Tuesday, 28 August 2018

Would moderate drinking be 'financially ruinous' for the booze industry?

Last week I discussed a laughably inept study from the Sheffield alcohol team and the Institute of Alcohol Studies which claimed that a 38 per cent cut in alcohol consumption - caused by drinkers suddenly deciding to drink 'moderately' - would reduce expenditure on alcohol by £13 billion in England.

From this plausible premise they went badly wrong by claiming that the booze industry would have to raise prices by £13 billion to make up for the loss. The lead author, IAS's Aveek Bhattacharya, claimed that their study proved that such a loss of revenue would be 'financially ruinous' for the alcohol industry.

In the IAS/Sheffield model, the price of a pint of beer would need to rise by £2.64 and a bottle of spirits would need to rise by £12.25. The underlying message is clear: people won't be prepared to pay this premium, therefore the industry's business model depends on selling 'cheap' alcohol to heavy drinkers.

I wrote about this here on Velvet Glove, Iron Fist and also at the Spectator. I explained that companies set profit targets, not revenue targets, and that if the booze industry increased prices by an extra £13 billion while selling 38 per cent less product, it would not be breaking even, it would be getting fantastically rich.

I expect that most readers understood what I was saying. It's not even a question of understanding economics. You just need to have some common sense and a basic idea of how business works. 

But it seems that one or two people are still confused, including one of the authors of the paper, so I'll explain it again with pictures.

The authors used figures from 2014 when the alcohol market was worth £35 billion in England. The authors describe this as the alcohol industry's revenue, but it isn't because £10.5 billion of it was duty and VAT.

Where does the rest of the money go? A lot of it goes on making the product, paying staff, investing in infrastructure, deliveries and so on. Some of it goes towards paying for the retailers' overheads, whether they are bars, restaurants, clubs or shops. The retailer then gets a cut and then the booze company takes its share.

How much profit are we talking? Ten per cent would be a healthy and fairly typical margin. Let's say that the retailer also gets ten per cent, although margins in retail vary enormously, with supermarkets typically only making around two per cent. 

The image below offers a reasonable estimate of where the money spent on alcohol goes...

To simplify matters, let's assume that the £35 billion comes entirely from 10 billion pints of lager being sold at £3.50 each. Here's where the money from each pint goes...

When sales fall by 38 per cent, spending drops to £22 billion (according to the IAS/Sheffield and there is no need to quibble with that for the purposes of this illustration). We are now only selling 6.2 billion pints and the industry's profit has fallen from £3.5 billion to £2.17 billion. The retailers' profit has also fallen to £2.17 billion. Since we are producing less beer, our costs have fallen by 38 per cent and the government has 38 per cent less beer to tax.

Alcohol industry profits have plunged to £2.17 billion. To get back to its £3.5 billion profit, it needs an increase of around 60 per cent. If it was going to achieve this by selling more beer, it would require the public to spend an extra £13 billion, but that's not going to happen because Dame Sally has persuaded everybody to stick to 14 units a week.

Fortunately, it doesn't need people to spend an extra £13 billion. It only needs them to spend an extra £1.33 billion on the beer that's already being drunk (£2.17bn + £1.33bn = £3.5bn).

(Note: In standard economics, we would assume that raising prices would lead to a further drop in consumption, but in the IAS/Sheffield scenario the raising of the prices and the 38 per cent drop in consumption happens simultaneously so don't worry about that.)

To get an extra £1.33 billion out of 6.2 billion pints requires a price hike of 21.5p per pint. With VAT, this means a price rise of 26p to a grand total of £3.76. In total, it requires a retail price rise of 7.2%.

The important thing to note is that there are no other upward pressures on costs. When sales fell by 38 per cent, pubs closed, redundancies were made and production was scaled down. If the industry was trying to make £1.33 billion by selling more beer, it would have to scale production up to make the damn stuff, but that isn't what's happening.

If more beer was being sold, the government would collect more beer duty, but that isn't happening either. Whether the beer costs £2 or £10 makes no difference to beer duty. Alcohol duty is a fixed cost charged by the litre.

With a 26p price hike, the industry is making the same profit as before despite total spending on alcohol having fallen from £35 billion to £23 billion.

IAS/Sheffield include all pubs, restaurants, bars, convenience stores and supermarkets as part of the 'alcohol industry' even though they are part of the hospitality and retail industry, but that's OK (although it means that their demand for the 'alcohol industry' to be excluded from policy making is more far-reaching than it appears). Retailers can also return to their previous profit by adding 26p to their retail price.

If both sectors raise their price by 26p, total expenditure on alcohol is around £25 billion and both the retail and alcohol industries are getting the £3.5 billion profit that they are accustomed to. The taxman is getting an extra £0.5 billion in VAT and the price of a pint has gone from £3.50 to £4.02, a jump of 14.8%.

The 'alcohol industry' has increased its margin by 60 per cent and yet the price to consumers has risen by only 15 per cent.

52p is not a trivial price hike but it is approximately the difference between a pint of Fosters and a pint of Peroni in the current market. And that's the point. It is clearly not ridiculous to imagine people paying this kind of premium, especially if they are drinking fewer pints. Many consumers are already doing so.

The mistake made by IAS/Sheffield is assuming that the price of alcohol needs to go up by 60 per cent for the industry's profits to go up by 60 per cent. That would be true if it was trying to make more money by selling more alcohol, but it is not true when moving from a budget market to a premium market.

The figures shown above are designed only to illustrate a basic economic point. There are other considerations, such as how many of the costs are fixed and what the economies of scale are, which would need examining before a more exact estimate could be made. We do not know - and IAS/Sheffield do not ask - how much the production costs differ between Fosters and Peroni, nor do we know what the respective profit margins are. It is, however, safe to say that the profit margin on premium brands like Peroni is higher in both absolute and relative terms. That is why the industry wants us to buy them. In no conceivable scenario would prices have to rise by 60 per cent, or anything close to it.

It is therefore perfectly possible for the industry - however it is defined - to make the same amount of money from selling a smaller quantity of pricier alcohol than a larger quantity of cheaper alcohol. Revenue is totally irrelevant and, therefore, the IAS/Sheffield study that focuses entirely on revenue does not answer the question it sets itself.

Whether this could actually happen in real life is another matter. It seems to me that it would require a combination of cartel behaviour and mass brainwashing, but that is not the point. IAS/Sheffield suggest that it is almost mathematically impossible for the industry to profit from moderate drinkers because prices would have to rise to unfeasible heights. Their hypothesis is that the industry 'depends on heavy drinkers' and would face financial ruin without them. This is nonsense. As I mentioned last week, the industry has done fine since 2004 despite an 18 per cent drop in consumption.

In every industry, the manufacturer's net profit margin is very small relative to total expenditure on the product. This is especially true in the alcohol industry where prices are inflated by hefty sin taxes. We know that tax amounts to about 30 per cent of retail price and various production, marketing and retail costs make up the bulk of the rest. The price rise needed to offset the lost profit may be greater or smaller than that suggested above, depending on what the margins are in practice, but it should be obvious that it would be a fraction of what IAS/Sheffield claim.

No comments: