The various meanings of cost
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.
Book value versus market value
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A Guardian headline in recent days says “Tesla shares soar 40% after analyst says firm’s value could hit $1.3tn“. Similar headlines could be seen in other newspapers. So, the market values Tesla at $1.3 trillion, yet their 2018 10K shows assets valued at around $30 billion, and accumulated losses of $5.3 billion. So, why are these values so different? This is something students of mine often ask. I’ll try to give a simple answer.
The market value is based on expectations for the future, and these drive up the share price – some media sources though suggest the price is being driven by short sellers trying to buy shares to cover losses they may be making as they bet against Tesla shares rising in price. Accounting values are in general based on historic cost – what was paid for something in the past. Also, for example, accounting does not include items which do not have a historic cost – such as the Tesla brand name. Thus, accounting statements do not reflect future plans or values in general. If another business were to buy Tesla, then its actual (market) values would be captured by accounting of course – brand value, goodwill and such things not captured previously. At this purchase point, there is a historic cost.
Free email is not free.
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.
Provisions – an interesting example from a central bank
If you live in Ireland and are of a certain age, you’ll remember the above £20 note, and maybe even the older one with W.B Yeats on it. Now, we have euro notes of course, since 2002. So what if you had old pound notes? Well, when currencies change, there is usually a period of time during which the note can be redeemed at the Central Bank of the country in question. That is exactly the case in Ireland.
So where is the accounting in this you may be thinking? Bank notes have their origin in a “promise to pay the bearer on demand” as it used to say on old Irish currency, and still does on some bank notes. In other words, there is a liability on behalf of a bank to pay something – historically something like “pounds of silver”. In the case of the Irish Central Bank, there is still a liability to repay the the bearers of old currency, namely the Irish pounds. As recently reported, the Irish Central Bank has a provision in its accounts (specifically in the Statement of Financial Position) of €350 million for old notes and coins to be redeemed. This is 18 years after the notes ceased to be in circulation and be legal tender. This is why the term “provision” applies, as according to International Financial Reporting Standards a provision is “a liability of uncertain timing or amount”. In this case of the outstanding old Irish currency, the amount is certain, but the timing is not. I would imagine at some stage, the provision will be reversed, maybe 30 years for example, but until then, it will remain on the books of the Irish Central Bank.
An example of the going concern principle
One of the fundamental accounting concepts is that of going concern. In simple terms, this typically means a business is unlikely to be able to continue in operation for the next 12 months.
It is not very often the examples come to light, but recently in Ireland we had one. The national football association, the Football Association of Ireland, has their auditors state the organisation could not be deemed a going concern. According to the RTÉ news website, the auditors noted:
“While the company has received some advanced funding from UEFA during 2019 to enable the company to meet some of its current liabilities there is not sufficient audit evidence that the company will be able to meet its liabilities as they fall due. Therefore we are unable to obtain sufficient audit evidence to support the assumption that the company will continue as a going concern.”
The piece also notes the levels of debt and losses over several years. The statement above provides a nice clear understanding of what going concern means. Do have a read of the RTÉ article and other coverage to get more insights on the association.
Why do I need to prepare a budget
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In my previous post, I mentioned being part of a local voluntary committee, and our efforts to bring a Christmas market to my local town. It’s all going well, but as we near our first year end, it has become apparent to me how important it is for us to plan better for the following year.
Like many voluntary organisations, we are probably still finding our feet. While I keep track of the monies in my role, what I do not have is the full picture of what monies will be spent. To be fair none of us do, as this is the first time we have organised this event and none of us within the organisation have prior experience of such an event. However, a budget is exactly what will bring us together and help us focus for next year. By the end of the Christmas period, we will know what costs we have incurred to host the market and these can be the basis for discussions for the coming year. Then, with a budget in place, we can start to plan for what we need to achieve and of course we can keep a control on things. If you read any management accounting textbook you will see pros and cons of budgeting. To me the biggest advantage of preparing a budget in this small voluntary organisation is that we can all talk from the same page – i.e. the communication value of the budget.
Opportunity costs – lost parking fees
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 🙂
Taiwanese whisk(e)y
Yes, there are some whiskies produced in Taiwan, and they are winning some awards and grabbing attention in the whisky world. I wrote an article on The Conversation recently which looks at how Taiwanese whisky producers have some costs and cashflow advantages over other producers. You can read it here. Sláinte
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Thomas Cook collapse – breakeven and operation leverage
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.
What is a provision for bad/doubtful debts?
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Back to some basics today, seen as it is almost the beginning of a new academic year for me. I’d like to provide a brief summary of the notion of a provision for bad debts – based on my experience as an accountant mainly, but of course, it is something I would teach too.
