Benchmarking not only helps an organisation identify performance gaps and thus establish important goals and planning priorities, but in so doing helps to sustain a competitive position for the entity in the markets it serves.
In simple terms benchmarking is the measurement and comparison of existing performance of an enterprise with that of:
It should be noted in the definition above that benchmarking is used to measure and quantify the current levels of performance against those of the industry leaders with the best practices. This is the most effective approach to benchmarking because the enterprise is then aiming above the industry average.
Benchmarks can be established for a range of functions and activities, and the measurement comparisons (yardsticks) will consist of both financial and non-financial information as shown later.
Recent studies have strongly emphasised the power of benchmarking. The MIT Commission on Industrial Productivity, for example, found that: ‘a characteristic of all the best practice American firms, large or small, is an emphasis on competitive benchmarking, comparing the performance of their products and work processes with those of the world leaders in order to achieve improvement and to measure programs’.
Benchmarking can take a number of different approaches within a business. The following summarises these approaches:
Most companies already undertake some form of performance measurement and comparison within their organisation. Most internal benchmarking or performance measurement comprises two main categories, namely:
Business function performance measurement – to measure and compare the performance of the following business functions:
Business operation performance measurement – to measure and compare the operations within an organisation, covering:
This requires comparisons or measures against the market leader or another successful company or against the average performance for the industry.
No enterprise is too small to be involved in benchmarking, the essence of which is the search for better work and management practices leading to improved business and profit performance.
Benchmarking consists of the following steps:
Step 1 – Process identification
This step involves the identification of the management or business function, but more specifically the processes, which needs to be examined and improved.
In most enterprises only a relatively small number of activities account for the key performance improvement outcomes. It is therefore important to focus on these activities and not attempt to cover too many or too broad a range of processes and practices.
Step 2 – Identification and selection of the best practice entity
The most difficult step in benchmarking is to identify the best practice entity performing similar processes in an outstanding manner. The most rewarding comparisons often come from examining practices outside of the industry sector in which the firm competes.
Step 3 – Examination (study) and measurement of the best practice organisation
Having carefully selected the more important processes or practices to be benchmarked, and identified similar processes in best practices companies, the next step is the examination of the processes and the performance comparisons with those in your enterprise.
The four primary comparison measures are:
Step 4 – Evaluating the results of benchmarking
It is critical that any differences in operating environment, industry or other identified differences between the benchmarking enterprise and the entity being examined are clearly identified. Rarely can identified performance improvement methods be copied directly into another business environment without change.
Step 5 – Follow up
When relationships are developed between the entities, follow up visits will tend to become commonplace. This may also lead to strong relationships and networking to the benefit of both businesses.
There are four primary methods of measuring tasks, activities and performance: cost, profitability, quality and time. Although businesses most commonly use accepted financial methods of measurement, and the commonly accepted financial comparisons, any activity of a business can be measured either in financial or non-financial terms. The key is ‘measurement’ – the calculation or assessment of historic, current or anticipated performance.
It is sometimes argued that a particular business activity cannot be measured. It is therefore worth repeating that any activity in a business can be measured in non-financial, or financial terms or a combination of both. The types of measurements and relationships that may be devised are virtually unlimited. Here are just a few examples:
Product or service design and development
Marketing and Sales
Human resource management
An understanding of financial performance measures and ratios is also essential for effective business management, benchmarking for continuous improvement and best practice performance. They are a prerequisite to:
The following summation provides a brief overview of finance and financial performance measures to enable a non-accounting person to interpret and understand data in financial statements.
All transactions of a business (assets acquired, liabilities incurred, sales made) are measured in monetary terms and all transactions result in changes to the asset structure, liabilities, or owner’s equity within individual account items.
It is possible to calculate the effects of every individual business transaction upon assets, liabilities and owners’ equity. However, in practice, it is only necessary to record and aggregate similar categories of transactions (such as sales and expense items) for a given period of time, and to report upon the effect of the sum of these transactions at the end of a given time period.
These periodic summaries consist of:
A comparison of the current balance sheet with the balance sheet at the end of the previous trading period will show the differences in asset, liability and owner’s equity accounts caused primarily, but not exclusively, by current trading period transactions – which e summarised in the trading report.
However, the above summarised financial statements contain financial data which are relatively meaningless until they are related and compared with each other. For instance:
A net profit before tax of $100,000 of itself is meaningless. However, if we relate this financial figure to sales of $1,000,000, we can say that the net profit earned on sales was 10 per cent. This percentage figure can then be compared with the same ratio of net profit/sales for previous years and with other companies within the same industry. These comparisons enable managers to identify favourable and unfavourable trends within their enterprise.
