Horsepower and Torque

Horsepower and Torque

Simple framework for assessing business profitability                                                             1/10/2012

Overview

Profits and productivity are the engine that drives every business.  But what makes some businesses able to deliver so much more in both of these areas than even their closest competitors?   And how can you gauge if a business is profitable without viewing its financial statements?  While most owners or CEOs of privately held companies are happy to share general sales and personnel information, rarely are they comfortable sharing profitability figures.  Over time, through the mapping of hundreds of monthly financial statements collected from telecom and technology businesses to their respective business profiles, several unique profit-related correlations have been found.  From these correlations, a framework was developed that allowed for the rapid assessment and subsequent management of two key areas that impact profitability.  As an owner or manager, you may want to compare your own business's result based on these ratios and see how your company stacks up.

Methodology

There are really two areas that have the greatest impact on overall business profitability.  First is how much gross profit the business produces.  When assessing a businesses gross profit potential, you’re really examining a) what products and services a company sells, b) how much it sells them for and c) how much direct expenses the business incurs in the process.  Gross profit has a direct correlation to a business’s competitive moat.  A competitive moat is simply how hard it is to compete with the business.  The wider the moat, the more differentiation it has from competitors, the less available substitutes are and thus, the higher the gross profit the business produces.  Think of the Coca-Cola Company.  It is one of the most profitable businesses in the world and has very few substitutes and very low direct selling costs.  In essence, it produces a product containing sugar, syrup and water and wraps it in an aluminum can.  It charges a premium for this flavored water and has only one or maybe two real competitors.  Impressive!  And so is its gross margin.  In 2010, it produced a gross profit margin of 63.8%.  Let’s also look at the opposite type of business, one that has a high cost structure and many substitutes are easily available.  A good example would be Darden Restaurants, one of the best managed restaurant chains in the country that includes marquee brands such as Olive Garden and Red Lobster.  Regardless of how well managed Darden is and the level of recognition its brands command, the food industry has very high direct costs and substitutions are everywhere.  A typical Red Lobster might have as many as 20 other restaurants within one half mile.  Hardly a wide competitive moat, as demonstrated by its gross margins.  Last year Darden was only able to produce a 24% gross profit margin, barely over 1/3 of that of Coca-Cola.  The point is, gross margin has a huge impact on a business’s profitability but from a purely controllable standpoint, it may be harder to impact then other areas.

Once you’ve reached the gross profit line on a financial statement, next up is operational expenses and that usually means employee expense.  Typically, payroll and related expenses are the second largest cost in the operation of any telecom business.  Based on aggregated financial statements collected in 2011 by SonicMG, telecom and technology business’s payroll and related expenses consumed 34.4% of revenue.  Although absolutely necessary to the success of the business, people are expensive.  It’s not only their salary or hourly wage but also the additional benefits, taxes, etc. that combine to the overall true employee cost to the business which is usually estimated to be anywhere from 20%-30% above their base salary.

Horsepower and Torque Framework

If you needed to figure out how fast it would take a car to go from say, 0 to 60mph, how would you do it?  My guess is that you would focus on two things.  First, you’d ask yourself what kind of vehicle it was- the make and model.  Second, you’d need to figure out what kind of engine it had- its size, efficiency and power potential.  Just understanding these two variables would give you great confidence in knowing whether you were dealing with Corvette or Chevette type speed.  Assessing a business's profitability is done in much the same way.  Start with the make and model.  Ask yourself what type of business it is and what industry does it operate in?  That will guide your estimation of its gross profit potential.  Next, take a peek under the business's hood at its engine, the org chart.  Employees are the engine and create the horsepower to make things happen on a day to day basis, driving the business plan and key initiatives forward.  Exactly as you would assess a car’s engine to determine its performance, look for the same components on the org chart.  1) Size (how many people?).  2) Utilization (What do they do?)  3) Power potential (How well do they perform in their roles?).  Although there is no doubt the last component (how well employees perform their job) is extremely important in creating a high performing business, due to the complexity and subjectivity of its assessment, for the purpose of this paper, we’ll just focus on the first two: How many?  And what do they do?

