Mgmt 469 Benchmarking and Regression

There are many definitions of benchmarking. For example, The

Benchmarking Network, an organization of benchmarking specialists,
defines benchmarking as, a performance measrement tool sed in
con!nction with impro"ement initiati"es to measre comparati"e operating
performance and identify best practices.# This definition sggests that
benchmarking in"ol"es the following se$ence of acti"ities%
&'( )easre comparati"e operating performance
&*( +dentify best practices
&,( +nstitte impro"ement initiati"es
-teps &'( and &*( sggest that regression can be a "alable tool for
benchmarking, becase regression allows s to identify how practices &the .
"ariables( affect performance &the / "ariable(. +n particlar, best practices
are those that impro"e performance the most.
The Benchmarking Regression
0 benchmarking regression shold look something like this%
1 2 3
4
5 3
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.
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5 3
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.
*
5 B
,
.
,
5 6 5 noise
7here 1 is some measre of performance, and .
'
, .
*
, .
,
, etc. are "arios
characteristics of the firm and its processes. The coefficients 3
'
, 3
*
, 3
,
, etc.
indicate whether the . "ariables are positi"e or negati"e determinants of
performance.
8et9s examine the benchmarking regression in more detail.
Unit of Observation
Benchmarking stdies can be performed across firms, work nits, or e"en
indi"idals. 0n indstry analyst might examine in"entory costs across a
sample of parts sppliers to the ato indstry &the nit of analysis is the
firm(. 0 $ality control manager at +ntel might examine chip failre rates
across chip fondries &the nit of analysis is the fondry(. 0 hman
resorces manager at 0T5T cable might compare cstomer call times across
cstomer ser"ice representati"es &the nit of analysis is the worker(.
The Benchmarking Sample
The se of regression has a "ery simple implication for sample selection%
/o belie"e that the nderlying model predicting for the comparison sample
is the same as for the firm in $estion.
By implication, yo belie"e that the 39s are the same for all the firms,
inclding the one in $estion
0n easy test to see if this holds%
: /o start with a sample of firms that yo are $ite certain belong in
the comparison grop
: -ppose there is a grop of firms yo are considering adding to the
sample to impro"e the precision of yor estimates.
: ;etermine if the slopes of the key predictors are the same for this
new grop as they were for the initial grop. /o do thisas follows%
'( <reate a dmmy "ariable for the new grop of firms
*( 0dd slope dmmy# interactions to the regression
,( Test the slope dmmies &bt not the dmmy intercept( for !oint
significance.
Performance Measures
The list of possible performance measres is "irtally nlimited. 0t the firm
level, one can examine o"erall profitability &measred as =>0, =>-, etc.(
>ther firm le"el performance measres inclde "arios acconting ratios
&e.g., administrati"e expense ratio( and worker prodcti"ity &otpt per nit
of labor(. Product level measres of performance inclde nit costs or
market shares. /o shold choose performance measres that are important
and within the control of managers. There is no need to always examine
profits. +f yo can impro"e performance at a particlar task, profits will
follow.
*
Predictors
1redictors inclde "ariables that are within the control of managers &e.g.
prodct offerings( and those that are not &e.g. local market conditions(. +n
constrcting yor list of predictors, think abot trying to identify the Key
Success actors.
'
The regression coefficients indicate which of the chosen
"ariables really do predict sccess.
!mportant Takea"ay# Regression coefficients in a benchmarking
study help identify the Key actors for Success
-ppose that yor regression identifies se"eral key sccess factors. 7hat do
yo do with this information? 1resmably, yo are stdying the
performance of a particlar firm. @ere is how to se this information to help
that firm.
&'( <ompare the characteristics of that firm with the key sccess
factors. @ow does it score?
&*( +f it is lacking one or more key sccess factors, then perhaps it
cold impro"e its performance by adopting them.
&,( The regression coefficients are a good measre of the potential
impro"ement.
'
1lease refer to The $conomics of Strategy for a definition and examples.
,
The Residual
The residal in a regression is the difference between the actal "ale and
the predicted "ale. +n a regression of firm performance, the residal is the
difference between actal and expected performance.
7e can se this concept to help identify firms that are not meeting
expectations.