Similarly a net profit before tax of $100,000 is meaningless until related to the amount of equity capital invested in the business. If equity capital (or shareholders funds) is $500,000 we can say that the pre-tax return on equity funds is $100,000/$500,000 (20 per cent). Is this an adequate return? What returns on equity capital has the company generated in previous years? What returns on equity capital are being generated by other companies within the industry and by best practice enterprises?
These relationships (ratios) of financial data can be related and compared to identify:
Ratios convert a large mass of financial data into a meaningful set of information for strategic management planning, benchmarking, best practice performance monitoring and control purposes.
However, there are no absolute or ideal ratio measures. They are merely pointers or indicators to performance improvement. They may also be used as a means of assessing the financial impact of proposed new activities and objectives upon the business.
There are no ‘right’ or ‘wrong’ answers in ratio analysis, merely pointers or indicators which, when analysed individually or in concert with other ratio information, show where management action is required.
When comparing changes in ratios from period to period, care must be taken in interpretation. For instance a change may primarily be due to a change in accounting methods rather than in performance. However, dynamic analysis (comparing changes in a ratio from period to period) does provide indicators for business performance improvement.
As previously discussed, it is possible to compare and contrast the performance of one entity within an industry with that of another within the same industry through use of financial ratios. It is also possible to compare and contrast the performance of one firm with that of the whole industry, or a large sample or particular segment of that industry. However these comparisons may suffer from one or more of the following limitations:
A summary of the most commonly used financial performance measures
There is no exclusive or standard set of ratios and performance measures. A number of different relationships can be developed and measured, depending upon the information needs of management. For instance, personnel management measures are usually not included within the commonly recognised financial ratios (such as the percentage of lost time through industrial accidents, sick leave and so on compared with total paid hours).
Other measure may include the percentage of export sales to total sales, or the percentage of reject parts to total parts produced, or the percentage of late deliveries. There is no constraint on the types of ratios that management may require for planning and control purposes.
The more common financial ratios may be grouped, or categorised, into liquidity, activity, debt/equity, coverage, profitability and other ratios. The relevance or significance of each ratio within each category will vary depending upon the financial structure of the firm and the nature of the industry, in particular, relevance will depend upon whether the enterprise:
Liquidity ratios are designed to measure or predict the ability of an entity to meet its financial obligations (liabilities due for payment) out of its ‘current’ or most liquid assets.
It is important to note that businesses do not fail in the short term because they are unprofitable, they fail because they run out of cash (that is, cash outflow commitments exceed cash inflows). Thus profitable businesses and growing businesses in particular, may fail through a liquidity crisis or poor cash management.
The most common liquidity ratios are:
Although the above ratio measures are helpful and meaningful to prospective lenders and investors, they should be supported by a detailed cashflow budget.
These ratios are designed to measure efficiency in the use of ‘working capital’ and point to improvements in working capital management.
These ratios show how the assets of the business are financed (that is, the proportion financed by debt) and the proportion financed by owner’s equity by means of contributed capital and reserves.
An enterprise with high debt levels, relative to its equity funds (a highly geared entity) has greater risk of financial failure than a low geared entity, because interest payable on loan funds must be met from cashflows as and when the debt falls due. The firm has a legal obligation to meet interest payments, and eventual payment of loan funds when they become due, whereas a firm financed by equity capital is under no obligation to pay a dividend or to return capital to the equity shareholder.
Thus a highly geared enterprise is more vulnerable in times of an economic or industry downturn affecting cashflows. It follows that entities within declining or volatile industries, where cashflows are uneven or irregular, should gear conservatively.
Measure the capacity of an enterprise to meet its short-term and long-term debt financing commitments.
Measure the performance, return for risk, and overall effectiveness of the entity.
A number of SME business failure studies have been done over the past twenty years. Although research is continuing there is sufficient evidence to show that low risk businesses:
The question is, ‘What is adequate, reasonable and acceptable?’ There is no clear answer to this question which would apply in all situations, to all industries and firms within an industry.
One approach to determining what is adequate, reasonable and acceptable resides within industry ratios (inter-firm comparisons) which give an insight into how a particular industry views its relevant liquidity, activity, risk and return ratios.
Improving return on funds invested, which is the same as return on total assets (ROTA), is the key to improving profitability and value of a business.
There are only three ways to improve the profitability and value of a business:
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