 Horsepower

Horsepower deals with the question of how many full-time equivalent employees (FTEs) a business has in relation to its total annual revenue.  To calculate a business's horsepower score, take the total annual sales and divide by the average number of FTEs used in the year.  For those in the industry a while, the concept and calculation of horsepower is not new.  You’ve probably have heard it referred to by its academic name, revenue per employee, for decades and hopefully are tracking it on a monthly management dashboard.  But what do the numbers mean and what is the right target for a telecom equipment dealer or VAR today? 

Benchmarks for horsepower will vary from industry to industry and business type to business type.  Typically, the lower the gross margin of the business, the higher revenue per employee must be for a business to be profitable.  In the small, privately held telecom VAR /dealer business, calculation of gross profit is a nebulous number and hard to compare on a relative basis from dealer to dealer because of the way some dealers calculate and burden their direct costs.  Some, surprisingly don’t add in direct labor expense and therefor show an “unbelievable” gross profit while others pack so much expense into direct costs it dilutes the value for peer comparison.  The standard calculation of gross margin should, at the most basic level, include both the cost of materials/equipment and any direct labor expense incurred in the sale and installation of the goods.

As I began mapping data points on financial statements to profiles of the respective businesses, I discovered several key levers that drive horsepower.  The first and most probably important is the amount of recurring revenue generated by the business.  Quite simply, the higher the recurring revenue generated, the higher the revenue per employee typically is.  Recurring revenue is contractual, and flows to the business on a monthly basis mostly without the need of employees to generate it.  A good example of this would be one of the VARs we work with that has a security monitoring division within their business.  The division collects just over $1 million in monitoring fees annually but needs only three employees to run the operation, generating over $333k/employee on an annual basis and generating an outsized, divisional profit for the company.  As a standalone business, the division would be quite a profitable venture.  On the other hand, businesses that depend solely on transactional sales, see their horsepower depressed well below the average.  These  antelope hunting lions, always looking for their next meal, need a much higher headcount to generate the sales necessary for operational expense coverage.  Very few telecom VARs, with less than 5-10% of their sales on a recurring basis, produce a revenue/employee number much higher than $150k/employee.  It's just the nature of the beast.

 When discussing recurring revenue, there are two things CEOs will sometimes try to put in the bucket of recurring revenue that will have to be taken back out.  The most common is Moves, Adds, and Changes (MAC) revenue.  Although, in many cases, this revenue may be steady and a business case can be made based on historical run rate performance showing it “recurs” every year, the fact is, it is not contractual and therefore should not be counted as recurring.  The second faux pas occurs when traditional VARs start selling things that have a recurring revenue stream (exp. Carrier Services) and try to claim the entire monthly amount billed to the end customer as their revenue.   That, obviously, will need to be backed out too leaving only the business's commission on the sale as recurring revenue. 

The other lever that can be used to improve horsepower is employee productivity.  Productivity, very simply, is how many employees are needed to do a given task.  Many times, as sales decline in a particular business, employees will find ways to look busy, perpetually rearranging their desks, if needed.  The first thing to do is to verify that there is a performance culture in place at the business.  A business that has a strong performance culture is one in which everyone knows what is expected of them, their individual and team performance is measured against these expectations and both feedback and recognition are provided to ensure continuous improvement is achieved.  These businesses will also characteristically move poor performers off the team quickly, constantly stretching their A and B employees to achieve even more.  However, sometimes even though signs of a strong performance culture exists, the business may simply be overstaffed.  When a business staffed to do $X in revenue only is forecasted to do $Y, the painful process of headcount adjustment must begin in order to bring it back in line with stated revenue/employee targets.

While exactly what the “right” horsepower level should be is subject to fierce debate, here are some facts.  Based on the gross margin rate at a typical telecom VARs and equipment dealers, rarely is one that generates less than $125k/employee profitable.  Businesses generating less than $100k/employee can usually be put on a “death clock” by using a simple formula ( (balance sheet cash/annual cash burn)/12) ) to give you an approximate number of months left that the business will be in operation.  Moving upstream on the measurement stick, those business that are focused on building recurring, contractual revenue streams will typically see their revenue/employee climb in direct relation to the increase in  recurring revenue as a percent of the total sales. 

