipped

$800,000 Scheduled throughput
= 6.25%
Since the company usually only earns about $40,000 per month, the monthly delay of
$50,000 in recognizing throughput threatens to have a major effect on the company.
Accordingly, management implements a crash program to locate the source of the dirt
particles, resulting in the installation of a close-grained air filtration system to screen out dirt.
Summary
The focus in this chapter has been on the concepts of constraints and throughput.
These concepts can apply to multiple functional areas within a business, including
sales (because of price points), procurement (because of material costs) and
production (since this is where bottlenecks are commonly found). Given their
universal usage, we have created a free-standing chapter for these concepts, so that
you may be encouraged to apply them to many parts of a business. Bottlenecks are
particularly prevalent in the sales area, where it can be difficult to develop enough
fully-trained staff to locate new sales and properly bid on work and complete
product demonstrations in a timely manner. Nevertheless, you will find that many of
the concepts discussed in this chapter carry over into the Production Measurements
chapter.
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Chapter 9
Cash Management Measurements
Introduction
The cash management function is separate from the normal operational part of a
company, where goods are produced and sold. Most measurements are designed to
monitor the performance of these other operational areas, since that is where most
company profits and losses are generated. Nonetheless, the cash management
function should be monitored with a small group of metrics. By doing so, the
treasurer can gain insights into how well the cash management staff can predict cash
flows, the earnings generated on invested funds, and similar matters. In this chapter,
we describe a variety of cash management metrics that can be of use to the treasurer.
Overview of Cash Management Measurements

At first glance, the cash management area might appear resistant to the use of any
ongoing, standardized metrics to measure its performance. After all, we are merely
finding a home for excess cash. In reality, there are a number of areas in which
metrics can be profitably employed. Consider the following conceptual areas for
measurement:
• Cash forecasting. The treasurer needs to know how well future projections
of cash positions are matching actual outcomes, so that investments can be
properly planned. Also, the ability of the company to apply incoming pay-
ments to receivables should be noted, so that actual cash receipts can be
compared to cash projections.
• Cash at work. The treasurer should be fully informed of those pockets of
cash not being put to good use earning income for the business, as well as
the extent of the returns on invested funds.
• Cash at risk. If the company has extensive positions in foreign currencies,
there should be a measurement system in place that tracks unhedged gains
and losses on those positions, thereby clarifying the extent of the risk to
which the company is subjected.
In short, there are a number of areas in which metrics can provide valuable
information for the cash management function. In the following sections, we discuss
specific metrics that address all of the conceptual areas just noted.
Auto Cash Application Rate

In a larger organization that has many cash receipts from customers, it can be cost-
effective to install a system that automatically sorts through the various receipts and
applies them to open accounts receivable. This is of use to the cash management
function, since cash appears in the accounting system more quickly than would be
the case with a manual application process. These “auto cash” systems are not very
effective initially, based on the generic application logic provided by the system
supplier. As a result, a large percentage of cash receipts are rejected, and must be
manually applied to open receivables. However, fine-tuning the system with
additional cash application logic for each individual customer will gradually
improve the auto cash application rate, to the point where very few cash receipts
require manual processing. Thus, continuing attention to the application rate of such
a system is of some importance from the perspective of cash management.
To calculate the auto cash application rate, divide the number of check payments
automatically applied by the auto cash system by the total number of check
payments received. All up-front payments received (i.e., not involving receivables)
should not be included in the measurement. The ratio is:
Number of check payments automatically applied in full

Total number of check payments received
Consider running this measurement every day during the early stages of an auto cash
installation. This is needed to focus attention on the constant updating of system
logic to accommodate the payment foibles of individual customers. Once a high
application rate has been achieved, the measurement frequency can be reduced.
EXAMPLE
Cud Farms bills its thousands of retail customers once a week for milk deliveries, and is
usually paid by check about one week later. Cud installs an auto cash system to handle this
incoming blizzard of payments. The treasury department tracks the performance of the
system using the auto cash application rate. In the first week, auto cash applications were
made for 5,100 out of 8,300 check receipts. A month later, the rate is 5,350 applications out
of 8,900 check receipts. The target application rate advertised by the auto cash system
provider is 80%. Since the initial application rate was 61% and the following rate was 60%,
Cud is clearly not going to achieve the target rate without additional assistance from the
system provider.
Suspense to Receivables Ratio

When payments are received from customers, some are so poorly documented that it
can be quite difficult to apply them to open accounts receivable. To ensure that these
payments are at least recorded somewhere in the accounting system, they are
assigned to a suspense account. By doing so, the cash balance is increased by the
amount of these payments, even if no specific receivable accounts are impacted.
However, this means that the cash management staff cannot determine the accuracy
of its cash forecasts, since it does not know which customers have submitted
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payments. Thus, there is a need to resolve the contents of the suspense account as
soon as possible.
The suspense account can be a quagmire of old and poorly-documented receipts,
and so tends to be avoided by the accounting staff. To focus attention on this area,
consider measuring the suspense to receivables ratio, which is a simple comparison
of the total balance in the suspense account to the total amount of trade receivables.
The ratio is:
Suspense account balance

Trade accounts receivable balance
The main problem with this measurement is that the suspense account may be
relatively small in comparison to the total balance of trade receivables, so the
resulting ratio may not generate much attention from the controller. There are two
variations on the concept that might trigger more vigorous attention:
• Use only the overdue receivables balance in the denominator of the ratio,
since this is probably the group of receivables related to the payments stored
in the suspense account. Since the denominator will be smaller, the suspense
account balance will appear comparatively larger.
• Track the average age of the payments stored in the suspense account, rather
than the suspense to receivables ratio. Many older payments will be more
likely to trigger additional clerical support.
EXAMPLE
Colossal Furniture hired a relatively inexperienced cash receipts clerk one year ago, and the
treasury staff is complaining that it can no longer accurately track cash receipts against its
cash forecast, since so many payments are sitting in the suspense account. To verify this
allegation, the controller assembles the following information about the contents of the
suspense account from just before the clerk was hired and from the preceding day:
Suspense Account Total Receivables Suspense to

Balance > 30 Days Receivables Ratio
One year ago $250,000 $25,000,000 1%
Yesterday 2,100,000 26,250,000 8%
The suspense to receivables ratio in the table indicates that there is indeed a problem, so the
controller assigns additional staff to investigate and resolve the contents of the suspense
account.
Actual Cash Position versus Forecast

It is of some importance to maintain a cash forecast that is as accurate as possible, so
that investments can be properly managed. If there are any variations in actual cash
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flows from forecasted results, the treasury staff must investigate them and use the
resulting knowledge to improve the forecasting model.
An excellent way to monitor cash forecast accuracy is to routinely compare the
company’s actual cash position, prior to financing activities, to the forecasted
amount. The main point of this metric should be to note the size of the difference
from the expected result. An unusually large variance, whether positive or negative,
should be grounds for a review. Thus, the calculation should be on an absolute basis,
rather than showing a negative or positive variance.
For example, the treasurer of a company compares actual to forecasted results
for the last six weeks, and obtains the following information:
Actual Forecasted Absolute Percent

Week Ending Cash Ending Cash Variance Variance Variance
1 $1,237,000 $952,000 -$285,000 $285,000 23%
2 1,080,000 1,274,000 194,000 194,000 18%
3 1,591,000 1,846,000 255,000 255,000 16%
4 826,000 727,000 -99,000 99,000 12%
5 739,000 658,000 -81,000 81,000 11%
6 2,803,000 3,083,000 280,000 280,000 10%
The actual versus forecast information in the table reveals that the treasury staff is
rapidly improving its ability to accurately forecast cash flows.
Average End of Day Available Balance

The treasurer should be aware of the average end of day available balance in each of
a company’s bank accounts. This information is useful for determining the amount
of funds being left in non-interest-bearing accounts. It is particularly helpful for
those businesses where no attempt is made to shift funds into investments, since
management can then discern the approximate amount of lost interest income. This
information can be transformed into a ratio, by comparing the average end of day
available balance to the total amount of invested cash. The measurement is:
Average end of day available cash balance

Total amount of invested cash
The ratio is intended to bring clarity to the level of effort being expended on the
investment of excess cash.
The metric can also be of use in companies where the cash balances in accounts
are being routinely swept into investment accounts. Theoretically, the average end of
day available balance should be zero for all accounts other than the investment
account into which cash is being swept. In reality, the treasurer may have set up
target balances that leave certain cash balances in outlying accounts. Further, it may
have been deemed too difficult to include some accounts in a cash sweeping
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arrangement, perhaps due to an obstreperous local manager or currency restrictions

in an account held in a different country. By tracking the average end of day
available balance for each account on a trend line, the treasurer can see if some
accounts are retaining excessively large balances. At a minimum, the result is a
useful reminder to periodically examine target balances and ensure that they are still
valid.
Earnings on Invested Funds

The treasurer is not being paid to put a company’s cash at risk in equity investments,
which usually leaves only interest income as the type of income generated by
invested cash, not changes in the market value of equity investments. Nonetheless,
there may be cases where management is willing to put some cash at risk in an
equity investment, which can generate equity gains or losses. Consequently, the
following formula for earnings on invested funds includes market value changes:
Interest income + Market value changes

Average funds invested
Note that the calculation uses average funds invested, not the amount of cash
invested as of the end of a reporting period. The amount of cash invested can change
substantially by day, so the average investment figure in the denominator should be
based on an average of the invested balance in every business day of a reporting
period.
EXAMPLE
A treasurer is authorized to invest in both short-term debt instruments and stocks. As a result,
the business earns $45,000 in interest income and $15,000 from an increase in the market
value of its equity holdings. During the measurement period, the company had average
investments of $3,000,000. The company’s earnings on invested funds is calculated as:
$45,000 Interest income + $15,000 Market value changes

$3,000,000 Average funds invested
= 2.0% Earnings on invested funds
In many organizations, a much higher premium is placed on risk avoidance than on

investment earnings, so it is fairly common to downplay this metric. If it is used, the
board of directors should confine the cash management staff to specific types of
conservative investment choices, so there is no temptation to earn outsized returns
by making risky investments.
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Unhedged Gains and Losses

There may be circumstances where the cash management staff chooses not to create
a hedge against a foreign exchange position, and the company subsequently incurs a
gain or loss on that position. It is also possible that the company does not have an
adequate foreign exchange forecasting system, and so does not know that it even has
unhedged positions, which will most certainly result in unhedged gains or losses.
In either case, it is extremely useful to keep track of gains or losses arising from
unhedged foreign currency positions, so that the treasurer can estimate when the size
of these gains or losses warrants the imposition of a more extensive hedging
program. The simplest form of metric is a trend line analysis. This trend line will
likely yield results that routinely bounce between gains and losses. The key issue to
watch for is an increasing trend in the size of the gains or losses over time. When
they become large enough to seriously impact the company’s reported results from
operations, it is time to consider a combination of a better forecasting system and a
more active hedging program.
Summary
In this chapter, we addressed ratios and other measurements that are used to monitor
the accuracy of cash forecasting, how cash is used, and risk related to cash positions.
The frequency of measurement varies substantially for each of these classifications.
Cash forecasting ratios are typically run once a week, to coincide with the
generation of weekly cash forecasts. Cash usage measurements can be limited to just
once a month, especially in economic environments where the return on invested
funds is quite low, and therefore of lesser importance. The most critical area from a
measurement frequency perspective is the risk associated with unhedged cash
positions, which may require daily reporting; this is the case only when the amount
of cash at risk is substantial.
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Chapter 10
Credit and Collection Measurements
Introduction
The credit and collection functions deal with large numbers of customers and
invoices on an ongoing basis. Given the high volume, this environment is suitable
for a variety of measurements that can be used to monitor and manage the credit and
collection functions. In this chapter, we begin with discussions of measurements
related to collections, since most measurements are concentrated in this area, and not
in the credit area.
Overview of Credit and Collection Measurements

The credit and collection functions deal with very large numbers of customers and
their invoices. On a day to day basis, it is easy to be lost in the minutiae of granting
credit and collecting receivables, without giving consideration to the overall result of
these efforts. The measurements described in this chapter can be used to monitor
performance, which is useful for deciding whether sufficient resources are being
allocated to the department, or if action should be taken to improve efficiency. Some
of the measurements can also be used to drill down to the specific issues causing
certain types of collection problems.
At a minimum, there must be a measurement that compares the amount of
accounts receivable to credit sales, in order to roughly estimate the average period
over which receivables are outstanding. The classic measure of this type is days
sales outstanding (DSO), as described in a later section. In addition, consider using
other measurements to obtain additional information about different aspects of the
credit and collection functions. Ideally, such a system begins with a high-level DSO
measurement and then drills down into the various components of the credit and
collection functions to give the user additional information about why receivables
are not being collected. For example, a manager may have an interest in the
following additional measurements:
• The gross amount of receivables in each time bucket on the aged accounts
receivable report, to determine the age range in which most overdue receiv-
ables are clustered
• The average number of days to pay, sorted by collector, which can be used
to identify the most effective collectors
• The time required to settle payment disputes, which can be used to improve
the deduction management process
When reviewing the results of a measurement system, keep in mind that the liquidity
of customers, and therefore their ability to pay, varies somewhat from month to
month, in a recurring cycle. For example, a partnership may pay out cash to its
partners at the end of the calendar year, and so may delay some payments at the end
of the year. Similarly, corporations may make estimated tax payments on a quarterly
basis, which may impinge upon their accounts payable at the times when these
payments are made. Further, there is a certain amount of seasonality in many
industries, which can impact cash flows. For all of these reasons, a system of
measurements will likely reveal that collection results differ from month to month,
and quite possibly through no fault of the credit and collection employees. To filter
out the effects of customers’ ability to pay, compare the results of a particular month
with the same month in the preceding year. For example, the DSO for this February
may bear more resemblance to the DSO for the preceding February than to the DSO
calculations for the adjacent January period in the current year.
The end result of a credit and collection measurement system should be specific
actions to reduce the amount of overdue accounts receivable, such as:
• Adding credit and/or collection staff
• Adjusting the method for dealing with payment deductions
• Altering the policy for granting credit
• Altering the procedure for contacting customers
• Curtailing management overrides of credit decisions
In short, a system of measurements is only as good as the actions that result from its
use. If measurements are routinely calculated and no action results, then the system
has failed.
Days Sales Outstanding

When evaluating the amount of accounts receivable outstanding, it is best to
compare the receivables to the sales activity of the business, in order to see the
proportion of receivables to sales. This proportion can be expressed as the average
number of days over which receivables are outstanding before they are paid, which
is called days sales outstanding, or DSO. DSO is the most popular of all collection
measurements.
Days sales outstanding is most useful when compared to the standard number of
days that customers are allowed before payment is due. Thus, a DSO figure of 40
days might initially appear excellent, until you realize that the standard payment
terms are only five days. A combination of prudent credit granting and robust
collections activity is the likely cause when the DSO figure is only a few days longer
than the standard payment terms. From a management perspective, it is easiest to
spot collection problems at a gross level by tracking DSO on a trend line, and
watching for a sudden spike in the measurement in comparison to what was reported
in prior periods.
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To calculate DSO, divide 365 days into the amount of annual credit sales to
arrive at credit sales per day, and then divide this figure into the average accounts
receivable for the measurement period. Thus, the formula is:
Average accounts receivable

Annual sales ÷ 365 days
EXAMPLE
The controller of Oberlin Acoustics, maker of the famous Rhino brand of electric guitars,
wants to derive the days sales outstanding for the company for the April reporting period. In
April, the beginning and ending accounts receivable balances were $420,000 and $540,000,
respectively. The total credit sales for the 12 months ended April 30 were $4,000,000. The
controller derives the following DSO calculation from this information:
($420,000 Beginning receivables + $540,000 Ending receivables) ÷ 2

$4,000,000 Credit sales ÷ 365 Days
$480,000 Average accounts receivable

$10,959 Credit sales per day
= 43.8 Days
The correlation between the annual sales figure used in the calculation and the
average accounts receivable figure may not be close, resulting in a misleading DSO
number. For example, if a company has seasonal sales, the average receivable figure
may be unusually high or low on the measurement date, depending on where the
company is in its seasonal billings. Thus, if receivables are unusually low when the
measurement is taken, the DSO days will appear unusually low, and vice versa if the
receivables are unusually high. There are two ways to eliminate this problem:
• Annualize receivables. Generate an average accounts receivable figure that
spans the entire, full-year measurement period.
• Measure a shorter period. Adopt a rolling quarterly DSO calculation, so that
sales for the past three months are compared to average receivables for the
past three months. This approach is most useful when sales are highly varia-
ble throughout the year.
Whatever measurement methodology is adopted for DSO, be sure to use it

consistently from period to period, so that the results will be comparable on a trend
line.
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Tip: If DSO is increasing, the problem may be that the processing of credit memos
has been delayed. If there is a processing backlog, at least have the largest ones
processed first, which may reduce the amount of receivables outstanding by a
noticeable amount.
Best Possible DSO

After running the DSO calculation, it may be useful to establish a benchmark against
which to compare the DSO. This benchmark is the best possible DSO, which is the
best collection performance that can be expected, given the existing payment terms
given to customers. The calculation is:
Current receivables
× 365
Annual credit sales
The key element in this formula is the current receivables. The calculation is
essentially designed to show the best possible level of receivables, based on the
assumption that DSO is only based on current receivables (i.e., there are no
delinquent invoices present in the calculation).
EXAMPLE
The collections manager of the Red Herring Fish Company has established that the
company’s DSO is 22 days. Since the company requires short payment terms on its short-
lived products, the question arises – is 22 days good or bad? At the end of the current period,
Red Herring’s current receivables were $30,000, and its trailing 12-month credit sales were
$1,000,000. Based on this information, the best possible DSO is:
$30,000 Current receivables

× 365
$1,000,000 Credit sales
= 11 Days
In short, actual DSO is running at a rate double that of the company’s best possible DSO, and
so should be considered an opportunity for improvement.
Collection Effectiveness Index

The days sales outstanding measurement operates at a relatively high level, and only
gives a general indication of the state of receivables in comparison to sales over a
fairly long period of time. An alternative that yields a somewhat higher level of
precision is the collection effectiveness index (CEI). This measurement compares
the amount that was collected in a given time period to the amount of receivables
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that were available for collection in that time period. A result near 100% indicates
that a collection department has been very effective in collecting from customers.
The formula for the CEI is to combine the beginning receivables for the
measurement period with the credit sales for that period, less the amount of ending
receivables, and then divide this number by the sum of the beginning receivables for
the measurement period and the credit sales for that period, less the amount of
ending current receivables. Then multiply the result by 100 to arrive at a CEI
percentage. Thus, the formula is stated as:
Beginning receivables + Credit sales for the period – Ending total receivables
× 100
Beginning receivables + Credit sales for the period – Ending current receivables
A collections manager can attain a high CEI number by focusing on the collection of
the largest receivables. This means that a favorable CEI can be generated, even if
there are a number of smaller receivables that are very overdue.
The CEI figure can be calculated for a period of any duration, such as a single
month. Conversely, the DSO calculation tends to be less accurate for very short
periods of time, since it includes receivables from prior periods that do not directly
relate to the credit sales figure in that calculation.
EXAMPLE
Milagro Corporation, maker of espresso coffee machines, has been relying on DSO to
measure its collection effectiveness, but wants to supplement it with a measurement designed
for a shorter period of time. The collection effectiveness index is selected as that measure.
For the most recent month, the company had $400,000 of beginning receivables, $350,000 of
credit sales, $425,000 of ending total receivables, and $300,000 of ending current
receivables. The calculation of its CEI reveals the following information:
$400,000 Beginning receivables + $350,000 Credit sales for the period

– $425,00 Ending total receivables
× 100
$400,000 Beginning receivables + $350,000 Credit sales for the period
– $300,000 Ending current receivables
= 72% Collection effectiveness index
Thus, Milagro was able to collect 72% of the receivables that were available for collection in
that month.
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Measurements Based on Time Buckets

After calculating total collection effectiveness, it is useful to drill down at the time
bucket level to see how old the clusters of overdue receivables are that are impacting
collection effectiveness. A time bucket is a time period listed on the aged accounts
receivables report, where each time bucket is in 30-day increments. Thus, the usual
increments are:
• 0 to 30 days
• 31 to 60 days
• 61 to 90 days
• 90+ days
Many reporting packages allow users to alter the duration of time buckets, so these
standard periods may not be reflected in all aging reports. For example, a company
that has 15-day payment terms may set its first time bucket to be 0 to 15 days, the
next time bucket at 16 to 45 days, and so on.
Usually, the amount of receivables in a time bucket is relatively consistent from
period to period, unless a disproportionately large receivable is creating a bulge in a
certain time bucket. Consequently, it is useful to calculate the percentage of total
receivables in each time bucket, and monitor these percentages on a trend line. The
following trend analysis for a six-month period illustrates the concept.
Sample Time Bucket Analysis

January February March April May June
0 to 30 days 58% 53% 49% 47% 45% 43%
31 to 60 days 30% 35% 34% 27% 29% 30%
61 to 90 days 10% 10% 15% 19% 10% 11%
90+ days 2% 2% 2% 7% 16% 16%
Totals 100% 100% 100% 100% 100% 100%
The sample time bucket analysis reveals a disturbing trend, where one or more large
receivables have shifted out of the shortest time bucket near the beginning of the
period, and gradually worked their way through the time buckets until they are now
firmly parked in the oldest bucket. In short, there appears to be a cluster of
uncollectible receivables burdening the aging report.
Some collection managers prefer to focus particular attention on the 90+ day
time bucket, since it contains the most intractable collection problems. The formula
for calculating the percent of receivables over 90 days past due is:
Receivables > 90 days past due

Total receivables
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We do not advocate focusing on the 90+ day time bucket to the detriment of the
earlier time buckets, since receivables are much more likely to be collected during
the earlier stages of their existence. Once a receivable reaches the 90+ time bucket,
the probability of its collection, simply due to the passage of time, has declined. If
anything, the collection manager should focus on the 31 - 60 day time bucket, where
collection problems first make their appearance and are most likely to be resolved.
Days Delinquent Sales Outstanding

Rather than focusing on the entire set of accounts receivable, consider focusing the
measurement only on those receivables that are overdue, and ignoring those invoices
that are currently within terms. This measurement is called the days delinquent sales
outstanding (DDSO), for which the measurement is:
365
(Annualized credit sales from delinquent customers ÷ Average
delinquent receivables)
When deriving this calculation, the main factor is defining at what point a receivable
is considered delinquent. Setting the threshold at 30 days when the payment terms
are net 30 days will likely catch a large proportion of customers that pay on time, but
whose payments have not yet arrived in the mail. Consequently, a somewhat higher
threshold should be set, such as 10 days past terms.
EXAMPLE
New Centurion Corporation translates Latin texts for a variety of educational institutions.
Most customers pay on time or early, but a small number of underfunded colleges pay quite
late. The collections manager of New Centurion decides to focus attention on this small
group by implementing the measurement of DDSO. She sets the delinquent account
threshold at 40 days, and finds that the annualized credit sales to the resulting group of
customers is $600,000, and the related average receivables are $150,000. The DDSO
calculation is:
365
($600,000 Annual credit sales ÷
$150,000 Average receivables)
= 91 Days delinquent sales outstanding
Average Days to Pay per Collector

When investigating the reasons for a lengthy DSO, one possibility is to subdivide
the measurement by collector, to see if any collectors are unusually efficient or
inefficient at collecting from overdue accounts. The result may be retraining of some
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collectors to enhance their collection skills, or perhaps shifting the more difficult
accounts to those collectors who are more adept at collecting funds.
A caution when using average days to pay at the collector level is that some
customers are more difficult to collect from than others, irrespective of who is
handling the account. Thus, an excellent collections person may have been assigned
several customers who simply are not going to pay anywhere near the date mandated
by their collection terms. Also, if collectors are being evaluated based on this
measurement, there may be infighting over who is assigned certain accounts, or
perhaps a rush to write off the more difficult receivables. Because of these issues, it
may not be wise to rely on measurements at the collector level, at least when making
determinations about changes in compensation or promotions.
Collection Dispute Cycle Time

While the days sales outstanding measurement provides a good overview of how
long receivables are outstanding, it does little to provide additional detail about why
the receivables are outstanding for so long. The next level of detail below DSO is to
track the time required to resolve collection disputes. This measurement is called the
collection dispute cycle time; when applied just to the resolution of payment
deductions, it is called days deduction outstanding, or DDO. The simplest approach
is to use the same case tracking system used by the customer support function, and
record within it the beginning and ending dates for each dispute, as well as the
amount in dispute, the cause of the problem, and who is handling its disposition.
When summarized over a large number of disputes, this information gives
management a good idea of the average time required to settle a dispute, as well as
which customers are repeatedly involved with the longest-running disputes, what
root problems caused them, and which collections staff have the best (and worst)
ability to resolve disputes within a short period of time.
When used properly, an ongoing examination of the collection dispute cycle
time can result in decisions to eliminate more difficult customers, provide training to
those employees who have problems resolving disputes in a timely manner, and
correct the underlying causes of disputed payments.
The measurement can be deliberately skewed by altering the recorded beginning
and ending dates of dispute cases. To keep this from happening, do not tie any
reduction in the dispute duration period to a bonus plan; this ensures more honest
record keeping.
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Deduction Turnover
If the company deals with a large number of deductions on an ongoing basis,
consider calculating the rate of turnover in deductions. This approach is useful for
tracking the ability of the collections staff to rapidly settle deductions. The formula
is:
(Number of deductions outstanding at beginning of the period

+ Number of new deductions created in the period) ÷ Number
of deductions at end of the period
EXAMPLE
Milford Sound routinely deals with a large number of customer payment deductions related
to its ongoing marketing cost reimbursement programs. The controller wants to know if the
collections staff is keeping up with the volume of these deductions, and so compiles the
following information for each of the past three months:
January February March

Beginning deductions outstanding 300 325 340
New deductions in period 1,200 1,250 1,280
Ending deductions outstanding 325 340 350
Deduction turnover 4.6x 4.6x 4.6x
The table reveals that the number of new deductions is rising through the period, as is the
number of unresolved deductions at the end of each period. However, in comparison to the
total volume of deductions under review, turnover has remained the same throughout the
period. Thus, if the controller uses a turnover rate of 4.6x as an acceptable standard, then no
operational changes are required.
Average Time to First Contact

If a company uses a computerized collection tracking system, the computer should
be able to track all collection actions taken through the system, such as issuing
dunning letters or autodialing a customer. If so, have the system compare the date
when an invoice came due and when the first collection contact related to that
invoice was first made. When aggregated, this should result in a fairly consistent
average time to first contact.
It is not always a good use of staff time to accelerate the average time to first
contact, since many payments really are in the mail, and will be received shortly.
Thus, a close examination of cash receipts will probably suggest a certain number of
days past the due date when it is most cost-effective to contact a customer.
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Bad Debt Percentage

The end result of the credit and collection process is the proportion of accounts
receivable that cannot be collected – the bad debt percentage. Ultimately, the bad
debt percentage, combined with days sales outstanding, are the core measurements
of the credit and collection function.
The bad debt percentage is a simple calculation, just the bad debt expense for
the year, divided by credit sales. However, be aware that the reported amount can be
“adjusted,” sometimes by a significant amount. Under the accrual basis of
accounting, bad debts are estimated and charged to the allowance for doubtful
accounts, which is a reserve against which actual bad debts are later charged. If the
collections manager wants to present a somewhat lower bad debt percentage at the
end of the year, he or she can simply underestimate the amount of bad debts
expected to be incurred, and reduce the size of the allowance for doubtful accounts.
This issue can be mitigated by adopting a standard procedure for calculating the
amount of the allowance, and rigidly adhering to that procedure.
EXAMPLE
Quest Adventure Gear, maker of rugged travel clothing, has been experiencing increasing
difficulty in collecting from its retailer base of customers over the past few years despite
growing sales, which has triggered a discussion to only sell through a website where
customers must pay in advance. The controller of Quest accumulates the following
information about the company’s bad debts to prove the case that collecting from retailer
customers is not going well:
20X1 20X2 20X3 20X5 20X6

Bad debt expense $35,000 $47,000 $68,000 $130,000 $176,000
Credit sales 2,900,000 3,100,000 3,250,000 3,500,000 3,900,000
Bad debt percentage 1.2% 1.5% 2.1% 3.7% 4.5%
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Collection Performance Report

If a manager wants to monitor the daily performance of the collection staff, the
following report format can be used, subdivided by individual collector:
+ Funds collected for the period to date

+ Cash expected from post-dated checks in the period
+ Promised funds expected by the end of the period
= Total expected collections
Total projected collections ((collections to date per day × days remaining in period) +
funds already collected)
Total period collection goal (for comparison purposes)

Proportion of goal achieved to date
The total projected collections number in the preceding list is particularly important,
since it is used to estimate, based on the historical collection rate, how much cash a
collector is likely to take in by the end of the period. This number is usually less
than the amount indicated by the promised funds line item, which tends to be overly
optimistic.
An example of the collection performance report is shown next, and is stated for
a single collector. There are 20 business days in the reporting period shown, of
which 15 days have been completed.
Sample Collection Performance Report

Collector: Edith Wharton
$140,000 Funds collected for the period to date
20,000 Cash expected from post-dated checks in the period
82,000 Promised funds expected by the end of the period
$242,000 Total expected collections
Total projected collections (($16,133 collections/day × 5 days remaining in

$220,665
period) + $140,000 funds already collected)
$240,000 Total period collection goal

58% Proportion of goal achieved to date
In the example, note that both the total projected collections figure and the
proportion of goal achieved to date indicate that the collector may have difficulty in
achieving her collection targets for the period.
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Average Time to Establish Credit

If a company wants to complete a sale to a new customer, it has to complete the
credit analysis process quickly and assign credit to the customer. Consequently, the
speed with which the credit department can process requests for credit is of some
importance. The calculation is based on an internal database of when requests are
logged in, and when the corresponding credit decisions are also logged in. The
aggregation of these processing time periods results in an average time to establish
credit. The same database could then be used to investigate those outlier credit
decisions that took much longer than the median time requirement.
Unfortunately, this measurement can be easily manipulated by adjusting the
dates and times when credit requests and credit decisions are logged in. Some of the
problem can be eliminated by having the sales department log in credit requests,
rather than the credit department.
General Management Measurements

There are a variety of additional measurements that can be used to monitor the costs
incurred within the department, the performance of employees, and the proportion of
costs incurred as a percentage of total credit sales. Consider the following
possibilities:
• Employee turnover
• The number of accounts assigned to each credit employee
• The number of accounts assigned to each collection employee
• The average rate of pay as compared to the median pay rate in the area for
similar jobs
• The total cost of the credit and collection functions as a percentage of sales
• The amount of credit sales divided by the full-time equivalent number of
credit and collection employees
Most general measurement systems in the credit and collection area should focus on
the employees, since they comprise nearly all of the expenses incurred in these
functional areas, and their effectiveness is central to the success of the company.
Summary
It is by no means necessary to use all of the measurements described in this chapter.
Only calculate and report a measurement if it will be used. Thus, if there is no
interest in reducing the amount of time taken to resolve payment disputes, do not
measure the collection dispute cycle time. It may be that management attention will
shift in the future, at which point the mix of measurements will change, and a
measurement that was previously ignored is now in vogue. Conversely, if no action
is now being taken in regard to a measurement that was actively followed in the
past, it may be time to discontinue that measurement, and let managers focus on a
different aspect of the credit and collection functions.
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Chapter 11
Customer Service Measurements
Introduction
At the core of a company’s profitability is the satisfaction of its customers with the
goods and services provided. A high level of satisfaction equates to higher customer
retention, as well as more willingness to pay higher prices. In this chapter, we
address a variety of measurements for those aspects of a business that most directly
impact the satisfaction of customers, with particular emphasis on deliveries and call
center capabilities.
Overview of Customer Service Measurements

The measurements in this chapter fall into several major areas. The first
classification addresses the ability of a business to provide the correct goods in a
timely manner. We note the on-time delivery percentage as being the most
important, though the order cycle time should be monitored at the same time to
ensure that employees are not altering the measurement information to improve the
on-time percentage. We also advocate using the order fill rate and orders damaged in
transit measurements to provide a complete picture of the ability of a business to
provide a complete, undamaged order to a customer.
These measures are followed by the customer turnover metric, which can be
used to generally estimate how many customers are not returning to place repeat
orders. This measurement concludes the basic set of measurements that most
businesses should use to monitor customer service.
We then turn to more specialized measurements that are intended for inbound
call centers (where customers are calling the company with problems). The first
contact resolution measurement is used to monitor the ability of the call center staff
to resolve customer issues on the first call, with no additional follow-up needed. An
ancillary measurement is the escalation rate, which is the proportion of customer
contacts requiring more in-depth contacts with additional company personnel. From
the perspective of the customer, these are the most important measurements.
We also note the caller abandonment rate, which is the proportion of callers
dropping their calls before getting in touch with a call center employee. This
measurement is used to monitor how well the call center manager matches staffing
with the volume of calls. A closely-related measurement is incident volume, which
is the number of calls received by time and date. Incident volume is used to estimate
the number of employees to have on hand to answer calls.
The remaining call center measurement is inbound caller retention, which is a
specialized metric that examines the ability of employees to persuade customers not
to cut off whatever service the company is providing.
Finally, we describe two measurements that track customer opinions, which are
the customer satisfaction ratio and the net promoter score. We take the unusual step
of using sales returns and allowances as the basis for tracking customer satisfaction,
since it is the most easily quantifiable way to do so. The net promoter score is only
applicable under limited circumstances, but can be useful for focusing company
attention on increasing the number of actively delighted customers, as well as
reducing the number of distinctly unhappy customers.
On-Time Delivery Percentage

The first component of customer service is the ability to ship goods to customers by
the requested date and time. Customers may even request that goods not be shipped
early, which leaves a company with a relatively narrow time slot in which to make a
delivery. If a delivery is not made in a timely manner, then the customer could be
seriously inconvenienced, and might even reject a delivery or refuse to pay the full
billed amount. Given these issues, it is critical for management to understand how
many orders are delivered on time.
The on-time delivery percentage is calculated as a binary result – that is, either a
delivery is made within a designated time slot, or it is not. For the measurement,
aggregate all on-time deliveries and divide by the total number of deliveries made.
The formula is:
Total number of deliveries made within requested time slot

Total number of deliveries made
While this is an excellent measure, be aware of several issues that can arise from its
use:
• Rush delivery fees. A company may rely too much on expensive overnight
delivery services to deliver goods to customers, resulting in an excellent on-
time delivery percentage, but no profits. Watch for this issue by examining
freight costs in conjunction with the measurement.
• Rescheduling. The customer service staff might contact customers and
convince them to accept a later delivery date. Doing so might make it look
as though delivery dates are still being met, even though the point of the
measurement – satisfying customers – is not being met. This issue can be
detected by having internal auditors compare initial order dates to revised
dates for a selection of customer orders. Also, see the following order cycle
time measurement.
• Buffer time. The order entry staff may insert a generous buffer into quoted
delivery dates, to ensure that orders will be delivered on time. While this can
be a reasonable way to manage customer expectations, it might also drive
away some customers who require delivery within a shorter period of time
than what is being quoted to them.
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If it proves to be exceptionally difficult to attain a high on-time delivery percentage

for all customers, consider instead using the percentage for only those core
customers with which the company does the bulk of its business.
EXAMPLE
The Red Herring Fish Company has been troubled by late deliveries for many months. This
is a problem, since the fish must be delivered fresh to the company’s restaurant clients
around town. If deliveries are even a few hours old, there is a significant risk of rejection. To
reduce the extent of this issue, the company president mandates that the on-time delivery
percentage be tracked on a daily basis. The initial percentage is only 42%, so the president
authorizes the purchase of several additional delivery vans and the installation of a delivery
routing system. After a three-month implementation period, the company is routinely making
a minimum of 32 deliveries per day on-time out of 35 total customers, which is an on-time
delivery percentage of 91%.
At this point, the president is considering the cost-benefit of additional capital purchases in
order to overcome the issues delaying the last few deliveries.
Order Cycle Time

We have just noted that an issue with the on-time delivery percentage is that the
order processing department could convince customers to delay their requested
delivery dates, thereby making it appear as though the company is shipping goods
on time. We can measure the propensity to have customers delay their requested
delivery dates by tracking the average time required to process an order (the order
cycle time). If the on-time delivery percentage goes up while the order cycle time
also goes up, this is an indicator that there is not really an improvement in the rate of
on-time delivery.
To measure the order cycle time, subtract the original order placement date from
the order shipping date, and average this figure for all orders shipped in a period.
The formula is:
Sum of (Order shipping date – Original order placement date)

Number of orders shipped
There are two considerations to be aware of when using this measurement, which
are:
• Multi-line orders. If some line items on an order are shipped and some are
not, assume that the entire order has not shipped until the last line item has
been shipped.
• Orders not shipped. An order that is extremely delayed will not appear in
the measurement, which only tracks orders that have been shipped. It may
be necessary to track these items separately.
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EXAMPLE
The human resources manager of Treasure Trove International has recently advocated the
use of a bonus plan that pays employees a percentage of company profits if the on-time
delivery percentage can be maintained at a level of at least 95% for the entire year. Strangely
enough, the on-time delivery percentage for the company’s sales of designer jewelry jump
from 65% to 95% almost immediately. Suspecting employee manipulation, she conducts a
comparison of the on-time delivery percentage and the order cycle time, creating the
following table for the past few months (the new bonus plan went into effect in January):
December January February March

On-time delivery percentage 65% 92% 95% 97%
Order cycle time 11 days 17 days 18 days 19 days
The table reveals that employees have been persuading customers to adjust their requested
delivery dates outward, thereby making it easier for the company to achieve its on-time
delivery goal. The human resources manager promptly scraps the bonus plan.
Order Fill Rate

We have just noted the on-time delivery percentage, which is perhaps the most
sensitive issue for customers. The second most critical issue, once an order has been
received, is whether everything ordered has been delivered. This issue can be
monitored by the order fill rate. To calculate the order fill rate, follow these steps:
1. Aggregate all customer orders within the measurement period that were
delivered by the requested receipt date and for which all order line items
were filled.
2. Aggregate all customer orders that were scheduled for delivery within the
measurement period.
3. Divide the first item (filled orders) by the second item (total orders).
The formula is:
Orders completely filled and delivered on time

