In this post, I recount a conversation I had with a great mentor some years ago. It questioned my notion of what costs are relevant and how to set prices once a plant/factory is not at full capacity.
In a factory ( or any business perhaps ) when there is free capacity we can start to look at the make up of costs a little closer. Traditionally, management accounting would suggest we should at least cover all variable costs in the selling price. But think about it like this – if we have spare capacity, then perhaps the only additional cost is the material cost. Let’s assume we have a machine with a full crew, but not at full capacity. The fixed costs of the machine are just that – fixed, and we cannot avoid them. The labour costs are in effect fixed too, as workers will be paid. So, in this case, only the material costs are relevant. And this, any selling price above the material cost contributes to profit.
Yes, there may be many simplistic assumptions in the above. However, it made me think back then and I always give this example to my students. It is of course an example of throughput accounting, which I will mention next week.
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”.
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.
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.
As an accountant, it is too easy to condition yourself to only think about costs when making decisions. Of course many business decisions must consider things other than cost, such as market share, customer satisfaction, quality and so on. I am often looking for examples of how decisions are made in organisations, which seem to be on the basis of cost alone and ignore important qualitative factors.
In May of this year, what seems like a great example of a tough decision which was influenced by cost came to light. The Irish government made a decision on at least re-opening talks with drug companies on whether or not to make a skin cancer drug called Ipilimumab – better known as “Ipi” – available through the public health system. The re-opening followed public pressure. It is what happened before this which provides the example of the tough decision. In September of 2011, it was recommended to the government that the drug should not be made available as it was not cost-effective. The drug costs approximately €80,000-90,000 per patient and according to reports at the time, might prolong life by 3-4 months. Now, I would not like to be the person making that decision I must say. But, from my external view, it would seem the decision was based on cost alone. What about the benefits? Three or four months may be invaluable to a family. And to put my accountants hat on, what would the cost be of not treating the patient. I’d have a wild guess that a three or four-month hospital stay costs way more than €90,000, so there are bound to be some cost savings if a patient is healthier. As I said, I would hate to be making these kinds of decisions, but it does show how cost information can be used in complex decisions where many other factors are at play.