It's The Economy, Stupid

Someone asked me this week about the fuss over high energy costs for industrial users.  They were referring to natural gas but we have had the same conversations about electricity in the recent past.  The truth is that decisions made by government can make or break the business model for some businesses and industries.

The energy file is just one example.  Take the following simplistic tables.  The first assumes a very high energy cost relative to sales.  This would be the case for a large forest products mill or fertilizer plant or any industrial process that uses tremendous heat.  A data centre might have a power cost ratio similar to this as well.  Assuming a base case where energy costs are 25% of revenue and the pre-tax profit margin is 7.5%, a significant increase in energy costs can kill the business model.  The second table shows that a 40% rise in energy costs turns the business model decidedly unprofitable.  I have a second set of tables where energy costs are only 10% of revenue (still a high percentage) but even at that a 40% increase in energy costs cuts profitability in half and takes a business model with moderate profitability and moves it into a marginal one.

This applies to other cost elements under the direct influence of government as well.

My point here is that policy decisions need to be made with an eye to their impact on economic development.  You may still have the view that we should ‘put the screws to those big industrial players’ but you should at least understand the economic implications.

I use this same economic model approach when I look at tax policy – it allows us to skim off the ideology and clutter.  When I looked at the impact of the corporate tax cut on the average export-based business, the cost implications were relatively marginal (less than one percent of total costs).   You can see how a company would be frustrated by high natural gas costs and not so interested in a tax cut when you do a basic economic analysis.

I am not saying that policy impacts on the margin don’t count (i.e. small businesses were mad they didn’t get some deal on energy costs even though energy is only a few percentage points in the cost basket for the average small business) but policy decisions impact different industries in different ways.  For example, small business tax cuts have far more impact on local businesses that only serve local markets (because they pay all their provincial corporate tax here) than businesses that have operations elsewhere and primarily export (and pay taxes elsewhere).

The same analysis can be used with the minimum wage discussion but here I would apply some caution.  Because the vast majority of businesses paying minimum wage are only serving local markets (i.e. retail, restaurants, personal services, etc.) there should be a case they could pass the higher costs onto customers.  I know this is fiercely debated but my point is that public policy decision making that impacts the economy needs to understand the competitive landscape.  If all the coffee shops are now paying $11 rather than $10/hour – they all face the same competitive environment.  If a manufacturer is now paying 20% more than his competitor in South Carolina – that will have a broader impact.

 

 

Base Case: Energy Costs @ 25% of Total Revenue

Revenue	$1,000,000
Costs
Labour	$275,000
Capital depreciation	$150,000
Raw materials	$200,000
Energy	$250,000
Other overhead	$50,000
Total costs	$925,000
Net profit before tax	$75,000
Net pre-tax profit margin	7.5%

 

Adjusted Scenario: Energy Costs Rise by 40%

Revenue	$1,000,000
Costs
Labour	$275,000
Capital depreciation	$150,000
Raw materials	$200,000
Energy	$350,000
Other overhead	$50,000
Total costs	$1,025,000
Net profit before tax	-$25,000
Net pre-tax profit margin	-2.5%

 

Base Case: Energy Costs @ 10% of Total Revenue

Revenue	$1,000,000
Costs
Labour	$350,000
Capital depreciation	$175,000
Raw materials	$225,000
Energy	$100,000
Other overhead	$75,000
Total costs	$925,000
Net profit before tax	$75,000
Net pre-tax profit margin	7.5%

Adjusted Scenario: Energy Costs Rise by 40%

Revenue	$1,000,000
Costs
Labour	$350,000
Capital depreciation	$175,000
Raw materials	$225,000
Energy	$140,000
Other overhead	$75,000
Total costs	$965,000
Net profit before tax	$35,000
Net pre-tax profit margin	3.5%