To maintain a competitive edge, it’s critical for a business to know where it stands financially. Beyond an understanding of cash flow and profitability, what else can be done to analyze and manage financial performance? One approach is benchmarking.
“The first thing to know about benchmarking is that it’s a very effective management tool. Benchmarking tells you how your company is performing and shows you where you can improve,” says Gerry Herter, partner, Accounting & Audit department at HMWC CPAs & Business Advisors in Tustin.
Smart Business spoke with Herter about how he helps local companies to utilize benchmarking.
What is benchmarking and how does the process start?
In the benchmarking process, management selects benchmarks, or metrics, to measure your company’s performance against your own past performance or against other similar businesses. The benchmarking process begins with creating baseline performance measures, which can then be tracked internally over time or compared externally to similar businesses.
Internal benchmarking, or tracking your own performance, is your guide to weaknesses and opportunities within your operation. If, for example, your long-term debt-to-equity ratio (an indicator of your ability to pay long-term debt) is rising, benchmarking will alert you early so that you can determine why it’s happening and how to bring it back into proper alignment. Similarly, if your repeat business percentage is declining, benchmarking can give you a heads-up so you can identify and correct the problem.
External benchmarking helps you understand how companies like yours have performed. It’s especially useful when the comparison is made to companies in the same industry with similar customers. Industry organizations, such as trade associations, can be a good source of information, though they tend to have a regional focus. Indeed, be wary of the source and content of any benchmarking studies you review. For example, national benchmarking, while informative, may not be useful for a locally or regionally focused company because practices within an industry vary widely across the country. Similarly, a company with nationwide coverage would likely find local or regional data to be less helpful or even misleading.
What are some common benchmarks?
In deciding which benchmarks would be best for you, consult with your financial advisor. There is a wide range of metrics to measure, dependent upon industry, company structure and other factors. Some you’ll likely consider include:
- A comparison of estimates to historical averages using a three- to five-year period
- How gross profit compares to historical averages
- How profit recognized to date compares to historical averages
- How labor costs (including overtime) have changed
- Fixed and variable overhead comparisons to similar-sized companies
- Materials and equipment costs for companies in your industry
The specific benchmarks you use should be those that have the most effect on your company. For example:
- An architect would likely be less concerned with capital equipment costs than would a manufacturer.
- Manufacturers typically benchmark inventory turnover, speed of handling inventory and filling orders, picking error rate, inventory accuracy and shipment error rates.
- Distributors would likely consider various metrics to measure their warehouse and shipping operations, such as inventory turnover, dock loading and delivery time, so as to reduce costs and inefficiencies.
- A contractor may find that surety information how your bonding compares to that of your peers is valuable. A bonding company is likely to be the most important user of your financial statement, so benchmarks you establish in that area can only help your bonding capacity.
What is the next step?
Once you’ve established your benchmarks, you’ll need to assemble the data you need to measure them. Again, your financial advisor can be a good partner in the process.
Make sure that you’re working with complete information that is relevant to what you’re measuring. A single financial statement from five years ago won’t provide an accurate representation of what you were doing back then, and a marketing summary that confidently predicts you’re going to double your gross revenues next year isn’t a reliable guide to the future.
Last, when you’ve collected all the information, keep it together benchmarking should become a regular part of your financial operations. If you report financial information every quarter, benchmark every quarter, too.
How should various levels of management be involved?
Your line supervisors may be more concerned with daily production than achieving financial benchmarks. However, with education and incentives they can be more focused on improving the ROI. Along the same lines, middle managers will likely benefit from an explanation of the basics of cost and profit and from showing them how much influence they have on the overall financial health of the company. Of course, upper management should be involved in the entire benchmarking process, from inception to monitoring to affecting changes in performance.
After all, if your managers aren’t fully engaged, they won’t help you address the findings with action plans and follow through. For example, it’s one thing to know your equipment maintenance costs are on the rise; it’s another to have managers who are determined to ferret out why and be aggressive in turning them around.
Gerry Herter is partner-in-charge of the Accounting & Audit department at HMWC CPAs & Business Advisors in Tustin. Contact him at (714) 505-9000 or firstname.lastname@example.org.