Orders scheduled to be delivered
This measurement is essentially a subset of the on-time delivery percentage, since an

order must be on-line and completely filled to qualify for inclusion in the numerator.
Thus, the order fill rate will always be equal to or less than the result for the on-time
delivery percentage.
This percentage is subject to manipulation, especially if it is being used to track
employee performance. If so, employees have an incentive to ship substitute items if
certain items are not in stock, or to alter the promised delivery date in customer
order records. Employees may also be tempted to fill simpler one-item orders first,
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since it is easier to bolster the results of the measurement by ensuring that these
orders are completed, rather than highly-complex, multi-line orders.
EXAMPLE
Smithy Ironworks sells iron garden curios to distributors and direct to individuals. The orders
from distributors are massive documents, routinely containing several hundred line items.
Orders from individuals usually contain only a single line item. The president is reviewing
complaints received from customers, and notes that most of the distributors have issues about
the ability of the company to fill orders on a timely basis, resulting in stockout conditions.
The president has a financial analyst develop the order fill rate for different classes of
customers, which results in the following measurement:
Distributors Individuals
Orders completely filled on time 140 780
Orders scheduled to be delivered 320 800
Order fill rate 44% 98%
The information in the table clearly shows that the warehouse staff is easily filling one-line
customer orders, but is struggling with the massive distributor orders. The president decides
to launch a major project that focuses on ways to improve order fulfillment rates for large
multi-line orders.
Orders Damaged in Transit

A company may think that it has done an excellent job of shipping on time and
fulfilling every line item in an order. However, these activities mean little if a
customer finds that the goods have been damaged in transit. The result is a flurry of
activity to issue a credit to the customer or to deliver a replacement (possibly using
an overnight delivery service). The end result is more expense incurred by the seller
and an unhappy customer.
To calculate the proportion of orders damaged in transit, divide the number of
complaints received regarding damaged goods by the total number of orders
shipped. The formula is:
Number of customer complaints regarding damaged goods

Total number of orders shipped
There is generally little time delay between when an order is shipped and when a
customer complains about damage, since damage is usually observed as soon as a
delivery is opened and inspected. Nonetheless, it is possible that an order recorded at
the end of one measurement period will not experience a complaint until the
beginning of the next period. To mitigate this issue, use a relatively wide
measurement period, such as three months, and adopt it on a rolling basis.
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This measurement is only the starting point for a considerable amount of

analysis into the reasons for product damage. Here are several possible areas in
which damage can occur:
• Product design. A product may not have been designed in a sufficiently
robust manner to withstand the rigors of transport.
• Components. Parts included in a product may be failing, which may require
re-sourcing the part with a different supplier.
• Packaging. The packaging in which a product is shipped may not provide a
sufficient buffer from transport movement.
• Transport. The transport company may be handling goods excessively,
stacking them inappropriately, or using the wrong form of transport.
• Receiving. The handling by the customer’s receiving department may be
damaging goods before they are opened.
In short, damage in transit has a multitude of causes, and so it can require a

prolonged amount of effort to understand and correct problems.
EXAMPLE
Country Figurines produces ceramic, hand-painted figurines from the 1800s era. These
figurines are fragile, and require special handling. The company suffers from an inordinately
high damage rate for shipped goods. A special task force has concluded that there is nothing
wrong with the company’s packaging or third-party shippers, and turns its attention to the
sole remaining issue that could impact damage – the quality of the production process. The
team finds that the temperature at which the glaze on the figurines is fired is inconsistent. A
temperature that is 30 degrees or more too high makes the ceramic brittle, rendering it five
times more likely to break in transit. After a new temperature control system is installed in
the company’s firing ovens, the before-and-after results of the damage in transit
measurement are as follows:
Before After
Temperature Temperature
Control Fix Control Fix
Damaged goods complaints 360 32
Total orders shipped 4,200 4,450
Proportion of orders damaged in transit 8.6% 0.7%
The temperature control issue has eliminated the bulk of the problem, though there appear to
still be some residual issues causing a small number of breakage problems.
Customer Turnover
It is usually much less expensive to retain existing customers than to acquire new
ones, so companies typically go to great lengths to retain existing customers.
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However, this logic is not entirely correct, for some customers order in such low
volume or require so much maintenance that a business should be indifferent to their
departure. Only the core group of customers that buy in volume or yield significant
profits should be encouraged to remain. For this select group, a company should
track the customer turnover rate.
To calculate the customer turnover rate, divide the number of customers not
having placed orders within a set time period by the total number of customers. The
set time period should be an interval judged sufficiently long that a customer is
likely not planning to place an order if they have not done so within this time period.
The formula is:
Number of core customers – Number of these customers placing orders

Number of core customers
There are two elements of this measurement that are subject to interpretation. The
first issue is which customers to include in the core group being tracked. One
possible threshold for this group is to use the 20% of customers that comprise 80%
of the company’s profits (i.e., pareto analysis). The second issue is the time period
within which orders must be placed in order to be considered a current customer.
This latter issue could be defined by individual customer, based on their ordering
history, or as an average ordering interval with an additional buffer period added.
EXAMPLE
The owners of Ambivalence Corporation sell various potions and brews to self-styled
witches around the world. An in-depth customer analysis finds that the company receives
90% of its sales from just 10% of its customers. To ensure that the company retains these
customers, the president decides that customer turnover for this key group will be the number
one metric followed by the measurement team. Over the past three quarters, the turnover rate
has been as follows:
Quarter 1 Quarter 2 Quarter 3

Customers not ordering 6 9 37
Total core customers 320 314 305
2% 3% 12%
Further investigation of the sudden decline in the third quarter reveals that all of the lost
customers are based in Jamaica, where a new competitor has opened a warehouse and is
offering same-day delivery. The management team decides to do the same, and notifies its
former customers of an impending plan to deliver within two hours of order placement.
First Contact Resolution

The ultimate goal of the customer service function is to resolve a customer’s
problems on the first contact between the customer and the company. This means
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that the customer service staff is allowed to stay on the phone with callers for as
long as it takes to resolve an issue, and escalate issues on the spot. Though it may
take more time to resolve issues on the first contact, customers are much more
satisfied, and the support staff does not have secondary and tertiary callers clogging
the queue.
To calculate the first contact resolution, aggregate the number of customer
interactions that are resolved on the first contact, and divide by the total number of
contacts received from customers. The calculation is:
Number of contacts resolved on initial engagement

Total number of customer contacts
This measurement can be falsely altered by the customer service staff, so it can be
useful to occasionally audit calls to see if the number of initial resolutions is being
correctly recorded.
EXAMPLE
Milagro Corporation sells an espresso machine for home use. The device is so complicated
that many users must call the customer support line and be walked through the process. The
initial engagement is considered to be resolved if a customer can produce a cup of espresso
by the end of a call. In the most recent month, the first contact resolution rate is as follows:
247 Initial contacts resolved

= 79% First contact resolution
311 Total customer contacts
This outcome means that 21% of all customers must call back to be walked through the
process again. Based on this result, the engineering manager decides to design a simpler
product for the next generation of the machine.
There are several variations on the first contact resolution that may be considered.
Here are two alternatives:
• Average resolution time. This is the amount of operator time required to
completely resolve a customer issue. While there should not be a focus on
requiring shorter calls, it can be instructive to learn why certain calls require
much more time than normal. Investigation of these calls may indicate the
need for additional employee training, or perhaps the presence of an unusual
customer problem for which the entire support staff should receive training.
• Incidents resolved in one day. Some customer issues cannot be resolved in a
single phone call. If so, it behooves a company to research and correct these
issues as fast as possible, or risk customer disaffection. Thus, if there are a
number of calls that cannot be resolved on the first contact, create a second
measurement that tracks the resolution speed for the residual items.
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One customer service measurement that we have elected not to feature is the average
call time, since it is counterproductive to the concept of customer service. The intent
of average call time is to reduce the amount of time spent on the phone with
customers, in order to reduce labor costs. However, doing so may mean that
customers do not feel that their issues have been completely resolved, which may
lead to additional calls to the company. Consequently, we suggest downplaying this
measurement in favor of the first contact resolution measurement.
Escalation Rate
The most difficult customer contacts are those that cannot be resolved by the
customer service staff, requiring special handling. These cases are of particular
concern, because they fall outside of the normal training of the customer service
staff. These cases could represent outlier issues that will rarely be encountered, but
they may also be early contacts concerning major issues that the main customer
service staff must be trained to deal with.
To calculate the escalation rate, divide the total number of calls shifted to a
second party by the total number of calls received. The formula is:
Number of calls escalated

Total number of calls received
How the escalation rate is handled is of some importance. The management team
must sort through the detailed list of escalated contacts to determine which calls are
related to rarely-encountered outlier issues, and which are the precursors to major
issues. When the latter items are noted, an escalated call becomes a major
management focus, not only to correct the underlying issue, but also in regard to
public relations activities and customer service staff training.
EXAMPLE
The Crumb Cake Café sells a variety of cakes through its website that are packaged in frozen
containers. Most customer service calls involve allegedly wrong items being shipped to
customers, with few calls requiring escalation. However, two calls are escalated in May that
involve alleged issues with allergic reactions to delivered cakes. The management team
decides that there could be a major issue, and authorizes a detailed investigation of the
baking process; it appears that a pan lubricant containing peanut oil was mistakenly used for
one batch of cakes. The company authorizes an immediate product recall, and issues
warnings and an apology through its public relations department.
Caller Abandonment Rate

When customers are calling the support line for a business, a certain percentage of
them will abandon the calls if they cannot get in touch with a company representa-
tive within a certain period of time. Thus, as the hold time increases, so too does the
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caller abandonment rate. Abandonment is a more comprehensive measure than

average hold time, since it can be mitigated by the types of messages being sent to
callers who are on hold (such as the estimated remaining wait time). A high
abandonment rate can be avoided through proper staffing of the call center,
especially during periods that have historically proven to have high call volumes.
Otherwise, customers are more likely to buy from competitors in the future, and may
also complain about the company’s poor service on social media sites.
To calculate the caller abandonment rate, divide the number of callers in queue
that abandon their calls prior to speaking with a company representative (usually
obtained from the company’s call management system) by the total number of calls
to the company’s customer service line. The formula is:
Callers abandoning their calls prior to contact with the company

Total number of calls received
The caller abandonment rate may increase as a result of messages sent to waiting
callers, informing them of alternative sources of information that may be of use
(such as the company’s web site). This is clearly a good way to expedite the
handling of customers, and yet may worsen the measurement.
EXAMPLE
Thimble Clean sells concentrated detergents. Caller volumes have proven to be extremely
difficult to predict, with call volumes spiking at numerous times of the day. Management has
elected to staff the customer support function for the average call volume, which routinely
results in lengthy wait times and customers abandoning their calls. The current call
abandonment rate is 20%. To improve the results, the company includes in a pre-recorded
message to callers a web page on which the answers to the most frequently asked questions
are noted. Of more importance, the company includes the phone number for a poison control
center, which is needed for those callers concerned about their children ingesting detergent.
Once these messages are included, the caller abandonment rate actually increases to 40%,
since many callers find that their questions are being dealt with by the messages.
Incident Volume
A key element of customer satisfaction is the speed with which customers are put in
touch with customer representatives. This can be a prolonged period of time if the
inbound call center is not properly staffed to handle the maximum number of calls
during peak periods. For most businesses, incident volume follows the same
historical pattern by time of day and day of the week. Thus, examining a trend line
of incident volume is a crucial requirement for obtaining high customer satisfaction
levels.
To calculate incident volume, aggregate the number of calls initiated on the
company’s customer support line. This is not a ratio, but rather a simple aggregation.
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Do not measure the number of calls answered, since this figure is capped by the
number of customer support people on hand.
It can require a lengthy analysis to properly interpret incident volume. For
example, there may be an initial spike in calls immediately after a new product is
released, after which calls decline. Or, there may be specific events during the year
that only occur once, and which cause unusual spikes in demand that are well
beyond the usual weekly pattern (such as calls to pizza delivery services during the
Super Bowl).
EXAMPLE
Clinician Reps, Inc. is a 24-hour call center service that takes calls on behalf of independent
doctors, and schedules appointments based on the severity of the conditions reported by
callers. Compensation is by far the largest cost for the company, so there is a strong incentive
to manage the staff size. However, the nature of the business is such that calls must be
answered as quickly as possible. Consequently, the key metric for the business is incident
volume. The manager of the call center reviews incident volume for each hour of the past 24
hours, as well as on a trend line for the past month. Based on the resulting information, she
increases the call center staffing based on the following factors:
• Add staff for the period 6 a.m. to 9 a.m. on Mondays, when callers are more likely
to want appointments for illnesses or injuries occurring over the weekend.
• Add staff for the 4 p.m. to 6 p.m. time slot during weekdays, for children injured
during after-hours school sports events.
• Add staff for the 10 a.m. to 3 p.m. time slot during weekdays, when most industrial
accidents occur.
Inbound Caller Retention

In some industries, it is customary to require customers to call the company in order
to cancel service. Doing so allows a business one last chance to convince a customer
to remain active. Examples of such businesses are anything involving a subscription,
a credit card operation, or a utility (such as cell phone coverage or home security
monitoring). Given the ability to earn a profit from these types of customers over a
long period of time, it is of considerable interest to try to retain them, perhaps with
special offers or other discounts. Accordingly, it can be useful to track the number of
inbound callers who are persuaded not to cancel service.
To calculate the number of callers who are persuaded not to cancel service,
divide the number of initial cancellation requests that were reversed by the number
of initial cancellation requests. The formula is:
Number of initial cancellation requests reversed

Number of initial cancellation requests
This measurement should be matched against the reduced profitability associated

with offering customers special discounts in order to continue buying from the
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company. It may turn out that the cost of retaining customers is greater than the
profits lost by letting them go.
Another issue with retaining customers is their high propensity to quit again,
once the special offer used to retain them has expired. If a customer wants to cancel
service immediately after a retention deal expires, it is likely that the company will
be continually subjected to this behavior. If so, it may be more profitable for the
company over the long term to let these customers go, despite the resulting negative
impact on the retention ratio.
EXAMPLE
Fire Alert Corporation sends an alert to the nearest fire station as soon as its detectors find
evidence of excessive heat in a residence. The company owns the detectors and offers
installation for free, in exchange for a $20/month fee. The company’s costs to maintain
service are entirely fixed, other than the occasional detector that must be swapped out due to
incorrect readings. In short, all of the proceeds from monthly fees drop straight to the
company’s bottom line.
There is a massive layoff by a major employer in the area serviced by Fire Alert, and the
company is inundated with calls from customers, saying that they can no longer afford the
service. The company decides to allow free service for six months, in hopes that laid off
employees will be able to afford the service again, once they find work with new employers.
Since there is no cost associated with these deals, the management team does not believe
there is any downside to offering free service.
Customer Opinions
We complete this chapter with a discussion of the less quantitative area of customer
opinions. One possible measurement is an estimation of customer satisfaction, while
the net promoter score focuses on that subset of customers actively engaged in
promotion on behalf of the company.
Customer Satisfaction Ratio

Customers may be asked to complete a satisfaction survey, in which they select a
numerical score in regard to several aspects of how they were treated by a seller.
These scores tend to be inordinately high or low, and so only give a general view of
how customers actually view a company. A more robust measurement is to compare
net sales to gross sales; if there are few product returns or requests for sales
allowances, this is a good indicator that customers are happy with what they have
purchased from the company. The formula is:
Net sales
Gross sales
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This measurement is only useful for businesses that sell tangible goods; other
measurements will be required for a business that provides services. Also, if a
company has an extremely restrictive returns policy, this measure does not work
well, since there will be little evidence of sales returns or allowances.
For this type of customer satisfaction ratio to work properly, there must be a
separate account in which sales returns and allowances are recorded. If these
transactions are instead grouped into the sales account, there will be no way to
differentiate between net sales and gross sales.
This ratio is essentially a “back door” approach to discerning customer opinions
of a company. For information about specific issues, it is necessary to investigate
each individual sales return or allowance transaction, to see why there was a
problem. For example, goods may have been damaged in transit, an order was filled
improperly, there was a pricing dispute, and so forth.
The result of this measurement is likely to be an apparently high level of
customer satisfaction. However, many customers never take action to contact the
company about a return or allowance, and instead just decide to buy from a different
supplier in the future. This latter group is typically larger than the more vocal group
that contacts the company, so even a high apparent satisfaction rate could really
represent a much lower level of customer satisfaction.
EXAMPLE
Lowry Locomotion manufactures toy cars and trucks, which it sells exclusively to retail
stores. It is difficult to discern customer satisfaction levels, since the retailers stand between
the company and its ultimate customers. The company elects to use a net sales to gross sales
comparison to estimate customer satisfaction levels. The results for the past four quarters are
noted in the following table.
(000s) Quarter 1 Quarter 2 Quarter 3 Quarter 4

Net sales $13,500 $14,200 $12,800 $15,100
Gross sales $13,600 $14,300 $14,500 $15,500
Customer satisfaction ratio 99.2% 99.1% 88.4% 97.3%
Upon further inquiry, the company finds that the reason for the large spike in returns and
allowances in the third quarter was a problem with the company’s new line of metal sports
cars, which broke more easily than expected.
Tip: An alternative way to measure customer satisfaction that avoids surveys is to

measure the volume and type of field service calls.
Net Promoter Score

Some products, usually of the consumer variety, are enthusiastically endorsed by
customers to friends and family through their social networks. These small clusters
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of avid customers can play a major role in expanding the sales of a business.
Consequently, it is useful to understand what proportion of the total customer base is
considered to be actively promoting the company’s products. The related
measurement is called the net promoter score.
To develop the net promoter score, conduct a survey of customers that only asks
them whether they would recommend the company’s offerings to others, using a
scale of 1 to 10. Only those customers ranking the company as a 9 or 10 on this scale
are considered to be promoters. Anyone scoring the company in the range of 1 to 6
are considered to be people who might actively persuade others not to buy from the
company. Anyone submitting a score of 7 or 8 is considered to be satisfied with the
company, but is not likely to go out of their way to promote the company. Next,
divide the number of customers scoring either 9 or 10 by the group that scored the
company in the range of 1 to 6. The calculation is:
Customers scoring 9 or 10 on survey

Customers scoring 1 through 6 on survey
A company can improve the score either by increasing the number of promoters or
decreasing the number of detractors. In many cases, the amount of negative publicity
can outweigh the amount of positive publicity, so it can make more sense to address
the needs of those scoring the lowest before working on the development of a core
group of delighted customers.
As noted earlier, the net promoter score is only useful for certain types of goods,
such as consumer electronics. However, it may be possible to provide outstanding
service for more pedestrian products. For example (and keeping with the pedestrian
theme), a company selling paving stones could focus on outstanding delivery and
installation service that might garner the company (rather than its products)
outstanding net promoter scores.
EXAMPLE
Treadway Corporation has sold paving stones in bulk for many years, and has managed to
not create a distinct market position during that time. The next generation of the owner’s
family takes over, and wants to create a distinctive image for the company that will allow it
to increase recognition among customers and thereby generate a high net promoter score. An
initial measurement reveals that the entire customer base is completely indifferent, and
would not detract from or recommend the company to anyone.
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The new management team decides to create an installation service that specializes in
designing paving stone layouts for home patios, as well as conducting the actual installation.
The before-and-after net promoter score is as follows:
Before New After New

Installation Service Installation Service
Customers scoring 9 or 10 0 16
Customers scoring 1 through 6 0 4
Net promoter score 0 4:1
The scoring reveals a growing number of enthusiastic customers, but some detractors are also
appearing, probably due to improper installations. The management team focuses on more
installation training to eliminate the lower scores.
Summary
This chapter has only addressed those factors most commonly associated with
customer satisfaction, which are the timely and complete delivery of goods, as well
as the ability to respond to direct customer contacts. In reality, there are several
other issues that can impact customer satisfaction. Product quality and the ability of
its design to meet customer expectations are crucial, as well as after-market
servicing, instruction manuals, and the price charged. These issues are tangentially
addressed in other chapters, particular the Product Design and Pricing chapters.
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Chapter 12
Facility Measurements
Introduction
The cost of the facilities in which a business operates is typically among the largest
expenditures incurred, and so is worthy of a detailed review. Management should
have a complete understanding of the cost of company facilities, and how well those
facilities are being utilized. Accordingly, we address a number of measures of
facility cost and usage.
Overview of Facility Measurements

One focus in this chapter is on the cost of facilities. There are two ways in which
facility costs can be measured, both of which are comparative in nature. One choice
is to measure cost per square foot, which is the classic measurement when space is
being leased. Another option is to compare total occupancy cost to sales, which can
apply to owned or leased facilities. Both measurements can be used to compare
facility costs to those of competitors or nearby companies.
Our other focus is on the usage of facilities. There are a number of ways to
measure usage. A common choice is square feet per person, which works well in an
employee-intensive environment, such as an office building. This measure can be
refined to focus on the percentage of storage in high-cost locations, which can be
used to shift stored items to less-expensive facilities.
If a company’s facilities are mostly related to production, then the floor space
utilization measurement could be a better choice than square feet per person. If there
is a warehouse facility, then the measurement should instead focus on the cubic
volume of space utilized, the percentage of storage bins utilized, and the
honeycombing percentage.
It may not be necessary to use all of the measurements noted in this chapter, but
a selection of them will focus management’s attention on a major expense category.
Cost per Square Foot

An excellent way to measure the cost of any facility is to aggregate all rent,
maintenance, and utility costs for it and then divide by the square footage of the
facility to derive the cost per square foot. This information can be used to compare
the cost of the facility to alternative forms of housing elsewhere in the area. The
result may be a switch to a facility with a lower aggregate cost per square foot.
This measurement does not track the usage level of a facility, only its total cost.
Thus, even an inexpensive facility could be shut down if its usage level is minimal.
EXAMPLE
Kelvin Corporation’s CFO is reviewing information regarding the possible lease of

replacement office space for the company. The company’s current facility contains 20,000
square feet, and the company pays its share of utility and maintenance costs, as well as for
the rental of parking spaces for employees. The proposed replacement facility contains
25,000 square feet and has the same cost sharing arrangement, except that parking is free.
The relevant information is noted in the following table:
Current Facility Proposed Facility

Square footage 20,000 25,000
Total rent $340,000 $400,000
Utilities and maintenance cost 52,000 60,000
Parking fees 28,000 0
Total cost $420,000 $460,000
Cost per square foot $21.00 $18.40
Based on the total cost of these facilities, it initially appears that the company should retain
the current facility. However, the lower cost per square foot of the larger facility could make
it more attractive if the company expects to add staff during the lease term, or can sublease
the excess space.
This measurement does not factor in the duration of a lease agreement, which could
be a critical issue. For example, if there is a choice between a long-term lease at a
very low rate per square foot and a short-term lease at a much higher rate, it may
still make sense to enter into the short-term lease, to give the company the option in
the near term to shift its operations elsewhere.
Occupancy Cost Ratio

The cost of company facilities is one of the higher expenditures made, usually in
third place after the cost of goods sold and compensation costs. Given its size, it
makes sense to track occupancy cost as a percentage of net sales, and see if this
percentage is reasonable in comparison to the same measurement for competitors
and nearby companies.
To calculate occupancy cost, aggregate all costs of a facility, such as rent (or
depreciation, if the business owns a facility), maintenance, insurance, real estate
taxes, and utilities, and divide by net sales. The formula is:
Rent expense + Depreciation + Utilities + Maintenance + Insurance + Real estate taxes

Net sales
There is no ideal occupancy cost ratio. A company may have an inordinately high
ratio, but chooses to incur this expense because its target pool of employees is
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located within a major metropolitan area, or because the facility must be located
next to a key customer. Conversely, a company’s strategic vision might require that
the occupancy cost be as low as possible, irrespective of whether qualified
employees live nearby, and so a facility is located in a rural area.
EXAMPLE
Big Data Corporation builds and leases out enormous server farms. The key cost of these
farms is the availability of cheap electricity, so all of the company’s locations are situated
near hydroelectric or geothermal generating stations, usually deep in the countryside. In this
case, utilities are the key element of the occupancy cost ratio.
Big Apple Produce sells its organic food products to restaurants in the New York City area.
Because of high property taxes, Big Apple’s facilities are always located just outside of the
property lines of the incorporated areas near New York.
The Twister Vacuum Company elects to move to Arizona from its current location near
Oklahoma City. The reason is the insurance component of the company’s occupancy cost.
The weather damage insurance associated with being located in Tornado Alley in Oklahoma
is too much for the company, so moving to the more benign environment in Arizona allows
the company to reduce its occupancy cost.
Square Feet per Person

The measurement of square feet per person places an emphasis on arranging a work
space to maximize space utilization, especially during the initial layout phase for a
facility. Likely outcomes of using this measurement are shifting storage space
offsite, increased use of cubicles, and the reduction of “dead space” that serves no
useful purpose. The following issues can impact the measurement:
• Hoteling. If a company transitions some staff to common-usage areas that
they are assigned upon arrival, there is an open question regarding how to
incorporate what may be quite a large number of hoteling employees into
the calculation.
• Part time staff. A part-time staff person still fills a cubicle, so unless several
people are using the same office space in sequence, it is probably best to
consider a part-time person a full-time employee for the purposes of calcu-
lating square feet per person.
• Work at home part time. Many employees work from home for a portion of
the week, but still retain their office space. If so, continue to count anyone as
a full-time, on-site employee if he or she retains exclusive use of a work
space.
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Based on these issues, we suggest the following measurement for square feet per
person:
Total facility square footage – Hoteling square footage

Total number of employees – Hoteling employees
In essence, that portion of the facility used for hoteling is stripped away from the
calculation, leaving only the portion of the facility that is regularly used by non-
hoteling employees.
EXAMPLE
New Centurion Corporation translates Latin texts for its university clients. There is an on-site
staff of translators that work primarily from cubicles, while a number of visiting scholars are
assigned space in a common area under a hoteling arrangement. There are also part-time
translators that are assigned their own office space on a permanent basis. Management wants
to understand the space utilization of the facility, and so compiles the following information:
Total square footage 20,000

Square footage of hoteling common area 5,000
Number of on-site full-time staff 38
Number of on-site part-time staff 12
Based on this information, square feet per person is calculated as:
20,000 Total square footage – 5,000 Hoteling square footage

38 Full-time staff + 12 Part-time staff
= 300 Square feet per person
This measurement is most useful in an employee-intensive environment, and much

less so where most of the square footage is taken up by retail, production, training,
or storage space.
Percent of Storage in High-Cost Locations

The most expensive facility space is invariably used by office staff, such as
corporate and administrative personnel. The cost per square foot for production and
warehousing space is typically lower, because it is located in a lower-rent area, and
may be a more simple structure on a concrete slab, and which is not air conditioned.
Given the higher cost of office square footage, it is not economical to set aside much
of this space for storage purposes. However, many offices are extremely cluttered
with files and other items that could be shifted to a lower-cost facility.
The percent of storage in high-cost locations highlights the amount of space that
could be eliminated or put to other uses if stored items are moved. To calculate this
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ratio, divide the number of square feet set aside for storage by the total number of
square feet of office space. The formula is:
Number of square feet set aside for storage

Total number of square feet of office space
Active use of this measurement should result in a reduced retention of files on-site,
along with an archiving program that shifts all other files to an off-site (and lower
cost) location. It may also trigger the use of a document imaging system that
eliminates the need for on-site paper documents.
EXAMPLE
The CFO of Tsunami Products notes a wide disparity between the rental rate for the
company’s corporate headquarters, at $35 per square foot, and the $5 rate for its production
facility. The company has 20,000 square feet in its corporate headquarters, of which 8,000 is
taken up by a file storage area for product designs and accounting records. Since storage
constitutes 40% of the total office space, the CFO decides to institute an off-site storage
program; doing so will open up space for an upcoming hiring campaign intended to bolster
the corporate staff.
Floor Space Utilization

The traditional layout of a production facility uses a great deal of space, since
production lines tend to be long and straight, with lots of space nearby for the
materials handling staff to move with their forklifts and deposit stacks of inventory
near operator workstations. This is not an efficient use of space, since a more
compressed environment can eliminate the need for buffer inventory that would
otherwise pile up next to work stations. Also, production lines are more effective
when set up in a serpentine configuration, since people working on the line can more
easily communicate with each other. For these reasons, a high degree of floor space
utilization is to be encouraged.
To calculate floor space utilization, measure the footprint of existing equipment,
as well as the space required by machine operators, the storage of inventory next to
the equipment, and the travel lanes needed by the materials handling staff. Then
divide this aggregate square footage used by the total square footage of the facility.
The formula is:
Square footage required for machinery, personnel, inventory, and transport

Total square footage
If this measurement is used as the basis for a reduction in square footage used, be
aware that there is likely to be an optimal layout that will still require a certain
amount of space. Any layout that uses an even more compressed footprint may have
safety issues, or not involve the best materials flow. Also, the cost of reconfiguration
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can be substantial, especially if a company has invested in very large machinery that
cannot be easily moved; in these situations, it may not be cost-effective to pursue the
compression of floor space used.
EXAMPLE
The management of Hodgson Industrial Design is interested in combining facilities for its
aerospace widget manufacturing operations, which currently occupy an aggregate total of
25,000 square feet of production space in two buildings. By centralizing in a single building,
the company can sell off the other building. A consultant who specializes in manufacturing
cells is brought in to examine the current layout, and issues the following report:
Two Facility One Facility

Layout (sq. ft.) Layout (sq. ft.)
Machinery footprint 4,500 4,500
Operator working space 1,750 1,500
Inventory storage 4,000 500
Materials handling travel lanes 14,000 2,000
Total space required 24,250 8,500
The analysis reveals that a more compressed layout is possible that will allow the company
to eliminate one of its production facilities. However, the compression can only be
accomplished if the traditional materials handling system is eliminated, in favor of conveyor
belts that move parts from one machine to the next. Management must consider the cost of
the reconfiguration and the investment in conveyor belts when deciding whether to eliminate
a building.
Cubic Volume Utilization

The warehouse is the only location in a business where storage space can go up into
the rafters, rather than being used on a single level. In this area, it makes sense to
maximize the entire cubic volume of the storage space, which may call for the use of
multi-level storage racks.
To calculate the utilization of cubic warehouse volume, determine the cubic
volume of the storage systems currently in use, and divide by the entire cubic
volume of the warehouse. The formula is:
Cubic volume of storage racks

Cubic volume of warehouse area
There are some issues with forcing too much storage space into a warehouse.
Consider the following issues:
• Storage racks may be so high that they are unstable when fully loaded.
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• Aisles must have sufficient space for forklifts and other materials handling
equipment to safely navigate without running into the storage racks.
• Overhead sprinkler systems may limit the extent to which rack height can be
increased.
In short, there will be an optimum usage percentage that is notably less than the
actual cubic volume of available warehouse space, due to the restrictions imposed by
safety issues, travel lanes, and building obstructions.
EXAMPLE
The Terminal Cow Company runs a slaughterhouse, and stores the resulting cuts of beef in a
nearby deep-freeze warehouse. The plant manager wants to take advantage of the full cubic
space afforded by the storage facility, and so commissions a study of how to maximize the
space. The resulting report contains the following points:
Current space usage 62%

Required for travel lanes 18%
Required for refrigeration units 6%
Required for building supports 4%
Residual space available 10%
Total cubic volume 100%
The analysis reveals that the facility is quite well utilized already, with only 10% of the space
available for the installation of additional storage racks.
Percentage of Storage Bins Utilized

A company may do an excellent job of setting up racking systems within a
warehouse, and yet not maximize the use of those racks. For example, the materials
handling staff may not want to use the uppermost bins, or those located furthest from
the receiving docks. If so, this represents space that could be more fully utilized, and
is a concern if the warehouse manager is instead paying for third party storage or
storage in trailers. The measure is also useful for budgeting purposes, since the
materials manager can use it to estimate when the warehouse will be completely
filled, based on budgeted sales volumes and production rates. Management can then
estimate when to purchase or rent additional warehouse space.
To calculate the percentage of storage bins utilized, count the number of bins
currently in use (this may be available through a report generated by the warehouse
management system), and divide by the total number of bins. The formula is:
Number of storage bins in use

Total number of storage bins
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The measure is somewhat flawed, in that storage bins may vary greatly in size,
where some can accept fully-loaded pallets, and others are essentially drawers in
storage cabinets. If this is the case, consider using one measurement for large-size
bins and another measurement for all other sizes. Another issue is that some bins
may only be partially filled, and so can still accept additional inventory.
EXAMPLE
Mole Industries requires a large amount of storage space for the raw materials needed to
construct its ditch digging and tunneling products. The CFO is trying to estimate when the
company will need to construct an extension to the warehouse. Currently, 80% of all storage
bins are being utilized, leaving 500 bins still open. The marketing manager is pushing for an
entirely new product line of digging machines that are targeted at the retail market, and
which would be rented from local home supply stores. These machines will require the
storage of 300 additional stock keeping units of various kinds, which will leave only 200
unused bins. The remaining bins will likely be required to store the finished goods related to
this product line.
Based on the addition of the new product line, the CFO begins to make arrangements for a
small amount of rented storage space to be used for overflow situations.
Honeycombing Percentage
Honeycombing is the amount of space in a warehouse that is not being properly
utilized. It can be triggered by a variety of issues, including the following:
• Assigning a specific rack location to goods, but not having any goods to
store in that location.
• Creating a long stacking lane but having insufficient pallets to fill the lane.
• Putting just one pallet in a double-deep storage rack.
• Incorrectly storing cases, so there is not sufficient room to store adjacent
cases.
There are two ways to calculate the amount of honeycombing, either as a proportion
of storage locations or as a percentage of cubic warehouse storage space. The
calculation of the first method is as follows:
Empty storage locations ÷ Total storage locations = Honeycombing percentage
This calculation is imperfect, for it does not account for those storage locations that
are partially filled, assumes a single stacking lane is one storage location (despite its
considerable size), and also assumes that all storage locations have roughly the same
footprint. Nonetheless, it is easily calculated from a warehouse report of storage bin
locations, or simply by walking through the warehouse and counting empty storage
locations.
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The more accurate honeycombing measurement is to track the percentage of

unused cubic warehouse storage space. This approach requires that you divide the
warehouse into locations of varying sizes, and then estimate the cubic volume of
each location size. The cubic volume of empty spaces can then be calculated and
compared to the total volume of storage spaces. The calculation is:
Cubic volume of empty storage locations ÷ Cubic volume of total storage locations
= Honeycombing percentage
The second calculation is still not perfect, for it does not account for partially-filled
storage locations. This issue can be corrected by conducting a manual walk-through
of the warehouse and adjusting the calculation for these partially-filled locations, but
doing so is quite labor intensive.
EXAMPLE
Entwhistle Electric operates a warehouse for its battery manufacturing facility, which houses
raw materials for battery construction, as well as finished goods for a variety of cell phone
battery products. It is becoming increasingly difficult to putaway goods in the warehouse, so
the warehouse manager wants to determine the effects of honeycombing to see if additional
storage space can be found. He accumulates the following information about the storage
locations in the facility:
Location Number of Cubic Feet Total Empty Empty

Type Locations per Location Cubic Feet Locations Cubic Feet
Pallet storage 600 100 60,000 80 8,000
Case storage 350 50 17,500 50 2,500
Broken case storage 150 40 6,000 20 800
1,000 83,500 150 11,300
The warehouse manager first calculates honeycombing based just on the number of empty
locations, which yields the following result:
150 Empty locations ÷ 1,000 total locations = 15.0% Honeycombing
The warehouse manager then runs the calculation based on cubic feet of storage space, with
the following result:
11,300 Empty cubic feet ÷ 83,500 Total cubic feet = 13.5% Honeycombing
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Summary
When using measurements to judge facilities, it is useful to keep in mind the
alternative uses to which excess space can be put. In some situations, it is possible to
sublease space that is made available through the concentration of existing
operations. In other cases, subleasing is not an option. Thus, facility measurements
may indicate that space is being poorly used, but the presence of a long-term lease
liability and the absence of alternative uses may mean that a business has no ability
to reduce its costs in this area. Even if this is the case, the measurements described
in this chapter should still be followed, so that management understands the real
usage requirements of the business when it is time to search for new facilities.
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Chapter 13
Financing Measurements
Introduction
A company may have an interest in obtaining debt to fund its operations or pay for
asset purchases or acquisitions. If so, there are a number of measurements available
that can be used to estimate the amount of debt that a company can safely take on. In
this chapter, we focus primarily on the ability of a borrower to repay its debts, with
some additional attention to measures of risk, debt usage levels, and the cost of debt.
Overview of Financing Measurements

Debt is usually the lowest-cost form of funding that a business can obtain, so there is
a natural interest in using debt funding when a business needs additional cash.
However, there is a limit to the amount of debt that a business can safely take on.
Above that level, the fixed cost of interest expense, as well as the obligation to pay
back debt, makes it increasingly risky to commit to more debt. From the perspective
of the borrower, it is useful to examine the Ability to Pay measurements noted in
this chapter, particularly in regard to the variability of earnings. If a business is
subject to seasonal or cyclical variations in earnings, then the ability to pay for debt
should be based on one of the following concepts:
• The worst-case cash flows of the business at the bottom of the business or
seasonal cycle; or
• Variable debt levels that are paid off during periods when the company is
flush with cash, in preparation for an expected decline in cash flows.
The first of these variations is recommended for modeling the correct level of debt
to take on, for the second variation can be quite difficult to predict. A company may
maintain a high debt load too far into a business cycle, and then see its cash flows
decline precipitously before it has a chance to pay off the debt.
A lender will look at the same ratios, but will also consider the proportion of
debt to equity, to see if the owners of a business have contributed a sufficient
amount of funds to the business. If not, a lender may curtail additional lending until
such time as a borrower can obtain additional equity financing.
Debt to Equity Ratio

The debt to equity ratio of a business is closely monitored by the lenders and
creditors of the company, since it can provide early warning that an organization is
so overwhelmed by debt that it is unable to meet its payment obligations. This may
also be triggered by a funding issue. For example, the owners of a business may not
want to contribute any more cash to the company, so they acquire more debt to
address the cash shortfall. Or, a company may use debt to buy back shares, thereby
increasing the return on investment to the remaining shareholders.
Whatever the reason for debt usage, the outcome can be catastrophic, if
corporate cash flows are not sufficient to make ongoing debt payments. This is a
concern to lenders, whose loans may not be paid back. Suppliers are also concerned
about the ratio for the same reason. A lender can protect its interests by imposing
collateral requirements or restrictive covenants; suppliers usually offer credit with
less restrictive terms, and so can suffer more if a company is unable to meet its
payment obligations to them.
To calculate the debt to equity ratio, simply divide total debt by total equity. In
this calculation, the debt figure should also include all lease obligations. The
formula is:
Long-term debt + Short-term debt + Leases

Equity
EXAMPLE
An analyst is reviewing the credit application of New Centurion Corporation. The company
reports a $500,000 line of credit, $1,700,000 in long-term debt, and a $200,000 operating
lease. The company has $800,000 of equity. Based on this information, New Centurion’s
debt to equity ratio is:
$500,000 Line of credit + $1,700,000 Debt + $200,000 Lease

$800,000 Equity
= 3:1 debt to equity ratio
The debt to equity ratio exceeds the 2:1 ratio threshold above which the analyst is not
allowed to grant credit. Consequently, New Centurion is kept on cash in advance payment
terms.
Supplier Financing of Assets

It can be quite a struggle for a business to obtain debt financing, in which case it
should make an effort to extract as much financing as possible from its suppliers in
the form of trade credit. In some cases where the supply of cash is extremely tight,
the managers of a firm may shift their purchases to those suppliers most willing to
provide it with longer-term financing. By doing so, they are gaining interest-free
lines of credit from their suppliers.
The supplier financing of assets measurement can be used to determine the
success of these efforts. This measurement is derived by dividing accounts payable
by total assets and then multiplying the result by 100. The calculation is:
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Accounts payable
--------------------- × 100
Total assets
A smaller company with poor financing prospects may consider its supplier
financing arrangements to be absolutely essential, and so will take great care to only
grow if it can obtain sufficient supplier financing to do so.
EXAMPLE
Ruff’n Tumble makes boat shoes for fishermen. It has no access to a traditional line of credit,
and so bases its expansion decisions on the willingness of its leather and sole suppliers to
provide it with credit. Over the past year, the company has averaged total assets of $3.6
million and accounts payable of $1.2 million. This results in the following measure of
supplier financing of assets:
$1,200,000 Accounts payable

------------------------------------ × 100 = 33%
The company has received an order for an additional $600,000 of sales from an overseas
distributor. Accepting the order will cause an increase of $400,000 in its assets. Since the
company is currently unable to obtain any additional financing from its suppliers, the
outcome of the sale would be the following change in the measurement:
$1,200,000 Accounts payable

------------------------------------ × 100 = 30%
Since accepting the order will result in a 9% drop in the proportion of supplier financing of
assets, the company’s managers decide to turn down the offer.
Ability to Pay Measurements

When estimating the correct amount of debt burden to maintain, it is useful to
measure the ability of a business to pay its fixed costs, which include interest
expenses. The following four measurements can be employed, beginning with the
narrowly-focused interest coverage ratio, and then expanding the focus of the
measurement in the debt service coverage ratio to include principal, and to other
fixed costs in the fixed charge coverage ratio. Also, the cash coverage ratio looks at
the ability to pay from the perspective of available cash, rather than earnings as
reported under the accrual basis of accounting.
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Interest Coverage Ratio

The interest coverage ratio measures the ability of a company to pay the interest on
its outstanding debt. A high interest coverage ratio indicates that a business can pay
for its interest expense several times over, while a low ratio is a strong indicator that
an organization may default on its loan payments.
It is useful to track the interest coverage ratio on a trend line, in order to spot
situations where a company’s results or debt burden are yielding a downward trend
in the ratio. An investor would want to sell the equity holdings in a company
showing such a downward trend, especially if the ratio drops below 1.5:1, since this
indicates a likely problem with meeting debt obligations.
To calculate the interest coverage ratio, divide earnings before interest and taxes
(EBIT) by the interest expense for the measurement period. The formula is:
Earnings before interest and taxes

Interest expense
EXAMPLE
Carpenter Holdings generates $5,000,000 of earnings before interest and taxes in its most
recent reporting period. Its interest expense in that period is $2,500,000. Therefore, the
company’s interest coverage ratio is calculated as:
$5,000,000 EBIT
$2,500,000 Interest expense
= 2:1 Interest coverage ratio
The ratio indicates that Carpenter’s earnings should be sufficient to enable it to pay the
interest expense.
A company may be accruing an interest expense that is not actually due for payment
yet, so the ratio can indicate a debt default that will not really occur, or at least until
such time as the interest is due for payment.
Debt Service Coverage Ratio

The debt service coverage ratio measures the ability of a revenue-producing property
to generate sufficient cash to pay for the cost of all related mortgage payments. A
positive debt service ratio indicates that a property’s cash outflows can cover all
offsetting loan payments, whereas a negative ratio indicates that the owner must
contribute additional funds to pay for the annual loan payments. A very high debt
service coverage ratio gives the property owner a substantial cushion to pay for
unexpected or unplanned expenditures related to the property, or if market
conditions result in a significant decline in future rental rates.
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To calculate the ratio, divide the net annual operating income of the property by
all annual loan payments for the same property, net of any tax savings generated by
the interest expense. The formula is:
Net annual operating income
Total of annual loan payments net of tax effect
There may be no tax effect associated with debt, if a company has no taxable
income. Otherwise, the tax effect is based on the income tax rate expected for the
year.
EXAMPLE
A rental property generates $400,000 of cash flow per year, and the total annual loan
payments of the property are $360,000. This yields a debt service ratio of 1.11, meaning that
the property generates 11% more cash than the property owner needs to pay for the annual
loan payments.
A negative debt service coverage ratio may result when a property is transitioning to
new tenants, so that it is generating sufficient cash by the end of the measurement
period, but was not doing so during the beginning or middle of the measurement
period. Thus, the metric can yield inaccurate results during transition periods.
Fixed Charge Coverage Ratio

A business may incur so many fixed costs that its cash flow is mostly consumed by
payments for these costs. The problem is particularly common when a company has
incurred a large amount of debt, and must make ongoing interest payments. In this
situation, use the fixed charge coverage ratio to determine the extent of the problem.
If the resulting ratio is low, it is a strong indicator that any subsequent drop in the
profits of a business may bring about its failure.
To calculate the fixed charge coverage ratio, combine earnings before interest
and taxes with any lease expense, and then divide by the combined total of interest
expense and lease expense. This ratio is intended to show estimated future results, so
it is acceptable to drop from the calculation any expenses that are about to expire.
The formula is:
Earnings before interest and taxes + Lease expense

Interest expense + Lease expense
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EXAMPLE
Luminescence Corporation recorded earnings before interest and taxes of $800,000 in the
preceding year. The company also recorded $200,000 of lease expense and $50,000 of
interest expense. Based on this information, its fixed charge coverage is:
$800,000 EBIT + $200,000 Lease expense

$50,000 Interest expense + $200,000 Lease expense
= 4:1 Fixed charge coverage ratio
Cash Coverage Ratio

The cash coverage ratio is useful for determining the amount of cash available to
pay for interest, and is expressed as a ratio of the cash available to the amount of
interest to be paid. This is a useful ratio when the entity evaluating a company is a
prospective lender. The ratio should be substantially greater than 1:1. To calculate
this ratio, take the earnings before interest and taxes (EBIT) from the income
statement, add back to it all non-cash expenses included in EBIT (such as
depreciation and amortization), and divide by the interest expense. The formula is:
Earnings before interest and taxes + Non-cash expenses

Interest expense
There may be a number of additional non-cash items to subtract in the numerator of

the formula. For example, there may have been substantial charges in a period to
increase reserves for sales allowances, product returns, bad debts, or inventory
obsolescence. If these non-cash items are substantial, be sure to include them in the
calculation. Also, the interest expense in the denominator should only include the
actual interest expense to be paid – if there is a premium or discount to the amount
being paid, it is not a cash payment, and so should not be included in the
denominator.
EXAMPLE
The controller of Currency Bank is concerned that a borrower has recently taken on a great
deal of debt to pay for a leveraged buyout, and wants to ensure that there is sufficient cash to
pay for its new interest burden. The borrower is generating earnings before interest and taxes
of $1,200,000 and it records annual depreciation of $800,000. The borrower is scheduled to
pay $1,500,000 in interest expenses in the coming year. Based on this information, the
borrower has the following cash coverage ratio:
$1,200,000 EBIT + $800,000 Depreciation

$1,500,000 Interest expense
= 1.33 Cash coverage ratio
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The calculation reveals that the borrower can pay for its interest expense, but has very little
cash left for any other payments.
Average Cost of Debt

A company that uses a large amount of debt financing may not be aware of the
average cost of the debt load that it has incurred. If so, consider deriving the average
cost of debt, which could lead to an investigation of the more expensive tranches of
debt, and possibly their payoff or refinancing with less-expensive types of debt.
The calculation of the average cost of debt should encompass all types of debt,
which includes the costs of bonds, bank loans, and capital leases. The calculation is:
Annual cost of interest on loans, bonds, and capital leases

Average amount of bonds, loans, and leases outstanding
It may be easier to calculate the average cost of debt on a monthly basis, rather than
an annual basis, if the amount of debt varies considerably over the one-year
measurement period.
There are several issues with the collection of information for the average cost
of debt, which are:
• Lease rate. It can be difficult to determine the interest rate contained within
a lease. If the amount of a lease is quite small, its inclusion in the average
cost of debt may be immaterial, and so it can be excluded. Otherwise, con-
tact the lessor to obtain the rate.
• Bond rate. The effective interest rate should be used as the interest rate for a
bond, rather than the stated interest rate. When a bond is sold for an amount
other than its face amount, this means the associated interest rate varies from
the stated interest rate. For example, if a company sells a bond for $95,000
that has a face amount of $100,000 and which pays interest of $5,000, then
the effective interest rate being paid is $5,000 ÷ $95,000, or 5.26%. Thus, if
a company sells a bond at a discount from its face value, the effective inter-
est rate is higher than the stated interest rate. If the company sells a bond at
a premium from its face value, the effective interest rate is lower than the
stated interest rate.
• Other expenses. There may be several additional expenses associated with
debt, such as an annual audit required by the lender, and an annual loan
maintenance fee. If these expenses would not be incurred in the absence of
the debt, include them in the interest cost of the debt.
The interest rate paid does not reveal a complete picture of the borrowing
instruments employed by a business. There may be restrictive covenants or
conversion clauses built into these instruments that are of more importance than the
interest rates being paid. For example, a covenant not to pay dividends could be of
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concern to a family-held business, while a conversion clause could allow debt

holders to convert their debt to equity at extremely favorable rates.
EXAMPLE
Puller Corporation, maker of plastic and wooden doorknobs, has acquired a considerable
amount of debt while acquiring competitors that make other door fittings. The CEO is
concerned about the cost of this debt, and asks for a derivation of the average cost. The
resulting report contains the following information:
Annual Principal Interest Other

Interest Cost Outstanding Rate Features
Factory lease $280,000 $2,300,000 12.1% No early payment clause
Senior bank loan 1,200,000 15,000,000 8.0% Balloon due in 24 months
Junior bank loan 975,000 6,500,000 15.0% Risk of acceleration
Bonds 1,680,000 24,000,000 7.0% Convertible into common stock
$4,135,000 $47,800,000
Based on the table, Puller’s average cost of debt is:
$4,135,000 Annual interest cost

$47,800,000 Principal outstanding
= 8.65%
Overall, the interest rate being paid by Puller is acceptable. However, the interest rate on the
junior bank loan is quite high, since the lender is unlikely to have access to the company’s
assets in the event of a default. There are also covenants associated with this loan that Puller
could breach, resulting in loan acceleration. Consequently, the junior bank loan is clearly the
loan to be paid off or refinanced, if the opportunity to do so is available.
Borrowing Base Usage

If a company does not have large cash reserves, it must rely upon a line of credit to
provide it with sufficient cash to keep the company operational. Lenders almost
always insist upon using a company’s accounts receivable and inventory as the
collateral basis (or borrowing base) for a line of credit. The amount loaned to a
company under a line of credit agreement cannot exceed the borrowing base.
Consequently, a critical financing metric to follow is borrowing base usage. This is
the amount of debt that has been loaned against the collateral provided by a
company.
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EXAMPLE
A business has $1,000,000 of accounts receivable and $600,000 of inventory on hand. Its
lender will allow a line of credit that is based on 75% of all accounts receivable less than 90
days old, and 50% of inventory. $20,000 of the accounts receivable are more than 90 days
old. This means that the applicable borrowing base for the company is:
Discount Allowable
Applicable Assets Rate Borrowing Base
Accounts receivable of $980,000 × 75% = $735,000
Inventory of $600,000 × 50% = 300,000
Total = $1,035,000
The unused amount of the borrowing base is crucial, since it must be compared to
any cash shortfalls projected in the cash forecast to see if a business has sufficient
available and unused debt to offset negative cash positions.
Borrowing base usage requires continual analysis, since the amount of receiva-
bles and inventory to be used as collateral is constantly changing. This is a particular
concern in seasonal businesses, since they tend to build inventory levels prior to the
sales season, followed by a build in accounts receivable levels during the sales
season, followed by a quiet period when assets are liquidated and debts are paid off.
The continual changes in debt needs and asset levels make borrowing base usage
perhaps the most important metric for the CFO of a seasonal business.
Summary
A lender or prospective lender is likely to use several measures to quantify the
ability of a borrower to repay its debts. The situation is considerably easier for the
borrower, which must focus its attention on borrowing base usage and the debt
service coverage ratio. These two metrics focus attention on the ability to maximize
borrowings and then pay back the debt. In addition to these measurements, the
borrower should pay particular attention to the maturity dates of loans and the status
of projected cash flows, to see if the business can indeed repay its liabilities. If not,
the CFO or treasurer should prepare to roll over loans as far in advance as possible.
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Chapter 14
Fixed Asset Measurements
Introduction
Fixed asset measurements are used to obtain a general understanding of the
adequacy of a company’s investment in fixed assets. Fixed asset ratio analysis is not
typically used within a business, since employees instead use detailed asset-specific
records to evaluate replacement, usage, and maintenance issues. However, ratios are
quite useful for an outsider who is investigating the investment in and usage of fixed
assets by a company. With this latter audience in mind, we present several
measurements in this chapter that relate to fixed assets.
Overview of Fixed Asset Measurements

An outsider who is reviewing the financial statements of a company can discern a
large amount about the efficiency with which a business employs its fixed assets,
how frequently those assets are replaced, and the state of the maintenance of that
equipment. Asset efficiency can be explored by measuring the proportion of the
carrying amount of fixed assets to annualized sales, and especially when this figure
is then compared to the same figure for other firms in the same industry. Asset
replacement speed can be estimated by comparing the amount of accumulated
depreciation to the carrying amount of fixed assets. Finally, equipment maintenance
can be tracked by comparing the reported amount of repairs and maintenance
expense to the carrying amount of fixed assets. In brief, there are several excellent
ratios available that can be used to extract crucial fixed asset information from the
financial statements of a business. These and other ratios are enumerated in the
following sections.
Sales to Fixed Assets Ratio

It requires a large amount of fixed assets to compete in some industries, such as
computer chips and automobiles. The sales to fixed assets ratio can be used to
determine how a company’s expenditures for fixed assets compare to those of other
companies in the same industry, to see if it is operating in a more lean fashion than
the others, or if there may be opportunities to scale back on its fixed asset
investment. This is quite useful to track on a trend line, which may show gradual
changes in expenditure levels away from the historical trend. The ratio is most
useful in asset-intensive industries, and least useful where the required asset base is
so small that the ratio would be essentially meaningless.
The ratio can also be misleading in cases where a company must invest in an
entire production facility before it can generate any sales; this will initially result in
an inordinately low sales to fixed assets ratio, which gradually increases as the
company maximizes sales for that facility, and then levels out when it reaches a high
level of asset utilization.
To calculate the sales to fixed assets ratio, divide net sales for the past twelve
months by the book value of all fixed assets. The formula is:
Trailing 12 months’ sales

Book value of all fixed assets
The fixed asset book value listed in the denominator is subject to some variation,
depending on what type of depreciation method is used. If an accelerated
depreciation method is used, the denominator will be unusually small, and so will
yield a higher ratio.
EXAMPLE
Mole Industries manufactures trench digging equipment. It has a relatively low sales to fixed
assets ratio of 4:1, because a large amount of machining equipment is needed to construct its
products. Mole is considering expanding into earth-moving equipment, and calculates the
sales to fixed assets ratio for competing companies, based on their financial statements. The
ratio is in the vicinity of 3:1 for most competitors, which means that Mole will need to invest
heavily in fixed assets in order to enter this new market. Mole estimates that the most likely
revenue level it can achieve for earth moving equipment will be $300 million. Based on the
3:1 ratio, this means that Mole may need to invest $100 million in fixed assets in order to
achieve its goal.
Mole’s CFO concludes that the company does not currently have the financial resources to
invest $100 million in the earth moving equipment market, and recommends that the
company not enter the field at this time.
Accumulated Depreciation to Fixed Assets Ratio

If a company is not replacing its fixed assets, then the proportion of accumulated
depreciation to fixed assets will increase over time. The ratio is quite useful for
analyzing prospective acquisitions, since it is an easy way to see if an acquiree is not
reinvesting in its business. This information is especially useful when tracked on a
trend line, since it shows gradual changes in the ratio that might not otherwise be
immediately apparent.
There are several situations where this ratio is not useful. For example, a
business may be using accelerated depreciation, which results in a large amount of
accumulated depreciation despite having relatively new assets. The ratio can also be
problematic if a company is not removing assets and accumulated depreciation from
its books as soon as it disposes of them. It is also possible that a company has
chosen to switch to leased assets under operating leases, where the fixed assets do
not appear on the company’s balance sheet. Finally, a company may acquire assets
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that have very long useful lives (such as hydroelectric facilities), where the gradual
accumulation of depreciation is a natural part of the business. Be aware of these
situations when deciding whether to use the ratio.
To calculate the accumulated depreciation to fixed assets ratio, divide the total
accumulated depreciation by the total amount of fixed assets (before depreciation).
The formula is:
Accumulated depreciation
Total fixed assets before depreciation deduction
EXAMPLE
Mole Industries is conducting an investigation of Vertical Drop, a heavy-lift helicopter

company that installs cell towers and power poles, with the intent of buying the company.
The primary asset of Vertical Drop is its fleet of Sikorsky helicopters, which must be
properly maintained and replaced at regular intervals. Mole collects the following
information about Vertical Drop’s fixed assets:
20X1 20X2 20X3 20X4

Accumulated depreciation $4,900,000 $6,000,000 $9,400,000 $10,450,000
Fixed assets $32,700,000 $33,400,000 $31,350,000 $29,875,000
Accumulated depreciation
15% 18% 30% 35%
to fixed assets ratio
The ratio calculation in the table indicates that Vertical Drop essentially stopped purchasing
replacement helicopters two years ago, which means that Mole may be faced with large-scale
replacements if it buys the company.
Cash Flow to Fixed Asset Requirements Ratio

Does a company have sufficient cash to pay for its upcoming fixed asset purchases?
The cash flow to fixed asset requirements ratio is useful both as a general internal
analysis of a company’s future prospects, and also as a means for determining the
health of a possible acquisition. The ratio must be greater than 1:1 for a company to
have sufficient cash to fund its fixed asset needs. If the ratio is very close to 1:1, then
a company is operating near the edge of its available cash flows, and should consider
bolstering its cash position with a line of credit. The ratio is less useful if the
company in question has substantial cash reserves, since it can always draw upon
these reserves to fund its fixed asset requirements, irrespective of short-term cash
flows.
To calculate the cash flow to fixed asset requirements ratio, divide the expected
annual cash flow by the total expenditure that has been budgeted for fixed assets for
the same period. The cash flow figure in the numerator can be calculated by adding
non-cash expenses (such as depreciation and amortization) back to net income, and
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subtracting out any non-cash sales (such as sales accruals). Also subtract from the
numerator any dividends and principal payments on loans. The formula is:
Net income + Noncash expenses – Noncash sales – Dividends – Principal payments

Budgeted fixed asset expenditures
EXAMPLE
Mole Industries has just compiled the first iteration of its budget for the upcoming year,
which reveals the following information:
Budget Line Item Amount

Net income $4,100,000
Depreciation and amortization 380,000
Accrued sales 250,000
Dividend payments 100,000
Principal payments 800,000
Budgeted fixed asset expenditures 3,750,000
Based on this information, Mole’s controller calculates the ratio of cash flow to fixed asset
requirements as:
$4,100,000 Net income + $380,000 Depreciation and amortization

- $250,000 Accrued sales - $100,000 Dividends - $800,000 Principal payments
$3,750,000 Budgeted fixed asset expenditures
$3,330,000 Cash flows

$3,750,000 Budgeted fixed asset expenditures
= 89%
The ratio is less than one, so Mole will either need to draw upon its cash reserves to pay for
the fixed assets, cut back on its fixed asset budget, or revise other parts of the budget to
increase cash flow.
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Repairs and Maintenance Expense to Fixed Assets Ratio

When reviewing the potential acquisition of a product line or entire company, it is
useful to review the target company’s ratio of repair and maintenance expense to
fixed assets, especially on a trend line. If the ratio is increasing over time, there are
several ways to interpret it:
• Old assets. The acquiree is relying on an aging fixed asset base, since it
must spend more to keep them operational. This is the worst-case scenario,
since the buyer may be faced with a wholesale replacement of the acquiree’s
fixed assets.
• High utilization. The acquiree is experiencing very high asset usage levels,
which calls for higher maintenance costs just to keep the machines running
fast enough to meet demand. This condition can be spotted by looking for a
high sales to fixed assets ratio (see the prior ratio). A high profit level is also
likely.
• Preparing for sale. If there is a sudden spike in the ratio in the recent past, it
may be because the owner of the acquiree is simply preparing it for sale, and
so is either catching up on delayed maintenance or is bringing machinery up
to a high standard of performance.
• Accounting changes. It is possible that the repairs and maintenance expense
has been moved among different accounts, such as from the cost of goods
sold account or an overhead cost pool to its own account, which means that
there could appear to be a sudden jump in expenses that is not really the
case.
This ratio is least useful when the bulk of the repairs and maintenance expense is
comprised of salaries paid to a relatively fixed group of repair technicians. In this
case, the expense is essentially a fixed cost, and cannot be expected to vary much
over time.
A problem that this ratio does not reveal is when an acquiree simply lets its
machinery decline by not investing in repairs and maintenance; this means that the
ratio would remain flat or could even decline over time. In this case, look elsewhere
for an indicator, such as declining sales or an inability to meet customer delivery
schedules.
To calculate the repairs and maintenance expense to fixed assets ratio, divide the
total amount of repairs and maintenance expense by the total amount of fixed assets
before depreciation. The amount of accumulated depreciation that may have built up
on older assets would otherwise bring the denominator close to zero for some
acquirees, so it is better not to use depreciation at all. The formula is:
Total repairs and maintenance expense

Total fixed assets before depreciation
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EXAMPLE
Mole Industries is investigating the purchase of Grubstake Brothers, a manufacturer of

backhoes. Its acquisition analysis team uncovers the following information:
20X1 20X2 20X3 20X4

Sales $15,000,000 $14,500,000 $13,200,000 $12,900,000
Profit $1,000,000 $200,000 $(150,000) $(420,000)
Repairs expense $400,000 $240,000 $160,000 $80,000
Fixed assets $5,400,000 $6,000,000 $6,050,000 $6,100,000
Repairs to fixed assets ratio 7% 4% 3% 1%
The information in the table strongly indicates that the decline in Grubstake’s profitability
over the past few years has led its management to cut back on repair and maintenance
expenditures. Thus, if Mole elects to buy Grubstake, it can expect to invest a large amount to
replace fixed assets.
Summary
The determination of the adequacy of an investment in fixed assets is a difficult one
to make just from ratio analysis. An analyst really needs to examine the capacity
level of each machine, its age and maintenance record, and how it relates to the
production flow to see if new equipment is needed. Also, the ratios enumerated in
this chapter are only as good as the quality of the reported information. For example,
if the accounting staff does not remove old assets from the accounting records when
the assets are disposed of, the amount of accumulated depreciation reported in the
balance sheet will be too high, leading to the false perception that a company’s asset
base is aging. In short, there are limitations on the use of fixed asset ratios.
Nonetheless, the ratios are still useful for forming an overall impression of the fixed
asset base used by a business.
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Chapter 15
Human Resources Measurements
Introduction
Measurements can be applied not only to the performance of the human resources
department in particular, but also to the productivity and cost of employees
throughout an organization. In this chapter, we explore a number of measurements
that can reveal hiring efficiency, as well as the ability of employees to generate
income in a cost-effective manner. The measurements discussed here are particularly
relevant in a labor-intensive business where the productivity of employees
represents the primary driver of profits.
Overview of Human Resources Measurements

There are several areas in which the human resources function can be measured. The
ability to fill job requisitions in a timely manner is the most obvious and measurable
function directly associated with this area. The concept can be further refined into
the speed with which positions are filled, which positions continue to not be filled,
the effectiveness of recruiters, and the proportion of interns hired into full-time
positions. All of these measurements are addressed in the following sections.
Human resources measurements can also be expanded to cover an entire
business. For example, a company in the service industry or which employs a large
number of skilled positions (or both) needs to understand the amount of employee
turnover, since this issue directly impacts its ability to compete. Also, if labor and
related costs are high, management needs to have a clear understanding of the total
cost of employees, which includes all forms of compensation, such as commissions,
stock, overtime, bonuses, and so forth. This total cost concept can be expanded to
address the net benefits cost per employee, which encompasses every type of benefit
paid, less employee deductions. The association between the number of employees
and revenue can also be explored with the sales per person measurement, and
refined further by calculating profit per person. There are other ways to delve into
specific aspects of employee costs, such as the ratio of administrative staff employed
by a business, and the effectiveness of a decision to outsource in-house labor to a
supplier. While it may not be necessary to track all of these measurements, a
selection of those most applicable to a company’s operations can yield insights into
where costs are being incurred, and whether those costs are appropriate.
Position Fulfillment Speed

When an organization is attempting to grow at a fast rate, the main restriction on
growth may well be the speed with which positions are filled. This is a particular
concern for skilled positions, such as programmers, where there may be competition
from other employers. Alternatively, it can be an issue even for lower-skilled
positions when hiring must be completed in bulk, such as when the staff for an entire
hotel must be hired within a short period of time. In these cases, it can make sense to
measure the success of the human resources team by tracking position fulfillment
speed.
To track position fulfillment speed, calculate the difference between the date of
offer acceptance and the original job posting date, aggregated for all jobs posted, and
divide by the total number of jobs posted. The measurement is:
∑ (Offer acceptance date – Original job posting date)

Total number of jobs posted
The calculation of this ratio can lead to incorrect results, since the underlying
information may be skewed in several ways. Consider the following issues:
• A job posting may have been frozen for some time due to a funding
constraint or other reasons, resulting in a longer measurement interval than
is really the case. These postings should not be included in the measure-
ment.
• Some positions are informally posted without notifying the human resources
department, with formal notice only being given at the same time that an
offer is extended to a recruit. This usually happens when a position is being
advertised informally among other employees and their friends.
• Some positions may have been open for some time and continue to be
unfilled on the measurement date. These positions can be reported separate-
ly as a total number of unfilled job postings. See the measurement described
in the next section.
In short, some positions will be excluded from the measurement, while problems
with the job posting system may cause others to appear to be instantaneous hires.
These issues can cause difficulty in developing the measurement.
An additional problem is that position fulfillment speed can be impacted by
factors that are outside of the control of the human resources department. For
example:
• The department managers who are approving hires may be inordinately
picky for certain positions.
• The company’s finances do not allow for offers to be extended at pay rates
at or above the industry median.
• The company has a reputation for laying off employees that reduces the
interest of recruits in being hired.
The reasons noted here are caused by the entire company, so position fulfillment
speed can be considered a measurement for the entire business, rather than just the
human resources department.
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EXAMPLE
Cupertino Beanery is planning to open a large number of coffee shops in the current fiscal
year. Fifty shops are planned, each of which requires 20 employees, for a total of 1,000 new
hires. The president knows that recruiting for these positions has interfered with the rate at
which Cupertino has been able to open shops in the past. She assembles the following
information for the last three months of hiring:
Aggregate days to fill all positions = 4,025 business days

Total number of positions filled = 175
Position fulfillment speed = 23 business days
Since it currently takes the company more than a month to hire an employee, the president
hires a consultant to review alternative hiring practices, and also doubles the size of the
human resources department (which, unfortunately, requires 23 days to complete!).
Unfilled Requisitions Ratio

We noted in the preceding measurement that position fulfillment speed does not
include any job postings that continue to be unfilled. These postings can be
addressed in a different ratio, called the unfilled requisitions ratio, which should
accompany the position fulfillment speed measurement to give a complete picture of
how well the human resources department is filling posted job requisitions.
The concept behind the unfilled requisitions ratio is to set a threshold number of
days, above which all unfilled job requisitions are counted. The threshold is set at a
level designed to capture requisitions that have been open for an inordinately long
period of time. For example, if the average position is filled in 30 days, then set the
threshold at more than 30 days, and only count open requisitions exceeding that
figure. Then divide by the number of job requisitions opened over a sufficiently long
period of time to give a sense of scale to the number of unfilled requisitions. A
smaller organization with minimal hiring needs could use the annual number of job
requisitions posted, while a larger organization with massive hiring needs could set
the figure at just the last few months. The calculation is:
Number of job requisitions open more than designated threshold

Number of job requisitions opened during past __ months
There is no standard format for this measurement, so the calculation of the

numerator and denominator can be set to whatever figures give management the best
feel for how well the company is filling positions. However, once set, the format
should be locked in, so that performance can be reliably compared over multiple
periods.
Though useful as a general measure of hiring difficulties, the unfilled requisi-
tions ratio suffers from a few underlying problems, which are:
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• Threshold manipulation. It can be manipulated by setting a threshold for the

numerator that is just high enough to keep most unfilled positions from be-
ing listed. The issue can be avoided by having a senior manager review and
approve the threshold being used, and having the calculation periodically
examined by the company’s internal audit staff.
• Closed postings. Someone could continually close old job postings and re-
establish them as new postings to keep old postings from being incorporated
into the ratio. This is a difficult issue to remedy.
• Position importance. The measurement includes all unfilled requisitions,
some of which may be for inconsequential positions that can be filled at
leisure without damaging the business. This issue can be avoided by only
calculating the ratio for specific departments, such as engineering, where
filling positions in a timely manner may be more important.
EXAMPLE
Luminescence Corporation is greatly expanding its research lab for LED lighting, and is
continually on the hunt for more electrical engineers to fill a number of positions for the lab.
In light of the great demand for these positions, Luminescence has been unable to fill
positions within a reasonable period of time. The following table illustrates the growing
problem, with the hiring threshold set at 45 days:

Requisitions open > 45 days 17 23 29 37
Annual requisitions opened* 81 82 91 109
Unfilled requisitions ratio 21% 28% 32% 34%
* The annual requisitions opened is derived on a rolling 12-month basis.
The measurements reveal that the company’s problem is worsening, so management may
need to take additional steps to accelerate its recruiting efforts, such as bringing in recruiting
firms, raising pay rates, and offering signing bonuses.
Recruiter Effectiveness Ratio

When a company employs an outside recruiting firm to locate prospective recruits,
the assumption is that the recruiter will do an effective job of screening candidates
before sending them on to the company for interviews. If not, company personnel
will end up spending an inordinate amount of time conducting pointless interviews
of underqualified candidates.
The measurement is a simple one: divide the number of recruits eventually hired
by the number forwarded to the company from a recruiter. The calculation is:
Number of recruits hired

Number of recruits forwarded by recruiting firm
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Though the measurement is simple, its interpretation is not. There are several factors
that can play a role in legitimately shifting the blame for ineffective recruiting away
from a recruiter. Consider the following issues:
• Job description. The company may not have done an adequate job of
defining the position for which it is hiring. This can be an iterative process,
where the initial job description is continually modified, based on the quali-
fications of the candidates being forwarded from a recruiter.
• Company reputation. If the company is known for low pay, poor benefits,
continual layoffs, and so forth, then recruits are much less likely to accept an
offer from the company.
• Pickiness. The people assigned by the company to interview candidates sent
from recruiters may be extraordinarily picky in recommending who should
be hired. Thus, the ratio could be skewed for a particular recruiter because it
is unfortunate enough to have its candidates be screened by a particular in-
terviewer.
• Regional demand. The ability of a company to attract recruits may be
impaired by supply and demand in the region. If there are few candidates
available, then recruiters may be forced to suggest only partially-qualified
recruits that are more likely to be rejected.
Despite these issues, it should still be possible to detect significant differences in the
effectiveness of different recruiting agencies, when multiple agencies are being used
at the same time.
EXAMPLE
The Atlas Machining Company routinely uses a group of three outside recruiting firms to
locate software engineers. The human resources manager wants to reduce the time spent by
company employees in the interviewing process, and so measures the recruiter effectiveness
ratio for each of the recruiting firms. The results are as follows:
Number Number Effectiveness

Recruiter Name Hired Forwarded Ratio
Heroes for Hire 11 41 27%
Rocket Recruiters 14 117 12%
Simple Staffing 16 52 31%
The analysis reveals that the number of recruits hired through each firm is roughly the same,
but that Atlas’ employees must expend much more interviewing effort to sort through the
recruits forwarded from Rocket Recruiters. The human resources manager concludes that it
is time to terminate the services of Rocket, and shift more business to the other two firms.
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Intern Conversion Ratio

Some organizations like to bring in interns from local universities during the
summer months, with the intent of allowing both parties to review each other and
see if long-term employment is a viable possibility. This concept is useful for the
human resources department, which views it as a relatively low-cost way to evaluate
possible recruits.
To measure the success of the program, divide the number of interns hired full-
time by the number of interns from which the full-time hires were drawn. The
calculation is:
Number of interns hired full-time

Number of interns employed by the company
There can be some variation in the derivation of the denominator. Interns who are
hired full-time are typically drawn from the pool of interns used by a company
during the preceding summer, so the total number of interns from the prior summer
is typically used as the denominator. However, if the company continually brings in
interns throughout the year, then a revised figure may be needed.
The intern conversion ratio should not necessarily be considered a goal, such as
increasing it to 100%. Doing so might result in the hiring of interns who do not meet
the company’s minimum performance criteria. Instead, the measurement can be
considered an historical benchmark to be used for planning purposes. For example,
the human resources manager can derive an annual hiring plan that is based on an
assumption of 50% of all interns being hired.
EXAMPLE
Franklin Drilling typically hires a number of geology interns from the local school of mines,
evaluates them over the summer, and offers a certain percentage of them jobs before they
graduate from school the following year. The human resources department incorporates an
estimate of the intern conversion ratio into its hiring plans for the upcoming year. In the past
three years, the intern conversion ratio was 55%, 62%, and 58%. Franklin currently employs
18 interns. The human resources department has been told to hire a total of 16 geologists for
the upcoming year. Based on the historical conversion ratio, the human resources manager
can expect to hire about 60% of the 18 interns, which fills 11 of the 16 positions. She must
therefore plan to use alternative methods to hire five additional geologists.
Cost per Hire

The real effectiveness of a hiring program is the quality of the recruits hired,
especially when highly-skilled employees are needed. However, even in these
situations, the human resources manager should pay attention to the average cost
required to hire employees. The issue is of considerably more importance in
situations where a business must hire in bulk, and expects to continue doing so over
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a long period of time. In the latter case, paying close attention to the cost per hire
can have a major impact on the reported level of profitability of a business.
The essential cost per hire calculation is to compile all hiring costs and then
divide by the total number of employees hired in the measurement period. A
refinement of the calculation is to only divide by the number of employees who have
passed a probationary period, thereby stripping away those hires that have clearly
been proven to not be suitable. The calculation is:
Total cost of hiring

Number of new hires
When deriving the cost per hire calculation, be sure to include all hiring costs, which
may be substantially greater than is initially apparent. The following costs should be
included:
• Administrative cost of new employee set up
• Advertising cost
• Assessment testing fees
• Drug testing fees
• Fees paid to outside recruiters
• Wages paid to all employees associated with the hiring process
• Wages paid to in-house recruiting staff
A portion of the salaries paid to interviewers working outside of the human

resources department should not be assigned to the cost per hire, since a salary is
paid irrespective of the specific activities on which these employees are engaged.
EXAMPLE
New Centurion Corporation translates Latin texts on behalf of major universities and
libraries. It is exceedingly difficult to hire fully-qualified Latin scholars, so the company
engages in a broad range of recruitment activities, including advertising in the Latin Scholar
Daily, underwriting translator conferences, and reviewing citations in scholarly texts.
In the most recent quarter, New Centurion hired five new translators and incurred the
following hiring costs:
Hiring Cost Amount

Newsletter advertising $3,000
Conference fees 12,000
Recruiter fee 9,000
Recruit entertainment expense 2,500
Total $26,500
The cost per hire is $5,300, which is calculated as $26,500 total hiring costs incurred, divided
by five new hires.
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Employee Replacement Cost

The cost to replace an employee can be exceedingly high, but the cost is so
dispersed that management is not usually aware of it. To bring replacement cost to
their attention, consider reporting the average employee replacement cost on a
periodic basis. The result may be greater attention to those factors that are causing
employees to leave the company, such as improved benefits or a more spacious
work environment.
Employee replacement cost can be derived at an aggregate level by compiling
all replacement costs and dividing by the number of replacements hired. A
refinement of the calculation is to only divide by the number of replacement
employees who have passed a probationary period, thereby stripping away those
hires that have clearly been proven to not be suitable. The calculation is:
Total cost of replacing positions

Number of replacement hires
The total cost of replacing positions includes all of the hiring costs just noted for the
cost per hire measurement. In addition, include the following costs:
• Lost productivity cost
• New hire training cost
• Overtime cost for employees filling in for missing employees
• Temporary replacement cost
The cost of lost productivity can be difficult to quantify. Depending on the situation,
possible costs that can be classified as due to lost productivity are an increased error
rate that requires additional staff time to fix, and lost customer sales that result in
reduced gross margins.
EXAMPLE
Lethal Sushi provides sushi to customers that is derived from the most toxic fish in the sea.
Customers pay a high price for properly-prepared sushi, since they might otherwise die.
Accordingly, the loss of a sushi chef is a major blow to the company. In the past year, Lethal
lost four sushi chefs who needed to be replaced. The costs of doing so were as follows:
Replacement Cost Amount

Recruiting fees $20,000
New hire training 40,000
Overtime costs 12,000
Insurance settlement 100,000
Total $172,000
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The insurance settlement was with the next of kin of a customer who died from consuming
improperly-prepared sushi that was prepared by a temporary hire who was not properly
trained by the company.
The average replacement cost is $43,000, which is calculated as $172,000 total replacement
costs incurred, divided by four new hires.
There can be a striking difference between the replacement costs for certain
positions. For example, replacing a qualified software developer with someone of
equal skill may be inordinately expensive, while replacing someone working on a
production line may require a considerably lower expenditure. Given this disparity,
it can make sense to separately report on the average employee replacement cost for
those job classifications that are exceptionally difficult to hire.
Accession Rate
In situations where a large number of new employees are being hired, the human
resources staff may have to engage in extensive planning for how the new
employees are to be properly trained and assimilated into the organization. This
issue can be discerned using the accession rate, which measures the proportion of
new employees hired to the total base of existing employees. When the proportion is
quite high, or is projected to be quite high in the future, the need for additional
training activities becomes more critical. The calculation is:
Total number of new employees

Number of employees at end of previous measurement period
The measurement is usually derived on an annual basis. If there is a need to track it

more frequently, a rolling annual derivation is acceptable. If the calculation is made
over a short time period, such as one month, and then annualized, there is a danger
that a one-time surge in hiring will be annualized, resulting in a much higher
calculated accession rate than is really the case.
EXAMPLE
The human resources manager of Nefarious Industries is anticipating a massive increase in

staffing in states where marijuana use has been legalized, especially in the company’s
farming operations. In farming operations, the company is expecting an increase of 100
employees over the existing staff of 40, which is a 250% accession rate. This calls for the
design of a detailed farm operations training program in anticipation of the hiring activities.
Employee Turnover
When an employee leaves a company, the cost of replacing that person is extremely
high. The business must pay for recruiting and training, and also endure a period of
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reduced efficiency before the replacement person is as efficient as the person who
departed. For these reasons, a close examination of employee turnover is a key
management task in almost any company.
To calculate employee turnover, obtain the number of full-time equivalent
employees who left the business during the measurement period, and divide it by the
average number of employees on the company payroll during that period. The
calculation is:
Number of departed FTE employees

(Beginning FTEs + Ending FTEs) / 2
An issue to consider is the time period over which employee turnover is measured.
In a larger company with thousands of employees, a single month may be an
adequate time period. However, in a smaller firm, it may be necessary to use the
preceding 12 months on a rolling basis in order to collect sufficient information to
derive a measurement.
EXAMPLE
Crosswind Tours employs a number of part-time pilots for its tours of the Alaskan back
country, which originate from multiple airstrips located near the ports where cruise ships stop
during their travels through the Inside Passage. Other than a small full-time administrative
staff, everyone in the company works on a part-time basis, mostly during the May through
September cruise ship season. The president of Crosswinds suspects that employee turnover
may be specific to the geographic location of the pilots, so he asks the payroll manager to
calculate employee turnover for the past year at each of the company’s locations. The results
are:
Ketchikan Skagway Sitka Wrangell

FTE resignations 1.0 4.5 0.8 0.5
Average FTEs 7.2 8.0 12.0 9.5
Turnover 14% 56% 7% 5%
The employee turnover calculation clearly shows that there is a major problem with the
Skagway flight operation, which experienced 56% turnover in the past year. The president
personally interviews all of the pilots who left the Skagway operation, and finds that they had
trouble with the local flight scheduler. He promptly replaces the Skagway flight scheduler,
and works on hiring back the departed employees.
There will always be some employee turnover due to issues that are beyond the
control of a company, such as a spouse being hired in another city, caring for
parents, and so forth. It can also be difficult to retain employees in a tight job market
where they have skills that are in high demand. Consequently, there will be a certain
amount of unavoidable employee turnover. Thus, the proper use of the employee
turnover measurement is to know when turnover is exceeding a normal baseline
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level, which requires a considerable knowledge of the precise reasons why

employees are leaving.
The employee turnover metric can be manipulated by shifting work to outside
contractors who fall outside of the parameters of this measurement. Consequently, if
a large amount of work is outsourced, this may not be a useful measurement.
Annualized Compensation per Employee

Some pay structures are quite complex, with employees being paid bonuses, stock,
overtime, and other forms of compensation. It is quite useful to aggregate all forms
of compensation on an individual employee basis, in order to fully understand pay
levels. This information can be used to determine the amount of additional pay
raises, as well as for comparing a company’s pay levels to those in the industry. It is
also useful when compiling annualized wages for a specific job title or position, and
comparing that average compensation level to industry standards.
If you elect to compile annualized pay for one person, then the calculation is to
add together the following amounts for the past 12 months:
+ Fixed base pay

+ Wages
+ Commissions
+ Overtime
+ Bonuses
+ Stock
+ Other pay
= Total annualized compensation
If you are compiling this information for a group of employees, then compile the
same information for the entire group for the past 12 months, and then divide it by
the number of full-time equivalents to arrive at the average annual compensation for
that group.
EXAMPLE
Colossal Furniture manufactures chairs for its oversized customers. The company’s repair
department has been overwhelmed with work recently, as the company finds that its
customers are so large that they are crushing its chairs, which must be reinforced with metal
support struts. Colossal’s president compiles the following information about the annual
compensation being paid to the repair department employees:
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$600,000 Wages + $250,000 Overtime + $50,000 Bonuses

----------------------------------------------------------------------- = $90,000/FTE
10 FTEs
Clearly, the repair staff is being paid a princely amount, largely because of the overtime they
are working to keep up with their repair queue. The president decides that it is time to
redesign the company’s chairs to handle a heavier load.
It is extremely useful to track annualized total compensation for each employee on a

trend line, to see compensation changes over the course of a person’s employment.
Net Benefits Cost per Employee

Management tends to spend a great deal of time observing the wage and salary cost
of company employees, but has a much lower awareness of the cost of net benefits
per employee. This can be a major failing, especially when a company has adopted a
disparate group of benefits whose total cost is difficult to discern. In many cases, the
net cost of benefits may be much higher than expected, which can cut deeply into
profits.
Measure the net benefit cost on a per-person or departmental basis, rather than
as an average figure for all employees, since employees make differing use of
benefits. For example, some employees may elect to take advantage of a company
401(k) plan that requires matching funds from the company, while others will not.
To calculate the net benefits cost per employee at the company level, follow
these steps:
1. Summarize the cost of all benefits. Examples of the more common benefits
are the cost of medical insurance, dental insurance, life insurance, and disa-
bility insurance, as well as pension matching funds. Less-common benefits
are reimbursements for health club or country club memberships, and the
leases on company cars.
2. Subtract employee deductions. If the company is deducting the cost of a
portion of benefits from employee pay, compile this amount and subtract it
from the total derived in the first step.
3. Calculate the average number of full-time equivalents during the measure-
ment period, and divide this number into the net benefit cost derived in the
first two steps.
Thus, the calculation of the net benefit cost per employee is:
Insurance cost + Pension matching cost + Other benefits – Employee deductions

Average number of full-time equivalents
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To calculate the net benefit cost for an individual employee, run the same
calculation using the benefit costs and deductions specific to that employee, and skip
the third calculation step.
EXAMPLE
Alien Battles Corporation (ABC) creates digital space battles for science fiction movies. To
stay ahead of its competitors, ABC offers a first-rate benefits package to its software
developers. The president of ABC wants to know the net benefits cost per employee, which
the accounting staff derives from the following information:
Gross Employee Net

Benefit Item Cost Deductions Cost
Medical insurance $420,000 $(85,000) $335,000
Dental insurance 35,000 (7,000) 28,000
Pension matching 85,000 -- 85,000
Long-term disability 15,000 -- 15,000
Short-term disability 48,000 -- 48,000
Other 39,000 -- 39,000
Totals $642,000 $(92,000) $550,000
ABC had an average of 40 full-time equivalent employees during the one-year measurement
period. Thus, the net benefits cost per employee is $13,750, which is calculated as the net
cost of $550,000 divided by 40 FTEs.
It is not always wise to use the information provided by this measurement to cut
back on the total cost of benefits, especially when employees are particularly
sensitive about benefit levels. However, a close examination of the various benefit
components may allow management to reconfigure the benefit package to provide
the largest amount of those benefits that are of the greatest value to employees,
while paring back less necessary benefits.
Sales per Person

In some industries, there is a direct relationship between the efficiency and
effectiveness of a company’s employees and its resulting sales. This relationship is
particularly true in industries where employees bill customers for their time. In such
industries, the sales per person measurement is closely watched.
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To calculate sales per person, divide the total sales for the preceding 12 months
by the average number of full-time equivalents during that period. The calculation
is:
Revenues (trailing 12 months)

EXAMPLE
Pulsed Laser Drilling Corporation (PLD) manufactures lasers that use a pulsed laser beam to
drill through rock. Its products are used in such applications as drilling for oil and gas, water
wells, and laying subsurface fiber optic cables. The company only employs full-time
technicians who assemble and field service its complex laser products. Headcount tends to
closely follow sales levels, since a great deal of the manufacturing process is by hand.
During the past year, PLD had revenues of $18 million and 90 full-time equivalents. The
calculation of its sales per person is:
$18,000,000 Sales
------------------------------ = $200,000 Sales per employee
90 Full-time equivalents
The sales per person measurement is not useful, and may even be misleading in the
following situations:
• Product based. If a company derives its sales from standardized manufac-
tured goods, there may not be a causal relationship between sales and head-
count, especially when production activities are highly automated.
• Step headcount. It is possible that a company may be able to use a fixed
number of employees to generate an increasing amount of sales, until it
reaches a “step” point where the company must hire a number of additional
employees to support the next incremental block of sales. This situation
arises when sales are supported by a single facility that requires a certain
minimum amount of staffing.
The sales per person measurement is a popular one, but it only focuses on top-line
sales. A company may have an astoundingly high sales per person measurement, and
still lose money. A more focused measurement is the profit per person measurement,
which is covered next.
Profit per Person

In a service-intensive industry, there is a direct relationship between employees and
the amount of profits generated. This is particularly true in such service areas as
equipment field servicing, management consulting, and auditing. In these situations,
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it makes sense to track profits per employee, not only for the company as a whole,
but also for those individual employees who are billable.
To calculate profit per employee, divide the company’s operating profit by the
average number of full-time equivalent employees. Do not use net after-tax profits
for this measurement, since doing so would include such financing line items as
interest expense and interest income, which have nothing to do with employee
performance. Also, do not include the impact of income taxes, since this expense
can be altered by tax strategy that has nothing to do with the operational efficiency
of employees. The calculation is:
Operating profit
EXAMPLE
Maid Marian is a nationwide maid service that is run by friars within the Franciscan Order.
The friars want to introduce a bonus system that encourages part-time maids to work
additional hours, and needs to determine the existing profit per employee, so that it can
determine how large a bonus pool to create.
During the past 12-month period, employees of Maid Marian worked a total of 832,000
hours, which is an FTE equivalent of 400 employees. This equivalent is calculated as
832,000 hours divided by the 2,080 hours worked by a full-employee in one year (52 weeks
× 40 hours/week). During that period, the service generated an operating profit of $3 million,
which is a profit per employee of:
$3,000,000 Operating profit

---------------------------------- = $7,500 Profit per employee
400 Full-time equivalents
The friars want to create a bonus pool that is 20% of operating profits, which is a $600,000
pool. Based on the 400 FTEs in Maid Marian, this works out to a potential bonus per FTE
per year of $1,500.
There are three caveats to the use of the profit per employee measurement, which
are:
• Industry-specific. The profit per employee measurement is least useful in
industries where there is a large investment in fixed assets and a proportion-
ally smaller number of employees, such as heavy industry. In these situa-
tions, there is not such a direct linkage between the quality or quantity of
employees, which makes the profit per employee measurement less relevant.
• Minimal profits. There is no point in measuring profit per employee when
the operating profit is near zero, since it divulges no relevant information.
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• Manipulation. The measurement is subject to manipulation by shifting work

to suppliers. Doing so reduces headcount, which drives up the profit per
employee.
Despite the caveats just noted, profit per person is an excellent measurement in
many services industries.
Administrative Staff Ratio

Only a certain number of employees are directly involved in the generation of
revenue for a business. This group must generate a sufficient amount of profit to pay
for the administrative staff that supports them. It is entirely too common for a
business to gradually accumulate more and more administrative staff for reasons that
may appear plausible on an individual hiring-decision basis, but which gradually
wear away at company profits. Thus, a key concern of management is to minimize
the proportion of administrative staff to revenue-producing staff.
Defining a position as administrative or revenue-producing is not always clear,
since someone may not directly engage in billable work, and yet supports the sales
effort. One of the simpler alternatives is to designate entire departments as
administrative or revenue-producing areas. For example, the corporate, accounting,
and human resources departments are unquestionably administrative, while the sales
and production departments are usually considered to be revenue-producing. A case
could be made in either direction for the marketing, materials handling, and
engineering departments.
The administrative staff ratio could be designed based on headcount, but this is
misleading, given the differences in pay among various positions. For example, a
low-cost accounting clerk qualifies as one administrative position, while a highly-
paid consultant qualifies as one revenue-producing position; this is a one-to-one
headcount ratio, but their corresponding pay rates are wildly different. Consequent-
ly, we recommend that the fully burdened costs of the administrative and revenue-
producing employees be used in the administrative staff ratio. The calculation is:
Fully burdened cost of administrative staff

Fully burdened cost of revenue-generating staff
The chief concern with this measurement is its binary nature – either someone is
designated as administrative or revenue-producing, with no intermediate
designation. This can result in pressure to skew the definitions of these two areas in
order to push more people into the revenue-generating classification and make the
ratio look better than is really the case.
There is also a risk that managers will simply outsource administrative positions
in order to remove the cost of these positions from the ratio. However, this concern
can be remedied by adding the outsourcing cost to the fully-burdened cost of
administrative staff.
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EXAMPLE
The CEO of Pensive Corporation has noticed a marked decline in profits over the past two
years, and initiates an investigation to determine the cause. A financial analyst notes the
following change in the administrative staff ratio over the past three years:
Year 1 Year 2 Year 3

Administrative staff cost $492,000 $711,000 $726,000
Revenue-producing staff cost $2,460,000 $2,810,000 $2,792,000
Administrative staff ratio 20% 25% 26%
The surge in administrative staff costs beginning in Year 2 can be traced directly to the
company’s expansion into government contracts, which require a large administrative staff to
create responses to request for proposal (RFP) documents. The CEO must now decide if the
incremental cost of this new business is resulting in such a large drop in profitability that the
government contract business should be shuttered.
Ergonomic Injury Rate

The human resources staff may be responsible for a program of locating and
correcting instances of ergonomic injuries in the workplace. For example, this may
involve compiling workers’ compensation claims for injuries caused by ineffective
seating, computer keyboards, lighting, and so forth. If there is such a program, it can
be useful to track the ergonomic injury rate before and after the implementation of
ergonomic changes, such as the wholesale upgrading of the types of chairs used in a
business. The change in the injury rate can be used as justification for the expense
associated with the ergonomic changes made. The formula for the ergonomic injury
rate is:
Number of hours lost due to ergonomic injuries

Total hours worked by all employees
A modification of the formula is to multiply the hours lost by the hourly

compensation rates of the affected employees, and to then divide by the total
corporate compensation expense. This approach restates ergonomic injuries into
monetary terms. However, this alternative approach can also under-represent the
impact of ergonomic injuries, since they are usually incurred by data entry and
manual labor employees who are paid less than other employees.
EXAMPLE
The human resources manager of Tsunami Products (maker of high-flow shower heads) has
noticed that a large proportion of employee sick time appears to be related to ergonomic
injuries, particularly among the order entry staff that spends all day entering customer orders
into the computer system. She implements changes to upgrade chairs, keyboards, and
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monitor viewing angles, resulting in the following before-and-after ergonomic injury rates
within the order entry department:
(monthly hours worked) Before Upgrades After Upgrades

Number of hours lost due to ergonomic injuries 288 58
Total hours worked by all employees 2,400 2,880
Ergonomic injury rate 12% 2%
The measurements reveal that the changes made have had a profound impact on hours
worked within the department.
One issue with using before-and-after measurements of the ergonomic injury rate is
that the recovery period from such injuries can be quite lengthy. This means that the
“after” measurement may need to be a number of months after ergonomic upgrades
have been implemented, to ensure that everyone affected by ergonomic issues has
had sufficient time to recover.
Outsourcing Cost Effectiveness

Managers may be tempted to outsource certain functions, on the grounds that the net
labor cost of shifting to a low-cost region will result in incremental profits to the
business. This is not always the case, since there are a number of additional costs
associated with outsourcing, including the following:
• Management time to oversee the outsourced operations
• Legal costs to create and monitor contracts with outsourcing suppliers
• Travel costs to and from outsourcing locations to oversee operations
• Customers lost due to dissatisfaction with outsourced services
• Inefficiency of staff brought in by outsourcing suppliers
• Initial costs to terminate staff and transfer knowledge to outsourcing
suppliers
When a company elects to engage in outsourcing, it can be useful to enumerate the

costs of the new arrangement and then compare them to the costs that the company
has eliminated by switching to outsourcing. The measurement is:
Total cost of outsourcing arrangement

Costs eliminated by outsourcing
There are additional factors involved in the outsourcing decision that are less easy to
quantify. For example, outsourcing can allow a company to avoid investing cash in
fixed assets, which can be critical for a rapidly-growing business. Conversely,
outsourcing some functions may shift a core competency to a supplier. Also, a
supplier in a dominant position may gain the ability to enforce outsized pricing
increases on a company that has few other alternatives.
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EXAMPLE
The management of Blitz Communications is considering outsourcing its entire accounting

function to a supplier located in India. The attraction of this move is a 50% reduction in
hourly labor costs, though the company will need an on-site supervisor, as well as a generous
travel and living allowance for that person. Given the higher employee turnover rate in India,
there is also likely to be a cost associated with more inefficient staff. An analyst models the
projected outsourcing cost effectiveness of the move, and compiles the following
information:
Cost of current department $500,000

Cost of replacement staff 250,000
Management oversight needed 85,000
Travel and living allowance 60,000
Cost of inefficient staff 75,000
This information is aggregated into the following outsourcing cost effectiveness ratio:
$250,000 Replacement staff + $85,000 Oversight + $60,000 Travel + $75,000 Inefficiency

$500,000 Current cost
$470,000 ÷ $500,000 = 94%
The analysis reveals that the initial promise of a 50% cost reduction is closer to a 6% cost
reduction. Since there are likely to be additional costs that have not yet been quantified, there
may be no savings from outsourcing at all. Based on this information, management might
want to rethink its decision.

There are several additional measurements that can be used to monitor the costs
incurred within the human resources department. Consider the following
possibilities:
• Employee turnover within the department
• The percentage of human resources staff pay to median rates in the region
• The total cost of the human resources function as a percentage of sales
• The proportion of human resources staff to total employees
Most of the cost of this department is derived from headcount, so the general
management measures should focus almost exclusively on this area. When deriving
measurements, a key concern is whether to measure headcount or the total cost of
employees. Since there can be a wide disparity in pay rates within the department,
we suggest that a focus on the total cost of employees yields more relevant
measures.
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Summary
The measurements discussed in this chapter are at a high level, and so only provide a
general clue that there are issues requiring further exploration. To be more effective,
human resources measurements should be applied at the department level, in order
to more specifically identify issues requiring correction. Further, it will probably be
necessary to provide supporting reports that identify the exact issues causing
negative measurement results. For example, the employee turnover measurement
should be accompanied by a list of the reasons given by departing employees for
quitting. Similarly, changes in the administrative staff ratio should be accompanied
by a listing of exactly which positions have been added or deleted during the
measurement period, and the justification for each change.
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Chapter 16
Inventory Measurements
Introduction
Any business that sells tangible products to its customers must deal with inventory,
either as the simple transfer of merchandise from a supplier to a customer, or as part
of a more comprehensive production system. In this chapter, we address the general
concepts of inventory turnover and obsolete inventory, along with several ancillary
measurements that are designed to focus attention on whether the amount of
inventory on hand is the correct amount, and what to do with any excess inventory.

discusses inventory measurements. The episode is available at: accounting-
Overview of Inventory Measurements

Inventory is technically considered an asset – at least, it is categorized as such on a
company’s balance sheet. However, it can be considered a liability, since inventory
is not easily liquidated, can become obsolete in short order, and can physically clog
a facility to such an extent that it interferes with operations. Because of the liability
aspects of inventory, all of the measurements in this chapter are intended to spotlight
when a business has too much inventory – not when it has too little.
The traditional measurement of inventory is turnover, which is a comparison of
the amount of inventory to sales, to see if the proportion is reasonable. We also
subdivide this measurement into turnover for raw materials, work-in-process, and
finished goods – each of which can be applicable under certain circumstances. When
using inventory turnover measurements, keep in mind that the results will be largely
based on the manufacturing system in place, as well as purchasing practices. For
example, a practice of buying in bulk and using a “push” production system will
inevitably lead to lower inventory turnover, while just-in-time purchasing and a
“pull” production system will be associated with much higher turnover results.
We also discuss inventory accuracy, which is an enormously important concept.
Inventory records must be as close to 100% accurate as possible, or else there will
be major issues with the ability to meet scheduled production targets and fulfill
customer orders in a timely manner.
Our last remaining major area addresses the concept of excess inventory. There
should be measurements for detecting any inventory that is either clearly obsolete or
which has aged past a certain number of days. These items will likely require
disposition at a reduced price, so we also address the amount of returnable inventory
and the rate at which its value is likely to decline over time. These concepts should
be built into an ongoing process of identifying and selling off inventory at a rapid
clip, so that no excess funds are stored in inventory that is unlikely to provide an
adequate return on investment.
Average Inventory Calculation

Average inventory is used to estimate the amount of inventory that a business
typically has on hand over a longer time period than just the last month. Since the
inventory balance is calculated as of the end of the last business day of a month, it
may vary considerably from the average amount over a longer time period,
depending upon whether there was a sudden draw-down of inventory or perhaps a
large supplier delivery at the end of the month.
Average inventory is also useful for comparison to revenues. Since revenues are
typically presented in the income statement not only for the most recent month, but
also for the year-to-date, it is useful to calculate the average inventory for the year-
to-date, and then match the average inventory balance to year-to-date revenues, to
see how much inventory investment was needed to support a given level of sales.
In the first case, where you are simply trying to avoid using a sudden spike or
drop in the month-end inventory number, the average inventory calculation is to add
together the beginning and ending inventory balances for a single month, and divide
by two. The formula is:
(Beginning inventory + Ending inventory) ÷ 2
In the second case, where you want to obtain an average inventory figure that is
representative of the period covered by year-to-date sales, add together the ending
inventory balances for all of the months included in the year-to-date, and divide by
the number of months in the year-to-date. For example, if it is now March 31 and
you want to determine the average inventory to match against sales for the January
through March period, then the calculation would be:
January ending inventory $185,000

February ending inventory 213,000
March ending inventory 142,000
Total $540,000
Average inventory = Total ÷ 3 $180,000
A variation on the average inventory concept is to calculate the exact number of

days of inventory on hand, based on the amount of time it has historically taken to
sell the inventory. The calculation is:
365 ÷ (Annualized cost of goods sold ÷ Inventory)
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Thus, if a company has annualized cost of goods sold of $1,000,000 and an ending
inventory balance of $200,000, its days of inventory on hand is calculated as:
365 ÷ ($1,000,000 ÷ $200,000) = 73 Days of inventory
Though useful, the average inventory concept has some problems, which are as
follows:
• Month-end basis. The calculation is based on the month-end inventory
balance, which may not be representative of the average inventory balance
on a daily basis. For example, a company may traditionally have a huge
sales push at the end of each month in order to meet its sales forecasts,
which may artificially drop month-end inventory levels to well below their
usual daily amounts.
• Seasonal sales. Month-end results can be skewed if a company’s sales are
seasonal. This can cause abnormally low inventory balances at the end of
the main selling season, as well as a major ramp-up in inventory balances
just before the start of the main selling season.
• Estimated balance. Sometimes the month-end inventory balance is estimat-
ed, rather than being based on a physical inventory count. This means that a
portion of the averaging calculation may itself be based on an estimate,
which in turn makes the average inventory figure less valid.
Inventory Turnover Measurements

The turnover of inventory is the rate at which inventory is used over a measurement
period. This is an important measurement, for many businesses are burdened by an
excessively large investment in inventory, which can consume the bulk of available
cash. When there is a low rate of inventory turnover, this implies that a business may
have a flawed purchasing system that bought too many goods, or that stocks were
increased in anticipation of sales that did not occur. In both cases, there is a high risk
of inventory aging, in which case it becomes obsolete and has reduced resale value.
When there is a high rate of inventory turnover, this implies that the purchasing
function is tightly managed. However, it may also mean that a business does not
have the cash reserves to maintain normal inventory levels, and so is turning away
prospective sales. The latter scenario is most likely when the amount of debt is high
and there are minimal cash reserves.
In this section, we address the classic inventory measurement, which is invento-
ry turnover, followed by the calculations for each component of inventory – raw
materials, work-in-process, and finished goods.
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Inventory Turnover Ratio

To calculate inventory turnover, divide the ending inventory figure into the
annualized cost of sales. If the ending inventory figure is not a representative
number, then use an average figure instead. The formula is:
Annual cost of goods sold

Inventory
The result of this calculation can be divided into 365 days to arrive at days of
inventory on hand. Thus, a turnover rate of 4.0 becomes 91 days of inventory.
EXAMPLE
An analyst is reviewing the inventory situation of the Hegemony Toy Company. The
business incurred $8,150,000 of cost of goods sold in the past year, and has ending inventory
of $1,630,000. Total inventory turnover is calculated as:
$8,150,000 Cost of goods sold

$1,630,000 Inventory
= 5 Turns per year
The five turns figure is then divided into 365 days to arrive at 73 days of inventory on hand.
Raw Materials Turnover

If a large part of a company’s total inventory investment is in raw materials, it may
be useful to focus attention specifically on this area with the raw materials turnover
measurement. This measurement is of interest to the purchasing manager, who is
responsible for maintaining the flow of goods into the production area. This
measurement can also be used by the engineering manager, who can focus on
designing products that use common parts already found in stock. Raw material
turnover is of particular interest in just-in-time environments where the intent is to
drive the investment in raw materials down to a level very close to zero.
To calculate raw materials turnover, divide the dollar value of raw materials
consumed in the period by the average amount of raw materials on hand through the
period, and then annualize the result. For example, if the measurement is for a one-
month period, multiply the result by 12. The calculation is:
Dollar value of raw materials consumed in period

× 12 = Raw materials turnover
Average dollar value of raw materials inventory
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There are a few situations in which raw materials turnover can be further refined.
Consider the following possibilities:
• Obsolete inventory. A high proportion of obsolete raw materials may be
keeping the turnover figure from being improved. If so, run a calculation of
which items have not been used recently, and forward this list to the pur-
chasing staff to see if the indicated items can be sold off. Then run the turn-
over measurement without the obsolete items.
• Overnight delivery costs. The turnover figure can be artificially reduced by
paying extra to have raw materials delivered through an overnight delivery
service. If this is happening, track the cost of incoming freight in conjunc-
tion with the raw materials turnover measurement.
EXAMPLE
Aberdeen Arquebus sells its old gun replicas in a highly seasonal business, where most
purchases are made in the spring, in anticipation of the summer battle re-enactment season.
Accordingly, the owner exerts pressure on the purchasing staff to minimize raw material
levels, so that there are few raw materials left in stock after the selling season is complete.
The following table shows the results of this effort by quarter, where production ramps up in
the fourth and first quarters, followed by a rapid decline in the second quarter.

Raw materials consumed $380,000 $210,000 $85,000 $420,000
Raw materials inventory $254,000 $93,000 $28,000 $335,000
Raw materials turnover 6x 9x 12x 5x
Note: The results of each calculation are multiplied by four to annualize results.
Work-in-Process Turnover
An excessive amount of work-in-process inventory is a strong indicator of an
inefficient production process. When production is not well-organized, clumps of
inventory will pile up throughout the production area. Conversely, a just-in-time
system can operate with very small amounts of work-in-process inventory.
To measure work-in-process turnover, divide the annual cost of goods sold by
the average cost of work-in-process inventory. The calculation is:
Annualized cost of goods sold

Average work-in-process inventory
This is the most difficult inventory turnover figure to compile, for there is usually no
formal system for tracking specific units of inventory through the production
process, as well as the state of completion of each unit. If so, compiling this
measurement is nearly impossible. However, if there is a formal tracking system in
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place, then the average work-in-process figure may be available through a standard
report.
Another issue with work-in-process inventory is its extreme variability. The
amount in process may vary to a noticeable extent on a daily or even hourly basis, so
the use of an average inventory level is advisable.
EXAMPLE
Creekside Industrial is in the throes of a manufacturing system changeover, from a

manufacturing resources planning (MRP II) system to a just-in-time system. The production
manager wants to be sure that the company is realizing the full benefits of the transition, and
so authorizes the compilation of before-and-after work-in-process turnover measurements.
The results are:
MRP II Just-in-Time
(results are annualized) Turnover Turnover
Cost of goods sold $16,500,000 $15,900,000
Average work-in-process inventory $1,375,000 $795,000
12x 20x
The measurement comparison reveals that Creekside has experienced a notable drop in its
work-in-process investment as a result of the switch to a just-in-time system.
Finished Goods Turnover

There are situations where a company may have quite a large investment in finished
goods inventory in comparison to its sales level. This situation most commonly
arises for one of the following reasons:
• Fulfillment policy. Senior management wants to differentiate the company
from its competitors by offering a fast fulfillment rate for all customer or-
ders, which can only be achieved with a large amount of finished goods on
hand.
• Seasonality. Sales are highly seasonal, so the seller increases its finished
goods during the months prior to the selling season, in order to meet de-
mand.
• Obsolescence. Some portion of the finished goods inventory is obsolete, and
so is selling at a very low rate.
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To calculate finished goods turnover, divide the dollar value of finished goods
consumed in the period by the average amount of finished goods on hand through
the period, and then annualize the result. For example, if the measurement is for a
one-month period, multiply the result by 12. The calculation is:
Dollar value of finished goods consumed in period

× 12 = Finished goods turnover
Average dollar value of finished goods inventory
One issue with finished goods turnover is how costing information is compiled. The
cost of finished goods is comprised of the costs of direct materials, direct labor, and
overhead. These amounts can vary if there are changes in the standard costing
methodology that a company employs. Also, these costs can be fraudulently altered
in order to increase the amount of ending inventory, thereby reducing the cost of
goods sold and increasing profits. Thus, the costing methodology can have an
impact on finished goods turnover.
EXAMPLE
The senior managers of Billabong Machining want to ensure the highest level of customer
satisfaction by promising order fulfillment on 99% of all orders placed within one day of
order receipt. Given the large array of widgets that Billabong offers for sale, this pledge
requires the company to maintain an inordinately large investment in finished goods. The
following table reveals the finished goods turnover rate before and after the fulfillment
policy was begun.
Before After
Fulfillment Fulfillment
(results are annualized) Policy Policy
Finished goods consumed $4,800,000 $5,100,000
Finished goods inventory $400,000 $1,275,000
12x 4x
Given the massive decline in turnover, the management team might want to rethink its
decision to fulfill customer orders so quickly, especially since sales have not increased much
as a result of the decision.
Inventory Accuracy Percentage

A business relies upon the accuracy of its inventory records to maintain its
production and customer fulfillment systems. For these records to be truly accurate,
they must contain accurate information in the following areas:
• Quantity on hand
• Location of inventory
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• Unit of measure
• Part number
If any one of these items within an inventory record is wrong, then the entire set of
information can be considered sufficiently incorrect to render the entire record
useless. For example, the inventory quantity may be completely accurate, but if the
location code is wrong, the materials handling staff cannot find the item. Or, if the
part number is wrong, a component cannot be used. Consequently, the inventory
accuracy formula encompasses all four elements.
To calculate inventory accuracy, divide the number of completely accurate
inventory test items sampled by the total number of all inventory items sampled. An
accurate inventory test item is considered to be one for which the actual quantity,
location, unit of measure, and part number matches the information stated in the
inventory record. If even one of these items is found to be incorrect, then the entire
item tested should be flagged as incorrect. The formula for inventory accuracy is:
Number of completely accurate inventory test items

Total number of inventory items sampled
EXAMPLE
An internal auditor for Radiosonde Corporation conducts an inventory accuracy review in the
company’s storage area. He compiles the following incorrect information for a sample test of
eight items:
Audited Audited Audited Audited Unit

Description Location Quantity of Measure
Alpha unit No No
Beta unit No
Charlie unit No
Delta unit No No
Echo unit No
Foxtrot unit No No
Golf unit No
Hotel unit No
The result of the test is inventory accuracy of 0%. The test score astounds the inventory
manager, who has been focusing solely on quantity accuracy. Even though the quantity
counts did indeed prove to be accurate, the inventory records were well below expectations
for the other data items.
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Excess Inventory Measurements

If a company maintains any inventory at all, it is quite likely that some portion of
this investment is obsolete. A business needs to have an ongoing inventory
evaluation system that highlights obsolete items, as well as a well-defined system for
disposing of these items as quickly as possible, and at the highest price. In this
section, we address several variations on obsolete inventory measurement, as well as
how to focus attention on the opportunity cost of not disposing of inventory in a
timely manner.
Obsolete Inventory Percentage

When a company has a significant investment in inventory, one of the more essential
accompanying metrics is the obsolete inventory percentage. This measurement is
needed to derive that portion of the inventory that is no longer usable. The
percentage should be tracked on a trend line and compared to the results of similar
businesses, to see if a company is experiencing an unusually large proportion of
inventory problems. Actions taken that relate to this percentage can include:
• Changes in the reserve for obsolete inventory, if the percentage is varying
from the long-term trend.
• Changes in the amount of activity to disposition obsolete inventory in a
manner as advantageous to the company as possible.
• Actions taken to reduce the underlying causes of obsolescence, such as
buying in smaller quantities, switching to a production system that is based
on customer orders, and better management of engineering change orders.
To derive the obsolete inventory percentage, summarize the book value of all
inventory items which have been designated as not being needed, and divide it by
the book value of the entire inventory. The formula is:
Book value of inventory items with no recent usage

Total inventory book value
The main problem with this percentage is figuring out which inventory to include in
the numerator. Whatever method is chosen should be used in a consistent manner, so
that trends in the percentage can be more reliably tracked over time.
EXAMPLE
The warehouse manager of Mole Industries wants to investigate the extent of obsolete
inventory in his warehouse, so that he can remove items and consolidate the remaining
inventory. He prints a parts usage report from the company’s manufacturing resources
planning system that only shows the cost of those items that are in stock and which have not
been used for at least two years. The total cost listed on this report is $182,000, which is 19%
of the total book value of the entire inventory. The warehouse manager brings this high
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percentage to the attention of the purchasing manager, who immediately contacts suppliers to
see if they will take back the obsolete items in exchange for a restocking fee.
Percent of Inventory Greater than XX Days

A variation on the obsolete inventory percentage is to track the amount of any
inventory that is older than a certain number of days. If an inventory item exceeds
the threshold, it could be targeted for return to the supplier in exchange for a
restocking fee. This approach is particularly useful when a company has instituted
just-in-time deliveries, but still has excess inventory on hand from before
implementation of the new system.
The precise number of days used for the threshold in this measurement can vary,
based on several factors. Consider the following:
• Warehouse-specific. If tighter inventory controls are being implemented at
just one location, set a minimal threshold for that facility, in order to target
the largest possible amount of inventory for disposition.
• SKU-specific. If a particular stock-keeping unit (SKU) is being targeted for
reduction, set a minimal threshold just for that item. This is particularly
common for any SKUs for which a company has a large amount of funds
tied up in inventory.
• Class specific. The measurement can be restricted to just raw materials, in
order to focus on tighter purchasing practices. Alternatively, it can be re-
stricted to just finished goods, in order to focus on production scheduling
and sales forecasting issues.
• Early warning. Analysis of obsolete inventory may have shown that any
inventory over a certain number of days old is more likely to eventually be
designated as obsolete. Thus, the threshold can be set for a certain number
of days prior to when inventory is usually declared obsolete, which gives the
company early warning to draw down these stocks.
The steps required to calculate the percent of inventory over a certain number of
days are:
1. Set the threshold number of days and the inventory type to be measured.
2. For the block of inventory to be measured, determine the dollar amount of
all inventory items exceeding the threshold number of days.
3. Divide the aggregate total from the second step by the total dollar amount of
inventory. Note that this should be the ending inventory balance (not an
average balance), since the inventory figure derived in the second step is as
of the ending inventory date.
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The calculation of the percent of inventory greater than XX days is:
∑ (Inventory dollars greater than XX days old)

Total inventory valuation
This measurement can be misleading in two situations, which are:

• Seasonal production build. A company may build inventory levels through-
out the year, in anticipation of a short selling season. If so, the amount of all
types of inventory may appear inordinately old with this measurement. In
this situation, consider only using the measurement immediately after the
selling season, to identify the extent to which inventory items did not sell.
• Production schedule. Certain raw materials may only be used in specific
products, for which production runs are only scheduled at relatively long
intervals. If the measurement is generated just prior to such a production
run, it could reveal what may appear to be an inordinate amount of raw ma-
terials on hand. This issue can be spotted by comparing the production
schedule to any items appearing in an initial version of the measurement.
EXAMPLE
Rapunzel Hair Products sells a hair spray that has been proven to lose much of its hold
characteristics after six months in storage; at that time, any remaining stocks cannot be sold,
and so are thrown in the dumpster. Accordingly, Rapunzel’s sales manager requests that an
inventory report be generated that aggregates the percentage of this inventory that is more
than 90 days old, so that coupons can be issued in a timely manner that will spur additional
sales of the hair spray. For example, as of the end of the last month, the ten products that use
the hair spray formulation, and which were more than 90 days old, had an aggregate book
value of $80,000. Since the total hair spray inventory value was $1,000,000, the percent of
inventory greater than 90 days old was 8%.
Returnable Inventory Valuation