First, a provision in accounting is simply an entry for something that has not yet happened but is probable. So, when a business sells on credit, it is likely some portion of customers will not pay – regardless of how good the credit controls are. Thus, based on past experience usually, the accountant in a business will create a provision for bad debts (sometimes called doubtful debts, or irrecoverable debts). At this stage, no specific debt which may be unpaid is identified, it is just a general estimate and the amount is captured as an expense in the income statement of the business. In my experience, the amount set by as a provision in the financial statements is typically about 1-3% of the amount of outstanding receivables, although this can vary from time to time. any adjustments to the amount provided are reflected through the income statement. When a debt is actually identified e.g. a customer goes bankrupt, then this specific amount is a separate expense to the income statement. Such specific debts may cause an accountant to review the amount of the provision too.
Accounting for rock stars
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Being an accountant is sometimes portrayed as being a boring path in life, but like all professions and jobs, it has its moments when you feel like you may have helped someone. It is great to see a business take your advice and see them grow and become a success. Of course, as you deal with businesses or clients, quite often you may give general advice which may also yield some fruit. At the end of July, The Guardian had a great little feature on Mick Jagger, and it seems he heeded advice from his accountant when he was younger. Seemingly, Laurence Myers was his accountant – and the accountant of many other famous rock stars of the era – and in a new book written by Myers, he outlines the business sense the young Rolling Stones had. This sense would, of course, be nurtured by a good accountant. And indeed, the Rolling Stones have been a financial and business success (see more here), certainly thanks in some part to the advice and partnering of a good accountant over the years.
The “cost” of refunds and claims – a management accounting view.
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.
Reasonable business expenses
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!
Accounting for Alcohol – part 15 “Accounting in the Port wine Chartered Trade Company (1756–1826)”
This is a brief summary of chapter 15 in our book, written by João F. Ribeiro, José M. Oliveira and Maria F. Brandão. This is also the final chapter in the book, so back to normal posts after this. I hope you enjoyed the chapter summaries.
This chapter details some accounting of the Portuguese Companhia Geral da Agricultura das Vinhas do Alto Douro (hereafter Companhia), which was founded in 1756. While also trading, the Companhia acted as a tax collector and regulation of the Douro wine sector. It was obliged to buy production excess, in accordance with the quantities determined by
the state, to avoid lowering of prices in the market. Furthermore, it acted as a creditor, as it had to lend funds to local farmers at a subsidized annual interest rate of 3%. Finally, it supervised improvement works in roads and waterways in the region, making use of collected taxes. All of this implied in needed to maintain good accounting records. The chapter provides a very detailed chart of the organisation of the accounting function and describes the various books of account maintained. The authors note how the “bookkeeping model is in harmony with the teachings of João Henrique de Sousa, the first teacher of the Aula de Comércio – the Portuguese Public School of Commerce created by Pombal in 1759”. This system was also used by other similar companies in Portugal. It is also noted by the authors that income smoothing was a typical feature after 1784, with reported earnings being very similar and accounts such as “Casks Depreciation, Bad Debt Provision, ‘Profit’ Provision and Extraordinary Income/Costs” being used to achieve this.
Accounting for Alcohol – part 14 “The Monastery of Silos and its wine cellar in Ribera del Duero through its accounting books (14th, 18th and 19th centuries)”
This is a brief summary of chapter 14 in our book, written by Lorenzo Maté, Begoña Prieto and Alicia Santidrián. This chapter details the activities at the Monastery of Silos relating to wine and its production, control and consumption through its accounting books. The monastery is a Benedictine monastery of Silos and was founded in the 11th century. The Rule of St Benedict has general rules on the moderate consumption of wine, and the account books at the monastery give some detail on what was consumed and what it cost.
The chapter reveals records from 1338. These accounts have information on the harvests of wheat and wine production. In the account, the incoming (recebta) and outgoing (despensa) of goods in kind (bread, wine) were noted first; and then income and expenditure in monies. A total of 1,550 16 lire pitchers were received during the year and over twice that was consumed (the being locally produced). The total cost is noted at 4,140 maravedis. Sample accounts from later years are also given and these tend to show more detail. The authors also provide a detailed chart of all the books of account of the monastery and outline how these books were used for various forms of accountability. For example, the Father General of the Valladolid congregation received accounts every six months, which were audited by monks having “intelligence in accounts”. The Father General also made two visits to the monastery during their four-year term of office. Such visits were a control mechanism, and the chapter provides some details on comments made during a visit in 1826.
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