In this post, I recount a conversation I had with a great mentor some years ago. It questioned my notion of what costs are relevant and how to set prices once a plant/factory is not at full capacity.
In a factory ( or any business perhaps ) when there is free capacity we can start to look at the make up of costs a little closer. Traditionally, management accounting would suggest we should at least cover all variable costs in the selling price. But think about it like this – if we have spare capacity, then perhaps the only additional cost is the material cost. Let’s assume we have a machine with a full crew, but not at full capacity. The fixed costs of the machine are just that – fixed, and we cannot avoid them. The labour costs are in effect fixed too, as workers will be paid. So, in this case, only the material costs are relevant. And this, any selling price above the material cost contributes to profit.
Yes, there may be many simplistic assumptions in the above. However, it made me think back then and I always give this example to my students. It is of course an example of throughput accounting, which I will mention next week.
The term “hidden cost” is one which we are probably quite familiar – the media like to use if a lot. But what is a hidden cost? Where do these costs hide? Can we avoid them in decision-making? Too many questions to answer in a single post, but let’s start with the term itself.
If you do a google search, you will get many definitions which define hidden costs as a similar concept to opportunity costs. I disagree with such definitions as if you have identified an opportunity cost, then it is not hidden is it? Ok, perhaps I am being a bit unfair here, but to me hidden costs are those which you may not foresee when making a decision. Of course, it’s never possible to foresee all costs when making a decision, but perhaps the hidden costs might emerge if more time is given to the decision – easier said than done in a business scenario.
Take the example of a house purchase decision. This is a big decision in anyone’s life, and we normally take the time to make the right decision on location, size, internal layout, price, amount to borrow and so on. After a few years in the house we might discover we are far from schools or work, or that it is hard to heat the house – these would be hidden costs of our house purchase as we probably did not factor them into our initial decision. There’s a good chance though that we would include such things in a second house purchase decision.
It’s probably fairly obvious that product development costs affect the overall profitability of any product. Some products like drugs and new technology incur huge development costs. New technology, at least at the consumer end, often incurs huge advertising and promotion costs too. And simply, if sales are not sufficient, then losses occur.
As an example, consider a report from the Irish Times on Microsoft’s efforts in the tablet market.
“Microsoft’s Surface tablets have yet to make any profit as sputtering sales have been eclipsed by advertising costs and an accounting charge, according to the software company’s annual report.
The two tablet models, introduced in October and February to challenge Apple’s popular iPad, have so far brought in revenue of $853 million, Microsoft revealed for the first time in its annual report filed with regulators yesterday.
That is less than the $900 million charge Microsoft announced earlier this month to write down the value of unsold Surface RT – the first model – still on its hands.
On top of that, Microsoft said its sales and marketing expenses increased $1.4 billion, or 10 per cent, because of the huge advertising campaigns for Windows 8 and Surface. It also identified Surface as one of the reasons its overall production costs rose.
The Surface is Microsoft’s first foray into making its own computers after years of focusing on software, but its first attempts have not won over consumers. By comparison, Apple sold almost $24 billion worth of iPads over the last three quarters.”
(Above is copyright of Irish Times/Reuters)
An internal auditor is someone who checks the internal control systems in an organisation – usually larger organisations. Staff typically fear the arrival of an external auditor, but at least they go away in a few weeks. The internal auditor is not only ever present, but knows a lot more about a business than any external person. Thus, in my own experience, internal auditors are perhaps less liked than external auditors. However, perhaps my experience was just a bad one. This articles from CGMA at least suggests that an internal auditor needs some decent communication and social skills to0.
(Image from CGMA)
It is not that often that we as accountants face the problem of currency devaluations. We would have to be an accountant in a large global firm who has assets denominated in a foreign currency that is devalued. You know I am a management accountant, so I will leave the complex accounting standards up to the experts. In other words, I avoid the complex issues here.
