A colleague pointed to an article on The Guardian Food and Drink blog recently which posed a question “Is £2 a fair price for a cup of hot water and lemon”. The article describes a review of a coffee shop on TripAdvisor where a customer complained about the price. The manager duly drafted a long and detailed reply, justifying the cost. The justification included everything from the staff member cutting a slice of the lemon, walking in and out of the kitchen and so on – you can read it all at the above link. He argued the cost might be even more than £2.
So what is my view? The manager is right if you include all costs (i.e. full costing). But here is another way to think about this. The waiter, chef, light, rent, cups, equipment, decor etc have all been paid for and are sunk costs. Thinking about it this way, the extra cost of the coffee/tea/water & lemon or whatever else is simply the water and ingredients. Thus, a cup could be sold for a few cent and still make a profit on that one cup as long as the costs are covered. Of course to do this all the time would probably not make business sense, but sometimes if a business has already covered all its costs (or wants to minimise losses) it can engage in such marginal cost thinking – take GroupOn vouchers as an example. Such thinking about pricing and costs is not of course supported by financial reporting, which encourages us to think only in full cost terms. But going back to our coffee shop, if a waiter costs €/$/£10 per hour to employ, then this cost will not change regardless of whether (s)he serves 1 cup or 20 cups in an hour. Lowering prices might bring more people in, and they might buy more than just a cup of coffee – but to do this the manager needs to be aware of the nature of costs and make an informed decision.
Twenty five years ago, I first saw Dire Straits live in Dublin. It was one of the first gigs I ever went to. Back then, there was a guy on O’Connell St in Dublin selling bootleg cassettes of live gigs for maybe £5. The quality was awful, but fans loved it. And it was illegal of course, making it all the more fun.
Move forward to 2015, and I was lucky enough to see Mark Knopfler live in Leipzig. Still an amazing guitarist. Of course, times have moved on and almost everyone has a smartphone to record a gig on – I hate doing this, but some artists don’t seem to mind. To my surprise, Knopfler in his 2015 tour not only seemed to encourage recordings at gigs, but found a way to make some extra revenue.
At each gig – including Leipzig, and yes, I did buy – you could download the actual gig recording for €15. This was sound desk quality, and unique. Add an extra €20 and you got the recording posted to your home on a souvenir USB stick.
Now think of this in marginal costs and revenues. The marginal cost is close to zero, as the stadium is fitted out, staff there and the sound desk set up. Maybe the only cost is a bit of rented space on a cloud server somewhere. On the revenue side, it is pretty much a no-brainer really – the full amount of the €15 per download is revenue, as I just argued the cost is close to nil. So if 1,000 fans at each gig buy the recording, that’s €15,000 x maybe 20 gigs = €300,000, a tidy sum. And of course, it is a legal recording 🙂
To this audience I ask two questions
- do you understand short-term versus long-term? If you do, which applies to your decision-making?
- are there any trained management accountants working in banks? I know there are, so read below if you are one of them.
While driving back from Cork recently, I heard a decent sounding lady with six kids telling a story about how a bank was repossessing the house her family rented – it was the Joe Duffy show on RTE Radio 1. The landlord could not afford the loan repayments it seemed and the bank wanted to sell the house. The family worked, and had sufficient income to pay rent into the future. The husband worked in a state-job, so as secure as you could get. She tried to communicate with the bank, but got a “computer says no” type response from the bank. To me, and I am just a management accountant, not a banking expert I could not see the logic in selling the house. Something instinctively told me taking a longer term view is a better choice.
Based on the information she gave during the radio show, when I reach my home I opened an Excel sheet. I checked the rent the lady might be paying – from daft.ie – and then I started to use the simple PMT function in Excel. I made assumptions that the landlord stopped paying the bank loan based on the original house value in 2010; that the bank would allow the lady to take over the mortgage at the present market value of the house and at the present interest rate. I did not adjust for the time value of money. You can see all my workings at this link:
The total time to do the above calculations was about 20 mins. I admit, Excel is not perfect, and I do not adjust for the time value of money – I don’t think it will make things vastly different. To keep it short, if the bank allowed the lady to take over the house as described above, they would gain to the tune of just under €86,000. Based on my simple calculations, the lady could afford to pay this. So, taking a longer term view, the bank (and by definition it’s shareholders) would benefit compared to ditching the house now.
Some further points on costs. I ignore legal costs, as the bank would have to suffer legal costs on either a sale or re-mortgage. But there is a bigger elephant in the room on costs. The lady would be homeless, someone would have to pay this cost – directly or indirectly, and ultimately the state. If I extrapolate the social costs, what is the family (who seemed decent) became homeless, the family fabric was disturbed and the kids turn to crime in the future. How much would this cost in money terms ?
