Fixed costs subsidy – a simple way governments can help business during Covid
Many governments are helping/have helped businesses during the last year since Covid 19 appeared on the scene. There are probably as many ways to help those businesses affected as there are countries in the world, and some sectors need more help than others. I would imagine from both the perspective of a business needing help, and from a government perspective, keeping this simple is key
Focusing solely on helping business with costs, probably the easiest thing a government can do is help a business with fixed costs. These costs are incurred even if a business is closed. Some such costs are imposed by government (e.g. business rates) and these are being postponed in many countries. Other fixed costs such as rent, security or insurance may still be incurred by a business, and some governments are helping business by covering a portion of such costs. Another method I have read about is how some governments are giving loans to cover such costs – as ultimately a surviving business can pay taxes, and of course government borrowing is very cheap at the moment.
Any schemes which help business by covering fixed costs should be relatively easy to operate and understand for two reasons. First, any business should have cost data to hand from its annual accounts at least, or from its accounting systems at best. Second, fixed costs are understood by even the smallest business. Of course, fixed costs are different for different businesses and sectors, and ideally any subsidy or help should take this in account.
Marginal costs of a coffee?
Image from wikipedia
A colleague pointed to an article on The Guardian Food and Drink blog recently which posed a question “Is £2 a fair price for a cup of hot water and lemon”. The article describes a review of a coffee shop on TripAdvisor where a customer complained about the price. The manager duly drafted a long and detailed reply, justifying the cost. The justification included everything from the staff member cutting a slice of the lemon, walking in and out of the kitchen and so on – you can read it all at the above link. He argued the cost might be even more than £2.
So what is my view? The manager is right if you include all costs (i.e. full costing). But here is another way to think about this. The waiter, chef, light, rent, cups, equipment, decor etc have all been paid for and are sunk costs. Thinking about it this way, the extra cost of the coffee/tea/water & lemon or whatever else is simply the water and ingredients. Thus, a cup could be sold for a few cent and still make a profit on that one cup as long as the costs are covered. Of course to do this all the time would probably not make business sense, but sometimes if a business has already covered all its costs (or wants to minimise losses) it can engage in such marginal cost thinking – take GroupOn vouchers as an example. Such thinking about pricing and costs is not of course supported by financial reporting, which encourages us to think only in full cost terms. But going back to our coffee shop, if a waiter costs €/$/£10 per hour to employ, then this cost will not change regardless of whether (s)he serves 1 cup or 20 cups in an hour. Lowering prices might bring more people in, and they might buy more than just a cup of coffee – but to do this the manager needs to be aware of the nature of costs and make an informed decision.
Management accountant’s travelogue- part 1 – free ferry trips
(Photo credit: Wikipedia)
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.
What is activity-based costing?
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.
Related articles
- Two activities for ABC and the appropriate cost drivers for those activities (globalexperts4u.wordpress.com)
- Introducing Overhead Cost (thebangaloresnob.wordpress.com)
CVP in farming
Farmers Market (Photo credit: Macomb Paynes)
As you may know CVP analysis looks at costs, revenues and volumes to determine things like at what output level a business will break even or make a certain profit. This post provides a simple example of the effects of volume on the viability of a business.
Recently, a local authority in Dublin, Ireland announced plans to build a large sewage treatment in the north of the city. As part of this, a vegetable farmer in the area will lose 35 of his 120 or so acres to the plant. I listened to a radio broadcast where the farmer simply said this is too much land to lose and his operation becomes uneconomic.
Let’s think about this briefly in CVP terms. If we assume a stable price for the farmer’s products and stable variable costs (seeds, labour, fuel, fertilisers for example), then it would seem that a loss of about 25% of capacity would reduce the farmer from a profit scenario to a loss one. I am not an agricultural expert, but I would assume that the fixed costs consist largely of the equipment and buildings needed to operate the farm. If the land area is reduced (i.e. capacity is reduced), then the farmer simply does not have enough land left to produce enough revenue to cover these fixed costs and make a profit.
You can read more here.
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