Chapter 15

Measuring Internal Efficiency and Quality

In This Chapter

Tracking efficiency and quality

Establishing how productive your internal operations really are

Making sure you’ve future proofed your business

Revenue, profit and growth are essential outcomes for business success. This particular trio is the Holy Grail of business objectives and yet they are very difficult to achieve consistently if you don’t focus on delivering product or service of sufficiently high quality in the most efficient manner possible.

Measuring internal efficiency and quality is therefore essential so you can effectively manage operations to make your resources go as far as possible while maintaining a tight control on quality.

Thankfully there are many KPIs that can help you to monitor progress and output from an operational perspective.

Assessing Quality, Lean and Six Sigma KPIs

Your business exists to provide certain products and services to your customers. This means you can make money. In order to do that effectively you first need to know what it is about your product or service that your customers really values so that you can satisfy their need at an affordable price that will drive growth.

Quality and efficiency are therefore very important – especially in manufacturing. Over the years many process have emerged to manage and monitor quality and efficiency but Lean and Six Sigma are perhaps the best known.

Why Lean matters

The principles of a ‘lean business’, often simply referred to as Lean look at operational efficiency from the perspective of the customer. Lean assumes that any expenditure of resources for any reason other than the creation of value for the customer, that is, something the customer is willing to pay for, is wasteful and should be minimised or eliminated.

Lean matters because profit is not just a function of how much money you make. The other side of the profit coin is how little you spend making your products or services or how efficiently you are able to utilise your resources. Effective and lean operational processes therefore allow you to minimise or eliminates as much waste as possible which means you make more profit.

There are seven types of waste to be considered for improvement:

• Transportation: Waste caused by the unnecessary transportation or handling of goods. For example, this may occur due to poor operational layout or excessive materials handling.
• Motion: Waste caused by the unnecessary motion of people or equipment. This may come about if people or equipment is moved too often between processes losing valuable time.
• Inventory: Waste caused by any work-in-progress (WIP), or finished goods that are in excess of requirements or don’t have value a value-adding function. For example, if you use perishable materials and employees don’t adhere to the FIFO (first in first out) principle where the goods with the shortest shelf life are used first.
• Waiting: Waste caused when people, parts, systems or facilities lie idle, waiting for a work cycle to be completed. For example, an employee may stop work or work slowly while they wait for an upstream process to deliver or for a machine to finish processing.
• Over-production: Waste caused by producing products in greater quantities or faster than the customer is demanding. For example if production is making larger batch sizes than is ordered.
• Over-processing: Waste caused by unnecessary work that goes beyond what is required to satisfy customer requirements. For example painting or polishing unseen areas that the customer will never see.
• Defects: Waste caused by anything that the customer would deem unacceptable. For example defects may be caused by operator error, insufficient training or poor supplier materials.

Getting data on the level of waste in your internal processes will allow you to become more efficient and profitable. There is more detail on how to do that later in this chapter.

What does Six Sigma really mean?

Six Sigma is a collection of tools and techniques to improve operational processes. Although pioneered by Motorola in 1986 it was made popular when General Electric adopted Six Sigma very successfully. Today it is widely used by businesses of all sizes in many sectors although it is still seen as a manufacturing focused process.

The term six sigma comes from the field of statistics and evaluates process capability. Technically speaking six sigma means that your defect level is below 3.4 per million opportunities. In other words for every million actions or steps in a production process an error is made less than 3.4 times!

As an analogy, consider a goalkeeper of a football team who plays 50 games in a season and who in each game faces 50 shots from the opposing team. If a defect is when the team scores, then a Six Sigma goalkeeper would concede one goal every 147 years! Clearly that is a very low error rate and Six Sigma in practice may not be quite so stringent. Essentially, Six Sigma’s purpose is to improve all processes, but not necessarily to the 3.4 defect per million level.

Ultimately you need to determine an appropriate sigma level for each of your most important processes and strive to achieve these, and where possible improve them.

Three assertions are central to Six Sigma:

• Stable and predictable process results, including the reduction of process variations and inconsistency, are central to business success.
• Business processes have specific characteristics that can be measured. And if they can be measured they can be analyzed, controlled and improved.
• Sustained quality improvement can only be achieved when the whole business is committed to that outcome – especially senior management.

