Money in football
A short post today. I am not a big football fan, but when you think of the amounts of money top football clubs earn and spend, it’s big business. The Economist published a great infographic and few months ago which show the revenues if the top European teams. Very interesting – you can see it here
London Underground – profitability and costs in the early days
London underground (Photo credit: @Doug88888)
I have been reading a book recently on the history of the London Underground. It’s called Underground to Anywhere by Stephen Halliday and I actually bought it in the London Transport museum, on Covent Garden. Of course the tube is 150 years old this year, and you will find more about that here.
Reading the book I was quite surprised by how much accounting was in there. Two things stand out from the early days of the tube which related to accounting. First, the financing seemed to be quite precarious. As each line was built by private companies, private finance was raised. And when results proved less than expected, it seems quite a bit of creative re-financing went on. The author actually notes that without the somewhat suspect and complex financing, London’s Underground may not have grown to what it is today.
The second thing was the fares structure in the early days. Before lines were connected, the fares seemed to have been standard at say 2 pence. However, the author notes that the various companies started to raise and lower fares and certain times, or lower fares overall to increase passengers numbers and revenue- a classic cost, volume profit (CVP) scenario.
What does ‘cost’ mean?
If we look at a management accounting text book such as the one by Burns et al (self promotion, sorry), the term cost is defined as follows:
“the monetary value of the resources forgone or sacrificed in order to achieve a specific objective such as acquiring a good or service”
And, if we continue to read their chapter on costs (or indeed a similar chapter in any other management accounting text) we’ll find that costs can be classified in many ways – fixed, variable, mixed, product, period, relevant are just some classifications commonly used. I recently watched two documentaries on BBC television which portrayed the different meanings and uses of the word cost. I’ll summarise them below.
The first example is from a documentary called Inside Claridge’s – Claridge’s is a up-market hotel in London. In the episode I watched, the hotel was being decorated for Christmas. The decorations inside and out were quite fabulous, and the Christmas tree was commissioned from a custom designer. The programme narrator asked the hotel manager how much the decorating cost. His reply: “How much does magic cost”. A great answer I thought. To try to convert this to management accounting speak, I would translate the answer as “That’s not a relevant cost, the decision is made”.
Fault (Photo credit: orkybash)
The second example was a documentary on BBC Four on living near an earthquake zone or fault lines. One seismologist spoke about a complex underground monitoring system, which could sense earthquake vibrations and give warnings (via sirens or signs) to residents in cities like Los Angeles and San Diego. The system would cost in excess of $100 million, and give enough time to do things like shut down nuclear reactors or close-up an open wound on a hospital operating table (the seismologist’s words, not mine). I was thinking $100 million, that’s a lot. The seismologist then quickly noted that the economic output of California is in the order of $200 billion per annum. This makes the cost look a lot smaller, given that large earthquakes probably are a once in a lifetime event.
Kindle Fire breaks even – but profits elsewhere
Image via CrunchBase
I have written a few posts before on breakeven, but here is a great example of how businesses are prepared to accept not making money on some products, for the sake of others. In October 2012, Amazon launched its Kindle Fire tablet and its Paperwhite e-reader in the UK and other European countries. The Kindle Fire retails at about £150, which is probably less than half the price of an iPad and about £100 cheaper than an iPad mini. In an interview with the BBC , Amazon’s boss Jeff Bezos said the company sells its hardware at cost i.e. they breakeven. This may explain the cheaper price of the Kindle Fire compared to the iPad. However Amazon earn profits on Kindle book sales, Kindle book rentals and its Prime service. In contrast, Apple have noted they breakeven on services such as iTunes and make profits on their hardware,
The learning curve – real life application
I have previously written about the learning curve and its use in management accounting practice. The learning curve effect refers to a possible tendency for tasks to be performed quicker as employees learn them and become more efficient. Thus, over time, costs may decrease. The term experience curve is also used to describe this effect – have a look at the previous post for detail on how to calculate the learning curve effect.
In October 2012, CIMA reported some research on two cases of actual use of the learning curve. The full details can be found here , but I will summarise them briefly here. Pricing was a key issue for one case, so they used the learning curve in their cost and pricing calculations to ensure they were giving customers the most competitive price. In the second case, the learning curve effect was used in investment evaluation to obtain the best future cash flow projections.
