Cost need to be managed. This is term I have probably heard or said many hundreds of times in my life as an accountant and teacher. Managing costs requires two things 1) a knowledge of costs and how costs are structured in the business, project or product and 2) managers. We probably take both of these for granted, but there are some classic examples of when one, other or both do not apply.
If you have ever been involved in a building project, or built your own house, you will know that construction costs are notoriously difficult to manage. Just think of any large building project in your country, was it delivered on time and within budget? Sometimes the answer is yes, but when it is no, it can be a resounding no. Take for example the Berlin airport which is due to be open on 31/10/2020 – probably the worst time in aviation history to open an airport due to the present pandemic. This project started back in 2006, and it is being opened at a cost which is billions in excess of plan. So what went wrong? I could probably write a book about it, but in essence bad management. Of course a large project may be late and over budget, but in the case of Berlin airport, the delay is about a decade and the cost overrun about 3 times. A BBC News article provides a good summary, and I will give some examples. First, there were changes during construction due to plans not including shops for example. This added time and money. Te question has to be how did the “managers” not notice a part of the airport which can give 50% of revenues was not there? Second, there were issues due to there being no specialist contractor, rather many smaller ones who the managers hoped could be compelled to reduce costs. However, not having a single point of contact in a the form of a specialist contractor implied the project management was very complex – and thus costly.
This is just a brief summary. Have a search around to find out more. Here is a nice article on the technical side, or here from CNN – which includes a final cost estimate of €7.3 billion (original plan c. €2 billion)
I hope a local distillery near my home does not mind me using their graphic above. As we are all dealing with the effects of the Covid 19 pandemic, I was really impressed to see how small local distilleries in Ireland (and indeed elsewhere and some large ones too) have changed to producing alcohol based hand sanitiser.
Many businesses cannot adapt their products to the current scenario, but the example of distilleries is a really good one. The Listoke Distillery is manufacturing and selling hand sanitiser at cost. Not only is this a good thing for society, it also in my view makes business sense. As the header of this post suggests, it is better to be “ticking over” and covering costs than losing money and not covering fixed costs. I would also bet that many of us (and certainly yours truly) will remember these local small businesses that helped us out in these strange times and, hopefully, they will see increased revenues and growth. Meanwhile, with costs covered, at least they have a good chance of surviving.
By the way, I’ve just bought my second bottle of sanitiser – accompanied by a bottle of gin of course.
If you have studied management accounting, or perhaps read some of my previous posts, you will know the word cost can have many meanings and descriptions. For example, a cost can be fixed, variable, mixed or opportunity.
In this post, I would like to think more about what the word cost can mean outside the world of accounting. The etymology of the word cost is from Latin constare which means to stand firm, stand at a price, which seems to suggest its origins are associated with business transactions. However, today cost can also be used to describe many non- business things. For example, the Alberta oil sands in Canada may have quite a high extraction cost in money terms, but also have and/or will have a large cost in terms of environmental impact.
As I write this post, many of us are working at home due to the global Covid 19 pandemic. This also provides a good example of the many meanings of the word cost. It is perfectly summed up in a phrase I heard on radio “we can count the cost in money now or in more lives lost later”. This comment was in response to plans (or lack of plans) by governments to respond to the pandemic and being more concerned with economic impacts.
These two short examples show cost has meanings which are perhaps commonly understood, and thankfully are becoming more and more a part of business decision-making- which is a good thing of course.
Telecommunication services in Ireland used to be provided by the State, through various entities. The most recent entity is eircom, now a private firm. eircom were one of the earlier providers of free email accounts, but that is about to change as the company now wish to charge €5.99 per month for email accounts. Well, there is no such thing as a free lunch as the saying goes.
But let’s put on our accounting hats for a minute. There is of course a cost involved in hosting email accounts – servers, cooling, power, buildings. This may have been okay when eircom was a state company and there was less of a profit motive. Gmail is free I hear you say; it is not, you give your data to them to make money from. So eircom probably need to recoup some of their costs, and that seems like a good accounting decision, The price does seem a bit high though – about €4.86 next of VAT will be earned by eircom. To me, it seem more like a prohibitive price, and the real objective to force email account holders to move to other providers.
I am a Treasurer on a local committee, whose task it is to bring a Christmas street market to my local town.
We raise sponsorship from local business and in turn the street market will boost Christmas trade it is hoped. Of course to do this, we need the approval of various local authorities, one being our county council. To hold the market, we need permission to close streets, and guess what, there is a small opportunity cost of doing this.
