Martin Quinn's management and financial accounting blog

Often, when I teach about types and classifications of cost in my management accounting classes, I use the term business model. For example, I might say “whether a cost is fixed or variable, can depend on the particular business model”. But, I am assuming the term business model is well understood. Perhaps it is not, and even when I asked myself what the term means,  I had to do a bit of thinking. So here’s a simplified explanation.

An article in the Harvard Business Review from 2002 describes a business model as “the story which explains how an enterprise works”. This is a deceptively simple definition, but it does capture exactly what a business model is. If I were to ask you what are the essential elements of a story such a Cinderella or The Frog Prince, you would probably says things like characters, what the characters do, when the characters do things, and of course the (moss likely) happy outcome. Using the story analogy, a business needs to ask itself, what is that we do, who are our customers, how much does what we do cost, and will we make money (the happy outcome!). In other words, “what’s our story”  in an economic sense (Read the full HBR article for more detail and examples).

Nowadays, business models have become a bit blurred though. For example, there are so many web-based “businesses” out there who, to be honest, do not immediately show a story which makes economic sense. For example, we now know how Google and Facebook can make money on a business model which changed the advertising world.  But, what about for example Twitter or off-shoots like paper.li. I love the latter, as I can bundle all the twitter users I follow into a daily newspaper, but how can this make money. I am guessing they will introduce advertising, but has this business model already been over-cooked?

I hope this helps you understand what a business model is. To conclude, I suppose the story of what it is a business does has to be infused with accounting concepts. For example, there is not point being the world’s best at something, but costing a fortune to do it.

As you many know, many scorecard type systems used to report on business performance often use some form of traffic-light system to display whether or not targets have been met (see one of my previous posts). While looking for examples of scorecards, I came across a German blog post, which equated the use of scorecards to Formula 1 (F1) flags – well taking the mick a bit really on the use of ideas such as traffic light type reporting. You can see the original post here, but below is a brief translation. It’s a bit funny, the idea being that the management accountant can be signalled by the security guard on whether or not to drive past the main gate.

Green – all is clear. Drive to the bank and plan to take over the competition.

Blue – a competitor is about to outperform us. The security guard has the phone number of a recruitment agency.

Yellow – not sure if there is real danger. The management accountant has not yet received a recent consultants report. Meet colleagues in the car park first.

Red – the business has been taken over or merged. The accounting department has been centralised. Go home

Red/Yellow stripes – danger of slippage. The board has discovered a good Business Intelligence software suite. Time for a training course

 If you have studied management accounting, you’ll have heard the term balanced scorecard. A scorecard is a report of key performance indicators – both financial and non-financial – of an organisation.  Many organisations not only use some form of scorecard, but also publish it on their websites or display it in a public place within the organisation.

Take for example London’s Heathrow airport. As you can see on the graphic here, they produce a monthly report (see here) which looks at many areas of performance for each terminal.  Like many firms, they use a colour-coded system, where red usually means a target has not been achieved – for example, seat availability seems to be an issue in Terminal 3 on the example here.

This scorecard is a great example – if you click the link above you’ll see it has much more than I show here. I have only one negative thing to say about it – and this falls from a recent trip through Terminal 1. I discovered this wonderful colourful (and positive) scorecard on my way to the gents – on the corridor into the toilets to be specific. Surely there’s a better place to display results? Or maybe it does not matter as only us management accountants take any notice of such things.

