Managing risk is managing the effect of uncertainties on our objectives. It could be related to the objectives of our strategy, financials, operations, compliance, etc. As it starts from the decision-making, we need some indicators at that stage. As such, we need to consider both relevant lagging and leading indicators. The following questions are then asked to risk professionals: ‘what exactly are the differences, and why does it matter?
Leading indicators are described as inputs. They define actions necessary to achieve the goals and objectives with measurable outcomes, hence they lead to successfully meeting the organization’s goals and objectives. Whereas a lagging indicator is sometimes described as output that’s already occurred to gain insight into an organization’s future success.
In essence, leading indicators are about trying to predict the future, and lagging indicators are about understanding what has already happened. Both are important for a risk-based decision-making purpose related to measuring an organization’s performance. As such, both indicators are equally needed for an organization to understand its performance and identify proper ways to improve them in the future.
Another thing worth considering for risk professionals is to be aware of the challenges of using the leading indicators and the downsides of using the lagging indicators. Such awareness is important to help organizations not be trapped into one indicator due to one-sided preference or limitations, especially those that might lead to an organization’s focus and leniency.
What are the challenges of using leading indicators?
They are important for building a broad understanding of performance because they provide information on likely future outcomes. Some examples are the increased portion of younger generations that consume our product or services, the increased portion of new products or services of a new market segment that contribute to our sales portfolio, and the more productive innovation cycle of an organization or the index of future-fit of people competencies. Hence, leading indicators are much more likely to be unique to the organization, making them harder to build, measure and benchmark. In such a situation, many organizations could be tempted not consciously and cautiously develop their leading indicators due to many reasons. As a result, they might gradually lose the foresight and horizon of the future relevant contextualization, which disables organizations from making quality risk-based decisions.
What is the downside of using lagging indicators?
They’re typically easy to identify, measure and compare against elsewhere in our industry, such as actual revenue, profit, etc., which makes lagging indicators very useful. However, the obvious downside of backward-looking indicators is they may provide insights too late to do anything about it. Even if it’s not too late, the lagging indicator is probably not telling us why this trend is happening and what you can do to stop it. Another downside is that lagging indicators encourage a focus on outputs (a number-based measure of what has happened) rather than outcomes (what we wanted to achieve).
Hope this short article is useful.
Dr. Antonius Alijoyo, founder of Center for Risk Management and Sustainability (CRMS Indonesia) and Chair of supervisory board of Indonesia Risk Management Professionals Association (IRMAPA).