The importance of integrating cost and risk into decision making
Olympic Stadium at Stratford, London (Photo credit: Wikipedia)
It’s always great to find and example of where some simple planning and management accounting type work would have done quite a bit for a particular company or decision.
During the summer just past, a great example came to life. The London 2012 Olympics have come and gone, but I’m sure you can imagine such an event needed a lot on planning. Mostly, the games went fine. However, a few weeks before the games kicked off, a story broke about how G4S would not be able to deliver the number of security personnel they were contracted to provide. You can read more on the BBC website here, but in a nutshell G4S racked up losses of £30-50m. Why? Well it seems to boil down to not been able to recruit enough new staff and train them within the timeframe, and thus G4S have to cover the cost of army personnel provided instead. According to the BBC, the value of the contract was £280m and one would think there should be scope for profit in this. I wonder did anyone ever ask this key question: What if we cannot recruit enough staff? If this question was asked, then the next question might be: how much will it cost us if we cannot provide enough staff. These two relatively simple questions might have forced managers at G4S to think about the risk of this happening and the costs. This does not mean they would have not faced the problems and costs they did, but at least they may have been more prepared to deal with the problem as it happened – or better still planned better from the start.
Another cost-volume-profit example – supersize portions
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 cost-volume-profit-example – a child care facility
The BRiC charging (Photo credit: fe2cruz)
In this and the next post, I will give you two simple examples of cost-volume-profit (CVP) analysis in action. CVP analysis, or sometimes it’s called break-even analysis, is a useful decision tool for any business to understand effects of cost changes or sales volume changes on underlying profit.
The first example relates to small Montessori school run by someone I know. In Ireland, preschool children get some free childcare and the owner of the facility gets paid €250 per child per month. The Montessori in question is insured to have 11 children with one staff member, but beyond this a second employee is needed. The full capacity of the school is 15 children and the extra employee costs €620 per month. This is a fixed cost. If you do some quick calculations, you can see that it takes 3 children (€ 750) to cover the employee cost. Thus, the owner needs to have 11 or less children with one employee, or 14 or more with two employees. So you can see how the fixed cost increase affects the volume needed to keep profit levels stable. There may of course be some additional variable costs with more children, but I am ignoring these to keep the example simple.
Expense tracking – there’s an app for that
To keep track of the many things I do, I have to take notes. For example, all the posts on this blog are noted somewhere first and then I write about them when I get time. I use a product called Evernote, which is just brilliant. I can do anything I want in this app in terms of taking notes. And, like all apps there tends to be adverts for related products from time to time. One I found interesting (but don’t use) is Expensify. This app seems to be very useful for track this annoying expenses. You can see more here on the app’s features. One thing it might be really useful for is those annoying fuel receipts small businesses have. For example, a sole trader might have 2 or 3 receipts for diesel each week, which are probably paid for in cash. These receipts frequently get lost and are a pain to store too. So it might be useful to use a product like Expensify to take a snap shot of these and store them. You can also use the app to track mileage, so this might be useful for small companies whose employees may get paid mileage.
Related articles
- Expensify Trips: Track your itinerary from your expense report (expensify.com)
- Apps I’m digging lately (intomobile.com)
Technology and new business-models – taxi despatching
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!
What is a step fixed cost?
by maccie1, flickr.com
From previous posts, you know what a fixed cost is. There is another type of fixed cost called a step (or stepped) fixed cost.
A step fixed cost takes its name from the fact that the cost can take a “step up” if certain things happen. This usually means a cost increases when the activity of a business exceeds a certain level, and the fixed cost then suddenly increases, but remains fixed at this new higher level.
Here are two examples which may help you to understand.
1) Employer liability insurance costs may remain quite stable until a certain threshold is reached. For example, it may cost €10,000 to have cover for up to 100 staff, but €15,000 if the staff number exceeds 100.
2) Typically, internet hosting costs include a high allowance for data traffic volumes. But if a company exceeds this, they may have to change to the next package up. This typically would give a much greater data traffic allowance, and the cost would increase in a step fashion.
What is a mixed-cost?
