A container lorry.
[image by 28481k, some rights reserved]

All businesses have two types of cost: fixed costs (that do not vary with output) and variable costs (that increase as output increases). To illustrate with a simple example, suppose you had a heavy goods driving licence and wanted to run a trucking service. You buy a truck for £100,000 and you can use it for five years. Before you drive a kilometre, you have a fixed cost of £20,000 a year to pay for the basic equipment. Items such as annual insurance and road tax raise the fixed costs to £25,000. Leaving aside your salary, every kilometre you drive costs (say) £1 in diesel, servicing, tyres and so on. So you have fixed costs of £25,000 and variable costs of £1 per kilometre. In the short term you have to work within those constraints.

The size of your business is critical. If you can sell transport at £6 per kilometre travelled, you need to sell at least 5,000 kilometres to break even:

Suppose the physical limitations are that you can drive a maximum of 75,000 kilometres a year. You can see that your profitability will vary according to the amount of work you do. Below 5,000 kilometres a year, you have no salary and are making a loss. Between 5,001 and 75,000 kilometres a year, every extra kilometre adds £5 to your earnings (£6 price less £1 variable cost) so your earnings rise uniformly to £350,000.

However, the moment you increase your activity beyond 75,000 kilometres, you have to acquire a second truck and hire a driver, so profits would then decrease as size increases. You’re either too big or not big enough at that level of activity.

There is also the issue of whether there is enough business available so that you can expand without limit. Often this is not the case and, as you look to boost business, you have to reduce prices. In an ideal world you would maintain your basic price of £6 for some business and offer special deals to gain extra business. As long as you were getting more than £1 and you were already covering fixed costs, you should increase earnings. However, it is difficult to reduce price in a limited way and you may find that existing business moves down from £6 to perhaps £4, so your increase in size reduces the value of your sales while increasing your variable costs – you’ve got too big.

The effects of size can be both beneficial and damaging.

Size matters at the individual business unit level but it also matters in the multi-unit business. The effects of size can be both beneficial and damaging. On the positive side, a multi-unit business can spread its risks better. A costly, failed business initiative can wipe out a single unit business instantly, whereas a multi-unit business can more easily bear the risk of expansion. Also, a multi-unit business can afford to have in-house specialists who bring extra expertise to aspects of management of the business.

On the negative side, key decisions are usually made remotely from the business unit. Normally the group operates with business budgets that must be agreed the year before and then adhered to. This can build in inflexibility because there is usually resistance to departing from the budget to take advantage of an opportunity that presents itself. Equally, central management will be concerned at managing risk across the group, and may turn down an expansion possibility in one unit because it prefers to take a risk in another. The group will probably establish standard procedures that sometimes do not make sense at unit level.

The bigger a group is, the more remote central decision-makers are from front line businesses and so the more controls the group needs in place to monitor what is happening at the unit level. These added layers add costs and not profits, they cause delays in seizing opportunities and often end up making front line staff feel frustrated and unappreciated. Big can be stifling.

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Professor Peter Walton is a member of the Accounting & Finance Unit at the Open University Business School. His research interests are in comparative international accounting and financial reporting in an international context.

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The value of brands - BA and Virgin airlines.

A number of competing models have been advanced to grapple with the measurement problem. A simple one would be to assess the ‘rent’ that can be earned from a branded good. This asks how much the consumer would pay for a branded good, say a Philips long life light bulb (€8 in my supermarket) as against the supermarket’s own brand (€5). The €3 difference, after adjusting for the retailer’s margin, is the rent. You then multiply this by the expected volume over a forecasting period (say five to ten years) and discount to get a present value.

Another way of getting at it is to look for an independent lamp-manufacturing business within Philips (a cash generating unit in the jargon) and look at its income and expense. Once you have deducted direct costs, depreciation for equipment and cost of capital for the tangible assets involved, whatever margin is left can be considered to be the brand value. As before, this needs to be forecast for a period ahead and discounted to give a capital value.

Both of these are approximations, and assume that what is left after deducting observable inputs to the model can only be the brand, whereas a more sophisticated analysis would suggest that there are a number of other potential contributors to this difference.

