Bechmarking Financial Performance Gaps:A Top-Down Approach

A classic article on the importance of top-down benchmarking

By Dr. Stephen G. Timme, 2001 Copyright

Are there pressures on your company’s profits margins? Over the last few years, eroding profitability has destroyed more than $1 trillion in market value for the companies in the S&P 500. Pressures on margins, changes in the dynamics of how value is created, as well as, less patient investors are forcing companies to seek new solutions to increase financial performance. This applies to both publicly traded and privately held firms.

This article describes a benchmarking methodology for uncovering opportunities to increase financial performance. The topics we explore are:

• A top-down financial benchmarking methodology
• Indentifying and Valuing Financial Performance Gaps
• Garnering Insights Into Gaps in Business Strategies & Processes
• FinListics Industry Gap Analysis for Selected Industries
• Summary

A Top-Down Financial Benchmarking Methodology
Unfortunately, the examination of many new solutions start-out something like one of the following:

• "Let’s do a benchmarking study of the activities within a business process (e.g., sales & marketing, forecasting, manufacturing, procurement, logistics, etc.)."
• "Look what’s on the cover of Fortune Magazine. We should also be doing that!"
• "Hi, I sell technology solutions. These will fix all your problems. Oh, by the way, what are your problems."

This are extreme examples, but the point is that often quests for new solutions to improve financial performance begin without know what is the question. And very seldom are these solutions linked back to improvements in the drivers of financial performance.

A top-down approach that we find very useful is:

• First, calculate gaps in key drivers of financial performance.
• Second, measure the value of the financial performance gaps.
• Third, use the value of the financial performance gaps to start exploring possible gaps in business strategies and process.
• Fourth, map possible solutions to gaps in business strategies and processes.

This is illustrated in Exhibit 1.

After this is completed, you can start examining solutions with a clearer idea of what is the question. And how solutions impact key drivers of financial performance.

Identifying and Valuing Financial Performance Gaps
The following shows an analysis for a hypothetical company called the "Target Company" that manufactures electronic components.

• The gap analysis is conducted for five areas of financial performance.
• These five areas are evaluated since they are the ones most commonly targeted to improve a non-service company’s financial performance.
• This does not mean however that your analysis would not focus on other areas to improve performance.

Like all financial analysis, great caution should be used when interpreting the results of the gap analysis. Differences in companies’ financial metrics typically reflect a myriad of factors. Some of those factors may be related to differences in product mixes and business models, as well as, differences in efficiencies.

Benchmarks
Target Company’s measures for the five key drivers are compared to three other companies, which may be from inside or outside the Target Company’s industry. Additional benchmarks could be from industry or other aggregates.

• The approach is to benchmark the Target Company’s performance to the best performance of the four companies (the three other companies plus Target Company).
• Exhibit 2 (columns 2 & 3) shows Target Company’s measures and the benchmark. For example:
  • Target Company has a 16.3% Operating Income Margin compared to the benchmark Competitor 2’s 17.5%.
  • Target Company has 62 Days in Inventory compared to the benchmark Competitor’s 45 days.

Percentage Gap Analysis
Exhibit 3 is a Financial Performance Percentage Gap Analysis. For example, Target Company is 72% effective in managing inventory (45 days / 62 days).

• The yellow area is the company’s effectiveness relative to the benchmark.
• The green area is the potential area for improvement.
• A word of caution. Just because a company has small or no gaps relative to other companies does not mean there are not areas for improvement. It maybe that all companies are doing poorly and the company you are examining is the best of the worst.

The percentage gap analysis in Exhibit 3 is an effective means to stimulate discussion why particular gaps may exist and possible solutions.

Valuing the Gaps
The next step in the analysis is to value the financial performance gaps (see Exhibit 2, last 2 columns).

• Each gap is converted into an annual cash flow measure. This measures by how much annual cash flow would increase if the gap was completely closed. For example:
  • Annual cash flow increases by $26 million if Target Company’s increased its operating income margin from 16.3% to the benchmark 17.5%.
  • Reducing Days in Inventory to the benchmark of 45 days from 62 days increases annual cash flow by $22 million.
• The gaps are also converted into a stock price benefit since Target Company is publicly traded. For example;
  • Closing the Operating Income Margin and Days in Inventory gaps potentially $1.49 and $1.15, respectively.
  • Closing all the gaps, potentially increases stock price by $5.86.
• The size of the gaps provides a guide to which ones to attack first.

Summary of Results 

• Target Company’s has gaps in all areas.
• The largest gaps, and the ones to examine first are:
  • Revenue Growth
  • Operating Income Margin
  • Days in Inventory
• If the Target Company closed all gaps, the potential impact approximately is a 27% increase in annual cash flow and a 29% increase in stock price.
• These are the kind of results that would pique the interest of any CFO.

Garnering Insights into Gaps in Business Strategies & Processes
The next step in the analysis is to use the gaps to stimulate discussion regarding possible gaps in related Business Strategies and Processes.

• There are numerous ways to conduct this step.
• Even though most gaps are interrelated, it is suggested that initially the discussion proceeds gap-by-gap.
• Again, focusing on those gaps that appear to have the highest financial pay-off.

For Target Company, the Operating Income Margin has the highest gap value -- $26 million annual cash flow and $1.49 per share. Examples of possible gaps in strategies and business processes related to the operating income margin for a manufacturer are:

• Business Strategies:
  • Make vs. Buy
  • Direct vs. Indirect Sales
  • Build-to-Order
  
  
• Business Processes:
  • Procurement
  • Manufacturing Conversion
  • Forecasting
  • New Product Speed-To-Market
  • Warehousing, Transportation, Shipping & Other Logistics Processes
  • Customer Service
  • Human Resources
  • Finance & Accounting

Summary
Improved business strategies and processes have the potential to significantly increase financial performances.

• The problem is that often a purported solution to improve strategies and processes is explored and/or implemented before the knowing the real question.
• In addition, these solutions are seldom linked to improvements in the key drivers of financial performance.
• By not knowing the real question and linkage to financial performance, the likelihood of a successful implementation is low. And it is nearly impossible to ascertain if there is an improvement in financial performance.

To address these issues, it is recommended that a top-down benchmarking methodology be utilized.

• First, calculate gaps in key drivers of financial performance.
• Second, measure the value of the financial performance gaps.
• Third, use the value of the financial performance gaps to start exploring possible gaps in business strategies and process.
• Fourth, map possible solutions to gaps in business strategies and processes.