The street has about 15 parking spaces, which are chargeable at a rate of say €1.50 per hour from 08:00 to 18:00. The local council makes the assumption these spaces will be filled – which is probably quite fair – and the have to be paid for the parking revenue lost. This is a classic opportunity cost example, as they lose revenue by granting permission to hold the market, and thus are choosing one option over another. They probably could also add on lost revenues from tickets for illegal parking – I’d be quite sure there are more than one of these each day – but I will keep quiet on that one 🙂
In the past few days, the Thomas Cook travel company has gone into administration – meaning it’s banks have taken control to recoup monies they have lended. The company dates back to 1841, and is (or was) a well-known brand in the holiday/tour sector.
Of course, here I am interested in the management accounting angle, with a teaching focus. There will no doubt be plenty of comments on the failure, but let others write that. A quote in The Sun (ok not the best source, I acknowledge) noted “the firm has been struggling with a £1.6 billion debt for years. It needs to sell 300 million holidays a year to break even.” I am not sure about the accuracy of the “300 million holidays a year” to break even, but regardless, it is quite likely Thomas Cook would have had to sell a lot of holidays to cover the costs of servicing a large debt (and making repayments) on top of its ongoing costs. What is probably more interesting it the operating leverage within a firm like Thomas Cook.
Operating leverage refers to the percentage of total costs which fixed costs compared to variable costs. If fixed costs are higher in proportion to variable costs, this is referred to as high operating leverage, and more profit is made from each incremental sale. More variable costs, on the other hand, is termed low operating leverage and results in a smaller profit from each incremental sale. Where would Thomas Cook sit on this scale? Well, it likely had high fixed costs (debt servicing, fuel, staff, lease payments on aircraft etc), so is probably on the high operating leverage end of the scale with lots of fixed costs. But, the package holiday (or even the airline sector) is historically a sector with low profit margins. With high fixed costs and low margins, this means a firm like Thomas Cook needed substantial sales volumes and cost controls to keep going (or even break-even) without further funding. It seemed not to be able to do this – 2018 loss after tax was £163m, 2017 profit was £12m, 2016 profit £9m, not great on revenues of about £8 billion.
In recent years in Ireland, business insurance costs have been increased dramatically due to increasing volumes of claims against them. In some cases, the costs have increased so much that the businesses have simply closed. This post is more about the smaller claims, claims for refunds or costs incurred because a product or service was not up to scratch.
I will use Ryanair as the example here. Despite all the criticisms levelled against it, it remains one of my favourite airlines. They run a tight operation and keep costs to a minimum. They also do not payout refunds or claims unless they have to, this is the fun part for me. In a recent Irish Times article, there are details of a customer claiming €222 for taxi fares incurred due to a Ryanair mistake. The company fought it, but the passenger pursued through a small claims court and got their money refunded. Fair play to the passenger.
Recently I was subject to a delay on a Ryanair flight from Bristol. Some passengers, those who were UK citizens I later found out, were offered £5 refreshment vouchers. I was not, and followed up. To be fair to Ryanair they said if I could produce a receipt, they would refund me.
Now the accounting part. In both examples above there are a lot of costs already incurred in having a customer service function to deal with such issues. Let’s deem these as sunk costs. Once a claim is initiated, then I think we could see the situation as an instance of activity based costing perhaps. In my own case, I sent three emails and I can guarantee the cost of dealing with me was way more that the price of a cup of coffee I was seeking to claim. In the case of the passenger taxi fares, costs of engaging solicitors by Ryanair would have far exceeded the cost of the refund had they simply paid it based on the passengers receipts.
The point I am trying to make is that while I fully agree that firms should not just pay refunds without any basis, there is likely some value at which it costs more to defend a refund claim than simply pay it – with vouched receipts of course, not like me and my coffee. But, if you are not getting satisfaction from a company if you feel you should get a refund, apart from legal options, you can always waste their time a little and get some satisfaction that way.
I am sure you have read or heard stories in your country about political leaders or CEOs spending large amounts of money on expenses – hotels, meals etc. I have read a lot of such reports in recent weeks and just wanted to give a view on it.
To me, and much of this is based on experience, the first principle to me is simple – no receipt or invoice, then any expense should not be reimbursed. Doing this sets a basic principle which is easily understood. I have heard some comments over the years that there is a cost is running an expenses reimbursement system, which may exceed the value of the expenses, so why bother. This may be true in some cases, but I do not agree.
