Wednesday, 30 June 2010

Prices and profiteering in the food sector

Michael Taft: There will be many attempts to explain the high costs of food and beverages in Ireland – a state of affairs that is hardly new. Everyone throughout the food supply chain, from the farm-gate to the retail shelf, will be blamed and will seek to lay the blame somewhere else. I’d like to highlight one aspect – profit levels in the food and beverage manufacturing sector. This is not the full explanation for high food and beverage costs; but any explanation that doesn’t factor in our extra-ordinary profit levels will be unsatisfactory.

There are three databases that refer to profit levels (or ‘gross operating surplus’ or ‘capital compensation’).

First, is the Eurostat dataset that measures gross operating surplus as percentage of turnover; in other words – how much turnover is taken as profit. The latest year we have data for this measurement is 2003. After that, Irish data is not disclosed on the grounds of ‘confidentiality’. But in that year, Irish profit levels headed the table by a long ways. Nearly a quarter of turnover was taken as profit. With the exception of the UK, profits made up less than 10 percent of turnover in other EU countries for which we have data.

The second measurement is contained in Eurostat’s European Business statistical book 2007. While this contains the same numbers as the Eurostat dataset, it provides nominal turnover and gross operating surplus numbers. From this, we can assess what would happen if Irish companies took the same amount of profit as other countries and reduced their prices accordingly.

• If Irish companies took the same amount of profit as UK companies, food and beverage prices could be reduced by 10 percent.

• If Irish companies took the same amount of profit as other non-UK EU-15 countries, food and beverage costs could be reduced by between 14 percent and 17 percent.

The third measurement comes from the EU Klems database. This has the advantage of having more current numbers – from 2007 with the ability to measure profits per employee hour worked in the Food & Beverage sector. This shows an even more dramatic gap between Ireland and the Eurozone.

Ireland is well ahead of the game, making well over four times the Eurozone average. If the profit take in Ireland were at Eurozone levels, prices could be reduced by 16 percent.

In all these measurements, however, there is a problem – the statistical distortions created by the accounting activities of multi-nationals which, through transfer-pricing, use Ireland as a tax-laundering stop-over. It is difficult, though not impossible, to assess the extent of these distortions. In the Food sector, such activities would be less than in the manufacturing sector at large. Indigenous companies make up nearly half of all turnover in this sector (as opposed to 21 percent for all industries). However, in the Food sector anyway, it is difficult to see profit levels returning to European averages even taking into account multi-national accounting activities, though I will try to follow this up in a subsequent post.

The only organisation that has considered this issue in any depth is UNITE the Union, with its publication, ‘The Truth About Irish Profits’. It took a similar approach – using European data – to assess the contribution of high profits to high prices.

This is only the manufacturing sector. A broader analysis of profit levels would have to be conducted in all elements of the food supply chain – wholesale, retail, input costs, etc. But it is clear that high, potentially inexplicably high, profit levels may be contributing to high costs.

PS: For the real devaluationists among you, labour costs can’t be blamed for high costs. Irish labour costs per hour in the Food & Beverage sector were in 2007, according to the EU Klems, 9 percent below the EU-15 average and 21 percent below our peer group (non-Mediterranean countries).


Mack said...

Michael, did this report take into account transfer pricing? Or low corporation tax would meant hat companies with Irish and other Europeans subsidiaries would have a big incentive to book profits in Ireland. Which would increase the profitability of the Irish subsiduary and decrease the profitability of their European arms?

Given the 'rip-off' Republic, I wouldn't be surprised if Ireland wasn't a highly profitable market.

What could we do to encourage investment here? Are we doing anything to discourage it? If Ireland is that much more profitable than other European states then surely European companies operating in lower profit margin markets should be queuing up to get a piece of the action here? Especially during a down-turn. Anything we could do to encourage them here?

Mack said...

Apologies for the typos in the first paragraph, might be more readable here -

Michael, did this report take into account transfer pricing? Our low corporation tax would mean that companies with Irish and other European subsidiaries would have a big incentive to book profits in Ireland. Which would increase the profitability of the Irish subsiduary and decrease the profitability of their European arms?