Only a portion of all excess inventory can be returned to suppliers. Other items are
too old or damaged to be returned, or suppliers refuse to take them back, even for a
restocking fee. Management should be aware of the total dollar amount of returnable
inventory, since the amount of cash that can be realized could be of use to the
company. This measurement usually takes the form of a report, which itemizes in
declining dollar value the amount of inventory that can be returned, based on the
expected disposal price, net of any restocking charges.
A key concern with the returnable inventory valuation is not to include in the
report any items for which there is a reasonable short-term prospect of usage.
Otherwise, the company will incur a restocking charge to return items to a supplier,
followed shortly thereafter by the repurchase of the same items at their full retail
price.
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One concern is whether to include in the valuation report any items for which
suppliers only offer a credit, rather than a cash repayment. If the company does not
expect to make any further purchases from a supplier that only offers a credit, then
the credit is essentially useless. In this case, it is better to exclude such items from
the report.
Opportunity Cost of Excess Inventory

Most companies have pockets of excess inventory on hand. This inventory may be
obsolete, or there may simply be more on hand than the company can reasonably
expect to use or sell in the short term. In these situations, the purchasing department
should be working on ways to disposition the goods in exchange for the largest
possible amount of cash. The disposition value of inventory almost always declines
over time, so there is an opportunity cost associated with not actively pursuing
inventory dispositions. To measure the opportunity cost of excess inventory, follow
these steps:
1. Compile the units of inventory that must be disposed of.
2. Estimate the disposal price that the company can obtain for these units if it
were to do so today.
3. Estimate the rate at which the disposal price will drop on a monthly basis.
4. Estimate the direct cost of holding the inventory on a monthly basis.
5. Multiply the disposal units by their estimated disposal prices, and multiply
the result by the monthly rate of price decline. Add the incremental cost of
holding the inventory.
The calculation of the opportunity cost of excess inventory is:
((Disposal units × Disposal price) × Price decline %) + Inventory holding cost
= Opportunity cost
When deriving this opportunity cost, be careful not to include fixed costs in the
inventory holding cost, such as the cost of warehouse utilities. The only relevant
inventory holding costs are those that will be eliminated if inventory is sold off –
thus, only completely variable holding costs should be considered.
An issue that will likely arise when this measurement is presented to manage-
ment is the amount of loss the company will record on its books as a result of an
inventory disposition. The correct response is that the company should be recording
an updated obsolete inventory reserve each month, irrespective of whether the
inventory is disposed of. Thus, the only decision remaining for management is
whether to hold onto old inventory or sell it now and convert it to cash at whatever
prices the company can obtain.
While there are a number of estimates involved in this measurement, it is still
one of the best ways to get the attention of management regarding the cost of
holding onto inventory for longer than is necessary.
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EXAMPLE
Green Lawn Care sells battery-powered lawn mowers, for which the selling season is quite
short. In the current season, the sales department estimates that the company will have 5,000
excess lawn mowers. The company can expect to sell these units for $200 right now
(August), and can expect this price to decline by 5% in each successive month. There is also
a holding cost of $2 per unit, per month, since the company is renting storage space for the
units from an independent warehouse. Based on this information, the opportunity cost of
excess inventory is:
((5,000 Disposal units × $200 Disposal price) × 5% Price decline) + $10,000 Holding cost
= $60,000 Opportunity cost
In short, the company stands to lose $60,000 for each month in which it does not dispose of
the excess lawn mower inventory.
Summary
It may appear that all inventory measurements are designed to draw attention to an
excessive investment in inventory. This is largely true, but can also represent a
problem, for some investment in inventory is usually needed. If inventory levels are
drawn down to near zero, the logistics and production functions of a business must
be precisely tuned to operate correctly at such a minimal level. If not, the business
will likely experience continually-stalled processes that interfere with its ability to
produce and sell goods to the satisfaction of its customers.
The intent of this chapter was to establish a tight focus on just those measure-
ments pertaining specifically to the inventory asset. In reality, inventory crosses over
with several functional areas – product design, purchasing, and production.
Consequently, you may need to review these other areas to find additional
measurements that have a tangential impact on the inventory asset.
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Chapter 17
Payroll Measurements
Introduction
The payroll function is a cost center, so its focus is on handling large numbers of
transactions at the lowest possible cost, and with few processing errors. In this
chapter, we describe a number of measurements designed to focus attention at a high
level on transaction errors, as well as the cost of payroll services provided.

discusses payroll measurements. The episode is available at: accounting-
Overview of Payroll Measurements

The ultimate goal of the payroll function is to eliminate all manual labor by the
payroll staff in the collection of hours worked information, as well as in the
calculation and distribution of payments to employees. Ideally, data entry for time
worked should be performed by employees, rather than the payroll staff, while
payroll software should handle all calculation and payment activities. With these
goals in mind, the first few measurements in this chapter are targeted at errors in the
payroll system, which are then used by the payroll staff to drill down into the payroll
data to understand why an error occurred. We also note a measurement for the cost
of payroll activities that are outsourced. When these measurements are actively used,
the result should be a payroll department with minimal transaction errors, which can
process employee pay at minimal cost.
Payroll Transaction Error Rate

A massive amount of raw data must be organized by the payroll department and
translated into a payroll, with the volume of data being highly dependent upon the
number of employees who are paid on an hourly basis. If there is an error in this data
stream, it takes a considerable amount of time by an experienced payroll person to
track down and correct it. If there are many such errors, the payroll staff will be
perpetually buried by the sheer volume of corrections. Consequently, it makes sense
to track not only the proportion of payroll errors, but also the types of errors.
To calculate the payroll transaction error rate, divide all errors detected by the
total number of payroll entries made. Use in the denominator the total amount of all
entries made, such as hours worked, deductions, memo entries, and goal entries,
since errors can occur in all of these areas.
EXAMPLE
Milagro Corporation employs a large staff of hourly production workers to assemble its
signature home espresso machines. Milagro’s payroll department is being overwhelmed by a
large number of payroll transaction errors. The payroll manager summarizes the payroll
errors from the past month into the following table:
Transaction Total Total Error

Type Entries Errors Rate
Hours entry 1,440 180 12.5%
Salary change entry 36 1 2.8%
Deductions entry 150 4 2.7%
Address change 14 -- 0.0%
Direct deposit 60 6 10.0%
Exemptions entry 24 2 8.3%
Totals 1,724 193 11.2%
The information in the table reveals that there is a significant error rate in its hours entry,
both on a proportional basis and in terms of the gross number of errors. The payroll manager
realizes that fixing the underlying problem will nearly obliterate her transactional errors, and
so targets this area for correction.
Of particular concern to the payroll manager is the proportion of recurring payroll

errors, rather than the stray errors that arise in small numbers on an occasional basis.
Recurring errors should be the focus of an intense amount of corrective action. By
making such corrections, the department can eliminate entire layers of transaction
errors.
Form W-2c to Form W-2 Ratio

When a payroll department makes mistakes in its calculation and recording of
employee pay, the information rolls into the annual wage and tax withholding
information contained in the Form W-2, which a company issues to its employees
and the government. If an employee spots an error in a Form W-2, the company
must issue a corrected version on the Form W-2c. It is important to track the
proportion of Forms W-2c to the total number of Forms W-2 issued, since it is an
indicator of the transactional errors being made by the payroll system.
The calculation of the Form W-2c to Form W-2 ratio is a simple one:
Total Forms W-2c issued

Total Forms W-2 issued
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This measurement can be calculated well after the initial issuance of all Forms W-2,
in order to give sufficient time for all errors to be located and Forms W-2c to be
issued.
EXAMPLE
Milford Sound issues a Form W-2 to each of its 412 employees following the end of the
calendar year. During the following few weeks, 38 employees point out that the pay totals
listed on their forms are incorrect. Milford issues 38 Forms W-2c to replace the incorrect
Forms W-2. The resulting ratio of Forms W-2c to Forms W-2 is calculated as:
38 Forms W-2c issued

---------------------------- = 9.2% Ratio of W-2c to W-2
412 Forms W-2 issued
This ratio does not represent a sufficient amount of information for corrective action
to be taken, so it should be accompanied by a detailed report that itemizes the
underlying transaction errors.
Proportion of Manual Checks

Manual payroll checks are usually cut because there was an error in the normal
payroll process that resulted in an under-payment to an employee. When there are a
significant number of manual checks, it can be an indicator of persistent data
collection or pay calculation problems somewhere within the payroll system.
The presence of manual checks can be measured as a simple total of these
checks cut, or it can be compared to the total number of payments (both direct
deposit and checks) issued to employees. In many cases, the payroll manager will
want to investigate every manual check, irrespective of the relative proportion of
these payments issued, in order to delve into the reasons for payroll errors.
If using this measurement, be aware that a manual payroll check could also be
issued to an employee as an advance, which is not indicative of an error. This
exception can be eliminated from the payroll system either by imposing a no-
advances policy or by issuing the payments through the accounts payable system,
rather than the payroll system.
Payroll Entries to Headcount Ratio

In some companies there may be a broad array of payroll deductions, goal entries
such as targets for annual pension deductions, and memo entries regarding the
amount of vacation or sick time remaining. If these entries are entered manually as
part of every payroll, then the payroll department is facing not only a major
efficiency problem, but also a high risk of data entry errors. These problems will
likely result in a major degradation of the efficiency of the payroll department.
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Consequently, the payroll manager should be keenly aware of the number of payroll
entries being made, particularly in proportion to the number of employees.
The calculation of the number of payroll entries to headcount is:
Total deductions + Total goal entries + Total memo entries

Average number of full-time equivalents
In a reasonably automated payroll department, many deductions are automatically

recurring, while goal entries may only be entered once a year. Consequently, the
level of automation drives the need for this measurement.
EXAMPLE
The extremely detail-oriented payroll manager of Milford Sound has retired. Her
replacement knows that the department has been burdened with an immense amount of data
entry work for years, primarily because the former payroll manager wanted to carefully track
all possible information about employees. The replacement manager compiles the following
information about the various payroll entries being made in each of Milford’s biweekly
payrolls:
Type of Number
Payroll Entry Description of Entries
Deduction Medical insurance 240
Deduction Dental insurance 224
Deduction Long-term disability 183
Deduction Short-term disability 172
Deduction Cafeteria plan – child care 36
Deduction Cafeteria plan – medical 92
Memo Vacation time remaining 270
Memo Sick time remaining 270
Total entries 1,487
1,487 Payroll entries

------------------------- = 5.5 Entries to headcount ratio
270 FTEs
The preceding information reveals that the payroll department is making an average of 5 ½
payroll entries per person, per payroll. The new payroll manager takes immediate steps to
consolidate and automate the entries.
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There are several action items that may arise from the use of this measurement,
including:
• The automation of as many payroll entries as possible
• Using recurring payroll entries that automatically populate the next payroll
• Consolidating deductions (such as one deduction for the entire package of
employee benefits)
• Having the company pay for all of a benefit, so there is no employee-paid
portion
Outsourced Payroll Cost per Employee

It is extremely common for a company to outsource its payroll processing to a
supplier, since doing so eliminates a great deal of payroll calculation, payment, and
tax remittance work. However, once outsourced, management tends not to closely
track the cost of this activity. The cost of outsourcing commonly balloons over time,
since suppliers typically bid low to obtain a company’s business, and then escalate
or add to the fees. These fees can involve special charges for garnishments, direct
deposit, sealing checks inside envelopes, tracking vacation as a memo item, and so
forth.
When calculating the outsourced transaction fees per employee, the simplest
approach is to add up the supplier’s invoices for the measurement period and divide
by the number of employees paid during that period. Supplier invoices tend to
contain a mixture of per-person charges and fixed fees; for the purposes of this
measurement, it does not matter if a cost is variable or fixed. Instead, obtain the
gross supplier cost and divide it by the headcount paid. Thus, the calculation is:
Total payroll cost billed by supplier during the measurement period

Total number of employees paid
EXAMPLE
Kelvin Corporation produces a variety of thermometers. The payroll director feels his
temperature rise when he reads the latest supplier invoice for processing the company’s
payroll. He runs a comparison of the outsourced payroll cost for the most recent month and
for the same period one year ago, which results in this summary table:
February 20X1 February 20X2

Monthly payroll fee $1,900 $3,045
Employees paid 380 420
Cost per employee $5.00/person $7.25/person
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The payroll director then compares the supplier billings from the two periods and discovers
the following three issues:
• The supplier implemented a 6% price increase, which accounts for $0.30 of the
increase.
• The company authorized overnight delivery by the supplier of check payments to 14
company locations twice a month, which accounts for $0.80 of the increase.
• The human resources department authorized activation of the supplier’s on-line
human resources package, which enables employees to update their own records on-
line. This purchase accounts for $1.00 of the increase.
Several minor items account for the remaining $0.15 of the cost increase. Based on this
information, the payroll director has the cost of the human resources package charged to the
human resources department, and arranges to have the payroll supplier use the company’s
own overnight delivery billing code to pay for the check deliveries.
This measurement will yield valuable insights into cost escalations over time.
Though it may not persuade you to shift payroll processing in-house, it may at least
initiate some management discussion of how to minimize supplier fees.
Summary
Of the purely payroll-related measurements described in this chapter, the most
important is the payroll transaction error rate, especially when the payroll staff
delves into the specific transactions that caused the errors. If they investigate and
correct the causes of these errors, it is possible to substantially improve the
efficiency of the payroll department. However, these measurements only provide
general indicators of the underlying problems – a great deal of additional
investigation is required to arrive at a truly efficient payroll department.
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Chapter 18
Pricing Measurements
Introduction
The prices at which products and services are sold are somewhat resistant to
evaluation, in terms of whether the correct prices are being used. We do not present
a perfect measurement for evaluating prices, but offer instead a set of measurements
and concepts that can be used to evaluate how the market may react to pricing
changes, internal factors that can impact price setting, and several variances that can
be used to evaluate the results of existing pricing policies.
Overview of Pricing Measurements

When setting prices, the management team must be cognizant of the extent to which
customer order volumes will change as the result of a new price. This concept is
known as the price elasticity of demand, which is caused by a variety of factors. A
small pricing change could engender a startling alteration in customer order volume,
or be greeted with indifference. A related concept is cross price elasticity of demand,
which is the change in the demand for one product when the price of a different
product changes. Both concepts should be considered when setting prices.
Price setting should be based on what the market will bear. However, a business
should also be aware of which products and services generate the most profit, and
design their marketing campaigns to maximize the sales of these items. Another
result may be that price increases can be attempted for less-profitable items. The
throughput per minute concept is the best measure for evaluating the profitability of
products.
Once prices have been set, a company may find that it is difficult to force
customers to accept the prices. This is particularly common when services are being
offered at an hourly billing rate. The proportion of discounted prices concept is used
to quantify the extent to which customers are requiring discounts before they will
place orders. This measurement can result in adjustments to the standard prices
offered, to reduce the number and volume of discounts taken.
We conclude the chapter with two classic variance analyses. One is the selling
price variance, which compares actual prices to budgeted prices. The second
variance is the sales volume variance, which compares the actual number of units
sold to the budgeted number expected to be sold. Both measurements are used when
there is a baseline budget against which actual sales are being compared. If there is
no budget, there is no way to calculate these variances.
In summary, the establishment of prices is an imperfect science for which
measurements provide a certain limited value. Understanding price elasticity,
throughput, and discounts taken can assist with the evaluation of prices, but there is
no ideal way to establish the perfect price.
Price Elasticity of Demand

Price elasticity is the degree to which changes in price impact the unit sales of a
product or service. The demand for a product is considered to be inelastic if changes
in price have minimal impact on unit sales volume. Conversely, the demand for a
product is considered to be elastic if changes in price have a large impact on unit
sales volume.
A product is more likely to have inelastic demand if customers buy it for reasons
other than price. This typically involves high-end luxury goods, or the “latest and
greatest” products that are impacted by style considerations, where there are no
obvious substitutes for the product. Thus, altering the price of a custom-made watch
may not appreciably alter the amount of unit sales volume, since roughly the same
number of potential customers are interested in buying it, irrespective of the price
(within limits).
A product is more likely to have elastic demand when it is a commodity offered
by many suppliers. In this situation, there is no way to differentiate the product, so
customers only buy it based on price. Thus, if prices were to be raised on a product
that has elastic demand, unit volume would likely plummet as customers go
elsewhere to find a better deal. Examples of products having elastic demand are
gasoline and many of its byproducts, as well as corn, wheat, and cement. The key
considerations in whether a product will have elastic or inelastic demand are:
• Uniqueness. If there is no ready substitute for a product, it will be more
price inelastic. This is particularly true where intensive marketing is used to
make the product appear indispensable in the minds of consumers.
• Percent of income. If something involves a significant proportion of the
income of the consumer, the consumer is more likely to look for substitute
products, which makes a product more price elastic.
• Necessity. If something must be purchased (such as a drug for a specific
medical condition), then the consumer will buy it, irrespective of price.
• Duration. Over time, consumers will alter their behavior to avoid excessive-
ly expensive goods. This means that the price for a product may be inelastic
in the short term, and increasingly elastic over the long term. For example,
the owner of a fuel-inefficient vehicle will be forced to pay for higher gaso-
line prices in the short term, but may switch to a more fuel-efficient vehicle
over the long term in order to buy less fuel.
• Payer. People who can have their purchases reimbursed by someone else
(such as the company they work for) are more likely to exhibit price inelas-
tic behavior. For example, an employee is more likely to stay at an expen-
sive hotel if his or her company is paying for it.
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The elasticity or inelasticity of demand is a consideration in the pricing of products.

Clearly, inelastic demand offers a great deal of room in price setting, whereas elastic
demand means that the appropriate price is very well defined by the market.
However, products having inelastic demand tend to have smaller markets, whereas
products with elastic demand can involve much larger sales volume. Thus, a
company pursuing a strategy of only selling products with inelastic demand is also
limiting its potential sales growth.
From a practical perspective, companies are most likely to set prices based on
what competitors are charging for their products, modified by the perceived value of
certain product features. Price elasticity can also be used to fine-tune prices, but it is
still more of a theoretical concept than one that has practical applicability.
The calculation for the price elasticity of demand is the percent change in unit
demand as a result of a one percent change in price. The formula is:
Percent change in unit demand

Percent change in price
A product is said to be price inelastic if this ratio is less than 1:1, and price elastic if
the ratio is greater than 1:1. Revenue should be maximized when a business can set
the price to have an elasticity of exactly 1:1.
EXAMPLE
Horton Corporation wants to test the price elasticity of demand for two of its products. It
alters the price of its blue widget by 3%, which generates a reduction in unit volume of 2%.
This indicates some inelasticity of demand, since the company can raise prices while
experiencing a smaller offsetting reduction in sales.
Horton then tests the price elasticity of its purple widget by altering its price by 2%. This
results in a reduction in unit volume of 4%. This indicates significant elasticity of demand,
since unit sales drop twice as fast as the increase in price. In this case, the company clearly
has little ability to raise prices.
Cross Price Elasticity of Demand

Cross price elasticity of demand is the percentage change in the demand for one
product when the price of a different product changes. The formula is:
Percentage change in demand of one product

Percentage change in price of a different product
If there is no relationship between the two products, then this ratio will be zero.
However, if a product is a valid substitute for the product whose price has changed,
there will be a positive ratio – that is, a price increase in one product will yield an
increase in demand for another product. Conversely, if two products are typically
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purchased together (known as complementary products), then a price change will

result in a negative ratio; thus, a price increase in one product will yield a decrease
in demand for the other product. Here are examples of different ratio results for the
cross price elasticity of demand:
Positive ratio When the admission price at a movie theater increases, the demand for
downloaded movies increases, because downloaded movies are a
substitute for a movie theater.
Negative ratio When the admission price at a movie theater increases, the demand at the
nearby parking garage also declines, because fewer people are parking
there to go to the movie theater. These are complementary products.
Zero ratio When the admission price at a movie theater increases, the demand at a
nearby furniture store is unchanged, because the two are unrelated.
A company can use the concept of cross price elasticity of demand in its pricing
strategies. For example, the food served in a movie theater has a strong complemen-
tary relationship with the number of theater tickets sold, so it may make sense to
drop ticket prices in order to attract more movie viewers, which in turn generates
more food sales. Thus, the net effect of lowering ticket prices may be more total
profit for the theater owner.
A business can also use heavy branding of its product line to mitigate the
substitution effect. Thus, by spending money on advertising, a business can make
customers want to purchase its products so much that a price increase will not send
them out to buy substitute products (at least not within a certain price range).
Throughput per Minute

Prices should rarely be based on the underlying costs incurred by a business, since
doing so could severely misprice a product in relation to the price that the market
will bear. However, there is an internal consideration that can impact the price
charged; this is the amount of throughput generated per minute at a company’s
bottleneck operation. The bottleneck is anything in a business that restricts the
ability of the entity to increase its sales and profitability. The classic bottleneck is a
machining operation in the production area, but it could also be too few salespeople,
a raw materials shortage, and so forth. When there is a bottleneck, its use must be
maximized by only processing through it those products that generate the largest
amount of throughput. Throughput is sales minus all variable costs directly related to
the sales. Thus, throughput per minute must be maximized in order to generate the
highest possible profit.
The concept of throughput per minute has a direct impact on prices charged,
since a company that wants to maximize profits should sell at the highest sustainable
prices that will maximize throughput per minute through the bottleneck operation.
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EXAMPLE
Horton Industrial Designs manufactures four types of widgets, each of which has a different
price point and which require differing amounts of bottleneck time. The relevant information
is:
Bottleneck Throughput
Throughput Time (minutes) per Minute
Aluminum widget $15.00 3.5 $4.29
Iron widget 4.00 2.0 2.00
Magnesium widget 9.00 1.5 6.00
Titanium widget 27.00 8.0 3.38
The information in the table reveals that the company should sell as many magnesium
widgets as possible, since doing so maximizes the throughput per minute. Also, management
should consider whether it is possible to increase the price of the iron widget, which has one-
third the throughput per minute.
The example shows which products have lower throughput per minute than others,
so it is a comparative measure. The measurement does not reveal the optimum price
that should be charged, but rather which products generate the most throughput per
minute, and which therefore should be sold in the greatest volume. This leads to the
following possible actions:
• Increased marketing expenditures to support those products generating the
most throughput per minute.
• A possible reduction in marketing expenditures for products having low
throughput per minute, on the grounds that increased sales of these items
will crowd out the production of items that generate more throughput per
minute.
• The possibility of raising a product’s price in order to increase its through-
put per minute.
Proportion of Discounted Prices

A company may set a standard list price for a product or service, but then allows the
sales staff to grant discounts from the standard price at their discretion. This
situation is particularly common under the following circumstances:
• Volume purchases. If a buyer is willing to buy in large volume, then a
volume discount is granted.
• Lead buyer. A prominent buyer is willing to buy a new product or service in
exchange for a discount. The seller is willing to grant the discount in order
to use the buyer’s name in its marketing of the new product rollout.
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• Soft prices. The standard price may be considered too high in some geo-
graphic regions, forcing the use of discounts in order to complete sales.
Management should be particularly concerned when it sees the proportion of

discounted prices increasing over time, since it implies that the sales staff cannot
make the list price “stick” in the current market environment. In this case, a
reduction in the standard price may be warranted.
There are two variations on how the proportion of discounted prices can be
calculated. One option is to divide the total number of discounted deals by the total
number of customer orders. However, this approach does not factor in the size of the
discounts given. The alternative approach is to divide the total dollar amount of
discounts granted by the total dollar volume of customer orders. However, this latter
approach can be skewed by a small number of very large discounts. The alternative
formulas are:
Option One: Option Two:
Total number of discounted deals Total dollar amount of discounts granted

Total number of customer orders Total dollar volume of customer orders
EXAMPLE
Newton & Matthews is an international safety consulting firm. The company is

headquartered in New York City (NYC), where hourly rates are set. The NYC pricing
structure is $500 per hour for partners and $250 per hour for associates. These rates are
accepted in the NYC area, but the regional offices are reporting that few customers will
accept the rates. The accounting staff reviews contracts being signed by branch offices, and
notes the following proportions of discounted prices reported by a selection of offices during
the last quarter:
Dollar Amount of Total Dollar Volume Proportion of

Discounts Granted of Customer Orders Discounted Prices
Boston $1,050,000 $21,000,000 5%
Charleston 1,200,000 8,000,000 15%
Des Moines 2,000,000 4,000,000 50%
Oklahoma City 3,375,000 7,500,000 45%
Seattle 2,520,000 14,000,000 18%
It is apparent that the central region of the country is having a particularly difficult time
enforcing the company-wide pricing structure. As a result, the senior management team
authorizes the use of regional pricing that is adjusted based on how local prices compare to
NYC prices.
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Selling Price Variance

The selling price variance is the difference between the actual and expected revenue
that is caused by a change in the price of a product or service. The formula is:
(Actual price - Budgeted price) × Actual unit sales
An unfavorable variance means that the actual price was lower than the budgeted
price.
The budgeted price for each unit of product is developed by the sales and
marketing managers, and is based on their estimation of future demand for these
products and services, which in turn is affected by general economic conditions and
the actions of competitors. If the actual price is lower than the budgeted price, the
result may actually be favorable to the company, as long as the price decline spurs
demand to such an extent that the company generates an incremental profit as a
result of the price decline.
EXAMPLE
The marketing manager of Hodgson Industrial Design estimates that the company can sell a
green widget for $80 per unit during the upcoming year. This estimate is based on the
historical demand for green widgets.
During the first half of the new year, the price of the green widget comes under extreme
pressure as a new supplier in Ireland floods the market with a lower-priced green widget.
Hodgson must drop its price to $70 in order to compete, and sells 20,000 units during that
period. Its selling price variance during the first half of the year is:
($70 Actual price - $80 Budgeted price) × 20,000 units = -$200,000 Selling price variance
There are a number of possible causes of a selling price variance. For example:
• Discounts. The company has granted various discounts to customers to
induce them to buy products.
• Marketing allowances. The company is allowing customers to deduct
marketing allowances from their payments to reimburse them for marketing
activities involving the company’s products.
• Price points. The price points at which the company is selling are different
from the price points stated in its standards.
• Product options. Customers are buying different product options than
expected, resulting in an average price that differs from the price points
stated in the company’s standards.
216
Sales Volume Variance

The sales volume variance is the difference between the actual and expected number
of units sold, multiplied by the budgeted price per unit. The formula is:
(Actual units sold - Budgeted units sold) × Budgeted price per unit
An unfavorable variance means that the actual number of units sold was lower than
the budgeted number sold.
The budgeted number of units sold is derived by the sales and marketing
managers, and is based on their estimation of how the company's product market
share, features, price points, expected marketing activities, distribution channels, and
sales in new regions will impact future sales. If the product's selling price is lower
than the budgeted amount, this may spur sales to such an extent that the sales
volume variance is favorable, even though the selling price variance is unfavorable.
EXAMPLE
The marketing manager of Hodgson Industrial Design estimates that the company can sell
25,000 blue widgets for $65 per unit during the upcoming year. This estimate is based on the
historical demand for blue widgets, as supported by new advertising campaigns in the first
and third quarters of the year.
During the new year, Hodgson does not have a first quarter advertising campaign, since it is
changing advertising agencies at that time. This results in sales of just 21,000 blue widgets
during the year. Its sales volume variance is:
(21,000 Units sold - 25,000 Budgeted units) × $65 Budgeted price per unit
= $260,000 Unfavorable sales volume variance
There are a number of possible causes of a sales volume variance. For example:
• Cannibalization. The company has released another product that competes
with the product in question. Thus, sales of one product cannibalize sales of
the other product.
• Competition. Competitors have released new products that are more
attractive to customers.
• Price. The company has altered the product price, which in turn drives a
change in unit sales volume.
• Trade restrictions. A foreign country has altered its barriers to competition.
Summary
There is no perfect pricing measurement that identifies the best price at which a
company should sell a product or service. Proper pricing can be identified within a
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general range, using the measurements described in this chapter. However, pricing is
also highly dependent upon the pricing strategy used by a business. For example, if
the freemium strategy is used, where a basic service is provided for free, then none
of the preceding measurements will be of much use. Conversely, a premium pricing
strategy under which prices are set extremely high might not yield the largest
amount of gross sales. In short, a business must first determine its pricing strategy,
and then decide how it is going to measure the efficacy of the resulting prices within
the boundaries set by the strategy.
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Chapter 19
Production Measurements
Introduction
In a manufacturing business, the production area typically absorbs the bulk of all
expenditures, and so is worth examining in the greatest detail. In this chapter, we
depart somewhat from the usual monetary measurements, and instead focus on ways
to improve the operational characteristics of production. This includes measure-
ments of the department as a whole, of specific equipment, and of the ability to
produce goods without error. We conclude with several of the more traditional
expense measurements.
Overview of Production Measurements

The production area achieves the highest level of performance when viewed as an
assemblage of systems that work together. To that end, we begin with department-
level performance measures that focus on order cycle time, manufacturing
efficiency, degree of unbalance, and similar metrics. By using these measurements,
management can sharpen its focus on those production areas that, when enhanced,
can contribute to department performance to the greatest extent.
Though the production system as a whole is of the most importance, it is still
necessary to attend to individual equipment measurements. To do so, we use the
most comprehensive measure, that of equipment effectiveness, as well as setup time,
unscheduled downtime, run time, and similar measures that provide clues about the
ability of equipment to adhere to the mandated production schedule.
We then shift to another aspect of production, which is the ability to produce
goods without error. Two measurements are presented that focus attention on
production yield without scrap or rework, so that the cost of materials is minimized.
Finally, we turn to expenditure levels, using comparisons of different aspects of
overhead and direct costs to highlight situations where indirect costs are trending
upward, and so may require attention.
Taken as a whole, the measures presented here can form the basis for a well-run
and responsive production department that can spot developing problem areas and
correct them in short order.
Department-Level Performance
The most important production measures are usually those that monitor the
performance of the entire system of production, rather than the performance of an
individual machine. The reason for this high level of performance is that goods are
not produced by a single machine or work station, but rather by an assemblage of
people and equipment, working together. In this section, we have several aggregate-
level measurements worth considering. These measures deal with the duration of a
customer order, the overall efficiency of operations, productivity, unbalance
between work stations, and the pace of production.
Order Cycle Time

A key competitive point in many business strategies is how quickly customer orders
can be fulfilled. An unusually short cycle time for an order can lock in customers
who value quick delivery. However, cycle time may not be an issue in cases where
the company strategy is to offer a very low price in exchange for a longer wait to
receive goods.
To calculate order cycle time, subtract the date of receipt of an order from the
ship date of the order. This calculation does not factor in any orders that are late for
delivery and have not yet been shipped, so also include in the calculation the
estimated ship date for these late orders. The resulting formula is:
(Ship date or if late, best estimate of ship date) – order date
This measurement should be presented in two parts, as an aggregated order cycle

time for all orders, and also as a detailed report that shows the measurement for each
underlying order. This type of presentation allows management to drill down into
the supporting information to determine which orders are causing problems, and
correct whatever the related issues may be.
A variation on the order cycle time concept is to run it for each individual
customer on a trend line, to see if any of the more important customers are suffering
from below-standard fulfillment rates. The same approach can be used for product
families, to see if certain types of products are more difficult to produce.
EXAMPLE
Sharper Designs is having trouble fulfilling some of its orders for an advanced form of
ceramic knife that has achieved cult status among executive chefs. The trouble appears to be
cracking in some of the blades, which can only be found through detailed inspection of every
knife. Each of the knives scrapped must be replaced from current production, which throws
off the shipping schedule.
The production manager calculates an aggregate order cycle time of 4.0 days to fill an order,
but then subdivides the information by product family to derive much more troubling results,
as noted in the following table.
220
Product Family Order Cycle Time Gross Margin

Steel knives 0.8 days 15%
Tungsten knives 1.2 days 24%
Titanium knives 1.1 days 18%
Ceramic knives 42.5 days 75%
The table shows a massive fulfillment problem for the ceramic knife product family. This is
particularly troubling, seeing that the high prices charged for these knives could yield
excellent profits for the company – if only the knives could be shipped. This information is
the basis for a full-scale assault by management on the production processes used to
manufacture ceramic knives.
Manufacturing Efficiency
The manufacturing process can be highly inefficient in terms of the time required to
produce goods. There are many areas in which work-in-process may be held up in a
work queue that can massively increase time requirements. It can be useful to
compare the total time required to produce goods to the actual time during which
goods are being transformed, to gain an understanding of the amount of wasted time
in the process. This wasted time represents an opportunity to cut deeply into the time
required to produce goods and get them into the hands of customers more quickly,
which can represent a major competitive advantage.
To calculate manufacturing efficiency, aggregate the total amount of time during
which products are being transformed, and divide it into the total time period during
which a job is in the production area. The formula is:
Total job time

Total transformation time
The main problem with the manufacturing efficiency measurement is that it only
leads to a reduction in the total time required to manufacture goods. There may be
no corresponding improvement in profits. For example, if there is a finished goods
inventory buffer already in place between the production process and customers,
customers may experience no change in the time required to fill orders, since their
orders are already being filled from stock. Also, there may be no increase in
throughput, since time reduction efforts could target areas other than the bottleneck
operation that controls throughput. Consequently, this measurement should be
targeted at those situations in which the result can actually yield a monetary gain.
EXAMPLE
Giro Cabinetry currently fills all orders for its generic apartment cabinets from stock, which
requires a large investment in finished goods. The president wants to reduce this investment
by shrinking the time required for jobs to pass through the company’s production process. He
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must first understand the level of manufacturing efficiency of the production operation, so he
commissions a study that yields the following results:
Transformation Time in Total time in

(hours) Work Center Work Center
Band saw 0.5 6.0
Drilling 1.0 10.0
Assembly 2.5 8.0
Finishing 3.0 40.0
Totals 7.0 64.0
If the president wants to improve the efficiency of the manufacturing operation, the area in
which the most time can be cut is the finishing department. The most efficient group appears
to be the assembly area, where any improvement efforts would yield the least results.
Productivity Cause and Effect Ratio

There are many instances where the production manager wants to test whether a
change in activity or expenditure will have a positive cause-and-effect relationship
with an output from the production system. If so, the relationship can be tested by
comparing the incremental change in activity or expenditure to the incremental
change in output. This is less of a performance ratio, and more of a tool for testing
whether various changes should be made to the production process. The formula is:
Incremental change in output

Incremental change in activity or expenditure
This is a notably vague measurement, but needs to be in order to accommodate the

many uses to which it can be put. Here are samples of possible applications:
• Scrap reduction. Invest in new equipment for which production tolerances
can be more easily set, thereby reducing scrap levels. The cause is the cost
of the equipment, and the effect is the reduced cost of scrap.
• Electricity reduction. Invest in solar panels to power production equipment.
The cause is the price of the solar panels, and the effect is the reduction in
electricity costs.
• Units of production increase. Add staff to the bottleneck operation in order
to prolong the run time of this work center. The cause is the cost of the extra
staff, and the effect is an increase in the number of units produced.
This measurement only works when there is a clear causal relationship between the
supposed cause and the effect. It is also not especially useful where there are a
cluster of causes that lead to one effect; in this case, improvement in one cause may
be offset by declines in other causes, leading to no discernible change in the effect.
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EXAMPLE
The bottleneck operation of Dude Skis is the lamination machine, which laminates graphics
on top of skis. The machine is already being run 24×7. The production manager discovers
that the machine is actually not running during company holidays. He learns that machine
operators would be willing to run the machine during these periods for an aggregate cost of
$200 per hour. For each of these additional hours of production, the company can produce an
additional $1,000 of throughput. This results in an excellent productivity cause-and-effect
ratio of 5:1.
Degree of Unbalance
In a lean manufacturing environment, machines are commonly clustered together to
most efficiently produce certain types of goods. Within each of these work cells is
likely to be a bottleneck operation that cannot produce as fast as the surrounding
equipment. If the capacity of this bottleneck is well below that of the nearby
machines, there is considered to be a high degree of unbalance in the work cell,
which affects its overall performance. When there is a high degree of unbalance, the
industrial engineering staff can review operations to see if the bottleneck operation
can be improved, resulting in a higher output level.
To calculate the degree of unbalance in a work cell, divide the maximum
capacity level of the bottleneck operation by the maximum capacity level of the next
most restrictive operation in the work cell. The formula is:
Maximum actual capacity of bottleneck operation

Maximum actual capacity of next most restrictive operation
The formula reveals two key points about this measurement:

• Use actual capacity, rather than theoretical capacity. Actual capacity takes
into account normal downtime for maintenance and other expected stoppag-
es, while theoretical capacity reflects perfect running conditions with no
stoppages. Theoretical capacity is rarely attainable.
• Only measure the difference in capacity between the bottleneck and the next
most restrictive operation, since adjusting this difference will lead to an
improvement in the overall output of the work cell. Using the average ca-
pacity of the entire work cell does not pinpoint the extent to which output
can be improved.
This measurement operates best in work cells that are heavily utilized, so that
improvements in the degree of unbalance are most likely to yield actual increases in
the rate of output. If a work cell is operating well below its capacity level, then the
industrial engineering staff might want to spend its time working on more critical
areas of the production facility.
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EXAMPLE
The Billabong Machining Company operates a work cell that produces a large number of
pink widgets for the fashion trade. The clear bottleneck in this work cell is the paint
application machine, which can produce no more than 100 units per hour. The other
operations in the work cell have the following capacity levels:
Maximum Actual
Capacity per Hour
Stamping 360
Lathe 425
Deburring 200
The next most restrictive operation is deburring, which can produce twice the number of
units as the paint application machine, resulting in a 50% degree of unbalance. The industrial
engineering staff could acquire an additional paint application machine to equalize the
maximum capacity of these two operations at 200 pink widgets per hour.
Operational Takt Time

A company is typically faced with a roughly predictable number of units that it can
expect customers to purchase within a given period of time. If so, the production
team must ensure that the manufacturing facility maintains an average pace of unit
production that ensures the number of items to be sold can be created. This concept
is called operational takt time, which includes all downtime expected during the
measurement period; downtime may include such factors as stoppages for
maintenance, equipment breakdowns, holidays and so forth.
To measure operational takt time, calculate the average amount of time that a
production facility is actually in operation each day, and divide by the number of
units that must be built each day in order to meet demand. The formula is:
Average amount of time in operation per day