Last February, the Venezuelan Bolivar was devalued by about 30%. The exchange rate was moved from 4.3 bolivars to one US dollar to 6.3 bolivars. So for example, if a company had assets worth 430,000 bolivars or $100,000, the value of these in $ terms is now $68,253 (4.3/6.3 x 100,000). As Venezuela has many foreign investing companies, the balance sheet of these have been hit a little. For example, Irish paper and packaging company Smurfit Kappa saw its asset values fall by €142m – see here
Internal controls and fraud are not really an area that I write a lot on. Just before Christmas I read this article from CIMA about fraud at Japanese firm Olympus. It includes interviews with Michael Woodward, who was at the heart of putting things right. The are a lot of issues in the article and it is worth a read.
Sustainability is a huge issue for us all, not just for accountants. It is not my specific area of expertise, so over the next few weeks Dr Stephen Jollands, University of Exeter, will be writing a few guest posts on my blog. He will give you much more on sustainability actually means, but let me tell you what inspired me to ask Dr Jollands to write some stuff.
I was travelling back to Ireland on an Aer Lingus flight recently. It was an early flight, so I ordered a breakfast, some muffins and drinks for my kids and a tea and cake for my wife. So we started to eat. As I was eating my breakfast I realised I had a portion or marmalade I did not want to eat just then, and portions of salt/pepper I did not use, and some plastic cutlery and some milk. So I thought why not bring some of it home and use it for lunch – which I duly did. Then I started to think about how many similar items would be simply waste on the flight. And, thinking further, the effort (and cost) that goes into produced all these portions is simply wasted too. This, I thought is completely daft, and here it come, not sustainable. All sorts of questions came into my mind – why do we waste so much, why do the flight attendants not ask if you want certain portions, how much money is wasted in this one flight, what natural resources are wasted etc.
This simple everyday experience of mine shows the kind of issues that might be part of the broader sustainability field. I’ll leave it up to Dr Jollands to give you some more insights over the coming weeks.
This summer, customers of the Irish based Ulster Bank faced 3-4 weeks of problems getting paid and paying bills as the banks payment system failed. Customers had to queue to get cash from their accounts and go to other banks to pay bills- see my post 2 weeks ago about how some countries are limiting the amount that can be paid in cash; these limits would be too low to pay a mortgage in Ireland for most.
When I worked in a paper firm, I was involved in the decision to set up a simple business recovery plan. At the time, I was IT manager at a plant with about €30m turnover and 150 staff. The whole place was more or less run by a single system which managed sales orders, production planning and invoicing. We had a server onsite which done all this. This was not always so, so once I realised we were so dependent on a single piece of hardware/software I initiated a discussion with the plant management board to get a recovery plan in place. To keep it brief the cost of having a server available to us at any location within 4 hours was €7000 per annum. As part of the contract we could also do a free trial run once a year to test how long it would take to recover our systems. I always remember the production manager saying this was a cheap deal as if we had no systems we would basically loose wall customers within a week. And all we did was made cardboard boxes. Surely a bank should have a much better system in place. The cost does not really matter in the decision, it’s much more about the list revenue and lost customers.
The photo by the way comes from a friends Facebook page .
In June this year, I was watching a programme called “The men who made us eat more” on BBC. It told the story of how super-size portions and combo-meals came about in fast-food chains like McDonalds, Burger King and other similar ones. One of the participants mentioned how the profit margin on the extra portion (or the additional products in a combo-meal) is huge. He explained why, and the explanation is again an application of understanding costs and volumes (or CVP).
Let’s take the example of a portion of french fries. If we think about the cost of a regular size portion first. The variable cost would be mainly the ingredients, i.e. potato, packaging cost and maybe energy costs. There would be quite a few fixed costs – all the costs associated with the running of the restaurant, including staff costs (they need to be paid even if there are no food orders). Now if we make the portion size larger, the additional cost will be very small – some extra ingredients, a slightly bigger package and that’s about it. But, the price increase is proportionately much higher than the cost increase usually. Thus, by encouraging a customer to super-size or buy a combo-deal, profits can rise at a much faster rate than the corresponding increase in costs.
