Are You Using the Right Economic Benchmarks for Your Business?
Tuesday, August 16th, 2011
The Bureau of Economic Analysis recently released its estimate of second quarter GDP for 2011. The number came in at +1.3%. Nearly all business owners immediately compared their performance against that to see how their business was doing versus the economy. Some felt good about their performance, some felt bad. Every business owner was wrong. Here's why.
First – why do we compare our business to national economic data?
We like comparing business performance against macroeconomic data because those data tell us how the entire economy is doing, and they are perceived to be fair and objective. We're all affected by these data and how they are used by businesses and consumers in the decisions that they make, especially within the financial system and government.
In some cases, when our customers are very large multinational corporations, insights into the general economy can give us a heads-up regarding what their plans for spending might be on the products we sell.
Second – should we compare at all?
Of course businesses should compare themselves to these general data. The question is how much weight to give those comparisons in business decisions. In most cases, surprisingly, they should be given very little weight. Businesspeople always like to know if what they are seeing in their business is what's going on in the general economy, but that's as far as the analysis should really go. There are more important comparisons, such as comparisons to competitors and to your own previous performance.
Third – what's the right way to compare?
Economic data are subject to more revisions than most businesspeople realize. Those revisions often occur years after the original reports were issued.
Also, most of the economic information is not adjusted for the effects of inflation. One exception is the report of Gross Domestic Product (GDP), which is the value of all goods and services produced by the economy for a defined period of time. It's called real GDP when the effects of inflation have been removed. Here's a first rule of thumb: post-WW2 average real GDP is about +3.4%. But that does not include inflation. Since that time, inflation has averaged +3%. So for a business to keep up with the historical averages, it has to grow, on average, +6.5% per year to stay even with this multi-decade average. (This is obviously difficult, especially in a market when overall demand is declining. Companies change their product offerings, add new products, add sales personnel, or seek share gains from competitors to attain this kind of growth rate.)
So many businesses are incorrectly comparing their businesses, tracked in current dollars and not adjusted for inflation, against real GDP. If they hear that GDP went up +3% on a news broadcast, and their company was up the same amount, and they're happy, they're actually wrong.Unless you adjust your business financial data for inflation, you're comparing apples to pebbles. They are quite different. Business executives know about inflation, but they are often unaware of how to adjust their internal reporting for it. Sometimes they do not know where to find current GDP because the business media often do not report it, mainly because of time or space issues in their publications or on their broadcasts.
Fourth – what should we compare against?
At best, companies should always compare themselves against their prior performance, their competitors, and their industry. If they are a geographically related business, most national economic data do not apply to the comparison, but some economic data are available on a statewide basis. There is a GDP report by state, for example, but it is often released months after the data might be useful for decision-making.
Managers should also develop a sense of market share for their trading area, whether that's geographic, by market segment, or by product class. Share of the customer's total budget is also important. These are not often available, of course, and are often subject to positive or negative embellishment. The general and relatively quick availability of national economic data are attractive in comparison.
Fifth – what should we do about it?
Make sure you're using the right data. Is it adjusted for inflation, or not? Is your company data adjusted for inflation, or not?
How to Adjust Your Data for Inflation
Comparing current dollar data against inflation-adjusted data (or “real” data) is an obvious problem. The table below shows how to adjust your company historical data for inflation. For example, take your 2005 income statement and multiply it by the factor below; do the same with the corresponding factor for all of the other years. This way, when you look at trends in your business, you'll see the real trends: it may not be pretty, so be prepared for things to look strange.
Now what? For the first time you are looking at your business in terms of the purchasing power that those dollars had at that time. When companies do this exercise, sometimes what they thought was mild growth turns into a decline. What was thought to be breakeven is now a loss. It's the reality of what has happened to the value of money for many reasons. Staying ahead of inflation is essential. To not go through this exercise only invites trouble.
