19 June 2019

The inevitability of the cost cap

Number-crunchers may not be the coolest of folk. They may not dance like Fred Astaire, nor pluck babes with their raffish charms, but they are good at numbers and forensic accountants are the Top Guns of their profession. They can figure out who is cooking the books by studying patterns and such things and then they can track down the bad guys using paper trails that are left behind. 

Formula 1 team bosses are very clever people – to a lesser or greater extent – but they are not generally Superman or Superwoman. They might think that they can rush into telephone boxes and change into costumes that allow them to fly, but those who have tried generally end up face-first in the dirt. Very few of them are engineering geniuses, fewer still are financial geniuses and not all of them are leadership geniuses. Some are good at juggling - and most are good at talking a good game.

One of the biggest problem that F1 has faced in recent years has been resistance to a budget cap, on the basis that those opposed to the idea think that they are smarter than forensic accountants. This is delusional – and has been very unhelpful.

The idea of an F1 budget cap was first suggested 15 years ago by Ford’s Richard Parry-Jones. In that era there were more cowboys and buccaneers and they all thought that the corporate honcho was naïve and his ideas unrealistic. Even then F1 was expensive and it was inevitable that, as F1 continued down the same path, with the numbers escalating and more corporate attitudes, the budget cap would make more comebacks than Frank Sinatra. And these days if you don’t give your sponsors ROI (return on investment) you don’t have sponsors for long. These days the sponsors are not so much interested in the exposure the sport brings, they want to make money. They want something that will prove to their shareholders that the sponsorship is a good idea.

In Formula 1, money is (and always has been) a weapon and the more money you have, the more competitive you can be – if you know what to do the money. That does not mean that money buys success, but if you employ people who know how to use money then you can achieve a lot. If one needs evidence of this one needs only to look at what Toyota achieved in F1 compared to the likes of Force India or Haas. Toyota has since gone to Le Mans to shoot fish in a barrel, which guarantees and, at the same time, undermines success.

What has happened in recent years in F1 is that the cost escalation has resulted in only three teams being in the unit for wins. The rest have become second tier players, without the budgets to climb the ladder. And this is not healthy. The gap between the leading teams and the rest of the field is too big because the top teams spend around twice the amount a midfield team can spend. At the root of the problem is the fact that the value of winning is too high. Obviously those who are doing the winning don’t want it to stop. Their shareholders and sponsors are happy and all is well, but for everyone else, including the fans, things are not quite so peachy. And the new owners of F1 are not simply ploughing profits into their pockets, as was previously the case. The company is listed and they have to answer not only to shareholders but also to corporate rule-making bodies. At the same time, the car industry is increasingly about managing margins cost-effectiveness. It is all about being efficient and so it is inevitable that the cost cap question will keep coming back until it is finally agreed. Formula 1 began by getting everyone to agree to the concept. After that came the number and the inevitable political games and threats, but let’s be sensible here. No manufacturer which wants to be in F1 is going to walk away because it has to save money. And more would enter F1 if it was more cost-effective. So it is logical to try to find a solution that will bring budgets down to a level where the big teams have only 10-20 percent more money than the little teams. With a cap of $175 million a year, around half the teams are not even involved. They have budgets below that number. They care more about the redistribution of revenues, so that they can earn more and create profits, which make their businesses more valuable.

Getting the people in Formula 1 to agree to anything is a very difficult task. Bernie Ecclestone found ways of forcing teams to do what he wanted them to do, often with the help of FIA President Max Mosley. But this created an atmosphere of mistrust and conflict that was a theme for more than 30 years. Changing attitudes is very difficult to do in such a circumstance but Liberty Media’s Chase Carey set out to try to do exactly that, to reform the sport with the competitors working together for the common good. Some laugh at such an idea, but there is no reason that cannot happen, particularly if one looks at the way in which a series such as NASCAR operates. The teams compete fiercely on the track, but they work together to improve the sport. Carey has found the process more difficult than he thought but finally we have not only the acceptance of the need for a budget cap, but an actual number as well. It took quite a lot of horse-trading but we now have a number of $175 million. This is not perfect for anyone.

The big teams say it is too low, the small teams say it is too high. But it is there and it is there without a glide path, which means that it will come into force in 2021 and not be introduced gradually. This is a good thing. The bad thing is that there are significant additional exclusions from the budget cap, which will mean that the budgets will end up being around $245 million because in addition to driver and highest-paid executive salaries, the cap will also not include engine bills, marketing and hospitality costs, depreciation and race weekend travel and accommodation bills. All of this adds up to around $70 million, although obviously it will be more for some of the teams than for others.

Nonetheless, there is also the potential to reduce the numbers once the manufacturers understand that to win on a limited budget is something that gives them MORE credibility than winning without a budget cap. It will show that they are cost-effective – or, to put it another way, clever. It was a little same with crash-testing. The manufacturers were all opposed to the idea until it became the norm, at which point they turned it into a marketing tool, as a high crash-test rating made cars more easy to sell.

When all is said and done, the key question is whether or not having a budget cap will make the teams cost-neutral and consequently put value into such organisations – which is the ultimate goal. With such a high budget cap, this is very difficult because although Liberty Media is saying that it will provide teams with an average of only $80 million a year in revenues. This is a big improvement for some teams, but it is still only 45 percent of the budget cap and 33 percent of what the real budget will be for the top teams, which means they will still have to find $165 million a year, unless the revenues increase. This is a major saving for most of them. The incentive to bring the limit down further is to try to make F1 cost-neutral, while retaining the key elements that make F1 unique. If they can do that, they will drive value into the teams and the sport will become more attractive to investors and manufacturers because the exposure is then a bonus in a sport that is making profits.

There really is no reason why F1 teams could not operate of $80 million if they wanted to. They would be smaller, of course, but $80 million is still a very substantial sum. Some people say that this would lead to lay-offs but in reality the expertise would end up being spread across the business, which would raise the level of the rival teams. Or at least that is the theory. You can understand why the big teams want to retain their financial advantages, but in the overall scheme of things, a much lower budget cap would be better.

Some still bang on about policing a budget cap but in truth the teams will end up policing themselves because the punishment for getting caught will be too high to pay. Not just in terms of the penalties that will be required  by the sport, but also in terms of the image damage done to brands. Renault’s disastrous activities in 2008 in Singapore are still felt today – which is how it should be if a team is dumb enough to get caught cheating.

Regulatory sanctions will be brutal, with the corporate entity and the individuals both being flensed if they are caught. It sounds dramatic, but the reality is that in the modern world of transparency and corporate responsibility, no manufacturer would ever sensibly condone cheating. Ask the folk at Volkswagen if they are going to try and cheat emissions again and you will understand. And even if think they can cheat forensic accountants, they will also know that the constant flow of people and knowledge between teams mean that transgressions will quickly come to light. Renault thought it was smart but when they kicked out Nelson Piquet Jr, he turned into a whistle-blower and brought down the whole house of cards.

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