What makes Six Sigma so useful is that it is a measurement tool focused on verifiable data and statistical methods, and a performance improvement methodology.

The Six Sigma tools are based on the DMAIC principles.

• Define your internal and external customer requirements or expectation of the process
• Measure the current performance; what is the current frequency of defects?
• Analyse the data you collect to determine cause and effect and opportunities for improvement; why, when and where the defects occur.
• Improve the target process by designing solutions to improve, fix or prevent problems.
• Control the improvements to keep the process on the new course; ask ‘How can we ensure that the process stays fixed?’

The implementation of this DMAIC process is done through an in-house team of Six Sigma-certified employees, known as Master Black Belts, Black Belts or Green Belts depending on their experience and level of involvement.

The promise of reaching Six Sigma performance levels is that you will significantly decrease customer dissatisfaction and achieve superior and sustainable financial rewards.

Finding your ways to track quality

Whilst the obsession with quality is universal thanks to quality pioneers such as W Edwards Deming, Josef Juran and Philip Crosby, the definition of quality is not unique.

Each business will perceive quality in a different way. For example, a bakery may consider they have produced a quality product when their cakes look fabulous. A restaurant may regard quality as the serving of locally sourced ingredients, where as a telecommunication company may believe they deliver quality because of the expertise of their customer service staff.

Even within the same sector, quality can mean radically different things. In car manufacturing for example one company may consider safety to be central to a quality product. Another company may consider design aesthetics to be central to their quality while another may be focused on the environmental pedigree of their cars or the performance.

The dimensions of quality for your business ultimately come down to whether or not your product or service fully meets (and ideally surpasses) your customers expectations and whether it is fit for purpose. As such it is your customers, not you, who decide whether you are delivering on quality.

It makes sense therefore that if you want to measure quality effectively you need to understand what your customers’ value. Your quality index will be unique to you as there is no quality index template. It should be a bespoke group of between 5 and 10 KPIs that measure the various dimensions of quality as identified by your customers.

Measuring the KPIs in practice

The quality, lean and Six Sigma KPIs that are most useful are Six Sigma Level and Quality Index.

KPI: Six Sigma Level

The key performance question Six Sigma level helps to answer is: ‘How capable are our processes in delivering error-free work?’

In order to answer this KPQ you need to know what a defect is and count the opportunities which exist for those defects to occur. In the context of Six Sigma a defect is anything outside of customer specifications, while a Six Sigma opportunity is the total number of times a defect could occur with a process.

First you need to calculate the Defects Per Million Opportunities (DPMO).

DPMO = (Number of defects × 1,000,000)/(Number of units × Number of opportunities)

The number for defects is the total number of defects found, the number of units is the number of units produced and the number of opportunities means the number of ways to generate defects.

For example say a online retailer wanted to examine their order and delivery process. To collect the data they examined 50 orders and found:

• 11 deliveries were not made on time
• 3 occasions where the order was wrong
• 4 instances where the product was damaged

DPMO = (11 + 3 + 4) × 1,000,000/(50 × 3) = 120,000

By comparing the result to the Sigma Conversion Table (see Table 15-1) the manager of the online retailer can establish that 120,000 defects per million opportunities is equivalent to a sigma performance level of between 2 and 3 (the number of defects is higher than 66,800 but lower than 308,500).

Table 15-1 Sample Sigma Conversion table

Sigma Level	DPMO	% Error
1	691,500	69.15%
2	308,500	30.85
3	66,800	6.68
4	6,200	0.62
5	230	0.00023
6	3.4	0.00034

If you implement Six Sigma then be sure to choose strategically relevant projects as well as those that are likely to deliver some financial gain. If you don’t, you run the risk of focusing too heavily on cost cutting without aligning your action to genuine performance improvement. A combination of the two is the best way to reap the considerable benefits Six Sigma can deliver.

KPI: Quality Index

The key performance question your Quality Index helps to answer is: ‘How is the organisation ensuring that it is delivering products/services that are fit for purpose?’

In order to create your quality index you need to find out what your customers value most about your product or service. And that means asking them properly not guessing! Once you know what they value you must then identify KPIs that will allow you to monitor the various aspects of quality they have identified so you can ensure ongoing delivery against their expectations.