Number of units that must be built each day
The measurement can be surprisingly useful for determining the amount of output
that an operation must complete within a given period of time. If the number of units
actually produced falls below the operational takt time, then management can take
steps to increase production, such as by authorizing a third shift or by outsourcing
work. Takt time is typically posted in a work cell or factory, so that employees can
see how closely they are adhering to production requirements.
The operational takt time concept can also be adjusted for conditions expected to
exist in the near future. For example, if a key work cell is scheduled to be down for
maintenance for a certain period of time, this can be incorporated into the numerator
of the measurement, resulting in a different requirement for the pace of production.
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EXAMPLE
Crumb Cake Café usually receives a massive number of orders in the days leading up to
Mother’s Day, to the extent that approximately 80,000 cakes must be baked within a four-
day period and then frozen for delivery by mail to customers. This means the company must
produce 20,000 cakes in four days. During this period, the company typically operates two
shifts, which involve a total of 960 minutes of production time per day. There is a 10-minute
downtime during the shift changeover, so the number of minutes in operation per day is
actually 950 minutes. The operational takt time for the facility is:
950 minutes in operation per day

= 0.0475 minutes/cake
20,000 cakes per day
Historically, the facility has only been able to produce at a rate of 0.06 minutes/cake, so there
is a projected shortfall of 0.0125 minutes/cake. The production manager decides to pay
overtime and have the two shifts work 12 hours each for one day, in order to catch up on the
required operational takt time.
Equipment Measurements
It may be necessary to measure individual machines, though this is not recommend-
ed unless they are so heavily utilized that the performance of a specific machine will
detract from the overall output of the production department. If it is necessary to do
so, then the following five measurements can be used to monitor equipment
effectiveness, setup times, unscheduled downtime, maintenance and repair time, and
average run times.
Equipment Effectiveness
A production operation may include several machines that are operated at near-
capacity levels in order to meet production targets. For these machines, the highest-
possible number of units must be manufactured that meet product specifications. An
excellent measure of this capability is equipment effectiveness, which combines
three different aspects of machine usage and output, as follows:
• Output quality. The units produced must meet targeted specifications. If not,
the units must be reworked or scrapped.
• Availability. The machine should be available for use as much as possible,
which calls for proper staffing and accurate preventive maintenance.
• Efficiency. The machine must operate as close to its rated number of units of
output as possible.
These concepts are combined into the following equipment effectiveness

measurement:
Percent of units accepted × Percent of time available for use × Percent of maximum run rate
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It is nearly impossible to attain 100% equipment effectiveness for any period of

time, since so many factors can impair effectiveness. The following examples are
issues that can interfere with effectiveness:
• A machine setup is incorrect, resulting in unacceptable units produced
• A machine operator calls in sick, so that no one can run the machine
• A machine is getting old, and so requires much more maintenance down-
time, which in turn reduces the percent of time available for use
Management can review the various components of machine effectiveness and

decide which steps to take to improve the overall effectiveness of a machine at the
least cost. For example, there may be a tradeoff of running at a reduced speed in
order to reduce the number of maintenance intervals. Alternatively, there could be a
tradeoff between paying the cost of a more skilled machine operator in exchange for
the machine running at a higher speed.
EXAMPLE
The production manager of Armadillo Industries, maker of body armor, has concluded that
the graphite lamination machine used to bond layers of graphite is a high-usage area that is
operating near its maximum capacity. He finds that the acceptance rate of the units produced
from this operation is 80%, the percentage of time available for use is 92%, and the
percentage of the maximum run rate is 98%. The resulting equipment effectiveness is:
80% Percent of units accepted × 92% Percent of time available for use × 98% Percent of
maximum run rate
= 72% Equipment effectiveness
Based on the components of the measurement, it appears that the best area in which to pursue
improvement is the quality of the units produced. For example, if the 80% acceptance rate
could be improved to 90%, this would result in a revised equipment effectiveness rating of
81%.
Setup Time
When equipment requires a lengthy setup time prior to manufacturing a part, there is
a natural inclination to favor long production runs, so that the cost of the setup is
spread over many units. This is a problem in a just-in-time environment, where
production runs may be for as little as one unit. Setup time is also an issue when the
use of equipment is being maximized due to high demand, and every second counts.
In both cases, it makes sense to focus intently on setup time, to see if the setup
process can be reduced.
To calculate setup time, measure the time period from the termination of the last
production run to the beginning of the next production run for a machine. This time
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interval covers every aspect of the setup process, including bringing tools, adjusting
equipment, and testing output to see if it falls within specifications. The formula is:
Start time for next job – Stop time for last job
Setup time can be difficult to measure manually, especially when the production
staff is being asked to self-report on its own performance. A better alternative,
though a potentially expensive one, is to install monitoring equipment that
automatically reports setup times.
EXAMPLE
The production manager of Ambivalence Corporation is concerned about the setup time
required for the potions line. When a batch of blue toadstools has been brewed, the vat must
be scrubbed and bleached before the next batch can be started. The result is a lengthy setup
process where the average setup time is roughly one hour. A consultant is brought in, who
suggests rotating out the old vat on a railing system and swapping in a replacement vat, so
that the old vat can be cleaned off-line. The resulting setup time declines to 30 seconds.
Based on this result, the company is now considering just-in-time potion manufacturing.
Unscheduled Downtime Percentage

When the demand for a company’s products is high, the production area must run at
a high level of utilization in order to meet demand. Under these circumstances, every
minute of downtime can result in a delayed delivery and unsatisfied customers.
Accordingly, the production scheduling staff blocks out specific time periods in the
production schedule when machines are to be maintained – and no additional time.
If unscheduled downtime occurs, the production schedule must be reconfigured to
work around the problem, causing delays and bottlenecks in the production area.
This issue can be highlighted by the unscheduled downtime percentage.
To calculate unscheduled downtime, divide the total minutes of unscheduled
downtime for a machine by the total number of minutes in the measurement period.
The formula is:
Total minutes of unscheduled downtime

Total minutes in the measurement period
This measurement should not be used in aggregate for all of the machines in the
production area, for some of this equipment is already underutilized, and additional
downtime is not of much importance. Also, requiring the recordation of downtime
can be quite a chore for the production staff. Instead, only measure unscheduled
downtime for the equipment that is regularly operating at a high level of utilization,
and which can impact the production flow if it is not available for use at all times.
Measuring just these items correctly places attention on areas that should be closely
monitored by the maintenance staff.
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EXAMPLE
The Atlas Machining Company is experiencing heavy demand for its widgets just prior to the
popular Wabash Widget Festival. The production manager is particularly concerned about
three work centers that have historically been brought down for unscheduled maintenance. In
the past week, the unscheduled maintenance for these work centers was as follows:
Unscheduled Total Time Unscheduled

Downtime in Period Downtime
(minutes) (minutes) Percentage
Wire wrapping 1,500 10,080 15%
Extrusion 2,120 10,080 21%
Thread rolling 1,915 10,080 19%
Given the downtime issues at these work centers, the production manager elects to have
some scheduled work outsourced to a third party.
Maintenance and Repair Ratio

Part of the capital budgeting decision is whether to replace equipment now or wait
until later, and incur a larger maintenance and repair cost in the meantime. This
decision is particularly important in the production area, where most of a company’s
fixed asset base is located. One way to track this issue is to compare the
maintenance and repair cost of a production fixed asset to its run time. The formula
is:
Maintenance and repair cost

Equipment run time
Note that the expense and the equipment run time are both measured for the current
reporting period only. The ratio is then compiled on a trend line, and will probably
show an increasing cost per hour of run time over the life of the equipment. If the
trend line reveals a sudden spike in the ratio, this is a strong indicator of the end of
the practical life of an asset, at which point it should be replaced.
Though this ratio is a good indicator of the increasing cost of old equipment, it
does not necessarily point to the exact date on which equipment should be replaced.
It is entirely possible that the replacement cost of a machine is so high that even an
elevated maintenance and repair cost does not justify swapping it for a new machine.
EXAMPLE
Blitz Communications owns an injection molding machine that is used to produce plastic
casings for the company’s line of office phones. The machine is twenty years old, and is
requiring more maintenance expenditures as the company continues to use it. The production
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manager asks for a review of the maintenance and repair costs of the machine for each of the
past five years, which is as follows:
Maintenance and Run Time Maintenance and

Repair Cost (hours) Repair Ratio
Year 1 $16,500 2,000 $8.25/hour
Year 2 17,000 1,900 8.95/hour
Year 3 23,000 1,850 12.43/hour
Year 4 45,000 1,600 28.13/hour
Year 5 47,000 1,625 28.92/hour
The ratio reveals a spike in the cost per hour in Year 4, which has since increased. It appears
to be time to replace the injection molding machine.
Average Run Time

When a company produces large numbers of units in a single production run, the
most efficient scenario is when equipment can run for extremely long periods of
time without interruption. In these cases, it makes sense to track the average run
time of a machine. A machine stoppage is assumed to be bad – perhaps due to a raw
materials shortage, power failure, or machine breakdown. When the average run
time declines, these underlying issues are examined and corrected in order to
increase the run time.
To calculate average run time, divide the sum of all run times by the number of
production runs. The formula is:
Aggregate production run duration

Number of production runs
This measurement is not to be used for just-in-time production environments where

batch sizes are very small. It is only useful when equipment is being run at
maximum capacity, so do not use it in cases where capacity levels are low and
equipment is therefore not used at all from time to time.
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EXAMPLE
The Excalibur Shaving Company does immensely long production runs for its razor blades,
which are necessary in order to meet demand for refills on the company’s shaving systems.
The production manager has noticed that the length of these production runs has declined of
late, due to problems with blade edges being out of spec. He accumulates the following
information about production run lengths:
Run Run Duration

Number (hours)
1 132
2 129
3 111
4 98
5 82
6 78
The average run time is 105 hours, which compares unfavorably to the historical run rate of
160 hours. Of more importance to the production manager is the obvious declining trend in
the duration of production runs. This may be due to a pending failure in the equipment.
Accordingly, he schedules a complete overhaul of the equipment.
Yield Measurements
A key element of the profitability of a manufacturing operation is its ability to
produce goods without error. Otherwise, the operation may incur extremely high
costs related to wasted raw materials, machine usage, and rework. The following
two measurements focus on yield, which is the ability to produce the expected
number of units.
First-Pass Yield
A potentially massive amount of additional work is required in the production area
when goods cannot be manufactured correctly on the first pass. These costs include
the repurchase of raw materials to create replacement goods, as well as rework for
those items that can be recovered. Management can focus on the measurement of
first-pass yield on the most troublesome work stations on a continuing basis, so that
issues are continually highlighted and corrected.
To measure first-pass yield, divide the number of units successfully completed
by a manufacturing process by the total number of units initiated. The formula is:
Number of units successfully completed

Number of units initiated
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EXAMPLE
The owner of Smithy Ironworks is annoyed that so many of the iron garden curios produced
by the company are found to have flaws, and must be melted down for recasting. The owner
closely follows the first-pass yield, which highlights the following problems with the
company’s casting process:
Number of units initiated 10,000

- Mold damage -237
- Incorrect furnace temperature -150
- Defective iron ore -80
- Improper finishing -270
First-pass yield 9,263
The first-pass yield is 92.6%. Based on the volume of errors, the owner elects to focus on
improper finishing issues in more detail.
Material Yield Variance

The material yield variance is the difference between the actual amount of material
used and the standard amount expected to be used, multiplied by the standard cost of
the materials. The formula is:
(Actual unit usage - Standard unit usage) × Standard cost per unit
An unfavorable variance means that the unit usage was greater than anticipated.
The standard unit usage is developed by the engineering staff, and is based on
expected scrap rates in a production process, the quality of raw materials, losses
during equipment setup, and related factors.
EXAMPLE
The engineering staff of Hodgson Industrial Design estimates that eight ounces of rubber will
be required to produce a green widget. During the most recent month, the production process
used 315,000 ounces of rubber to create 35,000 green widgets, which is nine ounces per
product. Each ounce of rubber has a standard cost of $0.50. Its material yield variance for the
month is:
(315,000 Actual unit usage - 280,000 Standard unit usage) × $0.50 Standard cost/unit
= $17,500 Material yield variance
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There are a number of possible causes of a material yield variance. For example:
• Scrap. Unusual amounts of scrap may be generated by changes in machine
setups, or because changes in acceptable tolerance levels are altering the
amount of scrap produced. A change in the pattern of quality inspections can
also alter the amount of scrap.
• Material quality. If the material quality level changes, this can alter the
amount of quality rejections. If an entirely different material is substituted,
this can also alter the amount of rejections.
• Spoilage. The amount of spoilage may change in concert with alterations in
inventory handling and storage.
Expense Proportions
The previous sections of this chapter were primarily concerned with ways to
enhance specific aspects of the production area. In this section, we turn to the
examination of expenses for the entire production department, with a particular
emphasis on changes in the relative proportions of production expenses over time.
Indirect Labor to Direct Labor Ratio

The modern production environment requires a substantial amount of indirect labor
support for such activities as production planning, quality control, and management.
The amount of indirect labor should be tightly controlled, to ensure that the
minimum expenditure is made in exchange for an adequate level of production
oversight. We can estimate the correct amount of indirect labor by comparing it to
the expenditure for direct labor. The proportion of expenditures between these two
categories of labor should remain relatively static over time.
To calculate the ratio of indirect labor to direct labor, compile the total labor
cost of indirect labor and divide by the total labor cost of direct labor. The costs of
benefits and payroll taxes are not included. The formula is:
Indirect labor compensation

Direct labor compensation
The relationship between indirect and direct labor does not move in lockstep, for
indirect labor tends to be incurred as a step cost. That is, an indirect labor position
will be hired when unit volume reaches a certain point, such as when a new shift is
added. When such a position is added, the proportion of indirect labor will increase
and then remain at a new and higher level.
The ratio can also change if there are differences in the pay increases awarded to
employees. For example, the direct labor group might be paid a guaranteed wage
increase under the terms of a union agreement, while the indirect labor staff may
have its wages frozen. These types of disparities can create variations in the ratio
over time that are not related to the amount of staffing.
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EXAMPLE
The production manager of Barbary Coast Rifles closely monitors the ratio of indirect to
direct labor, because he likes to keep overhead as low as possible. Despite his best efforts,
however, a shift supervisor must be added for the third shift, which the company just started
in order to meet recent increases in customer orders. This change occurs in the third quarter,
which causes a spike in the ratio, as shown in the following table. There is also a 3% pay
raise for the indirect labor staff in the fourth quarter, and a union-negotiated 5% raise for the
direct labor staff in the same quarter.

Indirect labor compensation $240,000 $240,000 $293,000 $302,000
Direct labor compensation $960,000 $960,000 $1,010,000 $1,061,000
Ratio 25% 25% 29% 28%
Overhead to Direct Cost of Goods Ratio

The overhead portion of the cost of goods sold can be extraordinarily high, and
encompasses much more than the indirect labor noted in the last measurement.
There can also be such expenses as depreciation, factory rent, utilities, insurance,
and production supplies. It can be useful to compare the cost of this overhead to the
total direct cost of goods sold on a trend line, to see how the cost of overhead is
changing over time. This can be used as a general control over overhead.
To calculate the ratio, divide the cost of all factory overhead by the direct cost of
goods sold. The direct cost is comprised of direct materials and direct labor. It is also
acceptable to include the cost of commissions in the direct cost of goods, if
commissions vary directly with sales volume. The formula is:
Factory overhead
Direct materials + Direct labor + Commissions
The direct cost of goods sold tends to vary more with sales volume than factory
overhead. These characteristics mean that sharp swings in sales can result in
outsized changes in the ratio, as the numerator reacts slowly to the changes while the
denominator shifts in concert with sales levels.
EXAMPLE
Entwhistle Electric produces compact batteries for a variety of mobile applications. The
equipment used to manufacture the batteries is highly automated, requiring major overhead
expenses for depreciation, utilities, and maintenance staff. There are also significant direct
materials costs for the batteries, with minimal direct labor. The company is implementing a
new sales channel that will sell internationally with large commission percentages for the
sales staff in this channel. The before and after ratio results for the company are as follows:
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Before International After International

Sales Channel Channel Installed
Factory overhead $1,200,000 $1,350,000
Direct cost elements:
Direct materials $650,000 $737,000
Direct labor 150,000 170,000
Commissions 0 400,000
Overhead to direct cost of goods 1.5:1 1.0:1
The table reveals that the direct cost component of the company’s cost of goods sold has
risen markedly as a result of allowing commissions for the new sales channel.

The production manager must be careful not to incentivize employees based on
other measurements that will cause them to take actions that do not benefit the
department. In particular, do not use the following measurements:
• Total output. There should be no incentive to produce more than the
production plan requires, since this will result in an excess investment in
inventory, and which may eventually result in obsolete inventory that must
be written off.
• Overtime reduction. If there is a bottleneck operation in the production area,
it must be operated at maximum capacity at all times, irrespective of any
attendant labor costs. This means that overtime in this area is entirely al-
lowable, and should not be discouraged.
• Equipment utilization. When equipment has been used to fulfill the produc-
tion schedule or the requirements of a kanban notification, the equipment
should then be shut down, irrespective of what this might do to its utilization
percentage. If there is an undue focus on maintaining high rates of equip-
ment utilization throughout a facility, there will inevitably be too much
work-in-process cluttering up the shop floor.
Summary
This chapter has delved into the measurements associated with not only the entire
production area as an operating unit, but also measurements for individual machines
and production yield. However, it has not addressed constraint and throughput
measurements. These issues are critical to the effective operation of a production
department; since they are also needed to evaluate other parts of a business,
constraint and throughput measures have been listed in a separate chapter. Please
refer to the Constraint and Throughput Measurements chapter to review this
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additional topic. When constraint and throughput measurements are combined with
the metrics stated in this chapter, management will have a complete set of tools for
maximizing the flow of production through high-usage production areas, with the
goal of enhancing profits.
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Chapter 20
Product Design Measurements
Introduction
It is all too common for a business to pour money into its product design efforts
without understanding how those funds are used, or whether the organization is
realizing a reasonable return on its investment. In this chapter, we address the best
ways to measure product development, as well as the financial outcome of new
product introductions.
Overview of Product Design Measurements

The measurement of the product design function centers on the efficiency of the
design teams and the financial outcomes of their efforts. We begin with an analysis
of how well product designers can use existing design platforms and components,
which can drastically reduce the time required to develop products. We also note the
design cycle time, which covers the time period from design inception to product
release (and which therefore covers considerably more than the time period under
the control of a design team). There is also a discussion of the accuracy of a key
work product, the bill of materials, which is used to order parts and assemble parts
for production jobs.
We then turn to the financial outcomes of the investment in product design. A
key emphasis is on the cost of products, so we review the percentage of target cost
attained. This figure is of some importance, since it refers to the cost designed into a
product, and which can only be subsequently altered with difficulty. We also note
the percentage of sales coming from new products, which can be of particular use in
industries where product life cycles are extremely short. The cost and profit figures
are then combined into a return on research and development measurement.
However, the calculation we use for this return on investment is more comprehen-
sive than a simple gross margin analysis, since we also include other types of
income that may be derived from research funding. We finish with a discussion of
the warranty claims percentage, which can be indicative of the quality of a product
design.
Product Development
In this section, we focus on the efficiency of product design, with particular
emphasis on the economical usage of design platforms and existing components, as
well as the time required to develop products and the accuracy of the accompanying
bill of materials.
Number of Design Platforms

The most efficient way to develop a range of products is to use a common design
platform as the basis for as many products as possible. Each design platform has a
common set of parts, can be produced by a production line that is specifically
constructed for it, and is supported by a group of experienced design engineers. This
leads to the following advantages for each product developed using an existing
design platform:
• A smaller incremental investment in inventory, since many of the compo-
nent parts are already in stock.
• Less time to ramp up production, since the manufacturing capability already
exists.
• Less risk of warranty claims, since the underlying platform has already been
tested by users.
• Less time to design new products, since designs may only be slight tweaks
of existing products.
Clearly, measuring the number of design platforms can be a key consideration for a
company that wants to rationalize a wildly proliferated set of products. A variation
on the measurement is to track the number of products using each design platform.
EXAMPLE
A new CEO has just been hired to run Grizzly Golf Carts, which is known for its robust
designs catering to overweight golfers. The CEO comes from a lean manufacturing
background where vehicle designs are based on the minimum number of design platforms.
He finds that Grizzly offers 30 models based on 15 different design platforms. He
immediately slashes 10 of the products, because they not only have poor sales, but also
operate on unique design platforms. Of the remaining 20 models, he orders the staggered
redesign of 14 models, so that they are based on one of the five remaining design platforms.
At the end of this process, the CEO expects to have 20 models that are based on five
platforms, for an average of four models per platform.
Reused Components Percentage

A company can reduce the complexity of its operations by using the same
components in multiple products. Doing so yields the following benefits:
• Fewer items to maintain in the inventory records
• Can purchase the smaller number of items in bulk, resulting in volume
purchase discounts
• Fewer suppliers to deal with
• Less likely to have obsolete inventory items, since parts can be repurposed if
a product is eliminated
• More historically-based knowledge of component failure rates
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In short, there are many reasons to push the design staff in the direction of creating
new products that reuse existing components.
To calculate the reused components percentage, aggregate the number of
existing parts in the bill of materials of a new product and divide by the total number
of parts in the bill. Ideally, the existing parts listed in the numerator are only those
that have been specifically approved in advance for re-use in new products. The
formula is:
Number of existing parts in bill of materials of new product

Total number of parts in the bill of materials
This measurement only works if the engineering department has issued a

comprehensive bill of materials.
If too much emphasis is based on this measurement, there may be a tendency for
the design staff to not experiment with new materials or suppliers. To mitigate this
concern, consider assigning some of the staff to an ongoing review of replacement
components that can be adopted throughout the company’s various product lines.
EXAMPLE
The Black Cat Ladder Company has a strong incentive to reuse existing parts for new ladder
designs, since some components have been certified to not collapse – a key element of a
ladder. Consequently, when the design manager envisioned a No Slip ladder, the reused
components percentage was mandated to be at least 85%, with new components only being
allowed for the grid pads used on the ladder steps to reduce slippage. As a result, 34 parts out
of 38 were reused, which is an 89% reused components percentage.
Design Cycle Time

In some industries, a distinct competitive advantage can be gained by designing new
products within the shortest possible period of time. By doing so, a business can
launch products ahead of competitors and gain market share.
To calculate design cycle time, subtract the design start date from the product
launch date for each product. Note that this time period encompasses not only the
work of the product design staff, but also the time required to procure components,
manufacture goods, distribute goods in preparation for sale, and launch a marketing
campaign. Thus, the responsibility for design cycle time rests with many
departments, not just the product design team. The calculation is:
Product launch date – Design start date
If the design cycle time is aggregated across all products, a number of minor product
updates could artificially give the appearance of an extremely rapid cycle time. To
avoid this skewed result, differentiate between minor updates and major new
products, and measure their cycle times separately.
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A possible issue with an excessive focus on design cycle time is that products
may be released to the market before they have been fully tested, possibly resulting
in excessive warranty claims or even product recalls. Thus, it can be useful to review
the trend line for warranty costs in conjunction with design cycle time.
EXAMPLE
The president of Grubstake Brothers is concerned that the Japanese competition is

developing new backhoes at a much faster pace than Grubstake, resulting in lost sales. He
initiates sweeping product development changes, with the following results in design cycle
time:
Average Design
Year Cycle Time
20X1 304 days
20X2 291 days
20X3 268 days
Thus, over the three-year measurement period, the company has succeeded in shrinking the
average cycle time by 12%.
Bill of Material Accuracy

When the engineering staff completes a product, it must also generate a bill of
materials, which is a listing of every component used to manufacture a product. The
bill of materials is used by the purchasing staff to acquire parts, and by the
warehouse staff to pick parts from stock for a production job. Every bill must be
extremely accurate, or else parts will be ordered incorrectly, and kitted jobs will not
contain the parts needed by the production staff.
Bill of material accuracy is calculated for each individual bill of materials. For
each one, conduct an audit to verify that the correct part numbers, quantities, and
units of measure are included. Then divide each accurate line item by the total
number of line items in the bill. The formula is:
Number of accurate line items in bill of materials

Total number of line items in bill of materials
This measurement should be conducted whenever there is an engineering change

order associated with a product, since these changes will typically result in an
adjustment to the contents of the associated bill of materials.
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EXAMPLE
The design team of Billabong Machining Company just completed a new agricultural widget.
As part of the design process, a junior member of the team is assigned the task of creating a
bill of materials. An audit of his bill of materials results in the following analysis:
Unit of Audit
Item Description Quantity Measure Result
Metal casing 1 Each Correct
¼” ball bearing 3 Each Correct
½” lug nut 4 Each Incorrect
Back plate 1 Each Correct
Cyan paint 3 Ounce Incorrect
Plug assembly 1 Each Correct
Label 2 Each Incorrect
The analysis reveals that the junior team member will remain junior until he can attain a
higher level of precision in his documentation of the bill of materials, since bill of material
accuracy is only 57%.
Financial Outcomes
The preceding measurements were targeted at the efficiency with which products are
designed, as well as the accuracy of related information. In this section, we turn to
the monetary outcome of product design, which encompasses product cost, sales
from new products, the return on investment, and the cost of warranty claims.
Percentage of Target Cost Attained

One of the best ways to assure that a product will generate a reasonable profit is to
design it to meet a specific cost target. If that target is met, and customers will
accept the product at a certain price point, then a reasonable margin can be earned
on a consistent basis. Consequently, if a company has a design program in place that
emphasizes cost goals, the engineering manager should routinely track the
percentage of target cost attained for each product.
To calculate the percentage of target cost attained, divide the actual cost at
which a product is being manufactured by its original cost target. The formula is:
Actual production cost per unit

Targeted production cost per unit
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There are several issues to consider when using this measurement. They are:
• Unit volumes. The cost of a product typically declines as its unit volume
increases, due to volume purchase discounts and the inherent efficiencies of
high-volume production. Thus, the percentage will look more favorable if
the underlying costs are based on more units being produced.
• Product features. The actual cost of a product can be forced down to the
target cost in almost all cases, if the number of product features or the quali-
ty of the product is reduced. Such reductions may not make the originally-
anticipated price point tenable.
Given the preceding issues, it may make more sense to compare the actual product
margin to the planned margin for an entire reporting period. Doing so incorporates
the actual volumes of units being produced, as well as the price points being
accepted by customers.
EXAMPLE
Billabong Machining Company has had a recurring problem with the costs at which its
titanium widgets have been produced for the consumer market. To mitigate the problem, the
engineering manager institutes a cost management program, under which the newest widget
model is targeted at a $12 cost per unit, and a price point of $20. The design project is
expected to take four months with four month-end milestone reviews to examine the ongoing
ability of the design team to create a widget that meets the $12 cost target. The outcomes of
the four milestone reviews are as follows:
Milestone Milestone Percent

Cost Target Cost Achieved Variance
January review $18.50 $18.00 +3%
February review 15.75 16.00 -2%
March review 13.25 13.75 -4%
April review 12.00 13.00 -8%
The table reveals that the design team started out ahead of the milestone cost target, but then
steadily fell further behind in later milestone reviews, ultimately resulting in a product cost
that is 8% higher than expected.
Percentage of New-Product Sales

One way to force the engineering staff to continually develop new products is to set
a target for what proportion of sales will come from new products, typically on a
rolling basis that looks back anywhere from one to three years. Doing so forces the
engineering staff to look for larger product opportunities that can have a notable
impact on sales.
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To measure the percentage of new-product sales, divide all sales related to new
stock-keeping units by total net sales for the measurement period. We use the
creation of a new stock-keeping unit as the most likely threshold for a product being
considered sufficiently new that it is given a separate identification. The formula is:
Sales from new stock-keeping units

Total net sales
This measurement is most commonly used in markets where there is such intense
competition that the only way to maintain sales is to continually release a stream of
new products. If the marketplace is instead a staid one, it may not be necessary to
place such a focus on new product sales.
EXAMPLE
Dude Skis manufactures wide skis most applicable to powder skiing. The buyers of these
skis are a fickle lot, basing their decisions mostly on the graphics laminated to the tops of the
skis. Consequently, Dude must continually issue new models with different graphics in order
to appeal to its buyers. The company targets having 75% of its sales come from new models
each year. In the most recent year, $3,400,000 of its total sales of $4,850,000 were from the
sale of new ski designs. This represents a proportion of 70% of new models, which is below
the corporate target. Accordingly, the company hires an additional graphics designer to
develop more ski graphics.
Return on Research and Development

One of the most puzzling aspects of funding allocation is how much money to invest
in research and development. Typically, the same amount spent historically is spent
again in the current period, or else funding is based on a percentage of sales, or
perhaps on the amounts being spent by competitors. An alternative approach is to
calculate the return on funds spent on research and development. This approach is
concerned with the effectiveness of funds spent, rather than with the gross amount of
cash plowed into research and development. To calculate the return on research and
development, follow these steps:
1. Aggregate the net profit from licensing deals generated by research and
development.
2. Aggregate the net profit from the sale of all products generated by research
and development.
3. Aggregate the net profit from all lawsuits related to intellectual property
derived from research and development.
4. Add together the preceding items and divide by the research and develop-
ment expense (which should include the cost of filing for and maintaining
patents).
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The formula is:
Licensing net profit + New product net profit + Lawsuit net profit
All research and development expenses
The expenditures for research and development that led to the various forms of
income noted in the numerator of this calculation may have occurred several years in
the past. Consequently, this measurement should span a long period of time. For
example, consider a trend line analysis, on which each data point represents one year
of activity.
EXAMPLE
High Noon Armaments has spent $5,000,000 per year on research and development for the
past five years, and the president is interested in the type of return the company has achieved
from this investment. In the most recent year, the company has earned $750,000 from
licensing the use of a new form of flashless gunpowder, as well as $250,000 from a lawsuit
settlement, and $1,500,000 from the ongoing sale of a newly-developed sniper rifle to the
military. Thus, the return on research and development for the current year is:
$750,000 Profit + $1,500,000 New product profit + $250,000 Lawsuit profit

$5,000,000 Research and development investment
= 50% Return on research and development
Warranty Claims Percentage

A customer may choose to return a product for a variety of reasons, many of which
can be traced to other parts of a business than the design of a product. Nonetheless,
product design is the core reason for a product return, for the design stage impacts
the following:
• The robustness of the product, which impacts its ability to survive transport
to the customer location, as well as its subsequent usage.
• The look and feel of the product, which impacts the perceptions of custom-
ers regarding the perceived value of goods received.
• The safety of the product, which could fail at an inopportune moment and
cause much greater losses for a company than a simple warranty claim.
For these reasons, we have inserted the warranty claims percentage in this chapter.
To calculate the percentage, divide the total number of product claims received by
the total number of units sold. An alternative measurement is to divide the
replacement cost of warranty claims by the aggregate price of the units sold. The
latter approach does a better job of quantifying the cost of warranty claims for the
seller. The two formulas are:
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Option One: Option Two:
Number of warranty claims Replacement cost of warranty

received claims
Number of units sold Aggregate sales of units sold
Depending on the length of a product’s warranty period, there may be a significant

time lag between the incurrence of a warranty claim and the original product sale. If
so, consider using as the measurement period the length of the standard company
warranty. Thus, if the warranty period is six months, the measurement period should
be six months on a rolling basis.
EXAMPLE
Green Lawn Care produces electric lawn mowers. The company has been plagued by failed
batteries on several of its lawn mower products. In the most recent quarter, the company paid
$120,000 for replacement batteries on sales of $2,000,000. The related warranty claims
percentage is:
$120,000 Replacement cost

= 6%
$2,000,000 Sales of units
Summary
The number of measurements in this chapter indicates the considerable extent to
which the results of a product development effort can be quantified. Product design
teams can be judged based on the efficiency of their work, the amount of time taken,
and the use of existing components, as well as their profitability. Consequently, we
recommend that a complete suite of these measurements be applied to each project
team, as well as to the product design department as a whole. By doing so, managers
can gain an understanding of how the investment in new products is paying off.
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Chapter 21
Purchasing Measurements
Introduction
The amount of cash spent on purchased materials can be the single largest
expenditure area of a company, even exceeding the cost of payroll. If so, particular
attention should be paid to how well a business is managing these costs. In this
chapter, we address how the purchasing department controls costs with purchase
orders, procurement cards, and a spend management program, while also noting a
variety of ways to track the performance of individual suppliers, and how well the
purchasing staff can dispose of excess inventory.
Overview of Purchasing Measurements

Purchasing measurements are designed to control costs. This cannot be done when
measurements are made at an aggregate level, since there is not a sufficient amount
of actionable information. Instead, virtually every purchasing measurement should
be produced at the individual transaction or supplier level. The purchasing staff then
uses this information to track down specific instances where costs can be more
tightly controlled. However, when creating detailed reports for the following
measurements, incorporate a cutoff materiality level, below which no measurements
are provided. Doing so focuses the attention of the report recipient on the most
actionable information.
The traditional method of controlling the cost of purchased goods has been to
issue a carefully-researched purchase order to each supplier. However, the cost of
generating a purchase order is impractical for low-value purchases, so a useful
metric is to track the proportions of purchases made both above and below a
designated threshold level with purchase orders. Similarly, the most cost-effective
method of purchasing below this threshold level is the procurement card. A card
usage percentage can be tracked that reveals the level of acceptance of procurement
cards among employees and suppliers.
A well-run purchasing department typically has a spend management system in
place, where purchases for certain commodities are concentrated with a small
number of suppliers in order to take advantage of volume purchase discounts. This
activity can be viewed with a measurement that tracks the proportion of total spend
managed. A variation is to track the proportion of spend already being directed
toward preferred suppliers.
The purchasing staff can assist the receiving and production departments by
certifying suppliers to bypass the receiving department and send their deliveries
directly to the production line. The associated measurement for the proportion of
certified suppliers yields general information about the number of qualified suppliers
with which the company is dealing, as well as the effort being put into the
certification program.
The purchasing manager needs a way to evaluate the performance of suppliers.
There are several measurements available for doing so, including the ability of
suppliers to fulfill orders in a timely manner, the proportion of received goods that
are defective, and whether suppliers tend to bill the company more than was
authorized by underlying purchase orders. All of this information can be used to
develop report cards for suppliers, which may eventually lead to their replacement.
We also make note of the classic economic order quantity, which is used to
determine the most cost-effective purchasing quantity, based on inventory carrying
costs and order costs. This calculation is not always used in more progressive
purchasing environments, where the absolute minimum order quantity is requested
in order to minimize total inventory levels.
Finally, we measure the ability of the purchasing staff to disposition inventory
that has been identified as not being usable by the company’s production processes,
or unlikely to be sold as merchandise. This is an area frequently ignored, since it
does not directly impact sales, but which can result in inventory obsolescence write-
offs if not addressed on a regular basis.
In total, the measurements described in this chapter are designed to fulfill a
valuable monitoring function that can yield notable cost reductions, not only in the
cost of the purchasing function, but also in the cost of purchased goods.
Proportion of Purchase Orders above Threshold

Purchase orders have traditionally been considered a key part of the purchasing
process, for they embody a formal authorization to purchase goods. Purchase orders
are also used in the three-way matching process by the accounting staff to ensure
that supplier invoices have been properly authorized for payment. However, it is
quite time-consuming to research and issue purchase orders, which makes them
wildly expensive for lower-cost orders. Accordingly, most organizations dispense
with purchase orders for smaller orders, electing to use procurement cards instead.
Consequently, a measure of when purchase orders should be applied is to set a
threshold above which purchase orders should be used, and track the usage level
above and below this threshold.
To measure the proportion of purchase orders above the ordering threshold,
create a report in the accounts payable system that aggregates all purchases made,
sorted by the dollar size of each purchase, and noting which ones had an associated
authorizing purchase order. Then aggregate the proportion of authorizing purchase
orders above and below the designated threshold at which purchase orders are
supposed to be used. The formula is:
Number of authorizing purchase orders issued above threshold

Total number of purchases made above threshold
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EXAMPLE
Sharper Designs, maker of ceramic knives for professional chefs, has long had a policy of
requiring a purchase order for all purchases made. The result has been a massive purchasing
staff that dutifully researches each order, puts larger purchases out to bid, and issues detailed
purchase orders. In an effort to save money, the CEO requires the purchasing manager to cut
his staff in half. To do so, procurement cards are to be used for all purchases under $5,000.
After three months, the purchasing manager measures the results of the program by
measuring the issuance of purchase orders both above and below the $5,000 threshold. The
results are:
Above Below
Threshold Threshold
Number of purchase orders issued 640 82
Total number of purchases made 670 5,400
Proportion of purchase orders issued 96% 2%
The measure shows good initial compliance with the new program. The organization is
generally taking the purchase order threshold into consideration when the decision is made to
use a purchase order or a procurement card.
Procurement Card Usage Percentage

A procurement card is a company-sponsored credit card that can be used to make
many types of purchases. The use of procurement cards drastically reduces the
amount of time required by the purchasing department to create purchase orders, and
so should be strongly encouraged for smaller purchases. To track the company’s
performance in using procurement cards, divide the total number of these
transactions below the procurement card threshold by the total number of purchasing
transactions below the card threshold. The card usage threshold typically starts fairly
low, at perhaps $250, and then tends to ratchet upward as an organization becomes
more accustomed to this form of purchasing.
EXAMPLE
The purchasing manager at Milford Sound has been pleased with the reduced purchasing
time spent by her staff since procurement cards were introduced a year ago, but suspects that
additional time can be saved. Her particular focus is on shifting 100% of purchases under
$500 to these cards. She conducts an analysis of card usage by department, and arrives at the
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Purchases with Total Purchases Card Usage

Procurement Cards Under $500 Limit Percentage
Accounting 40 43 93%
Engineering 208 212 98%
Maintenance 72 520 14%
Sales and marketing 190 202 94%
The information reveals that the best source of additional time reduction is purchases made
by the maintenance department, where the person in charge of the procurement card is
clearly not using it very much.
As illustrated in the example, the measure will typically reveal that a specific card
user is not employing the card to its full effect. Once corrected, there tend to be only
a few residual transactions for which procurement cards are not used.
Proportion of Spend Managed