Correlation of “Horsepower” to Profits

As an example, let’s examine horsepower as it relates to profitability at two large, publically traded system integrators; Blackbox (BBOX) and Hickory Tech Corporation (HTCO).  

Based on fiscal year 2010 10k filings by each company

Both Blackbox and Hickory Tech, based on their public filings with the SEC, have horsepower ratios above $200k/employee and a net margin that correlates as the metric rises.  On average, many of the smaller, traditional, privately held telecom VARs focused primarily on PBX sales, infrastructure projects or other equipment sales operating in the 125k-175k/employee range.  Their average net profit margin also matches exactly to the lower revenue/employee range.  To develop sustainability in the business over the long-term, theses companies will need to, amongst other things, right-size their org chart to the projected revenue levels and continue to develop additional recurring revenue streams.

Torque

While horsepower deals with the question of how many employees the business has, torque addresses the utilization question:  What do they do?  To calculate a business's torque score, take the total number of employees in the business and for each, determine if they either a) bring in revenue (Direct) or b) operate in an administration, management or other non-revenue producing role (Indirect).  Once all employees have been classified as either direct or indirect, take the total number classified as direct and divide that into the total headcount for the company.  This will produce the torque score for the business. Torque helps articulate just how many employees actually generate money for the company vs. how many total employees are in the business.  Torque speaks to the utilization of the engine.  By mapping financial performance to the utilization of the employee base, a strong correlation can be found between a business's torque score and net profit based on the analysis of actual financial statements of privately held telecom dealers.  Interestingly enough, the smaller the business, the more pronounced the correlation became.

When going through the exercise of classifying employees into either "direct" or "indirect", there are a couple games managers sometimes play.  First, only those employees that directly produce revenue for the company can be counted as direct.  They must either be able to bill for their time or expertise or, carry a sales quota.  While trainers, project managers, estimators, engineers, etc. all perform vitally important functions to the business, unless the case can be made that they can bill clients directly for their time, they will need to be seen as support staff and would fall into the indirect bucket.  Owners and management will also be classified as indirect in all but the smallest companies.  This typically leaves only the sales team and technicians as direct employees at most telecom businesses today.

The businesses that drive the very best profits usually have a direct employee ratio between 70-80% of the total employees in the company.  That leaves some to wonder: Why not 100%?  For starters, if everyone is out selling, installing and servicing equipment then no one will be around take care of important administrative and support functions like HR, accounting and marketing.  There should also be some latency in utilization to act as a buffer and allow the business to react to spikes in sales volumes.  On the flip side, when businesses fall below the 60% threshold of direct employees, rarely are they profitable.  These businesses often times fall into one of two camps; too much management or too much family in the business.  When managers are managing less than 3 or 4 employees or owners have created jobs just to accommodate family members, there is a high probability the business is operating at an artificially depressed levels of profitability .

To summarize torque, all Indians and no chiefs will create anarchy.  All chiefs and no Indians, tends to create an organization similar to government.  And we all know how profitable that is.

Summary and Conclusions

While there are always going to be a host of factors that contribute to a business’s overall profitability, it’s usually the biggest things that will move the needle the most.  In most businesses, that’s gross profit and employees.  When assessing the org chart of a business, the two biggest and most controllable factors are:  how many employees do you have in relation to the size of the revenue?  And what do they do (direct or indirect)?.  To drive horsepower higher, begin by reducing redundant staff and/or increasing the amount of recurring revenue the business generates.  If and when it is determined that any decline in revenue is terminal, the org chart will need to be downsized.  Owners should look first to non-revenue generating staff or underperforming team members.  To improve the business’s torque score, analyze closely what the team is doing.  Always remember, there are no cash registers at a business’s headquarters.  The best way to drive profitability is to have as many people as possible in the field producing sales for the company.  In addition, look to maximize the productivity of anyone in a support or administrative function.   

 

The horsepower and torque framework was created over years of observation of the best and worst performing privately held telecom companies to be an easy, initial assessment tool.  But, like anything that combines art with science, there will always be exceptions and outliers.  Whether you’re an outsider just trying to figure out if another business is profitable or an owner looking to maximize the organization’s potential, I hope you will find the horsepower and torque metrics a useful starting point to an important business conversation.