The KPIs you choose may be equally weighted or you may choose to attach higher value to certain KPIs. For example if your customers buy from you because they believe your product is safe and durable they may also like the colour range that you provide. But the safety is likely to be much more important to the customer than the colour it comes in and should be weighted accordingly.

Be careful not to turn the creation and maintenance of a quality index into a ‘tick box’ exercise. The purpose of the quality index is to highlight areas for continuous improvement.

Calculating Your Internal Productivity

When growth and profitability are at stake you must be able to measure internal productivity. You should be squeezing all the intended benefit from your resources – whether that means people, processes, plant or products.

Knowing the capacity of your business – what your business is capable of producing at any given time – is important, so that you can measure actual performance against that yardstick.

One of the key metrics for calculating internal productivity is the Capacity Utilization Rate (CUR). This metric provides insights into the extent to which a company actually uses its installed productive capacity. It therefore explores the relationship between actual output (what is being produced with the installed equipment) and the potential output that could be produced if everything was operating at maximum efficiency.

Looking at waste levels

Low capacity utilisation means there are potential inefficiencies in the internal processes of an organisation. It indicates waste, and waste costs money.

It also indicates opportunities to increase revenue without necessarily incurring additional costs. For example if you identify that you have an 80 per cent capacity utilization rate there is 20 per cent un-used but available capacity. This means that you can produce more products to sell without spending any more money on equipment, plant and machinery or people. As such capacity offers a significant opportunity to increase revenue, growth and profit.

Different ways to measure waste

In the effort to run a profitable and efficient company, waste obviously matters, yet most businesses have very little appreciation of how much waste is already built into their operational processes. Plus they don’t really appreciate the considerable number of ways waste can manifest itself inside a business.

There are many different ways to measure waste, because there are many different types of waste. For example, there is the waste related to inefficient use of resources, but there is also the waste related to the actual production process and the environmental impact that waste can and does have. Some of the waste KPIs you can choose from – and what they measure – are:

• Time to Market: This metric measures the time it takes from the initial idea for a new product to the point where that new product is ready for distribution. As an indicator it reflects how well your research, design, manufacturing and managing processes are integrated, and how quickly you can translate a great idea into a winning product. Wasted time in this process may cost your business money through the loss of your first mover advantage (benefit for being the first significant player in any market) and can allow competitors to pull ahead.
• First Past Yield (FPY): This metric measures the waste in the system caused by defects. Defects decrease operational effectiveness, increase costs through rework costs and reduce profit. It is essential that you know what defects are costing you and where they are happening. FPY helps you measure the yields of every step along the process, detect defects and rework requirements early so they can be fixed instead of remaining hidden until the customer complains!
• Overall Equipment Effectiveness (OEE): This metric is a composite KPI that measures wasted capacity which takes process availability, efficiency and quality into account. It rolls up a number of output wastes into a single index which reduces complex production problems into a useful and intuitive information source for overall production effectiveness.
• Process or Machine Downtime Level: This metric looks at the waste caused by non-productive time. If machines or people are not able to do their job because of hold-ups, breakdowns or poor management or organisation skills then your business is losing money. You will never reach 100% capacity for all machinery, plant or people but you should know where it’s happening so you can minimise it as much as possible.
• Energy Consumption: This metric looks at your energy consumption and will help you identify where you can reduce consumption and minimise waste. Energy is a huge issue for business. Energy costs are escalating at an alarming rate so identifying ways to conserve energy and reduce waste is going to be increasingly important.
• Waste Reduction Rate: This metric looks at the efficiency and effectiveness of your operations as well as the environmental and social impact of your operations. As well as being important to manage costs it’s also a growing area of competitive advantage as consumers become more demanding and discerning about how the products they buy are made. How are you dealing with waste products in the production process, for example? Cost-effective waste minimisation is a valuable investment that will always pay dividends for your business.
• Waste Recycling Rate: This metric looks at how effective you are at recycling waste products you create in the business process. While it may not be possible to eliminate all waste products you absolutely must minimise the impact that waste has on the environment. If you send waste to landfill sites or incinerators for example then there is commercial as well as environmental implications. A better solution would be to reuse or recycle the waste as much as possible and this metric helps you gauge how well you are achieving that objective.

