Figuring Out Your Critical Number
Eight months ago, Critz Inc., a Savannah, Ga.-based auto dealership, made the decision to start living by its critical number. Actually, the owners first made a decision to implement open-book management. The critical number decision followed shortly thereafter.
"We had gone through a Buick program called 'Living the Vision," explains Dale Critz Jr., vice-president and general manager of the 55-employee business. "Manufacturers were trying to get dealers to buy into a work-team, quality-management approach to business. We had three days of training for three key people, then one day for all the employees.
"That day, we broke up into groups and talked about things we'd like to change in the dealership. Everyone made recommendations. But then they looked at me and asked, 'Can we afford it?' That's when I realized the only way this could work would be if everybody understood how to drive the numbers." Dale's father, Dale Sr., had read about OBM, and in September the two Critzes and three others from the company attended the Gathering of Games conference in St. Louis, a seminar devoted to explaining and giving tips on how to share the basics of business management with the entire company. Not long after, they plunged in.
To get things rolling, Dale Jr. launched a 13-week class in business basics. Starting with the dealership's managers, the VP/GM has now given the class to about 36 employees and expects to have everyone graduated by the end of this year's third quarter. Meanwhile, he worked with an outside company, Great Game Coaching, in Villa Hills, Ky., to develop a so-called "critical-number scorecard"--a way to track the most financially important numbers of the company. Here's what Critz Inc. came up with, and what it learned in the process.
- What's the right critical number? It depends on your goal.
"We had been making about 10% return on assets [ RoA] ," explains Dale Jr. "To be good--to be world class--you need to be making at least 20%. As a result, one of our goals going into open-book management was to hit that 20% RoA." The critical number, he and his father decided, would involve operating profit minus 10% of assets (pro-rated for a given time period.) That effectively set 10% RoA as a floor; employees would know the company was doing well if the critical number stayed positive. The Critzes set up a bonus plan pegged to the critical number.
- Make sure your number establishes the right incentives...
The Critzes understood, however, that the conventional definition of assets wouldn't work in this formula. Lower assets--including lower cash--would boost the critical number, thereby sending employees the message that more cash was bad. So they excluded cash from the asset base. The denominator of Critz's RoA calculation is known in the company as measured assets. It includes inventories, receivables, and fixed assets.
- ...and incorporates key operational variables.
Critz initially derives its critical number by taking operating profit and subtracting 10% of measured assets for that time period. Then it adjusts the critical number by a customer-satisfaction index established by the manufacturer. Depending on the index, the number can be multiplied by anything from 75% to 125%. "Our goal of course is 125%. We have our CSI rating charted on boards all over the place."
- Where the number comes from must be plain as day.
Critz's scorecard takes three pages of financials and boils it down to a simplified one-page income statement. Boxes at the bottom summarize measured assets and derive the adjusted critical number according to the formula. "People see it every week," says Dale Jr.
- What it means to employees must be equally clear.
In addition to the scoreboard, he adds, "we have a chart for each quarter. There's a column marked 'adjusted critical number' which increases in increments of about $25,000. When employees read across, they see a percentage amount for each increment. Then they multiply that percentage by their year-to-date earnings. That's their bonus."
- Employees need to understand how they can move the number.
Players can do three things to boost their payout: increase the net profit, manage the measured assets better, or increase the customer-satisfaction index. People with different jobs naturally focus on different variables. The dealership's sales manager focuses on turning inventories faster. Salespeople watch a special receivables line called 'contracts in transit,' which reflects the amount of time it takes to get money from the bank on a financed sale.
The effect of all this? It's early yet, but Critz Inc. has rarely seen so good a year. "By year's end we hope to more than double what we did last year," says Dale Jr. "We're planning on it."
Editor's note: This story was excerpted from Open-Book Management: Bulletin. Copyright 1996, Open-Book Management Inc.
Finding your "critical number" can be a tricky business. "Ask most businesspeople what their critical number is, and they will tell you it's profit--or possibly cash," says Springfield Remanufacturing Corp. CEO Jack Stack. "The smartest ones I know, however, almost always look at something else, often something that drives both profit and cash, usually something unique to their business." Read Stack's column, "The Logic of Profit" from the March, 1996 issue of Inc.
You might also want to take a look at "How to Succeed in Business in 4 Easy Steps", by Bo Burlingham, the Inc. cover story back in July, 1995. Burlingham profiles a couple with a fledgling business idea who learned to get a grasp of their financial numbers.
And if you need really basic financial skills, a lot of people rave about the training video "The Balance Sheet Barrier," narrated by British funnyman John Cleese. The 30-minute video, produced by Cleese's business-training company Video Arts, takes the mystery out of the balance sheet by explaining terms and links to other financial statements in a very amusing, intelligent way. The video comes with a facilitator's guide and costs a hefty $800, but a 5-day rental is $150, and a preview is $50, which may be applied to the purchase or rental price. Workbooks start at $5.35 each; bulk discounts are available. Video Arts is in Chicago (800) 553-0091 and has a full catalog of training products.