Antoin O Lachtnain said...

Do you think that property prices and the development process have been a major barrier to the expansion of new entrants (who could have driven down prices and profits)?

Michael Taft said...

Mack - as pointed out in the post, to get a full picture at manufacturing level, one would have to factor in transfer-pricing. The UNITE report tried to compensate at a national level by either excluding the Chem/Pharm sector (which makes up 40% of all value-added produced by foreign manufacturing firms) or by using GNP figures in the OECD's calculation of gross operating surplus. The fact is, however, that the transfer-pricing activities of multi-nationals so distort firm level statistics, it is difficult to separate real economic activity from motivated accountancy. Nonetheless, the preponderance of evidence is that profit levels are higher than in other EU countries.

You raise serious questions. I'm a big fan of FDI - FDI that is real and wealth-generating (in the short-term I wouldn't want to rely on the indigenous enterprise sector even if that is the long-term road to sustainable prosperity). So what can be done?

I would have thought that serious business wants (a) a world-class infrastructure: everything from telecommunications to transport; (b) high-quality work skills - in particular, managerial skills; (c) a functioning financial system that serves the need of business (this is more relevant to the indigenous sector); (d) long-term stability that comes from a government that willingly acknowledges the massive economic deficits and sets out to repair such deficits within a realistic framework.

These are some of the things that we could start developing. These would win wide-spread support (an example of this was ICTU and IBEC joining together to argue for increased infrastructural investment).

But getting back to the distortions caused by MNC accountancy activities - don't forget: these distort our value-added numbers. And since GDP is based on value-added, this will distort the GDP figures (without taking into account profit-repatriation). We should remember that, especially with the CSO GDP figures coming out today.

Michael Taft said...

Antoin - high property prices/rents are always bad, diverting resources from wealth creating activities. They have particular impacts depending on the sector, never mind the general opportunity costs. High costs will impact on services more than manufacturing (especially the retail, hospitality sectors). High costs will also unnecessarily push up wages - workers compensate by demanding from employers; personally, I'm all for workers getting as much as possible - but as a conduit to repay interest? This hurts enterprise who might have otherwise benefitted from higher consumption of real goods and services.

There are differing impacts (almost all negative) on different sectors and we should subject each of them to ruthless analysis. But the starting point is Keynes's desire: euthanise the rentiers. How about this for an idea - reset the default button: tear up every rent and mortgage contract in the country and force renegotiation with a tribunal to decide in case of stand-off. Yes, there's that potentially pesky constitutional issue. But I would love to direct the campaign to amend the constitution to allow for this reset. Just about every business and every worker would all be on the same side. It would pass overwhelmingly without one leaflet distributed. Maybe not practical - but it poses important questions and points to realistic solutions.

Anonymous said...

I always think that the issue of rents is Ireland is a bit of a canard. As Ricardo pointed out - rents are/were high because those renting could afford them. Tesco's et al acquiesced to high rents because they could just pass them on to consumers. The real question is why they could pass on high prices with impunity. I’m going to speculate it is partly as a result of our
1. inability to shop around, (why don’t we? Is it in our psyche that we hate to be seen as mean?)
2. difficult in shopping around (most supermarkets need car access)
3. The erosion of local markets
4. The planning law that put a cap on the size of supermarkets.
I think the grocery orders can be cleared of blame – as inflation has been higher in goods covered by the grocery orders since the lifting of the ban.

Anonymous said...

Transfer pricing is not an issue in the food sector because of the structural way the industry is organised. Suppliers tend to deliver to the local operators, even when the supplier itself is part of a MNC.

One of the problems with any comments about the Irish retail sector is that no information is available on the profits or turnover of the main players. For example Tesco, Superquinn & Dunnes all trade through unlimited companies, obviating the necessity to publish accounts. Lidl trades in Ireland as a branch of a German company and I am not sure about Aldi.

There is/was a great acceptance of higher prices here over other countries. Margins appear to be very high at both wholesale and retail levels.