Brand valuation models look at the current value of the brand, and approximate what it would cost to buy the brand at that time. However, most elements of company balance sheets reflect the cost of acquiring assets at the time they were bought (i.e. ‘historical cost’), not at their current value (known as ‘fair value’ in accounting).

This causes an inconsistency in accounting because only the brands a company acquires in the market place appear in its balance sheet. A brand the company has itself built up over time is not reflected. Its costs have been expensed as incurred and so there is nothing to put in the balance sheet. You will look in vain for Cadbury or Nestlé in their owners’ balance sheets.

Is this a problem? Arguably this is where analysts earn their money, by pointing out value drivers not visible in the balance sheet. Also the balance sheet is not expected to show the current value of the company’s assets. Standard-setters see it as an inconsistency, but have more important inconsistencies to occupy their minds.

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Sharpen your business skills with the Open University Business School

Who shapes the look of a brand vision?

About the author

Professor Peter Walton is a member of the Accounting & Finance Unit at the Open University Business School. His research interests are in comparative international accounting and financial reporting in an international context.

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If you are down-sizing, then think – like GE - about what parts of the business you could most easily sell or close down, and what parts of the business you want to keep for the long haul. If the business is large enough, you may have loss-making divisions: these should be moth-balled at once.

If you are trying to maintain capacity, you need to look at discretionary costs that are not essential to stay in business. These are things like advertising, research and development, staff training, long term maintenance which are important in the long term but can be suspended temporarily.

Cutting advertising is potentially dangerous but, if customers are sitting on their hands because of the recession, this should be looked at. Cutting research and development will have long term consequences for the evolution of the business, but much of the expenditure, including the launch or trial of new products goes straight through to the bottom line. You should ask yourself if it could be deferred.

A cash conserving tactic is to defer routine capital expenditure. Supposing your policy is to renew your computers every three years, you could keep them longer. This keeps cash in the company and may also benefit the bottom line if they are already fully depreciated.

Finally, a delicate question is what you do with your staff. Loyalty and quality of service from staff is not helped by making them redundant! One possibility is to suggest they go on to a three- or four-day week, or take three months off, as have the Financial Times and KPMG in recent weeks. It is difficult and expensive to rehire staff when – and if - the boom times return.

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Managing costs is discussed in more depth in the courses Masters in International Finance and Management and in the Certificate in Accounting courses

About the author

Professor Peter Walton is a member of the Accounting & Finance Unit at the Open University Business School. His research interests are in comparative international accounting and financial reporting in an international context.

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Even so, there are a number of things that you should be aware of when assessing whether it is a practical proposition in your case. The opportunity exists because of cheap air fares and cheap property outside the UK. However, in effect it is there because the market is slow to adjust, and over the medium term house prices will probably rise to reflect the price differential between the costs of commuting internationally and locally.

The same equation includes cheap air fares, and here there is a risk that the airline will reduce its services or put prices up. The cheap British airline operating into my local airport (Granada) dropped from seven flights a week to four last year, meaning that now I have sometimes to drive for two hours to Malaga, or buy more expensive tickets from a regular airline.

The housing is cheap, but getting any work done on a house is a nightmare. If you just want to replace a leaky roof, you need planning permission. The Spanish building culture is such that no job is refused. The builder says they will start at once, they arrive, remove the window you wanted replaced, and if you don’t badger them constantly, it could then be six months or more before they turn up with the new window.

Of course, you have to speak Spanish to be able to handle all that, so a lot of time and effort has to go into that. If you do not speak enough Spanish, you’re forced into the hands of expat builders, who may or may not know much about building, and are quite likely to get you into trouble with the town hall as well.

You need to be clear whether you are going to aim to work in the UK (or elsewhere) or create a business locally at the same time. Around where we live there are lots of expats who have decided to set up a business locally. This is sometimes disastrous, often not only for them but for their clients as well. Often they are realising a dream, but have neither training nor experience for their new work, such as the hairdresser who bought a bar, or the insurance agent running an unlicensed taxi service. Expat businesses are rarely efficient and often illegal. People significantly underestimate the cost of being properly registered to trade in Spain, where the red in the national flag reflects the red tape which is everywhere. Most of these businesses fail or bump along at subsistence level, until the town hall or the tax office catch up with them.

