The Economic and Social Review, Vol. 29, No. 2, April, 1998, pp. 201-208
Benchmarking Company Profitability and
Growth: Some Measurement Issues for Small
F i r m s i n Ireland*
N O L A H E W I T T - D U N D A S S T E P H E N ROPER
Northern Ireland Economic Research Centre, Belfast
Abstract: International comparisons of productivity, purchasing power and inflation can depend crucially on differences in national statistical procedures. T h i s paper indicates that even in more localised comparisons of small firm performance, differences in accounting practice can have an important distortionary effect. I n particular, the tendency for small firms in Northern Ireland to under-value grant assisted asset purchases may be inflating asset based profit measures.
T h i s under-valuation is shown, however, to explain only part of the difference between the efficiency of asset utilisation in Northern Ireland and the Republic of Ireland. By contrast small firms in the Republic of I r e l a n d had higher levels of both sales per employee and profit per employee.
I I N T R O D U C T I O N
I
t has long been recognised t h a t i n t e r n a t i o n a l comparisons of productivity, p u r c h a s i n g power a n d i n f l a t i o n depend c r u c i a l l y on differences i n n a t i o n a l s t a t i s t i c a l procedures a n d currency c o n v e r s i o n .1 E v e n i n morelocalised comparisons, however, differences i n f i r m s ' o p e r a t i n g e n v i r o n m e n t can make comparisons difficult. I n t h i s note we h i g h l i g h t a n u m b e r of issues r a i s e d by a project designed to b e n c h m a r k t h e p r o f i t a b i l i t y a n d g r o w t h performance of s m a l l f i r m s i n N o r t h e r n I r e l a n d and the Republic of I r e l a n d .
• T h i s project was funded from the support given by the E U Special Programme for Peace and Reconciliation to C A M Benchmarking L t d . We are grateful for this support and to the companies which agreed to take part in the B e n c h m a r k i n g exercise. We are also grateful to B r e n d a n M c F e r r a n ( C A M Benchmarking Ltd); Donal D u r k i n ( L E D U ) and Peter McCarron ( I D B ) for their help with the study.
M o r e specifically we consider the i m p a c t on the relative p r o f i t a b i l i t y , g r o w t h and asset u t i l i s a t i o n of s m a l l f i r m s of differences i n accounting practice.
T h e m o t i v a t i o n for the comparisons originated from a desire on the p a r t of d e v e l o p m e n t agencies t h r o u g h o u t I r e l a n d to promote s m a l l f i r m g r o w t h (Government of I r e l a n d , 1994; D e p a r t m e n t of Economic Development, 1990). S m a l l companies, w i t h less t h a n 100 employees account for around a t h i r d of m a n u f a c t u r i n g e m p l o y m e n t i n I r e l a n d , b u t " r e l a t i v e l y few s m a l l f i r m s graduate i n t o the r a n k s of m e d i u m or large companies" ( G u d g i n et al., 1989, p. 64). The need to identify those companies w i t h significant g r o w t h potential led to a j o i n t b e n c h m a r k i n g i n i t i a t i v e between the Local Enterprise Develop m e n t U n i t ( L E D U ) and the I n d u s t r i a l Development Board ( I D B ) i n N o r t h e r n I r e l a n d and F o r b a i r t i n the Republic of I r e l a n d .
I I C O M P A N Y B E N C H M A R K S A N D M E A S U R E M E N T ISSUES A major element of t h i s j o i n t i n i t i a t i v e — called the Competitive A n a l y s i s M o d e l ( C A M ) project — has been t h e e s t a b l i s h m e n t of a database of p e r f o r m a n c e b e n c h m a r k s for d e v e l o p i n g companies t h r o u g h o u t I r e l a n d ( M c F e r r a n et al., 1996). T h i s was based on an extensive i n t e r v i e w survey conducted between A p r i l and September 1995 w h i c h led to a final sample of 703 s m a l l i n d e p e n d e n t l y o w n e d c o m p a n i e s .2 Response r a t e s differed
s i g n i f i c a n t l y between N o r t h e r n I r e l a n d (52 per cent) and the Republic of I r e l a n d (28 per cent) c o n t r i b u t i n g to a sample biased t o w a r d s N o r t h e r n I r e l a n d companies.3 As p a r t of the survey detailed information was sought on
f i r m s ' p r o f i t a b i l i t y , g r o w t h a n d asset u t i l i s a t i o n d u r i n g the 1991 to 1994 business years. V a l u e s for each measure are g i v e n i n Table 1, w h i c h also r e p o r t s t h e r e s u l t s o f M a n n - W h i t n e y tests for the independence of t h e N o r t h e r n I r e l a n d and Republic of I r e l a n d samples, i.e., w h e t h e r the samples are — i n s t a t i s t i c a l t e r m s — l i k e l y to have come from the same u n d e r l y i n g d i s t r i b u t i o n (population) of profitability or g r o w t h r a t e s .4
2. To be included in the survey, firms had to be manufacturers, employ between 10 and 100 workers, be trading for at least four years and be thought by the development agencies to have significant growth potential (as identified by the development agencies). T h e survey was therefore biased towards the most dynamic companies within the relevant population. F r o m an initial sample of 1,853 firms, usable responses were obtained from 406 firms in Northern Ireland and 297 firms in the Republic of Ireland.
3. T h e sample bias towards Northern Ireland firms reflected primarily a greater level of encouragement for firms to participate by the Northern development agencies. See B a r k h a m et
al. (1996) for a survey of the performance characteristics of Northern Ireland firms compared to
some other U K regions, and Gudgin et al. (1995) for an overview of the relative performance of the small business sectors in Northern Ireland and the Republic of Ireland.
Table 1: Relative Profitability, Growth and Asset Utilisation of Small Firms in Ireland: 1991-1994
n
Lower Quartile
Limit Median
Upper Quartile
Limit Mean
1. Return on Sales (% of turnover)
Northern Ireland 294 2.4 5.6 10.2 6.9
Republic of Ireland 131 2.9 4.9 10.0 6.8
2. Return on Assets (% of net worth)
Northern Ireland 264 9.1 22.5 42.9 27.1**
Republic of Ireland 126 8.1 13.8 22.2 17.9**
3. Profit per Employee (£'000 Stg. per employee)
Northern Ireland 275 1.0 2.0 5.1 3.5**
Republic of Ireland 133 1.2 2.9 6.2 4.7**
4. Sales Volume Growth (% per year)
Northern Ireland 324 1.0 8.3 17.6 11.5
Republic of Ireland 173 0.3 6 12.6 8.3
5. Employment Growth (% per year)
Northern Ireland 302 -1.9 2.6 12.5 5.7
Republic of Ireland 184 0.0 3.5 10 5.1
6. Turnover to Asset Ratio
Northern Ireland 280 3.0 4.6 8.8 3.6**
Republic of Ireland 141 1.9 2.8 4.0 2.2**
7. Turnover per Employee (£'000 Stg. per year)
Northern Ireland 302 25.5 41.0 62.6 56.9**
Republic of Ireland 173 33.4 55.4 96.5 85.1**
Notes:
L Profit for each business year was measured by firms' net profit on trading activities before bank interest and tax and excluding a l l extraordinary items (e.g., the sale of capital equipment).
2. Return on sales expresses net profit as a percentage of sales turnover. Return on assets is net profit as a percentage of net worth. Profit per employee is (real) net profit (in £'000) per person employed. Net profit figures were converted into 1994 prices using the producer price index and converted to sterling using an exchange rate of 1.0233 (Source: Financial
Statistics, C S O , December 1995, Table 7.1A).
3. Sales volume is defined as turnover (less any discounts given) deflated by the national rate of producer price growth. F o r Northern Ireland this implied a price increase of 6.75 per cent from 1991-1994 (Source: Economic Trends, Table 3.1). F o r the Republic the implied price increase was 7.54 per cent (Source: Economic Series, November 1995, p. 15). Employment growth relates to the total number of employees. No allowance is made for any change in part-time employment.
4. T h e turnover to asset ratio expresses turnover as a multiple of net assets or net worth. 5. Independence of the Northern Ireland and Republic of Ireland samples was tested using the
Mann-Whitney test. **indicates non-rejection of the hypothesis of independence at the 5 per cent level.
