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.
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.