Organizational Process Management and Measures (BOK II)

4. Performance Measures (BOK II.C.1)

Hey, welcome back. When you want to look at an organisation and find out how that organisation is doing, you look at performance metrics. For example, if you want to buy a stock in a company, the first thing you should consider is the earnings per share. That's a commonly used matrix for analysing a company's performance. So you need a matrix to measure the company, to measure a particular process. As a result, matrices are used to evaluate a process or a company. The most commonly used matrix when you are analysing a company are financial metrics. So as an outsider, if you want to buy stock in a company, you would be looking at the financialmatrix of that company. What's earning per share, what's aprofit, what's a net profit, what's a gross profit, all those numbers, you'll be looking at that. But then there is something which is internal to the organisation as well. So when you look at internal matrixes, these internal matrixes are used by the management of the company to run the company and to run a particular process. So department managers need that, and the CEO needs that. So you need to look at how a particular process or a specific activity is ongoing. For example, if you are a process company,you will be looking at the process yield. What's the yield of the process? How much of that is converted to final output in production? You need a defect rate to find out how your process is doing. Is it wasting too much time and money on repairing those defects? So for that, you need a defect rate and an average time to answer a call. If you are a call center, then you need that as a matrix schedule. If you are a project, then you need a schedule because you have committed a schedule to your client. So there could be a number of matrix depending on what sort of organisation you are, what sort of clients you have, what sort of commitment you have to the client, how to deal with these matrix when you have a number of these things. If you just focus on finance,is that enough for the company? What should all matrix companies be looking at? For that we have a balanced scorecard, ascorecard, which looks at the overall performance of all the aspects of the company. So let us look at a balanced scorecard on the next slide and see what does get measured when you have a balanced scorecard rather than just looking at the financial miracles. So the concept of a balanced scorecard was initiated by Robert S. Kaplan and David P. Norton. As per them, there are four aspects of the company which you should be looking at. There are four perspectives and four viewports which you should be looking at. These are financial, customer, internal business processes, and learning and growth. On the previous slide we talked about finances because generally people look at the financial things first, and then we even talked about some internal processes which department managers and other people within organisations are using. But here, in addition to that, it's recommended to look at the customer perspective, the learning perspective, and the growth perspective as well. So what do you look at in finances? We discussed how, for outsiders, financial numbers such as earnings per share are important, but within an organization, the cost of something, such as the cost of producing something, may be more important. So financial could include cost, financial could include savings, financial could include timely receipt of funds and timely disbursement of funds. So the payments, you might want to look at the payments as one of the matrix. What's the time of receiving money and the time of paying to your ownsuppliers and the productivity ratios, productivity, so productivity will tell you how much resources you put into the process and how much output is there. So the ratio of input to output, that's productivity. So all these things could become financial metrics. Looking at these ratios to find out how the company is doing financially, then coming to customers, you can look at the delivery time, you can look at quality, what is the perspective of the customer as regardsto quality, how the customer perceives your quality, and then service,what sort of service level you have. So you could have a number of metrics related to these: related to delivery time, related to quality, perception of customer or service, the responsiveness of the service that this company is providing to the customers. And then you might want to look at internal business processes. Internal business processes could include the defect rate, for example, could include the quality management system performance, how your quality management system is performing. You might want to look at your information system. How does information flow from one place to another place? How effective is that for learning and growth? Here you want to look at what training you are providing to your employees because, in finance, customer and internal processes, we are talking about the current situation. But when you want to look at the future, you need to look at the learning and the growth in the company, the parameters or the matrix related to the learning and growth, which could be your training, your continual improvement processes, and your planning processes, let's say. So these are the aspects and perspectives you need to analyse when you want to have a balanced scorecard. And once you have decided on the parameters of the matrices which you want to have in regards to financials, customers, internal processes, learning and growth, you can make a sort of a dashboard dashboard which will give a high-level overview of the company's top management and how each of these is performing. For example, if you are looking at finance, you can look at the return on investment, cash flow, capital, and the financial results. You can compile all these numbers into a single figure, for example, and that will become the financialmatrix that you can put on a dashboard. So, at a very high level, someone can look at that. So, if you look at this dashboard, it has the final performance, a summary of the financial performance, customer internal processes, and learning and growth. So if you look at financial, okay, it's in green. So financially, this company is doing well. So someone can just look at this dashboard and say, "Okay, financially we are doing good." As far as the customer service, as far as the delivery, as far as the customer's perception of the product, it's all good because we are green here, so we are good here. And similarly, if you look at those internal processes, looking at that, you might say, okay, we are not very good, but we are not very bad either. So internal processes are just doing well. So we are doing well here, but when you look here, you see that, okay, even though the company is doing well, as far as learning and growth is concerned, we are in the red. So there is something which we need to do as regards to learning and growth. That means there is a training programme you need to introduce. You might have to see why your employees are leaving. You might want to see why there is less job satisfaction. You might want to see if there is any opportunity to improve the relationship with your employees. So all these things will help in improving the parameters related to learning and growth. And this dashboard was just a simplifiedexample of what a balanced scorecard could look like at a very high level. So when we talk about matrixes, when we talk about indicators, when we talk about KPIs (Key Performance Indicators), there are two types here. One is a leading and one is Lagging indicators.Most of the time, what we look at is the final result, the outcome. And the outcome means we are looking at lagging indicators. Lagging indicators are things that show results, which show the final output or the outcome of the process. So, when you look at a delivery process, the delivery time, and the delivery delays, those are lagging indicators. So if you want to measure how many times we were late in delivery, delivering a service or product that we promised, that would be a lagging indicator, because that indicator comes once the eventhas actually happened. That's a lagging indicator. On the other hand, leading indicators are something which you can measure before that process actually happens. So lagging indicators are easy to measure because these are output. lagging indicators are post-event. Yes, we know that. We talked about that because those are output. Leading indicators, on the other hand, are predictive measures, and these are inputs. So if we want to talk about defect rate, defect rate would be an alagging indicator because defects have already occurred. The amount of training you provided the operators in the environmental control parameters would be a leading indicator of that. So those things would be leading indicators. The first thing is that leading indicators are predictive measures. Predictive measures imply that you make an educated guess at the outset that providing training will reduce the defect rate. Improving the work environment will improve the defect rate. For example, if you are doing welding and if there is humidity around that, that leads to defects. So you need to make that assumption. You need to make that prediction that if the humidity is reduced, then the defect is going to be less. If operators are trained, then defects are going to be less. So for leading indicators, you need to predict something. Many times, that prediction might be right. Many times, that prediction might be wrong. So leading indicators are good to measure because they tell things beforehand before they actually go wrong. But these are not guaranteed. You cannot guarantee that by training your operators, your wealth defect rate is going to be less. You might learn that from history,but it is not a guaranteed thing. So that way, if you are looking at indicators, it's always good to have a mix of both leading and lagging indicators. So another example which we can look at before we conclude our discussion on leading and lagging indicators is if you are looking at customer satisfaction. Customer satisfaction is a lagging indicator. The leading indicator of that could be your employee motivation or employee satisfaction. So if your employees are motivated and your employees are satisfied, you can very well assume that customer satisfaction is also going to be improved. So, as a Six Sigma Black Belt, you need to understand the difference between leading and lagging indicators and what the advantages and disadvantages of each are.

