2001 ANNUAL FINANCIAL RATIOS.

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In theory, financial benchmarks are a good way to measure how well a company takes common "raw materials"--the pool of available employees, basic technology, shared marketing channels, investment dollars, and the like--and transforms these ingredients into profits. Companies that use their raw materials well usually beat the benchmarks; inefficient companies tend to produce results that are below average. Nothing complicated here.

Trouble is, it's no longer clear which benchmarks we should use to measure corporate performance. In previous versions of our Annual Financial Ratios report, we simply looked at how a broad sample of public software companies spent money on marketing, R&D, and other traditional expense items. Increasingly, however, this formula seems to make red ink an acceptable standard of performance, which hardly makes economic sense. The alternative is to weight the benchmarking process by revenues and marketplace success--which means, in practical terms, that Microsoft's ratios become the standard by which all other software companies are measured. Again, that's not a comfortable conclusion.

This isn't just an academic quibble over methodology, either. During fiscal 2000, the 52 public software companies in our benchmarking universe generated a median operating loss of -2.8% of sales, while Microsoft finished the year with a hefty 48% profit on operations. And Microsoft operated more efficiently than most other companies in every key financial category. Microsoft spent just 4% of its revenues on G&A, for instance, while the rest of the industry spent 14% (median). In sales and marketing, Microsoft spent less than half as much as other companies (18% vs. 46% median) yet obviously didn't suffer from lack of visibility. The efficiency differences in other areas, such as COGS and R&D, were less dramatic but nevertheless significant in terms of benchmarking standards.

To be sure, Microsoft isn't entirely in a league of its own. It's worth noting that several companies last year managed to achieve near- Microsoft performance in at least a few benchmarking categories. Citrix and Adobe were almost as profitable as Microsoft, Symantec and SPSS managed to keep G&A almost as low, and four companies (Intuit, Phoenix Technologies, OnTrack Data, and Timberline) last year spent less than 25% of their revenues on marketing. Clearly, there's some middle ground between Microsoft's hyper-performance and the money-losing standards that prevail in much of the software industry these days.

There's no question, of course, that using Microsoft's numbers to measure the performance of small, struggling companies seems unfair. But is fairness really an issue in benchmarking? Customers and investors certainly have never been willing to apply a double standard to corporate performance: They expect smaller companies to operate as efficiently in their own market niches as Microsoft does in the mass market space. The market also lets managers make tradeoffs: Some companies choose to spend more on elaborate packaging to make up for low R&D investments, and others pick slower growth or higher profits as an alternative to aggressive marketing budgets. But in the end the test of all these tradeoffs is simple: Is the business able to produce a sustainable profit and grow at least as fast as its competitors? If not, then--fair or not--the company is a likely candidate for Darwinian extinction.

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