I’m a bit tight on time today, so here is a link to a nice article the Economist which gives some useful insights and summaries of how low cost airlines have reduced costs over time. Enjoy.
In November last year I wrote about hidden costs. You may have seen this story below doing the rounds in the internet. It made me stop to think for a while – a hidden cost of work perhaps!
“A man came home from work late, tired and irritated, to find his 5-year old son waiting for him at the door.
SON: ‘Daddy, may I ask you a question?’
DAD: ‘Yeah sure, what it is?’ replied the man.
SON: ‘Daddy, how much do you make an hour?’
DAD: ‘That’s none of your business. Why do you ask such a thing?’ the man said angrily.
SON: ‘I just want to know. Please tell me, how much do you make an hour?’
DAD: ‘If you must know, I make $50 an hour.’
SON: ‘Oh,’ the little boy replied, with his head down.
SON: ‘May I please borrow $25?’
The father was furious, ‘If the only reason you asked that is so you can borrow some money to buy a silly toy or some other nonsense, then you march yourself straight to your room and go to bed. Think about why you are being so selfish. I don’t work hard everyday for such childish frivolities.’ The little boy quietly went to his room and shut the door.
The man sat down and started to get even angrier about the little boy’s questions. How dare he ask such questions only to get some money?After about an hour or so, the man had calmed down and started to think:Maybe there was something he really needed to buy with that $25.00 and he really didn’t ask for money very often The man went to the door of the little boy’s room and opened the door.
‘Are you asleep, son?’ He asked.
‘No daddy, I’m awake,’ replied the boy.
‘I’ve been thinking, maybe I was too hard on you earlier’ said the man. ‘It’s been a long day and I took out my aggravation on you. Here’s the $25 you asked for.’
The little boy sat straight up, smiling. ‘Oh, thank you daddy!’ he yelled. Then, reaching under his pillow he pulled out some crumpled up bills. The man saw that the boy already had money and started to get angry again.The little boy slowly counted out his money, and then looked up at his father. ‘Why do you want more money if you already have some?’ the father grumbled. ‘Because I didn’t have enough, but now I do,’ the little boy replied. ‘Daddy, I have $50 now. Can I buy an hour of your time? Please come home early tomorrow. I would like to have dinner with you.’ The father was crushed. He put his arms around his little son, and he begged for his forgiveness.”
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.
In the previous post, I explained what a variable cost is. Now here, let’s look at fixed costs.
A fixed cost is a cost which does not change with the level of activity of a business. For example, there are some costs that a business will incur even if it is closed – such as buildings insurance. Other fixed costs might include a managers salary or other similar payroll costs which are fixed, taxes or business rates paid to a local authority or rent paid to a landlord. The term overhead is frequently used with reference to fixed costs.
Although the total fixed cost is that, fixed, as the level of activity of a business increases (more goods made or more services provided) the fixed cost per product/service actually falls. Let’s say for example if a business has total fixed costs of £48,000. If the business sells 24,000 units of product, then the fixed cost per product is £2, but if it can manage to sell 48,000 units of product, then the fixed cost per unit is just £1. As more and more units are made, the fixed cost will become negligible on a per product basis. Thus, I think it is easy to see how the level of fixed costs can affect the level of profit – high fixed costs with low volumes might spell trouble.
Are fixed costs fixed forever? No is the simple answer. As a business increases activity, then quite often more fixed costs are incurred e.g. more managers or a bigger premises. So fixed costs are not “fixed” indefinite, but they are fixed within what is called a “relevant range” of activity. A good example of this kind of effect is employer liability insurance – normally the cost is fixed with a range of employees (maybe 1-100) and the cost jumps once this range is exceed (i.e. 101 staff or more).
In this post and the next few, I’ll explain some basic terms used to understand costs in management accounting.
A variable cost is a cost which change in accordance with the activity of a business. For example, if I order a meal at a restaurant, the food itself is a cost that would not be incurred had I not walked in. As the restaurant fills up, then the food ingredient costs go up. Another variable cost example might be fuel in a car or truck. The more the car or truck is used, the higher the cost.
In a business, variable costs can usually be saved by simply not making any product or delivering a service, but this of course may not always be possible. Typical variable costs are labour and materials associated with a product or service. Such costs would not be incurred if the product or service was not delivered i.e something triggers the incurring of variable costs.Think of the chef in the kitchen of a restaurant – a customer order means food costs increase, or a variable cost has been incurred. You may be thinking of the chef’s wages – I’ll come back to that in the next post.