A short post today – holiday season.
You may know about tools like the Balanced Scorecard which are used by many organisations to monitor performance from financial and non-financial aspects. Here is another type of scorecard, developed by CIMA, which may be quite useful to managers and boards of directors when trying to formulate a strategy. The tool prompts managers to consider the business model of the organisation and reflect in the external environment, risks/opportunities, implementation and options available. Have a read of a document prepared by CIMA/CGMA by clicking this link .CGMA Strategic scorecard_T1 FINAL . This document explains the scorecard quite well.
I always like to read about new ways of doing business, or new technology can change existing businesses. You may have seen how various new technologies have helped the taxi-sector. For example, in London you can send a text from a smart phone requesting a taxi and your position can be pin-pointed by the GPS within the phone. Now let’s take this a step further and add an app to the smart phone and then the way the whole taxi industry operates could change? How you might ask. This post from the Babbage blog on Economist.com explains why. In several European countries, taxi users can now use apps to request a taxi. The apps ping the nearest cab, and once a customer accepts a particular offer they can track the taxi progress. All the taxi needs is the same app effectively. This changes the way business is done in the sector as the taxi dispatcher is effectively cut out of the picture. I don’t know about other cities, but I can tell you that a taxi dispatcher would charge its drivers in the order of €200 per week or more in Dublin. For this, the driver (who suffers all risks of owning and paying for the cab) gets fares directed to them usually through some system installed in their cab. Now, if I were a self-employed taxi-driver you could cut out that cost by using an app, I’d be giving it some serious consideration. Of course, as the post notes, taxi dispatchers are not seating idle and a race is on between taxi dispatchers and app developers!
In recent years hard economic times have hit Ireland and other developed economies. According to an article in the Guardian over a year ago now, the number of businesses failing in Ireland was 5 times that in 2010 – a huge chunk of these being construction firms. I hope have some sympathy for many of the hard-working business people who perhaps have seen a lot of their money lost. But, there is a part of me (probably the accountant) who is not at all surprised at so many Irish businesses failing. Why? Am I getting more cranky (Yes, of course I am)? Well, let me give me a few of many examples I have encountered over the last few years which seem to show poor decision making. But before I do, I should say that many Irish businesses who started during the “boom” years were already doomed to failure due to a pretty high cost structure e.g. rent.
The first example dates back about 2-3 years now. In the area where I live, we collect an amount of money each year to help maintain the common greens in the area. The landscaping business doing the work was charging about €7000 per annum and a new landscaper offered to do the work for €4500. Both were sole traders with similar costs (as best I could guess at least). The original landscaper said he could not do the work for that price and would not even reduce his current price, so the business was lost. Now I don’t know what either landscaper was thinking, but it fairly obvious that the original landscaper was living in the boom years in my opinion. He could have reduced his price by some amount, say €1500. This would mean his net contribution would fall by €1500, but instead he lost €7500 – a bad decision.
The second example relates to a really nice bakery I visited recently in a more affluent part of Dublin. Yes, the price is of course going to be affected by the area, but having paid €4.60 (ok my wife bought it) for a loaf of sour-dough bread I thought this is not a sustainable business. Even people in affluent areas cut back on spending in lean times. The point here is that I thought the price was more reflective of a time four or five years ago.
The third example relates to an employee within a business. The employee left as €900 per week income was not “enough” for him. The job involved manual labour and some skills, but nothing that could not be replaced readily. The right decision was made by the business owner, which was adiós amigo. The employees decision was rather silly though, as the immediate income from social benefits would be way lower.
