A few weeks ago, I read a nice article in The Telegraph by David Millward on one of my favourite topics, airlines and all things to do with airports – I was born close to Dublin Airport and it was a big part of my growing up.
Anyway, many of us have witnessed the phenomena of low-cost airlines emerge of the last 20-30 years, and as an accountant it’s the constant actions to reduce costs that amaze me. As Millward said in his article, one of the things that airlines have done is unbundle. This means you get the basic fare from origin to destination for as low as possible. If you want more you pay more. This is fine by me, on a shorter flight, but now as longer-haul low-cost carriers appear I am not sure – I have no experience yet, so I dare not say. The low-costs have of course eaten into some of the legacy carrier market, but they have also expanded the market by making flying more accessible. Millward suggests that the low-costs have by now probably stripped out all they can to reduce costs, but the legacy carriers can do more – if they wish. I read another article recently which mentioned how WestJet, a low-cost transatlantic carrier remove the in-flight screens to save 500 kg in weight and thus save fuel. They replaced the screens with a wi-fi system and the BYOD idea – most people have their own device on-board anyway. Surely such simple steps could be taken by any carrier.
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.
Marketing and design people tend to be very creative, and fair play to them, it’s part of what they are. But design is one thing and actually building or making sometime is tougher – if you have ever built even a standard house you will know what I mean.
The one thing I have learned about design of products is to not change the design after you agree it – this typically causes costs to go upwards. If a customer is willing to pay for this great, but that’s usually the exception.
My experience of product design is it is best to involve someone with good management accounting knowledge from the outset. This person need not be an accountant, but must has good knowledge of costs and or processes to build or make the final product. Otherwise big surprises can occur.
Maybe it’s an extreme example but take the main stadium design for the 2020 Olympic Games in Tokyo. According to reports, the cost of the design to be built has doubled to $2 billion since inception. Surely if someone with half decent knowledge of costs working with the designer would have spotted the additional costs.
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.
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.
I recently got a flat rate taxi fare from an airport in Europe – a bit of an adventure, the guy was really moving it. And the rate was of course cheaper than normal taxi fare which at airports are usually more expensive . So then I started to think about apps like Hailo (and the latest one Uber). Can these reduce taxi costs and in turn give us cheaper fares. Well I guess so. I don’t know for sure, but I would assume using Hailo is cheaper than “renting” a radio and a customer base from a taxi firm. If I’m right, will these reduced costs be passed on?
This is a question I often asked, well about all iPhone models since my iPhone 3. Below is a link to a post by Wendy Tietz which includes good estimates. It is set out like a student exercise too, so give it a go if you have the time. Seems Apple make quite a margin, and it seem the mobile operators subsidise quite a bit too.
In October of this year, Michelin star chef Derry Clarke had a go at Dublin restaurants selling “cheap meals” – see here. I guess Clarke was thinking from his own view when he said “the number of restaurants offering meal deals at economically non-viable prices just isn’t sustainable, it’s the same cost in McDonalds, but we have all of the overheads”.
He may have a point about the number of restaurants being sustainable, but Derry, stick to the cooking. Any management accountant could figure out that even if meals are sold cheap (and I doubt they are below cost as Clarke suggests), they still make a contribution towards overhead costs. It would be better to have 50 guests in a restaurant earning a contribution of €5 a head (€250 in total) than having an empty restaurant. In the latter case, costs such as labour, heating, rent and so on are still incurred.
As I drove through France and Spain on my holiday, I thought about the tolls one must pay (on most) motorways. I was thinking how do they set the prices of these tolls? Of course, public infrastructure like motorways is often now financed by a combination of public and private investment. Regardless of the investment type, can you imagine how tricky it is to pitch a price for a motorway toll. If it’s too high, less will use it (M6 Toll in the UK) and costs take much longer to be recouped. Set it too cheap and it floods with traffic, which in turn eventually results in less users, and that equals less money. Should the price be set with future investment and on-going maintenance in mind. Should it be a social good with a very low price – but then where will the money come from for re-investment? Lots of questions here, but I hope you can see a lot of management accounting is behind these decisions. I would imagine getting the initial price correct is the toughest part. Nowadays though, I am sure there are plenty of modelling tools to help toll operators and governments.
Sorry about the somewhat cheesy title ! This summer, I spent about 3 weeks on a driving holiday in France and Spain. I love driving to Europe – no airports, luggage limit is a much as you can carry in your car, and you can stop when you want where you want. I drove just over 3,000 miles and stayed in some beautiful places. During my journey, the old business brain was not completely switched off so I’d like to share some things I noticed and thought about. Of course, they will be related to management accounting one way or another.
The first thing I noticed was that the ferry trip to France gave us a free trip to the UK. A free something is nothing new – you can lots of examples of free products, two for three deals etc. in books like Freakonomics and Undercover Economist. The deal was simply I got a free trip in a car ferry to the UK for a car and 2 adults once I completed my trip to Europe. On my return, I phoned and all went perfect. I had to pay a small amount for the kids, but we got the dates we wanted. So how much is this promotion costing the ferry company. I guess there are two ways of looking at it:
1) it costs them the lost revenue from two other paying passengers with a car – so a sort of opportunity cost
2) it costs nil, and in fact increases contribution.
