Concepts to Consider When Comparing Your Business to the Industry

What business are you in? Most companies can answer this quickly and they readily know their six-digit NAICS code (North American Industry Classification System). Others might have to think about it. How do we define what business we are in?  Most companies decide their industry classification based on what they sell or provide to customers (service or products sold). Some decide based on how the company reaches the market (retail, distribution). Some  describe their industry segment based on where most of their profits or cash flow are derived while others use an industry code that their accountants put on their tax returns, which often is the incorrect industry classification code.

Some companies are easy to describe and some companies have more complicated business models. For example, if you manufacture kitchen cabinets, that is straight forward. If you are a distributor of dairy products, operate retail stores that sell men’s clothing or operate dental clinics, that too is straight forward. Problems arise if a company has two or more products or services or if they have a different business model typical of the industry. When comparing the company to the industry in these cases, will not be as useful unless we account for these differences. We suggest blending business classifications to define their business multiples and key operating and financial ratios. While not a precise science, the blended outcome is better than comparing 100% of the company to an industry where the company only has 60% of their sales. The sales or cash flow percentage is most practical to use.

Also See: THE FOUR VALUE DRIVERS OF A BUSINESS

Now that we developed a blended industry classification, we should have a mirror image of industry comparisons from which to measure operating and financial variances. Still, differences can still occur. Some companies might record an expense in the Cost of Goods Sold and many companies might report that same expense as an Operating Expense (also called Selling, General & Administrative Expenses). For example, I have seen real estate brokerage companies record brokerage commissions which are a big expense, in both Cost of Goods Sold and in Operating Expenses. Operating Expenses are fixed expenses and COGS are variable expenses that typically increase or decrease with sales. There is no right or wrong when allocating expenses. It is usually best to allocate expenses in a manner that allows management to better understand their numbers and manage the business. There may be an expense allocation issue between the company and the industry, which will become apparent when reviewing industry comparables.

When looking at your business, other things might impact your industry classification. I worked with an auto parts manufacturer that had almost 70% of their sales in manufacturing a specific auto part, however 30% of their sales was performing a specialized plating process that accounted for 65% of the company’s profits. The company could be defined as an auto parts manufacturer or a plating company depending on if you define a company by its revenue segments or by the profitability of those revenue segments.

Leasing and owning assets will differ also. Companies can own assets like buildings, equipment, trucks and other fixed assets, or they can lease them. By owning the assets, companies capitalize their assets on the balance sheet and depreciate them over time which is reflected as an Operating Expense. Companies that lease assets typically have the lease expense in the Operating Expenses and no debt on the balance sheet. The leverage factor (liabilities) is if leases are an Operating Lease or a Capital Lease (lease is capitalized on the Balance Sheet.

SO, WHAT DOES THIS ALL MEAN?

Spend a few minutes thinking about your company’s industry classification and if appropriate, select a few codes that represent your business. When reviewing the company-to-industry variances, remember that other metrics might help explain the variances. Consider these variances, but the best comparison is the company’s latest year compared to the company’s optimal past achievements in each category. This is a solid comparison that sheds light on what the company can achieve since it has already achieved this in the past. But keep an eye on the industry variances too, they can add some depth to the conversation.