A second principle to me is a basic accounting one – business expenses only. The idea of say using a business credit card for personal lunches or whatever at a weekend goes against the entity principle. This principle means only items for the business should no part of the accounting for that business.
Third, the expense, once for the entity should be reasonable, but what is reasonable? This is where common sense must apply. Let’s take hotels as an example. It may be that a room for €100 per night is ample for any business person, but in some cities this may not be enough for even a basic hotel. But, if I were to say €1000 per night, you would probably think that is a bit too much. Of course you may have read reports of business leaders and political figures spending many thousands of Euro/Pounds/Dollars per night on hotels. Is this reasonable? Personally I do think some of these people could be a bit more modest!
The gentleman above is Michael D Higgins, the Irish president – of course he is well known to me and other Irish people, but just for the benefit for others you might read my blog.
In October, there will be a presidential election and Michael D is up for a second term of office most likely. In recent months there has been a lot of media attention as of how much the presidential office costs to run. The office does not have much power, but is a great representation of Ireland as a country. According to the presidential website, the cost is about €3.6 million per annum. The vast majority of this consists of staff and travel costs. However, in various media outlets I have heard numbers being mentioned about the costs of the police officers and army associated with the presidential office. At the link above, these count for about €250,000 in 2017.
So what you say! Well, are these costs relevant to the cost of the presidential office? Would they be avoided if the office ceased to be? I doubt it, as the army and police would be put back to their normal duties. So this is a simple example of costs not bring relevant, and thus they probably should be excluded from any comments or analysis. I would guess too that the kind of simple analysis I have done here might be applied to many other political figures. What is probably most important though is that the costs of the office of the Irish president are now being discussed and new controls and checks may result – which is a good thing.
When I teach Activity-based costing (ABC), one of the example sectors often given to students is healthcare. Just in case you don’t know, ABC is a costing technique which allocates cost to products or services based on resources used by the product or service. If you think about healthcare, even in a standard medical procedure, no two patients are the same and use more or less drugs, time, hospital resources etc. Thus ABC appears useful – one patient may use more resources than the other and so cost more.
Of course, healthcare systems around the world vary. Some are fully funded by taxation, some are fully private. In Ireland, the system is mainly a public one, but unfortunately, it is not great in terms of access to treatment. So, if you can afford it, you can have private medical insurance (US style, but less costly) and this gives you more options. With this in mind, here is my recent experience which made me think about ABC and write this post.
Last year, I spent 11 days in a hospital for some heart surgery. Thankfully all is well. I am lucky enough to have health insurance. About three months post-surgery, I received an advice from my insurer stating how much the hospital had been paid – about €25,000. Phew, thankfully I did not have to find the cash for that! The advice was interesting in that showed little sign of ABC techniques – and as my hospital was one of the more advanced and modern I would have expected it to use ABC, to be honest. What the advice showed was a charge per day, with this charge being higher for two days in intensive care. Otherwise, there is little else. Unfortunately for me, I had some complications which required more drugs and attention from staff, so I took up more time and resources than some of my hospital mates (trust me, you make some good friends in hospitals). But this is not reflected in the cost. I suppose on balance things work out for the hospital and it may not matter, but to me, this simple example is a prime case where ABC could be used easily. If it were, then maybe health insurance costs would be a lot less in some cases – but that’s a whole other debate.
Having said all of the above, research on ABC use shows it is often less than 20% in practice. So maybe I should not be expecting its use in my hospital at all.
I’ve been quiet recently on here due to some illness. While I’ll and having some time on my hands I began to ponder the cost of medicine and where I live ( Ireland ). I know we are one of the more expensive places to buy medicine in Europe, but here I’m not going to refer to any price indices or similar. Instead I’m going to try to quickly break down the costs of doing business in two countries – Ireland and Spain – to explain price differences. A business manager might do this regularly to gauge the competition. To give an example of the price difference, I know that a common prescription pain killer costs €26 in Spain versus €42 in Ireland. Some medicine I use myself costs about €12, versus €23 in Spain. And just tonne clear, these two examples are for identical nongeneric medicines.
