Benchmarking: Reducing Performance Gaps
Benchmarking is a term we often hear about, but most businesses fail to take full advantage of the concept to maximize cash flow, and profitability. After WWII, the Japanese economy laid in ruins, and Japan had to convert its war-time economy to consumer and industrial production. Japanese companies developed a process where they identified exceptional companies that were leaders in their field, and selected performance metrics to measure and use as targets, to improve operational and financial performance. Once identifying the performance gap, processes were introduced as required, in order to reduce and erase these gaps completely. Benchmarking as we know it took hold. The Japanese economy transitioned from disrepair to the second largest economy in the world within 30 years.
It’s all about process
Benchmarking is successful because it is never finished! Benchmarking is a process that becomes part of the culture of a company—a continual effort to improve. And also, to maintain the performance level and not ‘give back’ any realized gains.
Benchmarking can be broken down into a six-step process. (See the Benchmarking seminar in our video library.) First, determine what company data is needed and target numbers you wish to use as comparables. Normally, industry averages are used in benchmarking.
Once you have documented your company’s data and the industry averages, you can see where performance gaps exist. In addition to looking at the industry, Fiscal Advantage recommends a company should compare itself to the best it has achieved in the past, especially if the company is performing better than the industry average. Review both the industry average and the company’s optimal results for gaps in deciding reasonable opportunities.
Share this information with those who will be key in the benchmarking process. The team must commit to a process as well as specific performance goals. An important part of this process is to devise and implement a plan to reduce or eliminate the performance gap.
One must make sure goals are communicated, results are measured properly and the process is documented with responsibility for the key people involved. A ‘buy-in is essential for success.
The team needs to monitor results to determine how the plan is progressing and determine what works and what doesn’t. If something is not working, find another way of accomplishing the goal. Access data in a timely fashion and don’t wait for the month-end numbers. Making changes as soon as possible will improve overall results.
A good process results in a consistent monitoring of performance and recalibrating for continued improvement. Most companies fail to realize the full benefits. The “recalibrating stage” is a fine-tuning of processes to strive for top performance. Once achieved, it is critical to continue to monitor and recalibrate to ensure performance does not deteriorate and the company loses its gains.
Cost of Income Statement Gaps
The key financial performance gaps that are found on the income statement drive profits. The profit gap variance is measured by analyzing the cost of goods sold and the operating expenses. Controlling these costs directly impacts profits and therefore business value. When looking at the past three years of cost of goods sold and operating expense gaps, the money left in the cost structure of the business can be substantial. Let’s look closer at the cost and value resulting from income statement gaps.
Let’s review a company with $7 million in revenues with COGS of 62% and Operating Expenses of 36% and compare it to their industry average.
Comparing the company’s cost of goods sold to the industry, the COGS gap was $205,000 and the Operating Expense gap was $283,000 for a total cost gap of $488,000. If the company could equal the industry average in its cost structure, they would add $488,000 of added profit.
Many businesses look to sales growth to improve profitability without realizing their profit goals can often be more easily attained through cost controls. Improving cost controls to reduce the performance gap should be analyzed before new sales initiatives are considered. In this case, sales would need to increase by $24 million in order to generate $488,000 in profit to equal the identified excess cost. In most cases, it makes economic sense to reduce the performance gap before committing to sales growth or new markets.
Let’s assume the industry is selling for 6.5 times EBITDA (earnings before interest, taxes, depreciation and amortization). If the company could achieve industry averages in its cost structure, this business owner could add $3,172,000 in business enterprise value
Cost of Balance Sheet Gaps
Let’s use the same analysis for the balance sheet. For the key working capital accounts – receivables, inventory and payables, when compared to the industry average, the company could improve its AR Days and Inventory Days. The AP Days were at the industry average.
|Total Excess Cash Invested||$347,000|
If the company’s AR and Inventory Days equaled the industry average, the company could reduce its cash investment by $347,000. There are other additional hidden costs that arise from this excess investment in assets. Receivables have a cost associated with write-offs, interest to carry the added AR and additional collection time. Inventory might have obsolesce cost, shrinkage, extra storage and added interest to carry the inventory. Then there is the opportunity cost. If the company could earn a return on the $347,000 in excess investment (equal to the company’s return on equity), that would equal the opportunity cost. Generally the total hidden cost is between 20% and 30% of the $347,000 or $69,400 to $104,100. These hidden costs are real. Below is an estimate of the typical hidden cost on excess investment.
Hidden Cost on Excess Investment
|AR and Inventory loss||10%|
|Added operating cost||5%|
|Total Hidden Cost||26%|
The first order of business a company needs to conduct, is a review of its cost structure and cash management, to determine if any gaps exist between the company’s performance, and that of the industry average. In addition, determine how the company compares to their best past performance and establish benchmarks to achieve excellence.
Where gaps exist in this comparison, conduct a diligent process to implement improvements to reduce or eliminate any performance gaps, and continue monitoring for optimal results.
The benchmarking process should become part of the company’s culture in order to maintain top efficiencies. Consistency adds value.
Only in unique circumstances should sales growth become the primary focus to improve profits. Instead, primary efforts should be on cost controls and cash management improvements first, then contemplate sales growth.