I have spent the majority of my working life either running my own
business or in a management role in other peoples’ businesses. When
I started I had little understanding of the concepts of modelling a
business and in any event, before the advent of computerised
spreadsheets, producing a model on paper was a laborious and
difficult activity.
Thus, in the 70's when
Banks and other sources of finance for a new and small business were
making a decision to lend or not, the decision was often based on
personality and confidence than on solid evidence.
However as spreadsheets
became more accessible the canny Bank manager would ask questions
that required the presentation of items such as a Business Forecast,
Marketing Plan and Cash Flow Forecast. In retrospect my first
presentations were based on intelligent guess work. These “guesses”
pandered to the widely held belief that such Plans are just window
dressing and they never work in practice.
At some stage in the
mid 80s’, a series of events occurred, related to my involvement in
the design of job costing, print costing and manufacturing control
software systems, that made me start to grasp the concept of “Total
Overhead Recovery” (TOR). The concept of TOR states that it must be
possible to model every aspect of a Business in a spreadsheet and as
a result be able to predict with a degree of accuracy the real
progress of the business through the proper management of the
resources that are utilised by the business.
An analogous situation,
in which I am interested as a hobby, is the relationship between
theoretical physics and cosmology where the scientists use
mathematics to predict how the universe should work and then
countries and their universities spend vast sums of money to
construct and furnish the equipment that proves (or otherwise) the
mathematical models and theories that have been conjured up, often
decades before.
Let us look at the
concept of TOR in action for the small information technology
business in which I have the most experience. I will describe in
words the process of building the spreadsheet model.
First of all we make a
fundamental difference between the expenditure on resources that are
directly related to or attributable to the work for that customer and
those that are “indirect” or “overheads”. As an example, if
the IT company was to supply a system comprising of servers,
workstations and peripherals., the direct costs of the purchase for
resale of the necessary equipment and software would usually
represent 60% of the final invoice and contain a profit element of
say 20%. In a TOR model, we do not include the monies related to the
purchase and resale of the materials but we do include the profit.
It has proved
reasonable to assume across the years for an IT business, that for
each 100 € of billable products and services that 40% will be for
materials and 60% for labour. Thus for each 100 € we may assume
that 68 € is available to cover all of the expenses of the business
and provide a profit. We can now discard materials and direct costs
from our TOR business model.
The type of resources
that we describe as “overheads” will be different from one
business type to another. The traditional categorisation of business
will often be a good indicator of the type of resources in use. A
quarry producing stone, sand and gravel will have to purchase or
obtain land, a cruise company will have to acquire a boat. In the
case of a cruise company the most important overhead by value will be
the boat. In an information technology business, the most important
resource is experienced, professional labour.
If the information
technology business is based upon the offer of available technicians
for 52 weeks of the year during reasonable working hours, there must
be more than one in order to provide the necessary coverage. In
addition, it would be extremely unusual that a technician would be
competent to provide every element of service sold by by an IT
Company. An obvious example would be a difference between software
programmers and hardware technicians. Most IT staff will have a
cognisance of all the roles within an IT Company but will tend to
specialise in one type of service provision. As a direct result of
this statement, experience in the IT industry suggests that the
minimum successful Technical Team size is five staff.
As this document is a
discussion about TOR, we are not interested in the overall business
but in the process or minutiae of the calculation. What we can say is
that each of the staff must have access to a vehicle in order to
visit Clients, they need to be housed in a premises, they need a
workshop, storage facilities, access to shared test equipment,
support by administrative and financial services, access to
communications facilities such as telephone and internet. They need
training, a technical library, equipment to play with and so on.
Every single element of the above list and more must be taken into
consideration in the TOR calculation.
Before starting on an
explanation of the detail of the calculation, there is another strand
to consider. The entire list of resources including the salaries and
direct costs of employed staff, must be paid for with money.
