Why You May Need Financial Benchmarking To Increase Profitability
The video tutorial referenced under Accounting Tips and Reminders is now ready and will be published on YouTube Wednesday, November 17 at 4:00 p.m.!
Mark had been poring over his profit and loss statement for hours trying to figure out where he was losing money. He could see his sales were down and his costs were up, but because his sales and direct costs fluctuate so much each month, it was difficult to see any type of trend or pattern that would help him identify which costs were creeping up. Without a place to start, he wasn’t sure how to address the problems and prevent them from eating away at his bottom line. As a small business owner, he knew there was not a lot of room for error, and time was of the essence to get this problem resolved.
Exploring Your Income Statement
In this article we will be exploring how internal financial benchmarking of your profit and loss statement (aka income statement) can help you monitor trends, identify areas that need your attention, and establish acceptable expectations for returns or profits. The best part is, you will find this tool useful, even if your financial statements vary month over month or from season to season.
What is Financial Benchmarking?
Financial benchmarking is the process of defining, collecting, analyzing and using internal and external financial data to identify proficiencies and deficiencies in business processes. The benefit of financial benchmarking is that it promotes continuous improvement. Financial benchmarking can help your business become cost-efficient and enhance productivity by allowing you to understand how your organization is running financially compared to some model to replicate. This model can be internal (your own company standard), or external, (other businesses with a similar business model).
Why is Financial Benchmarking Important?
Really understanding your financial statements and using data to make financial decisions supports good stewardship; but, if that isn’t enough to convince you of the importance of benchmarking, then consider these additional benefits. When you have a point of comparison to reference against your performance, it “provides an entry point for inquiry. A difference in performance measures does not necessarily mean there is an issue to be addressed, but looking at the variation helps you or your leadership explore important questions.”4 It provides insight into how well the various parts of your organization are working because it gives you a reliable basis for comparative analysis. These insights can help you set or adjust your goals for profitability and future growth.
A “Real Life” Example
Let’s go back to Mark’s story to find out why he was so frustrated and how internal financial benchmarking would have saved him a ton of time and headaches.
Gaining Profit & Loss Insights
This is a very simplified version of Mark’s quarterly financial statement. As you can see, his profits (Net Income) fluctuated quite a bit over this 3 month period. If we look at August, his revenue wasn’t less than July’s revenue, yet his profit was less than July’s profit. We can see that the payroll expense was quite a bit higher which was most likely the major contributor. However, this doesn’t tell us much else. Remember my earlier statement about how having a point of comparison to reference against your performance provides an entry point for inquiry? Here are the questions that immediately come to my mind when I look at these numbers.
- Were July’s numbers out of the ordinary because of an unexpected or planned change in the normal course of business?
- Is there an accounting error in July (like a payroll that didn’t get entered)? It would seem like this might be a possibility, since July payroll is about half the amount of August and September’s payroll.
- Sales were highest in September, but General and Administrative expenses were lower than July and August. Why?
Comparing these numbers to a standard or benchmark helps us answer these questions by showing us which categories were higher or lower than the profit and loss benchmarks for this organization. Here is an example:
Here is one way to look at the numbers, but this is too busy for me, I would simplify this by hiding the dollar amounts and just focusing on the percentages, since they are more telling. That would look something like the illustration below.
This is much easier to read, at least for a short period of time. However, if you are looking at a larger set of data, this still might be a bit much to dissect at one time. We can further assist our analysis by creating a chart. I am using a stacked bar chart here, but you can put this in any format that works best for you.
Visual Benchmark Reveals 4 Financial Patterns
Now we can visually see our benchmark for each category (aqua blue line) compared to each month (blue, red, green lines) and the quarterly total (purple line). What does this chart tell me at first glance?
- Cost of Goods Sold exceeded the benchmark in August, but the quarter overall was below the benchmark. This could mean that costs were not properly matched to revenues in the same period or that we negotiated lower pricing on some of our direct costs, or a multitude of other possibilities. But you see how this gives you a starting point to knowing where to begin digging for answers.