5. Financial Measures (BOK II.C.2)

Hey, welcome back. So earlier we talked about matrices, where we talked about financial customer growth and internal processes. Here we are looking at financial measures because when you propose a project to your management, this is the first thing your management will be looking into. What is the financial gain of this project? So here in this section we will be looking at some numbers, some matrices which management understands. So if you are proposing a project, then you need to tell what is the return on investment,what is the payback period of that, what is the net present value, what is the internal rate of return, and what's the benefit-cost ratio. You need to be familiar with these numbers because that's the language of the management. That's what they will be looking at before they approve your project. Let's look at these commonly used financial measures one by one in the next few slides, starting with return on investment. To understand these financial measurements, I have created a simple example, and let's learn these concepts with the help of that example I have kept the numbers round here so that we can do these calculations easily and we can understand the concept here. You are doing a project, a project on which you need to invest $2,000 fast. So this is something that is your initial investment. This could be in the form of changing the machine setup, getting a new machine, or whatever it is. So you spend $2,000 on day zero of the project. Once you implement the project, then one year from that, you get a return of $1,000. This return could be in the form of a savings in terms of extra orders or whatever it is. So just because of this project, you get $1,000 as a return. In year two, you get 1,000. So every year till five years you get a return of $1,000 because of this specific project, and you don't get anything after five years. So in this example, let's take that. So if I ask you, what is the return on investment? So return on investment is what is income and what is the cost? So in this example, we have got $5,000 which was received year after year for five years, so our income is $5,000 and our cost was $2,000, and if we multiply this by 100%, this comes out to be 250%. So if you present this project to your management for acceptance, there's a good chance that management will accept it because with any investment, what they are putting on that is giving 250% return, and that is a great return, so management is definitely going to accept that. So if you put that number, which is return on investment, another thing to look at is what's the payback period, or how many years we are going to pay back the money that we invested back. We will look at the next slide, which is the payback period. So we have the same example here as well. We invested $2,000 and we are getting $1,000 back every year for the next five years. So what is the payback period? When is the time to recover the investment? You can just visually look at that and say that in two years you are getting your money back because you invested in 2000 and you will get 2000 back in year two. But how do you actually calculate that? So you'll be taking a 2000 investment minus$1,000 which you received this year. So you are left with $1,000. And this $1,000, you take it here, $1,000 minus the $1,000 you got this year, which is equal to zero. So, once the balance is zero, you can say that now you have recovered your money back. So the time to recover the investment is two years. That's another number which you can talk to your management about. For this project, there is a return on investment of 250% and two years as a payback period. But what we are not considering here is the time value of money. When I say time value of money in this example,for example, instead of getting $1,000 each back for the next five years, suppose there is another alternative project which gets $5,000 back in the first year itself. So you invest $2,000 and you get $5,000 back after year one, and you don't get anything after that. Which project do you think would get selected? The one with the 5000 return after one year or the one which gives 5000 spread over five years? Definitely, management would be interested in the project that gives $5,000 back just after one year. Why? because there's a value to time as well. As a result, the $1,000 received after year five differs from the $1,000 received after year one. Because there is a depreciation of the currency. Because there is a cost, you pay interest. So, to consider the time value of money, we have another parameter, which is the net present value. So we will be looking at the net present value on the next slide. How to calculate that and what does that mean? Let's move on to the next slide for the net present value (NPV).Previously, when calculating return on investment and payback period, we did not account for the value of time, also known as the time value of money. When we are calculating net present value, we will be considering the time value of money. So, $1,000 received after one year is better than a thousand dollars received after five years. Because there is a cost of money, there's a cost of capital. And in plain and simple terms, that could be the interest rate, the interest which you are paying. To make things simple, in this example, we have considered the cost of capital as 10%. That will make calculations easy. So the example is the same. We invest $2,000 initially and then, for the next five years, we get $1,000 back every year. So how do we calculate the net present value of this project? There's a formula for that. So let's write down that formula and understand that this might look complicated, but once I put numbers into that, that will make it much clearer. So let's start with year one. This C zero is for initial investment, which is in our example, which is 2000. So we will take that later. But let's take this first part of the formula, which is Sigma. Sigma is the sum of all means. For each year, we need to put in one term. So let's say for year one we received $1,000. So we put $1,000 as a positive because we received that profit divided by one plus r and R, which here is 10% and 10% converted to decimal becomes zero to the power of t and T is the time. Here, the time is one year. So after one year, I bought a power one. The same thing for the second year, $1,000 we received in the second year, which is here and again one plus 0.10 to the power of two. This is for the second year, now coming to the third year and so on. So let me put all five years here. So these are for five years, whatever we received minus, which is C zero, the initial investment, which is $2,000, which we put into the project. Now, let's use a normal calculator and calculate this. So the first term becomes 1000 divided by 1.1,so 1000 divided by one, one square, and so on, one to the power of three to the power of five.