Logically the money is provided through the income achieved by the
sales of products and services to Clients. However there is a time
lag. We need the resources on day one before we can offer services to
Clients. In addition there is always a time lag between negotiating a
sale and receiving all of the money. There may be several ways to
ameliorate the problems caused by the time lag, such as deposits and
invoice factoring but fundamentally, the provision of the resource of
finance has a cost, irrespective of the source of that finance –
bank or other lending or introduction of capital by the proprietors
of the business or shareholders. These costs must be included in the
TOR and one of the classic mistakes in a TOR calculation is to forget
the cost of money.
Different businesses
have different models. In our IT business model, we start with a
fully costed technician. In a c ruise company or hotel complex, we
would start witha fully costed accomodation unit.
Experience demonstrates
that the salary cost and direct employment cost of a technician is
the largest element of the fully costed technician. For the purpose
of explanation we would be able to research the salary levels offered
in the marketplace and establish that 25k to 30k €uros per annum
for Spain would be reasonable. To this we add the cost of employment
in Spain and arrive at a figure of 45k €uros.
We have already
identified that we need at least 5 technicians. So we can immediately
say that the cost of our our productive labour force is 225k €uros.
We know that our team will need administrative, secretarial and
financial assistance. It is also clear that someone has to manage the
contact with Clients and carry out the sales and negotiation process.
Our ideal IT Business will also have an owner who should receive
remuneration for his/her activity. In our small IT business, the
staffing has now risen to say 10.
This additional
staffing cost must be paid for by our production staff. This
increases the cost of a productive technician to say 80k€ per year.
As we have said
previously, the productive labour force requires an establishment
from which to operate and access to all different types of facilities
and assets, including an office, workshop, computers, desks and so
on. In addition, we must add the cost of finance, borrowing costs
and other professional and sub contract costs.
This adds at least
another 20k € per technician per year. Thus for the purpose of our
TOR model we have a final figure of 100k €uros per year, or 500k
€uros in total for the whole business. Our 500k €uros reprsents
the 68€ of our nominal 100€ billed to the Client.
Thus our ideal small IT
Business needs to sell products and services to the tune of 736k
€uros to generate a small profit for the year.
There are plenty of
statistics about how many hours a person works in a year. For the
purposes of our calculation we will assume that a technician can be
productive for 200 days in a year and 7 hours in a day. This equates
to 1400 productive hours in a year. We have 5 productive staff.
Therefore our total productive hours is 7000 hours. If we divide the
target annual turnover by the number of hours in the year for this
model business, we would arrive at a requirement to charge 105 €
per hour for each hour worked.
In practice the figure
is a little lower than this because during our calculation process we
included the profit element of the sale of equipment and software.
This equates to 15€ of 105€, arriving at a final chargeable cost
of 90€ per hour.
So far we have built a
model. It is based on arbirary formulas which are individually
correct but when one introduces values into the formula, the results
are not that which we anticipated or desire. The most most important
issue for the modsel of our small IT Business, is that in the current
economic climate, it is not possible to sell a Technician for 90€
per hour.
Traditional micro
economic theory draws a graph relating the price of an item to the
demand for that item. In perfect competitive market conditions, if
the item is made available at a price of zero or nearly nothing, the
entire universe of potential clients for that item will make the
necessary sacrifice or payment to obtain it. At the other end of the
graph, where the price of the item is ridiculously high, no one in
the unverse of clients will consider the benefit that they obtain
from the item to be worth the cost and none will be sold. In the real
world, movement along the graph is restricted to the sensible middle
where the price and fluctuations in the price according to
circumstances, practicalities and pressure from competitors. In our
IT business, the financial management would set budgets for costs,
especially salaries and the market/sales staff would undertake to
obtain sufficient revenue when the chargeable hour was set at 70 €
per hour.
The important thing
that has been achieved by the creation of our TOR business model is
that every member of the staff can now understand their role and
importance in the business. Small business is stressful. If the
business owner wishes to ensure that the stress falls fairly on all
members of the business it is best that the owner creates a
cooperative as opposed to a combatitive approach to personnel
management.
