A FINANCIAL FABLE
COST DEFINITION, RECOVERY and SUBSIDY
PROFITABLE, PUBLIC AND PERSONAL AGENDAS
David C. Jones
Chartered Public Finance Accountant
Chartered Certified Accountant (UK)
David C. Jones, CPFA, FCCA (UK)
International Financial & Management
4936 Andrea Avenue,
Annandale. Virginia. 22003. USA.
A FINANCIAL FABLE
Omar is an Afghan taxi driver. He could work in Kabul, New York, London, Moscow or anywhere
else in the world. He has established himself in business with a gift of money from his father.
When Omar’s father gave the money to his son, he offered him three pieces of advice:
“You are not, primarily, in business to make money. You are in the money (i.e. you have
invested capital) to make business.”
“You must remember that you are a businessman. If you do not know who you are, or what
you are doing, this is a very expensive way to find out.”
“If you do not understand what it means to be a businessman, remember your name.”
A Private Business
Omar now carries around with him two keys. One is the key to his car. The other is the key to
business financial management. The latter can be, as in his father’s advice, related to his name and
his business “OMAR’s CAR.” It applies, however, to any kind and size of business activity. It
would apply, for example, to any small trader of goods and services. It would also apply to the
ownership of a single family house, as well as to the management of a multi-national corporation.
In a slightly different, but related, way it also applies to public sector financial management. The
words, used as an acronym, show the following:
O = Operation
M = Maintenance
A = Administration [C = Capital Consumption
+ [ +
R'= Rent -------------> [A = Adjustment of Value
+ [ +
S = Surplus [R = Return on Investment
Thus, Omar, like any other business, can consider himself in business if, and only if, he earns
sufficient revenue from the activity to cover the financial outgoings corresponding to the letters of
the name of his business – “OMAR’s CAR.” The first word (OMAR’s) carries the basic principle,
the second (CAR) is an essential corollary.
Therefore, revenues from any kind of business activity must cover: operations, maintenance of the
resources (fixed and working capital) used in the activity; administrative costs (including some
taxes); and rent. Taxes, as used in this paper, will depend upon their nature and how observed by
enterprises. They may be included as “administration” (part of the cost of doing business) or as the
government’s “share” of the “surplus.1“
All this must leave the business with a surplus, representing a saving of revenues over costs2. If
there is no surplus, after covering the declared costs, there is – by definition – no business. Thus,
instead of saving a surplus, the activity will create a loss, which must be subsidized. In such a case,
Omar is either using the activity as a hobby or providing a public service3. This is fine, so long as
he knows what he is doing. If not, as his father warned, it is a very expensive way to find out.
The example implies that Omar has rented his taxi. By analogy, other businesses are assumed to
have rented their capital plant. However, the owner of the car, in setting the rent, must cover the
costs related to the word “CAR”: capital consumption, adjustment of value, and return on
investment. If these are not covered, the owner will not be optimizing the use of the plant. If the
plant is owned by the business itself, it must also allow for the coverage of exactly the same costs.
Any Private Business
To take another example of a private business, consider a professional football team. The owner, in
order to be in business, must (like Omar) cover from revenues the costs of: operation,
maintenance, administration and rent, leaving a surplus. For a football team, rent will include at
least two major components.
First, there will be a stadium4. The owner, in calculating the rent, will need to cover three
components. The first is capital consumption, the depreciation of the structure. The second is the
adjustment of value. This is any likely increase – or decrease – in the value of the site and structure,
due to both inflation and alternative usage potential. Finally, there must be an adequate return on
the capital invested in the site and structure. This, based on an assessment of the next alternative use
of the (cash or physical) resources with comparable risk, is often referred to as the “opportunity cost
1 Strictly, the inclusion of taxes in the “OMAR'S CAR” costs is appropriate only when considering the business as a single entity.
When “externalities” are included, the situation becomes more complicated, as indicated later.
2 This need not, necessarily, occur in every single year. It must, however, be achieved when considering one year with another over a
reasonable period of time, appropriate to the type of business. If any resulting accumulated cash surpluses are invested and
accumulated cash deficiencies are borrowed (both at the required rate of return) a “discounted cash-flow” analysis could be calculated
for the entire working life of an activity, and its related assets. This would result in either positive or negative net present values
(NPV), depending on surpluses or losses.
3 Although this paper is written in “parable” form, the concepts of “business,” “hobby” and “public service” can be grounded in more
formal and rigorous reasoning. This is shown in Annex 1.
4 There will also be practice fields, equipment and probably much else, for which the “stadium” will serve as a simple surrogate.
