Benchmarking: To Boost Efficiency

Diederik Rietveldt
Vladimir Kachalin

Benchmarking – definition

Improving operational and financial efficiency is an essential task of a company’s management. A management tool which facilitates this task is benchmarking. The company elaborates a set of indicators that assess the operational and financial position. Consequently, the company compares the value of its efficiency indicators with the value of the same indicators of other companies, that have the best practices. Best practices do not only refer to the most optimal financial indicators but also include technologies used, production organization, management techniques, ability to meet specific customer demands, etc. Usually, financial indicators are included as well. This comprehensive comparison of the financial and operational efficiency of companies is called benchmarking. It can be defined as a comparative analysis of efficiency of companies based on a set of interrelated and independent indicators. Benchmarking implications for strategic planning can be formulated as follows: «To be a leader in this market niche, our company, in a defined period of time, needs to achieve certain goals such as cost of production per unit, product quality, earnings per share etc.» (EPS)

Benchmarking the market capitalisation of the company

When a company is traded on a stock exchange, benchmarking should start with a comparison of the shareholders’ value and the indicators directly related to this value such as EPS, Return on Equity (ROE), net profit to net worth etc. The result of the comparison between companies in the same industry reflect the extent of its ability to satisfy its owners and subsequently the possibility to finance new investments through equity.

Revealing the causes of the current company standing in the stock market. 4-layers of financial ratios

Benchmarking indicators include not only a ratio analysis based on annual report’s data, but should explain the current level of company value. The indicators can be organised in four layers: resulting financial ratios (RoE, for instance), causal financial ratios determining final financial ratios, techno-financial ratios and indicators, i.e. these are directly determined by the efficiency of the company’s business processes, and business process indicators, i.e. ratios and absolute values reflecting the efficiency of general operational processes.

Selecting a benchmark: benchmarking with direct analogues and with synthetic model

Benchmarking can be divided into two aspects: firstly the choice and utilisation of parameters and indicators to be compared and secondly the identification of an analogue to compare the company with. Thus, «What to compare?» and «With whom to compare?» The first question was briefly addressed above. Answering the se.cond is not straightforward. The ‘who’ can be an existing company with its analogues that are roughly equal to it in terms of production capacities, product range, size/volume of output, geographical market situation and business processes. However, in practice companies are different enough for using this approach. This is particularly so when making comparisons between Russian and Western companies. One way to deal with this problem involves the construction of a so-called synthetic model (SM), i.e. a virtual analogue of the company. The SM is built by virtual taking out separate divisions and/or business lines from existing companies and compiling them into a hypothetical one. The division taken from a «donor» company for inclusion in the SM should be roughly analogous to similar division of the company being benchmarked in terms of its production capacity and ability to produce a set of products and size.

Data comparison problems

During a benchmarking exercise at a Russian steel enterprise, substantial problems with data comparison can occur primarily due to the difference of their accounting systems from IAS and internationally accepted cost accounting principles. In the course of work on a Tacis steel industry project at enterprises several principal inconsistencies arose:

1. Direct costs are frequently attributed to overhead. For instance producers of electrically welded pipes allocate all their transformation costs to products in proportion with two factors: (1) amount/cost of strips consumed for its production and (2) the so called «complexity ratio.» In this sense transformation costs are calculated in a similar manner as overheads, i.e. they are not determined by direct measurement and their total amount is distributed by machine/type of product proportionaly to direct costs (costs of strips in our case) or volume/value produced. In the so called analytical forms for calculation of cost of production per type of pipes tube-makers often unite transformation costs and factory overheads in the same line-item.
2. Transformation costs are allocated proportionaly to complexity of production of each pipe. For this purpose complexity ratios are used, i.e. the complexity of some simple pipe is taken as 1 and complexity of pipes more difficult in manufacturing is related to the first one by choosing complexity ratios of 1,1, 1,2, etc. These ratios are prescribed in the Ministerial instructions effective for the whole industry since 1993. In our opinion this distorts the true cost picture even more since costs are calculated based on artificially invented ratios and not the actual production expenses.
3. Factory overheads are allocated proportionaly to transformation costs. Period expenses and these included in Cost of Goods Sold (CGS) in Western practices are not separated and totally allocated to CGS.
4. Most of the tube-makers do not have a written policy of dividing costs into fixed and variable ones. This division is taken at random and normally looks as follows:
5. are: wages – 100%, social security disbursements – 100%, repair and maintenance – 100%, depreciation – 100%, capital repair – 100%, other expenses – 100%, factory overheads – 100%, fuel – 30%, energy – 30%. Everything else is considered as variable costs. In average fixed costs amount to 15-20% of total production costs. The remaining 80-85% is considered to be variable costs.

Conclusion

The scope of this article prevents us to fully elaborate on the building of the SM, the indicators to be used, or the data problems that will occur. Nevertheless, during a benchmarking exercise at one of the major Russian tube producers, we discovered that the most serious problem that occurred was related to the data comparability and the organization of the data. If a Russian company wants to benchmark itself in order to assess its competitive position in the international market, for example to identify export possibilities, we strictly recommend the use of IAS accounting, especially for cost accounting. Otherwise, no correct comparisons and, thus, no correct strategic decisions can be made.

Diederik Rietveldt and Vladimir Kachalin prepared this article as part of a Tacis project « Assistance to the Russian Steel Industry Sector ». They can be reached by tel : ( 095 ) 784 6899 .