The first is taxes. I found that most medicines in Spain have 4% VAT, whereas most in Ireland are at 0%. So we can rule this out. Second, a tax consultant in Spain told me that to purchase a pharmacy in the city I stayed in would cost about €2 million. This is due to limits on how many pharmacy licences there are. This cost results in high depreciation from an accounting perspective, and is similar to Ireland. Third, by my guess, all other costs like labour, rent, light etc are cheaper in Spain, probably 10-50% less. So this leads me to one remaining thing – profit margins. The profit margin would be spit between the pharmaceutical company, a distributor and the pharmacy itself. Without insider information, it is very hard to know what these margins are. Having said that, they must be a large explanatory factor for the price difference.
And for the fun, to give a more marked price difference. I recently saw a TV programme on the cost of medicine in the US. It not the cost of a monthly supply of insulin at $900. This was quite unaffordable for pensioners on a low income. Many who are near the Canadian borders drive across to Canada, where the price of the same product is CAD$ 120.
Of course, I’m doing a quick and dirty, non- scientific analysis here. But business is full of gut instinct and similar, and my experience and gut tells me profit margins are a huge explainer for medicine price differences between countries.
In my daily work as an accounting academic, income across many papers and articles which explore the broader role of accounting in society and out daily lives. Lisa Jack from the University of Portsmouth writes about the role of accounting in the food supply chain. This is a very interesting area, as information on costs and margins is crucial in the food sector. She has just published an article on the recent contamination of eggs in some
European countries – you can read it here. It gives a good overview of how accounting is entwined in this and other food issues, and how it could help.
I probably don’t need to explain the title of this short post, it’s quite obvious. Any business needs to appreciate all costs of the products or services it delivers.
- In past years, manufacturing has shifted to some degree to lower cost locations such as China, and the Foxconn relationship with Apple is a classic case. In the case of a product like an iPhone or iPad, it’s quite easy to see how the assembly costs are probably the higher component, and as they are small, distribution costs are low. But as a recent article in Forbes shows, transport costs are often a reason for manufacturing being close to market. In the article, there is mention of Foxconn planning to $10 billion plant in the US to build larger displays – for say 60 inch TVs. The article notes that the cost of capital in the US is similar to anywhere else, and labour costs and relatively low, although higher than China. However, the transportation costs would be much lower for such larger displays and thus it makes sense to build a new plant in the US.
Recently, it seems United Airlines got themselves into a bit of a bad public relations scenario by ejecting passengers (with force) from a domestic US flight. I’ve never used United and based in this, I never will, as it seems they commonly overbook flights.
First, in the age of technology we live in, how the hell a system allows overbooking I cannot fathom. Maybe if a smaller replacement aircraft transpired in an emergency, I can understand, but this would not be an overbooking issue.
You can read an article about the event at the link above, but here’s a brief rundown:
- United over book
- They look for four volunteers
- They offer $400, then $800
- Nobody volunteers
- They forcibly remove four passengers
And all of this to get their own crew to a location for the next day – this alone says a lot about their ability to manage the business, not having a standard way to get staff, or reserving x seats for staff.
Back to management accounting, and we know that an avoidable cost is one which can be eliminated by not doing something e.g. close a production line. We also know that in the long term, all costs are avoidable. So what about the United story. Well, one thing that will no doubt happen is a string of expensive law suits – and I personally hope United get screwed. This is an avoidable cost, and surely are the costs associated with the apparent regular overbooking. I’d even have a wild guess that it may have been cheaper to charter an aircraft for the staff than what this will ultimately cost United. Even $5000 a passenger to entice volunteers would be cheap too, or maybe $50000. Regardless, United need to find a long term solution to avoid such costs. They have apparently now increased the offer to passengers to $10,000 to give to give up their seats.
IAG, or the International Airlines Group, is the the parent of Aer Lingus, British Airways and Iberia. In my university, we were lucky enough to have their CEO, Willie Walsh, speak to us before Christmas.
Some things he mentioned are relevant to this blog, and of course interesting. One thing Mr Walsh noted was how only in recent years has the airline sector actually made a return on capital. This must be attributable in some way to a focus on cost by the sector in recent years. The chart below from IATA shows what I mean. As you can see, the cost of capital was higher than the return until 2014.
As my last post indicated, a focus on cost and efficiency has been a feature of the airline sector in recent years. To give another example, Mr Walsh cited an example of using two larger aircraft on a route without a loss in passenger capacity. So fuel, crew and capital cost all decrease in such a scenario. In addition, it freed up a slot at London’s Heathrow airport, which can then be used to generate more revenues.