One of the questions I often get is about printing prices. I'm asked how this calculation is valid when printing prices have been flat or declining. There is no inflation in printing prices, for all practical purposes, and we all know that. But we don't spend printing prices at the supermarket. We have to create enough money in our businesses for ourselves and employees to be able to afford the goods in the marketplace at those prices. I know we'd like the special treatment of walking into a store and saying, “I'd like the prices you had in 2005 since printing prices have not gone up,” but that's not possible.
Comparing Performance with GDP
Gross Domestic Product is reported in the business headlines as real GDP, which has been adjusted for inflation. Of all of the major dollar-denominated data series, it is the only one in that format. You have to read deep into the press releases from the government agencies to see current GDP or real data of the other series.
If the whole idea of inflation-adjustment seems like a problem, and you want to compare your business to the general economy, look for current GDP. One of the issues is that GDP can jump around from year to year, so it's usually wise to take an average over time.
The table below (click to enlarge) has GDP data since 2005. Note that since 2005, the economy has grown on an average annual basis of +3.42% in current terms. If you adjust your company information for inflation, then the average GDP since 2005 has been just +1.18% in real terms.
Who Wants to be Just Average?
None of these are really satisfactory if you want to have a thriving business. Growth is important because it is an indication that your business is staying ahead of competitors and is adjusting to changes in the marketplace. Getting that growth profitably, of course, is a primary management challenge.
Remember, the long-run growth rate of GDP is +3.4% on a real basis and between +6% and +6.5% when inflation is included. Those are better goals than we have had recently, especially when those growth rates compound over the years. Averages include the activities of failing businesses, and comparing with those enterprises does not require any courage.
Comparing with Industry-specific Data
From government sources, only very aggregate industry total data are available. Because they relate to the industry for the entire country, it's not always applicable to what's happening in a specific geography. Nonetheless, it's still an independent benchmark to use.
If your business is in a trade association for your industry, it is likely that they have financial ratios and business conditions surveys that can be very worthwhile. Be sure to participate in them. They are worth the time to do so.
Financial ratios data need to be kept in perspective. Despite some methodological concerns that are basically of interest only to statisticians (if you keep in mind that all research is flawed in some manner, shape, or form, and is only a picture of the marketplace at one particular point in time, this should not spook you), these data come in quite handy. Financial ratios data only give the results of business decisions, but do not report the specific actions taken. This means that using ratios alone puts the manager in a situation somewhat like the fable of the blind men and the elephant. Ratios are essential tools, but have to be used in context with other data. Our industry is fortunate to have such a long-term data series available
Member business surveys also have a methodological concern. Most membership survey have a degree of membership bias to them. This does not mean the surveys are bad, because all research surveys have respondent bias and non-respondent bias, and they are each almost impossible to precisely measure. A good research practitioner knows this, and will compare results with other surveys and government data when available. The area of statistical bias in member surveys is one of participation. It has consistently been shown that trade association members have better financial results. Why? Is it because they get value from the membership and use those resources in their business, or is it because companies that cannot afford the membership fees are not included in the surveys? Or is it that companies in trouble don't have the time to participate in the surveys or don't want to admit what their business conditions really are? Research is a tough business.
So just beware that some of the association data may be biased in favor of better run companies. For that reason, they are likely to indicate an industry downturn later than it actually occurs, and show an upturn sooner than it occurs for everyone else. If your business consistently runs ahead of the important trends and financial conditions of your industry, that's great.
Putting it All Together
Judging the performance of a business is usually first focused on its bottom line, its comparison against the economy, and its comparison against competitors. As much as having one single benchmark for assessing performance would be attractive, it's not wise. Look at your business from all of its sides.
Most of all, when you are comparing against macroeconomic data, make sure you are using the right data when it is in dollars. Using inflation-adjusted data helps give a better, but not perfect, comparison over many years. Ask your accountant to report important company data, especially when preparing year-to-year comparisons for budgeting and sales trends, to inflation-adjust the data to add an additional perspective to your decisions.