-2000. So if you divide 1000 by 1.1, which is the time value of this first year of 1000 kwh. Using a plane calculator, that comes out to be 909.09. So if $1,000 is received after a year, the net present value of that is $909.09. And how do I calculate the next term? Next term, I will divide 909.09 by 1.1, which equals 826 45plus 751.31 plus 683.01 plus 620.92-2000, which equals 1790 78 and this is plus. And when this is plus, that means there's a net positive value to this project. So just by apparently looking at this example, without considering the time value, it might look like this project the company is getting $3,000 as a profit because of 2000 spent and $5,000 gained. So the net profit was $3,000. But in actual reality, when you consider the time value of $3,000, you end up with $1,790.78, which is much less than $3,000, which you would have assumed without considering the time value of the money. So this is the net present value. all right? So after calculating that net present value,let's do one more example here. This is an even more simplified example where you invest $2,000 and the project doesn't deliver anything. The only thing it produces is a profit of $2,500 after five years. So you spend 2000 playing and you get $2,500 after five years. What is the net present value of this? Is this project worth considering? Because if you just look at the numbers without considering the time value, you might assume that yes, there's a profit of $500 because we are spending 2000 and getting $2,500. So there's a profit of $500. But in actual reality, when we consider the time value, that might not be the case. So, let's solve this example as well. So here once again, net present value is equal to the sum of CT by one plus r to the power of t minus c zero. So the CT is the only one who is beyond the fifth year. So we put that $2,500 in after the fifth year. The cost of capital is again 10%, which is.1 to the power of five minus zero is the initial investment, which is $2,000. If you solve this using a plane calculator, it comes out to be one five five, which comes out to be.70-447.70, so you lose sort of a $450 roughly instead of gaining500 if you have not considered the time value. So this is how you calculate the net present value. So after understanding the net present value,let's do one more financial parameter, which is the internal rate of return. What rate of return is this project going to provide? Earlier, when we calculated the net present value,we assumed that the cost of capital was 10%. Now, when we are looking at finding out what the internal rate of return is, this is what we want to find out. What is the rate of return or what is the cost of capital assumed to be zero when the net present value is zero? At what rate is the net present value going to be zero? Let's understand that. So here we are taking the same example. invested and gained $2,500 after five years. So how do you calculate net present value? You calculate net present value is equal to $2500 divided by one plus the rate of return. Now here, I'm not taking the cost of capital as 10%. I need to calculate the rate of interest or what cost of capitalwill make the net present value zero. So here I'm keeping this as r only and to the power of five, 2000 is equal to zero because I want to see at what rate the net present value is zero. So that is going to be the internal rate of return. If you solve this, you can solve this by 2500 divided by one plus r to the power of five, which is equal to 2000. Then you can take this here. So this will become one plus r to the power of five, which is equal to 2500. And then you can calculate r from here. And then one plus r is equal to if I solve this side, this becomes I can cross this out, which becomes five by four, which is 125. So 125 to the power of one five can be calculated using a calculator. This value roughly comes out to be something around four 5%.So R is roughly equal to 4.5%. This is one way of doing that. Another way of doing that is by randomly putting a value of R here. and to see if the net present value comes out to be zero. So initially, if I put R equal to 10%, the net present value comes out to be this is at a 10% rate. And then if I go down to a 5% rate, my net present value is coming out to be -2000. I'm sorry. This should be -2000 here and if I take it at 5%, then the net present value. is coming out to be 1958–2000. So this number corresponds to this formula here. And now this is roughly zero. at 5%. And if I look at 4%, the net present value comes out to be 2054.-2000. So this is roughly 40 cents, and this comes out to be positive $54. As a result, the net present value is zero. That should be somewhere in between those. So that's how I calculated. R is equal to four 5% roughly, which is the internal rate of return coming to the last financial measurements here, which is the benefit to cost ratio. So, as the term says, it is benefit divided by cost. So, if the benefit is greater, the benefit-to-cost ratio will be greater than one. So you can take the time value of this in this example where we have $2,000 invested and $1,000 coming out of the project. for the next five years. You can calculate benefits. So benefits for year one will be equal to 1000 divided by one plus 1000 divided by I will simplify this. Make it one to the power of two thousand multiplied by one to the power of three thousand multiplied by one to the power of four plus ten multiplied by one to the power of five. And we already calculated this number in the previous example when we looked at the net present value, the first example of that. So this value is 3790 78.And the cost here is the cost here is only one time, which is $2,000 at time zero. So we don't need to divide this by one to the power of something. because this was the initial investment. So, if you want to calculate the benefit to cost ratio, multiply 37 90 x 78 divided by 2000. which comes out to be 1895. Since this is greater than one, So this project has a net benefit. And this thing we have already calculated by net net present value as well. So either you calculate the net present value or you calculate this benefit to cost ratio more or less, it gives the same result or a similar result. So with this, we complete our discussion on finances.

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