Operating leverage explained
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 4th, 2009
What organisations need to prepare acccounts?
One of the first few things that I would typically teach students that are new to accounting is that all most organisations need to control what they do in some way. Control can be of a financial nature, i.e. preparing financial statements, and this is something we typically associate with “for-profit” organisations.
However, many not-for-profit organisations also need to keep accounting records and have intricate financial/accounting based control systems. For example, a charity might like to know its sources of funding and keep a detailed trace on all expenditures. Similarly, any sovereign state needs to keep track of its income (usually taxes) and its outgoings e.g. expenditure on schools, roads and social welfare. A few months ago, a number of articles on the annual financial report of the Vatican State caught my eye (see here and here). In brief, the Vatican State had a surplus of about €10 million for 2010. The Vatican is a peculiar organisation in that it is somewhere between a Church and a State. I can’t find the annual report on-line, but as far as know one main source of income for the Vatican is the traditional “Peter’s Pence” collection held annually at all catholic churches across the world. The press releases surrounding the 2010 Vatican financial report seems to suggest that deliberate efforts were made compared to previous years to control costs and keep within budget. So, even the Vatican has a use for accounting information – both financial statements of some kind, and management accounting. By the way, if you do find the annual reports of the Vatican on-line, do get in touch
Football and banker’s pay – there is a link?
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.
Banning F1 – does it make sense (environmentally and on cost)?
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.
Changing product and market landscapes – effects on costs
Bromwich & Bhimani wrote a interesting short book in 2010 called “Management Accounting – retrospect and prospect” (see cimapublishing.com). In the book, they give a number of examples from modern business that makes us think about management accounting techniques. For example, what exactly does a company like Facebook or LinkedIn actually do? Do they offer products, services or what? Changing technologies, business markets and new ways of making/delivering products often causes changes to management accounting. For example recently I read that amazon.com now sells more e-books than paper books. Taking this e-book example, it is easy to visualise a shift in product costs. Arguably, an e-book has almost no variable costs. Instead the vast majority of costs are probably fixed – costs of running a data centre for example. This new way of doing business changes the information management accountants need and how that same information is collated and analysed. I have no idea what publishers or distributors like amazon.com do in their management accounting functions, but it is not too hard to think about how basic techniques like breakeven (CVP) analysis would change due to the changing cost structure.
Some “practical” economic indicators
Here’s an interesting blog post marking 25 years of the Big Mac index – http://www.accountingweb.co.uk/blog-post/mac-roeconomic-indicators
Microsoft Excel keyboard shortcuts
Like most accountants, I have to resort to Microsoft Excel quite a lot. No accounting software can ever give you all the information you need to make business decisions. Similarly, some ad-hoc decisions just use estimated figures and any calculations can be easily done in a spreadsheet. The more you use software, the more you realise that keyboard shortcuts are often the fastest way to do things. The typical Windows Ctrl+C is very handy to copy something you have just selected with the mouse.
Excel to has lots of keyboard shortcuts. Here’s a great webpage with a long (if not full) list of Excel’s shortcuts.
Rising prices, holding prices – Primark holds retail prices steady
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.
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