Which one would you use if you were making the decision/reporting to management ? I’d go with the second view, especially in off-season. The ferry in question hardly ever leaves the Irish Sea – going back and forward to the UK three times every 24 hours, all year round. In off-season, the boat is not full – but the costs of running it are the same – both fixed and variable costs. Thus, any extra monies I spend – buying food for example – reduces the fixed costs burden. If I were to think about this free trip in full cost terms, I would probably not offer it to passengers as the fixed cost are unlikely to be covered. This would be the wrong decision in my view, as anything that contributes to the bottom line is better that nothing, or suffering the fixed costs regardless.
Tune in over the coming weeks for some more holiday stories.
At the end of June this year, Michael O’Leary from Ryanair was his usual self at the Paris Airshow. He let a few jibes fly at almost everyone. He also signed an order with Boeing for new aircraft, worth around $1.5 billion. Plans for future aircraft purchase were mentioned too and O’Leary compared two possible aircraft – one from Boeing and one from Airbus. While he suggested both were similar aircraft, the Boeing has 9 more seats and he said ‘that’s worth a million bucks’. When I read this , I thought is this just another quip or does we know his numbers well?
So, here are my calculations:
9 seats at average revenue of €70 = €630
Assume four flights per day per aircraft, so 630 x 4 =€2,520.
Finally, assume 360 flying days per year, this gives 360 x €2,520 = €907,200.
Let’s not argue over the rounding, and maybe my sums and assumptions are not correct. But a round €1million per aircraft per annum adds up to a lot of money. So although O’Leary’s rule of thumb may seem like a quip, it seems to be quite a good rough measure. He is an accountant after all!
You may have heard of activity-based costing (or ABC), and here I will try to explain the basics of ABC. First, just a short reminder of the types of cost an organisation may have.
Costs are often classified as fixed or variable. Variable costs change in line with volume/output, and are often called direct costs as they can be attributed easily to a product or service. Fixed costs, often called indirect costs, do not change when business output changes. For example, a fixed cost might be rent of a premises or the salary of a general manager. Such costs cannot be easily traced to a product or service. However, if no effort is made to trace fixed costs to products or services, then the business does not know the full cost. This makes decision-making more difficult.
Traditionally fixed production costs are absorbed into a product by means of a rate per labour hour. For example if overhead was planned at €1 million for a year and 100,000 labour hours were to be worked, then each labour hour would mean a €10 overhead cost. So a product taking two labour hours to make would be charged €20 overhead.
The traditional method can be criticised as over the years more and more overhead has been non-production type overhead and not related to the number of labour hours spent making a product – indeed automation of production in many industries has seen labour being of decreasing importance.
Another more modern way to allocate overhead to products is using ABC. The key in ABC is the word “activity”. In ABC, we can think of an activity as a collection of tasks which are linked in terms of being an overhead cost. For example, customer service, facilities management, quality control and machine setup are all examples of activities. The resources of the activity are determined, which are used to determine the cost of the activity – typically for a year. Then, what causes these resources to increase or decrease is determined. This is called a cost driver. For example, more complaints from customers will increase the resources needed by a customer service department. Using the cost driver, the overhead cost driver rate can be determined. Here’s a brief example:
A design department costs €100,ooo per annum – costs such as salaries, design materials, computer running costs etc. The more designs for new products the greater the cost, this designs are the cost driver. Lets assume there are 5,00o designs per annum, thus the cost driver rate is €20 per design. A product which needs say three designs will thus incur a €60 overhead costs for designs using ABC. If a product has nor designs, then zero overhead is incurred.
In a business, design (as per the above example) may just be one cost driver. Thus, the more resources (activities) consumer by a product the higher the overhead cost. This seems to make a lot of sense, and thus ABC is often used where overhead costs are not easily traced using direct labour hours (or similar) as a means to allocate overhead cost.
With ABC, all direct costs are assigned to the product/service in the same way as traditional costing methods. It is just the allocation of overheads that differs. Typically, ABC considers not only production overhead costs, but many other overhead costs which can be defined within activities.
- Two activities for ABC and the appropriate cost drivers for those activities (globalexperts4u.wordpress.com)
- Introducing Overhead Cost (thebangaloresnob.wordpress.com)
Many years ago when I work in an accounting practice, we had a client who kept no wage records for a while. All we had was the net pay of each employee. We needed to get the gross pay, as well as the tax and social insurance, to do proper accounts and sort out the taxes owed. Back then we had no software to do this. So what did we do?
Well, we used algebra. We knew tax and social insurance rates and these were all a percentage of gross pay. We ended up with something like this :
G – 0.20G – 0.07G= Net
So we solved for G. It’s a bit more complicated today as back then the social insurance was a flat rate – and what I show above is only illustrative. What made me think about this past experience was a CIMA post about how we still use algebra in many management accounting tasks today – read more here.
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.
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.
- Expensify Trips: Track your itinerary from your expense report (expensify.com)
- Apps I’m digging lately (intomobile.com)