These three examples to some extent portray how high prices may have become engrained in the minds of business people following many years of the Celtic Tiger. I like to study how practices have become accepted/taken-for-granted, or institutionalised. When practices become institutionalised, there are hard to change. So I wonder are businesses in Ireland failing because some business owners cannot make the change in their minds to reduce costs or prices? In other words, they are finding it hard to break the institutionalised practices associated with past more affluent times. I know there are many other factors, but based on my experience, at least some business failures in Ireland result from a failure to change mindset.
Back in the late 1980’s and early 1990’s when I was young enough to be frequenting pubs/clubs around Dublin city centre, one of the biggest problems was getting a taxi home. At that time, the number of taxi’s was regulated, with (if my memory serves me right) about 1,200 taxis for a city of about a million people. The effect of this was a market for taxi licences. Many taxi drivers depended on this for their pensions, with a licence yielding IR£ 60,000- 80,000 (about €75-100,000). Now, Dublin has a de-regulated taxi system and has more taxi’s than New York (see here for a taxi-eye view). The price structure is also heavily regulated, and a common price structure applies to all fares throughout Ireland. And, of course, a taxi licence is nowadays worth very little.
Why and I writing about taxis you might ask? Well, while on holiday near Leipzig (Germany) over the Christmas period, I read an article in a local paper (Doeblener Allgemeine Zeitung, Dec 27, p.7) about how a taxi firm is dealing with rising costs. The taxi sector in Leipzig is de-regulated too as far as I know, and competition is strong. The article interviewed a manager from a local taxi firm, 4884. Rising fuel prices seem to be a major problem for the firm – and indeed for Dublin taxis too. However, as I read on I realised that Dublin and Leipzig taxi firms/owners, while having a lot in common (over/high supply, rising costs, relatively declining static/declining market), the Leipzig firm 4884 seemed to adapt well to become attract and keep customers. For example, in June 2011, 4884 launched an app to order taxis (using GPS). They also (according to the Dec. article) regularly train and annually update their drivers on things like customer service skills – it is even written into the drivers’ contracts. In Dublin too, there is at least one taxi app I am aware of (Irish Taxi), but I am not sure it is as advanced in terms of GPS. London too has a GPS service available for ordering a taxi.
So what’s the management accounting point? Well, if we compare the market for taxis now to compared to the past (in most countries, but certainly Ireland), there is a far greater supply (volume). The cost structure is typically beyond the control of all taxis. Most costs are fixed – radio rental, advertising, taxi licence fee, insurance – with fuel being the main variable cost. With more taxis in supply, a static market, fixed prices and little ability to control costs, then the ability to earn a profit is likely to be more difficult now. So what can be done by taxi owners/firms to sustain profit. Most have joined forces to create firms/co-ops, which can share some costs (e.g. central booking). Other options are to increase customer retention through things like apps and improved customer service. At the end of the day, with so many costs beyond their control, taxi drivers/firms can only but be adaptive to stay in business. If they are not, they can (and do) go out of business.
Following on from my last post on what is a business model, here I recount two articles I had saved from last year on how climate change can force businesses to change – and in some cases even change the business model.
The first article comes from Time (Sep 04, 2011). It recounts how Spanish winemaker Torres are increasingly moving their crops to higher, cooler areas of Spain. Due to global warming, the hotter climate means sweeter fruit and earlier ripening. At the same time, the early ripening of the fruit is offset by the fact that the seeds and skin (which give flavour) are not ripe. Thus, as a possible solution, vines are being planted at a higher, cooler altitude in an effort to offset the warming experienced in traditional regions.
The second related article comes from The Economist (Sep 10, 2011, online). In this articles, you can read how English wine is being produced in increased volumes and better quality – with locally grown grapes. Again, it is climate change – bringing warmer climes to Southern England – meaning that more traditional grape varieties can be grown in England as opposed to the typically acidic German varieties. The result has been a product of increasing quality, and a tendency to produce higher margin sparkling wines – something that was not so easily done before. Thus, the business model of English vineyards may have changed from one where imported “grape juice” was added to make local wine, to one where high quality, high-margin product is the norm.
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.