Aldi & Lidl for example charge more for many goods here in Ireland than they do in other markets, even when those goods are locally sourced. Retail wages in Ireland are lower than in most of their other markets as is Employer PRSI. There are also no expensive restrictions on opening as in Germany or other employee protection issues that apply to German shop workers. Property taxes are also lower and while utilities may be slightly higher, they do not make up a high proportion of costs. Crucially VAT on food is levied at 0% in Ireland, yet it may be more expensive than countries which have VAT on food.

Both ALDI & LIDL tend to own their shops outright rather than renting. They charge what the market will bear, i.e what the customer will pay.

Michael Taft said...

Anonymous - if you are right regarding the structural organisation of the industry precluding transfer-pricing, then the profit levels are truly phenomenal. However, we will only get the data re: prices, profits, mark-ups, etc. with great difficulty. As you point out, unlimited status hides a lot of information.

Mack said...

Anon -

I don't think transfer pricing is dependent on how goods are delivered. Nestle, for example, use transfer pricing for other purposes. This article details how they transferred ownership of Australian brands to low-tax Switzerland, the Australian subsiduary then pay the Swiss annual royalties for using the brand names (remember these were Aussie brands initially). The money paid reduces their tax bill in Oz, and is taxed at a lower rate than it would have otherwise have been when transfered as a royalty payment to the Swiss subsiduary (parent co. in this case).

Antoin O Lachtnain said...

Anonymous: The reason why Aldi/Lidl charge more here is because that is the only way they can maximize profit. They cannot cut prices, because they do not have enough floor space to be able to sell a larger volume of goods than they sell at the moment. They are already at full capacity.

This is also the reason why getting rid of the grocery orders had no effect. The real estate situation means that there are no new entrants coming into the industry.

The solution to this would be to make locations available to new entrants. This would allow them to grow market share.

Anonymous said...

Antóin, I cannot accept your comments regarding floor space. The Aldi/Lidl model is very specific, much the same as Zara in the clothing area. Shops are of a specific size, which can be managed by a small number of staff. The turnover of the shops depends not so much on the size of the premises but on the number of car parking spaces provided. As I pointed out earlier, Ireland actually allows for a far higher level of turnover because of its unrestricted trading laws than Germany. The model does not aim to provide all goods, indeed it is quite similar to the old East European model with certain goods arriving without any notice. Dishwasher salt for example is suddenly available at very cheap prices and then disappears again once sold.

Mack - IP write offs & Switzerland are a specific issue, but this of course no advantage to the retailer, because they do not own the goods or IP. Transfer pricing would only apply where the goods or IP are owned by the retailer itself.

Mack said...

Anon -

but this of course no advantage to the retailer, because they do not own the goods or IP.

The suppliers (e.g. Glanbia, Kerry Group, Marfrig, Nestle Ireland, Diageo, etc ) certainly do own both though.

And would still be possible (certainly not implying they do), that Tesco Ireland could own the Tesco brand and charge Tesco UK for using it.

It's just an example rather than the only route they could take. Where multinationals are operating Not a tax lawyer by any stretch of the imagination, but I'd be more surprised if they didn't find away to minimise tax & take advantage of Ireland's low corporation tax rate.

Antoin O Lachtnain said...

Firstly, do you agree that suitable sites are the issue, whether it is parking spaces or floor space?

I think you are wrong about the turnover of the stores being linked to parking spaces more than floor space. The reason is that the low cost operational model depends on being able to bring stuff in on a pallet, something you cannot do if the shop is at all busy. (A Tesco/Dunnes is different. because you are moving the goods to a cart, you can restock the shelves as the day goes on.) Apparently as a result of this, LIDL/ALDI seem to have opend larger and larger shops.

ALDI and LIDL have a fair few stores that have no parking at all.

There is no relation between cost of operation and size of a store really. As an example, IKEA is an enormous store, but employs few staff.

I think the solution, anyway, would be to attract new entrants to expand by making more sites available.

Another solution would be to build an alternative direct-to-home distribution system. I think this would be the 'green' knowledge-society-oriented answer.