The d i s t r i b u t i o n s of r e t u r n on sales, sales volume g r o w t h and employment g r o w t h rates were very s i m i l a r among s m a l l firms i n N o r t h e r n I r e l a n d a n d the Republic of I r e l a n d . B y contrast, the d i s t r i b u t i o n s of profit per employee and r e t u r n on assets were significantly different as i l l u s t r a t e d by the M a n n W h i t n e y test statistics (Table 1). M e a n and median rates of r e t u r n on assets were h i g h e r (by 5 1 and 56 per cent respectively) a m o n g s m a l l firms i n N o r t h e r n I r e l a n d , r e f l e c t i n g h i g h e r average levels of t u r n o v e r per u n i t of assets. B o t h m e d i a n and mean t u r n o v e r to asset ratios i n N o r t h e r n I r e l a n d were 64 per cent h i g h e r t h a n t h e i r s o u t h e r n equivalents. T u r n o v e r per employee, on the other h a n d , tended to be higher i n the Republic of I r e l a n d leading to higher profit per employee (see Table 1).
These contrasts may reflect differences i n s m a l l business performance or differences i n firms' o p e r a t i n g e n v i r o n m e n t or accountancy practices. I n the measurement of profit, for example, i t is i m p o r t a n t to use pre-tax indicators as business tax rates and thresholds differ between N o r t h e r n I r e l a n d and the Republic of I r e l a n d . S i m i l a r l y , as the interest rates available on deposits and those charged by banks can also differ between the t w o areas i t is preferable to use a measure o f t r a d i n g profit r a t h e r t h a n an i n d i c a t o r w h i c h includes i n v e s t m e n t income or takes account of interest charges. The profit i n d i c a t o r used i n the benchmarks was therefore f i r m s ' net profit on t r a d i n g activities before b a n k i n t e r e s t and t a x and excluding a l l e x t r a o r d i n a r y items (e.g., the sale of c a p i t a l equipment). E v e n t h i s profit measure, however, is subject to u n c e r t a i n t i e s r e l a t i n g to directors' r e m u n e r a t i o n / d r a w i n g s and the account ing approaches w h i c h firms use to take account of capital grants.
I n large firms, or i n s i t u a t i o n s where a s m a l l f i r m ' s directors are not employees of t h e company, directors' d r a w i n g s or r e m u n e r a t i o n w i l l be included i n net profit. I n s m a l l firms, the directors of a business may also be employees. I n t h i s s i t u a t i o n , the directors of a business may choose to draw-out money e i t h e r as wages/salaries or i n the form of directors' d r a w i n g s or r e m u n e r a t i o n . I n the former case, net profit w i l l be reduced, i n the l a t t e r , the s i t u a t i o n w i l l reflect t h a t i n larger firms and, net profit w i l l be unaffected. Ex post i t is impossible to determine how an i n d i v i d u a l s m a l l f i r m is d e t e r m i n i n g t h e s p l i t b e t w e e n wages and salaries a n d d r a w i n g s , r e s u l t i n g i n some
u n c e r t a i n t y i n the measurement of net profit. There is no reason, however, to a n t i c i p a t e any systematic difference between the approaches being adopted by s m a l l firms i n N o r t h e r n I r e l a n d and the Republic of I r e l a n d .
I n N o r t h e r n I r e l a n d a r o u n d h a l f o f a l l m a n u f a c t u r i n g f i r m s also adopt t h i s approach (Roper, 1993). The r e m a i n i n g N o r t h e r n I r e l a n d f i r m s adopt a net cost approach i n c l u d i n g new assets i n t h e i r balance sheet at purchase value less any g r a n t received. They t h e n depreciate t h i s smaller value. T h e i m p a c t of t h i s difference is twofold. F i r s t , the average book value of f i r m s ' assets i n N o r t h e r n I r e l a n d is l i k e l y to be lower t h a n t h a t i n t h e Republic o f I r e l a n d . Second, t h e t i m e - p r o f i l e o f c a p i t a l g r a n t receipts on t h e n e t p r o f i t o f a n i n d i v i d u a l f i r m w i l l be more h e a v i l y front-loaded i n N o r t h e r n I r e l a n d .5 I n
aggregate t h e former of these t w o effects is l i k e l y to be most i m p o r t a n t , r e d u c i n g asset values i n N o r t h e r n I r e l a n d a n d i n t r o d u c i n g an u p w a r d bias i n t o asset-based profitability and efficiency measures.
Because o f i t s p o t e n t i a l significance i n t h e i n t e r p r e t a t i o n of t h e p r o f i t a b i l i t y ratios i t is i m p o r t a n t to t r y to q u a n t i f y — at least i n broad t e r m s — t h e l i k e l y scale of any asset u n d e r - v a l u a t i o n i n N o r t h e r n I r e l a n d . Suppose, for example, t h a t a l l asset purchases by s m a l l firms i n N o r t h e r n I r e l a n d were g r a n t - a i d e d at 40 per cent. T h e n , as a r o u n d h a l f of N o r t h e r n I r e l a n d firms were u s i n g the net cost approach, the u n d e r e s t i m a t i o n of the t o t a l asset value w o u l d be 20 per cent. I n practice, however, the t r u e level of u n d e r - v a l u a t i o n is l i k e l y t o be l o w e r t h a n t h i s because average c a p i t a l g r a n t r a t e s are t y p i c a l l y m u c h lower t h a n 40 per cent and because only a p r o p o r t i o n of asset purchases by s m a l l firms are g r a n t assisted. F r o m 1991-1994, for example, only 30.1 per cent of N o r t h e r n I r e l a n d s m a l l firms received any support for investments i n p l a n t , machinery and equipment ( M c F e r r a n et al., 1996).
F r o m the p r o f i t a b i l i t y and g r o w t h figures i n Table 1 i t is possible t o derive t h e e x t e n t o f asset u n d e r - v a l u a t i o n t h a t w o u l d be necessary to reduce t h e r a t e of r e t u r n on assets and t u r n o v e r per u n i t of assets i n N o r t h e r n I r e l a n d to t h a t i n t h e Republic of I r e l a n d . For example, assets w o u l d have t o be under v a l u e d by 33.8 per cent to reduce the p r e v a i l i n g r a t e of r e t u r n on assets i n N o r t h e r n I r e l a n d (27.1 per cent) to equal t h a t i n the Republic of I r e l a n d (17.9 per cent). S i m i l a r l y , a 39.0 per cent u n d e r - v a l u a t i o n of assets w o u l d be r e q u i r e d to reduce the t u r n o v e r per u n i t of assets r a t i o i n N o r t h e r n I r e l a n d (3.6) to t h a t of the Republic of I r e l a n d (2.2). I n b o t h cases t h i s is considerably greater t h a n the level of asset u n d e r - v a l u a t i o n w h i c h is l i k e l y , as seen above. T h e i m p l i c a t i o n is, therefore, t h a t only p a r t of the d i f f e r e n t i a l between the r a t e o f r e t u r n on assets a n d the t u r n o v e r to asset r a t i o i n N o r t h e r n I r e l a n d a n d t h a t i n t h e Republic o f I r e l a n d could be e x p l a i n e d by asset under v a l u a t i o n , i.e., even a l l o w i n g for asset u n d e r - v a l u a t i o n both ratios w o u l d s t i l l be h i g h e r i n N o r t h e r n I r e l a n d . A s i n d i c a t e d earlier t h i s contrasts s t r o n g l y
w i t h h i g h e r t u r n o v e r per employee a n d profit per employee i n Republic o f I r e l a n d s m a l l f i r m s .
T h e q u e s t i o n t h e n is w h e t h e r these r e m a i n i n g differences c a n be a t t r i b u t e d t o differences i n sample composition or other aspects o f f i r m s ' c h a r a c t e r i s t i c s . F o r e x a m p l e , r e f l e c t i n g differences i n t h e u n d e r l y i n g populations, a l a r g e r p r o p o r t i o n of the Republic of I r e l a n d sample was i n mechanical and electrical engineering and food processing. I n the case of food processing, i n p a r t i c u l a r , t u r n o v e r per employee w o u l d be expected to be h i g h e r t h a n t h e average for a l l m a n u f a c t u r i n g b u t p r o f i t m a r g i n s w o u l d t y p i c a l l y be below average. For example, sales per employee i n the I r i s h food, d r i n k a n d tobacco sector i n 1995 was £IR245,645 as compared to £IR161,898 for a l l m a n u f a c t u r i n g i n d u s t r i e s .6 P r o f i t a b i l i t y was, however, l o w e r i n t h e
I r i s h food, d r i n k a n d tobacco sector, at 4.3 per cent of sales, as compared to t h e average o f 6.2 per cent for a l l m a n u f a c t u r i n g f i r m s .7 G i v e n t h e s l i g h t l y
h i g h e r c o n c e n t r a t i o n o f food processing f i r m s i n the Republic of I r e l a n d sample i t w o u l d be expected t h a t t h i s w o u l d reduce the t u r n o v e r to asset d i f f e r e n t i a l between t h e N o r t h e r n I r e l a n d a n d Republic of I r e l a n d samples. Y e t , t h i s was not found w i t h the i m p l i c a t i o n being t h a t sample composition was not an i m p o r t a n t factor i n e x p l a i n i n g the performance ratios.
