An essential component for successful growth is the utilization of proper benchmarking. Benchmarking allows you to compare current financial performance against several key metrics to gain an understanding of how your business stacks up in a particular industry as well as how current performance compares to prior periods. This tool is essential and relevant regardless of what stage of the life cycle in which your business currently exists. Benchmarking is an opportunity for a business to look at itself honestly and admit that it can be better than its previous version as well as striving to be better than the competition. While there can be a dizzying number of metrics to evaluate and various ways to structure your benchmarking analysis, essentially you are interested in two main, overarching components. You will want to understand internal benchmarking and external benchmarking and how each vertical can contribute to enhanced operations.
Internal benchmarking
Internal benchmarking is the process of comparing your company’s current financial performance versus prior period performance. The understanding of the nuances of your business model, market, current economic factors, etc., are all key aspects to successful internal benchmarking. To illustrate, imagine you are an owner of a restaurant in a growing market. You now have three years of data to understand the trends in your previous performance. To attack benchmarking in the most effective way, you always want to begin with your largest controllable expenses: prime costs. What has the last three years of data told you about how your business has managed your cost of goods sold and your labor? What are the key factors driving these costs and how do you expect them to be impacted in the coming period? Perhaps labor has been steady but a local mandate to increase minimum wage has been enacted and you know your hourly labor costs will increase significantly overnight. Given this new assumption, you will want to adjust what is achievable in terms of labor cost percentages. Are you able to raise prices to combat the rising labor costs? Or if your market doesn’t allow for price increases, do you adjust your model to convert part-time employees to full-time and use salaried positions to take the place of multiple part-time positions? All these considerations are key to developing a proper benchmark for your labor costs and then, as frequently as possible, comparing your target to your actual results. In this case, a good minimum frequency would be each occurrence of a payroll. A successful benchmark is one that is both ambitious and achievable. A poorly considered benchmark can lead to a damaging incentive structure that can severely impact the quality of your offering. After gaining an understanding of the assumptions for your internal benchmarking, it is time to look to the competition and see how your operations compare.
External benchmarking
This is the process of looking into the industry and understanding how similar businesses perform. A great place to start is to investigate industry associations and publications for data on KPIs to help you get a sense of what other businesses of your size are paying attention to and how they may be performing. If you are a franchisee of a national brand, you likely will not have to look far to find data on your segment of your industry. If you are more of an original concept, the process can be a little less obvious but there are ways to procedurally determine what are appropriate comparisons to your model. First, look at pure revenue per operation. If you are a business owner who generates $6 million a year from a particular restaurant concept, start here and see what other style of restaurants are in this tier. Now, you will want to identify your style of service. Are you what would be considered fast food, fast casual, or are you more of a higher-end offering? Depending on your model, your prime cost structure will be different. A fast food concept will have cheaper prime cost inputs and, therefore, your percentage of prime costs relative to your revenue will likely be lower than what would be considered an industry standard for a higher-end concept. Once you have narrowed your industry comparisons to match your operations, it is time to combine the internal and external benchmarking into actionable progress.
Take action
So, you now have a history of your own performance and can compare this performance to the best-in-class operations in your segment. It’s time to get granular and understand the nuance in the differences understand the nuance in the differences between your historical and current performance, as well as your current performance relative to the industry. Perhaps you have been significantly outpacing industry standards. Before you project a continuation of this trend, you need to do your best to understand the contributing factors. Maybe you were the first to an underserved market that is now experiencing increased competition. In this situation, you may want to plan for a reduction in revenue, which will apply increased pressure on your prime cost percentages. If you were to set a benchmark based on historical performance alone without taking into consideration the new market realities, you could find yourself in a position where your business has overinvested in resources relative to the volume you will be able to sell. Conversely, you could be operating in a smaller market with a few key competitors and in a particular season one of your competitors may be down for a period due to renovations. This could be an opportunity to get ambitious in deploying additional resources to achieve increased market share while the opportunity exists. In both cases, relying on historical and/or industry benchmarks alone could leave you in a suboptimal position. But by considering both in combination, you can better understand what is possible and how to best approach your operations in the short to medium term to help achieve the best possible outcome.
Benchmarking is a tool and a process that a business never outgrows. In the early stages, a business will likely lean on the industry metrics as the starting point for benchmarking. As operations continue, the information gained from historical data will become more useful and a larger piece of the consideration in terms of your benchmarking makeup. Whatever the ratio of internal to external, the continual examination of the “why” is the most important question to answer. A business that employs a well-designed benchmarking process can answer this question better than the competition, giving that business a competitive advantage.
This article is a selected piece from By the Books: FORVIS' Complete Guide to Small Business Accounting & Finance, which we are excited to release in April 2023. Subscribe to our Small Business list to get future updates and articles and be the first to receive the full guide.