In my former life as a management accountant in industry, I worked in a number of projects which automated either production itself, production planning, or both. A term I was use to at that time was Manufacturing Execution System or MES. So what is an MES and why should management accountants know about them?  Well, an advertisement in the November 2011 edition of Financial Management  (CIMA’s monthly magazine) prompted me to write about it. AN MES is a system which basically communicates from sales through to the actual making of a product or a the start of a process.  An MES may include a sales order module, which would gather customer orders and pass these on to planning modules or directly to process equipment. Typically, an MES will improve a production process as production is scheduled more efficiently and can be monitored for back-logs and jams.  Also, an MES will also typically integrate with an ERP system, which means that a businesses systems are fully integrated. According to the advert in the CIMA magazine, Carlsberg (yes the brewer) improved performance in several areas once it used an MES; sales increased bu 1.5%, gross margins up 1.2%, downtime decreased from 28% to 13%, material loss decreased by 1%. All of these translate into increased profitability, which of course is of interest to managers and management accountants. I would argue that understanding how an MES works in a business is a vital piece of kit for any management accountant, particularly if such performance improvements can be made. If you are interested in reading some more, here are two websites I am familiar with which offer MES systems; Kiwiplan and ATS.

When a business or manager refers to their cost structure, they are talking about the composition of the costs of the business. Typically, costs are either fixed or variable. Fixed costs stay the same regardless of what happens e.g. how much is sold. Variable costs increase or decrease in line with business activity e.g. the more product sold, the higher the purchase or manufacturing costs. It goes without say that a business manager needs to have a full knowledge of how their business responds to changes in output and how the business itself actually operates.  I read a great example of this back in June this year in the Guardian.  The article mentioned how Ryanair had started talks with a Chinese aircraft manufacturer (Commercial Aircraft Corporation of China) in an effort to build a cheaper alternative to its current aircraft, the Boeing 737. What struck me was not the cheaper cost of the aircraft, but attempts by Ryanair to design the aircraft with exactly 200 seats – about 15 more than the Boeing. Why 200 seats? Simple answer actually, anything above 200 seats and one additional crew member is needed.  Keeping the seats at 200 means that each extra seat could yield anaverage profit of about €40 per seat.  Now that’s knowing your cost structure and operations in detail

CIMA’s e-zine (June, 2011) suggests a more responsive corporate reporting system is  need for organisations.  The report by CIMA, PwC and a think-tank called Tomorrow’s Company suggests that an evolving reporting system is necessary to reduce risk within organisations and meet the changing needs to both organisations and society. From from brief reading of the report, a central argument seems to be that the traditional (and incumbent) corporate reporting system is still primarily aimed at the providers of capital. Other elements or reporting have been appended on to this system e.g.  environmental reporting, rather than the full reporting system itself called into question. You may ask why change what is currently there. I’m not sure this is the definite answer, but changes in technology, the business environment and business risk (to mention but a  few) have been arguably more drastic in the past 20 years than the previous 100 years.

The report argues that a new corporate reporting systems needs to have six characteristics, which I summarise below. It argues that if these are incorporated within internal reporting and management processes, the external reporting will likewise improve.

1. Encourage innovation and change.  This should allow a reporting system to respond effectively to shifts in the business environment.
2. Balance judgement and compliance i.e. go beyond compliance reporting solely. What information is needed as a basis for good decisions.
3. Focus more on long-term value, by more integrated management and external reporting.
4. Make reporting accessible, timely and relevant.
5. Give shareholder and investors more information in long term sustainability and value creating capabilities.
6. Ensure some balances and checks are incorporated into the overall reporting system and make someone responsible for this.

In the May 2011 edition of Financial Management (CIMA’s monthly journal), Richard Young writes a very nice summary of how managements accountants can provide good and relevant financial information and feedback to business units. I’ll summarise the main points below:

1. Think strategically – in essence, the key metrics will the ones which support strategy. This may be cost, revenues or a non-financial measure
2. Focus on accountability – limit the feedback to factors which are controllable by managers/business units
3. Be clear – keep it very simple, use  only a few key metrics
4. No surprises – keep the information useful, less detailed and relevant to the manager/business unit
5. Be clear – explain figures to non-finance people, highlight how finance can help managers
6. The big picture – target feedback so that no managers/units get enveloped in too much information. They need to able to see the “big picture”
7. Two-way process – finance can also be the receiver of information. Reports/metrics can be challenged by operational managers
8. Persevere – it may take some time for finance’s metric to be accepted by some managers/business units. But persevere