- Quarterly payroll exceeded the benchmark because August and September payroll was much higher than July. Since July is close to the benchmark number, this tells me that most likely there were one or more new hires added, increasing total payroll expense by the amount of their salaries or wages.
- General Administrative Expenses exceeded the benchmark for the entire quarter, but I see a downward trend which hopefully means that someone is doing cost mitigation in this area to try to get these expenses back down to an acceptable level. The other thing that may have happened here is that some larger purchases were made (like new office equipment for example) that were misclassified to expenses when they should have been classified to an asset account for depreciation purposes.
- Finally, Net Income (or profit) was below expected for the quarter. Since this chart is just giving us a high level overview of areas of concern, we would now want to dig deeper into those areas to get more specific about where the issues lie.
Based on this example, and assuming we know that there were one or more new hires added, I would start with July’s General and Administrative expenses, followed by August. I would do the same type of analysis as above, getting more and more granular as I go.
Here I have used an IF statement in my spreadsheet so that I only need to focus on the categories that were greater than the benchmark for this period. Rent, accounting fees and automobile expenses have some explaining to do! LOL.
How to Create a Benchmark Profit & Loss Statement
Now it’s your turn! There are many ways that you could create a benchmark profit and loss statement but I am going to give you one easy way to get you started. Please note that for this method you need to be certain you are starting with a complete, clean and up-to-date set of books. If you aren’t sure that your books are clean, you may want to consider having an accountant look them over first or do your own self-check. You may find this video helpful if you are doing your own self-check.
- Run a profit and loss statement from your accounting software for a time period of your choosing. I recommend a rolling 12-month period (12 months back from your desired end date). However, if your business had extraordinary events during that period (like COVID-19, for example), then you may want to choose a more normal period of time. Also, if your business is seasonal, you may want to choose a period for each season so that you have a more reliable benchmark for each season.
- Add a column that calculates each line item as a percentage of revenue. Most accounting software should have an option to add this within the software. If yours doesn’t, you can do this in any spreadsheet software by taking the line total divided by total income.
- Adjust or remove anything that was extraordinary (only happened one time and isn’t expected to happen again) that would skew the numbers.
- If there are any percentages that you are not happy with, set a goal for what you would like them to be. Then, put that goal number in your benchmark. This will allow you to see if you are inching closer to your goal as you make adjustments and changes to your operations.
These percentages are now your benchmark for comparing your profit and loss for any period of time – month, quarter, year, etc.
Of course, when you run future profit and loss statements, you will want to include that % of Income column for easy, side-by-side comparison. If any numbers are out of alignment, you know where to start asking questions to find out why and develop a plan to correct the situation for future periods.
Accounting Tips and Reminders
If you are having trouble with these written instructions, a video tutorial with step-by-step instructions to create your own financial benchmark profit and loss statement using QuickBooks Online and/or spreadsheet software will be available for viewing after Wednesday, November 17, 2021 at 4:00 p.m. To ensure you are the first to know about this video, subscribe to our YouTube Channel.
Prior to beginning this exercise, you may want to consider modifying your chart of accounts in order to obtain the detail needed for analysis. We recommend having a professional accountant assist you with this task if you are not an experienced accountant or bookkeeper. “Common alterations to the chart of accounts include creating accounts to:
- Break out employee compensation costs by department (i.e. Sales, Service, Administration).
- Break out revenues and costs for products that are strategic to the company so that their profitability and growth can be measured.
- Break out service revenues and their direct costs to measure their profitability and growth.”3
“Financial [data] should not only be compared to…benchmarks but should also be tracked over time to determine if their trends are favorable or unfavorable.”3
Improving Your Profitability
You probably still have questions about how you can effectively implement this strategy in your business. But don’t give yourself a hard time if you don’t get it perfect right away. Remember, it is meant to be an entry point for inquiry. Regardless of how this exercise turns out for you, the important thing is that it gets you asking questions and not just accepting the numbers for what they are. As Benjamin Franklin once said, “Beware of little expenses; a small leak will sink a great ship.”5