An active procurement program should aggregate all purchasing information by type
of commodity purchased, and gradually work through these commodities,
concentrating purchases with a smaller number of suppliers to gain volume
discounts. As the spending for each commodity is reviewed and improved upon, the
company should create a monitoring infrastructure to verify that the improvements
made will continue, thereby ensuring continuing reduced costs. To monitor the
amount of this active spend management, the purchasing manager should receive a
measurement for the proportion of spend managed. The calculation is to divide the
total spend on commodities under active management by the total amount of
company spend.
It is entirely possible that some portions of company spend are so minor or
difficult to manage that the company will never achieve 100% spend management.
At some point below the 100% level, the purchasing manager will likely find that
assigning more staff to spend management is not a cost-effective proposition, and
will cease further efforts in this area.
EXAMPLE
The purchasing manager of Armadillo Industries initiated a spend management program

several months ago, and wants to start tracking his progress toward a higher level of active
spend management. The company is in the business of manufacturing body armor, protective
shielding, and high-pressure containers (such as submarine hulls). This complex business
contains many commodity types, so the manager has been focusing on the top commodities
on which the company spends money. His analysis of spend being actively managed so far is
as follows:
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NAICS (000s) Percent of Cumulative

Code Commodity Area Spend Total Spend Spend Percentage
332111 Iron and steel forging $90,000 18.0% 18.0%
331523 Nonferrous metal die-casting 12,000 2.4% 20.4%
332114 Custom roll forming 42,000 8.4% 29.2%
332119 Metal stamping 4,500 0.9% 30.1%
332313 Plate work manufacturing 7,800 1.6% 31.7%
332912 Fluid power values 3,900 0.8% 32.5%
332613 Spring manufacturing 1,800 0.4% 32.9%
The table reveals clear progress toward a high level of active spend management, with nearly
a third of all spend now being closely monitored.
Proportion of Spend with Preferred Suppliers

The use of preferred suppliers is the best way not only to obtain volume purchase
discounts, but also to buy from those suppliers proven to have the best product
quality, delivery times, and other services and terms considered important to the
buyer. There are several ways to measure the amount of total spend being directed
toward preferred suppliers. Consider the following alternatives:
• Do so in aggregate, as a single percentage. This is most useful when
reporting high-level performance information to management.
• Do so by commodity type. This approach shows where commodities are
actively being managed, since close observation of a commodity tends to
lead to considerable supplier concentration.
• Do so by business unit. This approach shows the commitment to purchasing
management, and can lead to the revamping of purchasing departments
where the use of preferred suppliers is negligible.
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EXAMPLE
The vice president of procurement at Electronic Inference Corporation is pushing for the
redirection of spend to a small group of preferred suppliers. He elects to aggregate preferred
supplier information at the business unit level, which results in the following information:
Spend with Proportion

Preferred Total of Spend with
(000s) Suppliers Spend Preferred Suppliers
Atomic computing division $17,890 $21,200 84%
Calculators division 5,230 38,100 14%
Memory chip fabrication division 81,000 96,500 84%
National security computing division 58,280 60,800 96%
Totals $162,400 $216,600 75%
The vice president finds that, despite an overall excellent 75% spend rate with preferred
suppliers, the calculators division is far behind the other business units, which presents a
large opportunity for further improvement.
Proportion of Certified Suppliers

In a production environment, a large non-value-added step is the receiving
department, where incoming deliveries intended for the production area are first
identified, inspected, and logged into the computer system. If there are any hitches
in this area, there can be significant delays in the amount of time required for
materials to reach the production department. Because of this built-in delay, the
production staff will build up an inventory buffer to protect the production process
from any shortages in incoming materials. The delay represented by the receiving
department can be eliminated by certifying suppliers to deliver their goods directly
to the production area. Further benefits are a reduction of staffing in the receiving
area, and no need for a protective inventory buffer in front of the production area.
Clearly, there is a substantial payoff in maintaining a large proportion of suppliers
who have been thoroughly examined and certified to bypass the receiving
department.
To calculate the proportion of certified suppliers, first determine the number of
suppliers that service the production area (all other suppliers are ignored for the
purposes of this calculation). Then aggregate from this subset the total number of
suppliers that have been certified within the past 12 months, and divide by the total
number of suppliers servicing the production area. The formula is:
Number of production suppliers certified within the last 12 months

Total of all production suppliers
250
The measurement focuses on recent certifications, on the grounds that the company
will likely want to re-certify all suppliers on a regular basis. A variation on the
concept is to ignore minor suppliers that rarely send in any deliveries, since it will
not be worth the time of the company’s certification staff to subject these suppliers
to a certification examination.
EXAMPLE
Mole Industries has a convoluted receiving process that adds an extra day to the process of
obtaining goods from suppliers. In an effort to eliminate this delay, the purchasing manager
and engineering manager jointly undertake a project to certify suppliers to make direct
deliveries to the production line for Mole’s Ditch Digging machines. There are 43 suppliers
involved with this production line. After three months of certification activity, the analysis
team has concluded that 18 suppliers can be certified, and that the remaining suppliers have
such unreliable processes that they must be replaced. Thus, the company has a 42% certified
supplier rate for the designated area, until such time as it can upgrade its supplier base.
Supplier Performance Measurements

The purchasing department is responsible for the performance of suppliers,
especially those that supply the company’s production department. If a supplier
performs poorly, it is up to the purchasing staff to inform the supplier of the problem
and to rectify the situation – either by replacing the supplier or upgrading its
performance. In this section, we describe three measurements that can be used to
grade the performance of suppliers.
Supplier Fulfillment Rate

When a company is operating in a just-in-time production environment, it is
absolutely critical that items ordered from suppliers arrive on time. If not, the
company is forced to either stop its production lines or build inventory buffers to
protect against late supplier deliveries. In this situation, one of the key performance
metrics is the supplier fulfillment rate. This is the aggregate amount of order line
items that are received on time, divided by the total number of order line items
placed. The formula is:
Sum of all order line items received by due date

Number of all order line items placed
It is too simplistic to conduct this measurement at the level of purchase orders

placed and fulfilled, since there may be many line items on one purchase order, and
only a single line item on another.
When evaluating the results of the measurement, keep in mind whether the
purchasing staff has set unrealistic delivery goals for suppliers that are well inside of
their stated delivery capabilities. In these cases, the company should not have placed
the orders at all, or at least should not use the measurement as the basis for a poor
251
performance evaluation for a supplier that may have actually shipped in accordance
with its normal lead times.
EXAMPLE
The production manager of Quest Adventure Gear is planning to shift the company’s
production of backpacker stoves to a just-in-time process flow. To do so, it is critically
important that all suppliers involved with the parts for the stoves deliver their assigned
components to Quest by the designated dates and times. The purchasing manager is assigned
the task of measuring the performance of three suppliers. The measurement results are noted
in the following table:
Fuel Pumps Ltd. Titanium Corp. Windscreens Intl.

Sum of order lines filled 327 490 310
Total order line items 330 520 605
Supplier fulfillment rate 99.1% 94.2% 51.2%
The table reveals that the company has a potentially serious fulfillment problem with
Windscreens International, which only appears capable of delivering wind screens for the
stoves by the specified date and time for about half of all order line items placed. The
purchasing manager decides to look for a replacement supplier.
Supplier Defect Rate

Another element of supplier performance is whether they can deliver goods that are
free of defects. The concept of defectiveness means that the delivered goods meet
the specifications set by the buyer. Thus, if the buyer sets unusually tight tolerances
for a component, and the supplier delivers goods that are considered acceptable for
general usage but which do not fit the buyer’s tolerance limits, then those goods are
considered to be defective. Defective components are an especially pernicious
problem in a just-in-time manufacturing environment, for there may be no buffer
stock on hand to prevent production from stopping if a part proves to be defective.
To measure the defect rate, divide the total number of rejected components by
the total number of components received from a supplier during the measurement
period. The formula is:
Total number of rejected units

Total number of units received
Defect rates are one of the more important ways in which to evaluate a supplier, so
consider breaking down the measurement in several ways, such as by individual
part, by supplier facility, by defect type, and by the trucking firm used to deliver the
goods – in short, in any way that can yield insights into the reasons for defects or
damage.
252
Another issue to be aware of is increases or decreases in the defect rate that are
caused by changes in the company’s threshold tolerance limits. If these limits are
relaxed, then the defect rate will improve, and vice versa – and without any change
in supplier performance. Thus, it is useful to lock down the tolerance limits over
multiple reporting periods, if the supplier defect rate is being measured on a trend
line. Otherwise, there will be unusual spikes and declines in the reported defect rate
that have nothing to do with the supplier.
EXAMPLE
Billabong Machining Co. manufactures high-tolerance widgets for the military market. These
combat-ready widgets must be exactly ¼” thick. In recent months, the receiving department
has rejected a substantial number of deliveries from the company’s steel plate supplier,
because the delivered plates have been as much as 1/8” thinner than specified in the
authorizing master purchase order. This has resulted in several late widget deliveries to the
military, and a threatened cancellation of the company’s sole source contract with the
military. Accordingly, Billabong’s purchasing manager prepares the following defect rate
table, which clearly shows how the problem has increased over the past three months:

Rejected plate deliveries 5 10 15
Total plate deliveries 55 50 60
Supplier defect rate 9% 20% 25%
The purchasing manager uses this table as the basis for a difficult discussion with the steel
plate supplier, to either upgrade its performance or be dropped as a preferred supplier.
Supplier Billed Price Variance

A high-quality supplier will negotiate the price of goods and services with the buyer
up-front, and will not attempt to alter this price in subsequent billings under the
related purchase order. In this case, the billed price and purchase order price should
always match. A more ethically challenged supplier, or one with severe disconnects
between its billing and sales departments may issue invoices that bear little
relationship to the prices stated in the original purchase order. In the latter case, the
buyer may incur such excessive overbillings that the profitability of the business is
threatened, or at least seriously eroded. Consequently, management should know
which suppliers continually have price variances in their billings.
To calculate the supplier billed price variance, aggregate the amount of excess
billings over the amounts stated on purchase orders, divided by the extended prices
stated on the purchase orders. The formula is:
Total of excess billings

Total of extended prices stated on purchase orders
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This measurement is designed to be calculated for each individual supplier, so it

typically takes the form of a report that is sorted in declining order of billed price
variance. To save space, the report only lists those variances above a predetermined
materiality threshold.
There are cases where a billed price variance is justified. For example, a
purchase order may allow the supplier to ship slightly more than the requested
amount, in which case the extended price charged by the supplier will be higher than
what is noted on the purchase order. This situation usually arises when items are
purchased in very large quantities on an ongoing basis, so that slight overages in the
units delivered are a standard practice.
EXAMPLE
The purchasing manager of Luminescence Corporation is being paid a bonus if she can
restrict the amount the company pays to its LED suppliers for the components used in
Luminescence light bulbs. In investigating the company’s materials costs, she notes that
several suppliers are charging more than the contractual amounts for components. She
compiles the following information:
Extended Purchase Billed Price Billed Price

Supplier Name Price Paid Order Price $ Variance % Variance
Dome Ports Ltd. $52,600 $50,000 $2,600 5.2%
Flange Brothers 40,800 35,000 5,800 16.6%
Glow LED Modules Inc. 21,700 20,000 1,700 8.5%
Totals $115,100 $105,000 $10,100 9.6%
Based on these results, the purchasing manager meets with the controller and demands
tighter three-way matching of supplier invoices, so that these overages will be flagged in the
future.
Economic Order Quantity

The economic order quantity is a formula used to derive that number of units of
inventory to order that represents the lowest possible total cost to the buyer. It
essentially creates a least-cost balance between the cost of ordering inventory and
the cost of holding inventory. The economic order quantity is derived from the
following formula:
The inputs to the model are noted within the formula.
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EXAMPLE
Smithy Smelter uses 100,000 pounds of aluminum ingots per year, and the cost to place each
order is $15. The carrying cost for one pound of aluminum ingots is $5 per year. The
economic order quantity, based on this information, is the square root of:
(2 × 100,000 Pounds of ingots × $15 Order cost) ÷ $5 Carrying cost
= 775 Units economic order quantity
It is useful to test variations on the ordering cost and annual carrying cost to see how
they impact the economic order quantity. It is possible that driving down the annual
carrying cost of inventory can significantly alter the economic order quantity. A key
factor in this analysis is determining which carrying costs actually vary with
inventory volumes, and which are unrelated fixed costs. If they are unrelated, do not
include them in the denominator of this calculation.
The economic order quantity is not used in a “pull” manufacturing system,
where components are ordered from suppliers only as needed and in the quantities
needed; thus, a pull system tends to order fewer components at a time than would be
indicated by the economic order quantity formula.
Proportion of Targeted Inventory Dispositioned

Despite the best efforts of the purchasing and production planning staffs, some
inventory will never be used. There may be no demand for goods or raw materials,
or perhaps product redesigns leave some unused components in limbo. Whatever the
reason may be, a large amount of inventory may be targeted for dispositioning by
means other than sale to customers. If so, the purchasing department is typically
tasked with the dispositioning effort, where the items are sold off to third parties for
the best possible price, or returned to suppliers in exchange for a restocking fee.
It is useful to track the proportion of targeted inventory dispositioned on a
monthly basis, since the value of old inventory declines rapidly over time. Ideally,
the majority of all targeted items should be sold off within a few months of their
initial identification, while these items still retain some value. To measure the
dispositioning effort, divide the amount of cash and credits obtained through
dispositioning by the aggregate estimated disposition value of all targeted inventory
items. The formula is:
Cash receipts from dispositioning + Supplier credits from dispositioning

Total estimated dispositioned value of targeted inventory items
A potential problem with this measurement is that the actual amounts received from
dispositioning activities may vary from what was originally estimated. For example,
it may be estimated that a widget can be sold to a third party for $100, while it turns
out that the widget must be scrapped. Thus, even if every targeted item is
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dispositioned within a single reporting period, it is possible that the proportion of the
receipts from dispositioned items to their estimated values may not be 100%.
EXAMPLE
Smithy Iron Works has just acquired a small competitor, and intends to earn back a large part
of the $5,000,000 purchase price by disposing of excess inventory held by the competitor at
the highest possible price. An initial evaluation reveals that it may be possible to eliminate
inventory having a disposal value of $1,000,000. After two months of brisk activity, the
purchasing manager reports that he and his staff have generated $250,000 in cash from
dispositioned inventory, as well as $350,000 in supplier credits. This results in a proportion
of targeted inventory dispositioned of 60%.

The purchasing department has traditionally been buried under an enormous pile of
paperwork, especially when purchasing polices require large numbers of purchases
to be put out for competitive bidding, and where there are ongoing negotiations with
suppliers over the terms of prospective orders. To streamline purchasing, the general
measurements used for the department should change. Consider the following
measurements:
• Total department expense as a percentage of total spend. This places an
increased focus on the cost efficiency of the department.
• Employee turnover within the department. Purchasing agents are skilled
employees, so a strong effort to retain them should be encouraged.
• Process training hours per employee. Advanced purchasing techniques that
focus on spend management and a reduction in purchase orders involves a
considerable knowledge of the purchasing process. Tracking the hours of
training per employee per year places a particular focus on the importance
of staff training.
Summary
Nearly all of the measurements in this chapter are designed to support a streamlined
and efficient purchasing department. One measurement that has not been included is
the classic performance measurement for the department – the purchase price
variance. This variance is the difference between the standard price at which a
component should be purchased and the actual price. When the purchasing manager
wants to produce a positive purchase price variance, the simplest way to do so is to
purchase in bulk, so that prices per unit are at their lowest. The trouble with this
approach is that it goes against all modern manufacturing principles – to minimize
inventory balances on hand, so there is a reduced investment in working capital, less
storage space required, less risk of damage to materials, and so forth. Consequently,
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we strongly recommend eliminating this measurement in favor of a mix (or all) of

the measurements stated in this chapter.
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Chapter 22
Payables Measurements
Introduction
The payables manager should calculate measurements to determine how well the
department is performing. These are usually ratios, in which case they only provide
a high-level view of potential issues, which must then be investigated by drilling
deeper into the data to determine underlying causes. In this chapter, we delve into a
number of less-common measurements that can be used to detect excessive supplier
billings, transaction error rates, cost per person, the success of paperless efforts, and
similar issues.
Overview of Payables Measurements

The management of accounts payable has traditionally focused on the cost of the
department, usually in terms of its gross cost divided by the number of invoices
processed. We deal with this measurement in a more refined way with several
variations on the comparison of full-time equivalents to measures of departmental
activity. A factor contributing to the cost of the department is its efficiency, for
which key triggering items are transaction errors, the use of paperless transactions,
and the elimination of manual checks. We can measure these topics with the
transaction error rate, percent of paperless invoices, percent of paperless payments,
and manual payments tracking measurements.
The days payables outstanding measurement is a major payables measurement;
it was already covered in the Liquidity Measurements chapter.
Transaction Error Rate

It is critical to avoid transaction errors, since the cost of correcting them is several
multiples of the cost of initially completing them correctly. Consequently, one of the
better measurements is to monitor the transaction error rate. The error rate should be
monitored in conjunction with the total number of transactions processed by each
person, to see if error rates are higher for newer or less-trained employees. The
measurement can be further refined by focusing on those transaction errors that
require the most time to repair.
To formulate the transaction error rate, add up all transaction-related errors in a
reporting period and divide them by the total number of transactions completed
within the same reporting period. This calculation should match transactional errors
to the pool of the same types of transactions completed, which will result in a
separate error rate for each general type of transaction.
EXAMPLE
The senior payables clerk of the Divine Gelato Company wants to reduce the amount of staff
time spent correcting transactional errors. She has derived the following information for the
last reporting period:
Number of Total Number Transaction

Processes Errors of Transactions Error Rate
Supplier ACH payments 28 3,010 0.9%
Supplier address changes 175 1,390 12.6%
Supplier invoice data entry 200 1,720 11.6%
Based on the error rates of the types of transactions measured, it is evident that the clerk
should concentrate her attention on the address changes and invoice data entry. Of these two
processes, the one requiring the most effort to repair is invoice data entry, so she elects to
begin work in this area.
Full-Time Equivalent Measurements

There are several measurements available in which we can compare the headcount
in the payables area to various activity levels or costs. The outcome can then be
compared to the same measurement for “best in class” companies, to see if the
payables function has an appropriate amount of headcount or is paying its
employees a reasonable wage. Before discussing these measurements, we must
define the concept of the full-time equivalent.
The acronym "FTE" is a contraction of the term "full-time equivalent," and
refers to the hours worked by an employee on a full-time basis. On an annual basis,
an FTE is considered to be 2,080 hours, which is calculated as:
8 Hours per day

5 × Work days per week
52 × 52 Weeks per year
2,080 = Hours per year
When a business employs a significant number of part-time staff, it can be useful to

convert their hours worked into FTEs, to see how many full-time staff they equate
to.
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EXAMPLE
There are 168 working hours in January, and the Big Data Corporation staff works 7,056
hours during the month. When 168 hours are divided into 7,056 hours, the result is 42 FTEs.
There are 8 working hours in the day on Monday, and the Cupertino Beanery staff works 136
hours during that day. When 8 working hours are divided into 136 hours, the result is 17
FTEs.
There are 2,080 working hours in the year, and the Hubble Corporation staff works 22,880
hours during that year. When 2,080 working hours are divided into 22,880 hours, the result is
11 FTEs.
The 2,080 figure can be called into question, since it does not include any
deductions for holidays, vacation time, sick time, and so forth. Alternative measures
of FTE that incorporate these additional assumptions can place the number of hours
for one FTE as low as 1,680 hours per year.
FTEs per $1 Million of Revenue

One way to examine payables headcount is to compare it to the amount of revenue
being generated by a business. This could be defined as FTEs per $1 million or $1
billion of revenue. For example, a business has $500 million of revenue, and a
payables staff of 15 FTEs. This organization has one payables FTE for every $33.3
million of revenue.
This measurement can be of use when compared to the results of competitors in
the same industry, since the competitors will presumably have similar sales
environments and suppliers. The measure is of less use when compared to results in
other industries, since revenues in some industries can be supported with
substantially lower or higher payables volumes.
Staff Cost per FTE

The total labor cost of the payables department can be divided by the number of
payables FTEs to arrive at the average staff cost per FTE. For example, a payables
department has total labor costs of $2,000,000 and 50 FTEs, which translates into a
$40,000 staff cost per FTE.
This measurement can be compared to labor rates in the same industry or
geographic region to see if the company is paying an appropriate amount per person.
However, there are several factors that can skew labor costs. For example, a
company may be located in an unusually high-cost region, such as a major city,
where the cost of living is higher. Also, the corporate benefit plan may be unusually
rich or poor, which can impact the total cost assigned to labor. Further, a relatively
new and inexperienced staff may be paid less, but this does not factor in their
reduced level of effectiveness.
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Line Items per FTE

One of the better activity measures is to compare the number of FTEs to the number
of line items processed in supplier invoices. This approach accounts for the differing
amounts of detail included in each invoice received. This calculation only works if
the computer system can report on the total number of invoice line items processed
in each measurement period. For example, a payables department has entered
120,000 invoice line items in the past month, and the department employs 15 FTEs.
This equates to 8,000 line items per FTE.
This measure is more comparable across industry lines, and so can be used to
match a company’s results to those of a “best in class” organization located
elsewhere.
This approach may not work if only invoice totals are entered into the payables
system, rather than individual line items. If so, alter the measurement to track
invoices entered per FTE.
Paperless Measurements
If there is an efficiency drive to eliminate paperwork from the payables function, it
can make sense to track two paperless measurements, which are the percent of
paperless invoices and the percent of paperless payments. They are both described in
this section.
Percent of Paperless Invoices

If the company uses an electronic data interchange system or an on-line portal into
which suppliers can enter their invoices, invoices will be sent directly to the
payables software without any data entry. This is to be encouraged, since it reduces
payables staff time. For example, a company processes a total of 6,000 invoices in a
month, of which 500 were entered through paperless systems. This constitutes an
8.3% paperless invoice percentage.
It is entirely likely that this percentage will reach a certain point and then stall,
with no further improvement. The trouble is that some suppliers will continue to
send paper invoices, despite all encouragement to the contrary. Only when a
company is large enough to really influence the actions of its suppliers can it assume
that a high paperless invoice percentage can be achieved.
Percent of Paperless Payments

The payables manager can reduce the cost of check payments by switching to ACH
(Automated Clearing House) electronic payments instead. Doing so requires that the
company obtain bank account information for its suppliers. If they do not provide
this information, it will not be possible to issue ACH payments. Suppliers may not
provide this information when the relationship is not expected to be long-term, or is
only occasional. Consequently, the percent of paperless payments is likely to be
close to 100% for the core group of suppliers, and much lower for all other
suppliers.
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For example, a company has 800 suppliers, of which 160 are considered the core
group. The payables manager convinces 152 of this sub-group to accept ACH
payments, while only 300 of the remaining suppliers are amenable to the idea. This
results in a 95% success rate for the core group, and a 47% rate for the remaining
suppliers.
Additional Payables Measurements

There are several additional measurements for the payables area that can have a
noticeable impact on the function’s operations. The following measurements are
intended to be reviewed daily and to trigger immediate corrective action by the
payables staff:
• Remaining three-way matches. If a business uses alternative verification and
payment methods, there should be relatively few remaining supplier invoic-
es that are still being reviewed with the cumbersome three-way matching
process. Three-way matching involves comparing a supplier invoice to the
authorizing purchase order and a proof of receipt. Consider creating a report
that itemizes every invoice for which three-way matching was used, with the
intent of finding alternative ways to review these invoices.
• Invoices not mailed to accounts payable. Whenever an invoice arrives that
was mailed to someone other than the accounts payable department, include
the supplier name on a contact list. The payables staff should contact these
suppliers to request that the contact name be shifted to the payables depart-
ment. Doing so eliminates a possible bottleneck where invoice recipients
might not immediately forward invoices to the accounting staff.
• Supplier late fees. Any late payment fee charged by a supplier should be
recorded in a separate general ledger account. The information in this ac-
count is reviewed regularly to determine what circumstances caused the late
fee. The result may be procedural or other changes to keep the issue from
occurring again in the future.
• Manual payments. Track every manual payment made (including payments
by check, ACH, or wire transfer), determine the reasons why manual pay-
ments were mandated, and see if they can be converted to the regular pay-
ment system in the future.
Note that none of these additional measurements involve ratio analysis. Instead, they
mostly require that the payables staff investigate individual transactions in detail,
with the objective of locating transactions that either resulted in errors or which
required an inordinate amount of effort to complete. The result of these investiga-
tions should be a continual improvement in the efficiency of the payables function.
Summary
It is not necessary to maintain a comprehensive set of measurements for the payables
function. The payables manager is more likely to adopt a few measurements for the
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duration of a specific project, such as the rollout of ACH payments, and then stop
bothering with the measurements as soon as the project has been completed. These
measurements are needed as a feedback loop to determine the success of the project.
However, it can be useful to calculate a complete set of measurements once a year,
to see if there has been any backsliding in areas that had been considered high-
performance when they were originally addressed.
If there is one payables measurement worth monitoring on an ongoing basis, it is
the transaction error rate. This is more of a report than a measurement, and is
designed to detect and correct errors that creep into the payables system. Consider it
an early warning report for issues that can then be corrected before they expand into
more wide-ranging problems.
No matter which measurements are used, consider tracking them on a trend line.
Doing so gives immediate visual feedback regarding declines in performance, which
can trigger an investigation to locate underlying causes.
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Chapter 23
Sales and Marketing Measurements
Introduction
The sales and marketing functions of a company can absorb a notable proportion of
its total expenditures, and so are worthy of multiple measurements to ensure that
funds are expended wisely. In this chapter, we pay particular attention to
measurements that track the efficiency and effectiveness of the sales department.
Measurements for the marketing area are noted separately; there are far fewer
measurements for marketing, since this area is particularly resistant to evaluation.
Overview of Sales and Marketing Measurements

The traditional focus in the sales area is on the ability of a salesperson to generate
sales dollars. However, since this is a top-line item in the income statement that does
not necessarily relate to profitability, we instead suggest that the focus be placed on
the effectiveness of sales activities, which is essentially a comparison of the cost of
the department to the profits generated. Several measures are provided that deal with
different aspects of sales effectiveness.
Depending on the type of sales efforts being used, it may also be worthwhile to
examine the amount of solicitations being made to existing customers, since they
tend to buy more goods and services than first-time customers. Ancillary
measurements are sales per customer, the order placement rate, and the quote to
close ratio.
An extremely important measurement is the sales backlog ratio, which is a
strong indicator of the ability of a business to maintain its current sales level. This is
an excellent predictive measure for the amount of sales that will be recognized in the
near future.
We then turn to the concept of throughput, which is sales minus all totally
variable expenses. This is a much better measurement of the quality of selling
activity than the usual focus on gross sales, because throughput is a much stronger
indicator of profitability. If the sales staff remains tightly focused on the underlying
throughput of what they are trying to sell, there is a strong probability that low-
margin sales will not be pursued. The throughput measurements presented are
throughput quoted, the ratio of throughput awarded to quoted, and the ratio of
throughput booked to billed.
Though the marketing area tends to be quite resistant to detailed measurement,
we have aggregated several possibilities into the Marketing Measurements section
that can be used to gain some knowledge of the value of customers and media
activities, website sales, and the effectiveness of direct mail campaigns.
Of particular interest in this chapter is the number of measurements that can be

applied at the level of the individual employee, rather than for an entire department.
In particular, the incremental salesperson effectiveness, sales effectiveness, order
placement rate, sales per customer, and quote to close ratios can all be used to judge
the abilities of individual salespeople.
Sales Productivity
Sales productivity is the ability of the sales staff to generate profitable sales. A
profitable sale is considered to be one that has a high throughput, where throughput
is sales minus all totally variable expenses. We do not measure the sales generated
by the sales staff, since there may be little throughput associated with those sales.
To calculate sales productivity, divide the total estimated throughput booked by
the sales staff by the total sales department expense incurred. The formula is:
Total sales booked – All variable expenses associated with sales booked
Total sales department expenses
EXAMPLE
The president of Armadillo Security Armor is concerned that the sales department is not
being overly productive in booking new sales. He has the company controller accumulate the

Bookings $4,200,000 $4,315,000 $4,520,000
Related variable expenses $1,470,000 $1,726,000 $2,034,000
Throughput percentage 65% 60% 55%
Sales expenses $250,000 $260,000 $265,000
Sales productivity 10.9x 10.0x 9.4x
The analysis reveals that the sales staff is increasing sales, but giving away margin in order
to do so. The result is an ongoing decline in the department’s sales productivity. It would be
better to book fewer sales at higher margins, thereby generating more profit for the company.
Sales productivity should be judged over multiple periods, since some sales can take
several reporting periods to finalize, and so might yield a measurement that spikes
and slumps from month to month. Also, the measurement correlates with the
experience level of the sales staff, so expect it to decline immediately after new sales
employees are hired.
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Incremental Salesperson Effectiveness

A sales territory or product line typically supports a certain number of salespeople.
Beyond that optimal sales level, the profitability of each incremental salesperson
added to the sales department will decline. There are a number of reasons for this
peak level of effectiveness, including:
• The first salesperson in a territory has snapped up all of the higher-volume
customers
• All remaining potential customers are further away from the company
location, and so require more travel time for each incremental sale
• All remaining customers already buy from competitors, and so must be
pried away with more prolonged sales efforts
• It takes a long time to train additional salespeople
• New sales regions have different product requirements or cultural norms
that require a different type of sales effort
Whatever the reason may be, the sales manager needs a tool for determining at what
point it may not be useful to hire additional sales staff. That tool is the incremental
salesperson effectiveness measurement. This measures the sales generated by each
incremental salesperson added, divided by the total variable cost of that salesperson.
The formula is:
Incremental sales dollars

Salesperson compensation + benefits + travel + other variable costs
One problem with this measurement is that the numerator does not indicate the
amount of profits generated, only the amount of sales. A new salesperson might
decide to only sell the lowest-priced items in order to generate massive unit volume,
without necessarily generating much profit. This issue can be remedied by instead
using the incremental amount of throughput generated in the numerator (see the
Throughput Measurements section). This revised formula is:
Incremental throughput dollars

Salesperson compensation + benefits + travel + other variable costs
This measurement assumes that all salespeople are equally effective in their selling
ability, which is clearly not the case. However, the measurement is still useful for
tracking the effectiveness of a large number of salespeople, since effectiveness tends
to be clustered about an average point for this group.
EXAMPLE
Tsunami Products has developed a new shower head with a patented pulse feature that
creates a result similar to a massage. The product is initially sold through a group of
salespeople who sell it in bulk to large home construction companies. Tsunami’s sales
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manager then decides to hire additional sales staff to sell to smaller home builders, followed
by another tranche of sales staff that sell to home supply stores. Each group of salespeople
hired is less effective, because each targeted group of customers is progressively less
profitable. The result of these efforts is shown in the following table.
Incremental
Incremental Variable Cost of Salesperson
Throughput Sales Staff Effectiveness
Large home construction $17,000,000 $4,000,000 4.3x
companies
Small home construction 12,000,000 6,000,000 2.0x
companies
Home supply stores 3,000,000 2,900,000 1.0x
The table clearly shows a declining trend in salesperson effectiveness as the company adds
on a new sales channel. The sales manager should estimate the incremental salesperson
effectiveness for any additional channels chosen, to ensure that the company will still earn a
profit.
Sales Effectiveness
The preceding sales productivity measurement is useful for tracking the total amount
of throughput generated, but does not track the amount of time required at the
company’s bottleneck operation to generate that throughput. If sales are made that
require lots of processing time at the bottleneck, then a company will soon find itself
unable to process additional orders. The sales effectiveness measurement is designed
to monitor bottleneck usage in new orders. The measurement is used as feedback for
the sales staff, which can be encouraged to have customers order those goods
generating the largest amount of throughput per minute of bottleneck processing
time.
To calculate sales effectiveness, divide the total throughput for all orders booked
in a period by the total minutes of processing time required for these orders at the
bottleneck operation. The formula is:
Total sales booked – All variable expenses associated with sales booked
Total minutes of bottleneck processing time required
EXAMPLE
Horton Corporation manufactures widgets. The CFO wants to focus more sales attention on
the company’s new olive widget, introduced in February, which generates $25.00 of
throughput per minute of bottleneck processing time. This rate is significantly higher than the
average throughput per minute of Horton’s other widget products. The following table notes
the effect of the new product on sales effectiveness, with a notable increase in the metric
occurring in the final month.
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Throughput booked $910,000 $868,500 $1,014,300
Bottleneck minutes 50,000 45,000 49,000
Average throughput/minute $18.20 $19.30 $20.70
* Note that the amount booked in each month does not necessarily equate to the number of minutes
of bottleneck processing time available in that month.
Sales and Marketing as Percentage of Sales

The selling and marketing effort in which a business engages is a hit-or-miss
proposition, where the company must feel its way through a variety of possible
marketing options and selling efforts to determine which mix of activities generates
the highest sales and profitability. These activities are represented in the income
statement by a number of costs that are largely fixed, and for which corresponding
sales levels will not be clarified for several additional reporting periods. Thus, there
is a disconnect between sales and marketing expenses and sales. Nonetheless, it is
still useful to track these expenses as a percentage of sales on a trend line.
Eventually, as management figures out the optimum way to market and sell the
company’s goods and services, the percentage should settle down at a certain
percentage of sales.
To calculate sales and marketing as a percentage of sales, aggregate all selling
and marketing department expenses, and divide by net sales. Since there can be a
timing difference between these expenditures and related sales, consider running the
measurement on a trailing quarterly basis. The formula is:
Sales department expense + Marketing department expense

Net sales
There is no perfect percentage that a company should pursue. In some industries,

sales can be obtained with little effort, such as by maintaining an Internet store. In
other industries, it can require considerable marketing and prolonged selling
activities to procure a sale, such as in a competitive bidding situation for a large
infrastructure project.
Another issue is that the measurement does not include the throughput generated
by a sale, which would be a better measure of the ultimate profitability of sales and
marketing efforts.
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EXAMPLE
Milagro Corporation is a startup company that is figuring out the best way to sell its home
espresso machines. Sales are tracked by the cost of marketing and selling in three different
sales channels, which are direct sales through the company’s Internet store, sales through
department stores, and mailed catalogs. Sales and marketing as a percentage of sales appears
in the following table for each of these sales channels:
Internet Department Mailed

Store Stores Catalogs
Sales and marketing expense $108,000 $540,000 $210,000
Net sales $500,000 $4,500,000 $500,000
Sales and marketing % 22% 12% 42%
The analysis does not include the throughput generated from each sales channel. However, it
appears likely that the high cost of preparing and mailing catalogs makes this sales channel
unprofitable. It is relatively easy to sell to department stores, but we cannot tell from the
analysis whether Milagro is reducing its prices to obtain orders from the department stores.
Existing Customer Solicitation Ratio

When a business starts out, all sales calls are cold calls, which have a very low
success rate. Over time, the company will build a base of recurring customers, from
which the related sales will be substantially higher. The sales manager should track
the ratio of solicitations made to existing customers, which should be indicative of a
more efficient sales effort for a given volume of sales. Ideally, once a business is
fully mature, the existing customer solicitation ratio should be very high, which
indicates the highest level of efficiency in generating new sales.
To calculate the ratio, ascertain the total number of sales contacts made to
existing customers in the current period, and divide by the total number of all sales
contacts made. The formula is:
Total sales calls to existing customers

Total sales calls made
A 100% result for this ratio is not necessarily good, for it indicates that there are
either no new customers to be gained, or that the sales manager is not being overly
aggressive in pursuing new sales leads. Nonetheless, an increasing trend in the ratio
over time is to be encouraged.
EXAMPLE
Hammer Industries is a start-up company that sells lightweight tools to construction

companies that must haul gear into remote construction sites by helicopter. At its inception,
the sales manager researches the potential market, and finds that the potential customer base
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is comprised of 500 companies. The sales department begins cold calling, and achieves
notable success over the next four years in establishing relationships with this core group.
The result is shown in the following table:
20X1 20X2 20X3 20X4

Sales calls to existing customers 15 160 270 380
Total sales calls made 300 340 380 450
Existing customer solicitation ratio 5% 47% 71% 84%
The ratio trend line reveals that Hammer is beginning to run out of customers. Accordingly,
the sales manager calls a meeting with the executive team to discuss how the company can
expand its market to appeal to a larger group of potential customers.
Order Placement Rate

The core ability of a salesperson is to close a sales transaction. This means
convincing a customer to buy goods or services, rather than dithering over a
prospective purchase and delaying closing the deal. The ability to close a deal can be
measured with the order placement rate. The sales manager should use this
measurement on an ongoing basis to determine the closing capabilities of his or her
sales staff. The outcome of the measurement may be additional sales training, or the
termination of those salespeople who have not proven to be sufficiently capable.
To calculate the order placement rate, divide the total number of initial customer
contacts into the total number of customers from this group that placed orders. The
measurement can be further refined by excluding repeat orders from existing
customers, and can also be broken down at the level of the business unit, region, or
salesperson. The formula is:
Number of customers placing an order

Number of initial customer contacts
The order placement rate is best employed in high-volume environments where there
are many customer interactions. It is least useful when multiple salespeople may be
involved in a customer contact, so that assigning a successful sale to a specific
salesperson is more difficult.
EXAMPLE
The sales manager of Colossal Furniture wants to determine the ability of his sales staff to
sell the company’s oversized furniture to the people entering its stores. The stores use
automated counters to track the number of people entering each store, and order forms are
used to track the number of orders placed by stores. He compiles the information by store,
which yields the following information for the preceding month:
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Initial Order
Orders Customer Placement
Store Placed Contacts Rate
Ann Arbor 142 189 75%
Boston 319 560 57%
Chicago 241 636 38%
Denver 417 952 44%
The table reveals that the Ann Arbor store has an excellent order placement rate. The sales
manager decides to investigate the sales staff at this location, to see if any best practices or
training methods can be copied from there to the other stores.
Sales per Customer

