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How to lose readers

Thanks are due to the Adam Smith Institute for their recent link to one of my postings. My reader figures have responded accordingly. This next post will probably scare most of them away again.

Never mind.

Nick Clegg has been regaling us with his thoughts on the profits made by electricity.

PENSIONERS sitting in coats, hats and scarves in their sitting rooms to keep warm. Others living the whole winter in their bedroom because they can only afford to heat a single room. Our senior citizens reduced to a choice between heating and eating.

And all the while, British Gas is raking in £1,000 of profit every minute of the day. The truth is, the only people who are cosy this winter are the companies who send us our ever-rising bills.

Statistically speaking this is a load of old cobblers. Pensioners, of course, have larger disposable incomes than pretty much anyone, although I accept that there may be exceptions.

However, Clegg is not only statistically wrong, but he's also wrong in about the profits of the utilities companies. The profits may look huge, but there is a reason for this. It's down to a quirk of accountancy which I will endeavour to explain. (With a bit of luck there might still be a couple of readers who will still come back to my humble blog after reading it through).

British companies are required by law to state their profits using the historic cost convention. That means you measure the profits on the basis of what you sold something for, less what you paid for it. This is fine for many businesses, but for a company which is experiencing fluctuating raw material prices, the effects of this rule is to make the profits fluctuate wildly. Let me demonstrate with an example.

Let's say you buy a widget for 10. It sits in inventory for a couple of months. At this point widgets cost 20 and you can therefore sell in the marketplace for 30. You report profits of 20 and Nick Clegg tells the Yorkshire Post you're a heartless capitalist, responsible for starving grannies to death.

When the market goes the other way though, things are different. You've bought another widget at 20, and again it sits in inventory for a while. But by the time you manage to sell it, raw widget prices are back down to 10. You can only sell for 15 and you've made a loss of 5 on the historic cost basis. At this point Nick Clegg would probably compound his error by writing to the  Yorkshire post and demanding you receive a subsidy. He would no doubt declare that your widget business was a key part of the economy. This would obviously just underline his woeful lack of understanding about what was actually going on.

In companies dealing with this kind of marketplace, profits are rarely measured against historic cost. There is too much temptation to give margin away to customers when prices are on the up. Customers never give margin back again when prices are falling. Instead companies measure profits against replacement cost - how much does a widget cost to buy from suppliers now, at the point of sale. This essentially means that they keep two sets of books. One is used internally to measure how the company is doing (the management accounts). The other is a load of old nonsense and it's this which is sent to HM Government (the financial accounts). The former is reasonably stable, while the latter will fluctuate wildly in line with raw material prices.

What we're seeing then is either ignorance by the LibDem leader, or perhaps he's turning a blind eye to the facts so that he can wallow in a little headline grabbing.

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Reader Comments (4)

I will ignore the factual accounting errors you make, but feel compelled to point out that the profits you refer to, however measured, demonstrate an obvious case of monopoly profit.
Feb 27, 2008 at 9:12 AM | Unregistered Commenteralastair

Very interesting - you claim I've made accounting errors, but refuse to say what they are, and then you claim BG demonstrates monopoly profits,when it doesn't actually have a monopoly.

Are you in fact just venting?
Feb 27, 2008 at 10:03 AM | Registered CommenterBishop Hill
What accounting error would that be?

What Hill is referring to is FIFO (First in, first out), which indeed is the UK reporting standard. However, it also better reflects the true movement of money through the company.However, as the above blogger also claims, it doesn't represent the cost of re-purchasing the "widget". And as company has to go back on the market to buy replacement widgets, surely selling at the higher market rate makes sense.

The opposite to FIFO, is, predictably, LIFO, which is used generally for internal costings - i.e. it's a current measure, not historical. However it is unsuitable for *accurate* tax purposes as it doesn't reflect the actual revenue flow.
Feb 27, 2008 at 10:47 AM | Unregistered CommenterAaron Heath

Determining what, exactly, is "profit" is quite different for two different activities. The first activity is called "running a business," while the second is called "taxing a business."

In running a business, the entrepreneur wants as accurate a picture of "where he's at" in order to plan for the next moment or the one after--whatever they may bring. In taxing a business, the underlying aim is to maximize tax revenue (but with a caveat having to do with auriferous geese and their ovarian depositions). The rule for the former is always to use that system which provides the most accurate understanding at any given moment simply because that is what guides an entrepreneur's action--the decisions on which future gaining of profits and avoidance of losses is based. The classic system of accountancy is not perfect but it's the best we've got so, in planning, the entrepreneur combines it with other semi-scientific methods (such as guesses and hunches).

The taxman, as I said, has a different purpose and, thus, different rules for behavior. Where the businessman pays obeisance to the ancient mantra "make profits, avoid losses," the taxman observes equally time-honored admonitions: "never give a sucker an even break." and "kick 'em when they're down."

Don't judge these different kinds of behaviors with the same sense of morality or justice, though, Alastair. The businessman has the whole world of public opinion on his side. Every single person is keenly aware that the businessman is unlikely to do well unless he brings them a product they want at a price they can afford; so, naturally, they all want him to do well--because they understand that his success is conditioned, to some degree, on their own satisfaction with his performance. "The customer is always right" might not be a perfect summation but there are plenty of business failures attesting to its generalized accuracy and the perils of its neglect..

Lo, pity the poor taxman. Where the businessman has all those customers to acclaim him and support his efforts, the taxman is nearly bereft. He's supported only by wildly unpopular laws and an administrative apparatus of investigators, armed policemen, courts and judges, who must resort to threats, confiscation, arrests, detention, physical and mental coercion, and even deprivation of liberty and life. He is denied the businessman's best advertisement--the satisfied customer--and must find both refuge and solace in the private reflection that, "when you've got 'em by the balls, their hearts and minds will follow."

Sorry--I'll have to postpone a synopsis of taxmath to some later time (I've got a business to run and cutomers with demands which must be met--or else.)
Mar 2, 2008 at 12:58 PM | Unregistered Commentergene berman

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