Leading vs. Lagging Indicators

Money is such a great score keeper. Profit is the purpose of business. It is the end-all be-all indicator of business success.

Alas, profit is not a perfect indicator of progress. It can send very misleading signals. In a booming economy, profits will usually increase naturally without your business doing anything different or better.

Furthermore, companies who are growing smartly often find themselves with profit that ebbs and flows. Rarely does a business' sales and profits grow unimpeded.

The point is that while profit is a great validator of success over the long run, it stinks as a indicator of short term progress. That's because profit is a lagging indicator. Its value lags in time that which created it.

If you are going to run your firm effectively, you need to monitor a grab bag full of metrics, a few of which are lagging indicators and many of which are leading indicators.

Leading indicators are items that project end-result performance. For example, labor productivity is a leading indicator of job profitability.

Lagging indicators are where the rubber meets the road. Leading indicators tell you how a part of your progress is going.  Here are some examples for each:

Lagging Indicator 

Leading Indicator

Net Profit

Gross Profit

Negotiated Work 

Customer Satisfaction

Turnover

Wage rate

Accidents

Safety Meetings

Cash in bank

AR aging

Liquidated Damages

Days delay

Project over-budget

Low productivity

Leading  and Lagging Indicators - Which to Watch
Leading indicators give you a chance to correct a problem before it kills the lagging indicator. Leading indicators allow you to be proactive. Lagging indicators, by their very nature, force you to be reactive.

That raises a natural question. Should you only monitor leading indicators?  Heck no. That wouldn't be prudent.

It's quite possible to have healthy leading indicators yet lagging indicators that under-perform. How is that possible?

You may have overlooked a leading indicator that greatly affects the final outcome. For example, sales volume is a legitimate leading indicator. Without sufficient sales, your business will wither away.

However, sales sold at low margin or below cost will break you faster than almost anything. As a contractor, you've probably experienced that unpleasant situation at some point in your evolution. You also need to be tracking gross margin. When both are scoring well, the odds of poor financial performance are pretty slim.

Your Dashboard
You need to monitor a basket of leading and lagging indicators. It shouldn't take you long to identify four or five leading indicators that drive your financial success. You need to identify a lagging indicator for cash flow and one for financial performance (probably net profit, return on assets, or earnings per employee). 

Once you've identified your basket of indicators you need to create a presentation system that will simplify monitoring. Let me give you an example of simplicity. The dashboard gauges in a Sprint Cup race car are rotated so that their needles point straight up when their readings are normal. Simple, right? No thought involved.

You need a similar dashboard for your basket of indicators.  Each indicator needs to contain a mark for targeted (budgeted) performance. In that way, a quick glance will tell you when one of your indicators is performing poorly and corrective action is advisable.

The Balanced Scorecard
You might have heard of the term Balanced Scorecard. It is a useful concept for our exploration of leading and lagging indicators. It is also a great process to work through as it will give you clarity about the cause and effect relationships inherent to your construction business.

The idea behind the Balanced Scorecard is that you identify the success measurement along each of four perspectives of your business: financial performance, internal business processes, customer, and learning and development. The scorecard is then developed by breaking down each of the four key lagging indicators into key success factors, each of those into key drivers, and each of those into a representative leading indicator. When you finish, you will have somewhere between eight and 16 leading indicators.

The key to all of this is understanding the cause and effect of the systems that run your construction business. If you don't understand them correctly, you will not identify to the leading indicators that are right for you.

Ron Roberts teams with Guy Gruenberg as The Contractor's Business Coach. They show contractors how to grow their businesses profitably. To sign up for their FREE Newsletter or join their Private Club, visit www.FilthyRichContractor.com.

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