So back to my questions. The scenario I describe above is being repeat all across Ireland. As a person, and an accountant this annoys me. The view of banks seems to be short-term only, driven by profit only. Now don’t get me wrong, profit is good, it creates jobs and investment. But we must not view profit from a short-term perspective. So, to the bankers, give me an answer to the above questions. If you are a trained management accountant, you should be thinking long-term, and if not, don’t think you cannot fail by taking short-term views. As you know banks have failed, as the leading image here should remind you.
It’s 13 years since Ireland introduced a plastic bag levy of 15c, then 22c. Since then, around €200m has been collected from consumers. England recently introduced a similar scheme and this prompted me to reflect on what the less use of plastic bags has meant for Ireland – with a cost/accounting angle of course.
The first thing that strikes me is the lack of plastic bags stuck in hedges. Not only does this mean a cleaner countryside, but much lower clean up costs for local councils.Second, I would say the packaging industry did not lose out, as paper bags are generally available in stores – cost neutral in terms of employment. This is good too as paper is renewable, but also lost people have a car boot full of reusable bags. I still have some dating back to 2002 believe it or not. Third, as a tax it worked in that it changed our behaviour as a nation – for the good of the exchequer and the environment.
Following from my last post, here is another example of costs and design problems -but this one is a real project. A bridge crossing the Bay Area in San Franciso had an original cost estimate of $250, but the final cost was in excess of $6 billion. This occurred for many reasons, bad cost estimates, politics and the length of time involved. Read the article at the link for full detail – it’s a great example of the cost problems associated with infrastructure projects.
You may or may not know that Ireland has only recently started to charge for domestic water use. There has been some heated debate, but here are some simple numbers based my own household.
With two simple water butts – small 100l capacity costing about €60 In total (see the photo above) – I have saved at least 6,000 litres of water in the past year. At the metered rates this is not a lot saved financially, about €22. But if half of Irish households did this (about 600,000 houses) that is a total of €13.32 million per annum across the country. Not to mention how I have seen my kids get instilled with the idea of conserving water.
Of course that’s only half the story. Saving water from rainfall means less produced water, less stress on infrastructure, less energy consumed and so on. I have no idea what these effects would do to my savings figure above – certainly a multiplier.
Typical accountant you may be thinking, but that’s it, we need to think not only about costs we pay for water, but other costs too.
Sorry for another airline related post!
I was on a flight recently from Dublin and as the above photo shows, there was a little incident on the taxi to takeoff. Two aircraft touched each other. The one I was on (above) incurred wing damage, the other one tail damage. I’m not going to try to guess who made a mistake, but someone did. So what did this mistake cost?
Let’s think of costs in a broad sense. Here is my thinking
- Repair costs of both aircraft
- Lost revenue as aircraft are out of service
- Cost of renting replacement aircraft and crew
- Cost of emergency services attending the incident
- Customer service costs e.g. passenger refunds
- Cost of buses to return passengers to the terminal
- Increased compliance costs to ensure such mistakes do not happen again.
And there may be more. I’m just using this incident as an illustration of how we need to think of costs in a broad sense.
The April 2015 edition of National Geographic includes a very nice short article which draws on the work of two MIT aeronautical engineers. The article to me is a very nice mix of explaining why airlines charge more for more weight (of bags usually, but some airlines are considering weight of passengers too), and how we as passengers can reduce CO2 emissions as we fly.
For many years now, low-cost carriers in particular have charged more for checked in bags. They also step-up the charges as bags get heavier. The key reason for this is to reduce ground-handling time – less checked bags, less baggage handling, faster turnaround, all of which reduce cost or increase revenue. But, as the National Geographic article also points out, more weight equals more fuel consumption and higher fuel cost. The MIT engineers used a Boeing 737-800 (as used by Ryanair) at 75% capacity as a model to calculate how much extra fuel cost various passenger items incur over a year. A 25kg suitcase increases costs by $3,267 per annum, a 1okg carry on $980, a laptop $291 and a full-bladder $29 – among other examples. Ryanair currently have 303 aircraft (per their website), so taking just the costs I quote, this is $4,567 per passenger per year x 190 seats x 303 aircraft, this equate to $262,922,190 – and that’s a big potential cost saving. I can already see Ryanair’s next advert 🙂
There are two points to take from the above. It is obvious that airlines may charge more for weighty items as these drive fuel costs up. The second point is look how much cost we could save the environment by taking even small steps like taking a pee before boarding – $29 x 190 seats x 303 = $1,669,530 worth of fuel. This is just one airline, and I have no idea how much CO2 emissions are reduced by, but as Tesco say “every little counts”.
I’ve often wondered why craft beer costs more than our normal mass-produced and popular brands. Is it because it tastes better – like the Bru brand to the left, it’s really nice. Or because it cost more to produce? Or the smaller breweries have less economies of scale? Or does tax have something to do with it. It may be a combination of all of these, or some other factors I have not mentioned. However, a quick search of the internet revealed the answer to me – it is about cost of production, but not the raw materials. It is also about volume, but not volume sales.