I t is also possible t h a t differences i n c a p i t a l i n t e n s i t i e s between t h e N o r t h e r n I r e l a n d a n d Republic of I r e l a n d firms could help to e x p l a i n the r e t u r n on assets and profit per employee d i f f e r e n t i a l s .8 Unfortunately as data
was only collected on net assets, no accurate assessment of fixed and w o r k i n g c a p i t a l could be made to relate to labour i n p u t s . On-going analysis however, suggests t h a t i n v e s t m e n t p a t t e r n s a n d t h e age of c a p i t a l e q u i p m e n t are r e m a r k a b l y s i m i l a r for N o r t h e r n I r e l a n d and Republic of I r e l a n d s m a l l firms (see H e w i t t - D u n d a s , 1998).
O t h e r c h a r a c t e r i s t i c s of the Republic of I r e l a n d a n d N o r t h e r n I r e l a n d samples suggest counteracting effects. For example, the share of firms' sales accounted for by new or i m p r o v e d products was greater i n t h e Republic o f I r e l a n d w h i c h , product life-cycle models w o u l d suggest is l i k e l y to increase profit m a r g i n s and firm g r o w t h rates ( K a y , 1979). I n neither case, however, was t h i s evident from the e m p i r i c a l comparisons (Table 1).
6. C S O , 1995. Census of Industrial Production, Table A, p. 11, Dublin: C e n t r a l Statistics Office.
7. Forfas, E n t e r p r i s e Policy and Planning Division, 1997, Irish Economy Expenditure Survey, Preliminary Results from 1994 and T r e n d s 1988-1994, Table 3, Forfas, Dublin.
I I I I M P L I C A T I O N S
I n t e r n a t i o n a l p r o f i t a b i l i t y and g r o w t h comparisons depend significantly on t h e r e g u l a t o r y a n d legislative regimes w i t h i n w h i c h f i r m s operate. E v e n i n l o c a l i s e d comparisons, such as t h a t between N o r t h e r n I r e l a n d a n d t h e Republic o f I r e l a n d , these issues are not u n i m p o r t a n t . I n p a r t i c u l a r , because of differences i n accounting practice, firms i n N o r t h e r n I r e l a n d t e n d t o u n d e r value assets relative to t h e i r counterparts i n the Republic of I r e l a n d . T h i s is a consequence o f t h e fact t h a t a r o u n d h a l f of N o r t h e r n I r e l a n d f i r m s include assets i n t h e i r balance sheet net of any government grants.
T h e effect of t h i s u n d e r - v a l u a t i o n is to d i s t o r t any r e l a t i v e p r o f i t a b i l i t y calculations w h i c h depend on asset values. I n the p a r t i c u l a r case considered here, however, a l l o w i n g for the differences i n asset v a l u a t i o n was insufficient to account for higher rates of r e t u r n on assets and t u r n o v e r to asset ratios i n N o r t h e r n I r e l a n d . O t h e r p r o f i t a b i l i t y indicators, less seriously affected by differences i n accounting practice, suggested t h a t p r o f i t per employee a n d t u r n o v e r per employee were h i g h e r i n t h e Republic o f I r e l a n d t h a n i n N o r t h e r n I r e l a n d . These contrasting strengths suggest the potential develop m e n t a l value of continued cross-border b e n c h m a r k i n g i n i t i a t i v e s . A n y such i n i t i a t i v e s m u s t , however, t a k e careful account o f possible d i s t o r t i o n a r y effects due to differing accountancy practice.
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