Being a Euro-commuter can be lots of fun, and you can have a great life. But you need to be prepared to work hard to get it set up, and spend a lot on professional advice – only after that can you sit on your sundeck with a glass in your hand. Cheers!

Further reading

• 24 hour working – discover what’s driving our long hours culture, and how it impacts our health
• Join the discussion – would you commute from another country?
• Dream Commuters – The Money Programme investigates the British workers who are moving to other countries, but keeping their jobs in the UK

About the author

Professor Peter Walton is a member of the Accounting & Finance Unit at the Open University Business School. His research interests are in comparative international accounting and financial reporting in an international context.

Subscribe to Peter Walton's posts

 

It’s more or less true that tax avoidance is for the rich. It costs money to arrange your affairs to reduce taxation, so tax avoidance is only interesting in regimes where income tax is steeply progressive and you earn enough to be paying tax at the highest rates. This is one reason for the popularity of so-called flat tax rates in Central Europe – high earners have little incentive to avoid tax when it’s not progressive.

If your income comes from employment, there is very little scope for avoidance. HM Revenue has it pretty well pinned down. Even if your employer might be prepared to go along with a complex scheme, they might find themselves having to pay your tax themselves, and this discourages them!

However, some avoidance is available because the government encourages it. One of the simplest ways of reducing the tax burden is through paying extra into a pension scheme. You reduce your tax (within limits), but also lose access to the money paid into the pension scheme until you retire, so you need enough income for this not to be a problem. Another way is to invest in small businesses: government has promoted schemes to encourage this in the past.

Assuming you have income other than from a single full time employment (which rules out most people), you could look for more complex schemes, but then the next obstacle is knowledge. You have to find out about schemes, and this means paying fees to tax advisers, and being confident that they know what they’re talking about.

The nature of tax avoidance is such that an adviser may come up with a complex scheme but you cannot be certain that it is fireproof until it has been tested in court – which is not an experience you would enjoy. How do you know what adviser to talk to? KPMG, one of the world’s biggest networks of accountants, paid $500m in 2005 after selling illegal tax shelters.

As you move up the scale of complexity, avoidance schemes take advantage of the issues of territoriality and legal personality. Although there are bi-lateral tax agreements between many countries, taxation is essentially limited to activities in a particular territory, and subject to national statutes. If you have international transactions, you can try to organise things so that you do not fall into any tax net. This is a particularly interesting issue in electronic trading on the internet: whose territory does the transaction fall in?

"National tax authorities have an armoury of weapons"

However, you need to have either investment capital or income which comes from outside the UK, or you need to be resident in a tax haven such as Jersey. And of course, national tax authorities have an armoury of weapons to try to limit your opportunities. Equally the European Union has started to introduce tax cooperation arrangements between member states that provide for exchanges of information, and for tax to be deducted from investment income at source.

Taxation falls on individuals, but legal personality extends to companies: if you form a company and that company receives income, the company becomes a taxable person separate from you. Personal service companies were very popular in the UK, until HM Revenue started taking an interest. The company receives fees from selling the services of an individual, that individual then receives a salary from the company. The company can retain a proportion of the income and might use it to supply facilities and goods to the individual. The company will also pay a lower rate of corporate income tax than the marginal rate of 50% (40% tax and 10% national insurance) that the individual would pay on extra earnings.

"Can you be certain the Revenue is not going to come knocking on your door?"

There are generally some limited opportunities for tax avoidance (legal diminution of tax as opposed to evasion which is simply illegal) even in a mature tax system like that of the UK. However, even the simplest forms require you to have money available that you do not need right now. The more complex forms mean that you will have to pay potentially substantial fees to advisers, so up to a certain level of income the tax saving will be less than the professional expenses. Finally there is always the question of knowledge and uncertainty. Finding out about schemes could have a high initial cost, and then can you be certain the Revenue is not going to come knocking on your door years later?

Further reading

• Tax shelters – nobody likes paying tax – but how far would you go to avoid it?

About the author

Professor Peter Walton is a member of the Accounting & Finance Unit at the Open University Business School. His research interests are in comparative international accounting and financial reporting in an international context.

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