David McGuire is a leading expert on cost segregation, fixed assets and depreciation law and a co-founder of McGuire Sponsel.
Business owners often hear about benchmarking. Go to any management conference in any field, and you will likely hear multiple discussions on various benchmarking practices. While benchmarking can be a powerful tool to understand best practices and do comparative analyses, it also can lead to bad conclusions if the wrong information is compared.
Years ago, I met with a company to discuss its marketing practices and learned it had worked with a group to benchmark its spending on marketing to its competitors. When I asked what they were getting for their spending, they were not able to answer. This is an example of bad benchmarking, comparing prices only but not results.
Benchmarking can be easier to understand if you think of it outside the realms of business. Take new cars. The average new car in the fourth quarter of 2020 cost $40,107. If the only goal of having that information is to spend less on a car, a consumer might make a bad deal. Just knowing the average cost of a new car is $40,107, a consumer buying a car for $35,000 might think they got a great deal. However, if that consumer spent $35,000 to buy a car with a starting base price of $18,500, they obviously did not get a good deal. It is much more important to compare comparable cars that fit the needs of the consumer.
It gets more complicated in the business realm. The accounting industry tends to talk in terms of utilization and realization. Utilization is the hours an employee bills divided by their total number of available workable hours. For example, an employee who bills 1,600 hours out of 2,000 hours is 80% utilized. Realization is the rate per hour a firm makes on a specific project compared to its billing rate. Take a CPA firm with a $250 hourly billable rate. If a job takes 10 hours and it bills $2,500, it would have a realization rate of 100% (10 hours at $250 per hour). However, if it can only bill $1,250 for that job, the realization rate would be 50%.
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This is where benchmarking comes into play. Often firms will value realization over utilization or vice versa. However, when realization goes up, utilization often drops and vice versa. Spending too much time pushing utilization can cause employees to put more time into projects — on fixed-price work, this drops realization. The real metric firms should be looking at is revenue per employee.
This gets even more confusing when it comes to other aspects of business, like buying cyber insurance. How much cyber insurance does a company need? Simple benchmarking could lead to bad results. Because of resources, small tech companies often purchase policies with a $1 million per occurrence limit, while larger companies may purchase larger policies. But are they similarly protected? Not if the small company has a lot of records at risk. NetDiligence publishes a cyber claims study that shows the average cost per record in a cyber breach. This is a better benchmark to use to understand a company’s risk rather than the cyber insurance policies of other companies. By combining the cost per record with the total number of records, a more relevant calculation can be made to ensure adequate insurance coverage.
This example shows why benchmarking should be approached with caution: Understanding the end goal leads to better results. In the accounting scenario, profitability is the goal, and overreliance on benchmarking a utilization metric or a realization metric can cloud assessment of its profitability. A specialty practice may have an employee with a billing rate of $200 per hour. If that employee bills $300,000 per year utilizing 1,500 hours, that employee has a realization rate of 100% and a utilization rate of 75% (assuming a 2,000-hour year). Another employee with the same billing rate works 1,800 billable hours but can only bill clients $300,000 for their time, for a utilization rate of 90% and a realization rate of 83.3%. Overbenchmarking one metric over the other might make one CPA look better, but both employees billed the same amount at the end of the year.
For assessing cyber risk and other issues dealing with data, it is even more important to have the right information. Companies must have a base understanding of how much data they have, then use this information to benchmark against useful statistics in their industry. Many tools provide valuable insight and help companies accurately benchmark their risk needs.
To use benchmarking effectively, companies must consider their end goal. If the end goal is profitability, benchmarking must take that into consideration. If the goal is to reduce risk, it is more important for companies to understand their risk portfolio than to compare revenue between companies when assessing cyber insurance policies. As data analytics and artificial intelligence tools continue to grow, more benchmarking tools will become available. Businesses need to understand how to utilize these tools to grow bottom-line revenue.