Creating a Total Overhead Recovery business model

 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.