An article I found on the Huffington Post is a good example of the cost issue faced by craft brewers. If you look at the article, you will see that largest cost item is packaging – the bottle and label you may think. A bit of further digging around the internet revealed that the greatest part of the packaging cost is shipping. But not shipping to end customers, shipping to be bottled. It seems a bottling machine is quite expensive, and at small volumes is not easy for a craft brewery to purchase. Instead, they often send the beer away in vats to be returned in bottles. The Huffington Post article suggests that 50% of the cost to the customer is margin. I am not sure if this is the case in Europe, but certainly small craft breweries are unlikely to be able to invest in a large bottling plant at the outset. As volume increase, they may be able to do so. Let them stay small I say, the variety of beers is better then.
We all know what it is like to sit in traffic, but ever wondering how much money is wasted through lost time? An article from The Economist gives a good picture. Some research conducted by the Centre for Economics and Business Research and INRIX looked at costs of traffic jams in three ways – 1) reduced productivity, 2) higher transport costs and 3) carbon costs of fumes. Their cost estimates across four countries comes to some $200 billion. Quite a sum I think you will agree. I wonder how much of this cost relates to lost labour time – or in other words what is the opportunity cost to firms of having staff delayed in traffic. Of course, you could think of this from the view of the worker too – the opportunity cost might be at least some extra time in bed instead of the morning rush hour.
I read an article in a leading Irish newspaper recently which has a typical cost volume profit theme underlying it.
The article related to the “Western Rail Corridor”, a route from Sligo to Limerick which had been closed down many years ago. In recent years with the help of local campaigns and some political backing, some of the line re-opened. According to the article:
“A report by consultants drawn up before the service began concluded that, even with healthy passenger numbers, it would not be able to wash its face and would need hefty subventions. And the passenger projections in that report were substantially higher than those that actually travelled in the first few years”
It seems the passenger volumes have been quite low in recent years too. But then Irish Rail did something – they lowered fares and made tickets available online. With online fares as low as €6, the passenger number have increase from 23,000 to 41,000 in the year to November 2014. I do not know what the operating costs are, or whether these passenger numbers are sufficient in the long term, but it is a classic example of the relationship between price, cost and volumes. Assume the costs are the same at 23,000 or 41,000 passenger levels, the rail company is likely to be better off – maybe not making a profit on the route, but at least covering more of its costs.
You have probably heard of Gangnam Style, – if not click here. Anyway, it broke Youtube’s counter in December and now has over 2.1 billion views. The video runs at just over 4 mins, which is 140 million man hours. Some writers at the Economist took a nice angle on Gangnam Style – the opportunity cost of us all watching it. You can read their post here, but can you believe we could have built 20 Empire State buildings, built 3 aircraft carriers or written the entire contents of wikipedia 1.5 times. It’s certainly an interesting take on the time we could have used to do better things.
A while ago, I was asked to write some entries for an Encyclopaedia of Corporate Social Responsibility. I enjoyed this and the research behind the writing. One of the terms I wrote about was Local Food. Without repeating the definition verbatim, local food is basically food grown within a local area. But what exactly is local? Town, region, state, country or what? That’s the hard part.
The image to your right shows some nice juicy strawberries. When I was a kid, we had these as treats from about May to July. And they are a treat, once in season and local. But now I can get strawberries at Christmas – but they taste c**p usually and come from many miles away. This is definitely not local food.
Bringing consumers year round fruit (and other food types) is an expensive and difficult business. An article in the November edition of National Geographic gives some idea. Yes the example is US based, but it has some hard facts. The article follows the 3,200 mile journey of strawberries from California to Washington DC. The berries are grown on large-scale farms and over 500 trucks a day can be involved on just one farm. The retail value of each truckload is $90,000, and fuel for each truck costs $2,700. Total journey time is 80 hours, for which a driver must be paid etc, and think about the wear and tear of the truck. This is hardly a local food example I would argue, and it easy to see the money involved. And I’m not even starting on the true cost, which includes costs of large-scale farming (pesticide run-off for example) and CO2 emissions.
You may have seen the typical product life cycle graph in your previous studies (see left). The basic idea is that sales in money and volume increase over time, but gradually tail off as the product comes to the end of its cycle.
When we think of management accounting and product costing, we are generally looking at short-term costs, and not all costs a product may incur over it’s life cycle. For example, there may be advertising costs to boost sales of mature products, costs of product development or even remediation/disposal costs. Life cycle costing include all costs of a product or service from design to end-of-life. All recurring and once-off costs are included over the entire life cycle. These costs can then be compared with expected revenues to determine if a product is profitable or not.
To give you an example, consider the drug development life cycle. It may take many years and cost €billions to bring a drug to market (see here for example, which depicts the process at Bayer), before a single euro in revenue is earned. Then, there are the on-going manufacturing costs. Perhaps the drug has side effects, and needs some improvement during its life. And perhaps as the drug ends its life, there may be costs in dismantling purpose-built manufacturing facilities. Taking all these items (and more no doubt) a drug company can consider if a particular drug is profitable.