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)
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.
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.
Back in the late 1980’s and early 1990’s when I was young enough to be frequenting pubs/clubs around Dublin city centre, one of the biggest problems was getting a taxi home. At that time, the number of taxi’s was regulated, with (if my memory serves me right) about 1,200 taxis for a city of about a million people. The effect of this was a market for taxi licences. Many taxi drivers depended on this for their pensions, with a licence yielding IR£ 60,000- 80,000 (about €75-100,000). Now, Dublin has a de-regulated taxi system and has more taxi’s than New York (see here for a taxi-eye view). The price structure is also heavily regulated, and a common price structure applies to all fares throughout Ireland. And, of course, a taxi licence is nowadays worth very little.
Why and I writing about taxis you might ask? Well, while on holiday near Leipzig (Germany) over the Christmas period, I read an article in a local paper (Doeblener Allgemeine Zeitung, Dec 27, p.7) about how a taxi firm is dealing with rising costs. The taxi sector in Leipzig is de-regulated too as far as I know, and competition is strong. The article interviewed a manager from a local taxi firm, 4884. Rising fuel prices seem to be a major problem for the firm – and indeed for Dublin taxis too. However, as I read on I realised that Dublin and Leipzig taxi firms/owners, while having a lot in common (over/high supply, rising costs, relatively declining static/declining market), the Leipzig firm 4884 seemed to adapt well to become attract and keep customers. For example, in June 2011, 4884 launched an app to order taxis (using GPS). They also (according to the Dec. article) regularly train and annually update their drivers on things like customer service skills – it is even written into the drivers’ contracts. In Dublin too, there is at least one taxi app I am aware of (Irish Taxi), but I am not sure it is as advanced in terms of GPS. London too has a GPS service available for ordering a taxi.
So what’s the management accounting point? Well, if we compare the market for taxis now to compared to the past (in most countries, but certainly Ireland), there is a far greater supply (volume). The cost structure is typically beyond the control of all taxis. Most costs are fixed – radio rental, advertising, taxi licence fee, insurance – with fuel being the main variable cost. With more taxis in supply, a static market, fixed prices and little ability to control costs, then the ability to earn a profit is likely to be more difficult now. So what can be done by taxi owners/firms to sustain profit. Most have joined forces to create firms/co-ops, which can share some costs (e.g. central booking). Other options are to increase customer retention through things like apps and improved customer service. At the end of the day, with so many costs beyond their control, taxi drivers/firms can only but be adaptive to stay in business. If they are not, they can (and do) go out of business.
When I teach management accounting to students, I am always looking for examples to relate what I say to a real life example. So, a while back I was trying to think of an example which might convey the fact that management accountants are not (or should not be) just bean-counters. The role of a management accountant/business analyst/business partner is much more than just accounting. My experience tells me that a good management accountant (and manager too) get’s their hand dirty i.e. knows a good deal about the business in terms of how things are made/delivered. If you don’t know the business, then how for example can you actually undertake a cost-saving exercise. So now for the example. I read a blog post on The Economist website a while back. The title caught my eye actually “Reducing the barnacle bill”. The article post mentions how barnacles attached to a ships hull below the waterline can increase drag so much that fuel costs increase 40%. The post then mentions several chemical solutions currently available and some being worked on. The point from this example is that should a management accountant at a shipping company know such detail of operations. I’d like to suggest, yes they should. Only such detailed knowledge of the operations would highlight the need to control the “barnacle cost”. I’m sure there are many more similar examples out there.
I recent read a research paper from the German “ControllerVerein” whcih I found quite interesting (controlling is the German word for management accounting by the way, and a controller is their nearest to the English term”management accounting” ). The paper is about business excellence and quality programmes. What I found interesting was the definition of “cost” from a quality perspective and well as a controlling (management accounting) perspective. I’ll do my best to translate them here.
According to the Deutsche Gesellschaft fuer Qulaitaet (DGQ or German Quality Assoc in English) costs are:
The value of physical and intangible materials, activities and other tasks which realise and subsequently recovery a product or service.
The above definition has some added notes too:
- These costs should include providing and maintaining the necessary capacity (of the product)
- Too many error and failure costs are indicators of a need for organisational and process improvement.
Now here’s the definition of costs from the Internationler Controller Verein (a leading German management accounting body):
The value of goods and services used in the creation/delivery of business activities. The cost is calculated according to management needs. Different costs may be used according to the decision being made, the type of product or the organisational structure.
So what’s the difference between these two definitions? I think the most obvious one is the time focus of each. In management accounting, we are sometimes criticised for providing too much short-term information. For example, one criticism of traditional budgeting techniques is its short-term focus. Looking at the definition of cost from the DGQ above, it clearly perceives cost as a longer-term concept. Yes, management accounting does have techniques like “life-cycle costing” which makes us consider longer-term costs of product or services, but this is a more “specialised” technique and not normally within the armaments of the typical management accountant. Although having said that, nowadays the increased focus on longer-term sustainability has focused management accountants on much broader and longer-term concepts. However, I can’t help but think if the basic definition of cost were broadened to embrace longer term thinking, like how costs are perceived by quality professionals, it would be of great benefit to us.