A mixed cost is a cost that contains both variable and fixed costs (see my previous two posts for more on these). Utility bills traditionally were a food example of a mixed cost. Take a telephone bill. Traditionally, a phone bill had a fixed cost which you had to pay even if you made no calls – the line rental in other words. Then you paid for each call, and the more calls you made the greater the total cost – in other words the call cost was variable. Nowadays phone bills tend to be fixed costs – all calls, line rental and Internet are bundled together into a flat monthly charge. Electricity and gas bills still tend to have a small fixed cost – the standing charge – which is paid regardless of use.
What is a fixed cost
From Flickr by Medieval Armour
In the previous post, I explained what a variable cost is. Now here, let’s look at fixed costs.
A fixed cost is a cost which does not change with the level of activity of a business. For example, there are some costs that a business will incur even if it is closed – such as buildings insurance. Other fixed costs might include a managers salary or other similar payroll costs which are fixed, taxes or business rates paid to a local authority or rent paid to a landlord. The term overhead is frequently used with reference to fixed costs.
Although the total fixed cost is that, fixed, as the level of activity of a business increases (more goods made or more services provided) the fixed cost per product/service actually falls. Let’s say for example if a business has total fixed costs of £48,000. If the business sells 24,000 units of product, then the fixed cost per product is £2, but if it can manage to sell 48,000 units of product, then the fixed cost per unit is just £1. As more and more units are made, the fixed cost will become negligible on a per product basis. Thus, I think it is easy to see how the level of fixed costs can affect the level of profit – high fixed costs with low volumes might spell trouble.
Are fixed costs fixed forever? No is the simple answer. As a business increases activity, then quite often more fixed costs are incurred e.g. more managers or a bigger premises. So fixed costs are not “fixed” indefinite, but they are fixed within what is called a “relevant range” of activity. A good example of this kind of effect is employer liability insurance – normally the cost is fixed with a range of employees (maybe 1-100) and the cost jumps once this range is exceed (i.e. 101 staff or more).
What is a variable cost
(photo from Flickr.com)In this post and the next few, I’ll explain some basic terms used to understand costs in management accounting.
A variable cost is a cost which change in accordance with the activity of a business. For example, if I order a meal at a restaurant, the food itself is a cost that would not be incurred had I not walked in. As the restaurant fills up, then the food ingredient costs go up. Another variable cost example might be fuel in a car or truck. The more the car or truck is used, the higher the cost.
In a business, variable costs can usually be saved by simply not making any product or delivering a service, but this of course may not always be possible. Typical variable costs are labour and materials associated with a product or service. Such costs would not be incurred if the product or service was not delivered i.e something triggers the incurring of variable costs.Think of the chef in the kitchen of a restaurant – a customer order means food costs increase, or a variable cost has been incurred. You may be thinking of the chef’s wages – I’ll come back to that in the next post.
Cleaner transport (and cost savings?)
Back in February this year I wrote a short post about how Tesco were increasing their use of rail travel to reduce CO2 emissions. It was a good example of how to change your business to both deliver cost savings and be more environmentally friendly. In the February 2012 edition of CIMA’s Financial Management (pp 26.30), there is a great article written by Ben Schiller which provides a number of examples of firms which are seeking ways to reduce transport costs and CO2 emissions. One quote from the article sums up the problems around transport costs “many ships operating today were built to run on $150 a tonne bunker fuel, not a price four times that”. Of course, it is not only ships but all forms of transport which are facing these price increases, such as road haulage and even company cars (for example, when I bought my first diesel car just over 3 years ago, diesel was 99 cent per litre at my local station, now it’s over €1.50). As a result of these increasing costs, we can see more sleek looking fuel-efficient trucks for example on our motorways.
I found Ben Schiller’s article really great less for some examples we might know about – chip fat being converted to biodiesel, electric vehicles – but more for some real examples from firms we all probably know well. The first way firms can save on transport costs (and green up) is to bring production closer to the market – L’Oreal for example have brought some of their supply chain in-house, by producing thinks like packaging on-site. A second way, is to change the modes of transport. For example, both Philips and Tesco use canals to transport bulky product. Phillips use barges to transport goods to Rotterdam port, while Tesco ship wine between Liverpool and Manchester. In Spain, SEAT rebuilt a short rail line to Barcelona port, carrying 80,000 cars annually using 2 trains a day. Even large shipping companies like Maersk are doing things like “slow-steaming ” (or sailing slower) to reduce CO2 emissions and fuel costs.
There are more examples in the article itself. You can read an online summary here.
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