Measuring waste in practice

The KPIs most often used for measuring waste are Capacity Utilisation Rate (CUR) and Process Level Waste.

KPI: Capacity Utilisation Rate

The key performance question Capacity Utilisation Rate helps to answer is: To what extent are we leveraging our full production/work potential? This metric is often measured daily or weekly, depending on what is being assessed. For example, you could calculate the CUR for a single machine hourly while for an entire factory or company you could calculate the CUR weekly or monthly.

CUR = Actual Capacity over specified time period × 100/Possible Capacity over specified time period

For example say your production plant could potentially produces 20,000 units per day but only produces 15,000 units per day. The CUR is:

15,000/20,000 × 100 = 75 per cent

Your CUR is particularly useful for working out when you unit costs will change because additional investments have to be made to increase capacity such as buying a new machine, recruiting more staff or finding a bigger business location. If you are currently producing 15,000 units at a cost of $0.75 per unit and your CUR is 75% then you can produce up to 20,000 units without raising the costs per unit.

KPI: Process Level Waste:

The key performance question Process Level Waste helps to answer is: To what extent are our processes lean and effective?

All businesses should aim to have effective and lean operational processes that seek to minimise or eliminate waste. Under the principles of Lean waste is considered any activity that does not add value to the end customer.

Formula: This metric doesn’t have one formula because it looks at many different types of waste. As a result you will need to collect this data manually by following and observing the various processes. Individual measures will have to be designed for each waste type.

An example of how productive process level waste assessment can be however can be seen in Portakabin. Portakabin is an international company that produces portable buildings. You will no doubt have seen a Portakabins on building sites or outdoor events.

The modular buildings are made in a factory and then put up wherever the customers need them. As part of their commitment to lean production methods Portakabin regularly conducts exercises to measure process waste levels. This has allowed the company to identify and cut out waste from the manufacturing system including improved module design, re-use or changes to materials used, pre-cut steel beams, boards and floors to remove the need for trimming.

Measuring process waste levels takes a lot of time and effort because of the manual data collection processes that are required. But it can make a significant difference to profitability and customer satisfaction.

Focus on the areas where you can reduce waste easily. For example you would be better to re-design a process that can be done fairly quickly and without great expense than you would be moving plant and heavy machinery or re-designing the distribution area.

Monitoring rework levels

After WWII businesses and manufacturers could pretty much create anything and people would buy. Quality wasn’t an issue because even a bad product was better than no product at all. But as the world economies got back on their feet quality began to matter and competition gave consumers choice.

Japan and China started to really prosper and on investigation US and European companies realised that they were able to produce better goods at lower prices because they were paying attention to quality and employing the principles of Total Quality Management (TQM).

One of the key principles of TQM is that quality needs to be built into the manufacturing process rather than just inspected for quality at the end. If a product is defective or found to be of poor quality – it’s too late by then. However building quality into the process dramatically reduced costs because it minimised the instances where a product would have to be re-worked.

For US and European manufacturers seeking to emulate their Eastern competitors monitoring rework levels became a key quality KPI. Rework is defined as a product that fails to meet the specifications but, with some alterations can be brought up to scratch.

Why rework levels matter

Clearly rework matters because getting your product or service right first time is much more efficient than having to go back and do something again. It wastes resources, time and manpower.

You should always be aiming for no rework or zero defeats. As well as providing your business with cost benefits it establishes how effective your business is at delivering what your customers want without further fine-tuning, correction or revision.

Plus if you focus on quality all the way through the production process you ensure that problems are flagged quick enough to rectify “in-situ” so that the quality of the product is not compromised moving forward. It also avoids the waste that can occur after a failure or defeat is already built into the product. If a product is only inspected at the end but a defeat was built early on in the production process then the product is defective and will need to be re-done. So all the other additional processes that occurred after that initial defeat were wasted and simple added to the cost as often they will also need to be redone once the initial defeat is fixed.

Monitoring rework level also matters because it sends a very clear message to employees to focus on getting the products right first time. This metric can also illuminate where additional training is required to improve performance.

Measuring rework levels in practice

The key performance question Rework Level helps to answer is: How effectively are we driving waste out of our processes? How often you measure rework will depend on your industry or sector. Manufacturers would be wise to measure rework levels weekly whereas service companies may only need to measure rework on a monthly basis. The formula is

Number of defective products requiring rework over a specific period/ Total number of products produced over a specific period × 100

So for example if your company produces 1,500 widgets a month and 112 of them need to be reworked.

112/1500 × 100 = 7.46 per cent rework level

The information you need access to in order to calculate rework level will be available from the processes that create your product or service.

Be careful to avoid a “blame culture” when it comes to rework levels. If this metric is perceived as an invitation for a witch hunt or to track down and shame poor workmanship then problems are more likely to be covered up and hidden. Instead foster a culture of openness and use rework level as a companywide invitation to move closer to zero defects and elevated performance.

Scrutinizing order fulfilment

Whether your customers are happy with you or unhappy with you largely comes down to how well you meet their expectations. We’ve covered the quality expectations they may have but customers also have delivery expectations.

When your customers buy from you they expect to receive their goods or services reasonably quickly. Technology has made most customers impatient so you need to scrutinize your order fulfilment process to make sure it is meeting and preferably exceeding expectation.

One of the key metrics to help you monitor order fulfilment is order fulfilment cycle time (OFCT).

OFCT is a continuous measurement defined as the time from order confirmation to receipt of the goods or services. And as a KPI it applies equally well to goods or services.

OFCT, also known as customer order cycle time considers performance from end-to-end rather than looking at one individual part of the operational process. This is important because it helps to identify opportunities that may be missed in conventional efficiency programs.

For example you may decide to focus your efforts on reducing machine down time but if machine down time only account for 5% of the total OFCT then any gains in that area will be minimal. If on the other hand you identify rework level at 25% then clearly gains in that area are going to make a significant different to order fulfilment.

Understanding what your customer sees

The only part of the supply chain your customer sees is the ordering process and the delivery process. As such you are effectively being judged by those two processes. How easy is it to order and how quickly do I get my products or services once I order.

For some customers how you create your product or service is important and they will always care about the quality and price but responsiveness is increasingly important. Understanding what your customer sees and managing those processes closely is therefore critically important. And it’s only going to become more so.

Customers are becoming more and more discerning and less and less accommodating or forgiving of error. Flawless and efficient deliver will often mean the difference between repeat sale and a defection to your competition.

Measuring OFCT helps to improve efficiency because the re-engineering that is usually required to reduce cycle time often leads to significant improvements as the process becomes more and more responsive to internal and external customer needs

Measuring it in practice

The key performance question Order Fulfilment Cycle Time (OFCT) helps to answer is: ‘How efficient are our processes?’ The formula for OFCT is:

OFCT = Average actual cycle time consistency achieved to fulfil customer orders.

This is calculated through an analysis of the end-to-end order fulfilment process over a specific period of time. In order to calculate the cycle time for each order you need to pay attention to each step of each sub-step within the overall process. In each case the cycle time starts from the day the order is placed to the day the customer receives all the goods or services they ordered.

Measuring end-to-end processes can be tricky because it requires data from various different functions and departments – each with their own powerbases and potentially agendas.

To manage these challenges it may be wise to appoint an end-to-end process manager who is skilled in change management and has the authority to make any necessary improvements.

Dissecting delivery

Whereas OCFT looks at the end-to-end process of fulfilment it can also be worthwhile to focus in on and dissect delivery. In a world of instant gratification if ordered products or services are not in the customers hands in a matter of days then questions are asked and often the rating of the overall service will drop off.

Delivery matters.

And delivery is especially important if you supply products or services to other companies that operate a just-in-time supply chain to minimise inventory and expense.

Did you provide what the customer expected?

On time delivery metric therefore provide vital insight into your ability to deliver what the customer expects when the customer expects it.

In addition delivery metrics give you valuable information about the effectiveness of your internal processes and highlight inefficiencies in your supply chain.

The key metric used to monitor whether your deliveries arrive at the customer – either internal or external on time and in full is delivery in full, on time rate (DIFOT). This metric ensures you are aware of when the customer takes receipt of the complete order. In the end your customers don’t really care when you shipped the goods, or whether they have part of the order they will judge you based on when they receive what they ordered in full.

Measuring it in practice

The key performance question Delivery in full, on time (DIFOT) rate helps to answer is: To what extent are our customers getting what they want at the time they want? The data you will need to calculate the DIFOT rate is contained in your order tracking system. If you use a third party in your supply chain then you will need to gain information from them too in order to calculate this metric.

DIFOT = Units or orders delivered in full, on time/Total units or orders shipped × 100

For example say you run an online electrical retailer. The days of telling a customer their washing machine will be delivered sometime on Tuesday between 8am and 6pm are going. Customers expect a delivery window of an hour or two at the most – and rightly so. Who has the time to hang around all day waiting for a washing machine to be delivered?

The delivery drivers have a handheld mobile device that records delivery and the customer must sign acceptance. The device also tracks if the order is rejected or incomplete.

In the first week of March 2013 you received 487 orders for various large white goods. Of those 398 were delivered in the designated delivery window meaning that 89 were not delivered on time or within the designated window. 480 were delivered in full meaning that 7 orders which contained multiple orders did not deliver all the products orders. And 2 order were rejected as being the wrong product, but those order were also late so must be removed from the calculation as they are already accounted for in the on-time delivery calculation.

• On-time delivery = 398/487 × 100 = 81.72%
• In-full delivery = 480/487 × 100 = 98.56%
• DIFOT = (487 – (89 + 7 – 2))/487 × 100 = 80.69%

Your DIFOT rate will depend on your industry but in today’s competitive environment no company should let their DIFOT rate slip below 95%.

This metric can be difficult and costly to measure if you don’t already have an internal or automated order and delivery tracking system.

Investigating inventory

Part of measuring internal productivity is investigating inventory and how inventory changes over time. For example are you losing inventory becayse of damage or expiration?

The metric that can help you keep a handle on inventory is the Inventory Shrinkage rate (ISR). Inventory shrinkage looks at the loss of products between production and purchase. Obviously, loosing inventory for any reason will push up your costs and reduce your profit margin. If these escalating costs can’t be stemmed then they may eventually be passed on to your customers, which could in turn impact repeat purchase and customer loyalty.

Managing inventory properly is therefore critical to your on-going efficiency and profitability.

The key reasons for shrinking inventory

There are many different reasons for inventory shrinkage such as breakages, damages caused by poor handling or storage, administrative mistakes, misplaced goods and perishable goods not sold in time. If for example a company has sell by dates or best before dates and the inventory is not managed in an ordered fashion according to these dates than inventory can be wasted.

Sloppy dispatching and poor handling may be the cause of some inventory shrinkage but unfortunately the biggest culprit is often theft. It is estimated that about 44% of inventory shrinkage is down to employee sticky fingers and another 35% due to shoplifting!

Investigating inventory and specifically inventory shrinkage may be a distressing business but it is absolutely essential if you are to pinpoint areas of loss and stem the loss occurs.

Plus when everyone in the business knows that inventory is scrutinized and measured regularly the thieves or would be opportunist thieves will probably think twice about foolishly risking their job.

Measuring it in practice

The key performance question Inventory Shrinkage Rate (ISR) helps to answer is: To what extent are we losing inventory along our internal processes?

The data needed to calculate ISR is collected from the inventory management system, manufacturing data, purchasing data, stock taking information as well as sales and shipping data. Ideally this metric should be measured every 6 months or more frequently is it is considered high.

Inventory can either be measured in actual stock-keeping unit (SKU) or in financial terms using average selling prices.

ISR = (Inventory you should have – Inventory you do have)/Inventory you should have × 100

For example a knitwear accessories manufacturer may create 5000 scarves, 5000 pairs of gloves and 5000 hats ever month. Unfortunately there is flood damage in the warehouse and a box of 200 scarves is ruined. In addition a stock take at the end of the month shows that a further 150 hats and 100 pairs of gloves are missing.

15,000 – 14550/15,000 × 100 = 3% ISR

It is common only to look at Inventory Shrinkage Rate inside a business but it can be really illuminating to look at IRS all along the supply chain to assess where most of the shrinkage is occurring. That way you and your suppliers can seek to minimise shrinkage for the benefit of all parties.

Asking Yourself Whether You’re Future Proof

Just because business is good today doesn’t mean it will automatically be good tomorrow. Every business needs to be plan for the future and ensure revenue, profit and growth are secure moving into the future.