I remember some meetings in my past life, when I had to justify expenditure on information to my boss – a chartered accountant with not too much in-depth knowledge of IT. This was in the late 1990′s. Of course, technology has moved on dramatically since then, but I’d be fairly sure that any accountants today would still be questioning the costs if IT/IS infrastructure and software.  And today, it is not only the cost of the equipment that needs to be considered, it is the cost of the information held by companies. This is a very difficult thing to cost, but the problems at Sony in recent months gives some idea. In May 2011, the Los Angeles Times wrote about the cost of the first hacker attack on Sony (there was another one in June 2011). The article reports a cost of  $171 million, which is believe it or not is nearly as much as the impact of the Japanese earthquake/tsunami earlier that year on the companies profit ($208m). I’m not sure what the hackers did to break in to Sony’s systems, but I bet it would have cost a lot less than $171 million to make their systems hacker-proof. And I’d also bet the hacker’s would be happy to repair the damage for a lot less than $171 million too!

Operating leverage refers to relative amount of costs that are fixed and variable in the cost structure of a business. Some companies will have relatively high fixed costs compared to variable costs and are said to have a high operating leverage. For example, pharmaceutical companies incur up to $1billon to develop new drugs over a 10 to15 period[1], whereas the manufacture cost pennies – just think of the price of a pack of paracetemol in your local pharmacy. Low operating leverage means variable costs are a relatively high proportion of total costs. Retailers like Tesco or Sainsbury have relatively low fixed costs and relatively high variable costs – the variable cost of each item sold (e.g. the purchase price) is likely to be much higher than the associated fixed cost for that item. The degree of operating leverage of a company can be used to assess its risk profile. Companies with high operating leverage are more vulnerable to decreasing sales e.g. sharp economic and business cycle swings. Companies with a high level of costs tied up in machinery, plants and equipment cannot easily cut costs to adjust to a change in demand. So, if there is a downturn in the economy revenues and profits can plummet. On the other hand, companies with lower operating leverage can adapt their cost structure more rapidly as it has more variable costs.

[1] http://www.washingtontimes.com/news/2009/mar/13/blocking-drug-development/ accessed  Dec 4^th, 2009

Okay, so I have no much interest in football, but this recent piece in The Economist makes for great reading if you’re into the footie – or like me trying to paint peformance management issues in a lighter way!  You can read the articles for yourself, but the basic theme is that while both banks and football clubs pay high salaries to retain/attract the best talent, the question is does this make economic sense. Arguably, the more successful banks and football clubs get to keep more of their revenues as they make more money by having the best traders/players.  So it seems to make sense that pay and performance are linked in banks and football clubs.  However, if bankers/players pay is capped, they can move elsewhere, which may have an effect on the performance of the bank/club they leave.  So, according to the article, unless a cartel scenario exists in banks it is unlikely that any cap on pay  will be useful in an economic sense. It may be what politicians want, but it’s unlikely to make economic sense.

I was in Germany a few months ago and seen a copy of Handelsblatt  (a leading business newspaper) on July 20th last at a hotel bar. As you do, I scanned it while ordering a local beer (Moritz Fiege Pils). I noticed that the German Green Party wanted to ban F1 from the Nurburgring and Hockenheim. I read the article and it made me laugh to be honest. The reasoning was that the F1 circus is bad on CO2 emissions and all that stuff. Now a few facts first – I love motor sport, I am a management accountant, I like the old ways of doing things (now called environmentally friendly/recycling/grow-your-own) and I could not resist the picture of the F1 girls for this post.

