Benchmarking For Success
By Albert D. Bates, Ph.D.
The recently completed 2008 MHEDA Distributor Performance Benchmarking Report provides the most comprehensive set of benchmarks available for financial performance in the industry. The report suggests that the industry was not immune to the economic challenges that emerged during the last half of the year.
However, some firms continued to prosper despite sales and margin pressures. The differences between the typical firm and the high-profit one are significant for both planning and control purposes. They need to be well understood by every manager in the firm.
What “High-Profit” Means
The typical firm in the benchmarking survey is the firm exactly in the middle of all firms in terms of its financial results. That is, half of the companies will perform better than the typical one and half will perform worse. Most firms tend to produce results that are fairly close to the typical results. The continual challenge is, however, that being typical is simply not good enough. To see why, it is useful to compare typical and high-profit results.
The typical firm generates sales of $22,980,168. On that sales base, it produces a pre-tax profit of $597,484. This means the firm produces a profit margin of 2.6 percent of sales. Stated somewhat differently, every one dollar of sales results in 2.6 cents of profit.
The high-profit company, operating with the exact same set of economic and competitive challenges, generates a profit margin of 5.6 percent. This means that the high-profit company, even if it had the same sales as the typical one, would generate more profit to invest in the firm which will allow it to produce even more sales and more profit. It is an ongoing advantage that is magnified over time.
How Do They Do That?
Reaching high-profit performance is a matter of identifying what is important and developing a plan to do better on those factors. In benchmarking terms, the items that are important are called the critical profit variables (CPVs). The CPVs are outlined in Exhibit 1 with specific information on the results produced by both the typical and high-profit firm.
| Exhibit 1 |
The Critical Profit Variables |
| |
Typical |
High-Profit |
| Net Sales |
$22,980,168 |
$17,909,180 |
| Profit Margin (pre-tax) |
2.6% |
5.6% |
| The Big Three |
|
|
Sales Growth
|
0.2% |
-0.9% |
Gross Margin
|
29.6% |
32.7% |
Payroll Expenses
|
16.1% |
16.7% |
| The Little Three |
|
|
| Non-Payoll Expenses |
10.4% |
10.3% |
| Inventory Turnover (times) |
5.2 |
5.6 |
| Average Collection Period (days) |
35.6 |
35.0 |
|
One caution is always in order when comparing typical and high-profit firms. Namely, no single business produces superior results for every single CPV. It is simply not possible. Successful firms combine the CPVs in a way that maximizes overall profitability.
The “Big Three”
In planning, the CPVs should be thought of in terms of the “big three” and the “little three.” The big three are sales growth, gross margin and payroll expenses. These are the factors with the greatest potential to impact profit. Firms that can successfully control these items have a major financial advantage.
- Sales Growth — Managers almost always think of sales growth in absolute terms. That is, they think of five percent growth or ten percent growth. Ideally, managers should modify their thinking to focus on relative growth. This means, think of sales growth in relationship to expense growth. Ideally, firms should target sales increases of somewhere between one to two percentage points faster than operating expenses. If they do so, profits will improve.
- Gross Margin — The ability to generate an adequate gross margin continues to be one of the major determinants of profitability. Financial success over the long term demands strong gross margin performance. While the high-profit firm does not necessarily have a higher gross margin every year, it always produces superior margin performance in relationship to operating expenses.
- Payroll Expenses — Payroll is by far the most important expense factor, which means that controlling payroll is essential to controlling expenses. In recent years, payroll has rivaled gross margin in its importance as a driver of profitability. This is because payroll expenses, especially the fringe benefits component, have increased relentlessly.
The “Little Three”
Firms that can control sales growth, gross margin and payroll are much more likely to generate high profits than those that do not. In contrast, these “little three” CPVs represent opportunities to fine-tune the business. They are important but are secondary to the “big three.”
- Non-Payroll Expenses — In analyzing non-payroll expenses, it is usually found that only minor adjustments are required. Unfortunately, there are numerous areas within the firm that need to be examined. Controlling non-payroll expenses will probably always involve examining every expense category with the hope of making modest improvements in a number of different areas.
- Inventory Turnover — The rate of inventory turnover has a dramatic impact on cash flow. As a result, it has been a major area of concern for the last several years. It was suggested above that firms need to generate at least a modest rate of sales growth. If that growth is to be maintained without running out of cash, then inventory turnover must be improved, at least slightly. For most businesses that slight increase in turnover will be enough to ensure financial integrity. Making excessive changes in turnover has the potential for out-of-stock situations.
- Average Collection Period — The average collection period (sometimes called “days sales outstanding”) has proven to be the most difficult of the CPVs to improve unilaterally. This is because in every line of trade there is an industry-standard set of terms of sale. However, continual review of the average collection period can result in important improvements and a resulting improvement in cash flow.
In reviewing these CPVs, remember that the high-profit firm is far from perfect. Individual firms may significantly outperform high-profit firms on individual factors. What high-profit firms accomplish well is assembling a set of CPVs that result in greater profitability. This is a model that every firm can use to improve financial performance. |