A business can increase its sales either by adding new customers or by increasing
the volume of sales to existing customers. Since it is quite expensive to obtain new
customers, the sales and marketing staff should focus its attention on customers who
have already made purchases from the company. For example, it may be possible to
sell warranty services, additional products, or services on top of what a customer
may have originally ordered.
To calculate sales per customer, aggregate net sales for the reporting period, and
divide by the number of customers billed during the month. Given the need to count
the number of customers, this calculation may not be possible in a retail
environment where many sales are paid for in cash, since there is no tracking
mechanism for aggregating sales by customer. The formula is:
Net sales for the reporting period

Number of customers billed
One issue with the outcome of this ratio is that a focus on acquiring entirely new
customers will likely force the ratio to decline. The reason is that new customers
tend to buy less than more established customers, who have a longer-term
relationship with the company and so are more familiar with its products.
EXAMPLE
The sales manager of Pianoforte International is perusing information about the cost of
acquiring a new customer, which is $5,000. Since the company’s average sale is for a
$20,000 concert-grade piano, the cost of customer acquisition is the next-largest cost after
the cost of goods sold. Based on this information, the sales manager decides to concentrate
the efforts of her staff on selling large numbers of pianos to the music departments of
colleges and universities. The results of this effort are noted in the following table:
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Before New After New

Sales Strategy Sales Strategy
(20X1) (20X2)
Net sales $29,000,000 $40,000,000
Number of customers billed 1,450 800
Sales per customer $20,000 $50,000
The table reveals that the sales staff tightly focused its efforts in 20X2 on a much smaller
group of larger customers, resulting in higher sales per customer, and far more total sales.
The only downside is that the company deliberately reduced the number of customers with
which it interacts.
Quote to Close Ratio

In an environment where the sales process requires the issuance of a formal quote on
a competitive basis, the quote to close ratio is valuable for determining the ability of
the sales staff to convince a customer to accept a quote. A high ratio can indicate a
combination of excellent quote writing ability, product quality, and product
demonstration skill. Conversely, if few quotes are leading to customer orders, then
the same factors must be investigated to see where the problem lies.
EXAMPLE
The sales manager of Milford Sound believes that the company’s recent revamping of its
quote-writing unit has improved sales. Accordingly, he asks the company’s financial analyst
to prepare a quote to close ratio for each of the last four quarters. The following results
indicate that quoting effectiveness has indeed risen.
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Sales booked $12,000,000 $12,500,000 $14,000,000 $17,000,000
Sales quoted $54,500,000 $62,500,000 $56,000,000 $58,600,000
Quote to close ratio 22% 20% 25% 29%
An issue to be aware of is that the quote to close ratio only measures sales booked,
not throughput booked. Thus, it is possible that an increase in the ratio could be
caused by lower price points that give away profits.
Sales Backlog Ratio

The sales backlog ratio provides an indicator of the ability of a business to maintain
its current level of sales. When noted on a trend line, the measurement clearly
indicates changes that will likely translate into future variations in sales volume. For
example, if the ratio exhibits an ongoing trend of declines, this is a strong indicator
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that a business is rapidly working through its backlog, and may soon begin to report
sales reductions. The opposite trend of an increasing sales backlog does not
necessarily translate into improved future sales, if a company has a bottleneck that
prevents it from accelerating the rate at which it converts customer orders into sales.
To calculate the sales backlog ratio, divide the total dollar value of booked
customer orders by the net sales figure for the past quarter. Only quarterly sales are
used, rather than sales for the past year, in order to more properly reflect a
company’s short-term revenue-generating capability. The formula is:
Total order backlog

Quarterly sales
A different way of deriving the same information is to calculate for the number of
days sales that can be derived from the existing order backlog. This figure is derived
by dividing the average sales per day into the total backlog. The formula is:
Total order backlog

Quarterly sales ÷ 90 days
The customer order information needed for this ratio cannot be entirely derived from
a company’s financial statements. Instead, it must be derived from internal reports
that aggregate customer order information.
The ratio is of less use in the following situations:
• A retail environment, where there is no backlog
• A seasonal business, where the intent of the business model is to build
order volume until the prime selling season, and then fulfill all orders
• A just-in-time “pull” model, where the intent is to fulfill orders as soon
after receipt as possible
EXAMPLE
Henderson Mills reports the following sales and backlog information:
April May June

Rolling 3-month sales $9,000,000 $9,500,000 $9,600,000
Month-end backlog 5,000,000 4,000,000 3,500,000
Sales backlog ratio 0.55:1 0.42:1 0.36:1
The table indicates that Henderson is increasing its sales by chewing through its order
backlog, which the company has been unable to replace. The result is likely to be the
complete elimination of the order backlog in the near future, after which sales can be
expected to plummet, unless steps are taken to book more customer orders.
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Throughput Measurements
Thus far, we have offered a number of sales-related measurements that are fairly
traditional in nature. In this section, we instead offer several sales measurements that
are focused on throughput – which is sales minus all variable expenses. A company
that generates a large amount of throughput can more easily cover its fixed costs,
and so is more likely to generate outsized profits. There are three sales measure-
ments related to throughput, which focus on the amount of throughput quoted, the
proportion of these quoted sales awarded to the company, and the proportion of
these awarded sales actually billed to customers. Thus, the measures are intended to
track the volume of throughput quoted, the success of this quoting activity, and the
ability of the company to fulfill its contracts. Some of the preceding measurements
also incorporated throughput concepts; see the sales productivity and sales
effectiveness measures.
Throughput Quoted
When formal quotes must be issued to customers in order to obtain a sale, the classic
measurement is the total dollar amount of sales quoted in a period. This
measurement gives management an impression of the overall activity level of the
group that issues quotes. Unfortunately, it does not inform management of the
throughput that will result from these quotes. After all, the quoting group could
deliberately lower the price on a quote in order to increase the probability of
securing a customer order, even though doing so may eliminate any possibility of
generating enough throughput to earn a profit. To avoid this issue, consider
replacing the total amount of sales quoted in a period with the total amount of
throughput quoted. Doing so focuses the attention of the sales staff on generating
bottom-line profits, rather than top-line sales.
To measure throughput quoted, subtract from each quoted price all variable
costs expected to be incurred if a sale is made, and aggregate the result for all quotes
issued in the measurement period. The formula is:
∑ (Quoted sales – Expected variable costs)
EXAMPLE
Mulligan Imports is an importer of exotic foreign golf clubs, which it sells in bulk to the pro
shops in golf clubs around the country via a formal quoting process. Mulligan’s only variable
cost is the cost of each club that it imports; all other costs relate to the sales and marketing of
its inventory. The company is suffering from paltry profit levels, so the president reviews the
throughput generated by each type of driver, to see if there are any differences that can be
exploited. The result is the following table:
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Unit Unit Units Total Quoted

Price Throughput Quoted Throughput
Gold Coast Driver $150 $20 14,000 $280,000
Mahogany Swing 210 55 750 41,250
Soviet Driver 180 70 210 14,700
Timbuktu Thumper 310 140 150 21,000
Totals 15,110 $356,950
It appears that the sales staff is consistently quoting large quantities of the Gold Coast Driver,
which has the lowest throughput of any of the drivers. The president decides to alter the
commission plan of the sales staff to incentivize them to include more of the other drivers in
quotes. Even if overall sales plummet, the throughput associated with these other drivers is
so high that the company should still earn a larger profit.
Ratio of Throughput Awarded to Quoted

In the preceding measurement for throughput quoted, the outcome of using the
measurement is likely to be a shift in quotes to focus on higher-throughput products.
However, this shift may not be accepted by customers, who may not appreciate the
change in product offerings or higher price points being quoted. If so, fewer quotes
may be awarded to the company. To see if this is the case, measure the ratio of
throughput quoted to awarded. The calculation is to aggregate the throughput
contained within all awarded quotes, and divide by the aggregate throughput
contained within all quotes issued in the period. The formula is:
Aggregate throughput in quotes awarded
Aggregate throughput in quotes issued
If there is a significant delay in the time required for customers to respond to quotes,
it is entirely likely that the quotes awarded will be in a different reporting period
than the period in which the quotes were issued. If so, expand the measurement
period somewhat, such as by using a rolling three-month period.
EXAMPLE
To continue with the preceding example, the president of Mulligan Imports has forced his
sales staff to issue bids to pro shops for drivers that have higher throughput rates than had
previously been the case. The result is shown in the following table:
Total Awarded Total Quoted Ratio of Throughput

Throughput Throughput Quoted to Awarded
Gold Coast Driver $65,000 $65,000 100%
Mahogany Swing 93,000 120,000 78%
Soviet Driver 160,000 200,000 80%
Timbuktu Thumper 82,000 215,000 38%
$400,000 $600,000 67%
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The result of this change in quoting practices is an increase in throughput of $43,000. Much
of this increase can be traced to the Mahogany Swing and Soviet Driver products, which the
president decides to support with an increased marketing expenditure.
Ratio of Throughput Booked to Billed

If a business wants its sales to remain steady, the amount of throughput in its
backlog should roughly equate to the amount of throughput billed. If management is
interested in growing sales, then the amount of throughput booked should also
increase – otherwise, the backlog will eventually be eroded, and the company will
suffer a catastrophic decline in its sales. Conversely, the amount of throughput
booked should not continue to build, since this means that the company’s bottleneck
operation is controlling the amount of output, and the company is at risk of losing
sales when it mandates longer lead times for its customers.
To calculate the ratio of throughput booked to billed, aggregate the total amount
of throughput booked as of the end of the reporting period, and divide by the amount
of throughput billed in the period. A ratio of approximately 1:1 indicates a steady-
state and supportable sales situation, while an increase in the ratio reveals that the
company’s bottleneck is restricting sales. A decrease in the ratio indicates that the
company is not replenishing its backlog, and is likely to suffer a major sales decline
in the near future. The formula is:
Total throughput booked as of the measurement date

Total throughput billed in the period
EXAMPLE
To continue with the Mulligan Imports example, the company must import all of its products
from overseas, which means that its bottleneck is the production operations of its suppliers.
The president tracks the ratio of throughput booked to billed for each of the driver brands
sold by the company, and notes the following disturbing trend for the Timbuktu Thumper:
Throughput Throughput Ratio of Throughput

Booked Billed Booked to Billed
May $82,000 $41,000 50%
June 93,000 28,000 30%
July 107,000 21,000 20%
The table reveals that the supplier in Timbuktu is clearly unable to fulfill Mulligan’s orders
for the Thumper driver on a timely basis. It turns out that the supplier is dealing with an
insurgency from Mauritania which keeps stealing drivers from its delivery trucks and selling
them on the black market in nearby Niger. Consequently, the president concludes that the
source of supply is too unreliable to continue offering the Thumper product.
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Marketing Measurements
The marketing function is one of the more difficult areas in a company to measure,
since there may be only a vague link between marketing expenditures and sales
generated. Nonetheless, there are some niches in the marketing area for which
performance can be measured, which we note in this section.
Advertising Value Equivalency

An ongoing conundrum for the marketing manager is how to split her budgeted
funds and staff time between advertising and media coverage. Media coverage
requires a much-reduced expenditure in comparison to advertising, but takes up far
more staff time. It is possible to derive a common basis of measurement for these
two marketing activities by converting the amount of printed media coverage to
what it would have cost to purchase the space as advertisements. This is called
advertising value equivalency.
To calculate equivalency, measure the physical dimensions of the space taken up
by media coverage, and multiply the square inches of space by what it would have
cost the company to purchase ad space in a similar quantity in an equivalent
publication. The formula is:
Square inches of printed coverage × Equivalent ad rate
The same approach can be taken if the media coverage is of the audio or video
variety; just measure the time interval covered, and multiply by the equivalent cost.
While advertising value equivalency at least provides some measure of the value
of media coverage, it is only an approximation of value, for the following reasons:
• The value of a media piece can vary based on its content, where a highly
positive article is worth much more than one that is neutral or negative.
• What if a media story is negative, and the marketing staff spends a large part
of its time to keep the story from running? In this case, what is the value of
having zero negative media coverage?
• Positive media coverage may be worth substantially more than advertising
coverage, since consumers are more likely to trust information generated by
an independent third party.
• Media coverage may only mention a company in passing, as part of a larger
article. If so, how is the equivalency to be measured?
• A massive article about a company may have no advertising equivalent,
since it may not be possible to derive a volume discount for the equivalent
amount of advertising space.
EXAMPLE
The marketing manager of Quest Adventure Gear usually spends $20,000 per month on
advertising, with little effort going toward positive media coverage. She is interested in the
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possibility, however, and remembers how a small profile about the company by a national
news service generated a significant bump in sales. She estimates that the one-minute audio
clip on the news service’s radio program would have cost $8,000 as an advertisement, and so
assigns this value to the media coverage.
Sales to Unique Visitors Ratio

When a business sells goods through a website, the profitability of the site will be
highly dependent upon a number of factors, such as site design, price points, and
promotions. Ultimately, the mix of these (and other) issues will yield a certain
amount of sales in proportion to the number of unique visitors viewing the site. The
ability of an organization to sell through such a site can be measured by comparing
sales generated to the number of unique visitors to the site.
To measure the sales to unique visitors ratio, divide net sales by the number of
unique visitors to the site during the measurement period. The unique visitors figure
is available through a number of site tracking services. The formula is:
Sales traceable to web site

Number of unique visitors to web site
As has been noted elsewhere in this chapter, performance should be tied to

throughput, rather than sales, so the measurement can be modified as follows to
incorporate throughput into the numerator:
Throughput traceable to web site

Number of unique visitors to web site
It is not advisable to use the total number of sales transactions in the numerator,
since this can have quite a distant relationship with profitability. Many small
transactions could look impressive, but unless they generate throughput, there will
be little contribution to profitability.
EXAMPLE
Prickly Corp. sells cactus plants through its website. Prickly recently paid an outside website
developer to overhaul the site. In the most recent month, the number of unique visitors to the
site was roughly the same as in previous months, but the resulting throughput was
substantially different, as noted in the following table:
Throughput Number of Throughput to Unique

Generated Unique Visitors Visitors Ratio
Before site redesign $36,000 150,000 $0.24/unique
After site redesign 92,000 152,000 $0.61/unique
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Based on the success of the redesign, the owners of Prickly decide to hire the same website
designer for a revision of the company’s other website that sells thorn bushes.
Direct Mail Effectiveness

Some organizations send out targeted mailings to customers, usually advertising
reduced pricing on specific products or services. If there is an identification number
(such as a coupon code) attached to these offers, it should be possible to trace the
sales generated by a direct mail campaign back to the cost of that campaign. The
cost of a direct mailing can be substantial, since it includes the costs of mailer
design, printing, mailing lists, and postage. This comparison can tell the marketing
manager if a particular mailing campaign was effective, or should be revised to
boost profitability.
To calculate direct mail effectiveness, divide the sales generated by a direct mail
campaign by the variable cost of that campaign. The formula is:
Incremental sales traceable to direct mail campaign

Variable cost of the direct mail campaign
The flaw in this measurement is that sales dollars are assumed to be the key product
of a direct mail campaign, when in fact the more desirable outcome is a large
amount of throughput (see the earlier Throughput Measurements section).
Accordingly, the measurement can be revised to use throughput in the numerator, as
follows:
Incremental throughput traceable to direct mail campaign

Variable cost of the direct mail campaign
EXAMPLE
The Hegemony Toy Company’s marketing director has developed a mailing piece that is sent
to the company’s mailing list of military toy collectors. The mailing piece comes in three
versions, with one selling Roman-era soldiers, another highlighting Colonial-era soldiers,
and yet another selling a set of Crusader knights. Based on subsequent sales information, she
compiles the following direct mail effectiveness measurement for the mailers:
Incremental Incremental Direct Mail

Throughput Mailer Cost Effectiveness
Roman mailer $120,000 $110,000 1.1x
Colonial mailer 42,000 105,000 0.4x
Crusader mailer 270,000 115,000 2.4x
Totals $432,000 $330,000 1.3x
The incremental mailer cost is similar for all three direct mail campaigns, so the paltry
returns from the Colonial mailer inevitably result in a major loss. However, the Crusader
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campaign is a major success, to such an extent that its profitability easily offsets the loss
incurred on the Colonial mailer. Nonetheless, the marketing manager may need to consider
selling the Colonial-era toy soldiers through a different sales channel.
Market Share
A general measure of the effectiveness of a company’s sales and marketing efforts is
market share, which is the proportion of sales in a market niche accumulated by a
specific company. This measure is only available if someone is estimating the total
size of the market; for example, a trade association may guesstimate the market size
based on surveys of its members. Market share is a particularly important
measurement if the size of a market is changing dramatically. For example, a
company may be experiencing what it believes to be excellent sales growth, but
which may actually represent a shrinking market share. Conversely, flat sales in a
declining market may reflect excellent performance.
To measure market share, divide the company’s net sales by the total reported
size of the market. The formula is:
Net sales
Reported market size in sales dollars
This measurement should be treated with caution, for the following reasons:
• Accuracy. The market size may be wildly inaccurate, especially if market
participants are self-reporting information to a trade association, and have a
reason to overstate or understate their sales.
• Profitability. A company only wants market share if there is some associat-
ed profitability. Certain niches of any market may be seriously unprofitable,
and so should be avoided, even if doing so represents lost market share.
• Applicability of sales. A company’s sales may be associated with multiple
markets, so do not apply the entire sales of the business to a specific market
share calculation. Instead, the company may have a smaller share of several
markets.
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EXAMPLE
The Black Cat Ladder Company has seen ascending sales ever since the start of the last
building construction boom. However, all other ladder manufacturers appear to have been
doing fine as well, so the president commissions a market share study to ascertain the true
position of the company. The results are noted in the following table.
(000s) 20X1 20X2 20X3

Black Cat sales $20,000 $24,000 $28,000
Market size $200,000 $300,000 $467,000
Market share 10% 8% 6%
The analysis reveals that Black Cat has actually been falling seriously behind its competitors
for the last few years, despite what appeared to be robust growth.
We must extend a cautionary note about the ongoing pursuit of market share. An
ever-increasing share of the market is not necessarily correlated with increasing
profits, since some niches within the market are very price sensitive. However,
profits will increase in markets where there are significant economies of scale
(where unit costs decline as unit volumes increase). Consequently, one must
consider the structure of the market before making market share the essential
performance metric of a business.
Customer Lifetime Value

When deciding whether to engage in relationship-based sales, it helps to calculate
the lifetime value of a customer. Lifetime value is the present value of the profits
that will be generated from a customer over the life of the relationship. It is
calculated as follows:
1. Forecast the timing and amounts of payments that a customer will make to
the company over the estimated life of the relationship.
2. Forecast the timing and amount of payments related to referrals made by the
customer that bring in new customers.
3. Forecast the cost and timing of the goods and services sold to the customer
and the referred customers.
4. Forecast the unique relationship-related costs that will be expended to
service the customer.
5. Convert these payments into their present values, using the cost of capital of
the business as the discount rate.
The net amount of the present values of these revenues and expenses represents the
estimated lifetime value of a customer. The concept can be useful when deciding
upon the marketing activities to be used to obtain new customers, as well as the
expenditures to be made to retain existing ones. For example, when customers are
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unlikely to make repeat visits and the sale amount per visit is relatively low, then
marketing expenditures on a per-customer basis must also be low. Conversely, when
a customer is likely to return many times to make significant purchases, it can make
sense to spend much more to acquire customers, even if this means that the business
initially incurs losses to do so. For example, a car dealership may invest in an
exceptional facility in order to accommodate customers who are waiting for their
vehicles to be serviced, in hopes of selling them more cars in the future.

Sales and marketing require very particular skills that may not be readily available
on the open market. For example, direct sales can require employees with a flair for
hands-on selling transactions, while effective marketing may call for a deep
knowledge of the industry. Consequently, employee turnover among the more
experienced staff should be an area of great interest.
It is entirely possible that the corporate bottleneck for achieving more sales is
the sales staff itself. This is especially likely to be the case when individual sales
require significant sales expertise, or selling relationships require a long time to
mature, or there are specific technical aspects to certain parts of the selling process
flow. The situation is exacerbated if there are few salespeople in the industry who
have the required skill set, or if a long period of time is required to educate new
salespeople. Under these circumstances, a business may find that its sales could
potentially be devastated by the loss of just a few people in the sales department. If
so, employee turnover is an especially pernicious problem that must be guarded
against proactively.
Also, pay particular attention to the compensation being paid to the sales staff.
This group may be highly motivated by compensation, so employee turnover can be
closely linked to how well employees are being paid in comparison to the median
rate for the industry.
These two measurements are usually monitored by the human resources
department, but should also be a key concern of the sales manager and marketing
manager. In essence, if turnover among the senior staff increases for any reason,
then many of the performance measurements described in this chapter will decline.
Summary
The traditional focus of sales and marketing measurements has been on increasing
the gross sales of a business. In this chapter, we have continually advocated the use
of throughput as a much more appropriate outcome, since it is tied more directly to
the ultimate profitability of an organization. However, in order to use throughput, a
company must have a system in place that easily states the throughput for every
product or service, without a great deal of cost accounting analysis. The simplest
way to do so is to estimate the standard cost associated with each product or service,
and publish the resulting standard throughput figures as the de facto throughput
numbers that employees will henceforth use to manage the business.
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Glossary
A
Accrual basis of accounting. The recognition of revenue when earned and expenses
when incurred.
Asset base. The sum total of all assets used by a business to generate revenue.
Asset turnover. The proportion of the sales generated by a group of assets.
Available balance. The balance in a cash account where there is a delay by the
controlling bank in crediting funds to the account.
B
Backlog. The amount of firm orders from customers that have not yet been
processed.
Balance sheet. A report that summarizes all of an entity’s assets, liabilities, and
equity as of a given point in time.
Bill of materials. A listing of the parts used in a product.
Book value. Total assets minus total liabilities.
Borrowing base. The total amount of collateral against which a lender will lend
funds to a business.
Bottleneck. A chokepoint through which work must flow before goods can be
delivered to a customer.
Breakeven point. The sales level at which a company earns exactly no profit.
C
Capital lease. A lease in which the lessor only finances the lease, and all other rights
of ownership transfer to the lessee.
Carrying amount. The original cost of an asset, less any accumulated depreciation
and impairment.
Cash basis of accounting. The recognition of revenue when cash is received and
expenses when cash is paid.
Cash conversion cycle. The time period from when cash is expended for the
production of goods, until cash is received from customers in payment of those
goods.
Cash flow. The net amount of an entity’s incoming cash receipts and outgoing cash
payments over a period of time.
Cash sweeping. The practice of automatically transferring cash at the end of each
business day from an account into an investment option that earns interest income.
Glossary
Collateral. An asset pledged as security for the repayment of a loan.

Cost of capital. The cost of funds for a business.
Current asset. An asset expected to be converted into cash within one year.
Current liability. A liability for which payment is due within one year.
Current ratio. The current assets of a business, divided by its current liabilities.
D
Depreciation. The gradual charging to expense of an asset’s cost over its useful life.
Direct mail. Sales offers sent to recipients via standard mail or e-mail.
Discretionary cost. A cost that can be avoided in the short term without interfering
with the basic operation of a business.
Dividend payout ratio. A comparison of dividends paid to net earnings, used to
evaluate the level of dividend payments made by a business.
E
EBITDA. Earnings before interest, taxes, depreciation, and amortization. It is a
rough measure of the cash flows of a business.
Economic order quantity. The number of units ordered that minimizes the costs of
order placement and holding inventory.
Effective interest rate. The actual interest rate paid, as computed by dividing the
actual amount of interest paid by the amount of the principal that the borrower is
obligated to repay.
Engineering change order. A scheduled change to the contents of a product.
F
Financial leverage. The proportion of debt to equity used to fund the operations of a
business.
Financial statements. A collection of reports that describe the financial results,
condition, and cash flows of an entity.
First in, first out. The assignment of costs to sold goods based on the assumption
that the first items entering inventory are the first ones sold.
Fixed asset. An asset with a useful life greater than one year, and which exceeds an
entity’s minimum capitalization limit.
Free cash flow. The net change in cash generated by the operations of a business,
minus cash outlays for working capital, capital expenditures, and dividends.
Full-time equivalent. The number of working hours that equates to one full-time
employee.
284
Glossary
G
Goodwill. That portion of an acquisition price that cannot be assigned to the tangible
or intangible assets of the acquiree.
Gross sales. Sales before deductions for sales returns and allowances.
H
Hedging. A risk reduction technique whereby a derivative or similar instrument is
used to offset future changes in the fair value or cash flows of an asset or liability.
I
Impairment. A reduction in the value of an asset.
In the money. When the designated exercise price of an option or warrant is below
the current market price of a company’s common stock.
Income investor. An investor that invests based on the dividends paid by the issuers
of stock.
Income statement. A financial report that summarizes an entity’s revenue, cost of
goods sold, gross margin, other costs, and net income or loss.
Intangible asset. A non-physical asset having a useful life spanning more than one
accounting period.
Inventory buffer. A buffer placed in front of a constrained resource, to keep the
operation running in the event of a shortfall in incoming deliveries.
L
Last in, first out (LIFO). A cost layering concept under which the cost of the last
items added to inventory are assigned to the first items sold from inventory.
Leverage. The use of borrowed funds to increase profits.
Lifetime value. The present value of the profits that will be generated from a
customer over the life of the relationship.
Line of credit. A commitment from a lender to pay a company whenever it needs
cash, up to a pre-set maximum level.
Lower of cost or market. An accounting requirement mandating that inventory be
recorded at the lower of its cost or market value.
M
Margin of safety. The reduction in sales that can occur before the breakeven point of
a business is reached.
Mark to market. The practice of recording an asset or liability at its current market
value.
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Glossary
N
Net book value. The original cost of an asset, less any accumulated depreciation,
accumulated amortization, and accumulated impairment.
O
Opportunity cost. The cost of an alternative course of action that is being foregone.
P
Price elasticity. The degree to which changes in price impact the unit sales of a
product or service.
Procurement card. A company-sponsored credit card used to make purchases on
behalf of the company.
Purchase order. A formal authorization to buy goods and services under the terms
stated in the authorization document.
Q
Quick ratio. The ratio of cash, marketable securities, and accounts receivable to
current liabilities. The ratio does not include inventory or prepaid expenses.
S
Sales returns and allowances. Reductions in gross sales caused by merchandise
returns and credits granted to customers.
Shareholders’ equity. The share capital of a business, plus its retained earnings, less
any treasury stock.
Short interest. The number of shares that investors have sold short, and which they
have not yet closed out.
Short selling. The sale of borrowed stock, which a short seller expects to buy later
on the open market at a lower price, earning a profit on the decline in price.
Soft close. The process of closing the books for a reporting period, using fewer than
the normal set of closing activities in order to reduce the work required to close the
books.
Statement of cash flows. A part of the financial statements that summarizes an
entity’s cash inflows and outflows in relation to financing, operating, and investing
activities.
Stock-keeping unit. A unique identification code assigned to a product or service.
T
Takt time. The average rate at which units must be produced in order to meet
demand.
Tangible assets. Assets that occupy physical space, such as equipment and
buildings.
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Glossary
Tangible book value. Book value minus the recorded cost of all intangible assets.
Target balance. The amount of cash that a company plans to hold in an account.
Three-way matching. The process of comparing the authorizing purchase order to a
receiving document and supplier invoice, to ensure that a supplier invoice is
approved, and that the billed goods were received.
Throughput. Revenue minus all totally variable expenses.
W
Working capital. Cash plus accounts receivable and inventory, minus accounts
payable.
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Index
Certified suppliers, proportion of ........ 250
Accession rate..................................... 179 Collection dispute cycle time .............. 126
Accounts payable measurements ........ 262 Collection effectiveness index ............ 122
Accumulated depreciation to fixed assets Collection performance report ............ 129
ratio ................................................ 166 Contribution margin ratio ...................... 13
Actual cash position versus forecast ... 115 Core earnings ratio ................................ 18
Administrative staff ratio .................... 186 Core sales growth .................................. 92
Advertising value equivalency ........... 277 Cost per hire ........................................ 176
Affordable growth rate ......................... 96 Cost per square foot ............................ 146
Altman Z score ..................................... 45 Cross price elasticity of demand ......... 212
Annualized compensation .................. 181 Cubic volume utilization ..................... 151
Auto cash application rate .................. 113 Current ratio .......................................... 34
Average cost of debt ........................... 162 Customer growth ................................... 92
Average days to pay per collector ...... 125 Customer satisfaction ratio .................. 142
Average end of day available balance 116 Customer solicitation ratio .................. 269
Average inventory .............................. 192 Customer turnover............................... 136
Average run time ................................ 229
Average time to establish credit ......... 130 Days delinquent sales outstanding ...... 125
Average time to first contact .............. 127 Days payables outstanding .................... 32
Days sales in accounts receivable ......... 30
Bad debt percentage ........................... 128 Days sales in inventory ......................... 31
Best possible DSO .............................. 122 Days sales outstanding ........................ 120
Bill of material accuracy .................... 239 Debt service coverage ratio ................. 159
Book value per share ............................ 65 Debt to equity ratio ............................. 156
Borrowing base usage......................... 163 Deduction turnover ............................. 127
Bottleneck effectiveness ..................... 101 Defensive interval ratio ......................... 38
Bottleneck maintenance to operating ratio Deflated profit growth ........................... 16
....................................................... 104 Deflated sales growth ............................ 90
Bottleneck rework processing ............ 105 Degree of unbalance............................ 223
Bottleneck schedule fulfillment .......... 102 Delayed throughput ............................. 111
Bottleneck utilization.......................... 100 Design cycle time ................................ 238
Breakeven point .................................... 23 Design platforms, number of............... 237
Buffer penetration ............................... 103 Direct mail effectiveness ..................... 279
Discounted prices, proportion of ......... 214
Caller abandonment rate ..................... 139 Discretionary cost ratio ......................... 25
Capitalization rate ................................. 78 Dividend payout ratio............................ 73
Cash conversion cycle .......................... 29 Dividend yield ratio .............................. 74
Cash coverage ratio ............................ 161
Cash flow from operations ratio ........... 51 Earnings on invested funds ................. 117
Cash flow per share .............................. 49 Earnings per share ................................. 70
Cash flow return on assets .................... 51 Economic order quantity ..................... 254
Cash flow return on sales ..................... 50 Economic value added .......................... 59
Cash flow to fixed asset requirements Effective tax rate ................................... 18
ratio ................................................ 167 Employee replacement cost................. 178
Cash ratio.............................................. 37 Employee turnover .............................. 179
Cash reinvestment ratio ........................ 53 Equipment effectiveness ..................... 225
288
Ergonomic injury rate ......................... 187 Usage levels ........................................4
Escalation rate .................................... 139
Expense growth .................................... 93 Net benefits cost per employee ........... 182
Net book value ...................................... 63
Finished goods turnover ..................... 196 Net profit ratio....................................... 16
First contact resolution ....................... 137 Net promoter score .............................. 143
First-pass yield ................................... 230 Net working capital ratio ....................... 39
Fixed charge coverage ratio ................ 160 New-product sales, percentage of ....... 241
Floor space utilization ........................ 150
Form W-2c to Form W-2 ratio ........... 205 Obsolete inventory percentage ............ 199
Free cash flow ...................................... 48 Occupancy cost ratio ........................... 147
Full-time equivalent............................ 259 On-time delivery percentage ............... 132
Funds-flow adequacy ratio ................... 53 Operating income ratio .......................... 14
Operating leverage ................................ 22
Goal monitoring ..................................... 4 Operating ratio ...................................... 21
Gross profit ratio .................................. 14 Operational takt time ........................... 224
Opportunity cost of excess inventory .. 202
Honeycombing percentage ................. 153 Options to common stock ratio ............. 84
Order cycle time .......................... 133, 220
Illiquid asset conversion ratio ............... 42 Order fill rate....................................... 134
Inbound caller retention ...................... 141 Order placement rate ........................... 270
Incident volume .................................. 140 Orders damaged in transit ................... 135
Indirect labor to direct labor ratio ....... 232 Outsourced payroll cost per employee 208
Insider buy/sell ratio ............................. 82 Outsourcing cost effectiveness ............ 188
Institutional holdings ratio .................... 86 Overhead to direct cost of goods ratio 233
Interest coverage ratio ........................ 159
Intern conversion ratio ........................ 176 Paperless measurements ...................... 261
Inventory accuracy percentage ........... 197 Payroll entries to headcount ratio ........ 206
Inventory greater than XX days.......... 200 Payroll transaction error rate ............... 204
Inventory to current assets ratio............ 35 Position fulfillment speed ................... 171
Inventory turnover ratio ...................... 194 Post-bottleneck scrap .......................... 106
Price elasticity of demand ................... 211
Lifetime value..................................... 281 Price/earnings ratio ............................... 77
Liquidity index ..................................... 33 Procurement card usage ...................... 247
Loan covenants ....................................... 3 Productivity cause and effect ratio ...... 222
Profit growth ......................................... 95
Maintenance and repair ratio .............. 228 Profit growth consistency...................... 95
Manual checks, proportion of ............. 206 Profit per person .................................. 184
Manufacturing effectiveness............... 109 Public reporting .......................................3
Manufacturing efficiency ................... 221 Purchase orders above threshold ......... 246
Manufacturing productivity ................ 108
Manufacturing throughput time .......... 110 Quality of earnings ratio ....................... 20
Margin of safety ................................... 24 Quick ratio ............................................ 36
Market share ....................................... 280 Quote to close ratio ............................. 272
Market to book value ............................ 81
Market value added .............................. 80 Ratio limitations ......................................8
Material yield variance ....................... 231 Raw materials turnover ....................... 194
Measurement Recruiter effectiveness ratio ................ 174
Consistency ........................................ 6 Regulatory requirements .........................3
Timing ................................................ 5 Repairs expense to fixed assets ratio ... 169
289
Return on assets .................................... 67 Strategic insights .....................................5
Return on equity ................................... 56 Supplier billed price variance.............. 253
Return on operating assets .................... 68 Supplier defect rate ............................. 252
Return on research and development .. 242 Supplier financing of assets ................ 157
Returnable inventory valuation .......... 201 Supplier fulfillment rate ...................... 251
Reused components percentage .......... 237 Supplier late fees ................................. 262
Suspense to receivables ratio .............. 114
Sales and marketing percentage ......... 268
Sales backlog ratio .............................. 272 Tangible book value .............................. 64
Sales effectiveness .............................. 267 Target cost attainment ......................... 240
Sales growth consistency ...................... 90 Targeted inventory dispositioning ....... 255
Sales per customer .............................. 271 Throughput awarded to quoted ratio ... 275
Sales per person .................................. 183 Throughput booked to billed ratio....... 276
Sales productivity ............................... 265 Throughput per minute........................ 213
Sales returns and allowances to sales ... 12 Throughput quoted .............................. 274
Sales to fixed assets ratio .................... 165 Time bucket measurements ................. 124
Sales to unique visitors ratio ............... 278 Total shareholder return ........................ 79
Sales volume variance ........................ 217 Transaction error rate .......................... 258
Salesperson effectiveness ................... 266
Selling price variance ......................... 216 Unfilled requisitions ratio ................... 173
Setup time ........................................... 226 Unhedged gains and losses.................. 118
Short interest ratio ................................ 86 Unscheduled downtime percentage ..... 227
Soft close issues...................................... 6
Solvency ratio ....................................... 43 Variances from baseline ..........................4
Spend management, proportion of...... 248
Spend with preferred suppliers ........... 249 Warranty claims percentage ................ 243
Square feet per person ........................ 148 Working capital productivity ................ 40
Storage bin utilization......................... 152 Working capital roll forward ................. 41
Storage in high-cost locations............. 149 Work-in-process turnover ................... 195
290

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AccountingTools ® Series

Steven M. Bragg, CPA

Published by AccountingTools, Inc., Centennial, Colorado.

No part of this publication may be reproduced, stored in a retrieval system, or

Printed in the United States of America

Chapter 2 - Performance Measurements............................................................................ 11

Chapter 3 - Liquidity Measurements .................................................................................. 28

Chapter 4 - Cash Flow Measurements................................................................................ 47

Chapter 5 - Return on Investment ...................................................................................... 56

Chapter 6 - Share Performance Measurements................................................................. 76

Chapter 7 - Growth Measurements .................................................................................... 89

Chapter 8 - Constraint and Throughput Measurements .................................................. 99

Chapter 9 - Cash Management Measurements ................................................................ 113

Chapter 10 - Credit and Collection Measurements ......................................................... 119

Chapter 11 - Customer Service Measurements ............................................................... 131

Chapter 12 - Facility Measurements ................................................................................. 146

Chapter 13 - Financing Measurements............................................................................. 156

Chapter 14 - Fixed Asset Measurements .......................................................................... 165

Chapter 15 - Human Resources Measurements............................................................... 171

Chapter 16 - Inventory Measurements ............................................................................. 191

Chapter 18 - Pricing Measurements ................................................................................. 210

Chapter 19 - Production Measurements........................................................................... 219

Chapter 20 - Product Design Measurements ................................................................... 236

Chapter 21 - Purchasing Measurements .......................................................................... 245

Chapter 22 - Payables Measurements............................................................................... 258

Chapter 23 - Sales and Marketing Measurements .......................................................... 264

Glossary ............................................................................................................................... 283

Index .................................................................................................................................... 288

• How can I test the quality of earnings reported by a business?

The Business Ratios Guidebook is intended for managers, analysts, accountants,

7 Habits of Effective CEOs Cost Accounting (college textbook)

On-Line Resources by Steven Bragg

The Business Ratios Guidebook is also available as a continuing professional

• Sales growth. A common focus of attention is period-over-period increases

Consequently, the selection of the most appropriate measurements is crucial.

Breaking with Tradition

Measurement Usage Levels

panding the number of products offered, or reducing the amount of accounts

Measurements and the Soft Close

more likely to be inaccurate if either the numerator or denominator of a ratio

Exhibit: A Cluttered Measurement Report

Exhibit: Narrative Analysis of Measurements

Limitations of Ratio Analysis

• Aggregation. The information in a financial statement line item that is being

Related Podcast Episode: Episode 70 of the Accounting Best Practices Podcast

Overview of Performance Measurements

Sales Returns and Allowances to Sales

Sales returns + Sales allowances

May June July

Contribution Margin Ratio

Sales – Variable expenses

Gross Profit Ratio

Sales – Cost of goods sold

20X1 20X2 20X3

Operating Income Ratio

The formulation of the operating income ratio is:

Net profit – Non-operating gain and loss transactions

Reported net profits $4,500,000 $5,200,000

Operating income ratio 0.5% 2.1%