But, being serious. Research and development expenditure is one of those things a management accountants might find hard to deal with. It’s normally a substantial cost, but the return is often uncertain. Now back to F1 and the German Greens.  Motor manufacturers like Mercedes, Honda and Renault (among others) have over time spend $billions on F1. And what do they get out of it? Well, every car nowadays has an EMU (Engine Management Unit) or “brain” that controls and monitors every thing a car does – do you know most cars have no accelerator cables at all; it’s a sensor on the pedal which the EMU monitors and the pedal is tensioned to give the feeling of a traditional pedal. Where was this technology perfected? F1 of course. And nowadays, F1 cars are lighter, faster, more fuel-efficient and even capture energy under braking (the KERS system). Surely this will pass on eventually to normal road cars, which will mean lower fuel consumption and lower CO2 emissions and so on. So, to bring it all back to management accounting. If we were to do as the German Green Party suggests, there would be no F1 in Germany (home of Mercedes), which might mean less research and development expenditure in F1, which in turn might halt the development of  more fuel and energy-efficient road cars for you and I.  Okay, it might be hard to put a money value on the benefits of F1 research and development in the long run, but it seems daft to try to ban it. So far, the history of F1 has shown us what the cars of tomorrow will have on board.  If that means efficient, energy harnessing cars for the future, we need to encourage it. The costs (monetary and environmentally) may be easier to ascertain and outweigh the benefits in the short-term. However, I can only see future benefits from F1 for car manufacturers who should be able to produce (in time), better, safer and more environmentally friendly cars for Joe Bloggs.  Kind of goes against what I thought any Green Party stands for to go against such progress. But, hey I am no politician! But it seems a classic case (from the Green’s view) of not looking at all costs and benefits of an activity over the long term.

 With some commodity prices on the rise, and continued economic woes, some businesses are holding retail prices and reducing margins. Associated British Foods, which includes the low price high-street retailer in Primark (UK/Ireland and some European countries) is an example.  In late April 2011, the company reported it wished to absorb material price increases rather than pass them on to end-consumers. Increasing sugar and cotton prices reduce the company’s margins. However the CEO reported that the company did not want to relent it’s status as a low price retailer in the clothing sector.

Many young Irish people (and other nations too of course) are making their way to Australia to seek employment and/or better their career prospects. The Australian economy seems to be booming based in its natural resources and its closeness to the Chinese markets – who consume huge quantities of these resources.  This boom may be affected somewhat by the imposition of a carbon tax from 2012 on all firms emitting more than 25,000 tons of CO2 per annum. This will increase the output costs, which may affect consumer spending. To balance the affect, the Australian Prime Minister has promised some tax reductions.  Read the full story here

(Image from Economist.com)

A few weeks ago I was listening to the radio in the car. A news item  came on about why Ireland is attractive to companies like Google and Microsoft to set up data centres. It wasn’t tax, or our educated workforce.  Much to my surprise it was the Irish weather. Well, I suppose all three are important, but with an ambient average temperature well below 20 celsius, the cost of cooling the data centres falls considerably. Here’s a post I read earlier from Babbages’ blog on The Economist. It gives some great detail on the costs of running these data centres Data centres: Social desert | The Economist. I have to say, as a management  accountant weather conditions would not be the first thing I’d consider in cost decisions – a good reason to talk to other people in the organisation to find out what’s going on.

Setting a price for a small business can be a challenge.  Cut the price too much and you loose money. Raise the price and you loose business. An article in the New York Times recounts the experience of some US small business. The basic message is that price is not everything. One  business owner recounts how the quality customers gained outstrips those lost due to a perceived high price. Here’s one story

“About three years ago a computer error caused all of the prices on Headsets.com to be displayed at cost rather than retail. With the lower prices on display for a weekend, Mike Faith, the chief executive, expected sales to soar. Instead, the increase was marginal. “It was a big lesson for us,” Mr. Faith said.”

The basic lesson from this experience is that customers don’t think price is the be all and end all.  The experience of a gluten free flour business showed that competitors prices may not  matter as much as one thinks too. The company managed to raise its price by 20% in the first year in business by convincing customers that the product had more added value than competing flour. The most important lesson mentioned is that costs must be covered in the price charged.  Seem so obvious, but I have written several pieces on this blog about breaking even.