It’s easy to show that size impacts profitability but, in practice, managers frequently can only make decisions that affect size in the medium to long term. In the short term they are highly constrained by their existing set-up, always limited by demand in the market place.

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 valuation of brands and other significant intangibles has been controversial since the 1980s when international businesses started to buy national or regional brands and extend them globally. That process made it clear that some companies had significant assets whose value was not shown in the balance sheet and was not reflected in share prices either.

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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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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There are several things a business can do in a recession to protect the bottom line, although some may have negative consequences for the long term. The first issue is, are you are aiming to down-size or are you looking for temporary measures that will help while you wait for sales to pick up again?

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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