Do you know where tomorrow’s sales are coming from? Do you know about your market and whether it’s growing or contracting? Have you thought about future customer needs and product innovation in order to future proof your business?

Your innovation pipeline

Innovation is a critical component for most businesses. What customers want today may not be what they want tomorrow and you need to be ahead of the curve so you can pre-empt any changes in demand and adapt accordingly.

The innovation pipeline is the name of the new ideas, products of services that have potential and it is increasingly important for all businesses to foster a strong innovation pipeline so they can rise to the challenges of shifting markets and customer demands.

Innovation is key but hard to measure

Clearly paying attention to the demand for existing products and seeking to introduce new product and service offerings that go on to replace failing product lines or diversify the business into new areas is important for on- going growth and profitability. Yet according to a study conducted by McKinsey a large percentage of companies, even those that rely heavily on innovation don’t measure their innovation performance or potential.

When there is an attempt to quantify and measure innovation it is usually pretty crude such as identifying the proportion of revenue spent on research and development (R&D). However the amount spent on R&D does not necessarily tell us anything meaningful about how innovative a business is. A higher spend on R&D may indicate that new products or services are more likely to be developed but it is by no means guaranteed.

The KPI called Innovation Pipeline Strength (IPS) can help you to estimate revenue potential of the new products or services in development as well as the potential of completing the innovation and taking it to market. After all innovation for innovations sake it pointless – you need to know that there is a market and eager customers willing to buy the product or service in development otherwise why bother.

By measuring Innovation pipeline strength you will gain an understanding about the future potential and insight into the potential return on your R&D investments.

Measuring innovation in practice

The best KPIs to help you future proof your business are Innovation Pipeline Strength (IPS) and Return on Innovation Investment (ROI²)

KPI: Innovation Pipeline Strength (IPS)

The key performance question Innovation Pipeline Strength (IPS) helps to answer is: To what extent have we got a strong innovation pipeline? In order to calculate this metric you will need to look at the key innovation projects and estimate the potential future revenue they will generate. IPS is usually measured on a quarterly basis.

Formula: IPS = Sum (Innovation project x Future revenue potential)

For example, a company might have 3 new products in the pipeline:

• Product A, with a future revenue potential of $100,000
• Product B, with a future revenue potential of $200,000
• Product C, with a future revenue potential of $300,000

In this case, IPS would be:

IBS = $100,000 + $200,000 + $300,000 = $600,000

IPS is an estimation of future revenue generated by the innovation currently in development which means there are by definition uncertainties around the risks and opportunities involved in taking it to market.

KPI: Return on Innovation Investment (ROI²)

The key performance question Return on Innovation Investment (ROI²) helps to answer is: To what extent are our investments in innovation generating a return? Innovation is important but it’s also important to measure the effectiveness of that innovation to ensure that it’s justified and delivers a return. The data needed to calculate this metric is available through the accounting data and project data and ROI² is usually measured at the end of an innovation project or as a percentage return over a specific periods of time.

ROI²= Net Profit from new product or service/ Innovation costs for the products and services

For example as a simple ROI² calculation, an innovation project costs $150,000 to implement, and you derive $200,000 in net profits.

ROI² = $200,000/$150,000 = 1.33

This means that for every dollar you spend on the innovation project, you get $1,33 back in return. Obviously, if you have a ROI² of below 1 your return is negative and you are making a loss. Any ROI² above 1 is making a profit.

ROI² is most commonly used as a retrospective KPI taking into account actual costs versus actual profits. However, by using estimations about future revenues and projected costs, it is possible to estimate future ROI². This is especially useful to manage investment between competing products. If a product looks great but will cost a fortune to implement then it would be wise to shelve that product until such time as implementation costs are reduced and focus on other developments that look set to deliver a higher return on investment.

According to a 2010 Boston Consulting Group report half of all mangers are unhappy with their return on innovation investment Measuring ROI² helps to ensure that the business is future proofed and the innovation is worthwhile. This metric also allows you to compare investment between initiatives so you can compare results from innovation to marketing initiatives or other types of investment to see what delivers more reward.

The problem with any ROI metric is that the definition can be modified to massage the results. ROI is therefore very susceptible to manipulation. To make sure it’s a meaningful metric that drives performance improvements be clear on the definition and stick to it.