Begin by rnning a regression where the predictors are A-Fs that are trly
exogenos to the manager B factors otside the manager9s control. These
might inclde the choice of indstry, extent of competition, and local labor
market conditions. 1rodct choices may also be considered otside the
manager9s control, at least in the short rn.
The difference between actal and predicted performance B the residal B
represents the extent to which the firm is exceeding or lagging expectations,
gi"en its en"ironment.#
Now add A-Fs that are within the manager9s control. The coefficients on
these "ariables will reflect how they contribte to performance at the
a"erage firm. By examining how yor firm performs on these A-Fs, yo
can assess the extent to which management is scceeding or failing on these
areas that are nder its control.
The %&eficiency Score'
-ppose that yor hospital has costs that exceed the mean by C'444. +n
other words /
i
B /
m
2 '444. +t is possible to decompose this into
component parts.
=ecall that /
i
2 B.
i
5 D
i
0lso note that /
m
2 B.
m
7e can write /
i
B /
m
2 B.
i
5 D
i
: B.
m
2 B&.
i
:.
m
( 5 D
i
+n other words, the difference between yor performance and the mean can
be broken down into two components%
E
The difference between yor firm and the a"erage firm on the A-Fs,
mltiplied by the corresponding B9s, and the error term.
This sggests the creation of the following table%
1redictor .
i
.
m
.
i
:.
m
3 3&.
i
:.
m
(
A-F '
A-F *
Total : : : :
3&.
i
:.
m
(
This allows yo to eyeball the specific A-Fs that contribte to the relati"e
performance deficiency of yor firm.
Back to the Residual
The "ale 3&.
i
:.
m
( measres the extent to which firm performance exceeds
or falls short of expectations based on each A-F. The residal, or
/ : 3&.
i
:.
m
(, measres the extent to which firm performance differs from
expectations.
*
@ere is how to combine the deficiency score with
consideration of the residal to gain a fller nderstanding of performance.
'( -tart with a regression that contains only exogenos predictors.
*( <ompte the ;eficiency -core for each predictor and the residal.
These tell yo how factors otside of management9s control are
affecting performance, and how the firm is doing, holding those
factors constant.
,( =n a regression that incldes exogenos and endogenos
predictors &i.e., those the manager can control.(
E( =ecompte the deficiency scores and residal. /o now ha"e
estimates of how factors nder the managers control affect
performance, based on their a"erage effect at all firms.
*
+f yo take the log of the 8@- "ariable, yo will need to make the log ad!stment described in an earlier
lectre to obtain the correct residal.
F
The residal in any regression captres a combination of pre noise pls
omitted factors. +f a firm is nderperforming expectations &e.g., the residal
in a profit regression is negati"e(, then this is either becase of random
chance or omitted factors. >ne candidate for that omitted factor%
managerial competence. +n other words, if a firm is nderperforming
expectations, we might well consider whether management is to blame.
+t trns ot that this interpretation of the residal is contro"ersial in some
economic circles. This interpretation re$ires two assmptions%
'( There is a distribtion of managerial competenceG i.e., managers
can and do make mistakes.
*( The empirical model predicting performance is free bias. 7hat if
the firm has high costs becase it is located in a region where the
labor pool lacks proper training? 0 regression that fails to control for
training wold sffer from omitted "ariable bias. /o wold not
want to chalk this p to incompetence.
Key Success actors vs( !ncompetence
Halable benchmarking regressions shold inclde a comprehensi"e list of
predictors. 0s yo add predictors to yor benchmarking stdy, the =
*
will
increase, and the dispersion of the residals will decrease. /o will be able
to explain more and more of the difference in firm performance on the basis
of the A-Fs.
Bt as long as there is some nmeasred managerial competence, the =
*
will
ne"er e$al '. &)oreo"er, if some A-Fs are endogenos factors nder the
manager9s control, yo can interpret those as reflecting management
competence.(
>nce yo ha"e a robst model, yo can explain performance "ariation de to
key sccess factors &exogenos and endogenos( and residal managerial
competence.
)onclusion# Relative performance is determined by key success factors and
managerial competence( Regression gives you the tools to measure both(
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