Tuesday, 10 April 2007

The pound in their pocket

The profit motive – the idea of making surplus cash out of dealings with customers – is one of the most misunderstood concepts of corporate Britain. The public generally don’t object to companies making a little money, but are quick to pronounce a negative verdict on those they see as making ‘too much’ - although no one has yet come up with a robust definition of exactly how much constitutes ‘too much’. They also readily denounce the profits of those organisations they see as making money out of an inferior product. These indictments were the subject of a recent letter to the Maidenhead Advertiser from Anu Sharma. The topic of her correspondence: First Great Western.

It is not the job of this blog to defend the profit motive per se. Although, as has been said before, the role of profit on the railways works as it does elsewhere in the economy: to provide capital for future investment and expansion, both of which ultimately benefit consumers. Profit should not, therefore, be too much maligned. But are Ms Sharma’s specific charges against First Great Western justified?

First and foremost, it is obvious that First Great Western is going to make a profit from the running of the franchise. They wouldn’t have bid if they weren’t. And nor would any other company. But are they making too much? The best way to find out is to examine how each pound of income to FGW over the course of the franchise will be distributed. From the outset it is important to understand that this is not an exact science: to get the final numbers a large degree of estimating and forecasting is required (see note below). However, that caveat mentioned, each pound of income is distributed as follows:

Operational costs: 77 pence
Payment for the franchise: 15 pence
Capital investment: 3 pence
Operating profit: 5 pence

The operating margin (5 pence in every pound) is modest compared to other leading companies: Tesco makes around 6 pence in the pound in operating profit; Marks & Spencer, 11 pence; British Airways, 8 pence; and, Vodafone 24 pence). There are, of course, companies that do make lower margins, but not all that many. So, while the charge that First Great Western is profiteering makes for a good headline, or letter to the editor, it isn’t one which stacks up against the available evidence.

What is notable is the amount the government is taking in premium payments. This is the money First Great Western have to hand over for the privilege of running the franchise. Around 15 pence of every pound spent goes to the government’s coffers: triple the amount made in profit. Theoretically some of this money will be reinvested in the rail network; but not before a significant proportion of it is wasted on Whitehall bureaucracy. Moreover, not all of it will find its way into the Greater Western region; much will be diverted to other regions and even to subsidise other train operators. This should be of much more concern to Greater Western passengers than FGW’s profits.

The fact that the government wants to use the Greater Western franchise as a cash cow is a major factor contributing to some of today’s problems. It is natural that a franchise that once attracted £11.5m in annual subsidy (£56m paid to Wessex minus the surplus payments of First Great Western and First Great Western Link) is going to be squeezed when that subsidy is taken away and a massive premium payment put in its place. The government knew this when it demanded bidders for the franchise submit premium-paying tenders; and it knew it when it engineered service and timetable cuts to make such a financial transformation feasible.

Against this backdrop, Ms Sharma’s suggestion of fining First Great Western its profits makes no sense at all. If anything, the public should be demanding that the government surrender a large proportion of the premium payment and use it directly to improve rail services in the Great Western region.


Note: the calculations are based on the following assumptions: 6 percent annual growth for every year of the ten year franchise; an average annual increase of 2.6% in operating costs; synergy savings of £15m from Wessex following the merger with the other parts of the franchise; £200m investment in carriage refurbishment and new engines as stated by FGW; £1.13bn premium payment to the government as stated in the franchise agreement.

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