The team owner must also rent players and coaches. Because of unique skills, they will exert partial
monopoly power. This enables them to earn a monopoly rent. This is the difference between
potential earnings in football and those in alternative employment. They will negotiate salaries that
will cover the same three components. Firstly, there is capital consumption, the perception of
limited duration of their skill activity. Secondly, comes the adjustment of value, their potential for
service with another team. Finally, there is a return on investment. This is whatever is considered
the “cost,” especially training and career development5, of being able to perform competently –
compared with an alternative activity. These salaries are largely “economic” rents6. The remainder
can be perceived as operation costs.
Also, the football team may own the stadium. It may also “own” the players or coaches, in the sense
of having purchased longer-term proprietary and exclusive rights to their services7. Once again, net
revenues must cover the rents – as defined – and leave a surplus. If they do not, the owner will be
unable to stay in business and will need to dispose of his proprietary interests.
Thus, unless the team owner is able to cover the “OMAR’s CAR” costs, he will not be in business.
He will, like Omar, be involved in either a hobby or a public service. In either case, the activity will
need to be subsidized, by him or by others. Again, there is absolutely no objection to this, so long
as it is fully understood. It does, however, need to be fully understood by everyone likely to be
financially affected. Otherwise, they are being deceived. Indeed they are, perhaps, being cheated!
There are, of course, communities that may be prepared to subsidize sporting activities (albeit
private ones) out of taxes. Typically, such payments will be claimed as justified on the basis of (real
or claimed) positive economic or social benefits to the community as a whole8. To the extent that
these do not materialize, the subsidy will be a welfare payment to (and/or by) the team owner.
Public Sector Activity
Just as with a private business, investment of cash in a public sector activity will be a business
operation if it covers the “OMAR’s CAR” costs: operation, maintenance, administration, rent and
surplus. Such an activity is often referred to as a public utility. If the “OMAR”S CAR” costs are
not covered, the activity will be either a hobby9 or a public service. It will need to be subsidized.
5 This has an analogy to the broader concept of “human capital development.”
6 This follows the principles expounded by the classical economist, Ricardo. It is the extra payment necessary to use anything (not
just property) in short supply, in excess of its “costs of production.”
7 The purchase of any fixed asset is, effectively, a payment of the “present value” of all future rents. A good example is a house.
8 The “Washington Post” illustrates this possibility: “....baseball at a new stadium – at extremely modest cost – would enrich and
strengthen our community – economically, socially and culturally – and reintroduce the excitement of a local team to cheer.”
9 It may seem strange to consider public sector activity as a “hobby.” However, this concept is included in the theory of “public
choice” promulgated by – among others – Professor James Buchanan, of George Mason University, Virginia. It claims that some
public officials are performing work solely for personal enjoyment, with no particular regard for the outcome. There is also an
analogy to the theory's principal claim, that government actions are pursued according to the self-interest of politicians and lobbyists,
rather than for the public good. Until he retired, Senator Proxmire, of the U.S.A., made what he called “golden fleece” awards. These
were for the use of public funds on activities that he considered wasteful. Certainly, when publicized, some of these (or their costs)
appeared bizarre. Many were examples of what were really “pet” projects, for the benefit only of the immediate participants. These
were, in effect, hobbies. More recent US congressional concerns have referred to some of these as “earmarks!”
Like the other examples, if it is realized and accepted (in this case by public taxpayers) there can be
no objection. If not, however, taxpayers are being deceived.
For the majority of public sector activities, revenues will come from taxes rather than from direct
charges. Thus, the extent to which each separate activity will be subsidized in this way will be a
matter of judgement for those who represent (or claim to represent) the wider community interests.
These judgements will be based on a mixture of politics and welfare economics, sometimes
involving significant consideration of economic and social externalities.
In some cases, specific activities can be performed, on the basis of competition, by private
businesses10. In this situation, the public sector entity will be an allocator of funds and a contract
manager. It is important to realize, however, that any contractor that undertakes a public sector
activity is in business. It is not, normally, performing either a hobby or a public service!
Just like any other business, the contractor’s revenue for the activity – the fee from the public
service entity – must still cover the “OMAR’s CAR” costs. This specifically includes the “surplus,”
without which businesses will not survive. A business requires a surplus to cover: risk (against
which one can often insure); uncertainty (against which insurance is usually not possible); new
activities (capital investment for expansion or extension); and, stability (allowing for year-to-year
fluctuations and fortunes)11. If revenues do not cover these costs, several things will happen:
(a) the public sector entity – and its taxpaying public – will receive unsatisfactory
service – most probably because of cut-backs in expenditure;
(b) the contractor will go out of business, or decline to accept further contracts, thus
diminishing the potential availability of private service providers;
(c) the public sector entity – which still bears the ultimate (legal and administrative)
responsibility – will incur additional transaction costs for:
(i) rehabilitation and restoration of (as well as dealing with complaints about)
the unsatisfactory service;
(ii) entering into another contract;
(iii) by implication, a higher price for the replacement contract, which must now
cover the “OMAR’s CAR” costs, not achieved by the earlier contractor; and,
10 This is sometimes